Micro One Handout PDF

CHAPTER ONE
Review of some Basic Economic Concepts

1.2. What is economics?
Basically, there is no consensus among economists about the definition of economics. There are
many definitions of economics each trying to encapsulate the fundamentals of the subject.
Economics is the study of how societies choose to scarce resources to produce valuable
commodities and distribute them among different groups.
Economics is a social science concerned with the efficient allocation of scarce resources in the
production and distribution of goods and services to satisfy human material wants. All
specialized areas in economics are based on microeconomics and macro economics principles.
Micro means small, and Microeconomics analysis deals with the behavior and operation of
individual economic agents /units. These agents include consumers, workers, investors, owners
of land etc…macro economics, on the other hand, studies the activities and behavior of the
economy as a whole.
Examples which can be studied under microeconomics are, for instance, the price of a particular
product, number of workers employed in a particular industry etc…whereas, concepts like total
national output, the general price level (inflation or/and deflation), unemployment rate are some
of macroeconomic issues.
1.2 The fundamental economic fact
1.2.1 Human wants and resource

Two fundamental facts provide the foundation for the field of economics. These facts are:
a) Human wants are unlimited
b) Resources are limited/scarce
The need to balance the unlimited ends with limited means has given rise to the question of
efficient utilization of scarce means. Thus, the imbalance between unlimited ends and scarce
means provides a foundation for the field of economics. Scarcity forces people to make choice
and choice involves sacrifice. There are three fundamental choices to be made.
What to produce: it implies that the society must determine what kind of goods and services
should be produced and how much in each category.
How to produce: it refers to the method of production to be adopted.
For whom to produce: the concern of distribution.
Therefore, each economic agent needs to balance its resource use with the resources available so
as to meet their desired objectives; maximization of satisfaction for consumers, maximizing
profit for firms and maximizing social welfare for the government respectively. Generally we
can classify resources in to two as free and economic; free resources
are resource that can be obtained at zero prices like Air, sun shine…. Economic (scarce)
resources on the other hand are resources that can‘t be obtained at zero price.
Scarcity-This is the fundamental economic problem of any society when societies’ wants are
greater than resources.
1.2.3. Production possibility frontier (ppf/ppc curve))

Limited resources compel individuals and society to choose certain wants. Society’s choice
problem is illustrated by a new concept –the production possibility curve (PPC). It is curve that
shows the various combinations of two types of goods that an economy can produce when its
resources are fully utilized. It is a curve that shows feasible combinations of two goods that can
be produced with attainable and current technology.
Assumptions in using PPC for our illustration
a) Fixed resources: factors of production are not changed.

b) Efficiency: there is state of full employment and no idle resource is left.
c) Two products: there are only two goods to be produced.
d) Fixed technology: there is no advancement/change in technology.
e) Table 1 production possibilities of teff and Computer
f)
Types of product Production possibilities
A B C D E
Teff(in million tons) 0 1 2 3 4
Computer (in million units) 10 9 7 4 0
If all the resources are used in the production of only one of the two goods, a maximum of 10
million units of Computer or 4 million of tones of teff will be produced respectively. These are
two extreme possibilities .In between, various combination of teff and Computer can be
produced. Since resources are limited in supply and fully employed, if the society wants to have
more of teff, it must have less of Computer. Points inside the PPC are attainable but inefficient,
whereas, points on the PPC are attainable and efficient. Points outside the PPC are unattainable
in the short run. Each point on the PPF represents some maximum output. Society wants to use
its scarce resources efficiently. Efficiency concerns the relationship between inputs and outputs
and getting the most from available resources. So by productive efficiency the employed
resources should be utilized so as to make the most valuable contribution to total output. By full
employment, it is to mean that the available property and human resources should all be
employed. But if there are idle resources, the society is not producing on the PPF but rather
somewhere inside it, like point ‘G’.
Computers
10 A
9 B "J production possibility curve (PPC)
7 C
4. "G D
0 1 2 3 4 teff
Fig. 3 production possibility frontier/curve/PPF/PPC
The PPF illustrates the three basic concepts: scarcity, choice and opportunity cost. Explained
precisely as follows:
i. There is a limit to the amount we can produce in a given time period

with available resources and technology.
ii. The PPF shows the combination of goods that can be produced when
the factors of productions are utilized to their full potentials. Thus, the PPPC reveals the
economic choice open to society.
iii. We can obtain additional quantities of any desired good by reducing
the potential production of another good.
Failure is not shame but lack of effort is! Page 3

Opportunity cost is the amount of other products which must be forgone (give up) to
obtain a units if any given products. In equation form
Opportunity cost=
In the above table the amount of computer which must be scarified to get another tone of teff is
the opportunity cost of teff. In moving from Ato E, the cost of computer involved in getting each
additional tones of teff increases. That is when the economy moves from A towards E ,it must
give up successively large amount of computer (1,2,3,4)to acquire equal increments of teff
(1,1,1,1).this is reflected in the shape of PPC particularly the concavity of the curve illustrates
the law of increasing costs. The economic rationale for law of increasing costs is that, when
resources are first transferred to produce teff from computer, those resources which are most
productive of teff and least productive of computer is transferred. This means that resources are
not equally adaptable to alternative uses, lack of perfect flexibility on the part of resources and
this is called specificity of resources.
If the opportunity cost were constant rather than increasing, the PPF would be a straight line.
Free goods which are abundant in supply have zero opportunity cost, since nothing is scarified
for their consumption. A non scarce (free) good is one for which the quantity demand doesn’t
exceed quantity supplied, at zero price. In other words, a non-scarce good is available in the
amounts of that result in no shortages even if the price of the good is zero. If there is an
economic growth the PPC will shift to the right.
1.1 Micro economic theory and the price system

1.2 .1 the circular flow of economic activity
Micro economic theory –studies the economic behavior of individual decision making units such
as individual consumers (resource owners), and business firms, and the operation of individual
markets in a free enterprise economy. Micro economics focuses attention on two broad
categories’ of economic units: Households and business firms and it examine the operation of
two types of markets; the market for goods and services & the market for economic resources.
Households and firms (businesses are the two major decision making units of the economic
system .now let us use their interactions by using the circular flow model.)

The inner loop shows the flow of economic resources from households to business firms and the
flow goods and services, from business firms to households represents production flow.
The outer loop shows the flow of money incomes from business firms to households and the
flow of consumption expenditures from households to business firms, this represents financial
flow.
Expenditure of firms’ Resource income of resource owners

market
Flow of resources flow of resources
Firm Household
Flow of goods and services goods and services
Product
Revenue of firms’ consumption expenditure
market
Figure 1.1the circular flow of economic activity.
1.3 IMPORTANCE OF MICRO ECONOMIOCS

Micro economics has both theoretical and practical importance
• It is highly help full in the formulation of economic policies that will promote the welfare
of the mass.
• It shows how free market economy works to decide about the allocation of productive
resources among so many products.
• It shows how the products produced are distributed through price or market mechanism.
• It explains conditions of efficiency in production and consumption.
• It shows the welfare optimum or economic efficiency is achieved when there is perfect
competition in the product and factor markets.
• It shows how the imperfect mkt. (Monopoly, oligopoly,…)and externalities leads to
economic in efficiency and lower welfare of the society .
• Finally, it suggests suitable policies to promote economic efficiency and welfare of the
people.

1.4 . Methodologies and models
The fundamental objective of economics like any science is the establishment of valid
generalization s about certain aspects of human behavior. These generalizations are known as
theories (like the law of demand and supply). Theory is a simplified picture of reality that tells us
how one thing influences another thing. Establishment of valid generalization enables us to make
predictions about phenomena. The prediction in turn enables us to formulate policies to change
the outcome if the change proves appropriates.
Example the law of demand is a generalization about consumers’ behavior. It states that there
is an inverse relationship between the price of a good and quantity purchased. This theory will
enable the seller to predict the outcome of the change in the price of the good .the prediction will
help the seller to design pricing policy which maximizes his sales revenue.
Economic theories are often based on simplifying assumptions in order to reach conclusion.
This is because there are many economic factors in an actual situation that make the analysis
difficult. One example of simplifying assumption is “ceteris paribus” i.e. if other things
remaining constant. But if these things do no remain constant the result of models will be
affected. An economic theory provides the bases for economic analysis makes use of logical
reasoning. For driving generalizations and theories it has to adapt a certain methodology
.economics has in fact adapted both deductive and inductive methods of reasoning.
Deductive method: Is also known as analytical method. It is a logical reasoning to explain specific
events on the basis of the already established theory. Thus in deductive method, reasoning goes
from general to the particular (from theory to facts).Major steps in the deductive approach.
• Identification of the problem for analysis
• Specification of the assumption
• Formulation of hypothesis on the basis of assumption&
• Testing validity of the hypothesis.
Inductive method: Is a logical way of reasoning to arrive at a valid general statement, on the
basis of valid specific facts. In this method reasoning proceeds from the particular to the general
(from facts to theory). It involves the following steps;
• Selecting problem for analysis
• Collection ,classification , and analysis of data by using appropriate statistical techniques
in order to establish the relationship between variables and

• To find out the reasons for the relationship established through statistical analysis.
While deductive method is a descending process, inductive method is an ascending process. It is
now widely accepted that deductive and inductive methods are complementary. A combination
of the two methods yields a more reliable economic theory.
Another important distinction in economics also arises between positive analysis and normative
analysis.
Positive analysis: It deals with objective explanation of how the economy works. It is the
science of economics and concerns the analysis of facts. Positive analysis tries to answer the
questions what was, what is or what will be. Positive analysis is factual or hypothetically testable
and is devoid of ethical or value judgment. E.g. the inflation rate in Ethiopia is not greater than
three percent (3%).
Normative analysis: It deals with how the economic problem should be solved. It is a matter of
opinion which cannot be proved or rejected by reference to the facts it attempts to produce
answers to the questions “what ought to be” and is based on value judgments. We may or may
not agree with normative statements, since its validity cannot be checked by looking to facts.
E.g. The inflation rate in Ethiopia should not be greater than 3%.
CHAPTER TWO

Theory of consumer behavior
The theory of consumer behavior begins with three basic assumptions about people’s preferences
for one market basket versus another. These assumptions hold for most people in most situations.
Assumptions:
1. Completeness: Preferences are assumed to be complete. In otherworld’s, consumers can

compare and rank all possible baskets. Thus, 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. By indifferent we
mean that a person will be equally satisfied with either basket. Note that these preferences ignore
costs.
2. Transitivity: Preferences are transitive. Transitivity means that if a consumer prefers basket
A to basket B and basket B to basket C, then the consumer also prefers A to C. For example, if a
Ford is preferred to a Toyota and a Toyota to a Chevrolet, then Ford is also preferred to a
Chevrolet. Transitivity is normally regarded as necessary for consumer consistency.
3. More is better than less (No satiation): Goods are assumed to be desirable – i.e., to be
good. Consequently, consumers always prefer more of any good to less. In addition, consumers
are never satisfied or satiated; more is always better, even if just a little better. This assumption
is made for academic reasons; namely, it simplifies the graphical analysis. Of course, some
goods such as air pollution may be undesirable, and consumers will always prefer less. These
three assumptions form the basis of consumer theory. They do not explain consumer preferences,
but they do impose a degree of rationality and reasonableness on them.
2.1. The concept of Utility Theory and Concept of Marginal Utility

The satisfaction a consumer derives from the consumption of commodity is termed as utility.
Suppose a consumer eats five orange, the total satisfaction he gets from this is called total utility.
Suppose also that he consume an extra orange , the extra satisfaction he gets from consuming
this orange is called marginal utility of the six orange. Marginal utility is the extra or additional
satisfaction a consumer drives from consuming an additional unit of the product. Similarly, marginal
utility is change in total utility resulting from the consumption of one more unit of product.

The law of diminishing marginal utility states that marginal utility of a product diminishes as a consumer
consumes additional unit of that product. In other word, as a consumer takes more unit of good, the extra
utility or satisfaction that he drives from an extra unit of good goes on falling.
To illustrate the law of diminishing marginal utility, consider table 3.1 that shows total and marginal
utility derived by a person from a cup of tea consumed per day
Table 3.1: diminishing marginal utility
Cups of tea Total utility(utils) Marginal

consumed per day utility(utils)
0 0 -
1 12 12
2 22 10
3 30 8
4 36 6
5 40 4
6 41 1
7 41 0
8 39 -2
9 34 -5
When one cup of tea is taken per day, the total utility derived by a person is 12 utile. Since it is
the first cup of tea, its marginal utility is also 12 utile. With the consumption of the second cup
the total utility is raised to 22, but marginal utility falls to 10. It can be seen from the table that
TU increase at a decreasing rate. However, when the cup of tea consumed per day increase to
seven, then seventh cup gives negative marginal utility equals to -2. This is because too many
cup of tea may cause acidity or gas trouble. Thus, the extra cup of tea beyond six to the
individual in question gives him disutility rather than satisfaction
The relationship between TU and MU
As MU decrease but remains positive, TU is increasing

As MU assumed a zero value, TU is said to be at a maximum level in the above case TU
reaches its maximum at 7th cup with TU of 41.
As MU begins to assume a negative value, TU starts to decline. This happens after the
consumption of the 7th cup.

TU
41
From the above figure we can observe that
MU remains decreasing and positive up to
22 TU the 7th cup. MU becomes negative after 7th
cup of tea. Thus, the principle that marginal
12
utility declines as the consumer acquires
MU Tea
additional unit of a specific product is
known as the law of diminishing marginal
utility.
Tea
1 2 7 MU
Fig .3.1: total utility and marginal utility
2.2. Cardinal Approach and Consumer’s Equilibrium
A utility approach that describes by how much one market basket is preferred to another is called
cardinal utility analysis. The cardinal utility approach attaches numerical values (like 1, 2, 3…)
to utility obtained from a certain market basket. The following are assumptions of cardinal utility
analysis
1. The cardinal measurability of utility; the exponent of cardinal utility analysis hold that utility
is measurable quantifiable entity. Thus, a person can say that he drives utility equals to 10 utils
from consumption of good A.
2. The hypothesis of independent utilities; the utility which a consumers derives from a good is
the function of the quantity of that good only. On this assumption, the total utility which a person
gets from the whole collection of goods purchased by him is simply the total sum of the separate
utilities of the goods. This is to say that utility is additive.
3. Constancy of the marginal utility of money; while the marginal utility analysis assumes the
marginal utility of a commodity diminishes as more of them are purchased or consumed, the

marginal utility obtained from one unit addition in money results in equal increment in
satisfaction (utility) to the consumer.
4. Introspective method; introspection is the ability of the observer to reconstruct events which
go on in the mind of another person with the help of self observation. From his own response to
certain force and by experience and observation one gains understanding and of the way other
peoples mind would work in similar situation. We know from our own mind that as we have
more of a thing, the less utility we derive from it. We conclude from it that other individuals’
mind will work in a similar fashion.
Consumer equilibrium and its importance
Consumer equilibrium is explained by the principle of equi-marginal utility. The law of equi-
marginal utility state that the consumer will distribute his money income between the goods in
such a way that the utility derived from the last birr spent on each good is the same. This
indicates how a consumer allocates his money income among various goods, i.e. his equilibrium
position.
A consumer consuming only one commodity say,X, given his income level(I) will be at
equilibrium level of consumption when:
…………1
Where: marginal utility of good X and Price of good X
If the consumer can increase his welfare (utility) by purchasing more of good X.
If the consumer can increase his welfare by decreasing consumption of good X. That
is he will be better off if he reduces his consumption of good X. Thus consumer will be at
equilibrium or attains maximum satisfaction when the additional satisfaction obtained from a
good is equal to the price of the good, and if all of his income is spent for consumption of the
good.
Suppose there are two goods X and Y on which a consumer has to spend a given
income. The consumer’s behavior will be governed by two factors; first the marginal utility of
the good; second the price of the two goods. Suppose also that the prices of the two goods are

given for the consumer. The law of equi- marginal utility states the consumer will distribute his
money income between the goods in such a way that the utility derived from the last birr spent
on each good is the same. The law of equi-marginal utility can therefore be stated thus as; the
consumer will spend his money income on different goods in such a way that marginal utility of
money expenditure of each good is equal. That is, consumer is in equilibrium in respect of the
purchases of two goods X and Y when;
1) = and
2) Px X+ PyY = I
Table 3.2 Marginal utility of good x and y and marginal utility of money expenditure
Let the price of goods x and y be birr 2 and 3 respectively. Suppose a consumer has money
income of birr 24 to spend on the two goods.
Unit MUX MUY MUX/PX MUY/PY

1 20 24 10 8
2 18 21 9 7
3 16 18 8 6
4 14 15 7 5
5 12 9 6 3
6 10 3 5 1
From the table it is clear that MUX/ PX is equal to 5 utile when the consumer purchase 6 unit of
good x and MUY/PY is equal to 5 utile when the consumer purchase 4 unit of good y. therefore
the consumer is on the equilibrium when he is buying 6 unit of good x and 4 unit of good and
will be spending ( 2 ). Thus in the equilibrium position where he
maximizes his utility;
= 10/2=15/3=5
Generally, extending the above for many commodity cases if consumer consumes “n” number of
goods: thus optimum of the consumer will be:
= and PxX+PyY …+PnN=I

A rational and utility maximizing consumer consumes commodities according to their order of
utilities. He/she switches his/her expenditure from one good to another according to their
marginal utility. He/she continues to switch until he/she reaches the stage where marginal utility
of each commodity per unit of expenditure is the same.
2.3. Ordinal Approach
The ordinal utility implies that the consumer is capable of simply comparing the different level
of satisfaction. According to ordinal utility hypothesis, while the consumer may not be able to
indicate the exact amount of utility that he derives from commodities, but he is capable of
judging whether the satisfaction obtained from a good or a combination of goods is less, equal to
or higher than another.
2.3.1. Definition and meaning of Indifference Curves
Definition: An indifference curve represents all combinations of market baskets that provide a
consumer with the same level of satisfaction.
Given the three assumptions about preferences, it is known that a consumer can always indicate
either a preference for one market basket over another or indifference between the two. By using
this information, it is possible to rank all potential consumer choices. In order to appreciate this
principle in graphic form, assume that there are only two goods available for consumption: food
(F) and clothing (C). In this case, all market baskets describe combinations of food and clothing
that a person might wish to consume. The following table provides baskets containing various
amounts of food and clothing.
Table3.3; Alternative Market Baskets for Food and Clothing
market basket units of food units of clothing

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
Market basket A, with 20 units of food and 30 units of clothing, is preferred to basket G because
A contains more food and more clothing (third assumption no satiation). Similarly, market

basket E, which contains even more food and even more clothing, preferred to A. Note, however,
that B contains more clothing but less food than A. Likewise; D contains more food but less
clothing than A. Therefore, comparisons of market basket A with baskets B, D, and H are not
possible without more information about the consumer’s ranking. The following figure shows an
indifference curve, labeled IC, which passes through points A, B, and D. This curve indicates
that the consumer is indifferent among these three market baskets.
Food
It shows that in moving from market basket

50 A to market basket B, the consumer feels
neither better off nor worse off in giving up
40 D
10 units of food to 20 units of clothing.
30 E
Likewise, the consumer is indifferent
20 A
between points A and D. He or she will give
10 G H B IC1 cloth up 10 units of clothing to obtain 20 units of
10 20 30 40 50 food. On the other hand, consumer prefers A
Fig 3.2 an indifference curve to H, which lies below u1.
Indifference curve in the figure slopes downwards from left to right. To understand why this
must be the case, suppose instead it sloped upward from A to E. This would violate the
assumption that more of any commodity is preferred less. Because market basket E has more of
food and clothing than market basket A, it must be preferred to A and therefore cannot be on the
same indifference curve as A. In fact, any market basket lying above to the right of indifference
curve IC1 in the figure is preferred to any market basket on IC1.
2.3.2. Assumptions of indifference curve
An ordinal measure of utility is based on the following assumptions;
Ordinal utility: IC analysis assumes that utility can only be measured ordinary.
Rationality: the consumer is assumed to maximize his total satisfaction, given his income and
prices of goods and services s/he consumes.

Transitivity and consistency of choice: transitivity of choice means if a consumer prefers A to B,
B to C he must prefer A to C. Consistency of choice means that if he prefers A to B in one
period, he will not prefer B to A in on other period.
Non satiety: the consumer is not over supplied with either good in question. Therefore a
consumer always prefers a larger quantity of all the goods.
Diminishing marginal rate of substitution: it assumed that as more and more units of X are
substituted for Y, the consumer will be willing to give up fewer and fewer units of Y for each
additional unit of X.
2.3.3. Characteristics of indifference curves
Indifference curves have certain characteristics that reflect assumptions about consumer
behavior. In fact, one of the major uses of indifference curves is to examine the kinds of
consumer behavior implied by different preferences, prices, and incomes. For simplicity, assume
there are only two goods, Food and Clothing. Thus well behaved indifference curves have the
following properties.
1. Indifference curves cannot intersect.
2. Indifference curves are negatively sloped.
3. Indifference curves are convex in shape.
4. The higher or further to the right is an indifference curve, the higher the bundles on that
curve are in the consumer’s preference ordering, that is, baskets on higher indifference curves are
preferred to bundles on lower indifference curves.
2.3.4. Exceptional types of indifference curve
The shape of an indifference curve describes the willingness of a consumer to substitute one
good for another. An indifference curve with a different shape implies a different willingness to
substitute.
Two goods are substitutes when an increase in the price of one leads to an increase in the
quantity demanded of the other. In general, two goods are named perfect substitutes when the
marginal rate of substitution of one for the other is constant. The indifference curves describing
the trade-off between the consumption of the goods are straight lines. The slope of the
indifference curves need not be-1 in the case of perfect substitutes.

The following fig 3.3 shows preferences of a consumer for apple juice and orange juice. These
two goods are perfect substitutes for a consumer because he is entirely indifferent between
having a glass of one or the other. In this case, the MRS of apple juice for orange juice is 1:
consumer is always willing to trade 1 glass of one for 1 glass of the other.
Apple juice
1 2 3 4 Orange juice
Fig 2.3 indifference curves for perfect substitute goods
Goods are compliments when an increase in the price of one leads to a decrease in the quantity
demanded of the other. Two goods are perfect compliments when the indifference curves for
both are shaped as right angles. The following figure 3.4 illustrates consumers’ preferences for
left shoes and right shoes. For a consumer, the two goods are perfect complements because a left
shoe will not increase her satisfaction unless he/she can obtain the matching right shoe.
In this case, the MRS of left shoes for right 3.4. Perfect Compliments.
shoes is zero whenever there are more right Left shoes
shoes than left shoes; consumer will not give
4
up any left shoes to get additional right
3
shoes. Correspondingly, the MRS is infinite
2
whenever there are more left shoes than
right because consumer will give up all but 1
one of his/her excess left shoes than obtain 1 2 3 4 right shoes

an additional right shoe.
2.3.5. Marginal Rate Of Substitution (MRS)

To quantify the amount of one good that a consumer will give up to obtain more of another, we
use a measure called the marginal rate of substitution (MRS). The MRS of food, F, for clothing,
C, is the amount of clothing that a person is willing to give up to obtain one additional unit of
food. Suppose, for instance, the MRS is 3. This means that the consumer will give up 3 units of
clothing to obtain 1 additional unit of food. If the MRS is 1/2, the consumer is willing to give up
only ½ unit of clothing. Thus, the MRS measures the value that the individual places on 1 extra
unit of one good in terms of another.
When we describe the MRS, we must be clear about which good we are giving up and which we
are getting more of. We define MRS in consistent terms as the amount of the good on the
vertical axis that the consumer is willing to give up to obtain 1 extra unit of the good on the
horizontal axis. Assume that food is on the vertical axis and close is on the horizontal axis, and
if we denote the change in clothing buy ∆C and the change in food by ∆F, the MRSCF can be
written as -∆F/∆C. We add the negative to make the marginal rate of substitution a positive
number.
Thus, the MRS at any point is equal in magnitude to the slope of the indifference curve. In
Figure 3.4 for example, the MRS between points A and B is 6: The consumer is willing to give
up 6 units of clothing to obtain 1 additional unit of food. Between points B and D, however, the
MRS is 4: With these quantities of food and clothing, the consumer is willing to give up only 4
units of clothing to obtain 1 additional unit of food.
Diminishing marginal rate of substitution: (Assumption 4 of Consumer behavior (Preferences))

Indifference curves are convex or bowed inward. The term convex means that the slope of the
indifference curve increase (i.e., becomes less negative) as we move down along the curve. In
other words, an indifference curve is convex if the MRS diminishes along the curve. The
indifference curve in Fig 3.4 is convex, starting with market basket A in Figure and moving to
basket B, the MRS of Food F for Clothing C is -∆C/∆F = -(-6)/1 = 6. However, when we start at
basket B and move from B to D, the MRS fall to 4 and if we start at basket D and move to E, the
MRS is 2. Starting at E and moving to G, we get the value of MRS to be 1. As food consumption
increases, the slope of the indifference curve falls in magnitude. Thus the MRS also falls. (With
no convex preferences, the MRS increases as the amount of the good measured on the horizontal
axis increases along any indifference curve.

This unlikely possibility might arise if one or both goods are addictive. For example, the
willingness to substitute an addictive drug for other goods might increase as the use of the
addictive drug increased).
2.4. Budget Line (Constraints)
People are compelled to determine their behavior in light of limited financial resources. For the
theory of consumer behavior, this means that each consumer has a maximum amount that can be
spent per period of time. The consumer’s problem is to spend this amount in the way that can
yield maximum satisfaction.
The Consumption Basket of a consumer (X, Y) is simply a list of two numbers that tells us how
much the consumer is choosing to consume of good X and how much the consumer is choosing
to consume of good Y. Sometimes it is convenient to denote the consumer’s bundle by a single
symbol like X, where X is simply an abbreviation for the list of two numbers (x1, x2).
We suppose that we can observe the prices of the two goods, (PX, PY) and the amount of money
the consumer has to spend I, then the budget constraint of the consumer can be written as:
PXX + PYY < I (1)
Here PXX is the amount of money the consumer is spending on good X, and PYY is the amount
of money the consumer is spending on good Y. The budget constraint of the consumer requires
that the amount of money spent on the two goods be no more than the total amount the consumer
has to spend. The consumer’s affordable consumption bundles are those that do not cost any
more than I.
Figure3.6 Budget Line The budget set consists of all bundles that
Y are affordable at the given prices and
income.
I/Py
Budget set Rearrange the budget line in equation (1) to

get the formula
I/PX X

This is the formula for a straight line with a vertical intercept of I/PY and a slope of –PX/PY. The
formula tells how many units of good Y the consumer need to consume in order to just satisfy
the budget constraint if he or she is consuming X units of the other good. The slope of the budget
line measure the rate at which the market is willing to substitute good X for good Y. For
example, the consumer is going to increase consumption of good X by ∆X. By how much will
consumption of good Y have to change in order to satisfy his/her budget constraint?
PXX + PYY = I
PX(X+∆X) +PY(Y+∆Y) = I. Subtracting the first equation from the second gives:
PX∆X +PY∆Y = 0.
This implies that the total value of the change in consumption must be zero. Solving for ∆Y/∆X
the rate at which good Y can be substituted for good X while still satisfying the budget
constraint, gives
This is just slope of the budget line. The negative sign is there since ∆X and ∆Y must always
have opposite signs. Because consumption of more of good X leads to consumption of less of
good Y and vice versa, as long as the consumer continue to satisfy the budget constraint.
2.4.1. Change in income and price of the budget line
When prices and incomes change, the set of goods that a consumer can afford changes as well.
To find out, how these changes affect budget set consider the changes separately?
I. Change in income. It is easy to see from Y

equation (2) that all increase in income will
increase the vertical intercept and not affect
the slope of the line. Thus an increase in
income will result in a parallel shift outward
of the budget line as in the following figure
2. Similarly, decrease in income will cause a
parallel shift inward. I/Px I1/Px X
Fig 3.7 change in income and budget line

II. Changes in prices, first, consider increasing price of X while holding price Y and income
fixed. According to equation (4) increase in Px will not change the vertical intercept, but it will
make the budget line steeper since Px/Py will become larger.
Y What happens to the budget line

I/PY when we change the prices of good X and
good Y at the same time? For example, if
New budget line
the prices of both goods X and Y gets
doubled, both the horizontal and vertical
Old budget line
intercepts shift inward by a factor of one-
half, and therefore the budget line shifts
I/Px2 I/Px1 X inwards by one-half as well. Multiplying
Fig. 3.8 change in price and budget line both prices by two is just like dividing
income by 2.
2.5. Optimum choice
Given the indifference map of the consumer and his budget line, the equilibrium is defined by
the point of tangency of the budget line with the highest possible indifference curve (point e in
fig.). Fig.3.9 optimal choice
Y At the point of tangency the slopes of the

budget line (Px/Py) and of the indifference
A curve (MRSx,y=MUx/MUy) are equal:
MU x Px
e =
MU y Py
Thus the first-order condition is denoted

0 x* B X graphically by the point of tangency of the
two relevant curves.

The second-order condition is implied by the convex shape of the indifference curves. The
consumer maximizes his utility by buying x* and y* of the two commodities.
Mathematical derivation of the equilibrium:
Given the market prices and his income, the consumer aims at the maximization of his utility.
Assume that there are n commodities available to the consumer, with given market prices
P1,P2,…….Pn. The consumer has a money income (Y) which he spends on the available
commodities. Formally, the problem may be stated as follows:
∑q P
t =1
1 1 = q1 P1 + q 2 P2 + .... + q n Pn = Y
Maximize U = f(q1,q2,….,qn) Subject to
We use the ‘Langrangian multipliers’ method for the solution of this constrained maximum.
The steps involved in this method may be outlined as follows:
(a) Rewrite the constraint in the form, (q1P1+q2P2+…+qnPn - Y) = 0
(b) Multiply the constraint by a constant λ, which is the Lagrangian multiplier.
λ(q1P1+q1P2+…..qnPn – Y) = 0.
(c) Subtract the above constraint from the utility function and obtain the ‘composite function’.
φ = U – λ(q1P1+q2P2+…..qnPn – Y)
It can be shown that maximization of the ‘composite function implies maximization of the utility
function. The first condition for the maximization of a function is that its partial derivatives be
equal to zero. Differentiating Φ with respect to q1…qn and λ and equating to zero we find
∂φ ∂U From these equation we obtain
= − λ ( P1 ) = 0
∂q1 ∂q1
∂U
= λP1
∂φ ∂U ∂q1
= − λ ( P2 ) = 0
∂q 2 ∂q 2
∂U
= λP2
∂φ ∂U ∂q2
= − λ ( Pn ) = 0
∂qn ∂qn
∂U
= λPn
∂φ ∂qn
= −( q1P1 + q2 P2 + .......qn Pn − Y ) = 0
∂λ
∂U ∂U ∂U
= MU1 , = MU 2 ,....... = MU n
∂q1 ∂q2 ∂qn …………Substituting and solving for λ we find
MU 1 MU 2 MU n
λ= = = ..... =
P1 P2 Pn
We observe that the equilibrium conditions are identical in the cardinals’ approach and in the
indifference curves approach. In both theories we have
MU1 MU 2 MU x MU y MU n
= = .... = = = .... =
P1 P2 Px Py Pn
Change in income and prices of goods and services
Change in income: the change in income changes the purchasing power of the consumer.
Increase in income shifts the budget line outwards while decrease in income shifts the budget
line inward to the left. Corresponding to each budget line there is optimum of the consumer at
which indifference curve is tangent to each budget line.
If we go on increasing income we will have

a set of optimum points belonging to each
Income consumption curve (ICC)

budget line. The locus of optimum points
that we get as we shift budget line gives us a
curve called income consumption curve
(ICC).the shape and slope of ICC depends
on the nature of commodities.
Engle curve: is a curve that shows the relationship between equilibrium quantity and the income
level. It is a derived function of ICC and its slope is the slope of ICC. The slope of Engle curve is
positive for normal goods and negative for inferior goods. For luxury goods which are highly
responsive Engle curve is relatively flatter and for necessity goods which are less responsive to
change in income Engle curve is steeper.
Income income
Necessity
Luxury
X X
Engle curve for normal goods Engle curve for inferior goods
Change in price: when price of the commodity changes the slope of the budget line and its
intercepts changes under citrus paribus. Generally the change in consumption due to the change
in price is known as price effect. When price of a good (say, X) decreases the budget line
becomes flatter i.e move from AM to AN in the fig. bellow. The optimum choice will change
from E1 to E2 and the quantity demanded increases, if we decrease price of good X further the
budget line will be AP and optimum point will shift toE3.The locus of optimum points (E1, E2,
E3….) associated with the new budget line formed by reducing price of X keeping price of Y and
income of the consumer constant gives a curve called price consumption curve (PCC).
A E3 Price consumption curve (PCC)
E1 E2
M N P
The total price effect (PE) can be decomposed into substitution effect (SE) and income effect
(IE), I.e. PE=SE+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 resulted from decrease in price of the good.
Because now one of the goods becomes cheaper the consumer’s purchasing power increases so
that the consumer has left over income to purchase more.
Substitution effect: shows the change in quantity demanded of a good due to the consumer
inherent tenders to substitute the cheaper from the relatively expensive one. I.e. the consumer
buys more of the cheaper and less of the expensive good. These two effects occur simultaneously
but can be decomposed for the purpose of analysis using compensated budget line. Compensated

budget line is an imaginary line that eliminates the income effect from the total price effect.
There are two basic approaches to decompose price effect;
1. Hicksian approach
PE=X1X3
A IE=X2X3
D E1 E2 SE=X1X2
E3
X1 X2 X3 D’
E1- indicates the equilibrium the consumer before change in price

E2 –equilibrium after price of X declines
E3- equilibrium after eliminating income effect
NB: this analysis on price decrement can hold also for price rise
2. Slutsky approach
I PE=X1X3
J E1 E2 SE=X1X2
E3 IE=X2X3
JJ’=compensated budget line
X1 X2I’ X3 J’ I
E1-origional equilibrium
E2- equilibrium after decrease in price of good X
E3- equilibrium after income effect is eliminated using slutsky method
In short the difference between slutsky and hicksian approach is

Hicksian approach holds the consumer real income constant by remaining on the original
indifference curve (the compensated budget line must be tangent to the original indifference
curve).
In the slutsky’s approach the consumer is not held constant he/she is able to purchase the original
combination at the original price ratio.
Hicksian method is “cost difference” and slutskian method is”compensated variation”
Substitution effect is always negative but income effect can be positive or negative based on the
nature of the commodity. For most inferior commodities
A PE= negative =X1X2
D E1 E2 SE= negative=X1X3
E3 IE= positive=X3X2
X1 X2 X3 C D' C’
Fig. decomposition of PE for inferior good
The SE outweighs the positive income effect so that PE is negative. Thus the negative substitution effect
is in most cases adequate for establishing the law of demand i.e the law of demand is applicable for both
normal and inferior goods.
2.9. Revealed preference theory

Chapter two
Demand and supply
2.1 Demand
Demand in economics implies both the desire to purchase and the ability to pay for a good. And
willingness without ability to pay is mere wish. Quantity demanded is the amount that buyers are
willing and able to purchase at various prices in a given period of time other things remaining
constant. One peculiar characteristics of the definition is that demand is time specific hence
should be at a given period of time. Willingness unless is backed by the actual payment is not
effective and is called Nominal demand .While willingness that is backed by the actual payment
is called effective demand.
The low of demand states that, other factors remaining constant when price of a product
increases, quantity demanded of the product decreases and vice versa. This shows the negative
relationship between price and quantity demanded. The law of demand is a valid generalization
about consumers’ behavior but still there are exceptions to this law. The first exception is the so
called Veblen effect where goods having prestige value are likely to have increasing demand
when their price increases. This is mainly because consumers consider purchasing such goods as
expression of richness. Geffen goods are goods having positive relationship between their price
and quantity demanded, and thus can be considered as another exception to the law of demand.
The additional exception is considered as false exception and is manifested when consumers
expect future price to change and when homogeneous goods are sold using different brand
names.

2.1.1 Demand schedule and Demand curve
Is a table that represents the relationship Price Qd(quantity
demand)
between the various prices of an item and 12 10
the quantity demanded for the good other 10 20
8 30
things remaining constant. Table 4.1 shows 6 40
the price of orange and the corresponding 4 50
2 60
quantity of orange demanded.
Table 4.1.demand schedule
It will be seen from this demand schedule that when price is 12 birr quantity demanded is 10
units, when price falls to birr 10 per unit he/she increases its purchase to 20 units and so on,
clarifying the law of demand.
Demand curve is a curve which represents Price

the relationship between price and quantity 12
demand of an item and it is down ward 10
sloping curve because of the law of demand. 8
In other words demand curve is a graphical
6
representation of demand schedule.
4
Representing the above demand schedule for
2 dd
orange on a coordinate plain (Y-axis
0 Qd
represents price and X-axis quantity
10 20 30 40 50 60
demanded):
Fig 4.1 demand curve
Market demand: We can add or sum up the various quantities demanded by the number of
consumers in the market and by doing so we can obtain the market demand and by representing
that graphically we obtain market demand curve. Thus market demand is horizontal summation
of individuals demand for a product at various price levels.
E.g. suppose there are three individual buyers of a product in the market, individuals A, B &C
price A B market dd.

6 2 0 2

5 3 2 5
4 4 3 7
3 5 4 9
Table4.2 market demand
Graphically the above market demand schedule can be presented as follows:
p P P
3 DA DB Mkt dd
2 3 4 5 Q 2 3 4 Q 2 5 7 9 Q
2.1.4 Determinants of demand

While defining demand we have assumed that other things should remain constant, but what
are these variables that are supposed to be constant in the definition of demand and what will
happen to the demand for a commodity if these variables are going to change. The following are
the factors which determine demand for goods other than the price of the good
Taste and preference of the consumers: A good for which consumers tastes and preferences are
greater, will have greater demand and vice versa, this change in demand occurs due to change in
fashion and intensive advertisement. E.g. if wearing jeans becomes fashion of the day we
increase purchasing jeans on the ongoing price. As a result the demand for jeans will increase.
Income of consumers: The effect of change in income of a consumer on his demand for a
product depends on the nature of the product. Goods are called normal goods if an increase in the
income of consumers leads to increase in their demand and the vice versa. And they may be
luxury (e.g. gold, TV) or Necessities (e.g. meat, shoes). On the other hand if increase in income
of the consumer causes a decrease in demand and vice versa then such goods are called inferior
goods. E.g. cabbage, ”shiro wot”

Changes in the price of related goods: The demand for a good is also affected by the prices of
other goods, especially those which are related to it as substitutes or complements. We call two
goods are substitute if they are alternative to each other, or are alternatively consumed. E.g. Tea
and coffee. If X and Y are substitutes an increase in the price of good Y leads to an increase in
demand of good X and vice versa. Alternatively goods are said to be Complements if they are to
be used together. E.g. Car and petroleum, Sugar and tea, … etc. If X and Y are complements, an
increase in the price of good X leads to decrease in the demand for good Y.
Number of consumers in the market: If the number of buyers in the market increases the
demand for a product will increase as market demand is the summation of individual’s demand
and the vice versa also holds true. Number of consumers in a market may increase due to many
factors like migration and population growth, if sellers find new markets for their products.
Consumers’ expectations with regard to future price and income: If consumers expect price of
a certain good to increase in the future their demand for the product increases at present mainly
to get away the problem of huge costs in the future and vice versa. likewise, when the consumers
anticipate that of their income to raise in the future their demand today will obviously increase
and vice versa.
2.1.5 Elasticity of demand
We have explained the law of demand which stats negative or inverse relationship between the
price of a product and the quantity demanded for it, nevertheless this law only shows the
direction of relationship and not the extent by how much quantity demanded will change as a
result of change in price. Here, it is elasticity of demand, which measures this matter of extent.
Usually, it is price elasticity of demand which is referred as elasticity of demand. However, price
elasticity of demand is only one type of elasticity of demand. And elasticity of demand refers to
the degree of responsiveness of quantity demanded of a good to a change in the determinants of
demand and hence we have as much elasticity of demand as the number of determinants of
demand. Meanwhile, let us see the three common concepts of demand elasticity. These are:
Price elasticity
Income elasticity
Cross elasticity

1. Price elasticity of Demand
This measures the degree of responsiveness of quantity demanded of a good to the change in its
price, other things remain constant. And can mathematically be calculated as:
………….. This formula is known as
point price elasticity of demand: where, Ep = price elasticity of demand, ∆Qd = change in
quantity demanded, and ∆P = change in price NB: - Ep = Ed
NB:-
• Ep is unit free because it is a ratio of percentage change

• Ep is usually a negative number because of the law of demand i.e. negative relationship
between price and quantity demand. So we can take the absolute value of /Ep/.
• Ep varies between zero and negative infinity i.e. [-∞ < Ep ≤ 0] or [0 ≤ Ep < ∞]
Elasticity Description Implications

>1 Elastic %∆Qd > %∆P
=1 Unitary %∆Qd = %∆P
<1 inelastic %∆Qd < %∆P
Demand is most likely to be elastic for Luxurious goods (E.g. TV, Refrigerator, gold, etc), for
goods with non habitual consumptions (i.e. their expense represents a large portion of
consumer’s budget), or for goods on behalf of which consumers have adequate substitutes.
Demand is inelastic for Necessities (e.g. salt, water, bread), habitual consumptions (e.g. Tobacco
– when the expense represents a small portion of our budget), goods that do not have adequate
substitutes (e.g. sugar)
p p

P P
P’
P’ D D
O M M’ Qx O N N’ Qx
a) Elastic Demand b) Inelastic demand

Elasticity is a matter of degree only, meaning that (a) is only relatively elastic as compared with
(b) and not in absolute sense. For the same decrease in price from P to P' Qd (quantity
demanded) in “a” increases more than that of “b”, thus demand in “a” is more elastic than that of
“b”.
E.g 1) If 5% increase in price leads to a 20% decrease in quantity demanded, what will be the
price elasticity of demand?
Given solution
%∆Qd = 20% Ep = %∆Qd/%∆P
%∆P = 5% = 20%/5%
Ep =? =4
Since Ep = 4 >1, therefore demand is elastic
Interpretation: - This means that a 1% change in price leads a 4% change in quantity demand,
implies that the consumer is more sensitive to changes in price.
Eg.2 suppose you are a retailer of TOYOTA company and last year you sold 10,000 cars and
this year the price of cars is increased by 10% additionally from your past trend you know that
price elasticity of demand for cars is -2,how many fewer cars will you sell this year?
We also use another formula to determine price elasticity of demand if the change in price is
substantially large. This is called Arc price elasticity of demand or mid-point elasticity of
demand. And measures the average responsiveness of quantity demanded between two points on
the demand curve to change in price other things remaining constant.
Mathematically,
Ep=

= )*100%
= ( )* ………………….rearranging (P1-P0) to the left and (Q1+Q0) to the right

we have
= )*(
Ep = )*(
.
NB: - when the change in price is quite large (i.e. > 100%), we use this formula (Arc) and also
when we want to measure elasticity between two points.
Ep on Linear demand curve
The price elasticity of demand varies at different points on a linear demand curve though the
slope of the demand curve is the same throughout the curve.
lower segment
P eP =
upperse gment
EP=∞
EP>1
EP=1 EP=1
EP<1
O EP=0 Q
Fig 1) Price elasticity of demand on a linear demand curve
Ep on a Non-Liner demand curve declines as we move downwards on the curve from left to the
right. Because the slope of a curve and a straight line are equal at the point of tangency to
measure elasticity at point on the curve we can draw a tangent line to it and divide the lower
segment of the line to the upper segment.

For point a, Ep= >1
S for point B, Ep= <1,
A implies that Ep at point A is greater than Ep at point B.
o S1 T1
Fig 2) price elasticity of demand on a non- linear demand curve
p p dd
dd
Q Q
a) Perfectly elastic dd curve b) Perfectly Inelastic dd curve
Small p causes either Zero * p does not affect Qd.
Or larger Q.
In the case of perfectly elastic demand if a firm in perfectly competitive market increase its price
it will lose all customers and will attract all customers if it reduces the price for its commodities
since all products are identical in such markets. An interesting example for a perfectly inelastic
demand is the case of insulin for diabetic patient as he has to get insulin whatever its price is in
order not to die.
Price elasticity of demand and Total Revenue

An increase in price does not necessarily mean an increase in the total revenue of a firm. The
effect of change in price of goods on the total revenue all depends on the price elasticity of
demand for the goods. Table 2.4 bellow shows the relationship between price elasticity of
demand and Total Revenue.

P
EP>1(elastic)
Ep=1(unitary)
Ep<1(inelastic)
TR
Fig2.11 price elasticity of demand and total revenue
Direction of P-change When/Ed/>1 When /Ed/<1 When /Ed/=1
When price increases TR decreases TR increases unchanged

When price decreases TR increases TR decreases unchanged
Summary – 1
Sellers can increase their total Revenue (TR) by increasing their price for
commodities that have inelastic demand, and also they can increase their TR by decreasing price
of their commodities that have elastic demand, by selling more of their products.
Determinants of Price elasticity of demand

A. Availability of substitutes: If a product has adequate close substitutes its demand will be elastic
and the vice versa. E.g. Umbrella and rain coat
B. Time period: In a short run, demand is relatively inelastic, where as in the long run demand is
elastic, because in the long run more substitutes will be produced and consumers will adjust
themselves.
C. Proportion of income consumers spend for a product: the higher the proportion of income
absorbed by a product the more elastic will be its demand and the lower the amount of income
spent on a product, the more inelastic will be its demand.
D. Consumers income: the poorer a person the more elastic is likely to be his demand for most
things, and the vice versa.
E. Nature of the commodity:
- Luxury goods have elastic demand
- Necessities have in elastic demand
F. Frequency of purchase: The more frequently a good is purchased the more inelastic will be its
demand and the less the frequency of purchases the more elastic its demand will be.
N.B:- Consumers durable goods have elastic demand, Consumers Non-durable goods have
inelastic demand, Perishable goods have inelastic demand, and non- perishable goods have
elastic demand.
Importance of Price elasticity of demand
a) Pricing decisions by business firms: The business firms take in to account the price
elasticity of demand when they take decisions regarding pricing of the goods, in order to
increase their total revenue, they fix profit maximizing price based on elasticity of their
products.
b) Uses in economic policy regarding price: Regulation, especially of farm products, based
on the elasticity of products government can regulate and control price of products.
c) Uses in international trade: Governments of various countries have to decide about

whether to devalue their currencies or not when their exports decline and imports increases as
a result their balance of payment worsening
d) Importance in fiscal policy:
The government can succeed in increasing its revenue by the imposition of commodity tax only
if the demand for the commodity is inelastic. This is because imposition of indirect tax, such as
sales tax, raises price of a commodity. Then if the demand for the commodity is elastic increase
in price decreases sales, so this decreases government revenue. And the vice versa i.e. if the

commodity’s demand is perfectly inelastic, the whole of the burden of the commodity tax will
fall on the consumers, quantity demanded remains the same for whatever the price will be.
If the demand for a commodity is perfectly elastic imposition of tax will not increase in price,
thus the whole burden of the tax will be borne by the sellers/manufacturer.
Income Elasticity (E1)
Income elasticity of demand shows the degree of responsiveness of quantity demanded of a good
to a change in the income of consumers. And this is measured by:
%∆Qd  Q1 − Q0   Ι 0  ∆Qd I 0
EΙ = =     = ∗ …….. Point income elasticity of
%∆I  Ι 1 − Ι 0  Q0 ∆I Q0
demand
 Q − Q0   Ι1 + Ι 0 
E Ι  1    ……Arc income elasticity of demand formula
 Ι1 − Ι 0   Q1 + Q0 
Normal Goods (EI> 0): Consumption of the goods varies directly (positively) with
income i.e. when income increases consumption of these goods also increases& vice Versa.
- Necessities E1 – between zero and one
- Luxury E1>1
Inferior goods (EI < 0, Negative): Consumption of these goods varies inversely
(negatively) with income i.e. when income of consumer increase consumption decrease and vice
Versa. E.g. cabbage.
EI= 0, means consumption of the good does not vary with income, e.g. salt
N.B: A commodity may be a luxury at “low” level of income, necessity at “intermediate” level
of income and interior at “high” level of income. Engel curve shows the amount of a good that
the consumer would purchase per unit of time at various income levels.
Table 2.2 Income elasticity and classification of hamburgers at various daily income allowances.
I Qx % ∆ QX %∆I EI Classification

10 2 ---- ---- ------ ---------
15 4 100 50 2.00 Luxury
20 5 25 33 0.76 Necessity
30 6 20 50 0.04 Necessity
40 4 -33 33 -1.00 Inferior
For the following linear income demand function
Q = a+cI , C>0 -------------------- (1) where a and c are constants,
E I= ∆ Q
10
. ,but
∆I Q
0
dQ ∆Q 1
⇒ = = C Hence, EI = C . 0 ------------------- (4)
dI ∆I Q0
n
For the following non-linear income demand f
Q = aIc --------------------------------- (1)
E 1 = ∆Q
I0
.
but
dQ = ∆Q = caI c −1 ---------------- (3)
∆I Q dI ∆I
0
EI = caI c −1 . I
Q
e.g. consumer income rise from 16,000 Br to 20,000 Br, as a result his purchase of good ‘X’
increases from 15 to 18 units, then find EI and what type of commodity is it?
∆Q 10
Given I0 = 16,000 Br EI = .
∆I Q 0
I1= 20,000 Br =18-15/20,000-16,000*16,000/15
Q0 = 15 units =3/4,000*16,000/15
Q1 = 18 units, Find EI? =4/5 =0.8
Since, 0.8 <1 the good is normal and Necessity
Cross elasticity of demand

We can measure the responsiveness or sensitivity in the quantity purchased of commodity X as
a result of a change in the price of commodity Y by the cross elasticity of demand ( Exy). This
is given by:
∆Qx PY0
Exy = . ------------------------------- point formula
∆PY Qx 0
∆Q x  Py + Py 2 
Exy = .  1  ------------------------------ Arc Formula
∆PY  Qx1 + Qx2 
Substitute goods, Exy >0.
Complement goods, Exy < 0
Unrelated goods ,Exy = 0,
e.g.1, If price of ‘X’ rises from 55 Br to 60 Br per unit, and as a result demand of ‘y’ increase
from 40 to 50 units, then find Exy and what type of goods are these?
Given
Px1 = 55 Br Qy1 = 40 units find Exy?
Px2 = 60 Br Qy2 = 50 units
Soln
∆Qy Px 0
Exy = .
∆Px Qy 0
50 − 40 55 10 55"
= × = ×
60 − 55 40 5 40
= 11 ⇒ 2.75 Since, 2.75>0, they are substitute goods (X&Y)

4
e.g.2, If price of ‘Y’ increases from 10 to 20 Birr per unit as a result demand of “x” declines from 40 to 35
units, then find Exy & what type of commodities are these?
Given
Py1 = 10 Br Qx1 = 40 units find Exy?
Py2 = 20 Br Qx2 = 35 units
Soln

∆Qx py1
Exy = .
∆py Qx1
35 − 40 10
= . = −5 . 1
20 − 10 40 10 4
= −5 = -0.125 Since, -0.125 < 0, x and y are complements

40
• Consider the following liner demand function for commodity X:
Qx = a+bpx+cpy -------------------------- (1)
Let, Px-constant and py- changes, then Qx- depends on px and py
dQx d px dpy
=b. +c ------------------- (2)
dpy dpy dpy
= 0+C = C
∆Qx pQ
:. Exy = . -------------------------------- (3)
∆py Qx
py
Exy = C. ----------------------------------- (4)
Qx
2.2. Consumer surplus

Consumers’ surplus is simply the difference between the price that one is willing to pay and the
price one actually pays for a particular product. .
Consumer surplus=what a consumer is willing to pay –what he actually pays
=∑MU-P*Q
Marshal’s definition:“excess of the price which a consumer would be willing to pay rather than
go without a thing over that which he actually does pay is the economic measure of this surplus
satisfaction …it may be called consumers surplus.”
The concept of consumer surplus is derived from the low of diminishing marginal utility. It is
because of the law of diminishing marginal utility that consumer willing to pay for additional
units of a commodity declines as he has more units of the commodity. The consumer is in
equilibrium when MU from a commodity becomes equal to its given price.
Table 2.MU&CS
Q MU P Net marginal benefit

1 20 12 8
2 18 “ 6
3 16 “ 4
4 14 “ 2
5 12 “ 0
6 10 “ -2
Total consumer surplus from 5 units =20

Mu &P CS-is the area under the demand curve but above the price line
D CS= area PDC
P C
Q* Qd
The last unit of the commodity(Q*) does not yield any CS to the consumer since it is the last unit
purchased and for this price paid is equal to the MU which indicates the price that he is prepared
to pay rather than go without it.
Consumer surplus and gain from change in price
CS can be considered as net befit or extra utility which a consumer obtains from the changes in
price of a good or in the levels of its consumption.
Price total market value that consumer pays OQ level of consumption is the
D area OPcQ, total utility from OQ is equal to the area ODcQ, thus CS before
Change in price is area PcD. If price fall to P’ then CS will increase to area
P c P’aD thus net increase in CS= area P’aD- PcD
P’ b a = area PcaP’
D’ = area PcbP’ + area bca
O Q Q’ Quantity
Evaluating loss of benefit from tax

Loss in CS or welfare is caused by the imposition of an indirect tax (sales tax).
D equilibrium for the consumer before the imposition of
tax is at c, but after imposition of sales tax price
P1 a (supply) increase to p1 as a result number of cars
bought declines to Q1. And the new equilibrium
P0 b c D’ . will be at point a.
Q1 Q0
Fig.1 evaluating loss of consumer surplus from sales tax.
CS before sales tax = area DPoc and after sales tax = area DP1a, hence the net loss in consumer
surplus =area DP1a- area DPoc
= area P1acPo
If instead of sales tax, a lump sum tax or income tax were lived, there would have been no excess
burden or loss. Economists dub indirect tax such as sales tax or excess duty as economically
inefficient. Direct tax (lump sum tax) did not affect price of commodities & so, it causes less loss
of welfare than indirect tax that affects price.
Evaluating gain from a subsidy

The concept of consumer surplus can be used to evaluating the gain from subsidies.
D
A E
P S
P’ B C S’
D’
∆q
O Q1 Q2 X
Fig. Gain from a price subsidy.

Suppose govt. gives subsidy on food grains production as a result ,

P↓ to P’
SS ↑to Q2(s’)↑
DD↑ to Q2
CS ↑by P’PAC=SQ1+1/2∆q
S(subsidy)=P’PAC
Thus area ∆AEC is additional burden to government.
SQ1 represents the benefit or gain in consumer surplus due to the reduction in expenditure or
price foe Q1.Which is equal to the subsidy.(s)
1/2S∆Q represents the gain in consumer surplus due to the increase in quantity demand as a
result of the lower price made by the subsidy.
But the cost of subsidy to the govt. is SQ2 which is greater than the gain in consumer
surplus(CS).by the area ∆ACE ,thus if buyers would have been given the lump sum grant equal
to the total ↑CS They would have been better off than that of subsidy , which causes excess
burden to the govt.
Use of consumer surplus in cost-benefit analysis

An important applications of consumer surplus is its use in cost benefit analysis especially of public
investment projects .it should be noted that costs &benefits in cost benefit analysis do not merely mean
money costs & benefits but real costs & benefits in terms of satisfaction & resources. E.g. from bridge,
road, park, dam.etc.
P1 Gain in consumer surplus
= ∆ pq1+1/2. ∆ P. ∆ q
P2
∆Q
o Q1 Q2 x
fig.use of consumer surplus in cost benefit analysis of the construction of the flay over.
e.g new road is constructed ,thus the benefit of the new road is estimated by reference to the
expected savings of time & cost of fuel by all motorists who will make use of the flay over.
Before constructing the new flay over

CS=P1DA after constructing it
No- journey=OQ1 CS=P2DC
CS↑ by P2P1ACT
P2P1ACT =P2P1AT+ACT
P2 P1AT –results due to the lower cost per journey as a results of the construction of the new
journey.
ACT – results due to the increase in no- of journeys per month resulted from the lower cost
(price) caused from the constriction the fly over.
Supply
Supply is the relationship between the price of a good and the quantity supplied by producers. In many
ways, supply is similar to demand: A market supply is found by adding up individual producer supply
schedules. We can generate a supply schedule as we did for demand.
Quantity supplied is the amount of a good that sellers are willing and able to sell.
The law of supply claims that, other things equal, the quantity supplied of a good rises when the
price of the good rises.
Supply can be expressed in functional form, schedule, curve and equations like that of demand.
What can cause a change in supply? Several of the influences on supply are similar to the influences on
demand and others are unique to the supply-side of a market.
1. The prices of factors of production: As the prices of factors increase, the cost of production
increases, and supply decreases (shifts left). If factor prices decline, then it is cheaper to produce and
supply will increase (shift right).
2. The price of related goods: Prices of other goods influence the choice of what to produce.

Substitutes in production are goods that have similar production processes. Assume Good A and
Good B are substitutes in production. As the price of Good B increases, the supply of Good A
will decrease as suppliers shift production into Good B.
Complements in production are goods produced together using, for example, regular unleaded
gasoline and premium unleaded gasoline.
Assume Good A and Good B are complements in production. If the price of Good B increases, the supply
of Good A will increase. When the price of Good B increases, the quantity of Good B supplied also
increases, but this in turn increases the supply of Good A.
3. Expected future prices: If a sufficient number of suppliers expect the price of the good to increase in
the future, suppliers will hold off producing today and, instead, produce more tomorrow.
If a sufficient number of suppliers think the price will decline tomorrow, supply today will increase. This
is because suppliers would rather produce and sell today, when they can get a higher price, than to wait
until tomorrow when prices will have already dropped.
4. Number of producers: As the number of producers increases, ceteris paribus, the supply of the good
will increases.
5. Technology: An improvement in technology reduces the amount of factors of production required to
produce a given amount of output. Therefore, an improvement in technology will reduce the cost of
production and lead to an increase in supply.
1.8.2.3 Market Equilibrium
The equilibrium condition happens when economic forces balance so that economic variables neither
increase nor decrease. Market equilibrium is thus a situation in which the supply and demand forces
are in balance so that neither the market price nor the quantity demanded or supply changes. The
price prevailing in the market equates quantity demanded and quantity supplied, or the market clears
out.
A surplus (shortage) will exist in the market when at the prevailing price the quantity supplied of a
good exceeds (falls short of) the quantity demanded. Under such cases, there will be a tendency for
the market price and, thus, quantity to change.
Cases
(a) if the equilibrium price(P) falls short of the market prevailing price(P1),
There exists surplus in the market
✦ Downward pressure on price
(b) if the equilibrium price (P) exceeds the market price(P2),

There will not be enough products available in the market
✦ Upward pressure on price
Price
excess
supply/surplus Supply curve
P1
Point of
P
Equilibrium
Demand curve
excess demand
P2
=shortage
Quantity

CHAPTR FOUR
4. THEORY OF PRODUCTION
Production; refers to the transformation of resources into outputs or goods and services. For example
motor companies hire workers who use machinery in factories to transform steel, plastic, glass, rubbers
and so on, into automobiles. The output of firm may be a final commodity such as automobiles or an
intermediate product such as steel (which is used in the production of automobiles and other goods). The
output can also be a service rather than a good. Examples of services are education, medicine, banking,
legal counsel, accounting work, communication, transportation, storage, wholesaling, retailing, and many
others.
4.1. Classification of Inputs
Inputs, resources, or factors of production are the means of producing the goods and services demanded
by society. Inputs can be classified broadly into labor or human resources (including entrepreneurial
talent), capital and land or natural resources.
Particularly important among inputs is entrepreneurship. This refers to the ability on the parts of some
individuals to see opportunities to combine resources in new and more efficient ways to produce a
particular commodity or to produce entirely new commodities.
Input can be further classified into fixed and variable. Fixed inputs are those that cannot be varied or can
be varied only with excessive cost during the time period under consideration. Examples of fixed inputs
are the firm’s plant and specialized equipment.
Variable inputs; on the other hand are those that can be varied easily on a short notice during the time
period under consideration. Examples of these are raw materials and many types of workers, particularly
those with low levels of skill.
Thus whether an input is fixed or variable depends on the time horizons being consider. The time period
during which at least one input is fixed is called the short run. While the time period during which all
inputs are variable is called long run. Obviously, the length of time it takes to vary all inputs (i.e. to be in
the long run), varies for firms in different industries. For a street vendor of apples the long run may be a
day. For an apple farmer it is at least five years (this is how long it takes for nearly planted trees to begin
bearing fruit).
4.2. Production with one variable input
In this section, we present the theory of production when only one input is variable. Thus we are dealing
with short run.

4.2.1. Total, Average, and Marginal Product
A production function is a unique relationship between inputs and outputs. It can be represented by a
table, a graph, or an evaluation showing the maximum output of commodity that can be produced per
period of time with each set of inputs. Both output and inputs are measured in physical rather than
monetary units. Technology is assumed to remain constant. A simple short-run production function is
obtained by applying various amounts of labor to form one acre of land and recording the resulting output
or total product (TP) per period of time. It is illustrated by the table below:
The table show a hypothetical production function for a farm using various quantities of labor (i.e.
number of workers per year) to cultivate wheat on one acre of land (and using no other input). Note that
when no labor is used, total output of production is zero. With one unit of labor (1L), total product (TP) is
3 bushel of wheat per year. With 2L, TP=8 bushel. With 3L, TP=12, and so on.
From the total output or product schedule we can derive the average (per unit) and marginal products
schedules for the input. Specifically, the total (physical) output or total product (TP) divided by the
quantity of labor employed (L) equals the average product of labor (APL). On the other hand the change
in the output or total product per-unit change in the quantity of labor employed is equal to the marginal
product of labor (MPL).
TP
i.e. APL =
L
∆TP
MP =
∆L
L TP AP MP
0 0 - -
1 3 3 3
2 8 4 4
3 12 4 4
4 14 3.5 2
5 14 2.8 0
6 12 2 -2
MPL measures the change in total product per unit change in labor. Since labor increase by one unit at a
time in column 1, the MPL in column 4 is obtained by subtracting successive quantities of the TP in
column 2. For e.g, TP increases from 0 to 3 quintals when we add the 1ST unit of labor. Thus, the MPL is 3
tones. For an increase in labor from 1L to 2L, TP increase from 3 to 8 quintals. Thus the MPL is 5
quintals. For an increase in labor from 2L to 3L, the MPL is 4 quintals (12-8) and so on.
Plotting the Total, Average, and Marginal product quantities of the table gives the following product
curves shown in below.
When MP>AP, AP is increasing
When MP =AP, AP reaches maximum

Whenever MP<AP, AP is declining

Whenever MP>0, TP is increasing implying that the additional variable input will increase production.
Whenever MP=0, TP reaches its maximum and remains constant meaning the extra variable input has no
effect on the total product or it is idle. When MP<0, TP is decreasing magnifying that the additional input
will create chaos and reduce efficiency of previous production.
4.2.2. The Law of Diminishing Marginal Return
The decline in the MPL curve in figure below is a reflection of the law of diminishing returns. This is an
empirical generalization or a physical law. It postulates that as more and more units of a variable input are
used with a fixed amount of other input initially the return from an extra unit of variable input will
increase, however, after a point, a smaller and smaller return will occur to each addition unit of the
variable input. In other words, the marginal physicals product of the variable input eventually declines.
This occurs because each additional units of the variable input has less and less of the fixed inputs with
which to work.
4.2.3. Stages in Production and the Optimal Stages
In principle the marginal product of a factor may assume any value, positive, zero or negative. However,
basic production theory concentrates only on the efficient part of the production function, i.e., on the
range of output over which the marginal products of the factors are positive.
TP
Stage I stage II stage III TP
MP/AP
AP
MP
Stage I: this is the stage from initial production (AP= 0) up to the maximum of average product (where
MP=AP). In this stage a rational firm should increase production because the additional variable input
employed will by large induce production since both AP and MP are increasing in this stage. Hence it is
not worthy for a rational firm to quit production in this stage as there prevails positive marginal product.
The stage is called extensive margin and resources are underutilized.
Stage II: is the stage from the maximum of AP to the point where MP=0, a rational firm should produce
in this stage since TP goes on increasing, and the marginal product is positive though declining. The law

of diminishing marginal returns to (law of variable proportions) starts to operate after the maximum of
MP. This stage shows the decreasing efficiency of labor but the efficiency of capital continues to increase
because the total return continues to increase.
Stage III: is the stage after MP=0, stage III is not perfect choice of a rational firm as total product
declines due to negative MP. Hence, in this stage, both labor and the fixed input (capital) are over utilized
leading to inefficiency of production.
Stage II represents higher efficiency of capital-labor ratio than that of the other two stages. Furthermore,
the basic theory of production usually concentrate on the range of output over which the MPL although
decrease but positive, i.e. stage II is the choice of a rational (sage) firm.
4.3 Production With Two Variable Inputs
4.3.1. Isoquants: An isoquants shows the various combinations of two inputs (say labor & capital) that
can be used to produce a specific level of output. A higher isoquant refers to a larger output, whereas a
lower isoquant refers to a smaller output. If the two variable inputs (labor & capital) are the only inputs
used in production, we are in the long run. If the two variable inputs are used with other fixed inputs (say
land), we would still be in the short run.
4.3.1.1. Characteristics of isoquants
Isoquants have the same general characteristics of indifference curves. That is, they are negatively sloped
in the economically relevant range, convex to the origin, & do not intersect.
The non-intersecting property of isoquants can be explained as: intersecting isoquants would mean that
two different levels of output of the same commodity could be produced with the identical input
combination. This is impossible under our assumption that the most efficient production techniques are
always used.Isoquants are negatively sloped in the economically relevant range. This means that if the
firm wants to reduce the quantity of capital used in production, it must increase the quantity of labor in
order to continue to produce the same level of output(i.e. remain on the same isoquant).
4.3.1.2. Economic region of production
Upper ridge line
K Lower ridge line
0 L
The absolute value of the slope of the isoquant is called marginal rate of technical substitution
(MRTS).In the above figure the production function is depicted in the form of a set of isoquants. By
construction, the higher to the right an isoquant, the higher level of output it depicts. Clearly isoquants
cannot intersect, by their construction. We said that traditional economic theory concentrates on efficient
ranges of output I.e. ranges over which the MP of factors are diminishing but positive. The locus of points
of isoquants, where the MPS of the factors are zero, form the ridge lines. The upper ridge line implies that
the MP of capital is zero. The lower ridge line implies that the MP of labor is zero. Production techniques
are only (technically) efficient inside the ridge lines. Outside the ridge lines the MPL of factors are
negative and the methods of production are inefficient, since they require more quantity of both factors
for producing a given level of output. Such inefficient methods are not considered by the theory of
production. Since it imply irrational behavior of the firm. The condition of positive but declining MP of
factors defines the range of efficient production (the range of isoquants over which they are convex to the
origin).
4.3.2. Diminishing Marginal Rate of Technical Substitution (MRTS)
∂K
The slope of the isoquant (- ) define the degree of substitutability of the factors of production (see
∂L
figure below),
The slope of the isoquant decreases (in absolute terms) as we move down wards along the isoquant,
showing the increase difficulty in substituting L for K. as you can see from the graph the amount of K
scarified to obtain additional L decreases as we move from left to right on the isoquant.
MRTS L, K= - ∂∂KL
It can be proved that the MRTS is equal to the ratio of the MP of the factors,
MRTSL, K= - ∂∂KL = =
MPL
MPK
Proof: The slope of a curve is the slope of the tangent at any point of the curve. The slope of the tangent
is defined by total differential. In the case of the isoquant the total differential is the total change in Q
resulting from small changes in both factors K and L. clearly if we change K by , the output Q will
change by the product times the marginal product of capital:

( ( )
Similarly if we change labor by , the resulting change in Q is:
( ( )
Now along any isoquant the quantity Q is constant, so that the total change in Q (the total differential)
must be equal to zero. Thus;
dQ= ( ( )+( ( )=0
Solving for we obtain
- = / =
Along the ridge line the MRTS=0. In particular along the upper ridge we have;
MRTSK, L = / =0, =0
And along lower ridge;
MRTSL, K= / =0, =0
Within the economically relevant range, isoquants are not only negatively sloped but also convex to the
origin. That is, as we move down along an isoquant, the absolute value of its slope of MRTSL, K declines
and the isoquant is convex.
4.3.3. Isocost curves (Lines)
The combination of factors with which a firm produces the product also depends on the prices of the
factors & the amount of money which a firm wants to spend. Isocost line represents these two things – the
price of productive factors and the total amount of money which a firm wants to spend.
Suppose a producer wants to spend Br. 300 on factor L and K. If the price of K is Br. 3 per unit and if he
spends the whole sum of Br. 300 on it, then he can purchase 100 units of K. Now if the price of L is Br. 5
per unit and the whole sum of Br. 300 is spent on it, 60 units of L can be purchased.
E Isocost for 400 birr
100 isocost for 500 birr
60 F T

If we join together the points we get the isocost line on which will lay all those combinations of factors L
and K which can be purchased with Br. 300.
Now if the producer decides to increase the total money to be spent on the productive factors to Br. 400,
more of both factors can be purchased. As a result isocost line will shift outwards to EF. Similarly, with
Br.500 the isocost line will be PT. higher isocost line will show greater total outlay.
The slope of isocost line represents the ratio of the price of a unit input of L to the price of a unit input of
K. in case of the price of any one of them changes, there would be a corresponding change in the slope of
the isocost curve and the equilibrium would shift.
When the price of factors of production change (say only price of L), in this case the vertical or K-
intercept will remains unchanged, & the isocost line rotates upward or counter clockwise if PL falls and
dawn ward or clock wise if PL rises.
Graphically; K
100
50 60 100 L
The above graph shows isocost line with PL=3, isocost line with PL=5& isocost line with PL=6. The
vertical or K-intercept remains the same because income and PK don’t change. The slope of isocost line
PL br.3 br.5
with PL=3 is - =- =-1, the slope of the isocost line with PL=5 = - =-5/3. Slope isocost line
PK br.3 br.3
P
with PL=6 is - L =-6/3=-2 & the same is true when price of capital (K) changes.
PK
4.3.5. Optimum Mix of Resource Inputs
In this section we shall show the use of the production function in the choice of the optimal combination
of factors by the firm. We will examine two cases in which the firm is faced with a single decision,
namely maximizing output for a given cost, & minimizing cost subject to a given output.
In all cases we assume the following assumptions:
1. The goal of the firm is profit maximization-i.e., the maximization of the difference =R-C,where,
=profit R=revenue C=cost

2. The price of output is given, P
3. The price of factors is given as the wage rate (w) price of labor and interest rate(r) the price of capital.

Case I; Maximization of output
In the figure below we can see that the maximum level of output firm can produce, given the cost
constraint, is defined by the tangency of the isocost line, & the highest possible isoquant.
A
e
K2 Q3
Q2
Q1
L2 B L
The optimal combination of factors of production is K2 & L2 for prices w & r. higher levels of output (to
the right of e) are desirable but not attainable due to the cost constraint. Other points on AB or below it lie
on a lower isoquant than Q2, hence Q2 is the maximum output possible under the above assumptions (i.e.,
given cost, production function, & factors price). At the point of tangency (e) the slope of the isocost line
(-w/r) is equal to the slop of the isoquant (-MPL/MPK). This constitutes the first condition for equilibrium.
The second condition is that the isoquants be convex to the origin.
Formal derivation of the equilibrium conditions:
Maximize Q=f (L, K)
Subject to C=wL+rK (cost constraint)
We can solve this problem using lagrangian multiplier;
Step 1: rewrite the constraint in the form; wL+rK-C=0
Step 2: multiply the constraint by a constant which is lagrangian multiplier (wL+rK-C) =0
Step 3: Form the composite function as Z: Z=Q (wL+rK-C)
Z =f (L, K) - *the maximization of Z

function implies maximization of the output.
Step 4: take the partial derivatives of the above function with respect to L, K & . Maximization of Z
implies maximization of output constrained to cost. The first order condition for maximization is that its
partial derivatives should equal to 0:
= - (w) =0 …………………1
= - (r) =0 ………………….2
= -wL-rk+C=0 …………………...3
Step 5: solving equation 1 & 2 for we get the following:
= w or = /w=MPL/w
= r or = /r=MPK/r hence
/w = /r or MPL/MPK = / =w/r
This firm is in equilibrium when it equates the ratio of the marginal product of factors to the ratio of their
prices. And the second – order condition for equilibrium is that the MP curve of the two factors have
negative slope. The slope of the MP curve of a factor is the second derivatives of the production function.
Slope of MPL curve = ∂ 2Q/ ∂ L2
Slope of MPK curve = ∂ 2Q/ ∂ K2
2nd order conditions are: ∂ 2Q/ ∂ L2 < 0 & ∂ 2Q/ ∂ K2 < 0
Case II: Minimization of Cost for a Given Output

Formal derivation of the equilibrium conditions:
Minimize C = f (Q) =wL + rK
Subject to Q’ = f (L, K)
Rewrite the constraint in the form; Q’ – f (L, K) =0
Multiply the constraint by a constant which is lagrangian multiplier: (Q’ –f (L, K)) =0
From composite function we have the following:
Z=C- (Q’ –f( L,K ))=0
Z = (wL + rk) - (Q’ –f (L, K))
Take partial derivatives of Z with respect to L , K & & equate with zero.
=w - =0 w- =0 --------------- ( 1)
=r - =0 r- =0 ------------------ ( 2)

= -(Q’ –f( L,K ))=0 ------------------------------ (3)
From 1 & 2 we obtain:
W= w/r= =MRSL,K
r=
This condition is the same as output maximization. The second (sufficient) condition, concerning the
convexity of the isoquant, is fulfilled by the assumption of negative slopes of the MP of factors as in the
previous case.
4.3.6. The Expansion Path
In the above we explained how firms maximize their output with a given cost & minimize cost with a
given output. Thus, it is called constrained maximization. Now we see how firms will change his factor
combination as he expand his output & expenditure (cost) with a given factor price. We assume there are
four isocost (figure below) AB, CD, UF, & GH, shows different level of total cost. All isocost line is
parallel shows given price of factors (K&L).
G Expansion path
U
E4
C E3 Q4
E2 Q3 E
A E1 Q2
Q1
B D F H L
If firms wants to produce output level Q1 (100 units), it will chose factor combination E1, which minimize
cost & point of tangency between Q1, & isocost line AB.
When he wants higher output Q2, the factor combination is E2 which is the least–cost. For still higher
output levels like Q3 & Q4, firm will chose E3 & E4 respectively to minimize cost for the given output.
The line joining the minimum cost combinations such as E1, E2, E3, E4 is called the expansion path .
Thus, the expansion path may be defined as the locus of the points of tangency between the isocost & the
isoquant. Since the expansion path represents the minimum cost combination for various levels of output,
it shows the cheapest way of producing each level of output, given the relative prices of the factors.
4.4. Economies Of Returns To Scale
In this section we study the changes in output when all factors or inputs in a particular production
function are increased together. In other words, we study the behavior of output in response to the change
in the scale. An increase in the scale means that all inputs or factors are increased in a given proportion.

The study of change in output as a consequence of change in the scale forms the subject –matter of
“return to scale”.
In the long run expansion of output may be achieved by varying all factors. In the long run output may be
increased by changing all factors by the same proportion or by different proportion. Traditional theory of
production concentrates on the first case i.e., the study of output change by the same proportion. The term
‘RETURN TO SCALE’ refers to the change in output as all factors change by the same proportion.
4.4.1. Increasing, Decreasing and Constant Return to Scale
Suppose we start from an initial level of output
Q0 = f (L, K)
Now we increase all factors by same proportion x. We will clearly obtain a new levels of output Q*,
higher than the original level Q0.
Q* = f (xL, xK)
*If Q* increases by the same proportion x as the inputs, we say that there is constant return to scale.
*If Q* increases by less proportion than the increase in the factors, we say that there is decrease returns
to scale.
*If Q* increases by more proportion than with the increase in the factors, we have increasing return to
scale.
Returns to Scale & Homogeneity of the Production Function

Suppose we increase both factors of the production:
Q0 = f (L, K) by the same proportion x, & we observe the resulting new level of output Q*; Q* = f (xL, xK)
If x can be factored out (i.e. may be taken out of the brackets as a common factor), then the new level of
output can be expressed as a function of x (to any power v) & the initial level of output.
Q* = xv f (L, K)
Q* = xvQ0
And the production function is called homogeneous. If x cannot be factored out, the production function
is non-homogeneous. Thus, a homogeneous function is a function such that if each of the input is
multiplied by x, then x can be completely factored out of the function. The power v of x is called the
degree of homogeneity of the function & is a measure of the return to scale.
If v= 1 we have constant return to scale. This production is sometimes called linear homogeneous.
If v < 1 we have decreasing return to scale.
If v > 1 we have increasing return to scale.
Graphical Presentation of the Return to Scale
Constant return to scale; distance between successive multiple isoquant is constant. Doubling the factor
inputs results doubling the level of the initial output; tripling inputs results tripling output, & so on.
c Constant return to scale oa = ab = bc
o L
Decreasing return to scale; the distance between consecutive multiple isoquant increases. By doubling
the inputs, output increased by less than twice its original level. In the figure below the point a’, defined
by 2K & 2L, lies on an isoquant below the one showing 2Q.
o L decreasing returns to scale: oa<ab<bc
Increasing returns to scale; the distance between consecutive multiple isoquants decrease. By doubling
the inputs, output is more than doubled. In fig. below doubling K & L leads to point b’ which lies on an
isoquant above the one denoting 2Q.

c
o L Increasing return to scale: oa>ab>bc
Returns to scale are usually assumed the same everywhere on the production surface. All processes are
assumed to show the same returns over all ranges of output; either constant returns everywhere, or
increasing returns everywhere. But, the technological condition of production may be such that returns to
scale may vary over different ranges of output. Over some ranges we may have increasing or decreasing
returns to scale.
o Varying returns to scale.
4.3.2. COBB-DOUGLAS Production Function & Returns to Scale
An important production function which has been found by empirical studies by eminent economists
Cobb & Douglas ,& known after their name as cob-Doulas production function is given as;
Q = ALαKβ
In this production function the sum of exponents (α +β) measures returns to scale. Multiplying each input,
labor (L) & capital (K) by a constant factor x, we have.
Q*= A (xL) α (xK) β
=xα+β (ALαKβ)
Expression in bracket ALαKβ=Q
Q*= xα+β Q
This means that when each input is increased by a constant factor x, output Q increased by xα+β. Now, if α
+β=1 then, in this production function;

Q*= x1Q
Q*= X Q or
i.e. when α +β=1, output (Q) increase by the same factor x by which both inputs are increased.
When α +β>1, say it is equal to 2, then;
Q*= xα+β Q=x2Q
In this case multiplying input by constant x, then output (Q) increased by x2 , that is by more than x.
Therefore, when α +β>1, Cobb-Douglas production exhibits increasing return to scale.
When α +β<1, say it is equal to 0.8, then;
Q*= xα+β Q=x0.8Q
That is, increasing each unit by input by constant factor x will cause output to increase by x0.8,i.e. less than
x. returns to scale in this case are decreasing.
4.4. Choice Of Techniques
Technological Progress & the Production Function
As knowledge of new & more efficient method of production becomes available, technology change.
Graphically the effect of innovation in processes is shown with an upward shift of the production
function, or a down ward movement of the isoquant (figure below). This shift shows that the same output
may be produced by less factor inputs, or more output may be obtained with same inputs.
Q K
Q’=f(L)
Q=f(L) Q0
L L
Capital-deepening technical progress; when along a line through the origin on which the K/L ratio is
constant, the MRSL,K decrease. This implies that technical progress increases the marginal product of
capital by more than the marginal product of labor. The ratio of marginal products (which is the MRSL,K)
decrease in absolute terms.

K
A” A’ A
O L
Labor-deepening technical progress; when along a line through the origin on which the K/L ratio is
constant, the MRSL,K increase. This implies that the technical progress increase MPL faster than MPK.
Thus the MRSL,K being the ratio of MPS [( Q/ )]/[( Q/ )], increases in absolute value. The
downward-shifting isoquant becomes steeper along any given line through the origin.
B” B’ B
O L
Neutral-technical progress; technical progress is neutral if it increases the MP of both factors by the same
percentage, so that the MRSL,K (along any line) remains constant. The isoquant shifts downward parallel
to itself.
K c
C” C’
O L

CHAPTER FIVE
5. Theory of Cost
Cost functions are derived functions. They are derived from the production function, which describes the
available efficient methods of production at any one time. Economic theory distinguishes between short-
run and long-run costs. Short-run costs are the costs over a period during which some factors of
production (usually capital equipment and management) are fixed. The long-run costs are those cost over
a period long enough to permit the change of all factors of production. In the long-run all factors become
variable.
Both in the short-run and in the long-run, total cost is a multivariable function, that is, total cost is
determined by many factors. Symbolically long-run cost function can be written as
C = f (X,T,Pf), and the short-run cost function as
C = f (X,T,Pf,K),
Where C = Total Cost, X = Output, T = Technology, Pf = Prices of factors, K = Fixed

factor(s).Graphically, costs are shown on two-dimensional diagrams. Such curves imply that cost is a
function of output, C=f(X), ceteris paribus. The clause ceteris paribus implies that all other factors which
determine costs are constant. If these factors do change, their effect on costs is shown graphically by a
shift of the cost curve. This is the reason why determinants of cost. Other than output, are called shift
factors. Mathematically there is no difference between the various determinants of costs. The distinction
between movements along the cost curve (when output changes) and shifts of the curve (when the other
determinants change) is convenient only pedagogically, because it allows the use of two-dimensional
diagrams. But it can be misleading when studying the determinants of costs. It is important to remember
that if the cost curve shifts, this does not imply that the cost function is indeterminate.
The factor technology is itself a multidimensional factor, determined by the physical quantities of factor
inputs, the quality of the factor inputs, the efficiency of the entrepreneur, both in organizing the physical
side of the production (technical efficiency of the entrepreneur), and in making the correct economic
choice of techniques (economic efficiency of the entrepreneur). Thus, any change in these determinants
(e.g., the introduction of a better method of organization of production, the application of an educational
program to the existing labor) will shift the production function, the application of an educational
program to the existing labor) will shift the production function, and hence will result in a shift of the cost
curve. Similarly the improvement of raw materials or the improvement in the use of the same raw
materials will lead to a shift downwards of the cost function.

The short-run costs are the costs at which the firm operates in any one period. The long-run costs are
planning costs or ex ante (based on prior assumptions or expectations) costs, in that they present the
optimal possibilities for expansion of the output and thus help the entrepreneur is in a long-run situation,
in the sense that he can choose any one of a wide range of alternative investments, defined by the state of
technology. After the investment decision is taken and funds are tied up in fixed-capital equipment, the
entrepreneur operates under short-run conditions; he is on a short cost curve.
In summary, while the internal economies of scale relate only to the long-run and are built into
the shape of the long-run cost curve, the external economies affect the position of the cost curves; both
the short-run and the long-run cost curves will shift if external economies affect the prices of the factors
and/or the production function.
Any point on a cost curve shows the minimum cost at which a certain level of output may be produced.
This is the optimality implied by the points of accost curve. Usually the above optimality is associated
with the long-run cost curves. Usually the above optimality is associated with the long-run cost curve.
However, a similar concept may be applied to the short-run, given the plant of the firm in any one period.
SHORT-RUN COSTS
The short run is the period during which some factor(s) is fixed; usually capital equipment and
entrepreneurship are considered as fixed in the short run. Total costs are split into two groups: total fixed
costs and total variable costs:
TC = TFC + TVC
The fixed costs include:
(a) Salaries of administrative staff

(b) Depreciation (wear and tear) of machinery
(c) Expenses for building depreciation and repairs
(d) Expenses for land maintenance and depreciation
The variable costs include:
(a) The raw materials

(b) The cost of direct labor
(c) The running expenses of fixed capital, such as fuel ordinary repairs and routine maintenance.
TC
Total fixed cost is graphically denoted by a straight line parallel to the output axis (fig.5.1).
C
TVC
TFC
TVC
O X O X O X

The total variable cost has broadly an inverse – S shape (fig.5.2) which reflects the law of variable
proportions. According to this law, at the initial stages of production with a given plant, as more of the
variable factor(s) is employed, its productivity increases and the average variable factor(s) employed, its
productivity increases and the average variable cost falls.
This continues until optimal combination of the fixed and variable factors is reached. Beyond this point
as increased quantities of the variable factor(s) are combined with the fixed factor(s) the productivity of
the variable factor(s) declines and the AVC rises. By adding the TFC and TVC we obtain average cost
curves. The average fixed cost is found by dividing TFC by the level of output:
AFC = TFC
X ,
Graphically the AFC is a rectangular hyperbola, showing at all its points the same magnitude, that is, the
level of TFC (fig. 5.4).
AFC
O X
Fig5.4 AFC curve

The average variable cost is similarly obtained by dividing the TVC with the corresponding level of
output:
AVC = TVC
Graphically the AVC at each level of output is derived from the slope of a line drawn from the origin to
the point on the TVC curve corresponding to the particular level of output.
C SAVC
TVCC
C
0 x1 x2 x3 x4 X O x1 x2 x3 x4 X
Fig. 5.5 TVC curve Fig. 6AVC curve

For example fig.5.5 the AVC at X1 is the slope of the ray Oa, the AVC at X2 is the slope of a ray through
the origin declines continuously until the ray becomes tangent to the TVC curve falls initially as the
productivity of the variable factor(s) increases, reaches a minimum when the plant is operated optimally
(with the optimal combination of fixed and variable factors), and rises beyond that point fig.5.6.
The ATC is obtained by dividing the TC by the corresponding level of output:
TC TFC + TVC
ATC = = = AFC + AVC
X X
Graphically the ATC curve is derived in the same way as the SVAC. The ATC at any level of output is
the slope of the straight line from the origin to the point on the TC curve corresponding to that particular
level of output (fig.5.7). The shape of the ATC reaches a minimum at the level of optimal operation of
the plant (XM) and subsequently rises again (fig.5.8). The U shape of both the AVC reflects the law of
variable proportions or law of eventually decreasing returns to the variable factor(s) of production. The
marginal cost is defined as the change in TC which results from a unit change in output. Mathematically
the marginal cost is the first derivative of the TC function. Denoting total cost by C and output by X we
∂C
have MC = .
∂X
SATC
O x1 x2 xM xL X
O x1 x2 xM xL X Fig. 5.8 SATC curve
Fig.5.7 TC curve
Graphically the MC is the slope of the TC curve (which of course is the same at point as the slope of the
TVC). The slope of a curve at any one of its points is the slope of the tangent at that point. With an
inverse S shape of the TC (and TVC) the MC curve will be U-shaped. In fig.5.9, we observe that the
slope of the tangent to the total-cost curve declines gradually, until it becomes parallel to the X-axis (with
its slope being equal to zero at this point), and then starts rising. Accordingly we picture the MC curve in
fig.5.10 as U shaped.

C TC SMC
0 XA X O XA X
Fig5..9 TC curve Fig.10 SMC curve
In summary: the traditional theory of costs postulates that in the short run the cost curves (AVC, ATC and
MC) are U shaped, reflecting the law of variable proportions. In the short run with a fixed plant there is a
phase of increasing productivity (falling unit costs) and a phase of decreasing productivity (increasing
unit costs) of the variable factor(s). Between these two phases of plant operation there is a single point at
which unit costs are at a minimum. When this point on the SATC is reached the plant is utilized
optimally, that is with the optimal combination (proportions) of fixed and variable factors.
LONG-RUN COSTS
In the long – run all factors are assumed to become variable. It is known that the long-run cost curve is a
planning curve, in the sense that it is a guide to the entrepreneur in his decision to plan the future
expansion of his output. The long run average cost curve is derived from short-run cost curves. Each
point on the LAC corresponds to a point on a short-run cost curve, which is tangent to the LAC at that
point.
Assume that the available technology includes many plant sizes, each suitable for a certain level of
output, the points of intersection of consecutive plants are more numerous. In the limit, if we assume that
there are a very large number of plants, we obtain a continuous curve, which is the planning LAC curve
of the firm. Each point of this curve shows the minimum (optimal) cost for producing the corresponding
level of output. The LAC curve is the locus of points denoting the least cost of producing the
corresponding output. It is a planning curve because on the basis of this curve the firm decides what plant
to set up in order to produce optimally the expected level of output. The firm chooses the short-run plant
which allows it to produce the anticipated output at the least possible cost. In the traditional theory of the
firm the LAC curve is U-shaped and it is often called the ‘envelope curve’ because it envelopes the SRC
curves Fig. 5.11

C
LAC
O XM X
Fig 5.11 LAC curve
Let us examine the U shape of the LAC. This shape reflects the laws of returns to scale. According to
these laws the unit costs of production decreases as plant size increases, due to the economies of scale
which the larger plant size make possible. The traditional theory of the firm assumes that economies of
scale exist only up to a certain size of plant, which is known as the optimum plant size, because with this
plant size all possible economies of scale are fully exploited. If the plant increases further than this
optimum size there are diseconomies of scale, arising from managerial inefficiencies. It is argued that
management becomes highly complex, managers are overworked and the decision making process
becomes less efficient. The turning-up of the LAC curve is due to managerial diseconomies of scale,
since the technical diseconomies can be avoided by duplicating the optimum technical plant size.
A serious assumption of the traditional U-shaped cost curves is that each plant size is designed to produce
optimally a single level of output (e.g. 1000 units of X). Any departure from that X no matter how small
(e.g., an increase by 1 unit of X) leads to increased costs. The plant is completely inflexible. There is no
reserve capacity, not even to meet seasonal variations in demand. As a consequence of this assumption
the LAC curve ‘envelopes’ the SRAC. Each point of the LAC is a point of tangency with the
corresponding SRAC curve. The point of tangency occurs to the falling part of the SRAC curves for
points lying to the left of the minimum point of the LAC: since the slope of LAC is negative up to M the
slope of the SRAC curves must also be negative, since at the point of their tangency the two curves have
the same slope. The point of tangency for outputs larger than XM occurs to the rising part of the SRAC
curves: since the LAC rises, the SAC must rise at the point of their tangency with the LAC. Only at the
minimum point M of the LAC is the corresponding SAC also at a minimum. Thus at the falling pat of the
LAC the plants are not worked to full capacity to the rising part of the LAC the plants are overworked;
only at the minimum point A is the (short-run) plant optimally employed.
We stress once more the optimality implied by the LAC planning curve: each point represents the least
unit-cost for producing the corresponding level of output. Any point above the LAC is inefficient in that
it shows a higher cost for producing the corresponding level of output. Any point below the LAC is
economically desirable because it implies a lower unit-cost, but it is not attainable in the current state of
technology and with the prevailing market prices of factors of production.
The long-run marginal cost is derived from the SRMC curves, but does not envelope them. The LRMC is
formed from the points of intersection of the SRMC curve with vertical lines (to the x-axis) drawn from
the points of tangency of the corresponding SAC curves and the LRA cost curve (fig. 3).
C LMC
a
SMCM
SMC1
LAC
0 X|1 X1 X||1 X2 XM X
Fig. 3
The LMC must be equal to the SMC for the output at which the corresponding SAC is tangent to LAC.
For levels of X to the left of tangency a the SAC>LAC . At the point of tangency SAC=LAC. As we
move from a position of inequality of SRAC and LRAC to a position of equality. Hence the change in
total cost (i.e. the MC) must be smaller for the short-run curve than for the long-run curve. Thus
LMC>SMC to the left of a. For an increase in output beyond X1 (e.g. X||1) the SAC>SMC. That is we
move from the position a of equality of the two costs to the position b where SAC is greater than LAC.
Hence the addition to total cost (= MC) must be larger for the short run curve than for the long run curve,
Thus LMC<SMC to the right of a. Since to the left of a, LMC>SMC, and to the right of a, LMC<SMC, it
follows that a, LMC = SMC. If we draw a vertical line from a to the X – axis the point at which it
intersects the SMC (point A for SAC1) is a point of the LMC.
If we repeat this procedure for all points of tangency of SRAC and LAC curves to the left of the minimum
point of the LAC, we obtain points of the section of the LMC which lies below the LAC. At the
minimum point M the LMC intersects the LAC. To the right of M the LMC lies above the LAC curve.
At point M we have
SACM = SMCM = LAC = LMC
There are various mathematical forms which give rise to U-shaped unit cost curves. The TC curve is
roughly S-shaped, while the ATC, the AVC and the MC are all U-shaped; the MC curve intersects the
other two curves at their minimum points.

CHAPTER SIX
THEORY OF FIRM AND MARKET EQUILIBRIUM UNDER PERFECT COMPETITION
There are four types of market structures: perfectly competitive, monopoly, monopolistically competitive
and oligopoly market structure.
Perfect competition is a market structure by a complete absence of rivalry among the individual firms.
Thus, perfect competition in economic theory has a meaning diametrically opposite to the everyday use of
this term. In practice businessmen use the word competition as synonymous to rivalry. In theory perfect
competition implies no rivalry.
6.1 CHARACTERSTICS OF PERFECT COMPITITION
1. Large numbers of sellers and buyers.

The industry or market includes a large number of firms (and buyers), so that each individual firm,
however large, implies only a small part of the total quantity offered in the market. The buyers are also
numerous. Under these conditions each firm alone cannot affect the price in the market by changing its
output.
2. Product homogeneity
The industry is defined as a group of firms producing a homogeneous product. The technical
characteristics of the product as well as the services associated with its sale and delivery are identical.
There is no way in which a buyer could differentiate among the products of different firms.
3. Free entry and exit of firms

There is no barrier to entry or exit from the industry. Entry or exit may take time, but firms have freedom
of movement in and out of the industry. This assumption is supplementary to the assumption of large
numbers.
4. Profit Maximization
The goal of all firms is profit maximization. No other goals are pursued.
5. NO government regulation
There is no government intervention in the market (tariffs, subsidies, rationing of production or demand
and so on are ruled out).
The above assumptions are sufficient for the firm to be a price-taker and have an infinitely elastic demand
curve. The market structure in which the above assumptions are fulfilled is called pure competition. It is
different from perfect competition which requires the fulfillment of the following additional assumptions.
6. Perfect mobility of factors of production

It is assumed that all sellers and buyers have complete knowledge of the conditions of the market. This
knowledge refers not only to the prevailing conditions in the current period but in all future periods as
well. Information is free and costless. Under these conditions uncertainty about future developments in
the market is ruled out.Under the above assumptions we will examine the equilibrium of the firm and the
industry in the short run and in the long run.

6.2 SHORT-RUN EQUILIBRIUM
In order to determine the equilibrium of the industry we need to derive the market supply. This requires
the determination of the supply of the individual firms, since the market supply is the sum of the supply
of all the firms in the industry.
6.2.1 Equilibrium of the Firm in the Short-run
The firm is in equilibrium when it maximizes its profits (π), defined as the difference between total cost
and total revenue:
π = TR – TC
The firm is in equilibrium when it produces the output that maximizes the difference between total
receipts and total costs. The equilibrium of the firm may be shown graphically in two ways. Either by
using the TR and TC curves, or the MR and MC curves. In fig.6.1 we show the total revenue and total
cost curves of a firm in a perfectly competitive market.
TC
TR
C
П Max
0 XA XC XB X
The total revenue curve is a straight line through the origin; showing that the price is constant at all levels
of output. The firm is a price-taker and can sell any amount of output at the going market price, with its
TR increasing proportionately with its sales. The slope of the TR curve is the marginal revenue. It is
constant and equal to the prevailing market price, since all units are sold at the same price. Thus in pure
competition MR = AR = P.
The shape of the total-cost curve reflects the U shape of the average-cost curve, that is, the law of variable
proportions. The firm maximizes its profit at the output XC, where the distance between the TR and TC
curves is the greatest. At lower and higher levels of output total profit is not maximized: at levels smaller
than XA and larger than XB the firm has losses.
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 marginal cost and marginal revenue, uses price
as an explicit variable, and shows clearly the behavioral rule that leads to profit maximization. In fig.6.2
we show the average and marginal cost curves of the firm together with its demand curve.
C
SMC
P
SATC
e
P=MR
P
B
A
0 XC X X
Fig .6. 2 short run equilibrium of firms: marginal approach
The demand curve is also the average revenue curve and the marginal revenue curve of the firm in a
perfectly competitive market. The marginal cost cuts the SATC at its minimum point. Both curves are
U-shaped, reflecting the law of variable proportions which is operative in the short run during which the
plant is constant. The firm is in equilibrium (maximizes its profit) at the level of output defined by the
intersection of the MC and the MR curves (point e in fig.6.2). To the left of e profit has not reached its
maximum level because each unit of output to the left of Xe brings to the firm revenue which is greater
than its marginal cost. To the right of Xe each additional unit of output costs more than the revenue
earned by its sale, so that a loss is made and total profit is reduced. In summary:
(a) If MC>MR the level of total profit is being reduced and it shows the firm to expand its output.
(b) If MC = MR short-run profits are maximized.
SATC
SMC
e
P = MR
|
e
0 X|e Xe X
Fig.6.3

In fig.6. 3 we observe that the condition MC = MR is satisfied at point e|, yet clearly the firm is not in
equilibrium, hence profit is maximized at Xe|> Xe. Thus the first condition for the equilibrium of the firm
is that marginal cost be equal to marginal revenue. However, this condition is not sufficient, since it may
be fulfilled and yet the firm may not be in equilibrium.
The second condition for equilibrium requires that the MC must cut the MR curve from below, i.e., the
slope of the MC must be steeper than the slope of the MR curve. In the fig. 6.3 the slope of MC is
positive at e, while the slope of the MR curve is zero at all levels of output. Thus at e both conditions for
equilibrium are satisfied
1. MC = MR and
2. (Slope of MC) > (slope of MR).
It should be noted that the MC is always positive, because the firm must spend some money in order to
produce an additional unit of output. Thus at equilibrium the MR is also positive. The fact that a firm is
in short run equilibrium does not necessarily mean that it makes excess profits. Whether the firm makes
excess profits or losses depends on the level of the ATC at the short-run equilibrium. If the ATC is below
the price at equilibrium (fig. 6.4) the firm earns excess profits (equal to the area PABe).
If, however, the ATC is above the price (fig. 6.6) the firm makes a loss (equal to the area FPeC). In the
latter case the firm will continue to produce only if it covers its variable costs. Otherwise it will close
down, since by discontinuing its operations the firm is better off: it minimizes its losses. The point at
which the firm covers its variable costs is called the closing down point. In fig. 6.6 the closing-down
point of the firm is denoted by point w. If price falls below Pw the firm does not cover its variable costs
and is better off it closes down.

SMC
P SMC P
C SATC
C SATC
C
e F
P MR
MR P e
B
A
O Xe X 0 Xe X
Fig. 4 Fig. 5
SMC
SATC
SAVC
Pw
AFC
0 Xw X
Fig. 6

Mathematical Derivation of the equilibrium of the Firm
The firm aims at the maximization of its profit
∏ = R−C
Where ∏ = Profit
R = Total Revenue
C = Total Cost
Clearly R = f1(X) and C = f2(X), given the price P.
(a) The first-order condition for the maximization of a function is that its first derivative be equal to zero.
Differentiating the total-profit function and equating to zero we obtain
∂ ∏ ∂R ∂C
= − =0 ∂R ∂C
(b) ∂X ∂X ∂X or =
∂X ∂X
The term ∂R / ∂X is the slope of the total revenue curve, that is, the marginal revenue. The term
∂C / ∂X is the slope of the total cost curve, or the marginal cost. Thus the first-order condition for profit
maximization is MR = MC. Given that MC>0, MR must also be positive at equilibrium. Since MR = P
the first order condition may be written as MC = P.
(b) The second – order condition for a maximum requires that the second derivative of function be
negative (implying that after its highest point the curve turns downwards). The second order derivative of
the total-profit function is
∂ 2 ∏ ∂ 2 R ∂ 2C
= −
∂X 2 ∂X 2 ∂X 2
∂ 2 R ∂ 2C
This must be negative if the function has been maximized, that is − <0
∂X 2 ∂X 2
∂ 2 R ∂ 2C
This yields the condition < , But ∂ 2 R / ∂X 2 is the slope of the MR curve and
∂X 2
∂X 2
∂ 2C / ∂X 2 is the slope of the MC must cut the MR curve from below. In pure competition the slope of
∂ 2C
the MR curve is zero, hence the second-order condition is simplified as follows 0 < ,Which reads:
∂X 2
the MC curve must have a positive slope, or the MC must be rising.

6.2.2 Short-run Equilibrium of the Industry
Given the market demand and the market supply, the industry is in equilibrium at that price which clears
the market that is at the price at which the quantity demanded is equal to the quantity supplied. In fig. 6.7
the industry is in equilibrium at price P, at which the quantity demanded and supplied, is Q . However,
_
this will be short run equilibrium, if at the prevailing price firms are making excess profits fig.6. 8 or
losses Fig.6. 9. In the long run, firms that make losses and cannot readjust their plant will close down.
Those that make excess profits will expand their capacity, while excess profits will also attract new firms
into the industry. Entry, exit and readjustment of the remaining firms in the industry will lead to a long-
run equilibrium in which firms will just be earning normal profits and there will be no entry or exit from
the industry.
SATC
P SMC
P
P D S’ SMC
SATC C
C
F
e
F
B
S D
0 Q X 0 Xe X 0 Xe X
6.3 LONG-RUN EQUILIBRIUM OF THE FIRM AND THE INDUSTRY
6.3.1 Equilibrium of the Firm in the Long Run.
In the long run firms are in equilibrium when they have adjusted their plant so as to produce at the
minimum point of their long-run AC curve, which is tangent (at this point) to the demand curve defined
by the market price. In the long run the firms will be earning just normal profits, which are included in
the LAC. If they are making excess profits new firms will be attracted in the industry; this will lead to a
fall in price (a downward shift in the individual demand curves) and an upward shift of the cost curves
due to the increase of the prices of factors as the industry expands. These changes will continue until the
LAC is tangent to the demand curve defined by the market price. If the firms make losses in the long run
they will leave the industry, price will rise and costs inclusive of the normal rate of profit.

In fig. 6.10 we show how firms adjust to their long-run equilibrium position. If the price is P, the firm is
making excess profits working with the plant whose cost is denoted by SAC1.
P P
S LMC
C D C
S1 SAC1 LAC
SMC1
SAC
P P
S1 SMC
0 Q Q1 X 0 X
Fig.6.10 Fig.6.11
It will therefore have an incentive to build new capacity and it will move along its LAC. At the same
time new firms will be entering the industry attracted by the excess profits. As the quantity supplied in
the market increases (by the increased production of expanding old firms and by the newly established
ones) supply curve in the market will shift to the right and price will fall until it reaches the level of P1 (in
fig.6.10) at which the firm and the industry are in the long-run equilibrium. The LAC in fig.6.11 is the
final-cost curve including any increase in the prices of factors that may have taken place as the industry
expanded.
The condition for the long-run equilibrium of the firm is that the marginal cost be equal to the price and to
the long-run average cost
LMC = LAC = P
The firm adjusts its plant size so as to produce that level of output at which the LAC is the minimum
possible, given the technology and the prices of factors of production. At equilibrium the short-run
marginal cost equal to the long-run marginal cost and the short-run average cost is equal to the long-run
average cost. Thus given the above equilibrium condition, we have
SMC = LMC = LAC = LMC = P = MR
This implies that at the minimum point of the LAC the corresponding (short-run) plant is worked at its
optimal capacity, so that the minima of the LAC and SAC coincide. On the other hand, the LMC cuts the
LAC at its minimum point of the LAC the above equality between short-run and long-run costs is
satisfied.

6.3.2 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
(proceeding at the minimum point of their LAC curve and making just normal profits). Under these
conditions there is no further entry or exit of firms in the industry, given the technology and factor prices.
The long-run equilibrium of the industry is shown in fig.6.12. At the market price, P, the firms produce at
their minimum cost, earning just normal profits. The firm is in equilibrium because at the level of output
X.
LMC = SMC = P = MR. This equality ensures that the firm maximizes its profits.
P D P LMC
S|
C C SMC
SAC LAC
P P P = MR
S
D|
0 X 0 X
Q X
Fig. 6.12
At the price P the industry is in equilibrium because profits are normal and all costs are covered so that
there is no incentive for entry or exit. That the firms earn just normal profit (neither excess profits nor
losses) is shown by the equality
LAC = SAC = P
This is observed at the minimum point of the LAC curve. With all firms in the industry being in
equilibrium and with no entry or exit, the industry supply remains stable, and, given the market demand
(DD|) in fig.6.12, the price P is a long run equilibrium price.
since the price in the market is unique, this however, does not mean that all firms in the industry have the
same minimum long-run average cost. This, however, does not mean that all firms are of the same size or
have the same efficiency, despite the fact that their LAC is the same in equilibrium. The more efficient
firms employ more productive factors of production and/or more able managers. These more efficient
factors must be remunerated for their higher productivity; otherwise they will be bid off by the new
entrants in the industry. In other words, as the price rises in the market the more efficient firms earn a
rent which they must pay to their superior resources. Thus rents of more efficient factors become costs
for the individual firm, and hence the LAC of the more efficient firms’ shifts upwards as the market price
rises, even if the factor prices for the industry as a whole remain constant as the industry expands. In this
situation the LAC of the old, more efficient, firms must be redrawn so as to be tangent at the higher
market price. The LMC of the old firms is not affected by the rents accruing to its more productive
factors. (It will be shifted only if the prices of factors for the industry in general increase.)
Thus the more efficient firms will be in equilibrium, producing that output at which the redrawn LAC is
at its minimum (at which point the LAC is cut by the initial LMC given that factor LMC A prices remain
constant). Under these conditions, with the superior, more productive resources properly costed at their
opportunity cost, all firms have the same unit cost in their long-run equilibrium. This is shown in fig.
6.13.
S| LMCB
D
LMCA LAC|A
LACB
LACA
P1 P1
P1
P0
P0
0 X 0 XA A|A X 0 XB X
Market Equilibrium. Equilibrium of a more efficient firm. Equilibrium of a new entrant
At the initial price P0 the second firm as not in the industry as it could not cover its costs at that price.
However, at the new price, P1, firm B enters the industry, making just normal profits. The established
firm A earns rents which are imputed costs, so that its LAC shifts upwards and it reaches a new long-run
equilibrium producing a higher level of output (X|A).

CHAPTER SEVEN
PRICE AND OUTPUT DETERMINATION UNDER MONOPOLY
7.1 Characteristics: These are some of the characteristics or features of this market structure called
‘monopoly’
1. Single Seller: It is a market structure in which the entire supply is controlled by one firm, which
implies that the firm and industry are same.
2. No clear substitutes: there are no close substitutes for the goods produced.
3. The monopolist is the price maker: It does not take a price which is determined by the interaction of
market demand and market supply. In order to expand its sale, it decreases the price of the commodity.
4. Entry Barrier: Entry is blocked in such market structure. The barriers may be legal, financial, and
natural.
5. No Collusion and Competition: Because there is only one firm there is no competition exists and no
collusion among firms also.
7.2 Definition and sources of monopoly
Pure monopoly is the form of market organization in which single firm sells a commodity for which there
are no close substitutes.
The possible sources of monopoly are;
1. Exclusive knowledge of technology.

2. Exclusive ownership/access to strategic raw materials needed for production.
3. Government Policies: Patent Rights.
4. Size of market: The size of the market may not allow more than a single seller.
5. Natural Monopolies: Electricity, Water etc.,
7.3 Demand and Revenue for a Monopoly.
The whole market supply is controlled by a single firm. In order to sell more output the firm reduces
price and to increase price the firm reduces its output. Consequently, output and price decisions are
interdependent. So that increasing of one will result in a reduction of the other and vice versa. As a
result, the demand curve of the monopoly is downward sloping.
Note: The monopoly firm faces the industry demand function which is negatively slopped.
Costs: It is similar to competitive firms. ATC, AVC, and MC curves are U shaped and AFC is
rectangular hyperbola. The marginal cost curve is not the supply of the monopolist as in the case of pure
competition.

7.4 Short Run Equilibrium of the monopolist.
The monopolist maximizes his short run profit if the following two conditions are fulfilled.
1. The marginal cost is equal to the marginal revenue.

2. The slope of marginal cost is greater than the slope of the marginal revenue at the point of the
intersection.
Proof: The monopolist aims at the maximization of his profit (Π = R – C)
(a) The first – order condition for maximum profit Π
∂Π
=0
∂Q
∂Π ∂R ∂C
= − =0
∂Q ∂Q ∂Q
or
∂R ∂C
= , That is MR = MC
∂Q ∂Q
The second – order condition for maximum profit
∂2 ∏
<0
∂Q 2
∂ 2 ∏ ∂ 2 R ∂ 2C
= − <0
∂Q 2 ∂Q 2 ∂Q 2
∂ 2 R ∂ 2C
or < , that is [Slope of MR] < [Slope of MC]
∂Q 2 ∂Q 2
E.g Given the demand curve of the monopolist
Q = 50 – 0.5P……….. solving for p
P = 100 – 2Q
Given the cost function of the monopolist as C = 50 + 40Q
The goal of the monopolist is to maximize profit Π = R – C
(i) We first find the MR
R = QP = Q (100-2Q)
R = 100Q – 2Q2
∂R
MR = = 100 – 4Q
∂X
(ii) Next find the MC
TC = 50 + 40Q
∂TC
MC = = 40
∂X
(iii) Equate MR = MC
100 – 4Q = 40
100 – 40 = 4Q
60 = 4Q
⇒ Q = 15
(iv) The monopolist’s price is found by substituting Q = 15 into the demand-price equation
P =100 – 2Q = 70
(v) The profit is Π = TR – TC
= PQ –TC = 70(15) – [50 + 40 (15)]
= 1050 – 650 = 400
This profit is the maximum possible profit, since the second-order condition is satisfied:
∂ 2 R ∂ 2C
(a) When <
∂Q 2 ∂Q 2
∂MC ∂ ( 40)
= =0
∂Q ∂Q
∂MR ∂ (100 − 4Q ) ∂2R

(b) From = =-4 we have = −4 ..
∂Q ∂Q ∂X
Clearly -4 < 0.

So we can say output level 15 maximizes profit; and hence it is optimal. Therefore, we can see that the
classical condition for equilibrium of equating the marginal revenue and marginal cost remained intact,
except that price is different from marginal revenue (unlike the case of perfect competition).
Graphically: The decision for the maximization of the monopolists profit is the equality of his MC and
MR, provided that the marginal cost cuts the marginal revenue curve from below.
P D
SMC SATC
P D|
0 Q MR X
Profit = PCBATC
Fig. 7.1 equilibrium of monopolist firm in short run
7.5Monopolist supply curve in the short – run
There is no unique supply curve for the monopolist derived from his MC. Given his MC the same
quantity may be offered at different prices depending on the price elasticity of demand. Graphically this
is shown by the following diagram,
SMC
D1
D2
MR2 MR1
Qe is sold at P1 for some consumers and at

Failure is not shame but lack of effort is! P2 for others. Page 81
Fig 7.2
Similarly, given the MC of the monopolist, various quantities may be supplied at any one price,
depending on the market demand and the corresponding marginal revenue curve. Such a situation is
depicted in the following figure.
P
SMC
Both Q1 and Q2 are sold at the same price P.
D1
D2
0 Q1 Q2
Q
MR2 MR1
Fig.7.3
Since the monopolist can sell the same quantity of output at different prices and can sell different
quantities at the same price, depending on elasticity of demand, there is no distinct relationship between
price and quantity supplied by a monopolist. To conclude we must say that “the supply curve is not
clearly defined.
7.6 Long run Equilibrium of Monopolist
In the long run the monopolist has the time to expand his plant or to use his existing plant at any level
which will maximize his profit. But given entry impossibility into a monopolist market the firm may not

necessarily build the optimal plant size. (That is to build up his plant until he reaches the minimum point
of the LAC).
Given entry barrier, the monopolist will most probably continue to earn super normal profits even in the
long run. However, the size of his plant and the degree of utilization of any given plant size depend
entirely on the market demand.The monopolist may reach the optimal scale (minimum point of LAC) or
remain at suboptimal scale (falling parts of his LAC) or operate beyond the optimal scale (expand beyond
the minimum LAC) depending on the market condition.
(i) For instance if market is limited/small the firm will maintain a sub-optimal plant and may under
utilize the plant.
C
SMC LMC
P SAC
LAC
At long-run equilibrium
D SMC = LMC = MR
0 Q
Q
MR
Fig.7.4. Monopolist with suboptimal plant and excess capacity.
The firm is employing plant size smaller than the optimum and it is under utilizing the plant (excess
capacity).
(ii) If the market is so large relative to the expansion path, the firm may build a production plant larger
than the optimal and may over-utilize the plant.
When the market is larger, the optimum occurs to the right of the minimum point of Long run average
cost as at point e.
C LMC
A
LAC
D
SAC SMC
P
MR
0
Qε Q
Fig.7.5 Monopolist operating in a large market: his plant is large

than the optimal (e) and it is being over-utilized (at ε|).
(iii) If the market size is just large enough to permit the monopolist to build the optimal plant, the firm
will be operating at minimum point of LAC.
C
LMC
SMC
LAC
P SAC
D
Fig: 7.6 Monopolist operating at his optimal plant size (Full capacity
utilization)
If the monopolist is at his optimal plant size SMC = LMC = SAC =MR at minimum of LAC.
Note: The firm still earns supernormal profit because price is greater than the marginal revenue (profits in
the shaded area).
7.7 Multi plant Monopolist
A monopolist can produce identical product in different plants. For simplicity we assume the firm has
only two plants, Plant A and Plant B, each with different cost structures. In this case the monopolist has
to make two decisions.
a. Price and output levels.

b. How much to produce in the first plant and how much in the second plant.
The monopolist should know the market demand curve the corresponding MR curve and cost structure of
those plants.
MC = MC1 + MC2
mc
Mc1 mc2

Fig 7.7MC of multi plant monopolist
Optimum point is obtained by the equality point of MC1, MC2 and MR.
In other words, the monopolist maximizes his profit by utilizing each plant up to the level at which the
marginal costs are equal to each other and to the common marginal revenue. This is because if the MC on
one plant, say plant A, is lower than the marginal cost of plant B, the monopolist would increase his
profits by increasing the production in A and decreasing it in B, until the condition MC1 = MC2 = MR is
fulfilled.
Graphically the equilibrium of the multi-plant monopolist may be defined as follows. The total profit-
maximizing output and its price is defined by the intersection of MC and MR curves Point E in the
diagram. From the point of intersection we draw a line, parallel to the X-axis, until it intersects the
individual MC1 and MC2 curves of the two plants. At these points the equilibrium condition (MC = MR
= MC1 = MC2) is satisfied. If from these points (E1 and E2) we draw perpendiculars to the X-axis of
plant A and plant B, We find the level of output that will be produced in each plant. Clearly Q1+Q2 must
be equal to the profit maximizing output Q. the total profit is the sum of profits from products of the two
plants. The profit from plant A is the shaded area pbcd and the profit from plant B is the shaded hpfi.
E.g Given the monopolist’s cost and demand curve.
Q = 200 -2P or P = 100 – 0.5Q
C1 = 10Q1 C2 = 0.25Q22.
Find Q, Q1, and Q2, P Where Q = Q1 + Q2.
P = 100 – 0.5Q
TR = PQ = Q(100-0.5Q)=100.Q – 0.5Q2
MR = 100 – Q substituting Q = Q1 +Q2
= 100 – Q1 – Q2
TC1 = 10Q1 TC2 = 0.25 Q22
MC1= 10 MC2 = 0.5Q2

MC1 = MR 10 = 100 – Q1 – Q2
MC2 = MR 0.5Q2 = 100 – Q1 – Q2 solving simultaneously,
_ Q1 + Q2 = 90
Q1+1.5Q2 = 100
Q2 = 20
Q1 + Q2 = 90
Q1 = 90 – 20 = 70
P = 100 – 0.5 (90) = 100 – 45 =55
Monopolist profit ∏ = R − C1 − C 2
= 4950 – 10(70) – 0.25 (400) = 4150
7.8 SOCIAL COSTS OF MONOPOLY
Price is higher and output is lower in the monopoly market model than the competitive market model.
Because of these monopoly is said to be socially inefficient in allocating factors of production.
In Competitive Market P = MC
Monopoly Market P > MC
To calculate the degree of inefficiency due to monopoly we can use the concepts of producer’s surplus
and consumer’s surplus.
SS
Pm b
Pc c

DD
MR
Fig7.8 social cost of monopoly
Under Competition the net welfare gained by the consumers and producers is as follows:
Net Welfare = aepc + Pcef
Consumer’s Producer’s
Surplus Surplus
Under Monopoly the net welfare gained by the consumers is (aPmb) which is less than net welfare gained
under competitive (aePc). PmbcPc is taken by producers. But the area bed is totally lost. (This is not
consumer surplus & Producers surplus). Area bed is dead weight loss due to monopoly allocation as
opposed to competitive market.


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CHAPTER ONE

Review of some Basic Economic Concepts

1.2 The fundamental economic fact

1.2.1 Human wants and resource

a) Human wants are unlimited

b) Resources are limited/scarce

1.2.3. Production possibility frontier (ppf/ppc curve))

Assumptions in using PPC for our illustration

a) Fixed resources: factors of production are not changed.

Fig. 3 production possibility frontier/curve/PPF/PPC

i. There is a limit to the amount we can produce in a given time period

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1.1 Micro economic theory and the price system

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Expenditure of firms’ Resource income of resource owners

Flow of goods and services goods and services

Figure 1.1the circular flow of economic activity.

1.3 IMPORTANCE OF MICRO ECONOMIOCS

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1. Completeness: Preferences are assumed to be complete. In otherworld’s, consumers can

2.1. The concept of Utility Theory and Concept of Marginal Utility

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Table 3.1: diminishing marginal utility

Cups of tea Total utility(utils) Marginal

The relationship between TU and MU

As MU decrease but remains positive, TU is increasing

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Fig .3.1: total utility and marginal utility

2.2. Cardinal Approach and Consumer’s Equilibrium

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Consumer equilibrium and its importance

Where: marginal utility of good X and Price of good X

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Unit MUX MUY MUX/PX MUY/PY

= and PxX+PyY …+PnN=I

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2.3. Ordinal Approach

2.3.1. Definition and meaning of Indifference Curves

Table3.3; Alternative Market Baskets for Food and Clothing

market basket units of food units of clothing

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It shows that in moving from market basket

Fig 3.2 an indifference curve to H, which lies below u1.

2.3.2. Assumptions of indifference curve

An ordinal measure of utility is based on the following assumptions;

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Fig 2.3 indifference curves for perfect substitute goods

one of his/her excess left shoes than obtain 1 2 3 4 right shoes

2.3.5. Marginal Rate Of Substitution (MRS)

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Diminishing marginal rate of substitution: (Assumption 4 of Consumer behavior (Preferences))

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2.4. Budget Line (Constraints)

PXX + PYY < I (1)

Budget set Rearrange the budget line in equation (1) to

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2.4.1. Change in income and price of the budget line

I. Change in income. It is easy to see from Y

Fig 3.7 change in income and budget line

Y What happens to the budget line