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Microeconomics I Module Final

Econometrics (Addis Ababa University)

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WOLLO UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

COURSE NAME: MICROECONOMICS I

COURSE CODE: ECON 1021

AUTHORS: ABEBE FENTAW ([Link].)

MANDEFRO SEIFU ([Link].)

EDITOR: Dr. AMARE MITIKU (PhD)

WOLLO UNIVERSITY DISTANCE EDUCATION PROGRAM

MARCH 2017

DESSIE, ETHIOPIA

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Preliminary Sections

1. Inner Page

Title: Microeconomics I

By

Abebe Fentaw ([Link].)

Mandefro Seifu ([Link].)

Wollo University

Business Economics College

Economics Department

B.A. Degree in Economics

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2. Introduction to the Course

There are two broad approaches to the study of economic science: Microeconomics and
Macroeconomics. Because of their broadness these approaches can be split into two courses each,
for instructional purpose. The first part of microeconomics is covered by Microeconomics-I and
the second part with Microeconomics-II.

Regarding the organization, there are six chapters to be covered in Microeconomics I. The first is
an introductory chapter presenting an overview of basic concepts in economics; chapter two
explains the theory of consumer behavior; the third chapter dwells on choice involving risk and
uncertainty; chapter four presents the details of theory of production; chapter five explains theory
of costs; and chapter six is exclusively devoted to product market structures emphasizing on
perfectly competitive market, respectively.

All possible efforts have been made to enhance the usefulness of the material. It has been tried to
discuss the main principles of economics and to make the science of economics understandable.
Further, the explanation of various economic theories has been supported by appropriate tables,
figures, and examples. In addition, adequate number of activities and self-review exercises are
included for further thought of the distance learner.

3. Course Objectives

The course generally aims at introducing and acquainting students with theories of consumer
behavior, producer behavior, firms’ price and output determination under perfectly competitive
market. Besides, it aims at illuminating the applications of these theories.

Specifically, the course will

 Introduce the students to the fundamental concepts of economics in general and

fundamentals of microeconomics in particular.
 Acquaint the students with the neoclassical theory of consumer behavior, how each
consumer makes decision to maximize her/his utility.
 Provide the students with a detailed theory of production and cost, how firms organize their
production process, how firms decide to minimize costs.
 Offer a deeper understanding of how firms behave under perfectly competitive market

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4. Delivery Methods

The delivery method shall be student-centered. Students are highly expected to participate in
tutorial class works at the middle and end of each session and in group discussions inside and
outside of the class. Specifically, the course will be delivered through the following methods:

 Lecture method
 In-class problem solving
 Group work
 Assignment

Assessment Methods
Student evaluation in this module consist both formative and summative assessments including
assignment, attendance and final exam. Marks will be allocated according to the following
grading schedule.

Assessment method Weight

Assignment (Individual/group) 35%
Attendance 5%
Final Exam 60 %
Total 100%

5. Evaluation

Student evaluation in this module consist both formative and summative assessments including
assignment, attendance and final exam. Marks will be allocated according to the following
grading schedule.

Evaluation Type Frequency Weight

2 35%
1. Assignment
1 5%
2. Tutorial Attendance
1 60%
3. Final Examination

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Table of Contents
CHAPTER 1: INTRODUCTION ................................................................................................................. 1
1.1 The Fundamental Economic Facts: Limited Resources and Unlimited Wants................................ 1
1.2 What Economics is All about? Microeconomics and Macroeconomics .......................................... 2
1.3 The Need for Choice (Production Possibility Frontier) Factors of Production................................ 3
1.4 The Three Fundamental Economic Questions ................................................................................. 5
1.5 The Functioning of an Economy...................................................................................................... 6
1.5.1 Economic Systems .................................................................................................................. 6
1.5.2 Circular Flow Model ............................................................................................................... 8
Summary ................................................................................................................................................... 9
Self-Check Exercise ................................................................................................................................ 10
CHAPTER 2: THEORY OF CONSUMER BEHAVIOR AND DEMAND .............................................. 12
2.1 Consumer Preferences and Utility ................................................................................................. 13
2.1.1 Consumer Preferences ........................................................................................................... 13
2.1.2 Utility .................................................................................................................................... 13
2.2 Approaches to Measure Utility ...................................................................................................... 14
2.2.1 The Cardinal Utility Approach.............................................................................................. 15
2.2.2 The Ordinal Utility Approach ............................................................................................... 27
2.3 The Budget Line or the Price line .................................................................................................. 36
2.3.1 Effects of Changes in income................................................................................................ 38
2.3.2 Effects of Changes in Price ................................................................................................... 38
2.3.3 Effects of Changes in Government Policies .......................................................................... 41
2.4 Optimum of the Consumer: Ordinal Approach.............................................................................. 44
2.4.1 Effects of Changes in Income and Prices on Consumer Optimum ....................................... 50
2.4.2 Decomposition of Income and Substitution Effects (normal goods) .................................... 55
2.4.3 Derivation of Market Demand Curve.................................................................................... 57
2.5 Elasticity of Demand...................................................................................................................... 63
Summary ................................................................................................................................................. 74
Self-Check Exercise ................................................................................................................................ 77
CHAPTER 3: CHOICE – INVOLVING RISK AND UNCERTAINTY ................................................... 81
3.1 Expected Utility ............................................................................................................................. 82
3.2 Risk Aversion ................................................................................................................................ 88
3.3 Reducing Risk ................................................................................................................................ 92
3.4 Risk Spreading ............................................................................................................................... 93
Summary ................................................................................................................................................. 95
Self-Check Exercise ................................................................................................................................ 95
CHAPTER 4: THEORY OF PRODUCTION ............................................................................................ 96

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4.1 Production Function ....................................................................................................................... 97

4.2 Production with one variable input (short run production function).............................................. 99
4.2.1 Total, Average & Marginal product, & Their Relationship .................................................. 99
4.2.2 The Law of Diminishing Marginal Returns (LDMR) ......................................................... 100
4.2.3 Stages in Production ............................................................................................................ 102
4.3 Production with Two Variable Inputs (Long Run Production Function) .................................... 103
4.3.1 Isoquants ............................................................................................................................. 105
4.3.2 Returns to Scale................................................................................................................... 113
4.6.1 Isocost Lines........................................................................................................................ 117
4.6.2 Equilibrium of the Firm....................................................................................................... 118
4.6.3 The Expansion Path............................................................................................................. 125
Summary ............................................................................................................................................... 127
Self-Check Exercise .............................................................................................................................. 128
CHAPTER 5: THEORY OF COSTS........................................................................................................ 132
5.1 Types of Cost ............................................................................................................................... 133
5.2 Theory of Costs in the Short-run ................................................................................................. 135
5.3.1. Fixed Costs and Variable Costs .............................................................................................. 136
5.3.2. Unit Costs and Marginal Cost ................................................................................................. 138
5.3.3. Geometry of Average and Marginal Costs.............................................................................. 140
5.2.4. Nature and Relations among ATC, AVC, AFC and MC ........................................................ 142
5.2.5. Product and Cost Curves: A Comparison ............................................................................... 143
5.3 Theory of Costs in the Long-run .................................................................................................. 144
5.3.1 Long-run Average Cost (LRAC)......................................................................................... 144
5.3.2 Long-run Marginal Cost (LRMC) ....................................................................................... 146
5.3.3 Economies of Scale ............................................................................................................. 147
Summary ............................................................................................................................................... 153
Self-Check Exercise .............................................................................................................................. 154
CHAPTER 6: PERFECT COMPETITION MARKET ............................................................................ 158
6.1 Market Structures ......................................................................................................................... 158
6.2 Basic Assumptions of Perfectly Competitive Market .................................................................. 159
6.3 The Short Run Equilibrium of the Firm and Industry .................................................................. 160
6.4 The Long Run Equilibrium of the Firm and Industry .................................................................. 166
6.5 Consumer’s Surplus and Producer’s Surplus ............................................................................... 168
Summary ............................................................................................................................................... 169
Self-Check Exercise .............................................................................................................................. 170
Key Answers to Self-Check Exercise ................................................................................................... 174

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CHAPTER 1: INTRODUCTION
Introduction

Dear learner let us start our discussion with the concept of resources in the definition of economic
science. In this section, we will first define economics; then we will look into the concept of
scarcity and opportunity cost; and finally, we will discuss production possibilities.

The world is endowed with various resources. Some are free and others are available with cost.
Economics concerns itself with the latter type of resources. Economic resources are available in
limited quantity. The problem, therefore, is finding the best way of allocating these scarce
resources.

Chapter Objectives

After studying this chapter, you will be able to:

 Define economics and be able to make basic distinctions between microeconomics and
macroeconomics;

 Define and explain opportunity cost;

 Define the production possibility curve; and

 Define and explain free market system, mixed economic system and command
economics system.

Brainstorming Questions

1. What do you think is economics?

2. Why is economics important?

1.1 The Fundamental Economic Facts: Limited Resources and Unlimited Wants
How do you define economics? Ok! Economics has been defined in different ways by different
authors. Let you compare your definition with the following more general definition:

Definition: Economics is the scientific study of how people and their institutions go about
producing and consuming goods and services and how they face the problem of making choices

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in the world of scarce resources. That is Economics is the study of how societies use scarce
resources to produce valuable commodities and distribute them among different people.

1.2 What Economics is All about? Microeconomics and Macroeconomics

The study of economics is often divided into microeconomics and macroeconomics.

Dear learner, before you read the following, can you say something about the difference between
microeconomics and macroeconomics? Good! Read the following carefully.

Microeconomics looks at the interactions of producers and consumers in individual marketssay,

the market for shoesand the interactions between different marketssay, the market for coffee
and the market for tea.

Macroeconomics studies the behavior of economy-wide measures such as the Gross National
Productthe value of final output that the economy produces in a given time periodas well as
categories that cut across many markets, such as total employment in manufacturing industries or
total exports.

In both microeconomics and macroeconomics, the most important tools are the ideas of demand
and supply. They help explain price and output in individual markets and how prices and output
in different markets are related.

Similarity: Microeconomics is the foundation of macroeconomic analysis. In both

microeconomics and macroeconomics, the most important tools are the ideas of demand and
supply. They help explain price and output in individual markets and how prices and output in
different markets are related.

Difference: Microeconomics actually deals with the aspects like individual demand, individual
supply, individual income, individual employment, individual savings, and individual investment.
Macroeconomics, on the other hand, is a study of broad economic events that are largely beyond
the control of individual decision makers and yet affect nearly all firms, households and other
institutions in the economy.

 Dear learner, did you understand the difference between microeconomics and
macroeconomics? Good! Microeconomics actually deals with the aspects like individual

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demand, individual supply, individual income, individual employment, individual savings,

and individual investment. Macro-economics, on the other hand, is a study of broad
economic events that are largely beyond the control of individual decision makers and yet
affect nearly all firms, households and other institutions in the economy. That is
Macroeconomics deals with an analysis of aggregate issues like Economic growth,
Inflation and Unemployment

1.3 The Need for Choice (Production Possibility Frontier) Factors of Production
Dear learner, let us classify factors of production. In their production process, firms use factors of
production. These factors of production are often divided into five categories: natural resources,
labor, and physical capital, human capital and entrepreneurship. Can you differentiate among these
factors of production? Don’t worry. You can differentiate among these factors after careful reading
of the following.

The factors of production are often divided into four categories: entrepreneurship, labor, land, and
capital.

Entrepreneurship entrepreneurs combine the other factors of production by buying these factors
to produce a saleable product. When they put money into their production process, entrepreneurs
are taking risks. The return for entrepreneurship is called profit.

Laborlabor is defined as the physical and intellectual exertion of human beings. The efforts of a
teacher, factory worker, clerk, and a carpenter are all called labor. For its contribution in
production, labor is remunerated in the form of wages; i.e., the resource payments that
entrepreneurs make for the use of labor.

Landland refers to all natural resources that can be used as inputs to production, for example,
minerals, water, air, forests, oil, and even such intangibles as rainfall, temperature, and soil quality.
The key distinction between land and certain kinds of capital is that land consists of natural
resources or conditions unimproved by labor or capital expenditure. For example, land in Afar
region that has been irrigated represents more than land. It also represents capital. The income
payment to land is called rent.

Capitalcapital is defined as all man-made aids to production. Capital includes tools, factories,
warehouses, stocks of inventories, and the like. We should be clear to distinguish capital from

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money. Capital, as a factor of production, refers to physical things. In essence, capital goods are
the tools of production. Capital, like other factors of production, receives income. The payment to
capital is called interest. Investment is the act of adding to capital stock. Money, on the other hand,
is any asset that is generally acceptable in transactions and in settlement of debts.

The Production Possibilities Frontier (PPF)

The PPF curve shows the possible combinations of goods and services available to an economy,
given that all productive resources are fully and efficiently employed. When the economy is at
point b, resources are not fully employed and/or they are not used efficiently. Point c is desirable
because it yields more of both goods, but not attainable given the amount of resources available.
Point a is one of the possible combinations of goods produced when resources are fully and
efficiently employed.

Figure 1.1: Production Possibility Curve

Scarcity and the PPF

The PPF curve is bowed out because resources are not perfectly adaptable to the production of the
two goods. As we increase the production of one good, we sacrifice progressively more of the
other.

To see the production possibilities, open to a firm (or any production unit), consider the choice
between the production of food and clothing. It is possible to increase the production of both only
if there are some unused resources. That is, if there is some unemployed labor, unused land, idle
capital etc., the production of both food and clothing could be increased. But if factors of
production are fully employed, it is not possible to have more of both with the existing resources
and technology.

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Assuming that factors of production are fully employed, there are only two goods, food and
clothing, and each factors of production are homogenous; the production possibility open to a
production unit can be presented using the production possibility curve (PPC). The assumption of
homogenous factors of production implies that all units of labor, capital and land are identical.

There are three important regions in the figure. If resources are fully employed, the firm will be
able to produce combinations of food and clothing on the PPC such as point a. If there are some
unused resources (if there is underutilization) the firm will produce combinations to the left of the
PPC such points like b. Production above the PPC at points like c is impossible for any given
quantity of factors of production, and therefore is called unattainable region. For any given
quantity of factors of production, the attainable region of production is that on and below the PPC.

The production possibility curve illustrates three concepts: scarcity, choice, and opportunity cost.
Scarcity is indicated by the unattainable combinations above the PPC; choice, by the need to
choose among the alternative attainable points along the PPC; and opportunity cost, by the
negative slope of the PPC.

1.4 The Three Fundamental Economic Questions

Dear learner, in the previous section, we have seen the basic concepts in economics. The
production possibilities curve discussed above sets the stage for identifying the major
microeconomic and macroeconomic problems.

Economics is the study of the choices made by people who are faced with scarcity. Scarcity is a
situation in which resources are limited but can be used in different ways; so one good or service
must be sacrificed for another.

Society’s Choices
The decisions of producers, consumers and government determine how an economic system
answers three fundamental questions. The major economic questions can take many forms, but
they can be reduced to three basic ones:

1. What combination of goods and services is to be produced?

2. How or in what manner are the goods and services to be produced?

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3. For whom will the goods and services be produced, and how much will each person
receive?

Each of these questions is addressed in every society, and microeconomic theory concentrates on
the ways different types of economic organizations formulate answers to these questions.

1.5 The Functioning of an Economy

Dear learner, in the previous section, we have seen the basic concepts in economics. In this section,
we will differentiate among the different economic systems and then discuss how firms and
households interact using the concept of circular flow.

Over the course of the world, different economic ideas were dominant in different time periods.
Even in today’s world, different economic ideologies are adopted in different economies. During
the cold war, USSR, Eastern European countries and some African (Ethiopia for example), Asian
and Latin American countries followed communist ideologies while capitalist ideologies
dominated most of the west. The ideology followed by an economy affect the allocation of
resources in that economy to a larger extent.

1.5.1 Economic Systems

Dear learner, do you know the different economic systems prevailing in the world? Can you answer
the above basic economic questions from the point of view of these systems? Anyway, economists
divide economic systems into four major groupsthe traditional economy, the planned (command)
economy, the market economy, and the mixed economy. Just read attentively so as to understand
how the basic questions are answered in these four systems.

1) The Traditional Economy: The traditional economy answers the fundamental microeconomic
questions by appeal to tradition. What is produced is what the young have been taught by their
parents to hunt, to gather, or to plant. The techniques of production of how to produce are also
passed on, often without change, from generation to generation. The amount of production is, of
course, highly dependent on good fortune. The last question, concerning distribution, is also
traditionally determined. In fact, traditional societies may have rules on how output is to be
divided.

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2) The Planned Economy: It answers the fundamental microeconomic questions through planning
or through central command and control. The decisions regarding what, how, and how much to
produce are spelled out and documented. Detailed plans and orders are sent to producers, and these
instructions carry the weight of the law. A large part of the question of who gets what is determined
in the same way, because planners determine wage rates and the amount of production of consumer
goods. Of course, in any economy, people plan; that is, they think about the future and make
preparations for it. Economists use the term planned economy to refer to one in which the
government plays a large role in answering the production and consumption questions of the
society.

3) The Market Economy: The organizing principles, here, are the forces of demand and supply.
The determination of what to produce is made by consumers, and the force of demand causes
prices to go up for certain products when consumers desire more of them.

In a sense, consumers vote with their money. The result of this voting process determines what
will be produced. Suppliers combine resources, determining how things are to be produced.
Assuming suppliers are self-interested and seek to maximize their profits, they tend to combine
inputs to produce any good or service demanded at the lowest possible cost. This determination
depends on the prices of resources. Suppliers will use more of relatively abundant resources
because they are relatively cheap. This, in turn, helps conserve the scarcer (more expensive)
resources. The goods are then distributed to consumers who have the purchasing power to buy
them. Those who have more purchasing power receive more goods and services.

4) The Mixed Economic System: In the real world, we find that economies are the blend of
traditional, planned and market economic systems. In practice, every economy is a mixed economy
in the sense that it combines significant elements of all three systems.

Furthermore, within any economy, the degree of the mix will vary from sector to sector. For
example, in some planned economies the command principle was used more often to determine
behavior in heavy goods industries, such as steel, than in agriculture. Farmers were often given
substantial freedom to produce to varying market prices.

When we speak of a particular economy as being a centrally planned economy, we mean only that
the degree of the mix is weighted heavily toward the command principle. When we speak of an
economy as being a market economy, we mean only that the degree of the mix is weighted heavily

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toward decentralized decision making in response to market signals. It is important to realize that
such distinctions are always matters of degree, and that almost every conceivable mix can be found
across the world’s economies.

In a pure market economy, there are two distinct markets in which firms interact with households.
Households are purchasers of goods and services that firms produce, and there is a flow of money
to firms in payment for these goods and services. The market in which these exchanges take place
is referred to as the product market. Firms buy factors of production from households in order to
produce the goods and services they sell to the households. The market in which these transactions
take place is called the factor market.

1.5.2 Circular Flow Model

Assuming that all factors of production are owned by households and all goods are produced by
firms, the circular flow model is given in the following Figure 1.2.

The lower segment of the circular flow shows the flow factors of production such as labor and
capital from households to firms. In return, households receive factor payments, which then they
use for the purchase of goods and services from firms as shown in the upper segment of the
diagram. This flow of money represents the income of firms.

Product market

Payment for goods and services

Goods and services

Households Firms

Factors of production

Income to households

Factor market
Figure 1.2.: The Circular Flow

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Summary

 Economics is the scientific study of people and institutions from the point of view of
how they produce and consume goods and services and face the problem of scarcity.

 Microeconomics looks at the interactions of producers and consumers in individual

markets.

 Macroeconomics is the study of the economy as a whole and is concerned with

aggregates.

 Scarcity is a fundamental problem faced by all economies. The resources available are
not enough to produce all the goods and services that people would like to consume.
Scarcity makes it necessary to choose.

 Opportunity cost measures the value of foregone opportunities in order to enjoy a unit
of a commodity. It emphasizes the problem of scarcity and choice by measuring the
cost of obtaining one commodity in terms of the number of units of other commodities
that could have been obtained instead.

 Three basic questions must be answered in all economies: what commodities are to be
produced? How are these commodities going to be produced? And to whom are the
commodities to be produced?

 Different economic systems resolve these problems in different ways. There are three
pure economic systems: traditional, command and free market economic systems. In
traditional systems, these questions are answered through tradition and norm. In a
command system answers to the above questions are given through government
direction. In a free market system, the forces of demand and supply give answer to the
questions.

 The production possibility curve (PPF) shows the different possible ways of producing
goods and services. Production on the PPF indicates full utilization of existing
resources. Production below the PPF indicates underutilization of resources, while
production outside the PPF is impossible.

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Self-Check Exercise

i. Review your understanding of the following terms

Microeconomics Microeconomics
Scarcity Opportunity cost
Factors of production production
Consumption Production possibility curve
Traditional economics system Planned economic system
Market economic system Mixed economic system
ii. Multiple Choice Question
1. What do economic system mean when they state that a good is scarce?
a. There is a shortage or insufficient demand for the good at the existing price
b. It is possible to expand the availability of the good
c. People will want to buy more of the good regardless of price
d. The amount of the good that people would like to have exceeds the supply that
is freely available from nature.
e. None
2. Economic choice and competitive behavior are the result of
a. Absence of alternative uses for resources.
b. Abundance of resources.
c. Limited wants.
d. Scarcity.
3. The expression, "There's no such thing as a free lunch" implies that
a. Everyone has to pay for his own lunch.
b. The person consuming a good must always pay for it.
c. Costs are incurred when resources are used to produce goods and services.
d. No one has time for a good lunch anymore.
e. None
4. The basic difference between macroeconomics and microeconomics is that
a. Macroeconomics looks at the forest (aggregate markets), while
microeconomics is concerned with the individual trees (subcomponents).

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b. Macroeconomics is concerned with policy decisions, while microeconomics

applies only to theory.
c. Microeconomics is concerned with the forest (aggregate markets), while
macroeconomics is concerned with the trees (components).
d. Macroeconomics is more concerned with households and microeconomics with
the national economy.
e. None
iii. Discussion Questions
1. What do you think is the economic system that prevails in Ethiopia?
2. Wants are insatiable compared to the means available to satisfy. Discuss
Suggested Reading Materials

Lipsey R. G., Courant P. N., Purvis D. D., and Steiner P. O., Microeconomics, 10th ed. New York:
Harper Collins College Publishers, Inc., 1993.

Amacher R. C., and Ulbrich H. H., Principles of Microeconomics, 3rd ed. Ohio: South-Western
Publishing Co., 1986.

Stanlake G. F., and Grant S. J., Introductory Economics, 6th ed., Singapore, Longman, 1995.

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CHAPTER 2: THEORY OF CONSUMER BEHAVIOR AND DEMAND

Introduction

Dear learner in this section, we shall learn how does a consumer decide how much of good to buy
at a given price and why does he buy more of a good when its price decreases. This is the concern
of theories of consumer behavior. By consumer behavior we mean how consumers decide on the
basket of goods and services they consume. It is essentially decision-making behavior. In
analyzing an individual consumer’s decision making process, economists use two approaches. The
first approach, the cardinal utility approach, involved the concept of measurable utility. The
second approach, the ordinal utility approach, requires only the ranking of preferences as a basis
of making decisions using indifference curves.

Consumer behavior is best understood in three distinct steps:

Consumer Preferences: The first step is to find a practical way to describe the reasons people might
prefer a good to another.

Budget Constraint: In step two we consider the fact that consumers have limited income that limit
the quantities of goods they can buy.

Consumer Equilibrium: Given their preferences and limited incomes, consumers choose to buy
combinations of goods that maximize their satisfaction.

Chapter Objectives

After studying this unit, you should be able to:

 Define utility and consumer’s surplus;

 State the assumptions of cardinal utility approach and ordinal utility approach;

 Derive marginal utility curve from total utility curve;

 Define an indifference curve and budget line;

 Derive an income-consumption curve and price-consumption curve using indifference

curve analysis;

 Determine an individual’s utility maximizing consumption bundle;

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 Derive an individual’s demand curve both under cardinal utility approach and ordinal
utility approach; and

 Define and graphically show income effect and substitution effect of price change.

Brainstorming Questions

1. Why people buy goods and services?

2. How people decide on how much quantity of each good to buy?
3. What factors affect demand for a product?

2.1 Consumer Preferences and Utility

2.1.1 Consumer Preferences

Preference has three basic properties:

a) Completeness: For any two market baskets A and B, a consumer will prefer A to B, will
prefer B to A, or will be indifferent between the two.
b) Transitivity: If a consumer prefers A to B and B to C, then the consumer also prefer A to
C.
c) More is better than less: Consumers always prefer more of any good to less since
consumers are never satisfied.

2.1.2 Utility

Utility is the power or property of a commodity to satisfy human desire (needs). It is a feeling of
satisfaction that an individual receives from consuming goods or services. Utility is strictly an ex
ante concept; that is, it measures the way an individual feel about a commodity before the
individual buys or consumes it. Utility is the satisfaction that an individual expects to get, not what
he/she actually gets. You may want to take a bottle of Beer and enjoy yourself. When you decide
to buy that bottle of Beer, what matters the most is the satisfaction you expect to derive from its
consumption. In fact, the consumption may make you feel uncomfortable – that is irrelevant
economically.

CHARACTERSTICS OF UTILITY
1. The want satisfying property of a commodity is not objective rather subjective

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2. Utility is different from usefulness.

3. A commodity need not be useful for all: for example, cigarette has no utility for non-smokers
and meat has no utility for vegetarians.
4. Utility derived from a unit consumption of a commodity vary from person to person according
to urgency and intensity of want.
5. The concept of utility is ethically, morally and legally neutral; in the sense that it may satisfy
a frivolous, foolish or socially immoral need.

To analyze the behavior of consumers we need to make an important assumption that each
consumer has exact and full (perfect) knowledge of all information relevant to his consumption
decisions:

 Knowledge of the goods and services available.

 Knowledge of their technical capacity to satisfy his wants.

 Knowledge of market prices.

 Knowledge of his money income.

Consumers are generally assumed to be rational and hence, as an objective, seek to maximize their
satisfaction or utility from the consumption of goods and services for given money income. The
complete list of these goods and services is called consumption bundle. To achieve the
maximization of their objective, consumers, then, must be able to compare different consumption
bundles according to their desirability.

In relation to the comparison of the utility from different consumption bundles, cardinal approach
and ordinal approach take different views.

2.2 Approaches to Measure Utility

There are two approaches to the analysis of consumer behavior. These are:

 Cardinal or Neoclassical (Marshallian approach) utility approach

 Ordinal or indifference curve approach

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2.2.1 The Cardinal Utility Approach

This approach was first developed by neoclassical economists mainly by Alfred Marshal; due to
this most text books of microeconomics calls it as Marshalian approach to utility.
Cardinalists, the neoclassical economists, maintained that cardinal (objective) measurement of
utility is practically possible and is meaningful in consumer analysis. According to this school of
thought the most convenient measure of utility is money, i.e. utility of one unit of a commodity
equals the money which a consumer is prepared to pay for it.

[Link] Assumptions of Cardinal Utility Theory

The cardinal utility approach is framed based on the following workable assumption.
 Rationality: - The consumer is assumed to be rational in the sense that he/ she aims at the
maximization of his utility given his income level and market prices of goods and services
consumed.
 Utility is cardinally measurable or quantifiable. Some economists used the term “util"
meaning ‘units of utility’ to measure utility where as others used money as the measure of
utility and assumed that one unit of money equals one "util".

 The marginal utility of additional unit of money is constant: - The utility of each unit of
money remains constant whatever the level of consumer’s income is. This assumption is
necessary if monetary units are to be used as the measure of utility. If the marginal utility
of money changes with the level of income (wealth) of the consumer, then money cannot
be considered as a measuring rod of utility.

 There is a diminishing marginal utility of a commodity: - The more the amount of the
commodity consumed, the additional satisfaction derived from successive consumption
will diminish keeping the consumption of all other commodities constant.
 The total utility of “basket of goods” or combination of goods depends on the quantities of
the individual commodities. Suppose a consumer consumes ‘n’ number of commodities
(X1, X2……Xn) then the total utility obtained is a function of the quantity consumed of
each commodity i.e.QX1, QX2….QXn where QXi i, 1…………n shows the quantity of Xi
consumed at a given period of time in a function form. This can be written as; TU= f (QX1,
QX2….QXn)

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In the early version of the cardinalists theory total utility is additive i.e. the total utility derived
from the consumption of different goods and services can be added to get the total (aggregate)
utility; TU= U1(X1) + U2(X2) + U3(X3) +………+ Un(Xn) where Ui (Xi) indicates the level of utility
derived from the consumption of the ith commodity. In the later version of the cardinalists approach
this concept (additivity of utility) was dropped out because of the fact that the utility derived from
different commodities is not independent but in reality, they are interdependent on each other
(consider substitute and complementary goods in consumption).

[Link] Total and Marginal Utility

One of the important tools of analysis in economics in general and in microeconomics in particular
is the concept of marginal analysis of the classical school of thought. To determine and measure
the rate of change and responsiveness of one variable due to the change in other variable we need
the marginal analysis. The concept of cardinal utility makes it possible to define total and marginal
utility in quantitative terms.

i. Total utility is the total amount or level of utility derived from consumption of goods and
services in the given period of time. Utility function is a preference function ordering a
consumer’s desire to consume differing amounts of commodities. The use of utility
functions, that assign numerical value or utility level to consumption bundles, facilitates
the analysis of consumer behavior. Utility functions provide ordinal measurement of the
utility provided by consumption bundles, i.e., the particular values assigned to
consumption bundles do not have significance on their own right. They are simply used for
the purpose of ranking different consumption bundles.
ii. Marginal utility (MU) is the utility derived from the marginal unit consumed. It may also
be defined as the addition to the total utility resulting from consumption (acquisition) of
one additional unit. Marginal utility thus refers to the change in the total utility obtained
from the consumption of a commodity, as a result of change in consumption by one unit.
TU dTU
MU  =  where, TU= Total utility, C= total quantity of consumption and
C dC
ΔC=dC =1. For example, the marginal utility derived from consumption of fourth unit of a
commodity will be the difference between the total utility in the 4 units of consumption and 3 units
of consumption.

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Numerical example: Suppose that a certain consumer consumes bread. Determine the marginal
utility in consuming one additional unit of bread.

Table 2.1: Quantity consumed, total utility and marginal utility

Number of breads Total utility (TU) Marginal Utility (MU)

consumed per day
0 0 -
1 20 20
2 35 15
3 45 10
4 50 5
5 50 0
6 45 -5
Graphically we can present the above table and it can clearly show the relationship between TU,
MU and quantity of consumption (number of breads consumed per day).

TU M This point is the point of satiety i.e. the point at

which total utility reaches its maximum

TU Curve

0 5 Number of Bread Consumed per day

MU
* The reason why MU curve of bread is downward
sloping is due to the diminishing marginal utility
of bread (see law of diminishing marginal utility).

0 5 Number of bread consumed per day (Q)

MU curve

Figure 2.1: Total utility and marginal utility curves

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Graphically, MU is the slope of the total utility curve. Marginal utility is zero when total utility
reaches its maximum. To the left of this point marginal utility is positive and total utility rises. To
the right of this point marginal utility is negative and total utility falls.
Exercise 1: The total utility derived per period from the consumption of ‘injera’ is indicated in the
following table. Sketch the corresponding TU and MU curves given the numerical figures from
the table.
No of injera consumed Total satisfaction in Utils Marginal utility (TU)
per day (TU) dTU
MU 
dC
0 0
1 20
2 30
3 37
4 40
5 42
6 42
7 38
8 33

[Link] Law of Diminishing Marginal Utility (LDMU)

The additional utility, benefit or welfare, which a person derives (obtains) from a given increase
in his stock (amount) of a thing diminishes with every increase in the stock that he already has.
LDMU states the relationship between the changes in quantity consumed and the change in
marginal utility: it states that as the quantity consumed of a commodity increases per unit of time,
the utility derived from each successive unit decreases, consumption of all other commodities
remaining the same. In other words, as a person consumes more and more of a commodity per unit
of time, keeping consumption of all other commodities constant the utility which he derives from
the successive units of consumption goes on diminishing.

As the quantity of commodity consumed increases the total utility increases at a diminishing rate:
this implies the LDMU i.e. the rate of change of total utility diminishes.

The rationale behind MU curve is downward sloping is due to the LDMU. Mathematically, MU
curve is the slope of TU curve (it is the first order derivatives of TU at any level of consumption);

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when the later reaches its maximum (peak or satiety) the former (MU) becomes zero: -
dTU
 MU  0 .
dQ

Why Does ‘MU’ of a Commodity Decreases?

It is because, utility gained from a unit of a commodity depends in fact on how intensive is the
need for it; when a person consumes successive units of a commodity, his need is satisfied by
degrees in the process of consumption, and the intensity of his need goes on decreasing. Therefore,
the utility obtained from each successive unit goes on diminishing. For some commodities like
precious metal e.g. gold, diamond, silver, precious paints, precious coins etc. the LDMU seems to
be violated but the final response and trend towards the need for these commodities shows us that
the existence of LDMU. In the first instance the MU for these commodities increases, then
becomes stable but lastly it tends to diminish. So, whatever the rate, and time it may be the LDMU
applies for most consumable goods and services.

Assumptions of ‘LDMU’

It holds good only under certain given conditions. These conditions are often referred to as the
assumptions of the law.

 The unit of the consumer good consumed should be standard e.g. a cup of tea, a bottle of
cold drink etc. If the units are excessively large or small then the law may not hold true.
This assumption shows the reasonability and standard of measurement; the units of
measurement used by the consumer should be standard and reasonable.

 Homogeneity: - the additional or marginal unit of commodity consumed should be similar

in size, taste, quality and other features. i. e. it should be homogenous.

 Consumer’s taste and preference should remain the same during the period of consumption.

 Continuity: - there must be continuity in the consumption of the commodity. The consumer
should consume the good/ service continuously (with shorter time gap), without taking
more time, otherwise it is difficult to talk about DMU of the good.

 Consistency: - the mental and other behavior of the consumer should be consistent and
should be in a normal condition during the period of consumption of the commodity. If
he/she prefers commodity X to Y at some point in time when both goods are available to

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him/her, he/she should not prefer Y to X in another time if both goods are available.
Mathematically, if X>Y, then Y>X is impossible.

Real World Applications of “LDMU”

1) The Water - Diamond Paradox

There is a famous puzzle in economics, the water-diamond paradox, which is easily explained with
the proper understanding of diminishing marginal utility. The paradox is as follows:

Why are diamonds, which are not essential to survival are expensive while water, which is
essential to survival, is cheap?

The difference in price is due to the relative scarcity of diamond and water. While water is essential
to survival, in most situations water is abundant in supply. With diminishing marginal utility, the
last glass of water consumed contributes very little to a person’s well- being or utility. Diamonds
are relatively scarce. Thus, even though they are not essential to life, an additional diamond
contributes a good deal to a person’s wellbeing. Hence, water is of little value, while diamonds
valued highly. The other implicit lesson from this paradox is that utility is different from
usefulness.

2) In addition to the above contribution it has different applications in microeconomics. It is

the basis for economic laws like, the law of demand, consumer surplus, elasticity,
preference theories, etc.

[Link] Equilibrium of a Consumer

i. Model of one commodity
Given the assumptions of cardinalists the consumer consumes only one commodity say X with
his/her given level of income (I) and commodity price (Px). The consumer can either buy X or
retain his money income, I. Under these conditions the consumer is in equilibrium when the
marginal utility of X is equated to its price (Px) i.e. MUx=Px*MUm, assuming MUm=1.

 If MUx > Px the consumer increases utility by purchasing more of X.

 If MUx < Px the consumer increases utility by purchasing less of X.
Therefore, he/ she attains the maximization of his/her utility when MUx=Px.

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Mathematical Derivation of Optimum of the Consumer (One commodity case)

Mathematically, the utility function is U = f (qx) where, U is the total level of satisfaction derived
from consumption of commodity X, qx is amount of X consumed. If the consumer buys qx his
expenditure is [Link]. Presumably the consumer seeks to maximize the difference between his utility
and his expenditure (U - [Link]). At the optimal point the extra satisfaction that a consumer can get
from additional consumption of qx becomes zero, i.e., the necessary condition for a maximum is
that the partial derivative of the function with respect to qx be equal to zero. Thus,

 (U  [Link] ) U  ( [Link])
0  - =0
qx qx qx

U px qx px

 -( .qx  . px ) = 0, here  0 because we assume Px is constant.
qx qx qx qx

 Mux – Px =0 Here for one commodity case the partial and

 Mux = Px Total derivatives are one and the same. So, we can also

Mu x
1 use total derivative in place of partial derivative.
px

Graphically, the equilibrium of the consumer can be illustrated as

MUx

PX

MUx>Px

E Px

Px > MUx

0 MUx Quantity of X consumed

Figure 2.2: Optimum of the consumer the case of one commodity

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At point E, MUx=Px, i.e., the consumer in equilibrium.

Exercise 2: Suppose the price of a commodity X is given as 8 birr and the total utility schedule for
1, 2, 3 & 4 units consumption is given as 12, 22, 30, and 36 utils respectively. Find the equilibrium
amount of consumption.

ii. Model of two or more commodities

Here the income is used to purchase two and above good or services given their prices. If we
assume the given income is spent on two goods namely on X and Y with price Px and Py
Mu x Mu y
respectively then, from one commodity case  1 and  1 . From the property of
px py
Mu x Mu y Mux MU y
transitivity, we can have  1  .
px py Px Py
If we extend the above case to many commodities case, then the equilibrium of the consumer can
be easily illustrated using similar analogy. Suppose a given consumer consumes ‘n’ number of
commodities: U = f (qx, qy, qz…………., qn) and the equilibrium of the consumer is;
Mux MUy MU z MU n
   .........  It is the equation of equi- marginal utility.
Px Py Pz Pn
The utility maximizing consumer reaches his equilibrium position when allocation of his
expenditure is such that the last birr spent on each commodity yields the same utility.
A rational or utility maximizing consumer consumes commodities in their order of utilities. He
switches his expenditure from one commodity to the other in accordance with their marginal
utility. He/she continues to switch his/ her expenditure from one commodity to the other till he/she
reaches a stage where MU of each commodity is the same per unit of expenditure.
Example 2: Given the following table and some other information; show,
 The equilibrium of the consumer
 How many units of each commodity should be used to maximize utility?
PA= 2birr/unit and PB= 1birr/unit and Income I = 8birr

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Quantity MUA MU A MUB MU B

of A/B PA PB
1 36 18 30 30
2 24 12* 22 22
3 20 10* 16 16
4 18 9 12 12*
5 16 8 10 10*
6 8 4* 4 4*

As indicated in the above table, the consumer has three alternative points of equilibrium. In order
to decide which point is the ultimate equilibrium of the consumer we have to look at the income
constraint i.e. the person should maximize utility given the constraint of income.
MU A MU B
Case I: If = =4; in this case 6 units of commodity A and 6 units of commodity B is
PA PB
going to be consumed. To do so he /she needs an income of 12+6 =18 birr, which is greater than
8 birr. So, this point of equilibrium is unattainable for the consumer due to limited income that the
consumer has.
MU A MU B
Case II: if = =10, in this case three units of commodity A and 5 units of commodity
PA PB
B should be consumed. As a result of this the consumer should have 6+5=11 birr; it is also
unattainable with the given level of income (11>8).
MU A MU B
Case III: = =12 given this equilibrium condition, 2 units of commodity A and 4 units
PA PB
of commodity B should be consumed; to fulfill this the person should have 4+4= 8 birr, which is
compatible with the level of income that the consumer has. So, this point is the point of optimum
for the consumer with given constraints of income (8 birr) and given the prices of the commodities.
MU A MU B
= =12 and the budget constraint should be fulfilled at the optimum point i.e,
PA PB
[Link]+[Link] = I  (2.2) + (4.1) =8  8=8

Economic Contributions of the Optimum of the Consumer

1. It helps us to allocate a limited time for different activities which should be carried out by
the consumer. Expenditure of limited time (say 24 hours) a person should spend among

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alternative uses such as reading, attending class, going to library e t c in such a way that
marginal utilities from all these activities (alternative uses of time) are equal.
2. It also applies to production decision (production equilibrium). The prime motto of the
producer is to maximize the level of profit. To do so the firm should substitute one factor
of production for another factor of production up to the final equilibrium. At the optimum
production, the ratio of the marginal productivity of each factor to its price should equal
to the ratio of the marginal productivities to the prices of the other factors. If a firm uses
labor and capital as variable factors of production then at the optimum of production,
MU L MU K MPL MPK
=   where, MPL and MPK are the marginal productivity of
PL PK W r
labor and capital respectively. W (price of labor) and r (price of capital) are wage and rate
of interest respectively.
3. It also contributes toward the principle of maximum social advantage which is developed
by Hicks. According to this principle the revenue of the government should be distributed
to different programs or/ and projects in such a way that the last unit of expenditure for
various programs or/ and projects should bring equal welfare so that the social welfare
maximizes.

[Link] Derivation of the Cardinalist Demand

Graphical Derivation
The derivation of demand is based on the axiom of diminishing marginal utility. The marginal
utility curve of a certain commodity, say X may be depicted by a line with a negative slope.
Geometrically the marginal utility of X is the slope of the total utility function or it is the first order
dTUx
derivative of total utility function i.e.  MUx . If the MU is measured in monetary units the
dQx
demand curve for commodity X is identical to the positive segment of the MU curve. Graphically,

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This point is the point of satiety, i.e., the point at

which total utility reaches its maximum.
TUx

TU curve for commodity X

0 X Quantity of X consumed
Figure 2.3: Total utility curve
MUx=Px MUx=Px

MU1 MU1=P1 demand curve for commodity X

MU2 MU2=P2

MU3

0 X 0 X Quantity of X consumed
MUx curve

Figure 2.4: Marginal utility curve and demand curve

The negative section of the MU curve does not form part of the demand curve, since negative
prices do not make sense in economics.

Mathematical Derivation of Individual Demand Function

A certain consumer consuming two commodities (X and Y) with prices of Px and Py respectively
and has a limited income of I. The consumption pattern of the consumer is shown by the following
Cobb-Douglas utility function U (x, y) = KXnYm

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The demand curve for each good can be derived from the equilibrium condition:
MUx MUy

Px py

MUx Px
From this we can show that 
MUy Py

u / x Px

u / y Py

KnX n 1Y m Px
n m 1

KmX Y Py

nX n 1 nY m( m1) Px


m Py

nY Px
 (Substitute the budget line equation for Y)
mX Py

I Px
n(  X)
Py Py Px

m. X Py

n.I - [Link].X = Px.m.X

nI =n Px X + Px.m.X
nI
X=
Px ( n  m )

n I
X= .  this is the demand function for X.
n  m Px
By substituting the demand for X on the budget line equation, the demand for commodity Y is

m I
Y= .  this is the demand function for Y.
n  m Py

From the demand functions above the quantity demanded of a commodity and its price are
inversely related, which supports the law of demand for ordinary goods (non-Giffen).

Exercise 3: Suppose that the prices of good A and good B are Birr 3 and Birr 2 respectively.
Suppose a consumer is spending his entire income for buying 4 units of A and 6 units of B, and

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the marginal utility of both the 4th unit of A and the 6th unit of B is 6. Is the consumer at his
optimal position? Explain your answers?

Exercise 3: Given utility function U(x, y) = x1/2 y 1/2

, Px = 2 birr/unit, Py = 4 birr/unit and
I=48 birr.

a) Determine the demand functions for X and Y at any level of income and prices of the goods
b) Determine the utility maximizing levels of X and Y
c) The MRS x, y and MRSy, x at the optimal point & at X = 6 and Y =12.
d) If Px = 4birr/unit, Py = 8birr/unit and I = 96 birr what will be the effect of these chances
on X,Y and total utility (TU)

Criticisms on Cardinal Utility Approach

There are three basic weaknesses in the cardinalists approach.

i. The assumption of cardinal utility or measurability of utility is extremely doubtable. The

satisfaction derived from various commodities cannot be measured objectively. The attempt
by Leon Walras to use subjective units (utils) for the measurement of utility does not provide
any satisfactory solution.

ii. The assumption of constant marginal utility of money is also unrealistic. As income increases
the marginal utility of money also changes. Thus, money cannot be used as a measuring- rod
since its own utility changes.

iii. The axiom of diminishing marginal utility has been established from introspection so it is a
psychological law which must not be taken for granted.

2.2.2 The Ordinal Utility Approach

Ordinalists maintain that utility is a psychological phenomenon which is inherently immeasurable
theoretically, as well as practically. Ordinalists also maintain that the concept of ordinal utility is
a feasible concept and it meets the conceptual requirement of analyzing the consumer’s behavior
in the absence of cardinal measure of utility.

[Link] Assumptions of Ordinal Utility approach

i. Rationality: - the consumer is assumed to be rational; he aims at the maximization of his utility
given his income and market prices of goods and services.

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ii. Full knowledge/ full information: - ordinalists assumed that the consumer has full information
about the market prices of the goods consumed, the level and trend of income that he has and
about other relevant variables which helps him/ her to make consumption decision.
iii. Utility is ordinal: -the consumer can rank his/her preference (order the various ‘baskets of
goods’) according to the satisfaction of each basket. Therefore, in this approach the consumer
need not know the amount of satisfaction derived from consumption of a good/service.
iv. Diminishing marginal rate of substitution (MRS) of one good for the other.
v. The total utility derived by the consumer is dependent on the quantities of the goods consumed.
if the consumer consumes X, Y,Z,……….,M then the total utility is
U=F (qx, qy, qz…, qm) where, qx, qy, qz…, qm are the quantities of X, Y, Z… M consumed.
vi. Consistency of choices: - It is assumed that the consumer is consistent in his choice, i.e., if in
one period he chooses bundle A over bundle B, he should not choose B over A in another
period if both bundles are available to him: if bundle A is greater than B then B should not
be greater than A.
vii. Transitivity of choices: - the consumer choices are characterized by transitivity in the sense
that if bundle A>B, and B>C then A>C.

[Link] Indifference Set, Curve and Map

The basic tools of analysis in ordinal utility theory are: the indifference curve, the slope of
indifference curve or marginal rate of substitution (MRS) and the budget constraint of the
consumer
Indifference Curve(IC)
Indifference curve represents all those combinations of goods/services which give the same
satisfaction to the consumer. Since all the combinations on an indifference curve gives equal
satisfaction to the consumer he/she will be indifferent between them, no matter which one he gets.
It can also be defined as a set of points, each point representing a combination of goods, all of
which yield the same total utility.

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Good Y  From the definition of IC the total utility derived at

Points A and B is the same.

Y1 A

Y
Y2 B
X
IC
0 X1 X2 Good X
Figure 2.5: Indifference curve
All points on an indifference curve gives equal total satisfaction to the consumer, whatever is the
different combinations of the two goods.
The above IC is drawn by assuming that the commodities X and Y can substitute one another to a
certain extent but are not perfect substitutes. If they are perfect substitutes to each other the IC will
be a linear downward sloping one. The negative of the slope of an IC at any one point is called
marginal rate of substitution of the two commodities X and Y which can be expressed as the slope
of the tangent at that point.
Y dy
 Slope of IC=   MRS x , y . The MRSx,y is defined as the number of units of commodity
X dx
Y that must be given up (forgone) in exchange for an extra unit of commodity X so that the
consumer maintains the same level of satisfaction.

Mathematical Derivation of MRSX, Y

U U
Given U= F (X, Y), the total differential of the above utility function is dU = dY  dX
Y X
The equation of tangent, which is the slope of the curve at certain point, is given by the total
derivative or differential which shows the total change of the function as all its determinants
change.
U = f(x, y), which is constant along the same indifference curve.
 U = f(x, y) = K where K is constant

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The total differential of the utility function is:

U U
du = dY  dX  MUY (dY) +MUX (dX)  this shows the total change in utility as the
Y X
quantity of both commodities change.
du = MUY (dY) +MUX (dX) = 0  along the same indifference curve the change in utility is zero.
 dy MUx  dx MUy
By rearranging we obtain: either   MRSx , y or   MRSy , x . Given the
dx MUy dy MUx
convexity of the indifference curve the MRSx, y diminishes as we move along an IC. The amount
of Y that must be scarified for a unit of X diminishes because as we acquire more unit of X the
MU x
MUx diminishes but the MUy increases (MRSx, y= - ).
MU y

An indifference map is a set of indifference curves each corresponding to a different level of

satisfaction for the consumers.
The indifference curves in an indifference map rank the preferences of the consumer.
Combinations of goods situated on an indifference curve yield the same utility. Combinations of
goods lying on a higher indifference curve yield higher level of satisfaction and are preferred.
Combinations of goods on a lower indifference curve yield a lower utility, and, therefore, are not
preferred.
Y Y

III

II

0 X 0 X

[Link] Properties of Indifference Curves

Properties of ‘a Well-Behaved’ Indifference Curve
1) It is negatively sloped. Given the income of the consumer and prices of goods/services, the
consumer purchases the two goods (X and Y in our case) to maximize utility. In doing so if

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he/she purchases more units of one commodity (say X) he/she should purchase less of the
other good (Y) given the income and prices of the goods.
2) A family of ICs in a plane shows the indifference map of the consumer’s preference. So the
consumer can have as many ICs as possible consistent with his preference.
At point B (X1, Y1) with relative to point A contains more of Y given the quantity of X.
At point C (X2, Y2) with relative to point A contains more of X given the quantity of Y.
At point D (X3, Y3) with relative to point A contains more of X and Y.
Therefore, any point on IC2 represents at least one more of the two goods (more of X, more of
Y or more of X and Y).
Good
Y

Y1 B
Y3 D
A C IC4
Y2
IC3
IC2
IC1
0
X1 X3 X2 Good X
Figure 2.6: Indifference map

3) Indifference curves which are far away from the origin represent higher levels of satisfaction
than ICs near to the origin. This property of indifference curve is derived from the inherent
tendency of human being that more of a commodity is preferred to less of it. More of a
commodity most likely gives more utility so that higher ICs (ICs to the right of the origin)
constitute at least one commodity more.

4) ICs do not intersect each other. If they did, the point of intersection would imply two different
levels of satisfaction which is impossible.

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Good
Y IC1 IC2
A=B
A=C
B=C

C B

IC1
A

IC2
0
Good X
 Point A represents two different levels of satisfaction because it is on both IC1 and IC2. But
from property 3, IC2 is to the right of IC1 and it should represent more level of satisfaction
than IC1 (any point on IC1) which is against the equality of utility corresponding to point B
and C. So as to avoid such logical inconsistency ICs should not intersect each other.
5) ICs are convex to the origin. This is because of diminishing marginal rate of substitution
between the two commodities.
IC1
Good Y
* Y1> Y2> Y3

8 A
Y1=3

5 B Y2 =2

3 C Y3 =1
1.5 D
IC1
0
1 2 3 4
X1= X2= X3=1 Good X

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[Link] The Marginal Rate of Substitution (MRS)

As defined earlier the MRS of X for Y is the number units of commodity Y that must be given up
or sacrificed in exchange for an extra unit of commodity X so that the consumer maintains the
same level of satisfaction. The MRSx,y diminishes when we move down along a given
indifference curve. This is because, as a consumer consumes more of X then MUx diminishes,
while MUy increases as a result the magnitude of MRSx,y diminishes. And this is the cause for
the convexity of an indifference curve. The slope of indifference curve is measured by MRSx,y.

[Link] Types of Indifference Curves

1. Indifference Curve for Perfectly Substitutable Goods
i. The indifference curve for the two substitutable goods (say X and Y) is a straight line with a
constant slope (MRSx, y is constant along an IC) but not necessarily 1. In this case the optimum
is:
a. To consume only X if the market valuation (price ratio) is less than the individual’s
Px MU x
valuation of the good i.e. if < .
Py MU y

b. To consume only Y the market valuation should be greater than the individual’s
Px MU x
valuation, i.e., < . At the optimum, the consumer consumes only commodity Y.
Py MU y

Budget line

IC1 IC2 IC3

0 X
Figure 2.7: Straight indifference curve

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Px
c. To consume any combination of the two that satisfies the budget line equation if =
Py
MU x
MU y
ii If the two perfectly substitutable goods are one to one substitutes, the slop of the IC is
equal to -1. Here, the optimum is;

A. To consume the one with the lower price only; only X if Px < Py and only Y if Py < Px
B. To consume any combination of the two that satisfies the budget equation if Px = Py.
2. The Indifference Curve for Perfectly Complementary Goods
The indifference curve for two perfect complementary goods is right-angle at a vertex (L-shaped).
The MRSx, y = ∞ on the vertical portion of the IC whereas, MRSx, y = 0 on the horizontal part of it
0
and (undefined at the vertex). The optimum level of consumption which lies on the vertex can
0
be calculated as:
a) Substituting X for Y or Y for X in to the budget line equation if the goods are one-to-one
perfect complements.
 Px X+ Py Y = I
I
 Y= X =
Px  Py

Y
b) Substituting Y= nX or X = in to the budget line equation if the consumption of a unit of
n
X requires ‘n’ units of Y.
 Px X+ Py Y = I
 Px X+ (nX) Py = I
I
X= and
Px  nPy
nI
X=Y=
Px  nPy

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Good Y Y = nX
I
Py
IC4
IC3
IC2
Budget
Set IC1

0
I
Good X
Px
Figure 2.8: L-shaped indifference curves
Example 1: suppose that a unit of X requires 3 units of a complementary good Y to be consumed
with. Find the utility maximizing quantities of X and Y if Px =100, Py =200 and I = 63,000.
100X + 200Y=63,000 and given that Y=3X
 X=90 and Y=3X=270
Note that the minimum amount available of a good should be set first and the remaining amount
of the other left unconsumed if there is such a constraint on the availability of complementary
good.
Example 2: suppose a unit of X is consumed with 3 units of Y where Px =1, Py = 8 and 2,500 and
if there are 270 units of Y, the optimum consumption is:
X + 8Y = 2,500  Y=3X X=100
100X + 200Y=63,000  ỹ =270 Y= 300
But, we have only 270(ỹ =270) units of and the optimum consumption is:
Y 270
ỹ =270 and X= =  90 .
3 3
A. 10(100-90 =10) units of X remain unconsumed though feasible solely due to the lack of 30
(3x10 =30) units of Y.

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2.3 The Budget Line or the Price line

Economists assume that consumers choose the best bundle of goods that they can afford. The word
best indicates the utility maximizing combinations of goods/services whereas, the phrase can
afford indicates the budget constraint of the consumer. The budget line is the set of bundles of
goods and services that cost exactly the constant income level (I). Or it shows all the combinations
of goods and services that the consumer can buy given the assumed prices and incomes. The budget
set consists of all bundles that are affordable at the given prices and income.

A utility maximizing consumer would like to reach the highest possible indifference curve on his
indifferent map. But the consumer is assumed to have a limited income; limited income sets a limit
to which a consumer can maximize his utility. Therefore, the limitedness of income acts as a
constraint (a limiting factor in the utility maximizing behavior of the consumer). In general prices
of the commodities and the level of income of the consumer work to limit/constrain the nature and
size of the market basket that he/she can buy. Let the consumer consumes two commodities X and
Y in quantity of Qx and Qy and price of Px and Py respectively, with a total income to be spend on
both goods be I. Then the budget constraint/ budget set of the consumer is written as Px Qx+ Py
Qy ≤ I. It is shown by the equality of expenditure with income. Given the income and prices of the
I P I
goods the budget line of the consumer is: Px Qx+ Py Qy = I  Qy =  x .Q x  is the vertical
Py Py Py

Px
intercept of the budget line whereas,  is the slope of the budget line. Graphically,
Py

Good Y
I
Budget line
Py
Budget
Px
Set Slope=  .
Py

0 I Good X
Px

Figure 2.9: Budget line

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Any point on or inside the budget line indicates the budget set and usually we call it feasible or
attainable area at a given income and prices of the goods/services. But any point beyond or above
the budget line cannot be reached or not affordable to the consumer at the given income and prices.
In order to attain that point either the income of the consumer should increase (increase in the
nominal income of the consumer) or the prices of either X or Y or both should decrease (increase
in real income of the consumer). So, any point above a given budget line is on the unattainable or
non-feasible area.

The Slope and Intercepts of the Budget Line

The slope of the budget line has a nice economic interpretation. It measures the rate at which the
market is willing to substitute good X for Y. Note that if the consumer satisfies his budget
constraint before and after making the change in quantities of goods consumed he must satisfy Px
Qx’+ Py Qy’ = I. After the change in price(s) of X, Y or both then the quantity of X, Y or both will
change, then the budget line take the form:

Px (Qx+ Qx) + Py (Qy+ Qy) = I

in X in Y
 Px Qx+ Py Qy+ Px Qx+ Py Qy = I
=I
 Px Qx+ Py Qy=0
Y P
   x  it is the slope of the budget line
X Py
Therefore, the slope shows the rate at which good Y can be substituted for good X while still
satisfying the budget constraint. Implicitly, it measures the opportunity cost of consuming good
X.

‘How’ and ‘Why’ the Budget Line Changes?

The budget constraint sets upper limit to the quantities that a consumer wishes to buy. This
constraint gets relaxed or tightened as certain conditions change. Such changes are reflected by
shift of the budget constraint. The budget line changes due to the change in:
1. Income of the consumer
2. Prices of the commodities
3. Government policies (taxes, subsidies and rationing constraints)

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2.3.1 Effects of Changes in income

A change in income shifts the budget line either to the right or to the left. An increase in income
shifts the budget line upward/ outward to the right whereas decrease in income shifts the budget
line downward/ inward to the left. So, changes in nominal income of the consumer resulted in a
parallel shift of the budget line without affecting the relative prices of the goods (slope of the
I I
budget line). It affects the two intercepts (vertical ( ) and horizontal ( )).
Py Px

Good Y

I1
Original budget line
Py

I
New budget line
Py

Px
Budget Slope= constant =  .
Py
Set

I1 I2
0 Good X
Px Px
Figure 2.10: When the income of the consumer increases

2.3.2 Effects of Changes in Price

Proportional Change in Prices

Proportional rise in the prices of both goods (good 1 and good 2), with income remaining
unchanged, will reduce the total quantity of the two goods that the consumer can buy for a given
income. For example, if the prices of the two goods under consideration double, this would halve
the quantities of the two goods purchased to be reduced by half. Before the rise in price, if the
consumer decides to spend his entire income on X1, the total quantity purchased is M/P1. But after
the doubling of prices, the new quantity will be M/2P1. The new quantity is half that of the pre-
change quantity. Its effect is the same as that of reducing the consumer’s income by half. This
causes a parallel shift in the budget line towards the origin.

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Proportional rise in the prices of the two commodities, X1 and X2 causes fall in the intercepts but
leaves the slope of the budget line unchanged.

Y
M / P2''
M/P2
M / P2'

0 M / P1' M/P1 M / P1'' X

Figure 2.11: Proportional Changes in Price

Changes in Relative Prices

Dear learner, a change in relative price can occur, and often does, as a result of changes in only
one of the prices or changes in both prices in different proportions.

First, assume that the price of good 1 changes (increases) with price of good 2 and income
remaining fixed. Slope being the ratio of prices, this would make the budget line steeper. The
vertical intercept does not change, but the horizontal intercept will change. The resulting new slope
'
P
would be  1 where P1' is the new price of good 1.
P2

Given the equation of the budget line, when there is a change in Px but Py and Income held constant
P
then definitely the slope of the budget line (  x ) is affected. Increase in price of good X makes
Py
Px
it expensive, the budget line becomes steeper i.e. increases. This implies that at the changed
Py
price the consumer purchases less of commodity X.

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Good Y

I
Original budget line
Py

New budget line

Budget
Set

I I
0 Good X
Px 1 Px 2
Figure 2.12: Shows when the price of commodity X decreases from Px1 to Px2

 As an exercise show the effect of change in the price of commodity Y on the budget line
A decrease in the price of X makes the budget line flatter, i.e., the consumer is motivated to
purchase more of the commodity in which its price is relatively lower.

If PX, Py, and I changes by the same amount let ‘t’ then the equation of the budget line do not
change.

 Px Qx. t+ Py Qy .t = I. t

 [PX Qx+ Py Qy].t = [I].t

 Px Qx+ Py Qy = I  which is similar to the original budget line

This is the case of perfectly balanced inflation; one in which all prices and income increases or
decreases at the same rate. This does not change or affect anybody’s budget line or budget set, and
thus can’t change anybody’s optimal choice.

The effect of simultaneous change in the prices of the two goods in different proportions can be
shown in the same way as the previous case. In this case, however, both the vertical and horizontal
intercepts change.

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Y
M/P2

M / P2'

0 M/P1 M / P1' X

Figure 2.13: Relative Changes in Price

A proportional change in money income and in the prices of all commodities leaves the consumer
neither better off nor worse off. In relation to rise in income and in the prices of commodities, the
rise in income shifts the budget constraint outward, while the rise in the prices of commodities
shifts the budget line inward, the net effect leaves the budget line at its original position. In the
case of fall in income and commodity prices, the fall in income shifts the budget line in a parallel
manner towards the origin, while the fall in the commodity prices shifts the budget line to the right,
the net effect still leaves the budget line unchanged.

2.3.3 Effects of Changes in Government Policies

A. Taxes: there may be as many taxes as the kinds of income of the consumer. Among these let
us see three of them:
1) Lump-sum tax: - a kind of tax when the government takes away some fixed amount
of money, regardless of the individual’s behavior, status, and income. For example,
citizens of a country above the age of 18 should pay a fixed amount of birr 100 per
year regardless of their annual income. The marginal tax rate in this form of tax is
zero. It is relatively a burden sum type of tax if we compare it with other kinds of
taxes with equivalent revenue.
2) Quantity tax: - a kind of tax when the consumer pays a certain amount to the
government (tax collecting authority) for each unit of the good he/she purchases. It
is a consumption tax imposed on the consumer and paid depending on the amount of
purchase made by the consumer.

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3) Value (ad valorem) tax: - a tax levied on the value (price) of a good rather than the
quantity of the good purchased. It is usually expressed in terms of percentage terms.
For the analysis of budget line, this form of tax receives greater attention. So, our
analysis of tax on the budget line focuses on such kind of tax. The ultimate rusting
place of an advalorem tax is on the consumer i.e. it increases the price of the goods/
services consumed by the consumer. Suppose the government imposes an advalorem
tax, ‘t’ on the consumption of commodity X only. Then the budget line of the
P (t  1)
consumer be: Pxt = Px + tPx = Px (1 + t)  Qy = I  x .Q x
Py Py

Px Px (t  1)
The slope of the budget line increases from to . As a result of this the
Py Py

budget line becomes steeper towards the taxed good(X): the consumer purchases less
of the commodity X. if an advalorem tax is imposed on a good then the budget line
will be steeper to the good to which tax is levied.
Y
I
New budget line
Py1

I
Py 2

Original budget line

Budget set

I
0 X
Px
Figure 2.14: Ad valorem tax on commodity Y, which increases its price from Py1 to Py2
I I
(=Py1+ t Py1) and decreases the demand of Y from to .
Py1 Py 2

B. Subsidy: - In its effect subsidy is the opposite of tax. It is the government’s plan to motivate
and support the people especially to those with low income per period. Most of the time, the
incidence of subsidy is to reduce the prices of goods and services consumed.

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I
Py

New budget line

Budget Original budget line

Set

0 I I X
Px 1 Px 2

Figure 2.15: Subsidy on commodity X

From the budget line above if the government makes subsidy on commodity X to make it more
affordable for the ‘poor’ then the budget line of the consumer will have a form of:
 Pxs = Px - sPx = Px (1 - s) where, ‘s’ is the rate of subsidy made by the government on the
consumption of X, PXs is the price of X after subsidy.
P (1  s )
 Qy = I  x .Q x  budget line after tax.
Py Py

C. Rationing (Quantity restriction):- in an extreme command or socialistic economy the

government and other administrative parties can ration or restrict the amount, kind, size and
quality of goods and services to be consumed by the consumer.
Good Y

I
 Budget line after rationing
Py
Part of the budget set before rationing but
lopped off after rationing

Budget
Set after
Rationing

0
X1 X Good X
Figure 2.16: Rationing on Commodity X

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Suppose a certain consumer is consuming two commodities X and Y but his/her consumption of
X is rationed or restricted to the extent of X1: beyond this point consumption of X is not allowed.
If X is rationed, the section of the budget set beyond the rationed quantity will be lopped off.

2.4 Optimum of the Consumer: Ordinal Approach

The consumer attains his equilibrium when he maximizes his total utility given his income and
market prices of goods and services he consumes. The necessary (first order) condition for
Px MU x
maximization is the equality of MRSx, y = since MRSx, y =
Py MU y

MU x P MU x P
MRSx, y = = x  = x
MU y Py MU y Py

The sufficient (second order) conditions of maximization are

1) The necessary condition be fulfilled at the highest possible indifference curve.

2) The highest possible IC should be well behaved i.e. it should be negatively sloped and
convex to the origin.
Good plane A

Y The consumer is in equilibrium at E. At this

C Point, slope of indifference curve (MRSx, y)

E is equal to slop of budget line (price ratio).

IC3

IC2

D IC1

0 Good X

In the above diagram (plane a) the tangency of IC2 with the budget line (AB) indicates that IC2
is the highest possible well behaved IC which the consumer can reach, given his budgetary
constraints and prices. Due to the budget constraint, the consumer can’t move to an IC placed

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above and to the right of IC2. For example, his income would be insufficient to buy any
combination of two goods at the curve IC3.

Good Here the ICs are concave to the origin so the

Y A plane B point of tangency in between IC and budget line

Cannot be the equilibrium of the consumer

because the IC is not well behaved i.e. are not

Convex to the origin

IC2

IC1

0 B Good X

Figure 2.17: Convex and concave indifference curves

To conclude, a utility maximizing consumer, given his income, taste and preferences and prices of
goods will attain his equilibrium when MRS equals price ratio at the highest possible IC in our
case at point E in (plane A).

Y Y

It is an interior optimum.
(i.e. both goods are used)
Boundary
solution E

E IC

0 X 0 X
Figure 2.18: Boundary and interior solution

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However, there is a case where the optimal choice occurs at a point where the IC and the budget
line have different slopes. In such a case, no interior optimum exists and this represents a boundary
optimum (only one commodity is consumed).

Anywhere to the left of the tangency, MRSx, y is higher than at the tangency; and anywhere to the
right of the tangency, MRSx, y is lower than at the tangency. In Figure 3.16, the consumer maximizes
his utility by consuming X* amount of good X and Y* amount of good Y.

The marginal rate of substitution expresses the willingness of the consumer to trade a certain
amount of X for a certain amount of Y, and the slope of the budget line reflects the market’s
willingness to trade a certain amount of X for a certain amount of Y. The impersonal forces of the
market impose the relative price on the consumer, so the consumer adjusts consumption amounts
in such a way that his tradeoff is the same as that of the market.

Mathematical derivation of equilibrium:

Assume there are n commodities with prices P1, P2… Pn, and the consumer’s money income is M.
In this case, the problem to the consumer is maximizing his utility subject to his limited income
and market prices. In maximization, the function which represents the objective that the consumer
tries to achieve (in our case utility function) is called the objective function and the constraint that
the consumer faces is represented by the constraint function (here the budget constraint).

Maximize: U = f (Q1, Q2… Qn)

Subject to: M = P1Q1 + P2Q2 + … + PnQn
Rewriting the constraint
M - P1Q1 - P2Q2 - … - PnQn = 0
Multiplying the constraint by Lagrange multiplier 
(M - P1Q1 - P2Q2 - … - PnQn) = 0
Forming a composite function (also called Lagrange function)
 = U + (M - P1Q1 - P2Q2 - … - PnQn)
Since the rewritten constraint function is zero, adding zero to U makes no difference at all. Now
given the composite function which is obtained by combining the objective function and the
constraint function, the process of utility maximization requires that two conditions be satisfied:

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The first order condition requires that the partial derivatives of the Lagrange function with respect
to all quantities and the Langrage multiplier () be zero.

 U
   P1  0
Q1 Q1
 U
   P2  0
Q2 Q2

 U
  Pn  0
Qn Qn


 (M - P1Q1 - P2Q2 - … - PnQn) = 0

From these equations, we obtain
U
 P1
Q1
U
 P2
Q 2

U
 Pn
Qn

U U U
 MU 1 ,  MU 2 , …,  MU n .
Q1 Q 2 Q n

Substituting and solving for , we obtain the equilibrium condition:

MU 1 MU 2 MU n
   ...  .
p1 p2 pn

In a case where there are only two goods, this means

MU x MU y
 .
Px Py

Rearranging,
MU x Px
  MRS x , y
MU y Py

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The second order condition for maximum requires that the second order partial derivatives of the
Lagrange function with respect to all quantities be negative.
 2  2U
 0
Q12 Q12

 2  2U
 0
Qn2 Qn2
The second order conditions imply that the indifference curves be convex to the origin. It is
necessary that the second order condition be satisfied because for indifference curves with different
shapes, tangency may not necessarily represent equilibrium. Suppose the relevant indifference
curve were linear. In this case, the budget line will lie totally on the indifference curve, in which
case any one point on the indifference curve represents equilibrium. If the indifference curve were
rather concave equilibrium would be defined by corner solution.

Example

Suppose the utility function of a person consuming two commodities X and Y with income Birr
600 is given by U  2 X 0.6Y 0.4 . If the per unit price of X is Birr 20 and per unit price of Y is Birr
40.
a) Calculate the utility maximizing level of consumption of X1 and X2.
b) Find the MRSX, Y at the optimum.
Solution
The consumer’s objective is the maximization of his utility. Therefore, the utility function is
referred to as an objective function. However, the consumer’s utility maximizing behavior is
constrained by his limited income; accordingly, the budget constraint is referred to as constraint
function.
Objective function: U  2 X 0.6Y 0.4
Constraint function: 20 X  40Y  600
The consumer’s problem is then;
Max U  2 X 0.6Y 0.4
Subject to 20 X  40Y  600
Rewriting the constraint function
600  20 X  40Y  0
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Multiplying the constraint by a Lagrange multiplier

 (600  20 X  40Y )  0
Forming a composite function
  2 X 0.6Y 0.4   (600  20 X  40Y )
The first order condition for utility maximization requires that all the first order derivatives of the
composite function with respect to X, Y and λ be zero.
First order condition:
 1.2 X 0.4Y 0.4
 1.2 X 0.4Y 0.4  20  0    (1)
X 20
 0.8 X 0.6Y 0.6
 0.8 X 0.6Y 0.6  40  0    (2)
Y 40

 600  20 X  40Y  0 (3)


From equations (1) and (2) we have

1.2 X 0.4Y 0.4 0.8 X 0.6Y 0.6

 
20 40

Rearranging (by cross multiplication)

2.4 X 0.4Y 0.4

1
0 . 8 X 0. 6 Y  0. 6

3Y  X

Substituting this result in equation (3)

600  20(3Y )  40Y  0

60Y  600
Y 6

X  3Y
X  3(6)  18

Second order condition:

 2
2
 0.4(1.2 X ( 0.4 1)Y 0.4 )  0.48 X 1.4Y 0.4  0
X

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 2
2
 0.6(0.8 X 0.6Y ( 0.61) )  0.48 X 0.6Y 1.6  0
Y

The second order condition is satisfied; therefore, the consumer should buy 30 units of X and 10
units of Y in order to maximize his utility.

The MRSX, Y at the optimal point is obtained by substituting the optimal quantities of the two goods
in the ratio of marginal utilities that defines MRSX, Y.

MU X
MRS X ,Y 
MU Y
U U
MU X   1.2 X 0.4Y 0.4 and MU Y   0.8 X 0.6Y 0.6
X Y
Y 6
MRS X ,Y  1.5  1.5  0.5
X 18
2.4.1 Effects of Changes in Income and Prices on Consumer Optimum

[Link] Changes in Income: Income Consumption Curve and the Engel Curve
So far, we have assumed that the consumer’s income is constant during the period of consumption.
However, the income of the consumer changes because of different factors. If the income of the
consumer changes the consumer’s purchasing power will also change, i.e., the budget line shifts
to either the left or right.

 Increase in income of the consumer shifts the budget line to the right (causes up ward shift
of the budget line)
 Decrease in income of the consumer shifts the budget line to the left (causes down ward
shift of the budget line)
When the individual’s level of income changes, the consumer comes to a new position on his or
her indifference map and budget line; this indicates that both the purchasing power and the
preference pattern of the consumer changes. The consumer optimum point shifts from one point
to another due to the disequilibrium created by the change in income of the consumer. For the
purpose of simplicity, we consider increase in income throughout this discussion.

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Good Y Good Y

0 0
Good X Good X
Figure 2.19 (a): Increase in income of Figure 2.19 (b): Decrease in the income of
the consumer the consumer
Income consumption offer curve gives the path of increase in consumption resulting from the
increase in income. It also may be defined as the locus points representing various combination of
two commodities purchased by the consumer as his income changes, all other things remaining
the same.
Good Y

Income Consumption Offer Curve

(ICOC)

E3
E2

E1
IC3
IC2
IC1
0 Good X
Figure 2.20: Derivation of income consumption offer curve

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As it has been said increase in income shifts the budget line outward in a parallel manner (if the
prices of the commodities are kept constant). If we go on increasing income, we will have a set of
optimum points (the optimal demanded bundles) that we can get as we shift the budget line out
wards gives us the income consumption offer curve, also known as income consumption path. The
slop and shape of this curve depends on the nature of the commodities consumed by the consumer.
As indicated in the above diagram, if both the commodities (X and Y) are normal goods then the
income consumption path will have positive slope.
Income Effect and Nature of The Commodities
The income effect on the consumption of a commodity may be either positive, negative or zero. If
the increase in income leads to increase in consumption of a good or services, then the commodity
is normal and the income effect is positive. But if increase in income leads to decrease in
consumption of a good then the good is inferior and the income effect is negative.
In fact, whether a commodity is a ‘normal’ or an ‘inferior’ depends on whether income effect on
its consumption is positive or negative. If income effect is positive, then the commodity is
considered to be a normal good and if it is negative, the commodity is said to be an inferior good.
In a rare case the income effect on the consumption of a commodity is zero then the commodity is
said to ‘income neutral’ good. Thus income-consumption curve may take various shapes and
position depending on whether a commodity is normal, inferior or income insensitive. Graphically,

Good Y

Income Consumption Offer Curve

(ICOC)

E3

IC3
E2

E1
IC2

IC1
0 Good X
Figure 2.21(a): Commodity X is inferior whereas Y is superior or normal.

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Good Y

E1 E2 E3
Income Consumption Offer Curve
(ICOC)
0
Good X
Figure 2.21(b): Commodity Y is inferior whereas X is superior or normal.

Y
Y is income neutral ICOC X is income neutral
or income insensitive or income insensitive

E1 E2
Ÿ ICOC

0 X 0 X
Figure 2.21(c): Income consumption curve for income neutral goods
ENGEL CURVE (EC)

Engel curve is a function or schedule showing the relationship between equilibrium quantity
demanded of a good and the levels of income that the consumer possesses. Or simply it shows the
relationship between consumer’s income and his money expenditure on particular good. It is a
derived function from income-consumption offer curve and its shape is dependent up on the shape
of ICOC.
The Engel curve will have a positive slope for a normal good and negative slop for an inferior one.
Real Engel curves do not have to be straight lines. In general, when income goes up, the demand
for a good could increase more or less rapidly than income increases. If the demand for a good
goes up by a greater proportion than income, we can say that the good is a luxury and if it goes up
by lesser proportion than income, we can say that the good is necessity. The dividing line is where

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the demand for a good goes up by the same proportion as income. In such a case the Engel curve
is straight line through the origin. Here if income doubles, the demand for each good would double
such preferences are said to be Homothetic.

Y M
Income-consumption curve
Engel curve
Y3 c M3
Y2 b M2
Y1 a M1

0 X1 X2 X3 X 0 X1 X2 X3 X

Figure 2.22: Engel Curve

For each level of income, there will be some optimal choice for each of the goods. If we keep the
prices of the two goods constant (fixed) and focus on what happens to the demand for good 1 as
the level of income changes, we obtain what is known as the Engel Curve.

In general Engel curve shows the relationship between the change in income of the consumer and
the change in quantity demanded of a commodity. So, different goods have different Engel curves.

[Link] Changes in Price: Price Consumption Curve (PCC)

The effect of price changes on the quantity demanded of a commodity assuming that income, taste
and preferences of the consumer remains constant, represents price effect. When the price of the
commodity changes the slop of the budget line will be affected and it may also affect the intercepts
I P
of the budget line (Qy =  x .Q x ). In general, the change in consumption basket for a
Py Py

commodity due to the change in price is termed as total price effect. It may also be stated as the
additional quantity demanded resulting from the changes in price.

There are two factors which are responsible/ accountable for the total price effect. In other words,
the total price effect has two components namely substitution effect and income effect.

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Price Effect & Derivation of Price Consumption Offer Curve

When the price of a good, say X decreases, the budget line becomes flatter and cause a shift from
AM to AN as indicated in the figure below. The optimal choice of good X moves from E1 to E2
(moves to the right as well): the quantity demanded increases from X1 to X2. If we decrease the
price of X (Px) further the budget line will be AP and so on. The locus of the optimum points (E1,
E2, E3…) associated with the new budget lines formed by reducing Px (Py and income kept
constant) gives us price consumption offer curve or price- consumption path.

Y
A

Price consumption offer curve

E4 (PCOC)
E3
E2
E1

O M N O P X
Figure 2.23: Derivation of price consumption curve

PCOC is the locus of points of equilibrium on ICs resulting from the changes in the price of a
commodity. As it has been stated earlier price effect can be decomposed in to income and
substitution effect: price effect (PE) = substitution effect (SE) + income effect (IE). Income effect
here means, the change in quantity demanded of a good due to the change in real income or
purchasing power of the consumer’s income which is resulted from the change in price of the good
keeping all factors (I and Py) remaining the same. While substitution effect shows the change in
the quantity demanded of a good due to consumer’s inherent tendency to substitute cheaper goods
to expensive ones.

2.4.2 Decomposition of Income and Substitution Effects (normal goods)

There are two methods or approaches to split/ decompose total price effect in to substitution and
income effects. These are:
1. Hicksian approach

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2. Slutskian approach
1. Hicksian Approach to the Decomposition of Total Price Effect

IC1 IC2
A

E
E1 E2

E3
Compensated
Budget line

O C B D X

X1 X2 X3
SE IE

PE
Figure 2.24: Hicksian approach to split price effect into substitution and income effect.

E1 is the original equilibrium, i.e., before the decreases in price of good X. Movement from E1 to
E3 is due to the change in relative price of the commodities (X and Y). This is also called
substitution effect. It can be defined as the change in quantity demanded of a commodity (say X)
resulting from a change in relative / comparative price after real income effect of price change is
eliminated. The movement from E3 to E2 is due to the change (increase in this case) in real income
of the consumer. It is called income effect. Income effect is the change in quantity demand of a
commodity (X) because of the change in real income of the consumer which is the result of the
change (decrease in this case) in price of that commodity (Px). Note that in most of our analysis
discussed so far, we were concerned with decrease in price of the good but the theoretical
framework and graphical illustrations are equally applicable and valid for the increase in the price
of the commodity.
The substitution and income effects of price change are different for different products.

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2. Slutskian Approach to Decomposition of Total Price Effect

IC1 IC3
A IC2

E
E1 E2
E3 IC3
IC2 Compensated
IC1 Budget line

O C B D X

X1 X2 X3
SE IE

PE
Figure 2.25: Slutskian approach to split price effect into substitution and income effect.

What are the differences and similarities between the two approaches of decomposing total price
effect?
In the case of Hicksian approach, the consumer is in equilibrium and derives the same level of
satisfaction as before price reduction (i.e. the consumer is in equilibrium on the same indifference
curve, IC1 after the real income effect of price reduction is eliminated). But in the case of Slutskian
approach, after the elimination of the real income effect of price reduction the consumer attains
higher level of satisfaction, IC2 as it compared with satisfaction level derived by the consumer
before price reduction, IC1.

2.4.3 Derivation of Market Demand Curve

The quantity of a commodity which an individual is willing to buy at a particular price of the
commodity during a specific time period given his money income, his taste, and prices of
substitutes and complements, is known as individual demand for a commodity. The total quantity

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which all the consumers of a commodity are willing to buy at a given price per time unit, other
things remaining the same is known as market demand for the commodity.
In other words, the market demand for a commodity is the total of individual demands by all the
consumers (buyers) of the commodity, per time unit, and at a given price, other factors remaining
the same. For instance, suppose there are three consumers namely A, B, C of a commodity X and
their individual demand at its different prices is given in the following table. The last column
presents the market demand i.e., the aggregate of individual demand by three consumers at
different prices.
Table 2.2: Price, quantity demanded and market demand
Price of commodity the, Quantity of X demanded by Market demand
Px Consumer: (MD)
(in Birr per unit) A B C
10 5 1 0 6
8 7 2 0 9
6 10 4 1 15
4 14 6 2 22
2 20 10 4 34
0 27 13 0 50

Graphically, Market demand curve is the horizontal summation of individual demand curves. The
individual schedules plotted graphically and summed up horizontally gives the market demand
curve.
In general, the market demand for a given commodity is the horizontal summation of the demands
of individual consumers. In other words, the quantity demanded in the market at each price is the
sum of the individual demands of all consumers at that price. This following table shows the
demands of for consumers at various price of a certain commodity and the total market demand.
We observe although that for consumer B commodity X is Giffen good, the market demand has
the normal negative slope because the demands for other consumers more than offset the Giffen
case in B.

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Table 2.3: Individual and Market demand (draw the individual (A, B, C and D) and market demand
curve for the commodity in the market).
Price Quantity Quantity Quantity Quantity Market
demanded demanded demanded demanded Demand
by consumer by consumer by consumer by consumer MD =
A B C D (A+B+C+D)
2 40 4 45 18 107
4 30 2 35 16 83
6 24 5 30 13 72
8 18 7 20 12 57
10 14 10 15 11 50
12 10 7 13 8 38
14 8 5 10 6 29
16 6 3 8 4 21
18 4 2 0 0 6
20 3 0 0 0 3

Why market demand curve is more elastic than that of the individual demand at a given
price of the good?
Is there a case when the market demand is equal to the individual demand?
Demand is a desire backed (supported) by ability and willingness to pay. And the term demand
refers to the quantity demanded of a commodity per unit of time at a given price. Quality demanded
is a flow concept because it changes due to the change in time
The law of demand
The price of a commodity is the most important determinant of its demand and the only
determinant in the short period when all other determinants of demand are assumed to remain
constant (citrus paribus). The relationship between price and quantity demanded is expressed by
the law of demand.
 The law of demand states that quantity of a product demand per unit of time increase
when its price fall and decreases when its price increases, other factors remaining
constant.
The assumption other factors remaining constant implies that income of the consumers, prices of
substitutes and complementary goods, consumers test and preferences, the number of consumers,
weather condition, expectation about the goods consumption pattern etc. remain unchanged.

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Why Demand Curve Slopes Down Ward to the Right?

The reasons behind the law of demand i.e. inverse relationship between price & quantity demanded
and the down word sloping of demand curve are the following:
i. Substitution effect (se)
When the price of a commodity falls; it becomes relatively cheaper if prices of all other related
goods, particularly of substitutes remain constant. Since consumers substitutes cheaper goods for
costlier ones, demand for relatively cheaper commodity increases. This increase in demand on
account of this factor is known as substitution effect.

ii. Income effect

As a result of fall in the price of a commodity, the real income of its consumer increases in terms
of this commodity. In other words, his purchasing power increases since he is required to pay less
for the same quantity. The increase in real income (Purchasing power) encourages demand for the
commodity with reduced price. The increase in demand on account of increase in real income is
known as income effect. In come effect is negative in case of inferior good. Thus, the income effect
on the demand for inferior goods become negative but it is positive for normal (superior) goods.
iii. The Law of Diminishing Marginal Utility
Diminishing marginal utility is also responsible for increase in demand for a commodity when its
price falls. The consumer continues to buy goods and service so long as marginal utility of the
commodity (MUc) is greater than the marginal utility of the money income that he/she going to
pay for it (Pc).
Utility maximizing consumer fixes his purchase where
MUm = Pc = MUc where; MUm = marginal utility of money
Pc = Price of the commodity
MUc= Marginal utility of the commodity
When P decreases then, MUc > Pc: therefore, to regain the equilibrium i.e. (Pc = MUc), he/she
purchases more of the commodity. When the stock (amount) of a commodity increases, its MU
decreases. That is why demand for a commodity increases when its price decreases. When the
price of the commodity falls and if the consumer buys as many units as before the fall in price he
saves some money on this commodity. As a result, the marginal utility (MUm) of money will be
decreased due to the more accumulation of money. But the marginal utility of the commodity
(MUc) is remaining the same then Pc < MUc. So, to reach the equilibrium (Pc = MUm = MUc) the

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consumer should purchase more of the commodity to decrease marginal utility of the commodity
(MUc) consequently, demand for a commodity increases when its price falls.
Some exceptions to the Law of Demand
a) Expectations regarding future price
If consumers anticipate continuous increase in the price of a commodity, they buy more if it despite
increase in its price. They also buy less of it if they expect price decrease.
b) The law may not apply to the commodities which serve as a “status symbol”, enhance social
prestige or display wealth and richness like precious metals and special ornaments (for further
analysis of this concept refer the case Veblen goods, bandwagon and Snob effects).
c) The case of Giffen Goods
Giffen good does not mean any specific commodity. It may be any commodity much cheaper than
its substitutes, consequently consumed mostly by the poor households as an essential consumer
good. If price of such goods increase (price of its substitute remaining constant), its demand
increase instead of decreasing.
Determinants of demand
Although as stated above, price is the most important determinant of the quantity demanded, there
are also various factors which determine (affect) it. These determinants are: -.

1. Price of substitute and complementary goods

The demand for a commodity depends also on the levels of the price of its substitute and
complementary good. Two commodities are said to be substitute for each other if changes in the
price of one affects the demand for the other in the same direction. In other words, if a rise in price
of x good increases the demand for y and vise verse. Eg. Tea & coffee, Pepsi and coca. A
commodity is deemed to be a complement of another when it complements the use of the other. In
other words when the use of any two goods goes together so that their demand changes (increases
or decreases) simultaneously they are treated as complements. For example, gun &gun powder,
camera & film, petroleum & vehicle.
2. Consumer’s income
The consumer’s income is also the basic determinant of the quantity demanded of a product. That
is why the people with higher disposable income spend larger amount on goods & services than

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those with lower income. But since consumer’s income-demand analysis depends on the type of
the good, we look this income -demand analysis with related to different categories of goods.
A. Inferior goods: -Are goods which are given low value / class/ by the society. The demand for
such goods may initially increases with the increase in income up to a certain limit. But it decreases
when income increases beyond that limit.
B. Normal goods: -Technically normal goods are those goods which are demanded in increase
quantities as consumer’s income increases. Normal goods are divided into luxuries and necessities.
i. Essential consumer goods / basic goods/: -Are goods which are essentially consumed by almost
all parts of the society. E.g. food grains, vegetable oils, sugar, etc. The quantity demand of such
goods increases with the increase in consumer’s income only up to a certain limit/ citrus paribus/.
ii. Prestige or luxury goods: -Are goods which are mostly consumed by the rich section of society.
E.g. Costly cosmetics, jewelry and luxury cars. Demand for such goods arises only beyond a
certain level of consumer’s income.
3. Consumer’s future income
Consumer’s future income has positive relationship with demand. That means if the consumer
expects future income, he consumes more today and vice versa.
4. Consumer’s expected price: - It has also positive relationship with demand. That is if consumer
expected price of goods increases in the future, his today’s consumption /demand/ for that good
increases & vice versa.
5. Consumers taste & preferences: - It also plays an important role in determining the demand
for a product. Taste & preferences generally depend on the social customs, religious values
attached to a commodity, habits of the people and general life style of the society.

Movement along the Demand Curve

Movement along the demand curve refers to that change in the quantity demanded of a good
because of changes in the prices of that good while other factors affecting demand (such as price
of other goods, income, etc.) remaining the same (unchanged).

The consumer buys larger quantities at lower prices and lower quantities at higher prices.
Therefore, such movements take the consumer from one point on the demand curve to another
point on the same demand curve.

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Shift in the demand curve

When the demand curve changes, its position keeping its shape we call it a shift in demand curve.
Shift in the demand curve for a good result from changes in one or more of the factors that affect
demand except the price of own good. Increase in demand is shown by outward shift of the demand
curve whereas inward shift of the demand curve represents decrease in demand.

2.5 Elasticity of Demand

There are as many elasticities of demand as its determinants the most important of these elasticities
are:
a) Price elasticity of demand
b) The cross-price elasticity of demand
c) The income elasticity
a) The own price elasticity of demand
It is the measure of the responsiveness of demand to changes in the commodity’s own price.
If the changes in price are very small we use as a measure of the responsive of demand the point
elasticity of demand. If the changes in price are not small we use the arc elasticity of demand as
the relevant measure.
The point elasticity of demand is defined as the proportionate change in the quantity demanded
resetting form a very small proportionate change in price symbolically we may write it as:
Q P dQ dP
ep  
Q P Q P
If the demand curve is a linear (straight line) like Q = bo-b1P
dQ P
 b1 Therefore, ep= -b1 . Here the parameter b1 shows the inverse of the slop of the
dP Q
dP 1
demand curve. The slope of linear demand curve (  - in our case) is the same at each &
dQ b1

every point on the curve. But the elasticity changes at the various points of the linear demand
curve.

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Graphically the point elasticity of a linear demand curve is shown by the ratio of the segments of
the line to the right and to the left of the particular point. In the following figure the elasticity of a
FD'
linear- demand curve at point F is the ratio .
FD
Given the graphical measurement of point elasticity, it is obvious that at the mid- point of a linear-
demand curve ep =1 (i.e. =FD’)
P ep=∞

D ep>1
FD'
(ep)F = =1
FD
P1 F

ep<1
ep= 0

0 Q1 D’ Q
Figure 26: Graphical illustration of range of values of point elasticity of demand
The price elasticity is always negative because of the inverse relationship between (quantity
demanded) Q and (price) P implied by the law of demand. However, traditionally the negative sign
is omitted when writing the formula of the elasticity i.e. its positive value (magnitude) is only
considered for analysis sake. Therefore, the range of values of ep is 0≤ep≤ ∞
 If ep= 0, demand is perfectly inelastic
 If ep= 1, demand is unitary elastic
 If ep= ∞, demand perfectly elastic
 0≤ep≤ 1, demand is inelastic
 1≤ep≤ ∞, demand is elastic

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P P P

Perfectly Perfectly elastic

inelastic Demand
Demand Unitarily elastic
demand

0 0 0 Q
ep = 0 ep = ∞ ep = 1

P ep>1
Q/Q > P/P
A 0< ep<1
P P Q/Q < P/P

0 Q Q 0 Q Q
Figure 2.27: Different rice elasticity curves

Approaches to Elasticity Measurement

Dear learner, let us look at the different approaches for measuring elasticity. There are two main
approaches to elasticity computation: the arc elasticity and point elasticity. If we are measuring
the elasticity between points, we are actually calculating the average elasticity over the space
between the points. This is called arc elasticity.

Elasticity between two points:

Q
(Q  Q 2 ) / 2 Q P1  P2
 1  
P P Q1  Q 2
( P1  P2 ) / 2

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P1 a

P2 b
D
0 Q1 Q2 Q

Figure 2.28: Arc Elasticity

Suppose you wish to measure price elasticity of demand as price falls from P1 and P2. In this case
you are, in a way, measuring the average elasticity between point a and point b.

When measuring the responsiveness of quantity demanded to changes in price at a particular point
on a curve, you are actually measuring point elasticity.

Elasticity at a point is measured by assuming infinitesimally small changes in price and quantity
demanded. When dealing with the concept of arc elasticity, however, we are working with sizable,
discrete changes.

Elasticity at a particular point:

Q P
 
P Q

P1 a

D
0 Q1 Q
Figure 2.29: Point Elasticity

Price elasticity of demand at a particular point, such as point a, can be obtained by multiplying the
slope of the demand curve at that point by the corresponding price/output ratio.

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P
  slope
Q

The determinants of own price elasticity of demand

Determinants of the elasticity of demand of a commodity with respect to its own price are:
1) the availability of substitutes: the demand for a commodity is more elastic if
there are close submitters for it.
2) The nature of the need that the commodity satisfies: In General luxury goods are
price elastic, while necessities are Price inelastic
3) The time period (short-run Vs long-run): Demand is more elastic in the long run because
more substitutes will be available in the long run.
4) The number of uses to which a commodity can be put: The more the possible uses of a
commodity the greater its price elasticity.
5) The proportion of income spent on the particular commodity.

Price Elasticity of Demand and Total Revenue

Dear learner, here, we are going to discuss about the concept of revenue and its relationship with
elasticity. Try to follow carefully.

When dealing with demand curves, the concern is with price and quantity relationships. Quantity,
or the number of items sold multiplied by price equals the total revenue generated.

TR  P  Q

In order to see how firms set and change prices, the relationship between total revenue and
elasticity could be considered.

It is important to recognize that a price change has two opposite effects on total revenue. The first
is that a price decrease, by itself, will decrease total revenue. The other is that with a price decrease,
quantity demanded increases, thus increasing total revenue. The net effect on total revenue depends
on whether the relative price decrease exceeds the relative increase in quantity demanded or vice
versa.

If demand is elastic, fall in price causes increase in total revenue. If, on the other hand, demand is
inelastic, the effect of fall in price would be decrease in total revenue.

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These relationships are summarized in the table below.

Table 2.4: Relationship between Elasticity and Revenue

Price change Quantity demanded change elasticity total revenue

Rise Decrease >1 Decrease

Rise Decrease =1 Unchanged

Rise Decrease <1 Increase

Fall Increase >1 Increase

Fall Increase =1 Unchanged

Fall Increase <1 Decrease

Example

Price .50 1.00 1.20 1.40 1.60 1.80 2.00 2.20 2.40 2.60 2.80 3.00

Quantity 25 20 18 16 14 12 10 8 6 4 2 0
demanded

In the table above, at a price of Birr 2.00, the total revenue (TR) is Birr 20.00. An increase in price
form Birr 2.00 to Birr 2.20 causes TR to fall from Birr 20.00 to Birr 17.60. This is because the 10
percent increase in price caused an even greater percentage decrease in quantity demanded. The
elasticity is greater than one. Conversely, if price rises from Birr 1.00 to Birr 1.20, TR increases
from Birr 20.00 to Birr 21.60 because the percentage increase in price is greater than the percentage
decrease in quantity demanded. The elasticity is less than one.

Total revenue, being the product of price and quantity, its function can be obtained by multiplying
the inverse demand function by the quantity.

A demand function that gives quantity as a function of price (Q = f (P)) is called direct demand
function. If the demand function gives price as function of quantity (P = f (Q)), it is called inverse
demand function.

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An inverse demand function is given as P  a  bQ

TR  P  Q

TR  ( a  bQ )Q

TR  aQ  bQ 2

Here, total revenue is a quadratic function. At the maximum point of the function its slope is zero.

The slope of any function is the first derivative of that function.

dTR
Slope of TR =  a  2bQ
dQ
At the maximum point of TR, a  2bQ  0
a
Q
2b
Let’s show the relationship between TR and price mathematically.
TR  P  Q
TR P Q
 Q  P
P P P
TR Q
Q P
P P
TR  Q P 
 Q1   
P  P Q 

Q P
But   
P Q
TR
 Q (1  e )
P
TR
If e  1 ,  0 . This implies that rise in price leads to fall in TR.
P
TR
If e  1 ,  0 . This implies that rise in price leads to rise in TR.
P
TR
If e  1 ,  0 . This implies that rise in price will not affect TR.
P

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Example

1
Suppose a demand function is given as Qd  50  P . Let’s show that total revenue is maximum
2
when  = -1.
The inverse demand function is P  100  2Qd .

TR  100Qd  2Qd2

dTR
Slope of TR =  100  4Qd
dQd
At the maximum point of TR:
100  4Qd  0
Qd  25
At Qd  25 price obtained by substitution into the inverse demand function.
P  100  2(25)  50
Price elasticity of demand is defined as:
P
  slope
Q
1 50
    1 . Therefore,  = -1 when TR is maximum
2 25
b) The Cross- Price Elasticity of Demand
The cross-price elasticity of demand is defined as the proportionate change in the quantity
demanded of one good (say X) resulting from a proportionate change in the price of another good
(say Y) symbolically we have:
dQ x dPy dO x Py
exy  = .
Qx Py dPy Q x

 The sign of the cross- price elasticity of demand is negative if X and Y are complementary
goods and positive if X and Y are substitutes to each other. And if exy = 0, they are unrelated
goods.
 The higher the valve of cross – price elasticity the stronger will be the degree of
substitutability & complementarity of X and Y.

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 The main determinate of the cross elasticity is the nature of the commodities relative t their
uses. If two commodities on satisfy equally well the some need the cross elasticity is high
and vice versa.
Py Demand (DX) Py

Demand (Dx)
0 Qx 0 Qx
Figure 2.30(a): X & Y are substitutes Figure 30(b): X and Y are complementary
c) The Income Elasticity of Demand
It is defined as the proportionate change in the quantity demanded resulting from a proportionate
change in income which represented symbolically as;
dQ dI dQ I
eI = = .
Q I dI Q
 If eI < 0, then the commodity is inferior good
 If eI > 0, then the commodity is normal good
If eI >1, then the commodity is luxury good
If 0< eI <1, then the commodity is necessity good
 If eI =0, then the commodity is income- insensitive (neutral) good
Determinants of Income Elasticity of Demand (eI)
1) The nature of the need that the commodity covers.
2) The initial level of income of a country. For example, a TV (television set) is a luxury in
poor countries while it is necessity in a country with higher per capita income.
3) The time period, because consumption pattern adjusts with a time – lag to change in
income. There is a time – lag in between the change income of the consumer & change in
consumption pattern or behavior of the consumer.

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Relation between Demand, Total Revenue and Marginal Revenue

P
ep=1
A

Q1 Q
TR Demand
A TR reaches maximum
TR

Q1 Q
MR

MR =1
A
Q1 Q
MR
Figure 2.31: Demand, total revenue and marginal revenue curves
Graphically the marginal revenue is the slope of the total revenue cure at any level of output, i.e.,
TR dTR
MR = 
Q dQ
Graphical derivation of MR curve from demand curve
P
D note that in a downward linear
demand curve the MR is less than
the price (demand).
P C A

Demand curve
0 Q1 D
MR
Figure 2.32: Derivation of marginal revenue curve from demand curve

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Mathematical Derivation of Total and Marginal Revenue Functions

TR dTR dPQ
MR=  
Q dQ dQ
dP
MR= P+Q  using multiplication property of derivative
dQ
Let the demand give is linear and represented as:
 Q = bo-b1P
b 1
P = o  Q
b1 b1
bo 1
 TR= PQ= Q  Q2
b1 b1
bo 2
 MR=  Q
b1 b1
2 1
This shows that MR curve is twice steeper than the demand curve (  ) but both the
b1 b1
b
demand curve and the MR curve have the same vertical intercept which is represented by o
b1
at zero consumption level.
Relationship between marginal revenue and Own-Price Elasticity of demand
P=f (Q)
TR= PQ = Q f (Q)
TR dTR dPQ d [ f (Q)Q]
MR=   
Q dQ dQ dQ
dP
MR = P+ Q . But the price elasticity of demand is defined as:
dQ
dQ P Q
ep =  (By multiplying both sides by )
dP Q P
P dP
  By taking the reciprocal of the ratios in two sides
e p Q dQ
dP  1
Substituting in the expression of the MR we find MR = P 1   . This is a crucial
dQ  e p 
relationship for the theory of pricing and business decision making.
We said that if the demand curve is falling then the TR curve initially increases, reaches a
maximum, and then starts declining we can use the earlier derived relationship between MR, P and
ep to establish the shape of the total revenue curve.

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 The total revenue curve reaches its maximum level at the point where ep = 1, because
1
[1  ]
at this points its slope, the marginal revenue is equal to zero, MR = P ep = 0

 If e >1, the total revenue curve has a positive slope, i.e. it is still increasing, and hence
1
has not reached its maximum p>0 and [1  ] > 0 hence MR > 0
ep

 If e <1, the total revenue curve has a negative slope that is, it is falling given that P>0
1
and [1  ] < 0; hence MR<0
ep

We may summarize the result as follows:

1. If the demand is inelastic (e < 1), an increase in price leads to fall in total revenue and
decrease in price leads to fall in total revenue.
2. If the demand is elastic (e > 1), an increase in price will result in a decrease of the total
revenue, while a decrease in price will result in an increase in the total revenue
3. If the demand has unitary elasticity, total revenue is not defected by changes in price
since (e =1) and MR = 0
Table 2.5: The relationship change in price, TR and price elasticity of demand (ep)
Changes Elasticity Changes in total
in price (ΔP) (ep) Revenue (ΔTR)
Price increase e >1 Decreases
Price decrease e >1 Increases
Price increase e<1 Increase
Price decrease e<1 Decrease
Price increase e =1 No change in TR
Price decrease e =1 No change in TR

Summary

 Total utility is the total amount of satisfaction expected from consuming an item.

 Marginal utility is the addition to total utility from consuming one more unit of a good.

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 Consumers, in deciding among items, choose those items with the highest marginal utility
per a unit of money (Birr).

 An individual maximizes total utility by consuming all items so that the marginal utilities
per Birr spent are equal.

 Consumer surplus is a measure of the benefits derived from a purchase in excess of the
price that is paid.

 Indifference curve shows combinations of goods that yield equal amounts of satisfaction.
The slope an indifference curve shows the marginal rate of substitution between goods.

 Diminishing marginal rate of substitution means that as more of one good is substituted
for another, its value in terms of the other good declines.

 A budget constraint is represented by a budget line which shows the combinations on

consumption bundles that are attainable at a given level of income and a given set of
prices.

 The position of a budget line changes as income or prices change. A change in income is
represented by a parallel shift of the budget line. A price change is represented by moving
the intercept of the goods whose price has changed; this changes the slope of the budget
line.

 When price falls, the quantity demanded increases because of income effects and
substitution effects. The substitution effect is a result of the change in relative prices. The
income effect comes about because real income changes as prices change.

 The amount of a commodity that households wish to purchase is called the quantity
demanded. It is determined by commodity’s own price, the price of related commodities,
consumers’ income, tastes, and size of population.

 Quantity demanded is negatively related to price, ceteris paribus. The relationship

between price and quantity demanded is graphically shown by the demand curve. The
effect of change in price is given by movement along the demand curve.

 Any change in all factors that affect demand except commodity’s own price cause shift of
the demand curve. This represents a change in demand. The demand curve of a normal

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good shifts to the right (an increase in demand) if income rises, population size rises, if
price of substitutes rises, if price of complements falls, or if there is a change in tastes in
favor of the product. The opposite changes shift the demand curve to the left (a decrease
in demand).

 The amount of a commodity that firms wish to sell is called the quantity supplied. It
depends on the commodity’s own price, the costs of inputs, the number of firms, and the
state of technology.

 Quantity supplied is positively related to price, ceteris paribus. The relationship between
price and quantity supplied is graphically shown by the supply curve. The effect of
change in price is given by movement along the supply curve.

 A shift in supply curve indicates a change in the quantity supplied at each price and is
referred to as a change in supply. The supply curve shifts to the right (an increase in
supply) if the costs of producing the commodity fall or if, for any reason, producers
become more willing to produce the commodity.

 The equilibrium price is the one at which the quantity demanded equals the quantity
supplied. Graphically, it is shown by the point of equality of the demand curve with the
supply curve.

 At any price below the equilibrium price, there will be excess demand and at any price
above the equilibrium price, there will be excess supply.

 With supply remaining the same, increase in demand causes rise in equilibrium price.
Fall in demand, on the contrary, causes fall in equilibrium price.

 With demand remaining the same, increase in supply causes fall in equilibrium price
while decrease in supply brings forth rise in equilibrium price.

 Price elasticity of demand measures the extent to which the quantity demanded of a
commodity responds to a change in its price. It is defined as the percentage change in
quantity demanded divided by the percentage change in price. It ranges between zero and
infinity.

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 The main determinants of price elasticity of demand are the availability of substitutes for
the commodity and the time period involved for adjustment. A commodity that has close
substitutes will have elastic demand. Similarly, the longer the time for adjustment, the
higher will be elasticity.

 Cross elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in the price of some other commodity. Positive cross elasticity implies
that the products are substitutes while a negative cross elasticity indicates that the
products are complementary.

 Income elasticity of demand measures the percentage change in quantity demanded due
to a given percentage change in consumers’ income. If a commodity has positive income
elasticity, it is referred to as a normal good. If income elasticity is negative, then, the
commodity is inferior.

Self-Check Exercise

i) Review your understanding of the following terms

Demand function Supply curve

Demand curve Market supply

Market demand Price elasticity of supply

Price elasticity of demand Market equilibrium

Income elasticity of demand Excess demand

Cross elasticity of demand Excess supply

Supply function

ii) Multiple Choice Questions

1. Choose the correct statement.
a) An increase in input prices will increase the supply of a good, ceteris paribus.
b) The supply for a good will not change as a result of changes in the price of the good
itself, ceteris paribus.
c) Other things constant, supply of a good will increase as sellers expect lower price for
their commodity in the future.

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d) Fall in the number of producers increases the supply of a good.

e) None
2. Availability of substitutes
a) Increases with the broadness of the definition of the good.
b) Increases with the narrowness of the definition of the good.
c) Is not affected by such definitions.
d) May increase or decrease even with the narrowness of the definition.
e) None
3. In Harar stadium, the number of people watching a given football match is usually less than
the capacity it can accommodate. Which of the following means enable to increase the
number of people and simultaneously generate more revenue?
a) Lowering the price of tickets if the demand for tickets is inelastic.
b) Lowering the price of tickets if the demand for tickets is elastic.
c) Raising the price of tickets if the demand for tickets is elastic.
d) Raising the price of tickets if the demand for tickets is inelastic.
e) None
4. If good X and Y are substitutes, a decrease in the price of good Y would cause,
a) The demand curve for good Y to shift to the right.
b) The demand curve for good X to shift to the left.
c) The demand curve for good Y to shift to the left.
d) The demand curve for good X to shift to the right.
e) B and C
5. If a firm’s demand increases and its supply decreases, one of the following is necessarily
true.
a) The equilibrium price and quantity will both rise.
b) The equilibrium price will rise.
c) The equilibrium output will rise.
d) Equilibrium output will fall.
e) None.

iii) Workout Questions

1. The demand and supply functions that a firm faces are given by:
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Qd = 40 – 2P
Qs = 10 + P
a) Find the equilibrium price and quantity.
b) Show the effect on equilibrium if the supply curve shifts to Qs  15  3P .

2. Find the equilibrium price and quantity if demand and supply functions are given as
P  32  Q 2 and P  Q 2  4Q  16 respectively.
3. Find the price elasticity of supply at price of Birr 8 if the supply function is:
Q = 25 – 4P + P2
What is elasticity at Birr 4 and at Birr 5? Interpret the result.
4. Suppose that Q  200  2 P 2 units of a commodity are demanded when Birr P per unit is
charged.
a) Calculate the elasticity of demand when the price is P = 6. Interpret the result.
b) At what price is elasticity of demand equal to -1?
5. The demand function is given by Q = 10 – P near the point Q = 4 and P = 6. If the price
increases by 5%; determine the percentage decrease in demand and hence an approximation to
the elasticity of demand.
Compare the result with the correct value of elasticity of demand corresponding to Q=4.

iv) Discussion Questions

1. Would the elasticity of demand for Coca Cola be higher or lower than the elasticity of
demand for soft drinks? Why?

2. If the government wants to place a tax on a certain commodity for the purpose of generating
revenue, should it look for goods that have relatively inelastic or relatively elastic demand
curves?

Suggested Reading Materials

Lipsey R. G., Courant P. N., Purvis D. D., and Steiner P. O., Microeconomics, 10th ed. New York:
Harper Collins College Publishers, Inc., 1993.

Amacher R. C., and Ulbrich H. H., Principles of Microeconomics, 3rd ed. Ohio: South-Western
Publishing Co., 1986.

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Stanlake G. F., and Grant S. J., Introductory Economics, 6th ed., Singapore, Longman, 1995.

Gould J. P. and Lazear E. P., Microeconomic Theory, 6th ed., Homewood, Richard D. Irwin, Inc.,
1998.

Koutsoyiannis A., Modern Microeconomics, 2nd ed., English Language Book Society, Macmillan,
1985.

Varian H. R., Intermediate Microeconomics, 3rd ed., New York, Norton & Company, 1993.

Additional readings:

 Ahuja, H. microeconomics theory and applications

 Hiwot & Hibret, microeconomics I
 Ayele K., microeconomics part I
 Salvatore D., microeconomics theories and applications
 H.S. Agrawal, Principles of Economics, 7th edition.
 C. Ferguson, Microeconomic Theory
 R.S Pindyck and D.L. Rubinfield, Microeconomics
 E. Mansfield, Microeconomics: Theory and Applications
 Robert H. Frank, Microeconomics and Behavior

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CHAPTER 3: CHOICE – INVOLVING RISK AND UNCERTAINTY

Introduction

Dear learner our discussion of consumers’ choice in chapter two the Neoclassical utility analysis
studies have assumed about the individual’s behavior in regard to the choice among quite certain
and riskless alternatives. In their study a consumer face no uncertainties regarding the availabilities
of commodities, their prices and the size of his income and so forth. With full knowledge and
information about these things, the consumer makes his choice and maximization his utility from
his given money income. As we have seen in our previous chapter, indifference curve analysis of
Hicks and Allen gives up the cardinal measurability of utility analysis confine themselves to
individual’s choice among riskless alternatives, that is, when individual faces no uncertainties
regarding the availability of commodities, prices charged and the size of his income, etc.

Many of the choices that people make involve considerable uncertainty. For instance, most people
borrow money to finance large purchases, such as houses, a car and the like and plan to pay for
the purchase out of future income. But for most people future income is uncertain. Their earnings
can go and up or down: they can be promoted, demoted or even lose their jobs. Or if they delay
buying a house or a car, they face risk of having its price rise in real terms, making it harder to
afford in the future. How should they take these uncertainties into account when making major
consumption or investment decisions?

Sometimes we must choose how much risk to bear. What, for example, should we do with your
savings? Should we invest our money in something safer, like a saving account, or something
riskier but potentially more rewarding, like an investment? Another example is the choice of a job
or even a career. Is it better to work for a large, stable company where a security is good but the
chances for advancement are limited, or to join (or form) a new venture, which offers less job
security but more opportunity for advancement?

Another example, if an individual chooses alternative A, and has one chance in four of ending up
with birr 5000, three chances in four ending up with birr 50. In such situations involving
probabilities (i.e, risky and uncertain situations) Von Neumann and Morgenstern felt it necessary
to go beyond ordinal ranking of the various alternatives and to construct a utility measure

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(popularly known as N-M indexes) for assigning numbers of various risky and uncertain
alternatives.

To answer questions such as these, we must first be able to quantify risk so we can compare the
riskless alternative choices. We therefore begin this chapter by discussing about calculating
expected value and measures of risk. Afterwards, we will examine peoples’ attitude (i.e.,
preferences) towards to risk. Next, we will see how people can deal with risk.

Chapter Objectives
Dear learner let us start our discussion with the concept how consumers make optimal decision
when they are not sure the likely returns of their choice. We will also examine the way how
consumers behave in case of uncertainty about future events and the consequent risk involved in
expected returns.

After completing this chapter, therefore, you will have

 Understand the concept of expected utility and be able to calculate the expected returns
using the concept of probability
 Distinguish between risk and uncertainty
 Different preferences toward risk, such as risk averse, risk neutral and risk loving,
 Learn how to diversify risk
Brainstorming Questions

1. What do you think is risk and uncertainty?

2. Do you like taking risk?

3.1 Expected Utility

According to Daniel Bernoulli1 , a rational individual will take decisions under risky and uncertain
situations on the basis of expected utility rather than expected monetary value. He further
contended that the marginal utility of money to the individual declines as he has more of it. Since
the individual behaves on the basis of expected utility from the extra money he wins in a game and
the marginal utility of money to him declines as he has extra money, a rational individual will not
play the game, that is, will not make bets.

1
D. Bernoulli, Exposition of a New Theory on the Measurement of Risk, Econometrica, Jan 1954

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The expected value (or expectation) associated with an uncertain situation is a weighted average
of all possible outcomes, with probabilities of each outcome used as weights. The expected value
measures the central tendency, i.e., the outcome that would expect on average. Expected value
measures the mean value of all possible outcomes.

Interpreting Probability

– Probability is the likelihood that a given outcome will occur

Objective Interpretation

• Based on the observed frequency of past events

Subjective interpretation

• Based on perception or experience with or without an observed frequency

– Different information or different abilities to process the same information can

influence the subjective probability

That is, the probability of a repetitive event happening is the relative frequency with which it will
occur. That is, it refers to the likelihood that an outcome will occur.

– The probability of obtaining a head on the fair-flip of a coin is 0.5

• If a lottery offers n distinct prizes and the probabilities of winning the prizes are i (i=1,n) then
n

 i 1
i 1
For example, a lottery (X) with prizes X1,X2,…,Xn and the probabilities of winning 1,2,…n, the
expected value of the lottery is
E(X) 1x1 2x2 ...nxn
n
E(X) ixi
i1
• Suppose that Smith and Jones decide to flip a coin
-heads (x1)  Jones will pay Smith $1

-tails (x2)  Smith will pay Jones $1

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From Smith’s point of view and, more generally, if there are two possible outcomes
having values X1 and X2 and the probabilities of each outcome are given by 1 and
it 2, then the expected value denoted by E(X) is given by

E(X) 1x1 2x2

1 1
E( X )  ($1)  ($1)  0
2 2
Suppose, for example, that you are considering where to invest in private drilling exploration under
establishment. Let the price of a stock, before it starts operation, is birr 300 per share. Suppose that
if the said company becomes successful, its stock price will increase from Birr 300 to 400 per
share; if not , it will fall to birr 200 per share price. Thus, there are two future outcomes, a birr 400
per share price and a birr 200 per share price. Thus, the return from the investment is in this case
is risky since it entails the chance of either losing or gaining. In order to make a choice in this
situation an individual need to know, among other things, the probability of various outcomes, the
expected value and variability of choice.

That is, two outcomes are possible

– Success -- the stock price increase from birr300 to birr 400/share

– Failure -- the stock price falls from birr300 to birr200/share

– 100 explorations, 25 successes and 75 failures

– Probability (Pr) of success = 1/4 and the probability of failure = 3/4

EV  Pr(success)(birr400 / share)  Pr(Failure)(birr200 / share)

1 3
EV  (birr400 / share)  (birr200 / share)
4 4

EV  bir 250 / share

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Note that we have limited the expected outcome to two only for simplicity purpose. In general, if
there are n outcomes having values of X1, X2, ………..Xn with the Probability given by 1,
2........and n, then the expected (average) value is given by

EV= 1X1+2X2+1X3+……….+1Xn

Self Review Question 3.1

1. What do you mean by expected value?

2. Suppose that you are planning to invest in a particular project. If the project is successful,
you will get birr 10000 next year. If not, your return is birr 5000. Calculate the expected
income if the probability of success is 0.30 and failure 0.70.
Expected Utility

• Individuals do not care directly about the dollar values of the prizes
– They care about the utility that the dollars provide
• If we assume diminishing marginal utility of wealth, the St. Petersburg game may converge
to a finite expected utility value
– This would measure how much the game is worth to the individual
Expected utility can be calculated in the same manner as the expected value
n
E ( X )    iU ( xi )
i 1
Because utility may rise less rapidly than the dollar value of the prizes, it is possible that expected
utility will be less than the monetary expected value.

The von Neumann-Morgenstern Theorem

– Suppose that there are n possible prizes that an individual might win (x1,…xn)
arranged in ascending order of desirabilityx1 = least preferred prize  U(x1) = 0
– xn = most preferred prize  U(xn) = 1
• The point of the von Neumann-Morgenstern theorem is to show that there is a reasonable
way to assign specific utility numbers to the other prizes available
• The von Neumann-Morgenstern method is to define the utility of xi as the expected utility
of the gamble that the individual considers equally desirable to xi
U(xi) = i · U(xn) + (1 - i) · U(x1)

• Since U(xn) = 1 and U(x1) = 0

U(xi) = i · 1 + (1 - i) · 0 = i

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• The utility number attached to any other prize is simply the probability of winning it
• Note that this choice of utility numbers is arbitrary
Expected Utility Maximization

A rational individual will choose among gambles based on their expected utilities (the expected
values of the von Neumann-Morgenstern utility index)

• Consider two gambles:

– first gamble offers x2 with probability q and x3 with probability (1-q)
Expected utility (1) = q · U(x2) + (1-q) · U(x3)

– Second gamble offers x5 with probability t and x6 with probability (1-t)

Expected utility (2) = t · U(x5) + (1-t) · U(x6)

• Substituting the utility index numbers gives

Expected utility (1) = q · 2 + (1-q) · 3

Expected utility (2) = t · 5 + (1-t) · 6

• The individual will prefer gamble 1 to gamble 2 if and only if

q · 2 + (1-q) · 3 > t · 5 + (1-t) · 6

If individuals obey the von Neumann-Morgenstern axioms of behavior in uncertain situations,

they will act as if they choose the option that maximizes the expected value of their von
Neumann-Morgenstern utility index

Describing Risk and Uncertainty

Uncertainty refers to a situation in which all possible outcomes cannot be in which all possible
outcomes can be listed with unknown probabilities. On the other hand, risk describes a
situation in which all possible outcomes can be listed with known probabilities. Note that to
describe risk quantitatively, we need to all the possible outcomes and the likelihood
(probabilities) that each outcome will occur. In your previous discussion, for example, you
were considering where to invest in private drilling exploration under establishment. If the said
company has become successful, its stock price would increase from Birr 300 to 400 per share;
if not, it would fall to birr 200 per share price. Thus, there are two future outcomes, a birr 400
per share price and a birr 200 per share price. Consequently, the return from the investment is

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in this case is risky since it entails the chance of either losing or gaining. In order to make a
choice in this situation an individual need to know, among other things, the probability of
various outcomes, the expected value and variability of choice.

Decision Making Using Expected Utility

Decisions made by individuals are not usually the same. This is because people differ in their
attitude towards to risk. Suppose you are choosing between the sales jobs described below
example. Which job would you take? If you dislike risk, you will take the second job. It offers the
same expected income as the first but with less risk. A risk loving person may choose job 1. In
both cases attitudes towards risk depends on the utility that an individual derives from the two
alternatives. For example, a risk lover person will choose job one the utility he derives from such
job is higher than the other choices.

Suppose if you are choosing between two part-time sales jobs that have the same expected income
($1,500)

– The first job is based entirely on commission.

– The second is a salaried position.
 There are two equally likely outcomes under the first job--$2,000 for a good sales
job and $1,000 for a modestly successful one.
 The second job pays $1,510 most of the time (.99 probability), but you will earn
$510 if the company goes out of business (.01 probability
Table: 3.1. Summaries these possible outcomes and their probabilities;

Income from Sales Jobs

Outcome 1 Outcome 2 Expected
Income Probability Income Income
Probability
($) ($)
Job1: 0.5 2000 0.5 1000 1500
Commission
Job1: Fixed 0.99 1510 0.01 510 1500
Salary

Job 1: Expected Income E(X1)=0.5($2000)+0.5)($1000)=$1500

Job 2: Expected Income E(X2)=0.99($1510)+0.01)($510)=$1500

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Decision Making

– A risk averter would choose Job 2: same expected income as Job 1 with less risk.
– Job 1: expected income $2,000 and a standard deviation of $500.
– Job 2: expected income of $1,510 and a standard deviation of $99.50

3.2 Risk Aversion

Attitude toward risk

We used a job examples to describe how people might evaluate risky outcome, but the principles
apply equally well to other choices. In this section, we concentrate on consumer choices based on
the utility that consumers obtain from choosing among risky alternatives. Note that people differ
in their willingness to bear risk. Some are risk averse, some are risk loving and some are risk
neutral. We can define these different attitudes towards risk and also draw the corresponding utility
function. In general:

Risk Averse: A person who prefers a certain given income to a risky income or risky job with the
same expected value. A person is considered risk averse if he has a diminishing marginal utility of
income. The use of insurance demonstrates risk aversive behavior.
For example, from the following figure 3.2, that the level of utility increases from 10 to 16 to 18
as income increases from $10,000 to $20,000 to 30,000. But note that marginal utility is
diminishing, falling from 10 when income increases from 0 to $10,000, 6 when income increases
from $10,000 to $20,000, to 2 when income increases from $20,000 to $30,000.

 Now suppose that a person is earning $15,000 and receiving 13 units of utility from the
job, she is considering a new, but risky job that will either double her income to $30,000
or cause it to fall to $10,000. Each possibility has a probability of 0.5.
 Notice that from figure 3.2 below that the individual derives a utility level of 16 if she
chooses the certain (for sure) income of $20,000. Therefore, for decision making the
risky job must be compared with the current job, for which the utility is 16 (at D).
To evaluate the new job, we need to calculate the expected value of the resulting income. Because
we are measuring value in terms of the person’s utility, we must calculate the expected utility she
can obtain. That is;

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 Risk Averse: A Scenario

– A person can have a $20,000 job with 100% probability and receive a utility level
of 16.

– The person could have a new, but risky job with a .5 chance of earning $30,000 and
a .5 chance of earning $10,000.

 Expected Income = (0.5) ($30,000) + (0.5) ($10,000) = $20,000

 Expected income from both jobs is the same -- risk averse may choose current job

 For risky job, we need to calculate its expected utility since we are not sure of specific
income individual will get from the risky job. The expected utility, (E(u)), from the new
job is found:

 E(u) = (1/2) u ($10,000) + (1/2) u ($30,000)

 E(u) = (0.5) (10) + (0.5) (18) = 14

 The expected utility from the risky job is 14 as represented at point E.

 E(u) of Job 1 is 16 which is greater than the E(u) of Job 2 which is 14.

Note that the new risky job is not preferred to the original job because the expected utility of 14 is
less than the original utility of 16. This individual would keep their present job since it provides
them with more utility than the risky job. She is said to be risk averse.

Note that the risk aversion is the most common attitude toward risk. For example, in your area, the
vast numbers of people are risk averters most of the time. They not only buy life insurance, health
insurance, and car insurance but also seek occupations with relatively stable wages

Figure 3.1: Risk averse

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Risk Neutral

On the contrary, a person is said to be risk neutral if they show no preference between a certain
income, and an uncertain one with the same expected value. In figure 3.2, the utility associated
with a job generating an income of either $10,000 or $30,000 with equal probability is 12, and this
is a utility of receiving a certain income of $20,000. The utility level for the risky and safe job is
equal. Because choice depends on utility, an individual be indifferent in this situation.

Figure 3.2: Risk neutral

Risk Loving Attitude

A person is said to be risk loving if they show a preference toward an uncertain income over a
certain income with the same expected value. Examples: Gambling, some criminal activity.

The following figure 3.4 shows the third possibility-risk loving. That is a person has a certain
income of income of $20,000, he derives a utility level of 8. On the other hand, if the individual
considers a risky new job that has a possible income of $30,000 0r $10,000 with probability of 0.5
for each.

The expected value from the risky job is given by the expected utility. That is;

 E(u) = (1/2) u ($10,000) + (1/2) u($30,000)

 E(u) = (0.5) (3) + (0.5) (18) = 10.5

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In this case, the expected utility of an uncertain income (which is 10.5) is higher than the utility
associated with a certain income of $20,000 (which is 8). That is the level of utility 10.5 is greater
than utility level 8 that she could obtain with certain income of $20,000.

Figure 3.3: Risk loving

Risk Premium

The risk premium is the amount of money that a risk-averse person would pay to avoid taking a
risk.

 Risk Premium: A Scenario

– As shown from the previous Figure 3.2 above, the person has a .5 probability of
earning $30,000 and a .5 probability of earning $10,000 (expected income =
$20,000).
– The expected utility of these two outcomes can be found:
E(u) = .5(18) + .5(10) = 14

Now the question is, how much would the person pay to avoid risk?

Here, the risk premium is $4,000 (i.e, $20,000-$16,000) because a certain income of $16,000 gives
the person the same expected utility as the uncertain income that has an expected value of $20,000.

– Variability in potential payoffs increase the risk premium.

– Example:
 The expected income is still $20,000, but the expected utility falls to 10.

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 Expected utility = .5 u($) + .5u($40,000)

= 0 + .5(20) = 10

 The certain income of $20,000 has a utility of 16.

 If the person is required to take the new position, their utility will fall by 6.
 The risk premium is $10,000 (i.e. they would be willing to give up $10,000 of the $20,000
and have the same E(u) as the risky job.
Therefore, it can be said that the greater the variability, the greater the risk premium. A job has a
.5 probability of paying $40,000 (utility of 20) and a .5 chance of paying 0 (utility of 0).

3.3 Reducing Risk

Reducing risk by allocating resources to variety of activities whose outcomes are not closely
related which is in line with or supports the old saying “don’t put all your eggs in one basket”.

Three ways consumers attempt to reduce risk are: Diversification and Insurance

1. Diversification
Suppose a firm has a choice of selling air conditioners, heaters, or both.

– The probability of it being hot or cold is 0.5.

– The firm would probably be better off by diversification.

Income from Sales of Appliance

Hot Weather Cold Weather
Air conditioner sales $30,000 $12,000
Heater sales $12,000 $30,000
*0.5 probability of hot or cold weather

 If the firms sell only heaters or air conditioners their income will be either $12,000 or
$30,000.

 Their expected income would be:

– 1/2($12,000) + 1/2($30,000) = $21,000

– If the firm divides their time evenly between appliances their air conditioning and
heating sales would be half their original values.

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– If it were hot, their expected income would be $15,000 from air conditioners and
$6,000 from heaters, or $21,000.

 If it were cold, their expected income would be $6,000 from air conditioners and $15,000
from heaters, or $21,000.

 With diversification, expected income is $21,000 with no risk

 Firms can reduce risk by diversifying among a variety of activities that are not closely
related.

2. Insurance:
We have seen that risk-averse people will be willing to give up income to avoid risk (which is
referred to as risk premium). If the cost of insurance equals the expected loss, risk averse people
will buy enough insurance to recover fully from a potential financial loss. While the expected
wealth is the same, the expected utility with insurance is greater because the marginal utility in the
event of the loss is greater than if no loss occurs. Purchases of insurance transfers wealth and
increases expected utility.

 Assume:
– 10% chance of a $10,000 loss from a home burglary
– Expected loss = .10 x $10,000 = $1,000 with a high risk (10% chance of a $10,000
loss)

The Decision to Insure

Insurance Burglary No Burglary Expected Standard

(Pr=0.1) (Pr=0.9) wealth Deviation

No $40,000 $50,000 $49,000 $9,055

Yes $49,000 $49,000 $49,000 $0

3.4 Risk Spreading

While the expected values are the same, variability is not. Greater Variability from expected
signals greater risk.

Variability

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Whenever a choice involves risk the other concept the we must make us about it is Variability. Let
your take our previous example and suppose if you are choosing between two part-time sales jobs
that have the same expected income ($1,500)

– The first job is based entirely on commission.

– The second is a salaried position.
 There are two equally likely outcomes under the first job--$2,000 for a good sales
job and $1,000 for a modestly successful one.
 The second job pays $1,510 most of the time (.99 probability), but you will earn
$510 if the company goes out of business (.01 probability
Deviation is difference between expected payoff and actual payoff (income). That is;

Deviation: Xi-E(Xi)
Deviation from Expected Income
Outcome Deviation Outcome Deviation Expected
1 2 Income
Job1: $2000 $500 $1000 -$500 $1500
Commission
Job1: Fixed $1510 $10 $510 -$990 $1500
Salary
Adjusting for negative numbers, the standard deviation measures the square root of the
average of the squares of the deviations of the payoffs associated with each outcome from
their expected value

  Pr 1 X 1  E ( X ) 2
  Pr 2 X 2  E ( X ) 2

Calculating Variance ($)
Outcome Deviation Outcome Deviation Standard
1 square 2 square Deviation
Job1: 2000 250000 1000 250000 500.00
Commission
Job1: Fixed 1510 100 510 980100 99.50
Salary
 The standard deviations of the two jobs are:
 1  .5($250,00 0)  .5($250,00 0
 1  $ 250 , 000
 1  500
 2  .99($100)  .01($980,1 00)
 2  $ 9 , 900
 2  99 . 50

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Summary
Many of that people make involve considerable uncertainty and entails risk in it. We saw how a
consumer should take these uncertainties in to account when making major decisions. Uncertainty
refers to situations in which all possible outcomes can be listed with unknown probabilities while
risk describes situations in which all possible outcomes can be listed with known probabilities.

Consumers’ choices are primarily based on the utility that they drive from choosing among risky
alternatives. However, because people differ in their attitude to risk, decisions made by individual
are not usually the same. Some are risk lovers, some are risk averse, and some are risk neutral.
Thus, an individual makes choice by comparing the utility that he/she derives from a certain return
and uncertain one. The existence of consumers with risk averse attitude makes them pay (or give
up) some amount of money to avoid taking a risk. This is called risk premium whose magnitude
depends in general on the risky alternatives that the person face. In addition to this the methods
employed to minimize risks are diversification and arranging insurance services

Self-Check Exercise

1. A person attitude to risk depends on the utility he/ she derives. Discuss
2. Under what condition do we say that a person is risk take?
3. Describe the role of diversification and insurance scheme in reducing risk.
Suggested Reading Materials

 H.R. Varian, International Microeconomics: A Modern Approach, 4th ed.

 R.S. Pindyck and Rubinfeld, Microeconomics

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CHAPTER 4: THEORY OF PRODUCTION

Introduction

Dear learner this chapter in general focuses on the firm’s production technology, which describes
the physical relationship how inputs (labour, capital, etc.) are transformed in to outputs (such as
cars, wheat, maize, television etc.). Most of the time production technology is represented by
production function. In production process, firms turn inputs into outputs. Inputs, which are also
called factors of production, include anything that the firm must use as part of the production
process. For example, for a bakery, inputs include the labour of its worker, raw materials such as
flour and sugar; and the capital invested in its ovens, mixers, and other equipment to produce such
out puts as bread, cakes and pastries. This chapter deals with the supply side of the market and the
behavior of the producer in the market. It also focuses on:

 How firms produce efficiently?

 How their cost changes due to the change in the prices of factors (inputs) and the change
in the level of production?
 How a firm optimize in production? How this optimization decision is related to the
optimization decision of consumer.
Chapter Objectives

At the end of this unit, you should be able to

 Define production function;

 Derive average product and marginal product from total product schedule;
 Differentiate between short run and long run production functions;
 Define the principle of diminishing returns;
 Identify the efficient stage of production in the short run and in the long run;
 Define increasing, constant and decreasing returns to scale;
 Define isocost lines;
 Determine the least cost (profit maximizing) method of production both in the short run
and in the long run; and
 Define short run and long run expansion paths.

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Brainstorming Questions

1. What do you think is production?

2. How firms decide on how much quantity of inputs to use?

4.1 Production Function

The relationship between the input to the production process and the resulting output is described
by a production function. A production function indicates the highest output (Q) that a firm can
produce for every specified combination of inputs. For simplicity, we will assume that there are
two inputs, labour (L) and capital (K). We can then write the production function as;
Q = F (K, L) ……………………. equation 1
This production function might describe the crop in tones that a farmer can obtain using a specific
amount of machinery and workers. The production function allows inputs to be combined in
varying proportion, so that output can be produced in many ways. Therefore, output may be
produced using:
 Labour- intensive technique: a technique of production which utilizes more labour with
smaller amount of capital equipment (K/L is lesser).
 Capital- intensive technique: is another technique of production which makes use of more
proportion of capital and lesser amount of labour i.e. K/L will be higher.
Note that equation 1 above applies to a given technology of production. That is, it applies to a
given state of knowledge about the various alternative methods that might be used to transform
inputs to outputs. As the technology become more advanced and the production function changes,
a firm can obtain more output for a given set of inputs. Production functions describe what is
technically feasible when the firm operates efficiently that is, when the firm uses each combination
of inputs as efficiently as possible. The presumption that production is always technically efficient
need not always hold, but it reasonable to expect that profit seeking firms will not waste resources.
Types of Production Functions
The following are important types of production functions in economics.
1. Linear Production Function
This type of production functions is written in the form Q= a + bL. where Q is the level of output
produced, L is the amount of labour used for its production, a and b are parameters which indicate

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the intercept and slop of the production function respectively. For positive values of a and b it can
be shown diagrammatically as:

Q
Q= a + bL

a
0 L
2. Quadratic Production Function
Q= a + bL+cL2 if c<0 and a = 0

Q= a + bL+cL2

0 L
3. Cubic Production Function
Cubic production function can be written as; Q = a + bL +cL2 +dL3, where all the coefficients of
L are parameters and ‘a’ shows the vertical intercept. Graphically,

Q= a + bL + cL2 +dL3

0 L

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4. Cobb- Douglas Production Function

Q = A L K 
  and  Shows the share/ contribution of labour and capital to output.
 A is a scale factor which absorbs the effect of technology.
 The sum of  and  , i.e.,  +  shows the returns to scale exhibited by the
production function (it will be discussed latter in returns to scale).
 If  +  = 1 then the function exhibits constant returns to scale
 If  +  > 1 then the function exhibits increasing returns to scale
 If  +  < 1 then the function exhibits decreasing returns to scale

4.2 Production with one variable input (short run production function)
Because firms must consider, whether inputs can be varied, and if they can, over what period of
time, it is important to distinguish between short run and long run when analyzing production.
Therefore, the short run refers to a period in which one or more factors of production cannot be
changed. In other words, in the short run there is at least one factor that can’t be varied; such a
factor is called fixed input. In a two-input production process, in the short run, only one input is
variable. In a two-input production model, in the short run, the changes in the output (physical
product) are the result of changes in the variable input.

Here we consider capital as fixed and labour as variable factors of production i.e. short run analysis
of production because one factor (K) is fixed. For analysis convenience let us define two words;

4.2.1 Total, Average & Marginal product, & Their Relationship

Q
Average product: is output per unit of a particular input. Average product of labour (APL) =
L

Marginal product: is the additional output produced as input is increased by one unit. Marginal
dQ
product of labour (MPL) =
dL

In general, the average product of labour is given by the slop of the line drawn from the origin to
the corresponding point on the total product curve. However, the product of labour at a point is
given by the slop of the total product at that point.

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Example 1: a hypothetical firm produces wheat using the following production function using
labour as a sole variable factor of production. Q= 20+2L+4L2. Determine

a. The average product of labour if L =10

b. The marginal product of labour if L =1
Q 20  2 L  4 L2
APL= = = 20/L + 2+ 4L = 44
L L

dQ
MPL= = 2+ 8L= 10
dL

Example 2: consider the following table

Amount of Amount of Total out put APL= Q/L dQ

Labour(L) Capital (K) (Q) MPL=
dL
0 10 0 - -
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 -4
10 10 100 10 -8
When we draw graphs of Q, APL and MPL from the information presented in the above table we
can understand their trend and relationships in the short run.

4.2.2 The Law of Diminishing Marginal Returns (LDMR)

(The laws of variable proportions / The laws of diminishing returns to factor)

The law of diminishing marginal return states that as the use of an input (say labour) increases in
equal increments with other input (say capital) fixed, a point will eventually be reached at which
the resulting additions to output decrease. That is why total product curve increases at an increasing
rate, increases at a decreasing rate, reaches maximum and finally starts to diminish as the use of
labour in production process increases.

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When the labour input is small (capital is fixed) extra labour adds considerably to output, often
because workers can devote themselves to specialized skills or specialized tasks. Eventually,
however, the law of diminishing marginal returns applies: when there are too many workers, some
workers become ineffective and the marginal product of labour falls. This law usually applies to
the short run when at least one input is fixed. However, it can also apply to the long run; a manager
still may want to analyze production choices for which one or more inputs are unchanged. Note
that our entire analysis of production, we have assumed that all labour inputs are of equal quality;
diminishing marginal returns results from limitations on the use of other fixed inputs (like capital)
not from the declines in worker’s productivity (assuming homogeneous labour and absence of
wage differential).

The law of variable proportion applies to a given production technique or production technology.
Because overtime, however, inventions and other improvements in technology may allow the
entire total product curve to shift upward, so that more output can be produced with the same factor
inputs.

125 C

120 B

112 A TPL3

TPL2

TPL1

0 8 L

Figure 4.1: The effect of technology on the short run production function

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From the diagram above labour productivity (output per unit of labour) can increase if there are
improvements in the technology, even though any production process exhibits diminishing
marginal returns to labour. As we move from point A on TPL1 to point B on TPL2 to point C on
125 120 112
TPL3 labour productivity increases (   ). Therefore, technology improves the
8 8 8
productivity of the given factors of production (we will discuss this later under technical progress).

4.2.3 Stages in Production

Dear learner, now, we are going to discuss the different stages of production.

The marginal product of a factor may assume a positive, zero or a negative value. However, basic
production theory concentrates only on the efficient part of the production function, that is, on the
range of output over which the marginal product of a factor (labor in our case) is positive. No
rational firm would employ labor beyond 8 as in Figure 4.2, since the increase in labor beyond this
level would result in reduction of total output (MP is negative). Ranges of output over which
marginal product of a factor is negative imply irrational behavior.

We may split the whole production functions into three segments (or stages). Stage I represents a
range over which output grows at an increasing rate causing the MP to rise, therefore, there is no
rationale for a firm to stop its employment over this range because an additional unit of labor
produces more than the previous units. Stage III is one on which output decreases, implying that
employment of additional units reduces output, i.e. MP is negative.

The basic theory of production usually concentrates on the range of output over which the MP of
a variable factor (labor) decreases, but is positive; i.e., the range of diminishing (but non- negative)
productivity of the factor. This range of production is given by AC, which defines Stage II.

Formally, the efficient stage of production is defined by the condition:

Q
MPL   0  MP of labor should be positive.
L
MPL  2Q
 2 < 0  the slope of MP should be negative.
L L

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112 C

B TPL (Q)

stage I stage II stage III

0 3 4 8 L

MPL stage I stage II stage III

APL

10 B’

APL

APL

0
3 4 8 L
MPL
Figure 4.2: Analysis of production in the short run
4.3 Production with Two Variable Inputs (Long Run Production Function)
The long run is the amount of time needed to make all inputs variable. But there is no specific time
period, such as one year, that separates the short run from the long run. Rather, one must
distinguish them on case-by-case basis, which means it depends on the kind, duration and other
basis of production. In general, in the long run all factors of production are variable.

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So far, we have been discussing analysis of production using one variable input but in most of the
time, in reality, production is undertaken by using more than one variable input. Here let us see a
firm’s production function using two variable inputs; labour and capital.
Table 4.1: Production using capital and labor
Capital input Labour input (L)
(K)
1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

Form the above table with different combinations of labour and capital, we can construct an
isoquant. Isoquant is a curve that shows all the possible combinations of inputs that yield the same
output. Each axis in the below diagram measures the quantity of inputs. Theses isoquants are based
on the data given in the above table but have been drawn as smooth curve to allow for the use of
fractional amounts of inputs.
K

Q=90
Q=75
Q=55
0 L
Figure 4.3: Graphical derivation of isoquant
Isoquant map are graphs combining several isoquants, used to describe a production function.
When several isoquants are combined in a plan together they form isoquant map. Note here that
the properties of isoquant are similar to the properties of indifference curve in the theory of
consumer behavior (recall the properties of IC in chapter two).

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4.3.1 Isoquants
1. Two inputs are perfect substitutes to each other/ (production with constant MRTS)
Thus, the rate at which capital and labour can be substituted for each other is the same no matter
what level of input is being used.

Q1 Q2 Q3
0
L
Figure 4.4: Constant MRTS production function

2. If the two inputs are perfect complements to each other (fixed proportion production
function)

K
K= nL
C
r
Q4
Q3
Q2

Q1

C
0 L
w
Figure 4.5: Fixed proportion production function

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In this case, it is difficult to make any substitution among inputs because inputs are combined in a
fixed proportion (each level of output requires specific combination of labour and capital).
Additional output cannot be obtained unless more K and L are added in specific proportions. Points
A, B and C in the following figure represent technically efficient combinations of inputs. On the
vertical and horizontal segment of the ‘L’ shaped isoquant, either MPL or MPK is zero. Higher
output result only when both labour and capital are added, as in the move from input combination
A to input combination B.

The fixed proportions production function describes situations in which methods of production are
limited. These days the production of television show is the best example of complementary inputs
production function. The production of television show might involve a certain mix of labour
(producer, director, actor etc.). To make more television show, all inputs to production must
increase proportionally. In particular, it would be difficult to increase capital inputs at the expense
of labour because actors are necessary inputs to production. Likewise, it would be difficult to
substitute labour for capital, because film making today requires sophisticated film equipment.

[Link] Characteristics of Isoquants

 Given a set of isoquants, the higher to the right an isoquant, the higher the level of output
it represents. Conversely, the lower an isoquant the lower the level of output it represents. This is
because higher isoquants are associated with higher quantity of factors while lower isoquants are
associated with lower quantity of factors.

 Isoquants do not intersect each other. The point at which two isoquants cross each other
implies two different levels of output, which is not possible. In Figure 4.6, isoquants I and II cross
each other at point b. Points a, b and c are located on the same isoquant, therefore, represent the
same level of output. Similarly, points d, b and e are located on the same isoquant, therefore
represent the same level of output. Point d is, however, located to the right of point a; and must
represent a higher level of output. By rule of transitivity, since d represents higher level of output
than a and the same level of output as b, therefore, b must represent higher level of output than a.
Yet, this is not true.

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a d

c I

e II

0 L

Figure 4.6: Non-intersection of Isoquants

[Link] Substitution of Inputs

Dear learner, let us, now, turn to the discussion of substitutability between two factors. Along a
convex isoquant, a firm has to increase the quantity of one factor of production (L) for any fall in
the quantity of the other factor (K) in order to produce the same level of output.

  dK 
The slope of an isoquant   could be defined to show the degree of substitutability of factors
 dL 
of production. It declines in absolute value as we move from left to right along an isoquant. The
slope of an isoquant is called Marginal Rate of Technical Substitution of labor for capital
(MRTSL,K).

 dK MPL
MRTSL,K = =
dL MPK
Proof :
Suppose the production function is given as Q = f (L,K).
Q Q
dQ =  dL +  dK
L K
Along an isoquant output is constant (dQ = 0)
Q Q
dL  dK  0
L K
Q Q
dL   dK
L K

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Q Q
But  MPL and  MPK
L K
MPL dL  MPK dK
dK MPL
   MRTS L , K
dL MPK
As we have seen above, the MPL decreases while MPK increases as we move from left to right
MPL
along a convex isoquant. This causes fall in slope of the isoquant .
MPK

MRTSL,K measures the quantity of capital that must be given up in order to increase the quantity of
labor by one unit, so that output remains the same. In Figure 4.12 above, the movement from point
a to point b involves relatively lower increase in labor (from L1 ro L2) for a given fall in capital
(from K1 to K2). But if capital further decreases by an equal amount (from K2 to K3), labor increases
by higher magnitude (from L2 to L3) to keep output at a constant level. This implies, therefore, the
amount of capital sacrificed for a unit of labor decreases as we move from left to right along an
isoquant.

The substitutability of factors could be considered in relation to the ridge lines. Along the lower
ridge line MPL  0 and MPK is positive. Therefore,

MPL 0
MRTSL,K =  =0
MPK MPK

Since the productivity of labor is zero along the lower ridge line, there is no substitution between
L and K.

Along the upper ridge line MPK  0 and MPL is positive. Therefore,

MPK 0
MRTSK,L =  0
MPL MPL

Similarly, with MPK zero along the upper ridge line, L cannot be substituted by K and vice versa.
Substitution of one factor for the other is possible only between the ridge lines.

In order to understand how MRTSL, K is measured and interpreted, consider the following example.

Suppose the production function that a firm faces is given as Q  2 L  4 K .

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dQ dQ
MPL   2 , and MPK  4
dL dK

MPL
MRTS L , K   1/ 2 .
MPK

This result implies that for a unit rise/fall in labor, capital falls/rises by ½ units.

Dear learner, the marginal rate of technical substitution (MRTSL,K) as a measure of degree of
technical substitutability of factors has a serous limitation. It depends on the units of measurement
of factors. Suppose labor is measured in wage hours and capital is measured in Birr. Further assume
that MPL is 10 units per wage hour and MPK is 5 units per Birr.

10 per wage hour

MRTS L , K   2 wage hour/Birr
5 per Birr

Since MRTSL, K is not a unit free measure of substitution, it becomes impossible to compare MRTSL,
K across firms, industries, or over time if the units of measurement are not uniform. In other words,
comparison would be impossible if, for example, one firm measures MRTS L , K in terms of wage

hour per Birr and another firm uses number of workers per capital hour etc.

A better measure of factor substitution is provided by the elasticity of substitution.

Percentage change in K/L ratio


Percenage change in MRTS L, K

d ( K / L) /( K / L)

d ( MRTS L , K ) /( MRTS L , K )

The elasticity of substation (  ) is a pure number independent of the units of measurement of L

and K, since both the numerator and the denominator are measured in the same units.

Example

Given a Cobb – Douglas production function

Q   0 L1 K  2 ,

it can be shown that elasticity of substitution is unity.

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Q
MPL    0 1 L1 1 K  2
L
1 L1
 1 . . 0 L1 K  2 ; because L1 1 
L L
But  0 L K   Q
1 2

Q
MPL = 1
L
Q
MPK = =  2  0 L K  1 2 1

K
1 K 2
 2.  0 L1 K  2 ; because K  2 1 
K K
But  0 L K   Q
1 2

Q
MPK   2
K
MPL  .(Q / L ) 1 K
MRTSL, K=  1  .
MPK  2 .(Q / K )  2 L
d ( K / L) /( K / L)

d ( MRTS L , K ) /( MRTS L , K )
d ( K / L ) /( K / L )

 K  K
d ( 1 . ) /( 1 . )
 2 L 2 L
 1
The elasticity of substitution of a Cobb-Douglas production function is always 1. This implies that
for a one percent change in MRTSL, K, the factor proportion (K/L) changes by one percent. If both
L and K are assumed normal goods, the sign of  will be negative. This is so because MRTSL, K
rises if MPL rises by a higher percentage than MPK, which induces increase in employment of L
by a higher percentage than K.

[Link] The Efficient Stage of Production

Dear learner, how do you think is the efficient stage of production be determined using isoquants?
Ok. Don’t worry, we will see it together.

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A production function shows the different levels of output that can be produced using different
combinations of inputs. Hence, it is defined by a set of isoquants each of which representing a
different level of output. It shows how output varies as the factor inputs change.

K1 a Q1

K2 b c Q2

K3 Q3

0 L1 L2 L3 L

Figure 4.7: Long run Production Function

Each of the three isoquants in Figure 4.12 above represents distinct level of output with Q1 greater
than Q2 which in turn is greater than Q3.

Dear learner, do you remember what we have said while discussing short-run production function?
We have said that the general theory of production concentrates on ranges over which marginal
product of factors is positive but decreasing. With two variable factors involved in the production
process, the efficient stage of production is that the marginal product of labor and the marginal
product of capital are both positive but decreasing.

Mathematically:

Q Q
= MPL > 0 and = MPK > 0
L K
 2 Q MPL
Slope of MPL =  < 0 and
L2 L
 2 Q MPK
Slope of MPK =  <0
K 2 K
Consider isoquant Q2 in Figure 4.12 above. At point a, the firm uses L1 labor and K1 capital to
produce Q2 output. At point b, the firm uses more labor and less capital to produce the same amount
of output. At point c, the amount of labor required to produce Q2 further increases while the amount
of capital decreases.

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As we move along an isoquant from left to right, the quantity of labor increases while that of
capital decreases; implying increase in productivity of capital and decrease in the productivity of
labor. Eventually, the marginal productivity of labor becomes zero. As we move from right, in
order to produce the same level of output, the firm uses more and more units of capital and less
and less units of labor. This implies that the productivity of labor increases and that of capital
decreases. Eventually the marginal productivity of capital becomes zero.

Figure 4.13 below shows the efficient range of production with a production function involving
two variable inputs (labor and capital). For various levels of output, joining the points at which the
marginal product of labor and the marginal product of capital are zero yields what are called ridge
lines. Along a ridge line either the marginal product of labor or marginal product of capital is zero.

Upper ridge line

Lower ridge line

Q3

Q2

Q1

0 L

Figure 4.8: Efficient Stage of Production

The upper ridge line is formed by joining points on successive isoquants at which MPK is zero.
Similarly, the lower ridge line is formed by joining points on successive isoquants at which MPL
is zero.

Efficient production techniques are those inside the ridge lines. Outside the ridge lines MP of
factors is negative implying that techniques of production in this region are inefficient since they
involve more of at least one factor but not less of the other. The condition of positive but declining
marginal products of the factors defines the range of efficient production (the range in which
isoquants are convex to the origin).

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4.3.2 Returns to Scale

In the long run, with all inputs variable, the firm must also consider the best way to increase
output; one way to so is to change the scale of operation, by increasing all of the inputs to
productions in proportion. If it takes one farmer working with one harvesting machine on one
acre of land to produce 100 bushels of wheat, what will happen to output if we put two farmers,
to work with two machines on two acres of land? Output will most certainly increase but will
it double, more than double, or less than double?
Therefore, returns to scale is the rate at which output increases as inputs are increased
proportionally. Accordingly, we will have three broad categories of returns to scale.

[Link] Constant, Increasing, And Decreasing Returns to Scale

1. Increasing returns to scale
If we increase all the inputs to the production process proportionately, then output will increase by
more than proportionally (if inputs are double, then output increase more than double). This might
arise because the larger scale of operation allows managers and workers to specialize in their task
to make use of more sophisticated, large scale factories and equipment. The automobile assembly
line is a famous example of increasing returns.
K

Expansion path

2K C
B
A 3Q
K 2Q

Q
0 L
L 2L
 From the above diagram, the distance between isoquants along the same K/L become
narrow down (BC<BA<OA). Functionally, suppose we start with initial level of inputs and
out put the production will have the form Q0 = f (L, K) if all the inputs increased by the
same proportion (by m), Q1 = f (mL, mK). If Q1 increases by more than proportionally with
the increase in the factors (L and K), we have increasing returns to scale. If the function is
a homogenous one

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Q1= mv f (L, K) = mvQ0. Here v is the degree of homogeneity or the measure of returns
to scale.
 If V>1 then the function exhibits increasing returns to scale
 If V=1 then the function exhibits constant returns to scale
 If V<1 then the function exhibits decreasing returns to scale
2. Constant returns to scale
In some cases, if all inputs increased by the same proportion, then the final output would be
increased by the same proportion we call such a scenario constant returns to scale. If all the inputs
to the production process are double then output also be double. With constant returns to scale, the
size of the firm’s operation does not affect the productivity of its factors i.e. one plant using a
particular production process can easily be replicated, so that two plants produce twice as much
output. Graphically this can be illustrated as follows,

K Expansion path
3K C

2K B 3Q

K A 2Q

Q
0 L
L 2L 3L
Here, in the case of constant returns to scale the distance between each isoquant is the same i.e.
OA= AB= BC. Functionally this can be easily expressed using Cobb-Douglas production function
as, if Q0 = AL  K  and assume that both labour and capital are increased by an equal proportion
let (say by m) then the new production function will be Q1= A (Lm)  (Km) 
Q1 = (AL  K  ) m    = m    Q0 = mvQ0. Where, V=    which shows the returns to
scale exhibited by the production function.
If V=     1, we have a production function which exhibits increasing returns to scale.

If V=     1 , we have a production function which exhibits constant returns to scale.

If V=     1, we have a production function which exhibits decreasing returns to scale.

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So, in this case the returns to scale of the production is dependent on the sum of  and  .
3. Decreasing returns to scale
When all inputs to the production process are increased by a certain proportion as a result of this
output increases by less than the increase in the inputs, that means as inputs are double output will
be less than double. It applies to some firms with large scale operation. Eventually, difficulties in
organizing and running a large-scale operation may lead to decreased productivity of both labour
and capital. This is because of the fact that as the size of the firm increases, communication
between workers and managers can become difficult to monitor as the work place becomes more
impersonal. Thus, the decreasing returns case is likely to be associated with the problems of
coordinating tasks and maintaining a useful line of communication between management and
workers. Using diagram decreasing returns to scale can be analyzed as follows:
K

Expansion path
6 C

D
4 B Q= 25

Q=20
2 A Q=15

Q=10
0 L
5 10 15
Taking into consideration the previous ways of analyzing returns to scale and degree of
homogeneity, Q1= mv f (L, K) = mvQ0, here ‘v’ is the degree of homogeneity or the measure
of returns to scale is less than one for decreasing returns to scale (v<1). From the above diagram
in order to produce 20 units of output we need to have more than double amount of L and K,
i.e., the distance between each isoquant tend to be wider and wider.

[Link] Determining Returns to Scale from Production Function

Homogeneous functions

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Homogeneity of production functions have interesting implication to the returns to scale implied
by the production functions.

Given a production function

Q0 = f (L, K)

If both inputs are increased by the proportion c and the function can be rewritten in the form

Q1 = f (cL, cK) = cV(L, K)

The function is called a homogeneous function.

Definition: A homogeneous function is a function such that if each of the inputs is multiplied by
c, then c can be completely factored out of the function. The power v of c is called the degree of
homogeneity of the function and is a measure of the returns to scale. It shows by what percentage
output responds to a given percentage increase in both factors.

4.4 If v = 1  constant returns to scale.

4.5 If v > 1  increasing returns to scale.
4.6 If v < 1  decreasing returns to scale.

If, however, c cannot be factored out of the function, the function will be non-homogeneous.

In order to understand the relationship between homogeneity and returns to scale consider the
following equations.

Suppose a production function is defined as Q  LK . If the quantity of both L and K is increased

by a proportion c, the new level of output will be
Q   (cL )  (cK )

Q   c 2 LK
But Q = LK.
Q  c 2Q
Since the exponent (power) of c is 2, this function is said to be homogenous of degree two.

This result implies that an increase in L and K by a proportion c increases output two-fold. To put
it differently, since v >1, the production function exhibits increasing returns to scale.

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4.6.1 Isocost Lines

What do you think is the constraint to be faced by the firm in the production of a given product?
Yes, it is the cost to be incurred in using different factors. In order to show the production
decision of a firm we need to see the constraint that the firm faces. This constraint is given by
isocost lines.

If the production function of a firm is defined as Q = f (L, K), the total cost of the firm consists of
cost on labor and capital. This cost is summarized by the isocost line.

Definition: an Isocost line is a locus of all combination of factors a firm can purchase with a
given monetary outlay. It is given by the cost equation

C  wL  rK

Where, w is price of labor (wages) and r is price of capital (interest rate). The bar over C
indicates constant level of cost.

Isocost lines have the feature that cost of production is constant along an isocost line and that a
higher isocost line represents a higher cost condition than a lower isocost line.

C w
The equation of the isocost line is obtained by solving for K: K =  L
r r

The slope of the isocost line is the ratio of the prices of labor and capital. Slope of isocost line is
dK w

dL r

K
C /r

Isocost line

0 C /w L
Figure 4.9: Isocost Line

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4.6.2 Equilibrium of the Firm

Dear learner, what do you think is the major objective for firms to produce a given product? Ok.
Let us see it together.

The firm’s objective is the maximization of its profit, which is defined as the difference between
revenue and costs, for given factor prices and price of the product.

Definition: a firm is said to be at equilibrium when it maximizes its profit.

Max  = R – C, where  is profit, R is total revenue, and C is total cost.

To maximize its profit, a firm can adopt two approaches;

 Maximizing output for a given cost, factor prices and price of the product this involves
determining the best combination of L and K. which enables the firm to achieve the
highest possible output for any constant level of monetary outlay.
 Minimizing cost for a given output and output price this one involves finding the L and
K combination which costs the firm the least for any constant level of output.

Let us see each approach one by one as follows:

i) Maximization of Output Subject to Cost Constraint

In this case, the equilibrium of the firm is defined at the tangency of the isocost curve with the
highest possible isoquant. For any given cost condition represented by the isocost curve, the
highest attainable level of output is the one represented by the isoquant tangent to the isocost
curve.

K
A
a
K* e III
II
b I
0 L* B L
Figure 4.10: Equilibrium of the Firm: Output Maximization.

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The optimal combination of the two factors L & K is, consequently, given by L* and K* in Figure
4.10 below. Other points along the isocost line such as a and b lie below isoquant II and hence
correspond to lower levels of output. Operation on isoquant III is desirable but is not attainable.
Thus, given isocost AB, the optimal level of output is reached at point e.

w
At point e, the slope of the isoquant (MRTSL, K) is equal to the slope of the isocost line ( ). This
r
constitutes the first condition for equilibrium. The second condition requires that the isoquant be
convex to the origin. If the isoquant is concave, for example, the point of tangency will not
represent equilibrium.

K1
K* e

0 L* L1 L
Figure 4.11: Equilibrium with Concave Isoquant

Figure 4.11 shows what equilibrium would look like if the isoquant were concave. The point of
tangency e does not represent equilibrium of the firm; because the firm can produce the same
level of output at a lower cost by operating either at the vertical intercept of the isoquant (with K1
capital and no labor) or at the horizontal intercept of the isoquant (with no capital and L1 labor).
We have a corner solution in this case.

Formal derivation of the equilibrium

Maximize Q = f (L, K)

Subject to C  wL  rK

The bar over C represents that the level of monetary outlay is constant.

Rewriting the constraint using a Lagrange multiplier  gives

 (C  wL  rK )  0 ; Since C  wL  rK  0

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Here the firm maximizes its output for a given cost constraint, by differentiating the Lagrange
function  with respect to L, K and the Lagrange multiplier .

  Q   (C  wL  rK )
First order condition:
 Q
    w  0
L L
Q MPL
 w   
L w
 Q
    r   0
K K
Q MPK
 r  
K r

 C  wL  rk  0  C  wL  rK

At equilibrium of the firm,
MPL MPK MPL w
=   
w r MPK r
Second order condition:
 2  2 Q  2  2 Q
  0 and  0
L2 L2 K 2 K 2
This second order condition implies that the MPL and the MPK be decreasing, which is the case
in stage II.

At equilibrium, therefore, the slope of the isoquant must be equal to the slope of the isocost
curve. Furthermore, the isoquant must be convex to the origin.

Example

Suppose the production function of a firm is Q  20 L0.7 K 0.3 . If the maximum production
expenditure is Birr 600, wage rate (w) is Birr 20 and interest rate (r) is Birr 30, find the profit
maximizing level of labor and capital employment.

The cost constraint that the firm faces is 600  20L  30K

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MPL w
The first order condition for equilibrium is 
MPK r

Q Q
MPL   14 L0.3 K 0.3 and MPK   6 L0.7 K 0.7
L K

MPL 14 L0.3 K 0.3 7 K

 
MPK 6 L0.7 K 0.7 3L

Therefore, at equilibrium
7 K 20

3L 30
20 3L
K 
30 7
2
K L
7
Substituting this into the constraint function
2
600  20 L  30( L)
7
2
L  21 K (21)  6
7

 2Q  2Q
The second order condition for equilibrium requires that  0 and  0.
L2 K 2

 2Q
2
 4.2 L1.3 K 0.3  0 for all positive L and K.
L
 0.14

 2Q
2
 4.2 L0.7 K 1.7  0 for all positive L and K.
K
 1.68
Since the second order condition is satisfied, the firm will maximize its profit by employing 21
units of labor and 6 units of capital.

ii. Cost Minimization for a Given Level of Output

Dear learner, like the case with output maximization, the equilibrium of the firm in the case of
cost minimization is defined by the tangency of an isoquant with an isocost line.

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The firm wants to produce a given level of output with the least possible cost. Thus, we have a
single isoquant representing a given output level and a set of isocosts each denoting different
cost condition. These isocosts are parallel to one another (have the same slope) because they are
drawn on the assumption of a given factor prices.

The least cost combination of L and K is defined at the tangency e of Figure 4.18. Cost
conditions below e are preferred by a rational producer, but they are not compatible with output
level Q1. Points above e, on the other hand, represent higher cost conditions, therefore, are not
preferred. The least cost combination of factors is defined at point e with K* amount of capital
and L* amount of labor.

K* e
Q1

0 L* L
Figure 4.12: Equilibrium of the Firm: Cost Minimization.

Formal Derivation of Equilibrium

The problem that the firm faces in this case is given as
Minimize C = wL + rK
Subject to Q = f (L, K)
Rewriting the constraint, we have  (Q  f ( L, K ))  0 .
  C   (Q  f ( L, K ))
  wL  rK   (Q  f ( L, K )
First order condition:
 f ( L, K ) Q
=w = 0; (because Q is a constant and  0)
L L L
f ( L, K )
 w
L
 f ( L, K ) Q
 r   0 ; (because Q is a constant and  0)
K K K

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f ( L, K )
r
K

 Q  f ( L, K )  0

 Q  f ( L, K )
f ( L, K )
w   MPL
L
MPL
 
w
f ( L, K )
r =  MPK
K
MPK
 =
r
At the firm’s equilibrium
MPL MPK MPL w
  =
w r MPK r
This equilibrium condition implies that the ratio of the MP of labor and capital (slope of the
isoquant) must be equal to the ratio of prices of factors L and K (slope of the isocost line).

Second order condition:

 2  2 f ( L, K )  2 f ( L, K )  2 Q
=   >0   2 0
L2 L2 L2 L
 2  2 f ( L, K )  2 f ( L, K )  2 Q
   >0   0
K 2 k 2 K 2 K 2
Example
4
A production function is given as Q  f ( L, K )  3 L0.4 K 0.6 . The price of labor (w) is Birr 20 per
10

unit and the price of capital (r) is Birr 10 per unit. Find the cost minimizing quantities of labor
and capital for producing 30 units of output.
4
The constraint function that the firm faces is 30  310 L0.4 K 0.6 .
MPL w
The first order condition for equilibrium is  .
MPK r
4 4
Q Q
MPL   0.4(310 L0.6 K 0.6 ) and MPK   0.6(310 L0.4 K 0.4 )
L L

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4
MPL 0.4(3 L0.6 K 0.6 ) 2 K
10
Therefore,  4

MPK 10 0.4  0.4 3L
0.6(3 L K )
Therefore, at equilibrium
2 K 20

3L 10
K  3L
Substituting this in the constraint function,
4
30  310 L0.4 (3L) 0.6
30  3L
L  10 K  3(10)  30
 2Q  2Q
The second order condition for cost minimization requires that  0 and 0.
L2 K 2
4
 2Q
2
 0.24(310 L1.6 K 0.6 )  0 for all positive L and K.
L
 0.072
2 4
 Q
2
 0.24(3 L K 1.4 )  0 for all positive L and K.
10 0.4
K
 0.008
Since the second order condition is satisfied, the firm will minimize its cost at employment level
10 units of labor and 30 units of capital.
Exercise 1: A certain rational firm produces wheat using two variable factors of production (labour
and capital) and its production function is shown by the following Cob-Douglas production
function, Q (L, K) = 1000 L0.5 K0.5. Additionally, it is given that the hourly wage of labour is 8 birr
and the hourly rental rate of capital is 16 birr and the firm is endowed with a total of birr 96 to be
spent on labour and capital. Answer the following questions based on the above information.
a. What is the returns to scale exhibited by the function
b. What is the economic interpretation of the exponents of labour and capital in the
above production function? What is the economic significance of the sum of the
exponents?
c. Calculate MPL, MPK, APL, APK, MRTSL, K, MRTSK, L at L= 4 and K =16.
d. Determine the output maximizing quantities of L and K
e. Calculate the maximum out put
f. Calculate and interpret the value of 

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g. Calculate and interpret the value of elasticity of factor substitution at the maximum
output.
h. Determine the expansion path at the constant K/L ratio
i. Determine the factor intensity at the optimum
j. If the wage rate and interest rate of capital has been increased by 20% then what
additional cost to be incurred by the firm in order to be on the same level of output.

Exercise 2: If the total product function of a firm which produces wheat in the short run
is given by, Q = 90L2-L3 where L is the amount of labour used in the production process.
a. Show the level of employment of labour that maximizes the total product
b. Given the fixed employment of other factor, indicate the three stages of production
of the firm in the short run and support your answer with the appropriate diagram.
c. Indicate the range of employment of labour that a rational firm should operates
d. Does the law of variable proportion operates here? If yes how? If no why?
e. Calculate MPL, APL and TPL if L= 10

4.6.3 The Expansion Path

i. The Short Run Expansion Path

Now, let us look at another concept: expansion path.

Definition: the expansion path is the path that output follows over time, and shows the
alternatives open to the firm as defined by the production function. In the short run, output is
expanded by varying the quantity only of the variable factor(s) of production.

Given a production function Q = f(L, K ), in the short run capital is fixed and the firm is forced to
expand its output along a straight line parallel to the axis on which the variable factor labor is
measured.

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K a b c Short run expansion path

Q2 Q3
Q1

0 L1 L2 L3 L4 L
Figure 4.13: Short run Expansion Path.

If both factors were variable, the optimal path for expanding output would be 0A, which shows
the equilibrium combinations of L and K for producing different levels of output. With capital
constant, however, the firm expands its output by increasing the quantity of labor used in
production.

In Figure 4.13, the equilibrium point for producing Q1 is defined at a where the firm uses K
capital and L1 labor. The equilibrium quantity of labor required to produce Q2 would be L2 if
capital were variable. But, with capital constant at K , the firm will be forced to operate at point
b using L3 amount of labor. Compared to the point of tangency at which the firm maximizes its
profit, point b corresponds to a higher cost condition. Similarly, the firm can only produce Q3
using L4 of labor at point c, with capital constant at K . Yet, c is not a profit maximizing position.
The implication is, therefore, that the firm will not maximize its profit by expanding its output.

ii. The Long Run Expansion Path

Dear learner, we have said that all factors of production are variable in the long run. There is no
limit to the expansion of output imposed by fixed factors. The firm’s problem is the choice of the
optimal way of expanding output so as to maximize its profit. For a given factor price ratio, the
long run expansion path is obtained by joining the tangencies of successive isoquants and isocost
lines. The long run expansion path will be a straight line if the production function is
homogeneous.

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With factor price ratio w/r and given production function, the optimal expansion path is defined
by the locus of points of tangency of the isoquants with successive parallel isocost lines whose
slope is w/r, line 0A in Figure 4.19 below.

K
A
w
r
B

w
r
0 L
Figure 4.14: Long run Expansion Path.

If now the factor price ratio changes to w / r  , the tangencies of the new set of isocost lines and
isoquants yield long run expansion path 0B. The K/L ratio for producing a given level of output
is higher along expansion path 0A than expansion path 0B.

The factor price ratio w/r determines the tangencies of successive isoquants and isocost lines,
which in turn determine the slope to the expansion path. The slope of the expansion path shows
the optimal K/L ratio.

K/L ratio is a measure of factor intensity. A technology is said to be labor intensive if it uses
more labor than capital in the production process, i.e. K/L ratio is low. If a technology uses more
capital than labor in production, i.e. if K/L ratio is high, it is called capital intensive.

Summary

 The short run involves production decisions in which one or more factors of production are
fixed. In the short run output varies as the variable factor(s) of production are varied. In the
long run, all factors of production are variable. Therefore, a firm can vary output by varying
all factors of production.
 The production function shows the technical relationship between inputs and output. Short
run and long run situations can be interpreted as implying different kinds of constraints on
the production function. In the short run, the firm is constrained to use no more than a given

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quantity of some fixed factors; in the long run, it is constrained only by the available
techniques of production.
 Average product is defined as the total output divided by the quantity of variable factors
used in production. Marginal product is the change in total product due to employment of
one more unit of a variable factor of production.
 The law of diminishing returns asserts that if increasing quantities of a variable factor are
combined with given quantities of fixed factors, the marginal and the average products of
the variable factor will eventually decrease.
 An isoquant shows different combinations of factors of production that enable a firm
produce certain level of output.
 Isocost line shows different combinations of factors that cost the firm the same monetary
outlay.
 The production possibility curve shows the different combinations of two goods that can
be produced if resources are efficiently allocated.
 A firm is said to be at equilibrium in the short run when it maximized its profit, i.e. achieves
the highest possible profit for any given constraints that the firm faces.

Self-Check Exercise

i) Review your understanding of the following terms:

Production function Homogeneous function

Average product Isoclines

Marginal product Isocost

Stages of production Expansion path

Isoquant

ii) Multiple Choice Questions

1. Identify the correct statement.

a) The TP will rise as long as MP is positive.
b) MP continuously rises as long as AP is rising.
c) AP crosses MP at its maximum point.

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d) TP reaches its maximum level when AP is zero.

e) None.
2. Which one is true about MRTSL, K?
a) In most cases it will increase in absolute terms from left to right along isoquant
b) Its value will be zero if the two inputs are perfect substitutes
c) Its value will be negative and constant if the two inputs are complementary
d) Its value will be positive and constant if the two inputs are perfect substitutes
e) None.
3. Which of the following production function does not show increasing return to scale?
a) Q = 2KL b) Q = K L c) Q = K 2  5KL
d) Q = 2KL – L2 e) None.
4. Which of the following is a wrong statement about returns to scale?
a) It is a short run phenomenon.
b) If a production function exhibit increasing return to scale, the distance between
successive isoquants increases as all factors increase by a given proportion.
c) If a production function exhibits decreasing return to scale, the distance between
successive isoquants decreases as all factors increase by a given proportion.
d) If a production function exhibits constant return to scale, the distance between
successive isoquants remains the same as all factors increase by a given
proportion.
e) None.
5. Suppose the production function of a firm is given as Q  f ( L, K ) . Wage rate (w) is Birr 10
per unit and interest rate (r) is Birr 5 per unit.
a) The slope of the production function at equilibrium is 0.5.
b) If wage rate rises, the quantity of labor decreases and the quantity of capital increases
if labor and capital are complementary factors.
c) If wage rate and interest rate rise by the same percentage, the equilibrium output will
fall.
d) If wage rate rises, the quantity of labor increases and the quantity of capital decreases
if labor and capital are substitute factors.
e) None.

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iii) Workout Questions

1. Suppose a group of researchers in Debre Zeit area applied different amounts of a particular
fertilizer to ten identical plots of land. The results using identical seed grain are given in the
following table.

Plot Fertilizer dose Yield index* AP MP

1 15 104.2
2 30 110.4
3 45 118.0
4 60 125.3
5 75 130.2
6 90 132.4
7 105 131.9
8 120 130.3
9 135 128.5
10 150 126.2
* yield without fertilizer = 100
Compute average and marginal product of fertilizer, and identify the points of diminishing
average and marginal productivity.

1
2. Suppose a production function of a firm is given by; Q  20L  10L2  L3 , find the labor
3
employment levels
a) At the point of diminishing marginal productivity of labor.
b) At the point of diminishing average productivity of labor.
3. Given the production function
Q  L1 / 2 K 1 / 2
Price per unit of K and L is Birr 2 and Birr 4 respectively, and total cost is Birr 80.
a) Determine the maximum output subject to the cost constraint.
b) Calculate the MRTSL, K at the equilibrium point.
4. A manager has been allotted Birr 60,000 to spend on the development and promotion of a new
product Q. It is estimated that if X thousand Birr is spent on development and Y thousand on
promotion, approximately Q  f ( X , Y )  20 X 3 2Y quantity of output will be sold. How much
money should the manager allocate for development and how much for promotion in order to
maximize sales?

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5. Minimize the cost of 434 units of output for a firm when Q  10 K 0.7 L0.1 . The price of labor
(wages) is Birr 10 and the price of capital is Birr 28.

iv) Discussion Questions

1. Is there any parallel between diminishing utility in consumption and diminishing returns in
production? Describe any similarities you see.

2. Does the short run in farming have equal duration with the short run in electricity generation?
Discuss.

Suggested Reading Materials

Lipsey R. G., Courant P. N., Purvis D. D., and Steiner P. O., Microeconomics, 10th ed. New York:
Harper Collins College Publishers, Inc., 1993.

Amacher R. C., and Ulbrich H. H., Principles of Microeconomics, 3rd ed. Ohio: South-Western
Publishing Co., 1986.

Stanlake G. F., and Grant S. J., Introductory Economics, 6th ed., Singapore, Longman, 1995.

Gould J. P. and Lazear E. P., Microeconomic Theory, 6th ed., Homewood, Richard D. Irwin, Inc.,
1998.

Koutsoyiannis A., Modern Microeconomics, 2nd ed., English Language Book Society, Macmillan,
1985.

Varian H. R., Intermediate Microeconomics, 3rd ed., New York, Norton & Company, 1993.

Additional readings:

 Ahuja, H. microeconomics theory and applications

 Hiwot & Hibret, microeconomics I
 Ayele K., microeconomics part I
 Salvatore D., microeconomics theories and applications
 H.S. Agrawal, Principles of Economics, 7th edition.
 R.S Pindyck and [Link], Microeconomics
 E. Mansfield, Microeconomics: Theory and Applications
 Robert H. Frank, Microeconomics and Behavior

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CHAPTER 5: THEORY OF COSTS

Introduction

Dear learner, in the third unit, we have looked at the behavior of consumers and that behavior
relates to product demand. Now we turn to the behavior of producers enquiring how it relates to
product supply. Here, after examining the basic concepts in cost theory, we will consider the short-
run and the long-run periods; the nature of the short-run costs; long-run theory of costs; and finally,
economies of scale.

In the preceding chapter, you have examined the firm’s production theory, i.e., the physical
relationship how an input can be transformed in to output. In most business decisions, however, it
is the money value of input (cost) and output (revenue) which matters producers.

The production technology measures the relationship between input and output. Given the
production technology, managers must choose how to produce. To determine the optimal level of
output and the input combinations, we must convert from the unit measurements of the production
technology to dollar measurements or costs.

In this section, therefore, we shall discuss in detail various cost concepts, the relationship between
cost of production and output, short-run and long run costs.

Chapter Objectives

At the end of this unit, you will be able to

 Explain the distinction between accounting and opportunity costs by distinguishing

between explicit costs and implicit costs;

 Explain the shapes of the different cost curves and the relationships among these curves;

 Compare product and cost curves; and

 Illustrate and explain the role of economies and diseconomies of scale in determining the
shape of a firm’s long-run average cost curves.

Brainstorming Questions

1. What do you think is the cost of production?

2. What will happen to per unit cost of production as firms produce more output?

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5.1 Types of Cost

In this section, distinctions between implicit and explicit costs, economic and accounting costs,
and short-run and long-run periods will be briefly made.

A. Explicit and Implicit costs

Dear learner, can you explain the difference between explicit and implicit costs? Can you
differentiate price and costs? We will discuss these concepts briefly.

The basic factor underlying the ability and willingness of firms to supply a product is the cost of
making that product. The words cost and price are often confusing, especially for non-economists.
When we discuss costs we mean how much does something cost to produce? This might be
expressed as an opportunity cost, or in a currency such as dollars, birr, etc…. When a price is
mentioned, we mean the amount that the consumer pays. So, cost is a payment made by producers
whereas price is a payment made by consumers.

Before moving to the details of cost theory, it is important to make a distinction between explicit
and implicit costs.

Explicit Cost: The term explicit cost refers to the payments made to those outsiders who will
supply labor services, raw materials, fuel, transportation services, power, etc., to the firm. It is also
called money costs.

Implicit Cost: The term, implicit cost, refers to the cost/value of self-owned or self-employed
resources and it is also called imputed costs.

The total cost of production is the sum of explicit and implicit costs.

B. Social Vs Private costs

Social costs are costs which a society bears on account of production of a commodity. Social cost
includes both private cost and the external cost. External cost includes: -
(i) The cost of resources for which the firm is not compelled to pay a price e.g. atmosphere, rivers,
lakes, roads and drainage system.
(ii) The cost in the form of disutility created through air & water and noise pollutions etc.
Whereas private costs are costs which are actually incurred or provided for by an individual or a
firm on the purchases of goods & services from the market. For a firm all the actual costs, both

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explicit and implicit are private cost in the sense that the firm must compensate the resource owner
in order to acquire the right to use the resource.
C. Accounting Vs Economic cost
Accounting cost refers to the cost of purchased inputs / explicit / cost only, whereas the economic
cost includes both explicit and implicit cost.
D. Fixed Vs variable cost
Fixed costs are costs that do not vary with the change in firm’s output. These costs charged even
when the firm’s production is zero, e.g. the costs incurred for capital equipment, lease on land,
building etc.
Whereas variable costs are costs that changed with the change in the output and therefore can be
expressed as a function of output (Q) i.e. VC = f (Q)

Let us discuss all types of costs together. An accountant, while calculating the cost of production
may just take into account the explicit cost items only. Economists, on the other hand, base their
estimate of production costs on the concept of opportunity cost which is measured in terms of
forgone alternatives. As we have defined in unit one, Opportunity cost is the most attractive
alternative forgone or the next best choice sacrificed in the event of producing goods or rendering
services.

To illustrate the distinction between accounting costs and economic costs, consider the case of a
market trader who sells umbrellas. For simplicity, assume that the trader sells the umbrellas he/she
purchases during the relevant period. The accountant might prepare the simplified accounts in the
following way. If the total sale of the umbrellas is birr 30,000, the costs include the purchase price
of, say birr 20,000, and overhead expenses incurred by the trader of, say birr 4,000 for hiring
market place and cost of transport. From the accountant’s viewpoint, therefore, the trader has made
a net profit of birr 6,000.

The economist, adopting the opportunity cost principle, would argue that account must also take
the opportunity cost to the market trader of using capital and labor in this particular way. Suppose
that the trader has funds worth birr 5,000 tied up in the business, the trader could have lent this
amount at the market rate of interest, say 10 per cent per annum, and would have received birr 500
per annum. This sum is the opportunity cost of tying up funds in the business of selling umbrellas.
The trader might also have taken up employment elsewhere and earned, say birr 8,000 per annum.

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These additional opportunity costs, totaling birr 8,500 per annum, which are not included in the
accountant’s calculations, are added to the cost of sales and expenses in the economist’s calculation
of opportunity costs. Thus, the total opportunity cost of being a market trader is birr 32,500 per
annum. With the revenue from sales of only birr 30,000, from economists point of view, the trader
has made a loss of birr 2,500 over the relevant period.

Dear learner, look at the following figure for simplified presentation of economic and accounting
costs.

Economic
Profit
Accounting
Opportunity Profit
cost of capital Total Revenues
Economic Costs + any other
implicit costs
Explicit
Accounting
(Accounting)
Costs
Costs

Figure 5.1: Simplified view of Economics and Accounting Costs

5.2 Theory of Costs in the Short-run

Short-run is that period of time over which the amount of at least one input cannot be changed.
That means we have two major categories of inputs in this period: fixed inputs and variable inputs.
Usually capital equipment and entrepreneurship are considered as fixed inputs and labor and raw
materials can be taken as variable inputs in the short-run. Consequently, the costs are of two types:
fixed costs and variable costs. During this period, the firm can expand or decrease its output only
by varying the amounts of variable inputs.

Long-run, on the other hand, is that period of time over which all factors of production can be
varied. That means, in the long-run, all inputs are variable and hence all costs are also variable.
Since costs will vary quite differently in the long-run and in the short-run, we have to study costs
under two different cases: short-run theory of costs and long-run theory of costs as it is presented
in the following two consecutive sections.

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5.3.1. Fixed Costs and Variable Costs

Dear learner, we have discussed the concepts of fixed and variable inputs in production. Can you
define fixed and variable costs based on these concepts? Ok. Now, we are going to discuss the
details of these cost components.

Costs are broken down into several parts and looked at in different ways. Before we start, we have
to make one basic assumption that the firm is operating in the short-run time period. As it has been
briefly indicated, we have two major categories of costs in the short-run: fixed costs and variable
costs.

[Link]. Total Fixed Cost (TFC)

Fixed costs are the costs of the investment goods used by the firm on the idea that these reflect a
long-term commitment that can be recovered only by wearing them out in the production of goods
and services for sale. If cement is to be produced, then a factory is required. The land, the factory
building, the machinery and office equipment must be bought or rented. These costs are called
fixed costs and must be paid even when the factory has not produced anything. Fixed costs in total
do not vary with the changes in the level of output of a firm. Fixed costs are associated with the
existence of a firm’s plant itself, and they have got to be paid even if the firm’s rate of output is
zero.

Salaries paid to the top management and key personnel, rent paid to the factory building, interest
paid on loans raised, and insurance premiums, etc., are examples of fixed costs.

C (Cost)

TFC Curve

Q (Output)

Figure 5.2: Total Fixed Cost Curve

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As it is indicated in Figure 5.2, the fixed cost curve starts at some point above the origin (at Ĉ) and
it is horizontal. It indicates that the firm incurs fixed costs even when its level of output is zero.

[Link]. Total Variable Cost (TVC)

Variable costs are costs that can be varied flexibly as conditions change. Variable cost increases
with the increase in the level of output of a firm. The variable costs of production are incurred by
a firm only when there is an output.

Wages paid to laborers, payments made to the raw material suppliers, payments made to the fuel
suppliers and transportation agencies, etc., can be cited as examples of variable costs of production.

As indicated in Figure 5.3 below, the TVC curve starts from the origin and it slopes positively
upwards. It indicates that the variable cost is zero when the level of output of a firm is zero and
costs increase with the increase in the level of output (Q).

C TVC Curve

Q
O

Figure 5.3: Total Variable Cost Curve

[Link]. Total Cost (TC)

Dear learner, can you compute total cost, given fixed and variable costs? Good. Total cost is simply
the sum of total fixed and total variable costs (i.e., TC = TFC + TVC). In Figure 5.4 below, the TC
and TVC curves are ‘parallel’ and it reflects that the total cost of production in a firm increases in
proportion to the increase in total variable cost with an increase in the level of output. The distance
between the two curves (TC and TVC) is the amount of total fixed cost.

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C TC

TVC

TFC

Figure 5.4: TC, TVC, and TFC Curves

5.3.2. Unit Costs and Marginal Cost

[Link]. Unit Costs (Average Costs)

Dear learner, costs may be more meaningful if they are expressed on a per-unit basis as averages
per unit of output (Q). In cost theory, we have three averages: average total cost (ATC), average
variable cost (AVC), and average fixed cost (AFC). ATC is the sum of AVC and AFC. These three
averages can be computed from their respective totals as follows:

TC TVC TFC
ATC  AVC  AFC  ATC  AVC  AFC
Q Q Q
C

ATC

AVC

AFC
Q

Figure 5.5: The Three Average Cost Curves

As you can see in the above figure, ATC and AVC curves are ‘U-shaped’, while AFC is of
rectangular hyperbola in shape.

[Link]. Marginal Cost (MC)

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Dear learner, let us turn to the discussion of another important cost function: marginal cost. Can
you define marginal cost?

The Marginal cost of production is nothing but an extra cost incurred by a firm while producing
an extra unit of output, or it is the change in total cost as a result of the change in output by one
unit. That means, it is the cost of producing one extra unit.

the change in total cost TC

Marginal cost  MC 
the change in output Q

For a very small change, marginal cost is computed as a derivative of the total cost function with
dTC
respect to change in output as MC 
dQ

Now, let us introduce and overlay marginal cost curve over the three average cost curves.
C

MC
ATC

AVC

AFC

Q
Figure 5.6: Marginal Cost Curve and the Three Average Cost Curves

The shape of a marginal cost curve is also ‘U-shaped’ as it is indicated in the above figure.

The following table indicates how the short-run cost curves vary with the level of output, and how
these costs can be computed.

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Table 5.1: Variation of Short-run Cost with Output

Output (Q) TFC TVC TC AFC AVC ATC MC

0 48 0 48 - - - -
1 48 25 73 48 25 73 25
2 48 46 94 24 23 47 21
3 48 66 114 16 22 38 20
4 48 82 130 12 20.5 32.5 16
5 48 100 148 9.6 20 29.6 18
6 48 120 168 8 20 28 20
7 48 141 189 6.9 20.1 27 21
8 48 168 216 6 21 27 27
9 48 198 246 5.3 22 27.3 30
10 48 230 278 4.8 23 27.8 32
11 48 272 320 4.4 24.7 29.1 42
12 48 321 369 4 26.8 30.8 49

Exercise 5.1

Plot the seven cost curves (TC, TVC, TFC, ATC, AVC, AFC, and MC) and verify their shapes
based on the numerical example presented in the above table.

5.3.3. Geometry of Average and Marginal Costs

Dear learner, do you remember how we geometrically derived average and marginal product
curves from a total product curve in chapter four? Can you derive, geometrically, average and
marginal cost curves from the total cost curve in a similar fashion? Good. We will do it together.

As the average and marginal product curves are derived geometrically from the total product
curve (discussed in unit 4), the average and marginal cost curves may be derived from the
TFC
corresponding total cost curves. Since AFC  , AFC is given by the slope of a ray from the
Q
origin to a point on the TFC curve.

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Figure 5.7: Derivation of AFC from TFC

Consider the three rays on panel (a) of the above figure. The slope of these rays gets on declining
as we move from quantity levels of a to c. Hence, AFC at a > AFC at b > AFC at c as it is indicated
on the panel (b) of the same figure.

We can follow a similar procedure to derive AVC curve from TVC curve and ATC curve from TC
curve.

C TVC

AVC

Q
d e f g d e f g
(a)
(b)

Figure 5.8: Derivation of AVC Curve from TVC Curve

Exercise 5.2

a) Why is the AVC minimum at output level of f in the above figure?

b) Do you think that AVC at e is equal to AVC at g? Why?

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TC
C C
ATC

Q C

h h
(a) (b)

Figure 5.9: Derivation of ATC Curve from TC Curve

As we move from left to right on total cost curve indicated on panel (a) of the above figure, the
slope of a ray from the origin to a point on TC curve first decreases, and then attains its minimum
at h, and finally increases. As a result, the shape of the ATC curve becomes as it is indicated on
panel (b) of the above figure.

MC, on the other hand, can be given by the slope of a TVC or the slope of TC curves (since TVC
and TC curves are ‘parallel’) at a given output level. As we move from left to right on these two
curves, the slope initially decreases, reaches a minimum, and then increases and hence is the shape
of MC curve.

Exercise 5.3

a) Why is the ATC minimum at h in the above figure?

b) Assuming that the curves indicated in Figure 5.8 and Figure 5.9 are that of a given firm, compare
output levels at f and at h. Which one should be larger? Why?

c) If the total cost function is given as C = 200 + 10Q + 2Q2, find the functions for TFC, TVC,
MC, AVC, AFC, and ATC.

5.2.4. Nature and Relations among ATC, AVC, AFC and MC

Dear learner, can you explain the relationships among the different cost curves we discussed?
Based on the discussions made earlier, we can state the following nature of the cost curves and
relationships among these curves:

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1. AFC approaches both axes asymptotically.

2. Both AVC, ATC, and MC curves first decline, reach a minimum point, and then rise. The
U-shapes of AVC and ATC reflect the law of variable proportions discussed in unit four.
However, the minimum point of the ATC curve occurs to the right of the minimum point
of AVC. This is due to the fact that ATC includes AFC, and the latter falls continuously
with increases in output. After the AVC has reached its lowest point and starts rising, its
rise over a certain range is offset by the fall in the AFC so that the ATC continues to fall
over that range despite the increase in the AVC. However, the rise in AVC eventually
becomes greater than the fall in the AFC so that the ATC curve starts increasing.

3. As AFC approaches, asymptotically close to the horizontal axis, AVC approaches ATC
asymptotically.

4. MC equals both AVC and ATC when these curves attain their minimum values; it lies
below both AVC and ATC curves over the range in which these curves decline; and it lies
above these curves when the curves are rising.

5.2.5. Product and Cost Curves: A Comparison

Dear learner, let us compare product and cost curves. Follow attentively.

In order to simplify our analysis, let us assume that we have one variable input labor (L) with labor
price of wage (w). Hence, total variable cost is the product of L and w (i.e., TVC=wL).

TVC wL L  1  Q
AVC    w   w  , because average product of labor APL 
Q Q Q  APL  L

w
 AVC 
APL

This implies that we have inverse relationships between AP and AVC. As AP first increases,
reaches a maximum and then declines, AVC first declines, reaches a minimum and then rises.

Can you relate marginal cost with marginal product in a similar way? Ok.

Similarly,

TVC wL  L
MC   w . This is because wage (w) is assumed to be constant.
Q Q Q

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 1  w Q
 MC  w   , because marginal product of labor MPL 
 MPL  MPL L

This also implies that MC and MP are inversely related. As MP first increases, reaches a maximum
and then declines, MC first decreases, reaches a minimum and then increases. Look at Figure 5.10
below.

AP

and
AP
MP
Labor

MC
AVC

Cost

Output
Figure 5.10: Relationship between Product and Cost Curves

Generally, falling marginal cost reflects the rising marginal product and rising MC reflects falling
MP. Falling AVC indicates rising AP, and rising AVC indicates falling AP. AP equal to the MP
at the point where MC is equal to AVC. At these equality points, average product is at its maximum
and AVC is at its minimum.

The marginal product curve lies above the average product curve in the region, where the MC lies
below AVC. The marginal product curve lies below average product curve in the region, where
the AVC curve lies below the MC curve.

5.3 Theory of Costs in the Long-run

5.3.1 Long-run Average Cost (LRAC)

Dear learner, thus far, we have not considered the long-run in cost theory. We have defined the
long-run as a period long enough so that all inputs are variable. In other words, a business can vary
all of its inputs and change the whole scale of production in the long-run. In particular, this includes
capital, plant, equipment, and other investments that represent long-term commitments.

We will now think a bit about the long run, using the concept of average cost.

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Suppose you were planning to build a new plant, perhaps to set up a whole new company and you
know about how much output you will be producing. Then you want to build your plant so as to
produce that amount at the lowest possible average cost.

To make it a little bit simpler, we will suppose that you have to pick just one of the three plant
sizes: small, medium, and large. Average cost curves for the small (ACs), medium (ACm), and
large (ACL) plant sizes are as indicated in Figure 5.11 below:

ACs
C ACm

Cm ACL

Cs
LRAC

Q
Q1 Q2 Q3

Figure 5.11: Short-run Average Cost Curves for Different Plant Sizes and the LRAC

If you produce Q1 units, the small plant size gives the lowest cost as compared to medium sized
one (i.e., Cs<Cm). If you produce Q2 units, the medium plant size gives the lowest cost and if you
produce Q3 units, the large plant size gives you the lowest cost. Now, we can join these lowest
points of average cost curves for different plant sizes with a line, called long-run average cost
curve (LRAC).

The long run average cost, the lowest average cost for each output range, is described by the lower
envelope curve, shown by the thick curve (in Figure 5.11 above) that follows the lowest of the
three short run curves in each range.

More realistically, an investment planner will have to choose between many different plant sizes
or firm scales of operation, and so the long-run average cost curve will be smooth, as illustrated
below:

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C LRAC

Q
Figure 5.12: Long-run Average Cost Curve

As shown in the above figure, each point on the LRAC curve corresponds to a point on the short-
run average cost (SRAC) for the plant size or scale of operation that gives the lowest average cost
for that scale of operation. The LRAC curve envelopes a number of short-run average cost curves,
and hence it is also called an envelope curve.

Generally, the LRAC is more or less ‘u-shaped’, and the idea is that:

 for small outputs, indivisibilities predominate, and so long-run average cost declines with
increasing output;

 for intermediate outputs, operations can be expanded roughly proportionately, while

tendencies to increasing and decreasing costs, if any, offset one another; and

 for large outputs, the problems of management predominate, and hence long-run average
cost increases with increasing output.

5.3.2 Long-run Marginal Cost (LRMC)

Dear learner, can you draw the long-run marginal cost curve based on short-run marginal cost
curves? Ok. In fact, it is not simple as in the case for LRAC. Let us see it.

The long-run marginal cost is derived from the short-run marginal cost curves, but it does not
‘envelope’ them. It is formed from points of intersection of the short-run marginal cost (SMC)
curves with vertical lines (to the x-axis) drawn from the point of tangency of the corresponding
short-run average cost (SAC) curves and LRAC curve. The LRMC curve crosses the LRAC curve
when the latter attains its minimum value. Look at the following figure.

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Cost
LRMC
SAC SMC
LRAC

Output

Figure 5.13: Derivation of Long-run Marginal Cost Curve

5.3.3 Economies of Scale

Dear learner, can you say something about economies of scale before looking into this concept
together? Can you remember the concept of returns to scale discussed in unit four? What are
increasing returns to scale, constant returns to scale, and decreasing returns to scale? Please try to
discuss.

In our pictures of long run average cost, we see that the cost per unit changes as the scale of
operation or output size changes. Terminologies for describing these changes are increasing returns
to scale, constant returns to scale, and decreasing returns to scale.

Increasing returns to scale: This is the case of decreasing cost. Average cost decreases as output
increases in the long-run, and it is in the declining part of the LRAC curve. Economists usually
explain increasing returns to scale by indivisibility, i.e., some methods of production can only work
on a large scale, either because they require large-scale machinery, or because they require a great
deal of division of labor. Since these large-scale methods cannot be divided up to produce small
amounts of output, it is necessary to use less productive methods (indivisible plant) to produce the
smaller amounts. Thus, costs increase less than in proportion to output and average costs decline
as output increases. Increasing Returns to Scale is also known as economies of scale or decreasing
costs.

Constant returns to scale: This is the case of constant costs. Average cost remains constant as
output varies in the long-run. We would expect to observe constant returns where the typical firm

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(or industry) consists of a large number of units doing pretty much the same thing, so that output
can be expanded or contracted by increasing or decreasing the number of units. Consider the case
where we need one machinist to do a series of operations to produce one item of a specific kind.
If you want to double the output you had to double the number of machinists and machine tools.
Constant Returns to Scale is also known as constant costs.

Decreasing returns to scale: This is the case of increasing costs. Average cost increases as output
increases in the long-run, and it is in the rising part of the LRAC curve. Decreasing returns to scale
are associated with problems of management of large, multi-unit firms. Again, think of a firm in
which production takes place by a large number of units doing pretty much the same thing, but the
different units need to be coordinated by a central management. The management faces a trade-
off. If they don't spend much on management, the coordination will be poor, leading to waste of
resources, and higher cost. If they do spend a lot on management, that will raise costs in itself. The
idea is that the bigger the output is, the more units there are, and the worse this trade-off becomes.
So, the costs rise either way. Decreasing Returns to Scale is also known as diseconomies of scale
or increasing costs.

Did you understand the concept of economies of scale? Good. Now, let us illustrate the same
concept, but pictorially (Figure 5.14 below).

Diseconomies of scale LRAC

Economies of scale

Constant costs

Figure 5.14: Long-run Average Cost and Economies of Scale

Activity 5.1

Assume a smallholder farmer with only 2 hectares of land owns one tractor for its farming
operations. Assume also that the capacity of a tractor in terms of area of land to be plowed is 20
hectares per one production season. If the farmer expands his land holding season after season,

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say up to 18 hectares, what will happen to the average cost of production of this farmer? State
the type of returns to scale for this farmer.
______________________________________________________________________________
______________________________________________________________________________
_________________________________________________________________

Causes for Economies and Diseconomies of Scale

A. Causes for Economies of Scale

Dear learner, we have said that economies of scale occur when long-run average costs are falling
as output is increasing. Please try to list the different causes for economies of scale. What are the
causes for internal economies and for external economies? Try to list them and compare it with
our list indicated below.

Indeed, there are different causes of economies of scale and they are usually listed under two broad
headings: internal economies and external economies.

i) Internal Economies of Scale

Internal economies of scale occur as the output of the individual firm increases and the causes for
internal economies can be the following:

1. Fixed Costs are shared

Assume that the fixed cost of producing a car at a factory is birr120 million. If only one car was
made, all of the fixed costs are born by this car alone. If two cars are produced the average fixed
cost falls rapidly. Therefore, the greater the level of output the lower are the average fixed costs.
The average fixed cost curve continues to fall, but note that it will never reach the horizontal axis,
as AFC will always be a positive number (Table 5.2 below).

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Table 5.2: Variation of AFC with the level of output

Quantity Fixed Cost Average Fixed Cost

(number of car) (in million Birr) (in million Birr)

1 120 120
2 120 60
3 120 40
4 120 30
5 120 24
6 120 20

Thus, decline in the fixed costs as output expands is one cause for economies of scale.

2. Financial Economies

Assume two firms, one large and the other small. Where do you expect a lower interest rate for
borrowing? Where do you expect a better purchase discount?

A large firm might be able to borrow at lower rates of interest than a smaller one. Again, when
raw materials, components, office supplies, etc. are bought, it is usual to receive a discount for
large quantities bought. The larger the quantity purchased the bigger the percentage discount. The
office work needed for a big order is the same as that for a small order. These are sometimes called
bulk-buying or purchasing economies.

Activity 5.2

Think of a wholesaler and a retailer selling similar products at different prices. Which one do
you think will enjoy economies of scale. Why?
______________________________________________________________________________
______________________________________________________________________

3. Managerial Economies

The greater the output of a firm is, the greater the revenue will be. This allows the firm to hire
more workers, and therefore gain advantages from the division of labour. Small firms cannot afford
to permanently hire lawyers, accountants, human resource managers, etc., whereas larger firms
can. Note for your understanding that a large ship and a small ship both need a captain with
maritime skills. This means large firms will have better managerial economies.
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4. Container Principle

Look at the following cubes with sides of 1cm and sides of 3cm. A cube with sides of 1cm length
has an area of 6cm squared (1cm x 1cm x 6), and a volume of 1 cm cubed (1cm x 1cm x 1cm). A
cube with sides of 3cm has an area of 54cm squared (3cm x 3cm x6) and a volume of 27cm cubed
(3cm x 3cm x 3cm).

1
3
1
1
3

3
(a) (b)

Figure 5.15: Demonstration of Container Principle

Expressed as a ratio of area to volume for the cube with sides of 3cm, this is 54: 27 which is the
same as 2 to 1. This means, if we want to construct a container using metal sheet, we need 2cm
squared metal sheet for every 1 cm cubed volume. For a cube with sides of 1cm, however, area to
volume ratio is 6:1. This, again, means we need 6cm squared metal sheet for every 1 cm cubed
volume.

We can now compare the required area for the same volume of 1 cm cubed. We require smaller
area of 2 cm squared for the larger cube with sides of 3 cm long as compared to area of 6 cm
squared for the smaller cube with sides of 1 cm long.

What this demonstrates is that the 3cm sided cube can hold a greater proportionate volume than a
1cm sided cube. This principle helps explain why large oil tankers, factory buildings, chemical
plants, etc., are more economical to build than small ones.

5. Indivisibilities

Some machinery or processes only make sense for large firms. For example, assume we have two
farm owners; one with large farm size and the other with very small land size. Where do you expect
is purchasing a tractor economical? Good. A small farm of only a few acres cannot make use of a
big combine harvester.

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ii) External Economies of Scale

Based on the definition we provide for internal economies; can you explain external economies of
scale and provide its possible causes? Anyhow, external economies of scale occur as the output of
the industry increases, and the possible causes for external economies can be the following:

1. Labour

As an industry builds in size, a pool of trained labor emerges that each individual firm can make
use of. This means, because of emergence of trained man power in the industry, firms in that
industry will benefit economies of scale.

2. Cooperation

Dear learner, can you guess how cooperation brings external economies of scale? Good. Firms in
industries often cooperate so as to get more advantage over individual firms. For example, farmers’
cooperatives arise to buy or sell products more cheaply than the farmers could do alone, and as a
result, they will benefit more as compared to individual farmers.

B. Causes for Diseconomies of Scale

Can you indicate causes for diseconomies of scale? Anyway, diseconomies of scale occur when
long-run average costs are rising as output is rising. It can also be of internal diseconomies or
external diseconomies. The possible causes for these diseconomies are indicated below.

i) Internal Diseconomies of Scale

Internal diseconomies occur when long-run average costs are rising as the output of the firm is
rising. It can be caused by the following:

1. Interdependency

Dear learner, can you explain the disadvantages of having many departments in a given firm?
Good that is internal diseconomies. In large firms with many different departments, each part of
the company becomes interdependent, and hence, a machine failure in the packaging department
may result in stopping the whole production line, for example.

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2. Coordination and Communication

Large firms have long chains of command. What do you think is the negative effect of having long
chains of command? The possible consequence can be information from the top management may
not be communicated to the production line properly and vice-versa.

3. Industrial Relations

Dear learner, can you depict the effect of unhealthy relationship between the management and the
work force in the production process? Anyhow, because of the lack of contact between senior
management and the work force, the workers may feel insignificant or uncared for, and as a result
industrial disputes may arise and production may suffer.

ii) External Diseconomies of Scale

As output increases in an industry, each of the factors of production becomes scarcer, and as they
become scarcer, their prices increase. This will adversely affect the operation of individual firms
in that industry.

Summary

 Economists base their estimate of production costs on the concept of opportunity cost. This
is a wider definition of cost than that eyed by accountants.
 Explicit costs are money costs while implicit costs refer to the value of self-owned or self-
employed resources.
 Short-run is that period of time over which at least one input cannot be changed, whereas
long-run is that period of time over which all factors of production can be varied.
 Fixed costs do not vary with the changes in the level of output of a firm, while variable
costs are costs that can be varied flexibly as conditions change.
 Falling marginal cost reflects rising marginal product, and rising MC reflects falling MP.
Falling AVC indicates rising AP and rising AVC indicates falling AP.
 AFC, AVC, and ATC curves are given by the slope of a ray from the origin to a point on
the TFC, TVC, and TC curves, respectively. MC, on the other hand, can be given by the
slope of TVC or the slope of TC curves at a given output level.
 Under long-run theory of costs, the LRAC curve envelopes a number of short-run average
cost curves, and hence it is also called an envelope curve. The long-run marginal cost, on

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the other hand, is formed from points of intersection of the short-run marginal cost curves
with vertical lines to the x-axis drawn from the point of tangency of the corresponding
short-run average cost curves and LRAC curve.
 Returns to scale refers to how a firm’s output responds to a change in factor inputs.
Accordingly, increasing returns to scale is in the declining part of the LRAC curve, which
is also called economies of scale or decreasing costs; constant returns to scale is the case
of constant costs; and decreasing returns to scale is the rising part of the LRAC curve,
which is also called diseconomies of scale or increasing costs.

Self-Check Exercise

i. Review your understanding of the following terms.

Opportunity cost Average fixed cost
Implicit cost Average total cost
Explicit cost Marginal cost
Fixed costs Long-run average cost
Variable costs Long-run marginal cost
Total cost Economies of scale
Average variable cost Diseconomies of scale
ii. Workout Questions
1) Consider the following data on a firm’s total cost of production.

Quantity produced 1 2 3 4 5 6

Total cost (in Birr) 10 16 18 28 45 66

Given that the total fixed cost is birr 8, calculate TVC, ATC, AVC, AFC, and MC.

2) Assume that 3 workers can produce a total of 12 units of quantity (Q) per day. If each
worker is paid Birr 40/day and the firm’s total fixed costs (TFC) are Birr 240/day, then
compute the average total cost (ATC) of the output produced by these 3 workers.

iii. Multiple Choice Questions

1. Suppose the total cost of producing T-shirts can be represented by TC = 30 + 4q. What is
the average variable cost of producing 5 T-shirts.

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A. 4 B. 6 C. 10 D. 50 E. 2

2. If the average total cost of producing a good is increasing, which of the following must be
true?
A. AFC are rising B. AVC is falling C. AFC is constant

D. MC > ATC E. MC is increasing

3. The long-run is defined as

A. A period long enough so that at least one factor of production is variable.

B. A period long enough so that al least one factor of production is fixed.

C. A period long enough for a firm to figure out how to maximize profits.

D. A period long enough that all factors of production can be varied.

4. If the average total cost of producing a good is increasing, which of the following must be
true?
A. AFC is rising B. AVC is falling C. AFC is constant

D. MC > ATC E. MC is decreasing

5. Increasing returns to a firm are shown graphically by:

A. a downward-sloping long-run average cost curve

B. an upward-sloping long-run marginal cost curve

C. a horizontal long-run average cost curve

D. an upward-sloping long-run average cost curve.

iv. Discussion Questions

1. How does the economist’s definition of costs differ from the accountant’s?
2. What distinguishes the long-run from the short-run?
3. Long-run average cost curve can also be called an ‘envelope’ curve. What do you think is
the reason?

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Answers to Exercises

Exercise 5.1

a) The seven cost curves based on the given data can be drawn as follows. But, note that the actual
curves of these functions are drawn as smooth lines.
400

350

300

250
TC 48
TVC 0
TFC 48
Cost

200 MC -
ATC -
AVC -
150 AFC -

100

50

0
1 2 3 4 5 6 7 8 9 10 11 12
Output (Q)

AVC=MC when AVC is at 22 which is its minimum value.

ATC=MC when ATC is at 27 which is its minimum value.

TVC TFC
b) Yes MC  because =0
Q Q

Exercise 5.2

a) Of all the rays drawn from the origin to the points on AVC curve, the one with minimum slope
is a ray drawn from the origin to point f.
b) Yes, because the slopes of the rays drawn from the origin to these two points (e and g) are
equal.
Exercise 5.3

a) Of all the rays drawn from the origin to points on ATC curve, the one that is drawn to point h
has the minimum slope.
b) Output level at h is larger than output level at f, because AVC attains its minimum point at a
lesser output level than ATC.
c) TFC=100 TVC=10Q-2Q2 MC=10+4Q

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AVC=10-2Q AFC=200/Q
ATC=2Q+10+200/Q

Suggested Reading Materials

Agarwal, H.S. 1998. Microeconomic Theory. 6th ed., Konark Publishers Pvt. Ltd., Delhi, India.

Gould J.P. and Lazear. E.P. 1998. Microeconomic Theory, 6th ed. Hooomewood, Richard D. Irwin
Inc.

Hardwick, P, B. Khan and J Langmead. 1994. An Introduction to Modern Economics. Addison

Wesley Limited, England.

McConnel, R and S.L Brue.1999. Microeconomics: Principles, Problems and Policies.14th ed.
USA.

Miller, R.L. 1997. Economics Today: The Micro View. 9th ed., Addison-Wesley Educational
Publishers Inc., USA.

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CHAPTER 6: PERFECT COMPETITION MARKET

Introduction
In the previous units of this course, we have examined theories of production, cost and consumer behavior. In this
chapter, we shall see the behavior of price and output. We will use consumer and producer behavior as our building
blocks. By bringing together revenue and cost, we shall determine the behavior of a profit maximizing business
firm. This behavior determines supply for the entire market which interacts with demand to establish market price
and output. The most important factor that determines firms’ choice of price and output is market structure. In other
words, we shall see theory of firm and market structure.
A firm is an organization that employs factors of production to produce goods and services for the market. A firm
may be in the form of an individual proprietorship, a partnership or a joint stock company.
The objective of business firms generally classified as: maximization of profit, maximization of sales revere, firm’s
growth rate, managerial utility function, firm‘s net worth, satisfactory or standard profit and long-run survival and
market share. Since profit maximization is the primary objective of the firm, we shall see it in detail.
Chapter Objectives
At the end of this unit, you will be able to:
 Enumerate the different types of market structures;
 Outline the assumptions upon which the model of perfect competition is based;
 Show that a firm’s profit will be maximized at the point where the marginal cost curve cuts the marginal
revenue curve from below; and
 Illustrate and explain the short-run and the long-run equilibrium positions of a perfectly competitive firm
and industry.
 Define equilibrium and explain how equilibrium is reached;
 Show how changes in demand and supply affect the equilibrium condition; and
 Define elasticity and explain the difference among price, income, and cross elasticities.
Brainstorming Questions

1. How is price of a product determined?

2. What is the objective of business firms?

6.1 Market Structures

Dear learner, can you define market structure? What are the different types of market structures? Anyhow, let us
start our discussion with the definition of market structure.

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Market structure refers to the nature and degree of competition within a particular market. It shows the number
and relative size of firms in an industry. Market structures can be characterized by sellers or buyers or both; and
in fact, most economics texts classify markets by sellers.

Based on sellers, economic analysis classifies markets into different categories, or structures depending on the
degree of competition prevailing in them. The spectrum (continuum) of market structure ranges from perfect
competition to monopoly as briefly defined hereunder.

1. Perfect Competition: This is a theoretical market structure in which there are many buyers and sellers with no
individual power to influence market price.

2. Monopolistic Competition: In this market, there are many firms producing differentiated products. This market
structure is sometimes called competition among the many.

3. Oligopoly: Here, a few interdependent firms dominate the market for the product (differentiated or similar
products). This market is sometimes called ‘competition among the few’ and is relatively common in
manufacturing industries. Duopoly is a special case of oligopoly where two firms dominate the entire market for
the product.

4. Monopoly: This refers to a single supplier for the whole market.

Clearly, the nature and degree of competition vary in these markets. Examples of these market structures are
presented in the following table.

Table 6.1: The different market structures

Type of market Number of firms Examples

Perfect competition Very many Agricultural markets (approximately)
Monopolistic competition Many / several Builders, restaurants, suiting, …
Oligopoly Few Cement, cars, electrical appliances
Monopoly One Local water company, electricity, train
operators (over particular routes)

From among these market structures, we shall discuss about perfectly competitive market in the coming section.

6.2 Basic Assumptions of Perfectly Competitive Market

Perfectly competitive market is characterized by a complete absence of rivalry among the individual firms as there
are so many firms in the industry so that no personal recognition among individual firms in the market.
Perfect competition is characterized by the following assumptions:
A) Large number of sellers and buyers
The industry or market includes a large number of firms; so that on the supply side, each firm has small Share
relative to the total market, in that it cannot affect market price by changing its output supplied. The buyers are also
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numerous; so that on the demand side, individuals’ influences on the total market is very small. This means that
each buyer purchases a small portion of the total market that he cannot obtain special consideration of price
reduction from the seller.
B) Homogenous product
The product of each seller is identical to the product of every other seller. There is no way in which a buyer could
differentiate among the products of different firms.
The assumption of large number of sellers and of product homogeneity implies that the individual firm in pure
competition is a price taker. Its demand curve is infinitely elastic, indicating that the firm can sell any amount of
output at the prevailing market price. The demined curve of the individual firm is also its marginal revenue curve.

Figure 6.1: AR, MR and demand curve for perfect competition

C) Perfect knowledge or perfect information
Each buyer has full information about price, quality of the product and other characteristics of the product. Each
seller also has full information about price and quality of the product, input price, technology, future price of the
product etc.
D) Free entry and exit of firms
There is no legal or market barrier on entry of new firms to the industry as a result when normal profit of the
industry increase, new firms enter the industry and if profits decrease firms leave the industry.

E) Factors of production are perfectly mobile. It is assumed that land, labor, and capital can switch
immediately from one line of production to another, for these factors of production are free to move from one
firm to the other throughout the economy.

6.3 The Short Run Equilibrium of the Firm and Industry

Short –run equilibrium and supply curve of the firm

Before looking into the conditions for equilibrium, it is very important to introduce demand, revenue, average
revenue, marginal revenue, and cost concepts in perfectly competitive market structure.

Demand Curve: Since a perfectly competitive firm is a price taker, horizontal demand curve is its distinguishing
feature. If a perfectly competitive firm sets its own price above the competitive price (Pc), a firm will find that it
will eventually have no customers at all.

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PC Demand

Figure 6.2: Demand Curve of a Firm under Perfect Competition

Revenue Curve: Revenue is the income to the firm from the sales of its output. It is price multiplied by the
number of units sold (i.e., R=PQ). Since price is constant in perfectly competitive firm, revenue curve will be a
straight line through the origin. Look at panel (a) of Figure 6.3 below.

The slope of revenue line is marginal revenue which is the change in total revenue as a result of changing the
level of sales by one unit. It will be equal to the constant price level at all units of output.

As average revenue is total revenue divided by level of output, it is also the same as the constant price level.
Hence, in perfectly competitive market, demand curve of a firm is equal to marginal revenue (MR) and also to
average revenue (AR) as it is indicated in panel (b) of the following figure.

.
Revenue line P
R

P=MR=AR

(a) Q (b)
O
O
Q
Figure 6.3: Revenue, Marginal Revenue, and Average Revenue Lines for Perfectly
Competitive Firm

The firm’s objective is the maximization of its profit, which is defined as the difference between revenue and
costs, for given factor prices and price of the product.

Definition: a firm is said to be at equilibrium when it maximizes its profit or minimizes losses.

Max  = R – C, where  is profit, R is total revenue, and C is total cost.

A firm can use two methods to identify the profit maximizing output level, i.e., total approach and marginal
approach.

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A) Total approach: in this approach, we use total revenue (TR) and total cost (TC) curves to determine the profit
maximizing output level. It is the level of output where the positive difference between total revenue and total cost
will be maximum. This level of output is called optimal output whereas the output level which makes profit zero
is called break even output level.

Figure 6.4: Total approach to profit maximization

The equilibrium may be shown graphically in two ways: Either by using TR and TC curves or MR and MC
curves. As indicated in the above figure, profit is maximum at a point where the distance between TR and TC is
the largest (at Qe). Profit is negative within the output ranges of zero to Q1 and beyond Q2. This is because the
cost curve is above revenue line within these ranges. Profit is positive in the output range of Q1 to Q2 as revenue
is above cost curve in this range. The profit function, therefore, will have the shape indicated in Figure 6.5 below
where it attains its maximum at the same output level of Qe.

0 Q

Q1 Qe Q2 π

Figure 6.5: Profit curve

The total-revenue-total-cost approach is awkward to use when firms are combined together in the study of the
industry. The alternative approach, which is based on MC and MR, is assumed to be superior as it uses price as an
explicit variable. This is demonstrated hereunder.

B) Marginal Approach In this approach we use marginal revenue (MR) and marginal cost (MC) curves to
determine the profit maximizing level of output. At the point where the distance between TR and TC curves is
widest, the slopes of these curves are equal, and these slopes are MR and MC curves, respectively. This means,
the firm is in equilibrium (maximizes its profit) at the level of output defined by the intersection of the MR and
MC curves. Indeed, this approach is superior to the TR-TC approach.

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Figure 6.6: Marginal approach to profit maximization

Dear learner, in the above figure, equilibrium is at point e where MR is equal to MC. Can you identify profit
region in the figure? Let us define profit based on the above figure.

- Since TR is equal to price multiplied by quantity, total revenue in the above figure is the area of rectangle
aOQee. (Because price is segment Oa and quantity is segment OQe).

- Similarly, since TC is AC multiplied by quantity, total cost in the above figure is the area of rectangle bOQeg
(Because average cost is segment Ob and quantity is segment OQe).

Therefore, as profit is total revenue (TR) minus total cost (TC), the area of rectangle abge will be an excess profit
for the firm (i.e., the difference between areas of the earlier two rectangles for TR and TC).

There are two conditions for profit maximization.

The necessary (first order) condition for maximization of a function is that its first derivative would be equal to
zero.

i.e. = =0

i.e. = => MR = MC

The sufficient (second order) condition for maximum profit requires that the second derivative of the function must
be negative implying that

i.e. = <0

i.e. < => <

As you know, slope of the MR = 0 in perfect competition since it has horizontal demand curve. Thus, the MC to
be greater than zero it must be rising. That is why the maximum profit is attained when MR=MC and slope of MC
is greater than slope of MR.
In the short-run equilibrium, a firm may not earn profits. In the short-run, it may earn just a normal profit or even
make losses. Whether a firm makes abnormal profits, normal profits or losses, depends on its cost and revenue

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conditions. Given the price and cost information the firm should produce at a point where MR=MC and MC is
rising.
The fact that the firm is in equilibrium does not necessarily mean it makes profit. Whether the firm makes excess
profit or loss depends on the level of average total cost curve (ATC) with respect to price line at the short-run
equilibrium. Look at the following figures:

(a) (b) (c)

Figure 6.7: Equilibrium situations under perfect competition

In panel (a) of the above figure, the area of rectangle abge is profit as it is discussed earlier. But in panel (b) of
the above figure, the area of rectangle baeg is a loss. On the other hand, excess profit is zero for panel (c). The
firm in panel (c) is at its break-even, no profit no loss.

Now, we can say that the firm earns excess (abnormal or super normal) profit if average total cost is below price
at equilibrium; incur a loss if average total cost is above price at equilibrium; and breakeven (no loss no profit) if
average total cost is exactly equal to price at equilibrium.

Dear learner, as long as the loss from staying in a business is less than the loss from shutting down, the firm will
continue to produce, even if it is incurring a loss. This depends on the price level and minimum average variable
cost.

As long as the price per unit sold exceeds the average variable cost per unit produced, the firm will be covering at
least part of its fixed costs. But if price falls below average variable cost, it is better for the firm to shut down the
operation. Now, let us introduce average variable cost (AVC) curve.

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Figure 6.8: Break-even and shutdown points

In the above figure, if price is at P1 the firm's equilibrium is at point B. This point is called break-even point, no
loss no profit point, as it is discussed earlier. But, if price falls to P2, the firm's equilibrium is at point S. At this
point the firm will only cover its variable cost, and hence this point is called shut-down point. It means that the
firm has to shut down its business if price falls below this point.

Supply Curve of a Firm in Perfect Competition: The supply curve of a firm may be derived from the points of
intersection of its MC curve with successive demand curves. Assume that the market price increases gradually.
This causes an upward shift of the demand curve of the firm, as indicated in panel (a) of Figure 6.9 below.

Figure 6.9: Derivation of firm’s supply curve

We have discussed that the firm should not produce any level of output if price level is below minimum average
cost curve (below the shut-down point). In panel (a) of the above figure, the firm will not supply any quantity
(will close down) if price falls below P1. If price is at P1, the level of output to be supplied is Q1. Assume that the
market price increases to P2, the firm can now supply higher level of output at Q2. If price further increases to P3,
quantity to be supplied will be Q3; and if price is P4, quantity will be Q4, and so on. This implies that the quantity
supplied by the firm increases as price rises.

If we plot the successive points of intersection of MC and the demand curves on a separate graph we observe that
the supply curve of the individual firm is identical to its MC curve to the right of the closing down point (S), as
indicated in panel (b) of the above figure.

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Short run equilibrium and supply curve of the industry

Market supply curve is the horizontal summation of the supply curves of individual firms. Likewise, the supply
curve of a perfectly competitive industry is the horizontal summation of the supply curves of the individual firms
in that industry. This means that the total quantity supplied in the market at each price level is the sum of the
quantities supplied by all firms at that price. Consequently, the supply curve for the industry will also be an
upward sloping one.

On the other hand, though demand curve for the firm in perfectly competitive market is a horizontal one, demand
curve for the industry is a downward sloping curve.

Given the market demand and the market supply, the industry (market) is in equilibrium at that price which clears
the market. This is at a point where quantity demanded is equal to quantity supplied. The equilibrium has the
property that once the market settles on that point it stays there unless either supply or demand shifts.
Additionally, a market that is not at the equilibrium position moves toward that point. In the following figure, the
industry is in equilibrium at price Pe, at which the quantity supplied and demanded is Qe. However, this will be a
short-run equilibrium, if at the prevailing price, firms are making excess profits or losses. This equilibrium will
not stay longer if firms are making profits or losses because of readjustment process to be discussed in the next
section.

Figure 6.10: Short-run Equilibrium of a Perfectly Competitive Industry

6.4 The Long Run Equilibrium of the Firm and Industry

Long run equilibrium of the firm

In the figure below, assume P1 is short-run equilibrium price of an industry where equilibrium point is attained at
the intersection point of the supply and demand curves. Assume also that a given firm is making excess profit at
that price level. This excess profit, now, is an incentive for the firm to build new capacity in the long-run so as to
produce more and, on the other hand, new firms will enter the industry attracted by the current excess profit. This
expansion of the existing firms and entrance of new firms will result in an increment of quantity supplied to the
market.

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Increment in quantity supplied is expressed by rightward shift of the supply curve of an industry as indicated in
panel (a) of Figure 6.11 below. This in turn leads to a reduction in equilibrium price. This results in reduction of
the available excess profit. A fall in the price of output and reduction in profit will continue until the long-run
average cost (LRAC) curve is tangent to the demand curve of the firm as indicated in panel (b) of the same
figure. The long-run equilibrium of a firm (eL) is at a point where LRAC curve is tangent to the firm’s demand
curve. At this point, there is no excess profit. In the long-run, firms will be earning just normal profits which are
included in LRAC.

Normal profit is the return given to the entrepreneur of the firm for involving himself in the production of goods
and services as opportunity cost.

Figure 6.11: Long run equilibrium of a firm in perfect competition

If a firm is initially incurring a loss in an industry, they will exit from the industry searching for other profitable
ventures. This in turn results in leftward shift of the supply curve. This leads to an increment in equilibrium price.
The loss now starts to decline for the existing firms. A rise in the price of output and reduction in loss will
continue until the long-run average cost (LRAC) curve is tangent to the demand curve of the firm.

In the long-run, the firm adjusts its plant size so as to produce that level of output at which the LRAC is the
minimum possible. Hence, the condition for long-run equilibrium of the firm is that the marginal cost be equal to
the price and to the long-run average cost as indicated in Figure 6.12 below.

The following equality holds at the firm’s long-run equilibrium:

P = MR = SRMC = SRAC = LRMC = LRAC (Where SR is short-run and LR is long run.

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Figure 6.12: Conditions of firm’s long-run equilibrium

Dear learner, we have said, in unit five, that it is possible to vary all inputs in the long-run. Hence, in the long-
run, producers are able to alter their scale of plant. The LRAC or envelope curve is constructed from a series of
short-run periods with different plant sizes. The firm is essentially able to select the scale of plant associated with
the lowest short-run average cost, which coincides with the lowest point of LRAC curve. The plant size
associated with this lowest point of LRAC is called an optimum and efficient plant size. Hence, long-run
equilibrium in perfect competition results in an optimum allocation of resources.

Generally, in the long-run

a) Firms produce at the minimum of average total cost, that is, they achieve a minimum efficient scale, and there
is no excess capacity.

b) Price equals marginal cost (i.e., P=MC) or incremental cost equals incremental benefit and the allocation is
efficient.

c) There are zero economic profits in the long-run, and firms earn normal profits and not excess profits.

Equilibrium of the Industry in the Long-run

The industry is in long-run equilibrium when a price is reached at which all firms are in equilibrium, profits are
normal, and all costs are covered. Under these conditions there is no further incentive for entry or exit, and
industry supply remains stable. Since the price in the market is unique, this implies that all firms in the industry
have the same minimum long-run average cost.

6.5 Consumer’s Surplus and Producer’s Surplus

A demand curve shows the price consumers are willing to pay for an additional unit of a commodity. The negative
slope of the demand curve reflects the law of diminishing marginal utility. Consumers wish to pay less and less to
additional units of commodity because the additional utility that extra units of a commodity yield tend to be lower
as the quantity of the commodity consumed increases.

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In a market economy, consumers pay the same price to all units of a commodity purchased, though they are willing
to pay different units. The difference of the price that consumers are willing to pay and the price they actually pay
constitutes consumer’s surplus. Geometrically, it is the area below the demand curve and above the equilibrium
price (Pe).

Figure 6.13: Consumers’ and producers’ surplus

A supply curve shows the price firms are willing to accept to supply an additional unit of a commodity. As price
increases firms would like to supply more output. In a market economy, firms sell all units of a commodity at the
same price, though they are willing to sell different units at different prices. The difference of the price that firms
are willing to accept and the price they actually receive constitutes producers’ surplus. Geometrically, it is the area
above the supply curve and below the equilibrium price (Pe).

Summary

 Market structure refers to the number and relative size of firms in an industry. The spectrum (continuum)
of market structure ranges from perfect competition to monopoly.
 In a perfectly competitive market, no individual buyer or seller has any influence over the market so that
market forces have full rein to determine price and output.
 The basic characteristics of a perfect competitive market structure include: large number of buyers and
sellers; homogeneous products; freedom of entry and exit; perfect knowledge of both buyers and sellers;
and perfectly mobile factors of production.
 A firm in perfectly competitive market is in equilibrium when it maximizes its profit (฀), defined as the
difference between total revenue (TR), and total cost (TC). The conditions of profit maximizations are
equality of MR and MC, and that the slope of MR is greater than the slope of MC.

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 The fact that the firm is in equilibrium does not necessarily mean it makes profit. Whether the firm makes
excess profit or loss depends on the level of average total cost curve (ATC) at the short-run equilibrium.
When average cost curve is above the price at equilibrium, the firm will incur economic loss.
 Whether a firm will go out of a business when it incurs economic loss depends on the price level and AVC
curve. As long as the loss from staying in a business is less than the loss from shutting down, the firm will
continue to produce.
 The minimum points of ATC and AVC curves are called break-even point and shut-down point,
respectively.
 Supply curve of a firm in a perfectly competitive market is its MC curve above shut-down point, and supply
curve of an industry is the horizontal summation of the supply curves of all firms in that industry. Price is
determined by the interaction of demand and supply curves in an industry and firms are expected to sell
their product at this price level.
 In the long-run, firms will be earning just normal profits which are included in LRAC. The firm adjusts its
plant size so as to produce that level of output at which the LRAC is the minimum possible. This is called
optimum plant size and long-run equilibrium in perfect competition results in an optimum allocation of
resources.

Self-Check Exercise

i. Review your understanding of the following terms under perfect competition.

Market structures Short-run equilibrium

Perfect competition Long-run equilibrium

Price taker Firm’s supply curve

Shut-down point Normal profit

Break-even point

ii. Workout Questions

1. Consider a profit maximizing firm operating under conditions of perfect competition. Suppose that
the market price is birr 50 and the firm faces a total cost function of TC = 10 + 5Q2, find the profit
maximizing level of output and the maximum profit possible.

2. A firm in a perfectly competitive industry is producing 50 units at its profit-maximizing quantity.

Industry price is Birr 2 and average total cost of the firm at profit-maximizing level is Birr 1.50.
Find the firm's economic profit.

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iii. Multiple Choice Questions

1. The market type known as perfect competition is

A. almost free from competition and firms earn large profits.

B. highly competitive and firms find it impossible to earn an economic profit in the long-run.

C. dominated by fierce advertising campaigns.

D. marked by firms continuously trying to change their products so that consumers prefer their product
to their competitors' products.

2. Which of the following approximates a perfectly competitive market?

A. Health service C. Soft drinks

B. Shoe shops D. farming

3. In a perfectly competitive market, the type of decision a firm has to make is different in the short run than
in the long-run. Which of the following is an example of a perfectly competitive firm's short-run
decision?

A. what price to charge buyers for the product

B. whether or not to enter or exit an industry

C. the profit-maximizing level of output

D. how much to spend on advertising and sales promotion

4. A price-taking firm

A. cannot influence the price of the product it sells.

B. talks to rival firms to determine the best price for all of them to charge.

C. sets the product's price to whatever level the owner decides upon.

D. asks the government to set the price of its product.

5. Perfectly competitive firms are price takers because

A. each firm is very large.

B. there are no good substitutes for their goods.

C. many other firms produce identical products.

D. their demand curves are downward sloping.

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6. If a firm is in a perfectly competitive industry, which of these is not true?

A. The firm’s MR is equal to the market price.

B. The firm is a price taker.

C. The firm faces an inelastic demand curve.

D. There is free-entry and exit.

E. The firm will produce at a point where MR=MC.

7. The short-run supply curve for a firm in a perfectly competitive industry is

A. the same as its marginal cost curve above the shutdown point.

B. the same as the marginal revenue curve above the shutdown point.

C. the same as its demand curve.

D. horizontal at the going price.

8. At present output levels, a perfectly competitive firm is in the following position: output = 4000 units,
market price = $1.10, fixed costs = $2000, total variable costs = $1000, marginal cost = $1.00. This firm
is:

A. not maximizing its profit but could do so by decreasing its output.

B. making a zero-economic profit.

C. losing money, although it could make a profit by increasing its output.

D. Producing the output where ATC = MC.

E. not maximizing its profit but could do so by increasing its output.

9. In a perfectly competitive market, the type of decision a firm has to make is different in the short-run than
in the long-run. Which of the following is an example of a perfectly competitive firm's short-run
decision?

A. what price to charge buyers for the product

B. whether or not to enter or exit an industry

C. the profit-maximizing level of output

D. how much to spend on advertising and sales promotion

10. Which of the following is an example of a perfectly competitive firm's long-run decision?

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A. what price to charge buyers for the product

B. how much to spend on advertising and sales promotion

C. the profit-maximizing level of output

D. whether or not to enter or exit an industry

11. To maximize profits, a firm in a perfectly competitive industry will:

A. adjust output until marginal revenue equals marginal cost

B. adjust price until average revenue equals average total cost

C. adjust average total cost until it equals price

D. adjust price until marginal revenue equals marginal cost.

iv. Discussion questions

a) How much will a perfect competitor produce in the short-run?

b) Can a perfectly competitive firm earn economic profits in the long-run? Why?

Suggested Reading Materials

Lipsey R. G., Courant P. N., Purvis D. D., and Steiner P. O., Microeconomics, 10th ed. New York: Harper Collins
College Publishers, Inc., 1993.

Amacher R. C., and Ulbrich H. H., Principles of Microeconomics, 3rd ed. Ohio: South-Western Publishing Co.,
1986.

Stanlake G. F., and Grant S. J., Introductory Economics, 6th ed., Singapore, Longman, 1995.

Gould J. P. and Lazear E. P., Microeconomic Theory, 6th ed., Homewood, Richard D. Irwin, Inc., 1998.

Koutsoyiannis A., Modern Microeconomics, 2nd ed., English Language Book Society, Macmillan, 1985.

Varian H. R., Intermediate Microeconomics, 3rd ed., New York, Norton & Company, 1993.

Additional readings:

 Ahuja, H. microeconomics theory and applications

 Hiwot & Hibret, microeconomics I
 Ayele K., microeconomics part I
 Salvatore D., microeconomics theories and applications
 H.S. Agrawal, Principles of Economics, 7th edition.
 C. Ferguson, Microeconomic Theory
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 R.S Pindyck and [Link], Microeconomics

 E. Mansfield, Microeconomics: Theory and Applications
 Robert H. Frank, Microeconomics and Behavior

Key Answers to Self-Check Exercise

Chapter 1

ii) 1. D 2. D 3. C 4. A

Chapter 2

ii) 1. C 2. B 3. B 4. B 5.B

iii) 1. a) P=10 and Q=20

b) P=5 and Q=30 (A decreases in price and increase in quantity)

2. P=28 and Q=2

3. At P=8,  p =1.68 (elastic); at P=4,  p =0.64 (inelastic); and at P=5,  p =1 (unitary)

4. a)  p =1.125 (elastic)

b) P= P  100 3

5. Initial price is 6. After 5% increment it will be 6.3. At this price level, the new quantity is going to be 3.7
given the demand equation of Q=10-P. This means, we have 7.5% reduction in quantity. Using
percentage increment in price and percentage reduction in quantity, elasticity will be -1.5. If we use the
dQ P
formula of , we will have the same value of -1.5.
dP Q

Chapter 4

ii) 1. A 2. A 3. B 4. A 5. A

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iii) 1.
Plot Fertilizer dose Yield index* AP MP
1 15 104.2 9.65 0.28
2 30 110.4 3.67 0.41
3 45 118.0 2.62 0.51
4 60 125.3 2.09 0.49
5 75 130.2 1.74 0.33
6 90 132.4 1.47 0.17
7 105 131.9 1.26 -0.03
8 120 130.3 1.09 -0.11
9 135 128.5 0.95 -0.12
10 150 126.2 0.84 -0.15

The point of diminishing average productivity is at 15 units of fertilizer and the point of diminishing marginal
productivity is at 45 units of fertilizer.

2. a) Diminishing marginal productivity is at a maximum point of MP curve.

dQ
MP   20  20L  L2
dL
d (MP) d ( MP)
MP is maximum at  0 . Therefore,  20  2 L  0
dL dL
 L  10 at maximum point of MP.
b) Diminishing average productivity is at a maximum point of AP curve.
Q 1
AP   20  10L  L2
L 3
d ( AP) d ( MP) 2
At maximum point of AP,  0 . Therefore,  10  L  0
dL dL 3
 L  15 at maximum point of AP.
MPL w
3. a) at equilibrium, 
MPK r

0 . 5 L  0 .5 K 0 .5 4
   K  2L
0 . 5 L0 .5 K  0 .5 2
Substituting K  2L in isocost function of 2K+4L=80, we have:
L=80 and K=160. Maximum output is, therefore, Q  80 0.5160 0.5  Q  113.14

MPL 0.5L0.5 K 0.5 K 160

b) MRTS L , K     2
MPK 0.5 L0.5 K 0.5 L 80

4. Max Q  20 X 3 2Y subject to X+Y=60 (because X and Y are also in thousands)

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In composite form:   20 X 3 2Y   (60  X  Y )


Equating to zero, we have   30 X 0.5Y
X

Again, equating to zero, we have   20 X 3 2Y 1
Y
3
Equating the two  ’s, we have X  Y 2
2
Substituting this in isocost equation of X+Y=60, we have:
3 2
Y  Y  60
2
Solving for Y, we will have Y=6 and hence X=54
5. Maximize C=10L+28K subject to 434  10K 0.7 L0.1
MPL w
Equilibrium condition is 
MPK r

Q Q
MPK   7 K 0.3 L0.1 MPL   K 0.7 L0.9
K L
MPL w K 0.7 L0.9 10 14
Therefore,    L K
MPK r 7 K 0.3 L0.1 28 35

Substituting this in 434  10K 0.7 L0.1 and solving for K, we have K  125 .
Then L  50 .

Chapter 5

ii) Workout part:

Qn.1)

Quantity produced 1 2 3 4 5 6

Total cost (Birr) 10 16 18 28 45 66

TVC 2 8 10 20 37 58

ATC 10 8 6 7 9 10

AVC 2 4 3.33 5 7.4 9.67

AFC 8 4 2.67 2 1.6 1.33

MC - 6 2 10 17 21

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Qn. 2) Given: Output (Q) of 12 units produced by 3 workers; Payment per day for each worker is Birr 40; and
TFC is Birr 240.

TVC = 3 x Birr 40 = Birr 120

This implies TC = Birr 360 (i.e., TVC + TFC)

Therefore, ATC = Birr 30 (i.e., TC/Q)

iii) Multiple Choices:

1) C 2) E 3) D 4) D 5) A

Chapter 6

ii) Workout part:

1) TC = 10 + 5Q2 P = 50

TR = PQ = 50Q

 = TR – TC = 50Q – 10 – 5Q2

d
 50  10Q  0
dq

Q=5

 = (50 x 5) – 10 – (5 x 52 )

 = birr 115

2) Given: Q=50 units; P=Birr 2; and ATC=Birr 1.50

Now, Revenue (R) = PxQ = Birr 2 x 50 units = Birr 100

Total cost (C) = ATCxQ = Birr 1.50 x 50 units = Birr 75

Therefore, profit (  ) = R – C = Birr 100 - Birr 75= Birr 25

iii) Multiple Choices:

1) B 2) D 3) C 4) A 5) C

6) C 7) A 8) E 9) C 10) D 11) A

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