Chapter Two

Introduction to the Theory of Consumer Behavior

Theory of demand seeks to establish relationship between the quantity demanded of a

commodity and its price. It also explains variations in demand. The purpose of the
theory of demand is to determine the various factors that affect demand. Demand is a
multivariate relationship, that is, it is determined by many factors simultaneously.
Some demand for a particular product are its own price, consumer’s income, prices of
other commodities, consumer’s tastes, income distribution, total population,
consumer’s wealth, credit availability, government policy, past levels of demand and
past levels of income.

There are different approaches known to the economists to the theory of demand. The
oldest among them is the marginal utility approach. The marginal utility analysis
explains consumer’s demand for a commodity and derives a law of demand, which
shows an inverse relationship between the quantity demanded and the price of the
commodities. It should be noted that the traditional theory of demand examines only
the consumer’s demand for durables and non-durables. It is partial in its approach in
that it examines the demand in one market in isolation from the conditions of the
demand in other markets. An important implicit assumption of the theory of demand
is that firms sell their products directly to the final consumers.

All desires of a consumer are not of equal urgency or importance. Since his resources
are limited and he cannot fulfill all his desires, he must pick and choose more
important and more urgent desires for satisfaction. Thus, some desires take
precedence of others. This is how a consumer ranks his desires and builds up a scale
of preferences. Scarcity forces him to choose. Ability to arrange preferences in order
of importance or urgency is inherent in human nature.

A prudent consumer exercises a lot of discrimination in his purchases. We find him

substituting one commodity, partly or wholly, for another. He purchases a certain
quantity of a commodity and no more. All the time, he is aspiring to reach an
equilibrium position, i.e., a position in which he derives maximum satisfaction from
the use of money at his disposal. The consumer’s scale of preferences is independent
of the prices ruling in the market. He builds up his scale of preferences from the
commodities he consumes. Because of this scale of preferences, he knows that one
combination of the goods yields him the same satisfaction as another.

In the following material, we shall learn in detail Consumer Preferences, Budget

Constraints, Utility, Consumer Choice, Offer curve analysis of price and income,
Slutsky’ Equation, Consumer surplus, Derivation of the Market Demand, and
Elasticity of Demand.
1.1 BUDGET CONSTRAINTS
The budget constraints are that consumers face because of their limited incomes.
People are compelled to determine their behavior in light of limited financial

1
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 they yield maximum satisfaction.

The Consumption Basket of a consumer (x 1,x2) is simply a list of two numbers that
tells us how much the consumer is choosing to consume of good 1, x 1, and how much
the consumer is choosing to consume of good 2, x2. 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, (p 1,p2) and the amount of
money the consumer has to spend m, then the budget constraint of the consumer can
be written as
p1x1 + p2x2 < m (1)

Here p1x1 is the amount of money the consumer is spending on good 1, and p 2x2 is the
amount of money the consumer is spending on good 2. 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 m.

1. Two Goods Are Often Enough.

The two-goods assumption is more general. Because it is often interpreted as one of
the goods are representing everything else the consumer might want to consume. For
example, if we are interested in studying a consumer’s demand for milk, let x1
measure his or her consumption of milk in quarts per month. Then let x 2 stand for
everything else the consumer might want to consume.

When you adopt this interpretation, it is convenient to think of good 2 as being the
money that the consumer can use to spend on other goods. Under this interpretation,
the price of good 2 will automatically be 1, since the price of one birr is one birr.
Thus, the budget constraint will take the form

p1x1+x2 < m (2)

This expression simply says that the amount of money spent on good 1, p1x1, plus the
amount of money spent on all other goods, x2, must be no more than the total amount
of money the consumer has to spend, m.
Good 2 represents a composite good that stands for everything else that the consumer
might want to consume other than good 1. Such a composite good is invariably
measured in birrs to be spent on goods other than good 1. As far as the algebraic form
of the budget constraint is concerned, equation (2) is just a special case of the formula
given in the equation (1)., with p2 = 1, so everything that we have to say about the
budget constraint in general will hold under composite good interpretation.

2
2. Properties of the Budget Set.

The budget line is the set of bundles that cost exactly m:

p1x1 + p2x2 = m (3)

These are the bundles of goods that just exhaust the consumer’s income. The budget
set is depicted in Fig 1. The heavy line is the budget line – the bundles that cost
exactly m – and the bundles below this line are those that cost strictly less than m.

Figure 1 Budget Line.

X2
Vertical Budget line;
intercept = m/p2 slope = -p1/p2

Budget set

Horizontal Intercept = m/p1 X1

Fig . 1

The budget set consists of all bundles that are affordable at the given prices and
income.

Rearrange the budget line in equation (3) to get the formula

x2 = m/p2 – p1/p2 * x1 (4)

This is the formula for a straight line with a vertical intercept of m/p 2 and a slope of –
p1/p2. The formula tells how many units of good 2 the consumer needs to consume in
order to just satisfy the budget constraint if he or she consuming x1 units of good 1.

The slope of the budget line measures the rate at which the market is willing to
substitute good 1 for good2. For example that the consumer is going to increase her
consumption of good 1 by ∆x1.

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How much will consumption of good 2 have to change in order to satisfy her budget
constraint?

p1x1 + p2x2 = m

and p1(x1+∆x1) + p2(x2+∆x2) = m.

Subtracting the first equation from the second gives

p1∆x1 +p2∆x2 = 0.

This says that the total value of the change in consumption must be zero. Solving for
∆x2/∆x1, the rate at which good 2 can be substituted for good 1 while still satisfying
the budget constraint, gives

x2 p
 1
x1 p2

This is just slope of the budget line. The negative sign is there since ∆x1 and ∆x2 must
always have opposite signs. Because consumption of more of good1 leads to
consumption of less of good 2 and vice versa, as long as the consumer continue to
satisfy the budget constraint.

3. How the Budget Line Changes

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? First consider changes in
income. It easy to see from equation (4) 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.

4
 X2
m’/p1

m/p2

m/p1 m’/p1 X1
Fig. 2

To identify changes in prices? First, consider increasing price 1 while holding price 2
and income fixed. According to equation (4) increase in p1 will not change the
vertical intercept, but it will make the budget line steeper since p1/p2 will become
larger.

X2
m/p2 Budget Lines

Slope = -p1/p2
Slope =
-p1/p2

m/p`1 m/p1 X1
Fig. 3
Increasing Price. If good 1 becomes more expensive, the
budget line becomes steeper.

What happens to the budget line when we change the prices of good 1 and good 2 at
the same time? For example, if the prices of both goods 1 and 2 gets doubled, both the
horizontal and vertical intercepts shift inward by a factor of one-half, and therefore

5
the budget line shifts inwards by one-half as well. Multiplying both prices by two is
just like dividing income by 2.

To show this algebraically. Suppose our original budget line is

p1x1 + p2x2 = m

Now suppose that both prices become t times as large. Multiplying both prices by t
yields

tp1x1 +t p2x2 = m

However, this equation is same as

p1x1 + p2x2 = m/t.

Thus multiplying both prices by a constant amount t is just like dividing income by
the same constant t. It follows that if we multiply both prices by t and we multiply
income by t. then budget line will not change at all.

What happens if both prices go up and incomes go down?

If m decreases, p1, and p2 both increase, then the intercepts m/p1 and m/p2 must both
decrease. This means that the budget line will shift inward. How about the slope of
budget line? If price 2 increases more than price 1, so that – p 1/p2 decreases ( in
absolute value) then the budget line will be flatter; if price 2 increases less than 1, the
budget line will be steeper.

The budget line is defined by two prices and one income, but one of these variables is
redundant. We could peg one of the prices, or the income, to some fixed value, and
adjust the other variables to describe exactly the same budget set. Thus the budget line
p1x1 + p2x2 = m

exactly the same budget line as

p1/p2. x1+x2 =m/p2

or
p1/m. x1 +p2/m. x2 = 1.

Since the first budget line results from dividing everything by p2, and the second
budget line results from dividing everything by m. In the first case, we have pegged p2
= 1, and in the second case, we have pegged m = 1. Pegging the price of one of the
goods or income to 1 and adjusting the other prices to 1, as we did above we often
refer to that as the numeraire price. The numeraire price is the price relative to which

6
we are measuring the other price and income. It will occasionally be convenient to
think of one of the goods and being a numeraire good, since there will then be one
less price to worry about.

1.2 CONSUMER PREFERENCES

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.

1.2.i. Assumptions:

1. Completeness: Preferences are assumed to be complete. In other words,

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. A consumer
might prefer steak to hamburger but by hamburger because it is cheaper.

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 (Nonsatiation): 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.

1.2.ii. Indifference Curves

Consumer preferences are graphically shown with the use of indifference curves.

Definition: An indifference curve represents all combinations of market baskets

that provide a consumer with the same level of satisfaction.

7
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.

Table 1:- 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

The following figure shows the same baskets listed in the table above.

Figure 1:- Describing Individual Preferences.

Clothing
50 *B

40

*H *E
30

20

*A
10
(Units/week)

10 20 30 40 Food
(Units per Week)
*G *D

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The horizontal axis measures the number of units of food purchased each week; the
vertical axis measures the number of units of clothing. 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 nonsatiation). Similarly, market basket E,
which contains even more food and even more clothing preferred to A. In fact, it is
easy to compare all market baskets in the two shaded areas (such as E and G) to A
because they all contain either more or less of both food and clothing. 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 baskets A with baskets B,
D, and H are not possible without more information about the consumer’s ranking.

The following figure 2 shows an indifference curve, labeled U1, that passes through
points A, B, and D. This curve indicates that the consumer is indifferent among these
three market baskets.

Figure 2 AN INDIFFERENCE CURVE

Clothing
(Units/week)
50
*B

40
*H *E

30
*A

20
*G *D u1

10

10 20 30 40 Food
Food (Units per week)
It shows that in moving from market basket A to market basket B, the consumer feels
neither better nor worse off in giving up 10 units of food to 20 units of clothing.
Likewise, the consumer is indifferent between points A and D. He or she will give up
10 units of clothing to obtain 20 units of food. On the other hand, consumer prefers A
to H, which lies below u1.

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Indifference curve in the figure 2 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 u 1 in figure 2 is preferred to any
market basket on u1.

1.2.iii. 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.

1. An indifference curve passes through each point in the commodity space.

2. Indifference curves cannot intersect.
3. Indifference curves are negatively sloped.
4. Indifference curves are convex in shape.
5. 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 re preferred to bundles on lower indifference curves.

1.2.iv. THE 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.

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Figure 3. The Marginal Rate of Substitution

Cloth 16 A
Units/wee
-6

10 B
1
-4
06 D
1
04 -2 E
G
-1
02

0 1 2 3 4 5 Food Units/week

In figure 3 note that clothing appears on the vertical axis and food on the horizontal
axis. 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. In figure 3 the MRS refers to
the amount of clothing that the consumer is willing to give up to obtain an additional
unit of food. If we denote the change in clothing buy ∆C and the change in food by
∆F, the MRS can be written as -∆C/∆F. We add the negative to make the marginal rate
of substitution a positive number (∆C is always negative; the consumer give up
clothing to obtain additional food.)

Thus, the MRS at any point is equal in magnitude to the slope of the indifference
curve. In Figure 3 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.

CONVEXITY Also observe in figure 3 that the MRS falls as we move down the
indifference curve. This is not a coincidence. This decline in the MRS reflects an
important characteristic of consumer preferences. To understand this, we will add an
additional assumption regarding consumer preferences to the three that we discussed
earlier in the chapter:

1.2.v Diminishing marginal rate of substitution: (Assumption 4 of Consumer

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

11
MRS diminishes along the curve. The indifference curve in Fig 3 is convex. As we
have seen, 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. If we start at basket D and move to E, the
MRS is 2. Starting at E and moving to G, we get an MRS of 1. As food consumption
increases, the slope of the indifference curve falls in magnitude. Thus the MRS also
falls. (With nonconvex 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).

Is it reasonable to expect indifference curves to be convex? Yes, as more and more of

one good is consumed, we can expect that a consumer will prefer to give up fewer and
fewer units of a second good to get additional units of the first one. As we moved
down the indifference curve in figure 3 and consumption of food increases, the
additional satisfaction that a consumer gets from still more food will diminish. Thus,
he will give unless and less clothing to obtain additional food.

Another way of describing this principle is to say that consumers generally prefer
balanced market baskets to market baskets that contain all of one good and none of
another. Note from Figure 3 that a relatively balanced market basket containing 3
units of food and 6 units of clothing (basket D) generates as much satisfaction as
another market basket containing 1 unit of food and 16 units of clothing (Basket A). It
follows that a balanced market basket containing (for example) 6 units of food and 8
units of clothing will generate a higher level of satisfaction.

1.2.vi PERFECT SUBSTITUTES AND COMPLIMENTS

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.

The goods are substitutes when an increase in the price of one leads to an increase in
the quantity demanded of the other. In general, perfect substitutes when the marginal
rate of substitution of one for the other is a 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. For
more illustration, see the fig 3.a.

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Fig. 3.a Perfect substitutes.

Apple Juice

(glasses)

1 2 3 4
Orange Juice (glasses)
This fig 3.a shows preferences of a consumer for apple juice and orange juice. These
two goods are 2 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.
1
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.b
illustrates a consumer’ 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 shoes is zero whenever there are more right shoes than left shoes;
consumer will not give up any left shoes to get additional right shoes.
Correspondingly, the MRS is infinite whenever there are more left shoes than right
because consumer will give up all but one of his/her excess left shoes than obtain an
additional right shoe.

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3.b. Perfect Compliments.

Apple Juice

(glasses)

3
1 2 3 4
Orange Juice
Bads so (glasses)
far, all the examples mentioned above have involved only commodities that
have been considered as “goods” – i.e., cases in which more of a commodity is
preferred to less. But in the world there are also bad commodities which are preferred
by certain
2 groups of consumers. Bads are those commodities less of them is preferred
to more. Air Pollution and asbestos in housing insulation are some of the examples of
this kind of commodities. To analyze the consumer preferences for these
commodities, they have to be redefined under study so that the consumer tastes are
represented as the preference for less of the bad. This reversal turns the bads into
goods. For instance, instead of preference for air pollution, it can be discussed as the
preference
1
for clean air, which can measure the degree of reduction in air pollution.
Similarly, instead of referring to asbestos as a bad, it can be referred to corresponding
good, the removal of asbestos.

With this simple adaptation, all four of the basic assumptions of consumer theory
continue to hold.

1.3 UTILITY

Consumer theory relies only on the assumption that consumers can provide relative
rankings of market baskets. It is often useful to assign numerical values to individual
baskets. Using this numerical approach, it is possible to describe consumer
preferences by assigning scores to the levels of satisfaction associated with each
indifference curve. Generally, the word utility means “benefit or well-being.”

In the language of economics, the concept of utility refers to the numerical score
representing the satisfaction that a consumer gets from a market basket. In other

14
words, utility is a device used to simplify the ranking of market baskets. Ex: If buying
three copies of a textbook gives, you more pleasure than buying one shirt, then it is
said that the books give you more utility than the shirt.

1.3.i UTILITY FUNCTIONS

A utility function is a formula that assigns a level of utility to each market basket. For
example, that a consumer’s utility function for food (F) and clothing (C) is
u(F,C,)=F+2C. In this case, a market basket consisting of 8 units of food and 3 units
of clothing generates a utility of 8 + (2) (3) = 14. Consumer is therefore indifferent
between this market basket and a market basket containing 6 units of food and 4 units
of clothing (6+(2)(4) = 14).

Not all kinds of preferences can be represented by a utility function. For example,
suppose someone had intransitive preferences so that A  B  C  A . Then a utility
function for these preferences would have to consist of numbers u(A), and u(B) and
u(C) such that u(A)>u(B)>u(C)>u(A). However, this is impossible. So such kind of
perverse cases not considered for construction of utility function.

The figure 1 and illustration gives the details of constructing a utility function. A
utility function is a way to label the indifference curves such that higher indifference
curves get larger numbers. To do this, draw the diagonal line illustrated and label each
indifference curve with its distance from the origin measured among the curve.

How do you know this as a utility function? It is not difficult to see that preferences
are monotonic then the line through the origin must intersect every indifference curve
exactly once. Thus, every bundle is getting larger labels – and that is all it takes to be
a utility function. This is one way to find labeling of indifference curves, at least as
long as preferences are monotonic. This at least shows that ordinal utility function is
quite general: nearly any kind of “reasonable” preferences can be represented by a
utility function.
X2 Measures distance
from origin

Indifference
curves

X1

Figure 1: Constructing a utility function from indifference

curves. Draw a diagonal line and label each indifference curve
with how fat it is from the origin measured along the line.
15
1.3.ii ORDINAL UTILITY
A utility function that generates ranking in order of most to least preferred of market
baskets is called an ordinal utility function. In fact, numerical values are arbitrary,
interpersonal comparisons of utility are impossible.

The only property of a utility assignment that is important is how it orders the bundles
of goods. The magnitude of the utility function is only important insofar as it ranks
the different consumption bundles; the size of the utility difference between any two
consumption bundles does not matter. Because of this emphasis on ordering bundles
of goods, this kind of utility is referred to as ordinal utility.

Consider the following table 1. where several different ways of assigning utilities to
three bundles of goods is illustrated, all of which order the bundles in the same way.
In this example, the consumer prefers A to B and B to C. All of the way indicated are
valid utility functions that describe the same preferences because they all have the
property that A is assigned a higher number than B, which in turn in assigned a higher
number than C.
Table : 1 Different ways to assign utilities.

Bundle
Bundles U1 U2 U3

A 3 17 -1
B 2 10 -2
C 1 .002 -3

Since only the ranking of the bundles matters, there can be no unique way to assign
utilities to bundles of goods.

1.3. iii CARDINAL UTILITY

A utility function that describes by how much one market basket is preferred to
another is called cardinal utility function. Unlike ordinal utility functions, a cardinal
utility function attaches to market baskets numerical values that cannot arbitrarily be
doubled or tripled without altering the differences between values of various market
baskets.

There are some theories of utility that attach a significance to the magnitude of utility.
These are known as cardinal utility theories. In a theory of cardinal utility, the size of
the utility difference between two bundles of goods is supposed to have some sort of
significance.

In fact, there is no hard and fast rule to measure utility. It is almost not possible to say,
whether a person gets twice as much satisfaction from one market value as from
another. Not it is not known whether one person gets twice as much satisfaction as

16
another from consuming the same basket. In fact as far as theory is concerned this
constraint is not important. Because the objective is to understand consumer behavior
all that matters is knowing how consumers rank different baskets.

1.3. Marginal Utility

Consider a consumer who is consuming some bundle of goods, (x 1,x2). How does this
consumer’s utility change as we give a little more of good 1? This rate of change is
called the marginal utility with respect to good 1. We write it as MU1 and think of it
as being ratio,
U u ( x1  x1 , x2 )  u ( x1 , x2 )
MU1  
x1 x1

That measures the rate of change in utility (∆U) associated with a small change in the
amount of good 1 (∆x1). Good 2 is held fixed.

This definition implies that to calculate the change in utility associated with a small
change in consumption of good1, just multiply the change in consumption by the
marginal utility of the good.

∆U = MU1∆X1.

The marginal utility with respect to good 2 is defined in a similar manner:

U u ( x1 , x2  x2 )  u ( x1 , x2 )
MU 2  
x2 x2
When computing the marginal utility with respect to good 2 keep the amount of good
1 constant. We can calculate the change in utility associated with a change in the
consumption of good2 by the formula
∆U = MU2∆X2.
Marginal utility depends on the particular utility function that we use to reflect the
preference ordering and its magnitude has no particular significance.

Because of conceptual problems, economists have abandoned the old-fashioned view

of utility as being a measure of happiness. Instead the theory of consumer behavior
has been reformulated entirely in terms of consumer preferences, and utility is seen
only a s a way to describe preferences.

17
 1.4 CONSUMER CHOICE

Given preferences and budget constraints, it is possible to determine how individual

consumers choose how much of each good to buy. The basic assumption is that
consumers make this choice in a rational way – that they choose goods to maximize
the satisfaction they can achieve, given the limited budget available to them.

The maximizing market basket must satisfy two conditions:

1. It must be located on the budget line.

2. It must give the consumer the most preferred combination of goods and services.

These two conditions reduce the problem of maximizing consumer satisfaction to one
of picking point on the budget line.

We can graphically illustrate the solution to the consumer’s choice problem.

U3
U1
Clothing

D
B

U2
Budget line

Food

Fig 1:-Maximizing consumer satisfaction.

The above figure 1 shows how the problem is solved. Here, three indifference curves
describe a consumer’s preferences for food and clothing. Remember that of the three
curves, the outer most curve u3, yields the greatest amount of satisfaction, curve u2the
next greatest amount, and curve u1 the least.

The point B on indifference curve u1 is not the most preferred choice, because a
reallocation of income in which more is spent on food and less on clothing can

18
 increase the consumer’s satisfaction. In particular, by moving to point A, the
consumer spends the same amount of money and achieves the increased level of
satisfaction associated with indifference curve u2 like the basket associated with D on
indifference curve u3, achieve a higher level of satisfaction but cannot be purchased
with the available income. Therefore, A maximizes the consumer’s satisfaction.

*If you know the consumer choices that a consumer made, how to determine his
preferences? REVEALED PREFERENCES THEORY

The basic idea is simple. If a consumer chooses one market basket over another, and if
the chosen market basket is more expensive than the alternative, then the consumer
must prefer the chosen market basket.
X2 L1

(X1,X2)
*
*

*
(Y1,Y2)

Figure 2. Revealed Preferences: Two Budget Lines X1

The bundle (x1,x2), that the consumer chooses is revealed preferred to the bundle
(y1,y2), a bundle that he could have chosen.

Consider figure 2 where a consumer’s demanded bundle (x1, x2) and another arbitrary
bundle (y1, y2) i.e., beneath the consumer’s budget line are depicted. The bundle (y1,
y2) is certainly an affordable purchase at the given budget-the consumer could have
bought it, if preferred, and would even have had money left over. Since (x1, x2) is the
optimal bundle, it must be better than anything else that the consumer could afford.
Hence, in particular it must be better than (y1, y2).

The same argument holds for any bundle on or underneath the budget line other than
the demanded bundle. Since it could have been bought at the given budget but was
not, then what was bought must be better. Here is where we use the assumption that
there is a unique demanded bundle for each budget. If preferences are not strictly
convex, so that indifference curves have flat spots, it may be that some bundles that
are on the budget line might be just as good as the demanded bundle.

19
In figure 2 all of the bundles underneath the budget line are revealed worse than the
demanded bundle (x1, x2). This is because they could have been chose, but were
rejected in favor of (x1, x2).

Let (x1, x2) be the bundle purchased at prices (p 1, p2) when the consumer has income
m.

p1 y1  p2 y2  m.

Since (x1, x2) is actually bought at the given budget, it must satisfy the budget
constraint with equality

p1 x1  p2 x2  m .

Putting these two equation together, the fact that (y 1, y2) is affordable at the budget
(p1, p2, m) means that

p1 x1  p2 x2  p1 y1  p2 y2 .

If the above inequality is satisfied and (y 1, y2) is actually a different bundle from (x1,
x2), then (x1, x2) is directly revealed to (y1, y2).

Important point is that the left hand side of this inequality is the expenditure on the
bundle that is actually chosen at prices (p1, p2). Thus, revealed preference is a relation
that holds between the bundle that is actually demanded at some budget and the
bundles that could have been demanded at that budget. When we say that X is
revealed preferred to Y, it means that X is chosen when Y could have been chose; that
is, that

p1 x1  p2 x2  p1 y1  p2 y2

Optimum of the Consumer

A consumer is said to be at optimum when he/she maximizes utility subject to income

constraint.

Consider U = f(x), price of Px.

The consumer can either buy an additional unit of X or keep the income, which was to
be spent on that additional unit of X unspent. Both give some satisfaction to the
consumer. To determine the optimum of the consumer will need to compare the MU x
and Px.

MUx which the consumer will have to pay.

20
Px What the consumer has to pay.

MUx > Px the consumer can raise his/her satisfaction by purchasing more units of
good of X.

MUx <Px The consumer can raise his level of satisfaction by reducing
consumption of x.

MUx = Px Optimum of the consumer. When the utility function of the consumer
contains more than one good. U = f (x 1,x2,….xn). The optimum of the consumer
receives the following conditions to be fulfilled.

The condition.
MU x1 MU 2 MU xn
  .....
Px1 Px 2 Pxn

MU x1
The satisfaction the consumer derives by spending one unit of money x 1.
PX 1
Spending one unit of money should result in the same satisfaction regardless of the
good it is spent on. If spending one unit of money results in higher satisfaction when
it is spent on x1 compared to other goods. The consumer can raise his satisfaction by
spending more on x1 and less on other unit the above condition is fulfilled.

21
Appendix: Mathematical Derivation of Optimum of Consumer

Though the measurement of marginal utility is unnecessary

the optimality condition. We arrive at through the ordinal
approach is the same that of the cardinal approach.
Mathematically the optimum of the consumer can be derived
by maximizing the utility subject to the budget constraint.

max.u(x1 . x2)

subject to P1X1+P2X2 < m to combine the two use what is called

a Langragean function.

L = U (X1/X2) – λ (P1X1+P2X2 – m)

The Lagrangian theorem states that the optimum of the

consumer should fulfill the following three first order
conditions.

L u
  P1 Condition 1.
X x1

L u
  P2  0 Condition 2.
X 2 x2

L
 P1 X 1  P2 X 2  m  0 Condition 3.
L

From (1) MUX1 = λ P1

From (2) MUX2 = λP2

MUX 1 MUX 2
 , 
P1 P2

MUX 1 MUX 2

P1 P2

22
for the Cobb-Douglas utility function

u (X1.X2) = X1c X2d

 MUX 1  c X 2 MUX 1 c X 2 P1
 .   . 
MUX 2 d X 1 MUX 2 d X 1 P2

P2cX2=P1dX1

P1dX 1 P2 cX 2
X2   X1
P2c P1d
From (condition 3)

P1 X 1  P2 X 2  m  0

( P2cX 2 ) P cX
P1  P2 X 2  m  0 where X 1  2 2
P1d P1d

P2cX 2
 P2 X 2  m  0
d

( P2c  P)
.x2  m
d

c m
X1  .
c  d p1

d m
X2  .
c  d p2

23
The proposition of income spent on x1 at the consumer
optimum.
the % of income which is spent on the X1.
P1 X 1 P1 c m c
 ( . )
m m c  d P1 cd
Proposition of m spent on X1 and
X2 respectively.
P2 . X 2 P2 d m d
 ( . ) the % of income which is spent on X2.
m m c  d p2 cd

a 1 a
U ( X 1. X 2 )  X 1 X 2

a in the proportion of m spent on X1

1-a in the proportion of m spent on X2

U = f (X1,X2,……………..,Xn)

MUX 1 MUX 2 MUX n

  .......... 
P1 P2 Pn

U ( X 1 , X 2 ,.......... X n )   ( P1 X 1  P2 X 2  .......Pn X n )
L
n 1

Example:

Suppose a consumer spends his/ her entire income on food (x 1)

and clothing (x2) and 25% of the total income is spend on food.
If price of x1 = 2, prices of X2=3, m = 200, estimate function &
determine the optimum quantity of x1 & x2.

u (x1. x2) = X1 ¼ , X2 ¾

24
 c m
x1  . x1= 0.25*200/2 = 25,
c  d p1

c m
x2  . x = 0.75*200/3=50
c  d p2 2

OFFER CURVES OF INCOME AND PRICE CONSUMPTION

1. Introduction

The consumer’s demand function gives the optimal amounts of each of the goods as
a function of the prices and income faced by the consumer. The demand function is
written as
x1=x1 (p1,p2,m)

x2=x2 (p1,p2,m).

The left hand side of each equation stands for the quantity demanded. The right-hand
side of each equation is the function that relates the prices and income to that quantity.

Studying how a choice responds to changes in the economic environment is known as

comparative statics. “Comparative” means that we want to compare situations:
before and after the change in the economic environment. Statics means that we are
not concerned with any adjustment process may be involved in moving from one
choice to another, others be examined in equilibrium choice. In the case of consumer,
there are two things in the model that affect optimal choice: price and income. Two
comparative statics questions in consumer theory therefore involve investigating how
demand changes when prices and income changes.

2. Normal and Inferior Goods

Normal goods are those goods when their demand for each good would increase when
income increases. If good 1 is a normal good, then the demand for it increases when
income increases, and decreases when income decreases. For a normal good, the
quantity demanded always changes in the same way as income changes. Graphical
representation is shown in the following figure 1
x1
 0.
m Indifference curves

X2

Optimal choices

Budget lines

25
X1
Fig. 1 Normal Goods: The demand for both goods increases when income
increases.

If something is called normal, there must be possibility of being abnormal. where an

increase of income result in a reduction in the consumption of one of the goods. Such
goods are called as Inferior Goods. There are many goods for which demand
decreases as income increases: example, gruel, bologna, shacks, or nearly any kind of
low quality good.

Whether a good is inferior or not depends on the income level that we examining. It
might very well be that very poor people consume more bologna as their income
increases. But after a point, the consumption of bologna would probably decline as
income continued to increase. Since in real life the consumption of goods can increase
when income increases. Fig 2 shows the graphical presentation of inferior good.

X1

Optimal Budget lines

choices
X2

Fig. 2 An Inferior Good: Good 1 is an inferior good, which means that the demand
for it decreases when income increases.

26
3. Income Offer Curves and Engel Curves
Income offer curve is constructed by shifting the budget line outward. This curve
illustrates the bundles of goods that are demanded at the different levels of income, as
depicted in figure 3.a.

For each level of income, m, there will be some optimal choice for each of the goods.
First focus on good 1 and consider the optimal choice of each set of prices and
income, x1(p1.p2.m). This is simply the demand function for good1. If prices of goods
1 and 2 are held fixed and look at how demand changes because of change income,
for that purpose Engel Curve is generated. The Engel curve is a graph of the demand
for one of the goods as a function of income, with all prices being held constant. See
figure 3.b
X2
m
Income offer curve
Engel Curve

Indifference curves
3.a Income Offer Curve x1 3.b Engel Curve x1
How demand changes as income changes. The income offer curve (or income
expansion path) shown in panel A depicts the optimal choice at different levels
of income and constant prices. When you plot the optimal choice of good 1
against income, m, we get the Engel curve, depicted in panel B.

The income offer (for the consumption) curve is obtained by connecting successive
optimum points arising from increasing income. The curve is sloped positively, when
X1 and X2 are normal goods. But if one of the goods is inferior then the curve is
negatively sloped.

4. The Price Offer Curve and the Demand Curve

Suppose the price of good 1 change while p 2 and income are fixed. Geometrically this
involves pivoting the budget line. To construct price offer curve optimal points be
connected together as illustrated in figure 4.a.This curve represents the bundles that
would be demanded at different prices for good 1.

In other words, hold the price of good2 and money income fixed, and for each
different value of p1 plot the optimal level of consumption of good1. The result is the
demand curve depicted in figure 4.b. The demand curve is a plot of the demand
function, x1(p1, p2, m), holding p2 and m fixed at some predetermined values.

27
 Ordinarily,when the price of a good increases, the demand for the good will decrease.
Thus,the price and quantity of a good will move in opposite directions, which means
that the demand curve will typically have a negative slope. In terms of rates of
change,

x1
 0 ,which simply says that demand curves usually have a negative slope.
p1

X2 P1
Indifference curves

Demand Curve
The price offer curve is obtained as a locus of successive optimum points resulting
from successive changes inPrice Offer
price of one of the goods keeping income and prices of
Curve
the price offer curve shows you what happens in the optimal of consumer
consumption with respect to the decrease in price of X1.

1.6.1 INCOME AND SUBSTITUTION EFFECTS (Slutsky Equation)

4.a Price Offer Curve X1 4.b Demand Curve X1

Slutsky equation
The price offer is the equation
curve and demand showing
curve.how theAeffect
Panel on ademand
contains for a
price offer
good of awhich
curve, change in price
depicts can bechoices
the optimal decomposed into
as the price of the substitution
good1, effect,
changes. Panel
which showsthe
B contains theassociated
effect ofdemand
a changecurve,inwhich
relative prices
depicts a plotatofantheunchanged
optimal
choice of good 1 as a function of its price.
level of real income, and the income effect, which shows the effect of
change in real income holding prices constant.

When the price of a good changes, there are two sorts of effects: the rate
at which you can exchange one good for another changes, and the total
purchasing power of your income is altered. For example, if good1
becomes cheaper, it means that you have to give up less of good 2 to
purchase good1. The change in the price of good 1has changes the rate at
which the market allows you to ‘substitute’ good 2 for good 1. The trade-
off between the two goods that the market presents the consumer has
changed.

At the same time, if good1 becomes cheaper it means that your money
income will buy more of good 1. “The purchasing power of your money

28
 has gone up although the number of dollars you have is the same, the
amount that they will buy has increased.

The Substitution Effect

The part of the effect of a price change on demand due to the change in
relative prices, assuming that the consumers compensated sufficiently to
remain at the same level of utility.
The change in demand due to the change in the rate of exchange between
the two goods is called substitution effect.

X2 Original Budget Line

Indifference Curves

Original Choice

Final Choice

X2 *
Final Budget line

X1 x1
Figure 1. Pivot and Shift. When the price of good 1 changes and income stays fixed, the
budget line pivots around the vertical axis. We will view this adjustment as occurring in
What
two are first
stages: the economic meanings
pivot the budget of thethe
line around pivoted
originaland shifted
choice, andbudget lines?
then shift this line
outward to the new demanded bundle.
First, co
This “pivot-shift” operation gives us a convenient way to decompose the
change in demand into two pieces. The first step- the pivot- is a
movement where the slope of the budget line changes while its
purchasing power stays constant, while the second step is a movement
where the slope stays constant and the purchasing power changes. This
decomposition is only a hypothetical construction – the consumer simply
observes a change in price and chooses a new bundle of goods in
response. But in analyzing how the consumer’s choice changes, it is

29
useful to think of budget line change in two stages – first pivot and then
the shift.

First, consider the pivoted line. Here is a budget line with the same slope
and thus the same relative prices as the final budget line. However, the
money income associated with this budget line is different. Since the
vertical intercept is different. Since the original consumption bundle
(x1,x2) lies on the pivoted budget line, that consumption bundle is just
affordable. The purchasing power of the consumer has remained constant
in the sense that the original bundle of goods is just affordable at the new
pivoted line.

Calculate how much we have to adjust money income in order to keep the
old bundle just affordable. Letm1 be the amount of money income that
will just make the original consumption bundle affordable; this will be
the amount of money income associated with the pivoted budget line.
Since (x1, x2) is affordable at both (p1, p2, m|), we have
m1  p11 x1  p2 x2
m  p1 x1  p2 x2

Subtracting the second equation from the first gives


m1  m  x1 p|1  p1 .
This equation says that the change in money income necessary to make
the old bundle affordable at the new prices is just the original amount of
consumption of good 1 times the change in prices.

Letting p1  p11  p1 represents the change in price 1, and m  m1  m

represents the change in income necessary to make the old bundle just
affordable, we have
m  x1p1
Now we have a formula for the pivoted budget line: it is just the budget
line at the new price with income change by ∆m. Note that if the price of
good 1 goes down, a consumer’s purchasing power goes up, so we will
have to decrease the consumer’s income in order to keep purchasing
power fixed. Similarly, when a price goes up, purchasing power constant
must be positive.

30
The substitution effect x1s is the change in the demand for good1 when
the price of good 1 changes to p|1 and, at the same time, money income
changes to m|:
x1s  x1 ( p11 , m1 )  x1 ( p1 , m)
In order to determine the substitution effect, use the consumer’s demand
function to calculate the optimal choices at (p11,m1) and (p1,m). The
change in demand for good 1 may be large or small, depending on the
shape of the consumer’s indifference curves.

The substitution effect is sometimes called the change in compensated

demand. The idea is that the consumer is being compensated for a price
rise by having enough income given back to him to purchase his old
bundle. Of course, if the price goes down he is compensated by having
money taken away from him.

The Income Effect

The change in demand due to having more purchasing power is called
income effect. This is the part of the response in the demand for a good to
a change in its price which is due to the rise in the real income of
consumer resulting from a price decrease.
A parallel shift of the budget line is the movement that occurs when
income changes while relative prices remain constant. This second stage
of price adjustment is called income effect. Simply change the consumer’s
income from m| to m, keeping the prices constant at (p11, p2). In figure 2
this change moves us from the point Y to Z. It is natural to call this last
movement the income effect because changing the income while keeping
the prices fixed at the new prices.
More precisely, the income effect, x1n , is the change in the demand for
good 1 when we change income from m1, to m, holding the price of good
1 fixed at p`1:
x1n  x1 ( p|1 , m)  x1 ( p|1 , m| ) .
When the price of a good decreases, we need to decrease income in order
to keep purchasing power constant. If the good is a normal good, then this
decrease in income will lead to a decrease in demand. If the good is an
inferior good, then the decrease in income will lead to an increase in
demand.

31
 X2 Indifference Curves

m/p2

m1/P2
z
x y

0 Substitution Income X1
effect effect
Figure 2: Substitution effect and Income effect. The pivot gives the
substitution effect and the shift gives the income effect.

The Total Change in Demand

The total change in demand Δx1 is the change in demand due to the
change in price, holding income constant;

 
x1  x1 p11 , m  x1  p1, m  .

This can be broken up into substitution effect and the income effect. In
terms of symbols defined above,

x1  x s1  x n1
x1 ( p 11 , m)  x1 ( p1 , m)  [ x1 ( p |1 , m | )  x1 ( p1 , m)]  [ x1 ( p |1 , m)  x1 ( p | 1 , m | )]

This equation is called Slutsky’s Identity (Named after Russian

economist Eugen Slutskey, 1880-1948). In words, this equation says that
the total change in demand equals the substitution effect plus the income
effect. It is called identity because; it is true for all values of p 1, p|1, m and

32
m|. The first and fourth terms on the right hand side cancel out, so the
right hand side is identically equal to the left hand side.

The content comes from the interpretation of two terms on the right hand
side: substitution effect and the income effect. While substitution effect
must always be negative-opposite the change in the price-the income
effect can go either way. Thus the total effect may be positive or
negative. However, if we have normal good, then the substitution effect
and the income effect work in the same direction. An increase in price
means that the demand will go down due to the substitution effect. If
price goes up, it is like decrease in income, which, for a normal good,
means a decrease in demand.

The Law of Demand: If the demand for a good increases when income
increases, then the demand for that good must decrease when its price
increases.

This follows directly from the Slutsky’s equation: if the demand increases
when income increases, we have normal good. In addition, if we have a
normal good then the substitution effect and the income effect reinforce
each other, and an increase in price definitely reduce demand.

Some examples with Perfect compliments and substitutes.

Slutsky’s decomposition is illustrated in the fig 3. When we pivot the

budget line around the chosen point, the optimal choice at the new budget
line is the same as at the old one – this means that the substitution effect
is zero. The change in demand is due entirely to the income effect.

The case of perfect substitutes illustrated in figure 4. When we tilt the

budget line, the demand bundle jumps from the vertical axis to the
horizontal axis. This is because of the entire change in the demand due to

33
the substitution effect.

X2

Original budget
line

Final budget line

Pivot Shift

Income effect = Total effect

X1

Figure 3
Perfect Compliments. Slutsky decomposition with perfect
compliments

X2
Indifference curves

Final budget line

Original Choice

Final Choice
Original budget line

Substitution effect = total effect X1

Figure 4
Perfect substitutes. Slutsky decomposition with perfect substitutes.

To conclude, Slutsky equation says that the total change in demand is the
sum of the substitution effect and the income effect.

34
A Numerical Example: Calculating the Substitution Effect

Suppose that the consumer has a demand function for milk of the form
m
x1  10  .
10 p1
Originally his income is Br.120 per week and the price of milk is Br.3 per
120
quart. Thus his demand for milk will be 10   14 quarts per week.
10 * 3
Now suppose that the price of milk falls to Br.2 per quart. Then his
120
demand at this new price will be 10   16 quarts of milk per week.
10 * 2
The total change in demand is +2 quarts a week.

In order to calculate the substitution effect, we must first calculate how

much income would have to change in order to make the original
consumption of milk just affordable when the price of milk is Br.2 a
quart. We apply the formula m  x1p1  14 * (2  3)   Br.14.

Thus the level of income necessary to keep purchasing power constant is

m'  m  m  120  14  106. what is the consumer’s demand for milk at the
new price, Br.2 per quart, and this level of income? Just plug numbers
into the demand function to find.
106
x1 ( p '1 , m' )  x1 ( 2,106)  10   15.3
10 * 2
Thus the substitution effect is x s1  x1 (2,106)  x1 (3,120)  15.3  14  1.3 .

Calculating the Income Effect.

x1 ( p '1 , m)  x1 (2,120)  16
x1 ( p '1 , m' )  x1 (2,106)  15.3

Thus the income effect for this problem is

x n1  x1 (2,120)  x1 (2,106)  16  15.3  0.7 .

Since milk is a normal good for this consumer, the demand for milk
increases when income increases.

35
 DERIVATION OF CONSUMER DEMAND

The derivation of demand is based on the axiom of diminishing marginal

utility. The marginal utility of commodity x may be depicted by a line
with a negative slope (fig. 2). Geometrically the marginal utility of x is
the slope of the total utility function U=f(q x). The total utility increases,
but at a decreasing rate, up to quantity x and then starts declining (fig. 1).
Ux MUx

TU

0 x qx 0 x qx
Fig. 1 Fig. 2
MUx

Accordingly the marginal utility of x declines continuously, and becomes

negative beyond quantity x. If the marginal utility is measured in
monetary units, the demand curve for x is identical to the positive
segment of the marginal utility curve. At xt the marginal utility is MU1
(fig. 3). This is equal to P1, by definition. Hence, at P1 the consumer
demand x1 quantity (fig. 4).
MUx Px

MU1
MU2 P1
MU3
P2

P3

0 x1 x2 x3 0 x1 x2 x3 x qx
MUx
Fig. 3 Fig. 4

36
Similarly, at x2 the marginal utility is MU2, which is equal to P2. Hence, at
P2 the consumer will buy x2, and so on. The negative section of MU curve
does not form part of the demand curve, since negative quantities do not
make sense in economics.

Graphical Presentation of the Equilibrium of the Consumer:

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. 5).

Y* e

0 x* B X
Fig. 5

At the point of tangency the slopes of the budget line (P x/Py) and of the
indifference curve (MRSx,y=MUx/MUy) are equal:

MU x P
 x
MU y Py

37
Thus the first-order condition is denoted 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 P 1,P2,…….Pn. The
consumer has a money income (Y) which he spends on the available
commodities.

Formally, the problem may be stated as follows:

Maximize U = f(q1,q2,….,qn)
n

Subject to q P  q P  q P
t 1
1 1 1 1 2 2  ....  qn Pn  Y

We use the ‘Lagrangian 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’.
 = U – λ(q1P1+q2P2+…..qnPn – Y)

It can be shown that maximization of the ‘composite function implies

maximization of the utility function.

38
The first condition for the maximization of a function is that its partial
derivatives be equal to zero. Differentiating Φ with respect to q 1,…qn and
λ and equating to zero we find
 U
   ( P1 )  0
q1 q1
 U
   ( P2 )  0
q2 q2
. . . .
. . . .
. . . .
 U
   ( Pn )  0
qn qn


 ( q1 P1  q2 P2  .......qn Pn  Y )  0

From these equation we obtain
U
 P1
q1
U
 P2
q2
. . .
. . .
. . .
U
 Pn
qn

U U U
 MU1 ,  MU 2 ,.......  MU n
q1 q2 qn

Substituting and solving for λ we find

MU1 MU 2 MU n
   ..... 
P1 P2 Pn

Alternatively, we may divide the preceding equation corresponding to commodity x,

by the equation which refers to commodity y, and obtain

MU x P
 x  MRS x , y
MU y Py

39
We observe that the equilibrium conditions are identical in the cardinalist 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

Thus, although in the indifference – curves approach cardinality of utility is not

required. The MRS requires knowledge of the ratio of the marginal utilities, given that
the first order condition for any two commodities may be written as

MU x P
 x  MRS x , y
MU y Py

Hence, the concept of marginal utility is implicit in the definition of the slope of the
indifference curves, although its measurement is not required by this approach. What
is preceded is a diminishing marginal rate of substitution, which of course does not
require diminishing marginal utilities of the commodities involved in the utility
function.

1.8 THE CONSUMER’S SURPLUS

The consumer’s surplus is a concept introduced by Marshall, who maintained that it

can be measured in monetary units, and is equal to the difference between the amount
of money that a consumer actually pays to buy a certain quantity of commodity x, and
the amount that he would be willing to pay for this quantity rather than do with it.

Graphically the consumer’s surplus may be found by his demand curve for
commodity x and the current market price. Assume that the consumer’s demand for x
is a straight line (AB in Figure 1) and the market price is P. At this price the consumer
buys q units of x and pays an amount (q).(P) for it. However, he would be willing to
pay p1 for q1, P2 for q2, P3 for q3 and so on. The fact that the price in the market is
lower than the price he would be willing to pay for the initial units of x implies that
his actual expenditure is less than he would be willing to spend to acquire the quantity
q. This difference is the consumer’s surplus, and is the area of the triangle PAC in
figure 1.

40
 Px
A
P1

P2

P3

0 q1 q2 q3 q B

Figure 1

The Marshallian consumer’s surplus can also be measured by using indifference

curves analysis. In figure 2 the good measured on the horizontal axis is x, while on
the vertical axis we measure the consumer’s money income. The budget line of the
consumer is MM1 and its slope is equal to the price of the commodity x (since the
price of one unit of monetary unit is 1). Given P x, the consumer is in equilibrium at E:
he buys OQ quantity of x and pays AM` of his income for it, being left with OA
amount of money to spend on all other commodities.

Next, find the amount of money which consumer would be willing to pay for OQ
quantity of x rather than do without it.

M
Income

M1

A
E

A|
I1
B

O Q M| X
Fig. 2

41
This is attainted by drawing an indifference curve passing through M. Under
Marshallian assumption that the MU of money income is constant, this indifference
curve will be vertically parallel to the indifference curve I 1; the indifference curves
will have the same slope at any given quantity of x. for example, at Q the slope of I1 is
the same as the I0

MU x
Slope I1 for Q units of X = MRS x,M =  MU x
1
(Given that MUM = 1)

Similarly

MU x
Slope I0 for Q units of X = MRS x,M =  MU x
1
Given that the quantity of x is the same at E and B, the two slopes are equal.

The indifference curve I0 shows that the consumer would be willing to pay A1M for
the quantity OQ, since point B shows indifference of the consumer between having
OQ of x and OA` of income to spend on other goods, or having none of x and
spending all his income M on other goods. In other words A`M is the amount of
money that the consumer would be willing to pay for OQ rather than do without it.

The difference A`M - AM = AA` = EB is the difference between what the consumer
actually pays and what he would be willing to pay for OQ of x. This difference is the
Marshallian Consumer Surplus.

42
Other Interpretation of Consumer’s Surplus

There is also an other way to think about consumer’s surplus. Suppose that the price
of the discrete goods is p. Then the value that the consumer places on the first unit of
consumption of that good is r1, but he only has to pay p for it. This gives him a
surplus of r1-p on the first unit of consumption. He values the second unit of
consumption of at r2, but again he only has to pay p for it. This gives him a surplus of
r2-p on that unit. If we add this up- over all n units the consumer chooses, we get his
total consumer’s surplus:

CS  r1  p  r2  p  ......rn  p  r1  .....rn  np

Since the sum of the reservation prices just gives us the utility of consumption of
good 1. We can also write this as

CS  v( n)  pn

From Consumer’s surplus to Consumers surplus:

So fare we are considering the case of a single consumer. If several consumers are
involved we can ad up each consumer’s surplus across the consumers to create an
aggregate measure of the consumers’ surplus. Observe carefully the distinction
between the two concepts: consumer’s surplus refers to the surplus of single
consumer: consumers’ surplus refers to the sum of the surpluses across a number of
consumers.

Consumers’ surplus serves as a convenient measure of the aggregate gains from trade,
just as consumer’s surplus serves as a measure of the individual gains from trade.

Interpreting the changes in Consumer’s Surplus

Demand Curve
P

Change in consumer surplus

P11
T
1
P

0 X11 X1 X
Fig. 3 Change in consumer’s surplus. The change in consumer’s surplus will be
the difference between two roughly triangular areas, and thus will have a roughly
trapezoidal shape.

43
 R

In Figure 3 the change in consumer’s surplus associated with a change in price. The
change in consumer’s surplus is the difference between two roughly triangular regions
and will there has trapezoidal shape. The trapezoid is further composed of two
regions, the rectangle indicated buy R and the roughly triangular region indicated by
T.

The rectangle measures the loss in surplus due to the fact that the consumer is now
paying more for all the units he continues to consume. After the price increases the
consumer continues to consumer x|| units of the good and each unit of the good is now
more expensive by p|| - p1. This means he has to spend (p || - p|) x|| more money than he
did before just to consume x|| units of the good.

This is not entire welfare loss. Due to the increase in the price of the x good, the
consumer has decided to consumer less of it than he was before. The triangle T
measures the value of the lost consumption of the x good. The total loss to the
consumer is the sum of these two effects: R measures the loss from having to pay
more for the units he continues to consume, and T measures the loss from the reduced
consumption.

1.9 THE MARKET DEMAND

1. Derivation of the Market Demand

The market demand for a given commodity is the horizontal summation of the
demand of the individual consumers. In other words, the quantity demanded in the
market at each price is the sum of the individual demands of all consumers at that
price.

Table1 Individual and Market Demand

Price Quantity Quantity Quantity Quantity Market Demand

demanded demanded demanded demanded
by by by by
Consumer A Consumer B Consumer C Consumer D

2 40 4 45 18 107
6 24 5 30 13 72
10 14 10 15 11 50
14 08 05 10 06 29
18 04 02 0 0 06
20 03 0 0 0 03

44
 P

20
*
16
*
*
14
* *
*
10
** *
*
6
** * *
*
2
* * * *

0 10 20 30 40 50 60 70 80 90 100 110 Q
Fig. 1

Economic theory does not define any particular form of the demand curve. Market
demand is sometimes shown in textbooks as a straight line (linear demand curve) and
sometimes as a curve convex to the origin. The linear demand curve (Fig 1) may be
written in the form

Q = b0 – b1P

and implies a constant slope, but a changing elasticity at various prices. The most
common form of a non-linear demand curve is the so called constant – elasticity –
demand curve, which implies constant elasticity at all prices; its mathematical form is

Q = b0.pb1

Where b1 is the constant price elasticity.

2. DETERMINANTS OF DEMAND

Traditionally the most important determinants of the market demand are considered to
be the price of the commodity in question, the prices of other commodities,
consumer’s income and tastes. The result of a change in the price of the commodity is
shown by a movement from one point to another on the same demand curve. Thus
these factors are called shift factors, and the demand curve is drawn under the ceteris
paribus assumption, that the shift factors are constant. The distinction between
movements along the curve and shifts of the curve is convenient for the graphical
presentation of the demand function. Conceptually, however, demand should be

45
thought of as being determined by various factors (is multivariate) and the change in
any one of these factors changes the quantity demanded.

Apart from the above determinants, demand is affected by numerous other factors,
such as the distribution of income, total population and its composition, wealth, credit
availability, stocks and habits. The last two factors allow for the influence of past
behavior on the present, thus rendering demand analysis dynamic.

P1

P2

0 x1 x2 Q 0 x1 x2 x3 Q
Fig 3: Shifts of the demand curve as, for example
Fig:2 Movement along the demand curve as the price Income increases.
Of x changes.

1.10 ELASTICITY OF DEMAND

There are as many, elasticities of demand as its determinants. The most important of
these are (i) the price elasticity, (ii) the income elasticity, (iii) the cross-elasticity of
demand.
(i) The Price Elasticity of Demand:
The price elasticity is a measure of the responsiveness of demand to changes in
commodity’s own price. If the changes in price are very small, we use a measure of
the responsiveness of demand the point elasticity of demand. If the changes in price
are not small, we use the arc elasticity of demand as the relevant measure.
dQ
ep  Q
dP
P
or
dq P
ep  *
dP Q
If the demand curve is linear

46
Q  b0  b1 P
Its slope is dQ / dP  b1 . Substituting in the elasticity formula, we obtain
P
e p  b1 *
Q
Which implies that the elasticity changes at the various points of the linear-demand
curve. Graphically the point elasticity of a linear demand curve is shown by the ratio
of the segments of the line to the right and to the left of the particular point. In figure
FD`
1 the elasticity of the linear demand curve at point F is the ratio
FD

P
D F

P1
F1

P2 E

0 Q1 Q2 D| O
Figure 1

From Fig.1 we see that

ΔP = P1P2 = EF ΔQ = Q1Q2 = EF|

P = OP1 Q = OQ1
If we consider very small changes in P and Q, then P  dP Q  dQ

Thus substituting in the formula for the point elasticity, we obtain

dQ P Q1Q2 OP1 EF | OP1

ep  *  *  *
dP Q P1P2 OQ1 EF OQ1

From the figure we can also see that the triangles FEF| and FQ1D| are similar
(because each corresponding angle is equal). Hence

EF | Q1 D| Q1D|
 
EF FQ1 OP1

Q1D| OP1 Q1D|

Thus ep  * 
OP1 OQ1 OQ1

Furthermore the Triangles DP1F and FQ1D| are similar, so that

47
 Q1D| P1F OQ1
 
FD | FD FD
Re Arranging we obtain

Q1D| FD|

OQ1 FD
Q1D| FD!
Thus the price elasticity at point F is ep  
0Q1 FD
ep→∞
P
D ep>1

ep=1

M
ep<1
ep=0

0 Fig. 2 D| Q

Given the graphical measurement of point elasticity it is obvious that at the mid-point
of a linear demand curve ep = 1 (Point M in Fig.2)

At any point to the right of M the point elasticity is less than unity (ep < 1);
finally at any point to the left of M, ep > 1.
At point D the e p   , while as point D` the ep = 0. The price elasticity is always
negative because of the inverse relationship between Q and P implied by the ‘law of
demand’. However, traditionally the negative sign is omitted when writing the
formula of the elasticity.
The range of values of elasticity are 0  e p  
If ep = 0 the demand is perfectly inelastic
if ep=1 the demand has unitary elasticity
If e p   , the demand is perfectly elastic.
If 0<e<1, we say that the demand inelastic
if 1<e<  , the demand is elastic.
Figures 3, 4, and 5.
D

P D

48
 D

0 ep =0 0 ep =1 0 ep  
Fig 3 Fig 4 Fig 5

The basic determinants of the elasticity of demand of a commodity with respect to its
own price are:
(1) The availability of substitutes; the demand for a commodity is more elastic if there
are close substitutes for it.
(2) The nature of the need that the commodity satisfies. In general, luxury goods are
price elastic, while necessities are price inelastic.
(3) The time period. Demand is more elastic in the long run.
(4) The number of uses to which a commodity can be put. The more the possible uses
of a commodity the greater its price elasticity will be.
(5) The proportion of income spent on the particular commodity.
The above formula for the price elasticity is applicable only for extremely small
changes in the price. If the price changes appreciably, we use the following formula,
which measures the arc elasticity of demand:
ep = ΔQ P1+P2/2 = ΔQ (P1+P2)
ΔP Q1+Q2/2 ΔP (Q1+Q2)
The arc elasticity is a measure of the average elasticity, i.e., the elasticity at the mid
point of the chord that connects the two points (A and B) on the demand curve defined
by the initial and the new price levels (fig 6). It should be clear that the measure of the
arc elasticity is an approximation of the true elasticity of the section AB or if the
demand curve, which is used when we know only the two points A and B from the
demand curve is, the poorer the liner approximation attained by the arc elasticity
formula.
P D

A Aarc elasticity
P1

B
P2
D
.
O Q1 Q2 Q
Figure 6
(ii) The Income Elasticity of Demand.
The income elasticity is defined as the proportionate change in the quantity demanded
resulting from a proportionate change in Income. Symbolically we may write
ey = dQ/Q = dQ Y

49
 dY/Y dY Q
The income elasticity is positive for normal goods. A commodity is considered to be a
luxury if its income elasticity is greater than unity. A commodity is a necessity if its
income elasticity is small (less than unity, usually).
The main determinants of income elasticity are:
1. The nature of the need that the commodity covers: the percentage of income spent
on food declines as income increases (this is known as ‘Engel’s Law’ and has some
times been used as a measure of welfare and of the development stage of an
economy.)
2. The initial level of income of a country. For example, a TV set is a luxury in an
underdeveloped, poor country while it is a ‘necessity’ in a country with high per
capita income.
3. The Time period, because consumption patterns adjust with a time-lag to changes
in income.

(iii) The Cross-Elasticity of Demand

The cross-elasticity of demand is defined as the proportionate change in the quantity
demanded of x resulting from a proportionate change in the price of y. Symbolically
we have

dQx dPy dQx Py

e xy  /  *
Q Py dPy Qx

The sign of the cross elasticity is negative if x and y are complementary goods, and
positive if x and y are substitutes. The higher the value of the cross-elasticity the
stronger will be the substitutability or complemetarity of x and y.

The main determinant of cross-elasticity is the nature of the commodities relative to

their use. If two commodities can satisfy equally well the same need, the cross-
elasticity is high, and vice-versa.

CHAPER THREE
THEORY OF COST

Introduction

50
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 costs 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 multivariate 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, P f = 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 (other things being equal or
unchanged). 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.

51
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.

A distinction is necessary between internal (to the firm) economies of scale and
external economies. The internal economies are build into the shape of the long-run
cost curve, because they accrue to the firm from its own action as it expands the level
of its output. The external economies arise outside the firm, from improvement (or
depreciation) of the environment in which the firm operates. Such economies
external to the firm may be realized from actions of other firms in the same or in
another industry. The important characteristic of such economies is that they are
independent of the actions of the firm, they are external to it. Their effect is a change
in the prices of the factors employed by the firm, they are external to it. Their effect
is a change in the prices of the factors employed by the firm (or in a reduction in the
amount of inputs per unit of output), and thus cause a shift of the cost curves, both the
short-run and the long-run.

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 a cost curve.
Usually the above optimality is associated with the long-run cost curves. 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 Traditional Theory

52
 Traditional Theory distinguishes between the short run and the long run. 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. The long run is the period
over which all factors become variable.

In the traditional theory of the firm 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

Another element that may be treated in the same way as fixed costs is the normal
profit, which is a lump sum including a percentage return on fixed capital and
allowance for risk.

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.

Total fixed cost is graphically denoted by a straight line parallel to the output axis
(fig.1). The total variable cost is the traditional theory of the firm has broadly an
inverse – S shape (fig. 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 cost fall.
TC
C

TVC

TFC

O X O X O X
Fig. 1 Fig. 2 Fig. 3

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

53
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. 4). The average variable cost is similarly
obtained by dividing the TVC with the corresponding level of output:

AVC = TVC
X

AFC

O X
Fig.4

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. For example fig.5 the AVC at X 1 is the slope of the ray Oa, the AVC at X 2 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.6.
C
TVCC
C
SAVC

0 x1 x2 x3 x4 X O x1 x2 x3 x4 X
Fig. 5 Fig. 6

The ATC is obtained by dividing the TC by the corresponding level of output:

54
 TC TFC  TVC
ATC    AFC  AVC
X X

Graphically the ATC curve is derived in the same way as the SAVC. 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.7). The shape of the ATC
reaches a minimum at the level of optimal operation of the plant (X M) and
subsequently rises again (fig.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
C
TC function. Denoting total cost by C and output by X we have MC  .
TC X

SATC

O x1 x2 xM xL X
Fig.7 O x1 x2 xM xL X
Fig. 8
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.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.10 as U shaped.
C
TC SMC

In summary:
0 the
XAtraditional
X theory of costs postulates
O XA that in theX short run the cost
curves (AVC,
Fig.9ATC and MC) are U shaped, reflecting the law of variable proportions.
Fig.10
In the short run with a fixed plant there is a phase of increasing productivity (falling

55
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.

The relationship between ATC and AVC

The AVC is a part of the ATC, given ATC=AFC+AVC. Both AVC and ATC are U-
shaped, reflecting the law of variable proportions. However, the minimum point of
the ATC occurs to the right of the minimum point of the AVC (fig.11). This is due to
the fact that ATC includes AFC, and the latter falls continuously with increase in
output. After the AVC has reached its lowest point and starts rising, its rise is over a
certain range offset by the fall in the AFC, so that the ATC continues to fall despite the
increase in AVC. However, the rise in AVC eventually becomes greater than the fall
in the AFC so that the ATC starts increasing. The AVC approaches the ATC
asymptotically as X increases.

SMC SATC
a SAVC

AFC

O X1 X2 X
Fig.11

In fig.11 the minimum AVC is reached at X 1 at while the ATC is at its minimum at X 2.
Between X1 and X2 the fall in AFC more than offsets the rise in AVC so that the ATC
continues to fall. Beyond X2 the increase in AVC is not offset by the fall in AFC, so
that ATC rises.

The relationship between MC and ATC

56
The MC cuts the ATC and the AVC at their lowest points. We will establish this
relation only for the ATC and MC, but the relation between MC, but the relation
between MC and AVC can be established on the same lines of reasoning.

The MC is the change in the TC for producing an extra unit of output. Assume that
we start from a level of n units of output. If increase the output by one unit the MC is
the change in total cost resulting from the production of the (n+1)th unit.

The AC at each level of output is found by dividing TC by X. Thus the AC at the

TCn
level of Xn is ACn 
Xn

TC n 1
and the AC at the level Xn+1 is AC n 1 
X n 1
clearly TCn 1  TCn  MC

Thus:

(a) If the MC of the (n+1)th unit is less than ACn (the AC of the previous n units)
the ACn+1 will be smaller than the ACn.

(b) If the MC of the (n+1)th unit is higher than ACn (the AC of the previous n
units) the ACn+1 will be higher than the ACn.

So long as the MC lies below the AC curves, it pulls the latter downwards when the
MC rises above the AC, it pulls the latter upwards. In fig.11 to the left of a MC lies
below the AC curve, and hence the AC falls downwards. To the right of the MC curve
lie above the AC curve, so that AC rises. It follows that at point a, where the
intersection of the MC and AC occurs, the AC has reached its minimum level.

The Modern Theory of Short-run Costs

The U-shaped cost curves of the traditional theory have been questioned by various
writers both on theoretical a priori and on empirical grounds. As early as 1939
George Stigler suggested that the short-run average variable cost has a flat stretch
over a range of output which reflects the fact that firms build plans with some
flexibility in their productive capacity. The reasons for this reserve capacity have
been discussed in detail by various economists. As in the traditional theory, short-run
costs are distinguished into average variable costs (AVC) and average fixed costs
(AFC).

The Average Fixed Cost

57
This is the cost of indirect factors, that is the cost of the physical and personal
organization of the firm. The fixed costs include the costs for:

(a) the salaries and other expenses of administrative staff

(b) the expenses for maintenance of buildings,
(c) the wear and tear of machinery (standard depreciation allowances),
(d) the expenses for maintenance of buildings,
(e) the expenses for the maintenance of land on which the plant is installed and
operates..
The planning of the plant (or the firm) consists in deciding the size of these fixed,
indirect factors, which determine the size of the plant, because they set limits to its
production. Direct factors such as labor and raw materials are assumed not to set
limits on size; the firm can acquire them easily with a figure for the level of output
which entrepreneur anticipates selling, and he will choose the size of plant which will
allow him to produce this level of output more efficiently and with the maximum
flexibility. The plant will wants to have some reserve capacity for various reasons.

The businessman will want to be able to meet sensational and cyclical fluctuations in
his demand. Such fluctuations cannot always be met efficiently by a stock-inventory
policy. Reserve capacity will allow the entrepreneur to work with more shifts and with
lower costs than a stock – piling policy.

Reserve capacity will give the businessman greater flexibility for repairs for broken
down machinery without disrupting the smooth flow of the production process.

The entrepreneur will want to have more freedom to increase his output if demand
increases. All businessmen hope for growth. In view of anticipated increases in
demand the entrepreneur builds some reserve capacity, because he would not like to
let all new demand go to his rivals, as this may endanger his future old on the market.
It also gives him some flexibility for minor alternations of his product, in view of
changing tastes of customers.

Technology usually makes it necessary to build into the plant some reserve capacity.
Some basic types of machinery may not be technically fully employed when
combined with other small types of machines in certain numbers, more of which may
not be required given the specific size of the chosen plant. Also such basic machinery
may be difficult to install due to time – lags in the acquisition. The entrepreneurs will
thus buy from the beginning such a ‘basic’ machine which allows the highest
flexibility, in view of future growth in demand, even though this is a more expensive
alternative now. Furthermore some machinery may be so specialized as to be
available only to order, which takes time. In this case such machinery will be bought
in excess of the minimum required at present numbers, as a reserve.

58
Some reserve capacity will always be allowed in the land and buildings, since
expansion of operations may be seriously limited if new land or new buildings have to
be acquired.

Finally, there will be some reserve capacity on the organizational and administrative
level. The administrative staff will be hired at such numbers as to allow some
increase in the operations of the firm.

A B

O XA XB X
Fig.15

In summary, the businessman will not necessarily choose the plant which will give
him today the lowest cost, but rather that equipment which will allow him the greatest
possible flexibility, for minor alternations of his product or his technique.

Under these conditions the AFC curve will be as in fig.15. The firm has some largest-
capacity units of machinery which set an absolute limit to the short-run expansion of
output (boundary B in fig. 15). The firm has also small-unit machinery, which sets a
limit to expansion (boundary A in fig. 15). this is not an absolute boundary, because
the firm can increase its output in the short run (until the absolute limit B is
encountered), either by paying overtime to direct labor for working longer hours (in
this case AFC shown by the dotted line in fig.15), or by buying some additional small-
unit types of machinery (in this case the AFC curve shifts upwards, and starts falling
again as shown by the line ab in fig.15).

The Average variable cost

As in the traditional theory, the average variable cost of modern microeconomics

includes the cost of:
(a) direct labor which varies with output,
(b) raw materials,
(c) running expenses of machinery.

59
The SAVC in modern theory has a saucer-type shape that is broadly shaped but has a
flat stretch over a range of output (fig.16). The flat stretch corresponds to the built-in
the plant reserve capacity. Over this stretch the SAVC is equal to the MC, both being
constant per unit of output. To the left of the flat stretch the MC lies below the SAVC,
while to the right of the flat stretch the MC rises above the SAVC. The falling part of
the SAVC shows the reduction in costs due to the better utilization of the fixed factor
and the consequent increase in skills and productivity of the variable factor (labor)
with better skills and the wastes in raw materials are also being reduced and a better
utilization of the whole plant is reached.

C
MC
SAVC

MC

O X Fig. 16

The increasing part of the SAVC reflects reduction in labor productivity due to the
longer hours of work, the increasing cost of labor due to overtime payment (which is
higher than the current wage), the wastes in materials and the more frequent break
down of machinery as the firm operates with overtime or with more shifts.

The innovation of modern microeconomics in this field is the theoretical

establishment of a short-run SAVC curve with a flat stretch over a certain range of
output (fig.18). It should be clear that this reserve capacity is planned in order to give
the maximum flexibility in the operation of the firm. It is completely different from
the excess capacity which arises with the U-shaped costs of the traditional theory for
the firm. The traditional theory assumes that each plant is designed without any
flexibility: it is designed to produce optimally only a single level of output (X M in fig.
17). If the firm produces an output X smaller than XM there is excess (unplanned)
capacity, equal to the difference XM – X. This excess capacity is obviously
undesirable because it leads to higher unit costs.

In the modern theory of costs the range of output X1, X2 in fig. 18 reflects the
planned reserve capacity which does not lead to increases in costs. The firm
anticipates using its plant sometimes closer to X1 and at others closer to X2. On the
average the entrepreneur expects to operate his plant within the X1X2 range. Usually

60
firms consider that the ‘normal’ level of utilization of their plant is somewhere
between two-thirds and three-quarters of their capacity, that is, at a point closer to X2
than X1. The level of utilization of the plant which firms consider as ‘normal’ is
called ‘the load factor’ of the plant.

C C SAVC
SAVC

Reserve
Capacity
excess capacity

O X XM X O X1 X2 X
Fig. 17 Fig. 18

The Average Total Cost

The average total cost is obtained by adding the average fixed (inclusive of normal
profit) and the average variable costs at each level of output. The ATC is shown in
fig.19. The ATC curves falls continuously up to the level of output (XA) at which the
reserve capacity is exhausted. Beyond that level ATC will start rising. The MC will
intersect the average total-cost curve at its minimum point (which occurs to the right
of the level of output XA at which the flat stretch of the AVC ends).

C MC SATC

SAVC

AFC
MC
O Fig. 19 XA X

Mathematically the cost-output relation may be written in the form

C = b0 + b1X
TC = TFC + TVC The TC is a straight line with a positive slope over the range
of reserve capacity (fig. 20).

61
 TC
C C

TVC
SAC
SAVC=MC
TFC
AFC
O
O Fig. 20 X range of reserve capacity X X
Fig. 21

The AFC is a rectangular hyperbola

b0
AFC 
X

The AVC is a straight line parallel to the output axis

(b1 X )
AVC   b1
X
The ATC is falling over the range of reserve capacity

b0
ATC   b1
X
C
The MC is a straight line which coincides with the AVC  b1
X

Thus the range of reserve capacity we have MC=AVC=b1, while ATC falls
continuously over this range (fig. 21).

Note that the above total cost function does not extend to the increasing part of costs,
that is it does not apply to ranges of output beyond the reserve capacity of the firm.

62
 LONG-RUN COSTS

Long-run costs of the Traditional Theory: The Envelope Curve

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. Let us examine in detail how the LAC is derived from the SAC curves.

Assume, as a first approximation, that the available technology to the first at a

particular point of time includes three methods of production, each with a different
plant size: a small plant, medium plant and large plant. The small plant operates with
costs denoted by the curve SAC1, the medium – size plant operates with the costs on
SAC2 and the large – size plant gives rise to the costs shown on SAC3 (fig.1).

SATC1
C1
C| 1 SATC2
SATC3
|
C2
C2
C3

0 X1 X|1 X||1 X2 X|2 X3 X

Fig. 1
If the firm plans to produce output X1 it will choose the small plant. If it plants to
produce X2 it will choose medium size plant. If it wishes to produce X 3 it will choose
the large size plant. If the firm starts with the small plant and its demand gradually
increases, it will produce at lower costs (up to level x1). Beyond that point costs start
increasing. If its demand reaches the level X”1 the firm can either continue to produce
with the small plant or it can install the medium size plant. The decision at this point
depends on not on costs but on the firm’s expectations about its future demand. If the
firm expects that the demand will expand further thatnX” 1 it will install the medium
plant because with this plant outputs larger than X”1 are produced with a lower cost.
Similar considerations hold for the decision of the firm when it reaches the level X”2.
If it expects its demand to stay constant at this level, the firm will not install the large
plant, given that it involves a larger investment which is profitable only if demand
expands beyondX”2. For example, the level of output X 3 is produced at a cost C3 with
the large plant, while it costs C’3 if produced with medium size plant (C’2 >C3).

63
Now if we relax the assumption of the existence of only three plants and 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. 2

LAC

O Fig. 2 XM X

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.

64
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).
LMC
C

a
SMCM
SMC1 LAC
SMC2

0 X|1 X1 X||1 X2 XM X
Fig. 3

65
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 simplest total cost function which would incorporate the law of variable
proportions is the cubic polynomial

C = b0 + b1X – b1X2 + b3X3

TC = TFC + TVC

The AVC is
TVC
AVC =  b1  b2 X  b3 X 2
X

The MC is
C
MC =  b1  2b2 X  3b3 X 2
X

The ATC is
C b0
  b1  b2 X  b3 X 2
X X

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.

66
LONG RUN COSTS IN MODERN MICRO ECONOMIC THEORY:
The L – Shaped scale Curve.

These are distinguished into production costs and managerial costs. All costs are
variable in the long run and they give rise to a long-run cost curve which is roughly L-
shaped. The production costs fall continuously with increases in output. At very
large scales of output managerial costs may rise. But the fall in production costs more
than offsets the increase in the managerial costs, so that the total LAC falls with
increases in scale.

Production costs
Production costs fall steeply to begin with and then gradually as the scale of
production increases. The L-shape of the production cost curve is explained by the
technical economies of large-scale production. Initially these economies are
substantial, but after a certain level of output is reached all or most of these economies
are attained and the firm is said to have reached the minimum optimal scale, given the
technology of the industry. If new techniques are invented for larger scales of output,
they must be cheaper to operate. But even with the existing known techniques some
economies can always be achieved at larger outputs:

(a) economies from further decentralization and improvement in skills;

(b) lower repairs costs may be attained if the firm reaches a certain size;
(c) the firm, especially if it is multiproduct, may well undertake itself the
production of some of the materials or equipment which it needs instead of
buying them from other firms.

Managerial Costs
In the modern management science for each plant size there is a corresponding
organizational administrative set-up appropriate for the smooth operating of that
plant. There are various levels of management, each with its appropriate kind of
management technique. Each management technique is applicable to a range of
output. There are small-scale as well as large-scale organizational techniques. The
costs of different techniques of management first fall up to a certain plant size. At
very large scales of output managerial costs may rise, but very slowly.

In summary: Production costs fall smoothly at very large scales, while managerial
costs may rise only slowly at very large scales. Modern theorists seems to accept that
the fall in technical costs more than offsets the probable rise of managerial costs, so
that the LRAC curve falls smoothly or remains constant atv very large scales of
output.

We may draw the LAC implied by the modern theory of costs as follows. For each
short-run period we obtain the SRAC which includes production costs, administration
costs. Other fixed costs and an allowance for normal profit. Assume that we have a
technology with four plant sizes, with costs falling as size increases. We said that in

67
business practice it is customary to consider that a plant is used normally when it
operates at a level between two-thirds and three-quarters of capacity.

Following this procedure, and assuming that the typical load factor of each plant is
two-thirds of its full capacity (limit capacity), we may draw the LAC curve by joining
the points on the SATC curves corresponding to the two-thirds of the full capacity of
each plant sizes the LAC curve will be continuous (fig.4).
SATC1
C
Cost SATC2
SATC3
SATC4
2/3

2/3
LAC
2/3
2/3

0 Fig. 4 X Output

The characteristic of this LAC curve is that (a) it does not turn up at very large scales
of output; (b) it is not the envelope of the SATC curves, but rather intersects them (at
the level of output defined by the typical load factor of each plant). If, LAC falls
continuously (though smoothly at very large scales of output), the LMC will lie below
the LAC at all scales (fig. 5).
C C

LAC = LMC

LAC
LMC

0 Fig. 5 X 0 Fig. 6 x X
Minimum optimal scale

If there is a minimum optimal scale of plant (x in fig. 6) at which all possible scale
economies are reaped, beyond that scale the LAC remains constant. In this case the
LMC lies below the LAC until the minimum optimal scale is reached, and coincides
with the LAC beyond the U-shaped costs of traditional theory.

68
 DYNAMIC CHANGES IN COSTS – THE LEARNING CURVE

It is believed that a large firm may have long-run average cost than a small firm:
increasing returns to scale in production. So it is convincing to conclude that firms
which enjoy lower average cost over time are growing firms with increasing returns to
scale. But this need not be true. In some firms, long-run cost may decline over time
because workers and managers absorb new technological information as they become
more experienced at their jobs.

As management and labor gain experience with production, the firm’s marginal and
average costs of producing a given level of output fall for four reasons:

1. Workers often take longer to accomplish a given task the first few times they
do it. As they become more adept, their speed increases.
2. Managers learn to schedule the production process more effectively, from the
flow of materials to the organization of the manufacturing itself.
3. Engineers who are initially cautious in their product designs may gain enough
experience to be able to allow for tolerances in design that save cost without
increasing defects. Better and more specialized tools and plant organization
may also lower cost.
4. Suppliers of materials may learn how to process materials required more
effectively and may pass on some of this advantage in the form of lower
materials cost.

As a consequence, a firm “learns” over time as cumulative output increases. Managers

can use this learning process to help plan production and forecast future costs. Fg. 1
illustrates this process in the form of a learning curve – a curve that describes the
relationship between a firm’s cumulative output and the amount of inputs needed to
produce each unit of output.
Hours of labor / machine Lot

10 20 30 40 50
Cumulative Number of Machine Lots Produced

The Learning Curve (Fig. 1): A firm’s production cost may fall over time as managers and
workers become more experienced and more effective at using the available plant and
equipment. The learning curve shows the extent to which hours of labor needed per unit of
output fall as the cumulative output increases.

69
Graphing the Learning Curve

Fig.1 shows a learning curve for the production of machine tools. The horizontal axis
measures the cumulative number of lots of machine tools (groups of approximately
40) that the firm has produced. The vertical axis shows the number of hours of labor
needed produce each lot. Labor input per unit of output directly affects the production
cost because the fewer the hours of labor needed the lower the marginal and average
cost of production.

The learning curve in fig.1 is based on the relationship L = A + BN-β

Where N is the cumulative units of output produced and L the labor input per unit of
output. A, B, and β are constants, with A and B positive, and β between 0 and 1.
When N is equal to 1, L is equal to A + B, so that A + B measures the labor input
required to produce the first unit of output. When β equals 0, labor input per unit of
output remains the same as the cumulative level of output increases; there is no
learning. When β is positive and N gets larger and larger, L becomes arbitrarily close
to A. A, therefore represents the minimum labor input per unit of output after all
learning has taken place.

The larger is β, the more important is the learning effect. With β equals to 0.5, for
example, the labor input per unit of output falls proportionally to the square root of
the cumulative output. This degree of learning can substantially reduce the firm’s
production costs as the firm becomes more experienced.

In this machine tool example, the value of β is 0.31. for this particular learning curve,
every doubling in cumulative output causes the input requirement (less the minimum
attainable input requirement) to fall by about 20% (because (L - N) = BN -31, we can
check that 0.8 (L – A) is approximately equal to B(2N)-31). As fig.1 shows, the
learning curve drops sharply as the cumulative number of lots increases to about 20.
Beyond an output of 20 lots, the cost savings are relatively small.

Learning versus Economies of Scale

Once the firm has produced 20 or more machine lots, the entire effect of the learning
curve would be complete, and we could use the usual analysis of cost. If, the
production process were relatively new, relatively high cost at low levels of output
(and relatively low cost at higher levels) would indicate learning effects, not
economies of scale. With learning, the cost of production for a mature firm is
relatively low regardless of the scale of the firm’s operation. If a firm that produces
machine tools in the lots knows that it enjoys economies of scale, it should produce its
machine in very large lots to take advantage of the lower cost associated with size. If
there is a learning curve, the firm can lower its cost by scheduling the production of
many lots regardless of the individual lot size.

70
Fig. 2 shows this phenomenon. AC1 represents the long-run average cost of
production of a firm that enjoys economies of scale in production. Thus the change in
production from A to B along AC1 leads to lower cost due to economies of scale.
However, the move from A on AC 1 to C on AC2 leads to lower cost due to learning,
which shifts the average cost curve downward.

Cost (Birrs / unit of

output)

A Economies of Scale

AC1
Learning C
AC2

Output
Economies of Scale versus Learning Fig. 2 : A firm’s average cost of
production can decline over time because of growth of sales when
increasing returns are present ( a move from A to B on curve AC 1), or it can
decline because there is a learning curve ( a move from A on curve AC 1 to c
on curve AC2.

The learning curve is crucial for a firm that wants to predict the cost of producing a
new product. For example, a firm producing machine tools knows that its labor
requirement A is equal to zero, and b is approximately equal to 0.32. Table 1
calculates the total labor requirement for producing 80 machines.

Because there is a learning curve, the per-unit labor requirement falls with increased
production. As a result, the total labor requirement for producing more and more
output increases in smaller and smaller increments. Therefore, a firm looking only at
the high initial labor requirement will obtain an overtly pessimistic view of the
business. Suppose the firm plans to be in business for a long time, reducing 10 units
per year. Suppose the total labor requirement for the first year of production, the
firm’s cost will be high as it learns the business. But once the learning effect has
taken place, production costs will fall. After 8 years, the labor required to produce 10
units will be only 5.1, and per-unit cost will be roughly half what it was in the first
year of production. Thus the learning curve can be important for a firm deciding
whether it is profitable to enter an industry.

71
Predicting the Labor Requirements of Producing

Cumulative Output Per-unit labor Total Labor

(N) requirement for each Requirement
10 units of output (L)*
10 1.00 10.0
20 0.80 18.0 (10.0+8.0)
30 0.70 25.0 (18.0+7.0)
40 0.64 31.4 (25.0+6.4)
50 0.60 37.4 (31.4+6.0)
60 0.56 43.0 (37.4+5.6)
70 0.53 48.3 (43.0+5.3)
80 0.51 53.4 (48.3+5.1)

UNIT FOUR
PRICE AND OUT PUT DETERMNATION UNDER
PERFECT COMPETTION
4.1 Definition and Assumptions
Perfect competition is a market structure characterized 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.

72
Most of the time, we see business men using the word “Competition” as synonymous
to “rivalry”. However, in theory, perfect competition implies no rivalry among firms
4.2 Assumptions
The model of perfect competition was constructed based on the following
assumptions or imaginations.
1. Large number of sellers and buyers.
The perfect competitive market includes a large number of buyers and sellers.
How large should the number of buyers and sellers is large to the extent that the
market share of each firm (and buyer) is too small to have a perceptible effect on
the price of the commodity. That is the action of a single seller or buyer can not
influence the market price of the commodity, since the firm or (the buyer) is too
small in relation to the market.
2. Products of the firms are homogeneous.
This means the products supplied by all the firms in the market have uniform
physical characteristics (are uniform in terms of quantity, quality etc) and the
services associated with sales and delivery are identical. Thus buyers can not
differentiate the product of one firm from the product of the other firm.

The assumptions of large number of sellers and of product homogeneity imply

that the individual firm in pure competition is a price taker: its demand curve is
infinitely elastic, indicating that the firm can sell any amount of out put at the
prevailing market price. Since the share of the firm from the market supply is too
small to affect the market price, the only thing that the firm can do is to sell any
quantity demand at the ongoing market price. Thus, the demand curve that an
individual firm faces is a horizontal line.

Market P
P=AR=MR

73
 Out put

Fig 5.1 the demand curve indicates a single market price at which the firm can
sell any amount of the commodity demanded. The demand curve also indicates the
average revenue and marginal revenue of the firm.

3. Free entry and exit of firms

There is no barrier to entry and exit from the industry. Entry or exit may take time,
but firms have freedom of movement in and out of the industry. If barriers exist
the number of firms in the industry may be reduced so that one of them may
acquire power to affect the market price.

4. The goal of all firms is profit maximization.

Of course, firms can have different objectives. Some firms may have the aim of
making their product wise, others may want to maximize their sales even by
cutting price, etc. But, in this model, it is assumed that the goal of all firms is to
maximize their profit and no other goal is pursued.
5. No government regulation
By assumption, there is no government intervention in the market. That is there is
no tax, subsidy etc. A market structure in which all 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
Factors of production (including workers) are free to move from one firm to
another through out the economy. Alternatively, there is also perfect competition
in the market of factors of production.
7. Perfect knowledge

74
It is assumed that all sellers and buyers have a complete knowledge of the
conditions of the prevailing and future market. That is all buyers and sellers have
complete information about.
The price of the product
Quality of the product etc
Thus, a perfectly competitive market is a market which satisfies all the above
conditions (assumptions). In reality, perfectly competitive markets are scarce if
not none. But since the theory of perfectly competitive market helps as a bench
mark to analyze the more realistic markets, it is very important to study it.
Given the above assumptions (based which the model of perfect competition was
built), we will now examine how the firm operating in such a market determines
the profit maximizing out put both in the short run and in the long run. But to
determine the profit maximizing out put, first we have to see what the revenue and
cost functions of the firms operating in perfectly competitive market looks like.
Costs under perfect competition
In the previous chapter, we have said that the per unit cost (AVC &AC) have U –
shape due to the law of variable proportions (in the short run) and the law of
returns to scale (in the long run). There is no exception for firms operating under
perfect competition i.e., their cost functions have the behavior mentioned in the
last chapter.
Demand and revenue functions under perfect competition
Due to the existence of large number of sellers selling homogenous products, each
seller is a price taker in perfectly competitive market. That is, a single seller
cannot influence the market by supplying more or less of a commodity.
If, for example, the seller charges higher price than the market price to get larger
revenue, no buyers will buy the product of this ( the price raising) firm since the
same product is being sold in the market at lower price by other sellers.
Obviously, the firm will not also attempt to reduce the price. Thus firms operating
in a perfectly competitive market are price takers and sell any quantity demanded
at the ongoing market price.

75
 Hence, the demand function that an individual seller faces is perfectly elastic (or
horizontal line).
Graphically,
P

_ P
P

Fig 5.2 the demand curve that a perfectly competitive firm faces is horizontal line
with intercept at the market price. This indicates that sellers sell any quantity
demanded at the ongoing market price and buyers buy any amount they want at the
ongoing market price.
From the buyers’ side too, since there is large number of buyers in the market, a single
buyer can not influence the market price.
Thus, in perfectly competitive market, both buyers and sellers are price takers. They
take the price determined by the forces of market demand and market supply.
Given the horizontal demand function at the ongoing market price, the total revenue
of a firm operating under perfect competition is given by the product of the market
price and the quantity of sales, i.e.,
TR = P*Q
Since the market price is constant at P*, the total revenue function is linear and the
amount of total revenue depends on the quantity of sales. To increase his total
revenue, the firm should sell large quantity.
Graphically, the TR curve is as shown below.
TR
_
TR=PQ
_
TR=PQ

76

Q
 Fig 5.3 the total revenue of firm operating in a perfectly competitive market is linear (and
increasing function) of the quantity of sales.
The marginal revenue (MR) and average revenue (AR) of a firm operating under
perfect competition are equal to the market price. To see this, let’s find the MR and
AR functions from TR functions.
TR= PQ
By definition, MR is the change in total revenue that occurs when one more unit of
dTR
the out put is sold, i.e. MR   P .Hence MR=P
dQ
Average revenue is the TR divided by the quantity of sales. i.e.
TR P.Q
AR    P Hence, AR = P.
Q Q

Graphically, the demand curve represents the MR and AR of the firm

P= AR = MR

77
Fig: 5.4 the AR curve, MR curve and the demand curve of an individual firm
operating under perfectly competitive market overlap.
4.3 Short run equilibrium of the firm
If you don’t know the answer, don’t worry, just read what follows;
A firm is said to be in equilibrium when it maximizes its profit (). Profit is
defined as the difference between total cost and total revenue of the firm:
= TR-TC
Under perfect competition, the firm is said to be in equilibrium when it produces
that level of output which maximizes its profit, given the market price. Thus,
determination of equilibrium of the firm operating in a perfectly competitive
market means determination of the profit maximizing output since the firm is a
price taker.
The level of output which maximizes the profit of the firm can be obtained in two
ways:
 Total approach
 Marginal approach

Total approach
In this approach, the profit maximizing level of output is that level of output at which
the vertical distance between the TR and TC curves is maximum. (Provided that the
TR curve lies above the TC curve at this point).
Graphically TR TC
TC,TR

78
 Q
Q0 Qe Q1
Fig:5.5 The profit maximizing output level is Qe because it is at this out put level that
the vertical distance between the TR and TC curves (or profit) is maximum.
For all out put levels below Q0 and above Q1 profit is negative because TC is above
TR.
Marginal Approach
In this approach the profit maximizing level of output is that level of output at which:
MR=MC and
MC is increasing
This approach is directly derived from the total approach. In figure 4.4, the vertical
distance between the TR and TC curve is maximum where a straight line parallel to
the TR curve is tangent to the TC curve. Or simply, the vertical distance between the
TC and TR curves is maximum at output level where the slope of the two curves is
equal. The slope of the TR curve constant and is equal to the MR or market price.
Similarly, the slope of the TC curve at a given level of output is equal to the slope of
the tangent line to the TC curve at that level of output, which is equal to MC. Thus the
distance between the TR and TC curves () is maximum when MR equals MC.
Graphically, the marginal approach can be shown as follows.
MC, MR

MC

MR

79
 Q* Qe

Fig 5.6: the profit maximizing out put is Q e, where MC=MR and MC curve is
increasing. At Q*, MC=MR, but since MC is falling at this output level, it is not
equilibrium out put. For all output levels ranging from Q* to Qe the marginal cost of
producing additional unit of output is less than the MR obtained from selling this
output. Hence the firm should produce additional output until it reaches Qe.
Mathematical derivation of the equilibrium condition
Profit () = TR-TC
TC is a function of output, TC=f (Q)
TR is also a function of output, TR=f (Q)
Thus, profit is a function of output, =f (Q)
= TR-TC
To determine the profit maximizing output we find the first derivative of the 
function and equate the result to zero.
d dTR dTC
  0
dQ dQ dQ
= MR – MC = 0
= MR = MC ----------------------------------- (First order condition necessary
condition)
The equality of MC and MR is a necessary, but not sufficient condition. The sufficient
condition for maximization of II is that the second derivative of the II function should
be less than zero (or negative) i.e.
d 2 d 2TR d 2TC
 0  0
dQ 2 dQ 2 dQ 2

d 2TR dMR d 2TR

 , thus
dQ 2 dQ dQ 2 is the slope MR. Since MR is horizontal (or constant), the

slope of MR is equal to zero.

d 2TC dMC d 2TC
2 2
Like wise, dQ is equal dQ and thus, dQ is the slope of MC, which is not
constant

80
 d 2TR d 2TC
Thus,  means
dQ 2 dQ 2
Slope of MR < Slope of MC
- 0 < Slope of MC or
- Slope of MC > 0 or
- Mc is increasing………………. Sufficient condition
Thus, the condition for profit maximization under perfect competition is
MR= MC………………….necessary condition and
MC is increasing…………. sufficient condition
Conceptually, maximizing the difference between TR & TC means maximizing the
area between the MR and MC curve, i.e., maximizing  (MR-MC)dQ. And the area
between the MC and MR would be maximal only when the firm produces Qe level of
output.
The fact that a firm is in the short run equilibrium does not necessarily mean that the
firm gets positive profit. Whether the firm gets positive or zero or negative profit
depends on the level of ATC at equilibrium thus;
- If the ATC is below the market price at equilibrium, the firm earns a
positive profit equal to the area between the ATC curve and the price
line up to the profit maximizing output (see fig5.7below)

MC
AC

P
MR
Profit
C

Fig 5.7 the firm earns a positive profit because

Qe Q
price exceeds AC of production at
equilibrium
- If the ATC is equal to the market price at equilibrium, the firm gets
zero.

81
 - If the ATC is above the market price at equilibrium, the firm earns a
negative profit (incurs a loss) equal to the area between the ATC curve
and the price line.( see fig 5.8 below).
C,P
AC

MC

loss
C
MR
P

Qe
Fig 5.8 a firm incurs a loss because price is less than AC of production at equilibrium.
In this case, you may ask that “why do the firm continue to produce if it had to incur a
loss?”
In fact, the firm will continue to produce irrespective of the existing loss as far as the
price is sufficient to cover the average variable costs. In other words, the firm should
continue producing as far as the TR sufficiently covers the total variable costs. This is
so because if the firm stops production he will incur a loss which equals the total fixed
cost. But, if it continues to produce the loss is less than the total fixed costs because the
TR will cover some portion of the fixed costs in addition to the whole variable costs as
far as it is greater than TVC.
However, if the market price falls below the AVC or alternatively, if the TR of the firm
is not sufficient to cover at least the total variable cost, the firm should close (shut
down) its factory (business). It will only lose the fixed costs; but if it continues
operation while the TR is unable to cover even the variable costs, the loss is greater than
the fixed costs since part of the variable cost is also not covered by the existing revenue.
To summarize, a firm may continue production even while incurring a loss (when TC >
TR). This occurs as far as the TR is able to cover at least the TVC (TR > TVC). If the
TR is less than the TVC, the firm is well advised to discontinue its operation so that the

82
loss will be minimized. Hence, to continue its operation (or just to stay in the business)
the firm should obtain the TR which can at least cover its variable costs. The following
example will make the discussion clear.
Example:
Suppose a firm has a TFC of $2,000, a TVC of $ 5,000 and a TR of $6,000 at
equilibrium. Should the firm stop its operation? Why?
In fact the firm is incurring a loss of $ 1,000 because TC (2,000 + 5,000=7,000) is
greater than the total revenue. But the firm should continue production because the TR
is greater than TVC. If the firm stops operation, it will lose the fixed cost ($ 2.000). But
if it continues production the loss is only $ 1,000 (TR-TC). Thus, the firm requires a
minimum TR of $ 5,000 to continue operation. If the TR is equal to $ 5,000, the firm is
indifferent in between choosing to continue or to discontinue its operations because in
both cases the loss is equal to fixed costs. Thus the level output at which TR and TVCs
are equal is called shut down out put level. In other words, shut down point is the point
at which AVC equals the market price.
Equally important point is the point of break-even. Break-even point is the out put level
at which market price is equal to the average cost of production so that the firm obtains
only normal profit (zero profit).
Numerical example
Now let us see how to determine the short run equilibrium of a firm operating in a
perfectly competitive market by using a hypothetical example.
Suppose that the firm operates in a perfectly competitive market. The market price of
his product is$10. The firm estimates its cost of production with the following cost
function:
TC=10q-4q2+q3
A) What level of out put should the firm produce to maximize its profit?
B) Determine the level of profit at equilibrium.
C) What minimum price is required by the firm to stay in the market?
Solution
Given: p=$10
TC= 10q - 4q2+q3

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 A) The profit maximizing output is that level of output which satisfies the
following condition
MC=MR &
MC is rising
Thus, we have to find MC& MR first
 MR in a perfectly competitive market is equal to the market price. Hence,
MR=10
dTR
Alternatively, MR  where TR= P.q = 10q
dq
d (10q )
Thus, MR   10
dq
dTC d (10q  dq 2  q 3 )
MC=   10  8q  3q 2
dq dq
 To determine equilibrium output just equate MC& MR
And then solve for q.
10 – 8q + 3q2 = 10
- 8q + 3q2 = 0
q (-8 + 3q) = 0
q = 0 or q = 8/3
Now we have obtained two different output levels which satisfy the first
order (necessary) condition of profit maximization
i.e. 0 & 8/3
 To determine which level of output maximizes profit we have to use the second
order test at the two output levels i.e. we have to see which output level satisfies the
second order condition of increasing MC.
 To see this first we determine the slope of MC
dMC
Slope of MC = = -8 + 6q
dq
 At q = 0, slope of MC is -8 + 6 (0) = -8 which implies that marginal lost
is decreasing at q = 0. Thus, q = 0 is not equilibrium output because it
doesn’t satisfy the second order condition.
 At q = 8/3, slope of MC is -8 + 6 (8/3) = 8, which is positive, implying
that MC is increasing at q = 8/3
Thus, the equilibrium output level is q = 8/3
B) Above, we have said that the firm maximizes its profit by producing 8/3 units. To
determine the firm’s equilibrium profit we have calculate the total revenue that the

84
firm obtains at this level of output and the total cost of producing the equilibrium
level of output.
TR = Price * Equilibrium out put
= $ 10 * 8/3= $ 80/3
TC at q = 8/3 can be obtained by substituting 8/3 for q in the TC function, i.e.,
TC = 10 (8/3) – 4 (8/3)2 + (8/3)3  23.12
Thus the equilibrium (maximum) profit is
 = TR – TC
= 26.67 – 23.12 = $ 3.55
c) To stay in operation the firm needs the price which equals at least the minimum
AVC. Thus to determine the minimum price required to stay in business, we have to
determine the minimum AVC.
AVC is minimal when derivative of AVC is equal to zero
dAVC
That is: =0
dQ
Given the TC function: TC = 10q – 4q2 +q3, there is no fixed cost i.e. TC is equal to
the TVC.
Hence, TV C = 10q – 4q2 + q3
TVC 10q  4q 2  q 3
AVC = = = 10 – 4q + q2
q q

dAVC d (10  4q  q 2 )
0  0
dq dq
= -4 + 2q = 0
 q = 2 i.e. AVC is minimum when out put is equal to 2 units.
The minimum AVC is obtained by substituting 2 for q in the AVC function i.e., Min
AVC = 10 – 4 (2) + 22 = 6
Thus, to stay in the market the firm should get a minimum price of $ 6.
Exercise:
Show that the break even price is also equal to $ 6. What is the reason behind?
4.4 The short run supply curve of the firm and the industry

The short run supply curve of the firm

85
In the previous section, we have demonstrated how a competitive firm determines the
level of output which maximizes its profit for a given market price. The profit
maximizing level of output is defined by the point of equality of MC and market price
(because market price is equal to MR in the perfectly competitive market). By
repeating this analysis at different possible market prices, we observe how the
equilibrium quantity supply of the firm varies with the market price.
Now consider the figure 5.9 to understand how to derive the short run supply curve of
a perfectly competitive firm.
Suppose that initially the market price and MR is $6 and the demand curve is shown
by line P1. Given the MC curve, the level of output which maximizes the firm’s profit
is defined by the point of intersection of the MC curve and the demand line (P1),
which is equal to 50 units.
Now assume that the market price increases to $7. This is shown by an upward shift
of the demand curve (MR) to P2. Given the positive slope of MC, this higher demand
(MR) curve cuts the MC curve at higher out put level, 140. That is, when the market
price increases form $6 to $7, the equilibrium quantity supplied by the firm increases
from 50 units to 140 units. As the price increases further (say to $8), the equilibrium
output increases to 200 units.
This implies that the quantity supplied by the firm increases as the market price
increases.
The firm, given its cost structure, will not supply any quantity ( will shut down) if the
price falls below $6, because at a lower price than $6, the firm can not cover its
variable costs. Thus, supply is zero for all price levels below $6 (minimum AVC)
If we plot the successive equilibrium points on a separate graph we observe that the
supply curve of the individual firm over laps with (is identical to) to part of its MC
curve to the right of the shut down point.
P, C P

MC
MC of the
AC firm

86
 E2 AVC
$8 P3= MR3 $8
E2
$7 P2= MR2 $7

E1
$6 P1= MR1 $6

50 140 200 50 140 200

Fig,5.9 The short run supply curve of a perfectly competitive firm is obtained by
connecting different equilibrium points E1, E2, E3 that occurs at successive price
levels p1, p2 and p3 respectively. When the market price is $6, the firm supplies 50
units to maximize its profit. As the price increases to $7, the equilibrium quantity
supplied increases to 140 units and so on.

Thus, the short run supply curve of a perfectly competitive firm is that part of MC
curve which lies above the minimum average variable cost (Shut down point)

4.5 Short run supply curve of the industry

Dear learner, before we discuss the derivation of short run supply curve of the
industry, let us see what the word ‘industry’ refers to in this unit. The word ’industry’
is defined as group of firms producing homogeneous products. Thus the industry
supply is the total supply or market supply.

The industry –supply curve is the horizontal summation of the supply curves of the
individual firms. That is, the total quantity supplied in the market at each price is the
sum of the quantities supplied by all firms at that price. This is based 0n the
assumption that the factor prices and the technology are given.
For detailed information as to how to derive the short run industry supply curve from
the supply of individual firms, consider the following figure. S1, S2 and S3 denote the
supply curves of firms existing in a given industry. The industry supply curve is
obtained by adding the quantities supplied by all the firms at each price. For example,
at price which equals $ 6, firm 1 supplies 50 units, firm 2 supplies 80 units & firm 3
supplies 120 units. The market supply at $ 6 price is thus 250 units (50+80+120

87
units). The short run industry- supply is derived by repeating the above process at
each price levels.

S1 S2 S3

$6
50 Industry
supply curve
$5

$4

$3

80 120
Fig, 5.10 the industry- supply curve is the horizontal summation (at each price) of the supply

curves of all firms in the industry.

When the market price falls below $ 4, only firm2 exists in the market. Thus, for
prices below$ 4, the industry supply curve is identical with the supply curve is
identical with the supply curve of firm 2. Similarly, for price levels ranging from $4 to
$5, only firm1 and firm2 are producing and searching in the market. Thus, the
industry- supply curve for this range of price is the sum of the quantities supplied by
firm 1 and firm 2, and so on.

4.6 Short run equilibrium of the industry

In our previous discussions, we have seen the short run equilibrium of the individual
firm. At that time, we have said that the short run equilibrium of the firm is defined by
the point of intersection of the horizontal MR curve (or the demand curve that the
individual firm faces) and MC curve (or the supply curve of the firm). In other words,
the short run equilibrium of an individual firm is defined by equality of MC of firm
and the market price.

88
 Short run equilibrium of the industry is defined by the intersection of the market
demand and market supply. The intersection of market demand and market supply of
a given commodity determines the equilibrium price and quantity of the commodity in
the market.
While discussing the short run equilibrium of an individual firm we have said that the
demand curve that an individual firm faces is horizontal line (perfectly elastic). This is
due to the fact that; since there are large numbers of sellers in the market, an
individual firm is too small to influence the market price. Rather, the firm sells any
amount demanded at the prevailing market price.
Unlike the individual demand curve, the market demand curve (the total demand
curve that the industry faces) is down-ward sloping, indicating that as the market price
of the commodity increases, the total quantity demanded for the product decreases
and vise versa. In fig.5.11 the industry is in equilibrium at price P e, at which the
quantity demanded and supplied is Qe. At this equilibrium market price, individual
firms can earn a positive profit, zero profit (normal profit) or even can incur a loss
depending on their cost structures.
Firm 1
P P P
Firm 2 MC AC
Market
Supply
MC
AC
C Loss
Pe Pe MR MR
C
Profit Pe
Market
Demand

Qe
Q1 Q2
Fig5.11:- short run equilibrium of the industry. Short run equilibrium of the industry is
defined by the intersection of the market demand and the industry supply Curve. At
equilibrium price, Pe firm 1 gets a positive profit because the average cost of the firm at
equilibrium is less than the market Price, p e. On the other hand, firm 2 is incurring a loss as
its average cost is higher than the market price.

4.7 The long-run Equilibrium

1-Equilibrium of an individual firm in the long run

89
In the long run, firms are in equilibrium when they have adjusted their plant size 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. That is, the firm is in the long
run equilibrium when the market price is equal to the minimum long run AC. Thus
since price is equal to long run AC (LAC now on) at the long run equilibrium, firms
will be earning just normal profits (zero profits), which are included in the LAC.
Firms get only normal profit in the long run due to two reasons.
First, if the firms existing in the market are making excess profits (the market price is
greater than their LACs) new firms will be attracted to the industry seeking for this
excess profit. The entry of new firms results in two consequences:
A. The entry of new firms will lead to a fall in market price of the commodity (which
is shown by the down ward shift of the individual demand curve). This happens
because entry of new firms will increase the market supply of the commodity (which
is shown by the right ward shift of the industry supply), resulting in the lower market
price. More over, if firms are getting excess profit, they have an incentive to expand
their capacity of production, which increases the market supply and then reduces the
market price.
B. More over, the entry of new firms results in an upward shift of the cost curves. This
happens because, when new firms enter into the market the demand for factors of
production increases which exerts an upward pressure on the prices of factors of
production. An increase in the price of factors of production in turn shifts the cost
curves up ward. These changes (decrease in the market price and upward shift of the
cost curves) will continue until the LAC becomes tangent to the demand curve
defined by the market price. At this time, entry of new firms will stop since there is no
positive profit (since P = LAC) which attracts new firms in to the market.
Second, if the firms are incurring losses in the long run (P < LAC) they will leave the
industry (shut down). This will result in higher market price (because market supply
of the commodity decreases) and lower costs (because the market demand for inputs
decreases as the number of firms in the market decreases). These changes will

90
 LMC

continue until the remaining firms in the industry cover their total costs inclusive of
the normal rate of profit.
Thus, due to the above two reasons, firms can make only a normal profit in the long
run.
The following figure shows how firms adjust to their long run equilibrium position
excess profit ( higher price than minimum lack) if the market price is p, the firm is
making excess profit working with plant size whose cost is denoted by SAC, ( short
run average cost1). It will therefore have an incentive to build new capacity or larger
plant size and it moves along its LAC. At the same time new firms will be entering the
industry attracted by the excess profits. As quantity supplied in the market
increases(by the increased production of expanding old firms and by the newly
established ones) the supply curve in the market will shift to the right and price will
fall until it reaches the level of P1, at which the firms and the industry are in the long-
run equilibrium.

P P1 P
Market
LAC
Supply SMC1
New Market SAC1
Supply SMC2 SAC2

P Pe
P Pe

P1
Market
Demand

Q Q
Qe Qe

Fig5.12: Long run equilibrium of the firm. Entry of new firms reduces the market price from p
to p1 (in panel A) and the long run equilibrium is established at E (panel B).

91
The condition for the long run equilibrium of the firm is that the long run marginal
cost (LMC) should be equal to the price and to the LAC i.e. LMC = LAC = P.
The firm adjusts its plant size to so as to produce that level of output at which the
LAC is the minimum possible, given the technology and prices of inputs. At
equilibrium the short – run marginal cost is 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 condition, we have,
SMC = LMC = SAC = LAC = 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 minimum of the LAC and SAC coincide.
Long run shut down decision
Do you remember the short run shut down point of a firm? If you don’t remember,
please revise section-.for the time being the time being the following paragraph may
remind you. (About the short-run shut down point)
In the short-run the firm should continue production as far as the market price is
greater than the minimum AVC, If the market price falls below the minimum AVC,
the firm is well advised to shut down because if it shut down it well loose only the
fixed costs but if it continues production the loss is greater than the fixed cost.
The long-run shut down decision (point) is different from that of the short run. The
firm shuts down if its revenue is less than its avoidable or a variable cost. In the long
run all costs are variable because the firm can change the quantity of all inputs. Thus,
in the long run the firm shuts down when its revenue falls below the long run total
cost. In other words, in the long run shut down decision occurs if the market price
falls below the minimum LAC of the firm.
The long-run supply curves the firm
Previously, we have noted that in the long run the firm shuts down if the market price
is below the its minimum long run average cost. Thus, the firm will not supply for all
price levels below the minimum LAC. On the other hand, the firm's long run
equilibrium out put is defined by the equality of the MR and its LMC. As a result, a

92
 firm’s long- run supply curve is its LMC curve above the minimum of its long-run
average cost curve.
Long run supply curve of the industry
The long run supply curve of the industry is the horizontal sum of the supply of
individual firms just like the case of short run supply curve of the industry. Thus, the
long run supply curve of the industry is up ward sloping, provided that the firms are
of different size. This is because, firms with relatively lower minimum LAC, are
writing to inter the market than others. So that as the market price increased in the
long run more firms will find it profitable to inter the market, resulting in up ward
sloping long-run supply curve of industry.
Long-run equilibrium of the industry
An industry is in the long-run equilibrium when the price is reached at which all firms
are in equilibrium. That is, when all firms are producing at the minimum point of their
LAC curve and making just normal profits, the industry is said to be in the long-run
equilibrium. Under these conditions there is no further entry or exit of firms in the
industry (since all the firms are getting only normal profit), so that the industry supply
remains stable.
The long-run equilibrium of the industry is shown by fig 5.13.At the market price, P,
the firms produce at their minimum LAC, earning just normal profits. At this price all
firms are in equilibrium because
LMC=SMC=P=MR and they get only normal profit because LAC=SAC=P .

P P
Industry ss
LAC
SMC LMC
SAC

P=Me
P e Pe

Market dd

Q
Q
93
 Qe

Qe

Industry equilibrium Firm’s equilibrium

Fig5.13: long-run equilibrium of the industry is defined by the price at which all individual
firms are in equilibrium, marking just normal profit.

While the industry is in the short run equilibrium, we have seen that, individual firms
can earn positive, normal or negative profits depending on the level of their AC s
relative to the equilibrium market price. How ever, this is not the case in the long-run.
That is, while the industry is in the long run .equilibrium all firms earn only normal
profit.
Perfect competition and optimal resource allocation
In the perfect competition, the market mechanism leads to an optimal allocation of
resources. The optimality is shown by the following conditions all of which prevail in
the long run equilibrium of the industry;
a) The out put is produced at the minimum feasible cost. That is all firms produce at
the minimum of their LAC.
b) Consumers pay the minimum possible price which just covers the marginal cost of
production, that is, price equals just opportunity cost so that the consumers are not
exploited.
c) Plants are used at full capacity in the long- run so that there is no waste of
resources. That is, at the long run equilibrium the short run average cost is also
minimum.
d) Firms earn only normal profits.
These conditions justify the fact that perfect competition results in optimal resource
allocation.

94
 UNIT FIVE
PRICE AND OUT PUT DETERMNATION UNDER
MONOPOLY
5.1 Definition of monopoly
Monopoly is quite opposite to perfectly competitive market. And it is defined as: a
market situation in which a single seller sells a product or provides a service for
which there is no close substitute. In monopoly there are no similar products whose
prices or sales will influence the monopolist price or sales. In another words, cross
elasticity between monopolist product and other commodities is zero or low. Since
there is a single seller in monopoly market structure, the firm is at the same time the
industry.
Common characteristics of monopoly
Monopoly markets share the following common characteristics.
1-Single seller and many buyers
There is a single seller who sells the product to many buyers.
2-Absence of close substitutes
A product produced by a monopolist has no close substitute so that consumers have
no alternative choices to substitute one product for another.
3-Price maker

95
Dear learner, in perfectly competitive market, we have said that, both sellers and
buyers are price takers. How ever, the monopolist is a price maker. Facing a down
ward sloped demand curve for its product, the monopolist can change its product price
by changing the quantity of the Product supplied. For example, the monopolist can
increase the price of its product by decreasing the quantity of supply.
4-Barrier to entry
In monopoly, new competitors can not freely enter in to the market due to some
barriers which can be economical, technical, legal or other type of barriers.
5.2 Causes for the emergence of monopoly
Think of any monopoly firm in our country and try to analyze the reason why the firm
maintains its monopoly power. There are many factors that create monopoly and help
the monopolists to maintain monopoly power. Some of the factors will be discussed
below.
1. Ownership of strategic or key inputs.
A firm may own or control the entire supply of a raw material required for the
production of a commodity. Such firms are not willing to sell the raw materials to
another firm. For example, until the second world war, the aluminum Company of
America (Aloca) controlled practically the entire supply of Bauxite(the basic raw
material necessary for the production of aluminum), giving it almost a complete
monopoly in the production of aluminum in the united states. To come to our country,
Ambo Mineral Water can be taken as an example. Ambo mineral water has
monopolized the natural mineral water.
2. Exclusive knowledge of production technique.
Most of the beverage (soft drink) companies such as Coca Cola Company have
maintained monopoly power over supply of their product partly due to exclusive
knowledge of the ingredient chemicals required for the production of their product.
3. Patents and copyright
Patents and copyrights are government supported barriers to entry. Patents are granted
by the government for 17 years as an incentive to investors. Authors of books, artistic
works (such as cassette, video, etc) are the best examples of such monopoly. For

96
example, no one, except Adama University, can copy and sell this course material as
Adama University has an exclusive copy right over the material.
4. Government Franchise and License
Another cause for the emergence of monopoly is government franchise. Franchise is a
promise by the government for a firm to prohibit the establishment of another firm (by
another person) that produces the same product or offers the same service as the
original one.
For example, when the first Bank in Ethiopia, Abyssinia Bank was established,
Emperor Minilik has promised for the Egyptian firms (the owner of the Bank) that
they will monopolize the Banking service in Ethiopia for 50 years.Postal service in
Ethiopia, Ethiopian television, telecommunication service in Ethiopian etc. are other
examples of monopoly.
5. Economies of scale may operate (i.e. the long run average cost may fall)
Another cause for the emergence of monopoly is economies of scale in production. A
firm is said to have economies of scale if its long run average cost is declining. In
such a situation, when the incumbent firm observes that new firms are entering into
the market, it will produce large amount of output to minimize its unit cost of
production and will charge a lower price than the new firms to deter entry. Such a
monopoly is called natural monopoly.
Aside from the few cases of monopoly mentioned above, pure monopoly is rare and
most governments discourage pure monopoly because monopoly is deemed to create
inefficiency. For example, had it been the case that the telecommunication services
are not monopolized in our country, their prices would have been lower. But through
pure monopoly is rare, the pure monopoly model is useful for analyzing situations that
approach pure monopoly and for other types of imperfectly competitive markets (i.e.
monopolistic competition and oligopoly)
5.3The demand and revenue curves of the monopoly firm
In the previous unit, we have seen that the perfectly competitive firm is a price taker
and faces a demand curve that is horizontal or infinitely elastic at the price
(determined by the intersection of the industry or market demand and supply) of the

97
commodity. But, remember that the market demand curve is down ward sloping.
However, a monopolist firm is at the same time the industry and thus, it faces the
negatively sloped market (industry) demand curve for the commodity. In other words,
because a monopolist is the sole seller of a commodity, it faces a down ward sloping
demand curve. This means, to sell more units of the commodity, the monopolist must
lower the commodity price.
Conversely, if the monopolist decides to raise the price of the product, it will reduce
the quantity of supply with out worrying about the competitors, who by charging
lower prices would capture a large share of the market (customers) at the expense of
him. So the monopolist can manipulate the price of its commodity by changing the
quantity of supply. To sell more units of the commodity, the monopolist will charge
lower price and vise versa. Hence, the demand curve facing the monopolist is
negatively sloped, showing the inverse relationship between market price and quantity
demanded.

P1

P2

Q
Q1 Q2
Fig.6.1 the demand curve facing the monopolist firm is down wards sloping. At price p1, the
firm sells only Q1 outputs. To sell more units the firm should reduce the price.

98
Mathematically, assuming that the demand curve is linear, it can be written in the
following form.
P = a – bQ
Where P – is the market price

Q – is the quantity of sales (quantity demanded)

a&b – are any positive constants
The total revenue of the monopolist can be obtained by multiply the market price with
the quantity of sales

That is,
TR = P.Q
Substituting (a – bQ) for P
TR = (a - bQ) Q
TR = aQ – b Q2
Hence the total revenue curve of the monopolist firm has an inverse U- shape. The
total revenue of a monopolist firm first increases with the quantity of sales (over the
elastic range of the demand curve), reaches its maximum (when the demand curve is
unitary elastic), and finally decreases when quantity of sales increases (over the
inelastic range of the demand curve) the following figure illustrates this fact.

Ep>1

Ep=1
P1
Ep<1
Q
Q1 DD

TR

99
 TR

Q
Q1

Fig: 6.2 the shape of total revenue curve and its relationship with the price elasticity of
demand. When Ep>1 TR and Q have positive relation, at a point where Ep=1, TR curve
reaches its maximum and when EP<1, TR and Q have negative relation.
The MR curve of monopolist firm is down ward sloping (decreases with quantity of
sales). The fact that the monopolist must lower the price to increase its sales causes
the MR to be less than price except for the first unit. This is so because when the firm
reduces the commodity price to sell one more unit all units which would have been
sold at the original higher price will now be sold at the new (lower) price. The
following table may help you better understand this fact.

Price Quantity TR AR MR
$6 0 0 6 -
5 1 5 5 5
4 2 8 4 3
3 3 9 3 1
2 4 8 2 -1
1 5 5 1 -3
The above table shows that as output increases the TR first increases, reaches its
maximum (when the firm sells the third unit) and then starts to fall.
The MR is less P except for the first unit. For example, when the firm decreases the
price from$5 to $4 marginal revenue decreases from $5 to $3. That is, at the second
unit MR ($3) is less than the P ($4).
This is because, when the market price is $5, the firm will sell one unit and will get a
TR of $5 and the MR of this first unit is $5. When the price decreases to $4, both the
first and the second unit are sold at $4 and the firm receives total revenue of $8. Now,

100
the MR that the firm obtains from the second unit is only $3. Hence for a down ward
sloping demand curves (in monopoly) the MR of the firm is less than the market
price. Note that the AR of a monopolist is always identical to the P or demand curve.
In general, the MR curve of a monopolist firm is negatively sloped. The MR will be
positive over the elastic range of the demand curve (because TR is increasing over
this range), zero when the price elasticity of demand is unitary ( because the TR is at
its maximum level) and will have a negative sign over the inelastic range of the
demand curve( because TR is decreasing).
The following figure illustrates the relationship between price elasticity of demand
and MR
P

Ep>1

Ep=1

P1
Ep<1

DD

MR
Fig: 6.3 the relationship between MR and P. The MR of a monopolist lies below the
commodity price for each unit sold (except the first unit) and it is negative over the inelastic
range of the demand curve.
Mathematically, it can be shown that MR is less (steeper) than the AR or demand
curve. Suppose a monopolist’s demand curve is given by
P = a – bQ
Where a&b - are any positive constants
P&Q – are price and quantity.
TR = P.Q = (a - bQ) Q
= aQ – bQ2
By definition MR is change in TR that happens due to a one unit change in
quantity of sales. Symbolically,
dTR d (aQ  bQ2)
MR    a  2bQ
dQ dQ

101
Thus, MR = (a – 2bQ) has a slope which equals twice the slope of demand (average
revenue) curves. This implies that MR is less than AR or demand or price.
We have seen that a monopolist firm faces a down ward sloping demand curve.
Exception to the law of demand under monopoly is that the firm can increase the
quantity of sales only through promotional activities (with out price cut).
Profit maximization in the short run
Do you remember how a perfectly competitive firm maximizes its profit? In this
section, we examine the determination of equilibrium price and out put by a
monopolist in the short run. We will also show that a monopolist, like a perfectly
competitive firm, can incur losses in the short run. Finally, we demonstrate that,
unlike the case of the perfectly competitive firm, the monopolist’s short run supply
curve can not be derived from its short run marginal cost curve (the supply curve of
the monopolist is indeterminate).
To start with, it was discussed in the last chapter that in a perfectly competitive
market price is given and profit maximization involves only looking for the profit
maximizing unit of output, given the market price. But, under monopoly, the firm is a
price maker and has a power to alter the level of output. Thus, profit maximization
under monopoly involves determination of the price and output combination that
yields the firm the maximum possible profit.
Price and out put combination that maximizes the monopolist profit can be
determined in the similar fashion as that of the perfectly competitive firm. That is,
price- output combination that yields the monopolist the maximum profit can be
determined in two ways:
1. Total approach
2. Marginal approach
Now let us see the two approaches one by one.
1. Total approach
In this approach the profit maximizing unit of output is defined as that level of output
where the positive difference between TR and TC is maximal or the negative
difference between TR and TC is minima. The equilibrium price can be determined
by dividing the TR corresponding to the equilibrium output level to the equilibrium
output. The following figure tells more about this approach.

102
TR, TC
TC
Q
TR*

TR

PROFIT Q1 Q2 Q3

Q
Q1 Q2 Q3

MR
Fig 6.3 Short –run equilibrium of the monopolist Total approach: The TR of the monopolist
has an inverse U shape because the monopolist must lower the commodity price to sell
additional units. The STC has the usual shape. The total profit is maximized at Q2, where the
positive difference between the TR and STC is the greatest. Profit is negative for output
levels below Q1 and above Q .In this approach the profit maximizing price is given by the
ratio of TR* to Q2.

2. Marginal approach
In this approach the profit maximizing level of out put is that level of out put at
which marginal cost curve cuts the marginal revenue curve from below. The

103
equilibrium (profit maximum) price is the price corresponding to the equilibrium
price from the demand curve.
Consider the following figure:

a
P1

P2 SMC
d
P3

b
E
c DD or AR

Q1
Q3
Q2
MR

Fig. 6.4 Short- run equilibrium of the monopolist: marginal approach. Equilibrium output is
Q2, where MC and MR curves intersect each other and MC curve is up ward sloping.
Equilibrium price is the price corresponding to the equilibrium quantity, Q 2 (i.e. p2).
Note that, a monopolist charges a price which exceeds the MC of production, unlike
the case of the perfectly competitive firm. Now, how can we be sure that Q 2 is the
profit maximizing unit of out put? To answer this question, note that in the total
approach the level of profit at a given level of output is the vertical distance between
the TR and TC (i.e, ∏ = TR - TC.)
In the marginal approach, however, the level of profit at a given level of output is not
the distance between the MR and MC curves. Rather it is the area between marginal
revenue and marginal cost curves starting from the origin up to the given level of
output. Symbolically, the level of profit say at Q2 level of output is:
∏ at Q2 = TR at Q2 – TC at Q2 ---------------------------- Total approach
Q2

∏ at Q2 =  (MR  MC )dQ ------------------------- Marginal approach

0

Given the level of profit as the area between the MR and MC, let’s come back to our
question above.

104
In the above figure, we have said that the equilibrium price is Q2 and the level of
profit is the area between that part of MR and Mc curves between the origin and Q 2
(area abE).
Now we are going to prove whether this level of output is actually the profit
maximizing level of output. To prove this, suppose initially that the monopolist
produces a smaller quantity Q1 and receives the higher price, P1. The level of profit
at this level of output the area between that part of MR and MC curves ranging from
the origin up to Q1 ( i.e. area abcd). Hence the firm loses the level of profit given by
the area cde by producing Q1 level of output instead of Q2.Thus, any level of output
below Q2 can not yield the firm the maximum profit. Similarly, it can be shown in
the same way that any level of output above Q2 can not maximize the firm’s profit.
In other words, for any level of output below Q2, MR is greater than the MC,
implying that each additional unit of output yields larger additional (marginal)
revenue to the firm than the additional cost of producing it. Hence the firm should
produce additional units until Q2. On the other hand, for all levels of output above
Q2, the MC of producing additional unit of output is greater than the MR obtained
from it. Hence, the firm should not expand its output above Q2. This argument can
prove the fact that Q2 is the profit maximizing level of output.
Mathematically, the profit maximizing condition of MR = MC and MC is increasing
can be shown as follows.
∏ = TR – TC
d
∏ is maximized when 0
dQ

D dTR dTC
  0
That is, dQ dQ dQ
 MR – MC = 0
 MR = MC ………………………….. first order condition
The second order condition of profit maximization is

d 2
0
dQ 2

105
That is, d 2 d 2TR d 2TC
  0
dQ 2 dQ 2 dQ 2  dTR 
d  
2
d TR  dQ  dMR
dMR dMC  
 0 (Because dQ 2 dQ dQ and the same
dQ dQ
for MC)
Slope of MR- slope of MC<0
Slope of MC > slope of MR ------- the second order condition
Numerical example
Suppose the monopolist faces a market demand function given by P=40-Q. The firm
has a fixed cost of $ 50 and its variable cost is given as TVC=Q2 determine:
a) the profit maximizing unit of output and price
b) the maximum profit
Solution
Given: p=40-Q
TFC=50
TVC= Q2
a) equilibrium condition is MR=MC, and slope of MC>slope of MR.
TR=P.Q = (40-Q) Q =40Q- Q2
TC=TFC+TVC =50 + Q2
Now,
dTR d (400  Q 2 )
MR    40  2Q
dQ dQ
dTC d (50  Q 2 )
MC    2Q
dQ dQ
MR=MC 40-2Q=2Q
40=4Q
Q=10

dTR
MR   2
Second order condition: slope of dQ

dMC
Slope of MC  2
dQ

106
Thus, the profit maximizing level of dMC  dMR the second order
output is10 and the profit
dQ dQ
maximizing price is obtained by substituting the condition is met
profit
maximizing quantity (10) in the demand function.
Thus, P = 40 – Q
P = 40 – 10 = 30
b) The maximum profit is the level of profit obtained from selling 10 units at $ 30
each.
∏ = TR – TC
But TR = P.Q
= $ 30 * 10 = $ 300
TC = 50 + Q2 = 50 + 102 = $ 150
The maximum ∏ is thus $ 300 - $ 150 = $ 150.
Exercise:
144
Suppose the monopolist faces the market demand function given by Q  .The
P2
AVC of the firm is given as AVC = Q ½ and the firm has a fixed cost of $ 5

a) determine equilibrium P&Q

b) determine the maximum profit

5.4 Mark up pricing

Although prices can be determined by equating MC and MR, most managers have
only limited knowledge of the AR and MR functions that their firm faces. Mark- up
pricing helps us to translate the equilibrium condition MR = MC into a convenient
form that can easily be applied in practice. Accordingly,

MC
P
1
1
ed

This formula is derived from the equilibrium condition MR = MC as follows.

107
The TR of the monopolist is:
TR = P.Q
Marginal revenue is:
dTR d ( P.Q ) dP.Q dQ …… (1) (Product rules of differentiation.)
MR     .p
dQ dQ dQ dQ
On the other hand the price elasticity of demand, ep is
dQ P Q
ep  . . and by rearranging (Multiplying both sides by )
dP Q p

dQ P
 ep. ----------------------------------------------------------- (2)
dP Q

Taking the reciprocal of both sides we obtain :

dP P -------------------------------------- (3)

dQ eP.Q
Substituting equation (3) in equation (1) we get:
P
MR  .Q  P
eP.Q
1
MR = P (  1 ) ------------------------------------------ (4)
ep
By substituting equation ( 4) in the equilibrium condition MR = MC we get the
following

1
P (1  )  MC
ep

MC dQ p
P
1 , where Ep = .
1 dP Q
ep
Here, /Ep/ should be greater than one. Other wise the price would be
negative. In other words, if price elasticity of demand is inelastic (or /Ep/<1), it
implies that MR is negative, which requires the MC to be negative for equilibrium to
occur. But, MC can never be negative. Hence, a monopolist operates only over the
elastic range of its demand curve.
Numerical example:

Suppose the monopolist’s total cost function is given as TC = 10+1.5Q. The firm
estimates the price elasticity of demand to be -4, determine the profit maximizing
price.
Solution:

108
Given: TC = 10+1.5 Q
Ed = -4
Required: P=?
1.5 1.5
MC dTC P   $2
; P MC   $1.5 .Thus, 1 3/ 4
1 dQ 1
1 4
ed
5.5 Absence of unique supply Curve under Monopoly
Under Perfect competition, you remember that firms have unique supply curve. That
is there is unique supply price for each unit of output supplied. In monopoly supply
price is not unique. A given quantity could be supplied at different prices and different
quantities can be sold at the same price, depending on market demand and marginal
revenue. Hence there is no one to one correspondence between P and Q under
P
monopoly. Consider the following figures.
P
Fig.6.5

MC

MC
P1 P E1
P
E2
D D1

D D1 MR1
Q Q Q1 Q
MR
Q* MR1 MR

Panel-1
In this panel, the same quantity Q* is sold at
different prices depending on the market
demand. If the market demand is D1 and the
MR curve is MR1, equilibrium occurs when
MR1 cuts MC curve and the equilibrium price
and quantity are P1 and Q*. If the market
demand for the monopolist product decreases
to D, the monopolist can still sell the same
quantity Q* by lowering the price. So, there is
no unique (or one to one correspondence)
between P&Q, as the same Q* is matched with
two different price, P&P1
Panel-2
In this panel, initially equilibrium is E1
(where MR1=MC) and equilibrium
P&Q1. when the demand for monopolist
product decreases to D the new
equilibrium becomes E2 where the new
MR=MC At the new equilibrium, price is
the same, but the monopolist sell only Q
amount of output i.e. the monopolist sells
lower quantity at the original price when
the dd decreases.

109
 Therefore, there is no unique supply curve under monopoly.
5.6 Long – run Equilibrium under Monopoly
The monopolist’s long run condition is different from the perfectly competitive firms’
long run situation in respect of the entry of new firms into an industry. In perfectly
competitive market there is free entry in the long run. Nevertheless, entrance is barred
by several factors in monopoly. More over, we have seen that a perfectly competitive
firm can earn only normal profit in the long run. The monopolist firm can, however,
get a positive profit even in the long run because there are entry barriers that
discourage new firms to enter the industry, attracted by the positive profit.
Let us now examine the long run equilibrium situation for single plant monopolist. If
the monopolist incur loss in the short run (SAC>P) and if there is no plant size that
will result in super normal profit in the long run given the market size, the monopolist
must stop operation (shut down). If the monopolist makes (P> SAC) in the short run
in a given plant, the monopolist not only continue its operation but also looks for
different plant size to expand, so that could maximize profit in the long run. But at
what output level the monopolist maximizes its profit? A monopolist maximizes its
long run profit when it produces and sells that output level where LMC = MR , slope
of LMC being greater than the slope of MR at the point of intersection, and the
optimal plant size is the one whose SAC curve is tangent to the LAC at the point
corresponding to long run equilibrium output.
Let’s illustrate the equilibrium situation graphically.

SMC1
P1
C SAC1 LAC

SMC2 LMC

Pe SAC2

110
 MR
DD

Q
Q1 QE

Fig 6.6 Suppose initially the monopolist builds the plant size having the costs SAC1 and
SMC1 the equivalence of SMC1 and MR leads into producing and marketing output levels Q1
and P1, making a unit profit of P1 – C, since the monopolist is making a positive profit, it
decide to continue its operation and looks for a more profitable plant size in the long run.
This long run plant is attained when LMC = MR, and the corresponding output level and
price are Qe and Pe
respectively.

Finally, it should be noted that there is no certainty in the long run that the monopolist
will reach the optimal plant size (minimum LAC), as in perfectly competitive case.
The monopolist may reach optimal plant size or even may exceed the optimal size if
the market demand allows him (or if there is enough demand which absorb that level
of output).
5.7 Monopoly Power
Pure monopoly is rare. It is common to see market in which several firms compete
with one another. Although many firms compete with one another some firms may
have greater monopoly power than the others. Hence they can affect the market price
more than other firms. You may think that firms which share the larger part of the
market supply have greater monopoly power. But this can not be necessarily true.
What matters is the consumers’ preference for the firm’s product. If most consumers
prefer the product of the firm to other substitutes, the firm has greater monopoly
power than other firms in the market and the firm can slightly increase the price of his
commodity being confident that he will not lose its customers.
Now let us come to discuss measurement of monopoly power. The important
distinction between a perfectly competitive firm and a monopolist is that: for the
competitive firm price equals marginal cost; and for the firm with some monopoly

111
power price exceeds marginal cost. Therefore, a natural way to measure a monopoly
power is to examine the extent to which the profit maximizing price exceeds marginal
cost. In particular, we can use the mark up ratio of price minus marginal cost to price
that we introduced earlier. This measure of monopoly power, introduced by an
Economist Abba Lerner in 1934, is called Lerner index of monopoly power. Lerner
index (L) is the difference between price and marginal cost, divided by price.
Symbolically, L = P – MC L - is learner index of monopoly power
P
L always has a value between zero and one. For perfectly competitive firm, P = MC,
so that L = 0 i.e. there is no monopoly power in perfect competition. Hence, the larger
L is the greater the degree of monopoly power.
The learner index of monopoly power (L) can also be expressed in terms the price
elasticity of demand for the firm’s product as follows.
1 dQ P
L , where ep  . and /Ep/>1, since the monopolist operates only over the
ep dP Q
elastic range of its demand curve.
Proof: From the mark-up pricing, we know that
MC
P
1
1
ep
Re arranging this we get
1 MC
1 
ep P
1 MC
 1
ep P
1 MC  P

ep P
1 P  MC
 
ep P
P  MC
But, is the learner index of monopoly power (L),
P

112
 1
Thus, L 
ep

5.8 The multi- plant monopolist

We have seen that a monopolist maximizes its profit by producing that level of output
where MR equals MC. For many firms, however, production takes place in two or
more different plants whose operating cots can differ. To minimize transport cost, to
approach the consumers or for different reasons a monopolist may establish more than
one plant in different areas. The operating costs of these plants can also vary due to
many reasons such as variation in prices of raw materials, wage of labors etc. Now
let's examine how a monopolist facing such cases maximizes its profit by taking the
following a two- plant monopoly firm as an example. Data regarding cost and revenue
is given in a table below.

Out put Price Marginal Marginal Marginal Multi plant

and sales revenue cost cost Marginal
Plant -1 Plant-2 cost
1 5.0 - 1.92 2.04 1.92
2 4.5 4 2.00 2.14 2.00
3 4.1 3.30 2.08 2.24 2.04
4 3.8 2.9 2.16 2.34 2.08
5 3.55 2.55 2.24 2.44 2.14
6 3.35 2.35 2.32 2.54 2.16
7 3.2 2.30 2.40 2.64 2.24
8 3.08 2.24 2.48 2.74 2.24
9 2.98 2.18 2.56 2.84 2.32
10 2.98 2.08 2.64 2.94 2.34
Given this information, how can the monopolist decide the total production and how
much of that output each plant should produce?
The logic used in choosing output levels is very similar to that of the single-plant
firm. We can find the answer intuitively in two steps.
Step 1 - What ever the total output, it should be divided between the two plants so
that marginal cost is the same in each plant. Other wise, the firm could reduce its cost
by reallocating production. For example, if marginal cost at Plant-1 were higher than

113
at Plant-2, the firm could produce the same output at a lower total cost by producing
less output at plant -1 and more output at plant-2. Thus, for equilibrium to occur
marginal cost at firm-1 (MC1) must equal marginal cost at firm- 2 (MC 2) i.e. MC1 =
MC2
Step-2 We know that the total output must be such that marginal revenue equals the
multi plant marginal cost. Now it is essential to know first how the multi -plant
marginal cost is derived from each plant marginal costs. If the firm wants to produce
the first unit, it should produce it in plant 1 because, the MC is lower in plant 1 than in
plant 2 (i.e. 1.92 < 2.04). Hence, MC of producing the first unit for the multi –plant
monopolist is 1.92. If output is to be two units or if the firm wants to add one more
units, the second unit should also be produced in plant 1 because the MC of the
second unit in plant 1 is less than MC of producing one unit in plant 2 (i.e. 2.00 <
2.04). Hence, multi-plant marginal cost for the second unit is $2. If three units are to
be produced, plant 2 will enter into production since the MC of producing one unit in
plant 2 (2.04) is less than marginal cost of producing the third unit in plant 1, & 2.08.

Hence, multi-plant MC for the third unit is 2.04, the derivation of multi-plant
marginal cost continues in the same manner.
Once, multi-plant marginal cost is derived, the only thing left to obtain equilibrium
total output is equating the multi plant MC with the marginal revenue. So in the above
table, equilibrium output is 8 units where MC of multi-plant = Marginal revenue (i.e.
2.24 = 2.24).
Now the remaining issue will be how to allocate the total production between plants 1
and 2. The multi plant monopolist allocates production in a way that each plants MC
equals common value of multi plant MC and marginal revenue. The common value of
multi plant MC and marginal revenue is 2.24. Thus it follows that the allocation of
production is in a way that MC of plant-1 = 2.24 and MC of plant-2 = 2.24
i.e. Plant 1 produces 5 Units (because at 5 units MC1 = 2.24)
Plant 2 produces 3 units (because at 3 units MC2 = 2.24)
In short, the condition of equilibrium in multi- plant monopolist is: MR = MC of
multi plant monopolist and to allocate the total out put among each plant, the
condition must satisfy:
MC1 = MR = MC of multi plant monopolist
MC2 = MR = MC of multi plant monopolist
MR = MC1 =MC2
Graphically, the above table (problem) can be represented as follows
P, MC, MR

MC1 MC. Multi plant

MC2

114
 P
D=AR

MCa
E

3 5 8 Q
Fig 5.7 Multi-plant monopolist equilibrium. MC 1 and MC2 denote the MCs of production in
plants 1&2 respectively. MCm denotes the marginal cost of multi-plant firm which is derived
from MC1 and MC2. Note that, MCm is obtained from MC1 and MC2 by adding the levels of
out put produced in the two plants at equal marginal costs. E.g. when marginal cost is MCa,
the firm produces 3 units in plant 1 and 5 units in plant 2 and the monopolist marginal cost of
producing the 8th unit is MCa. The Multiplan monopolist’s equilibrium is defined by point E
and the two firms 1and2 produce 5 and 3 units respectively.

Now let us derive this rule algebraically,

Let Q1 and C1 be the output and production cost of plant1 and C1 = f (Q1)
-Q2 and C2 be the output and production cost of plant-2 and C2 = f (Q2) and
- QT = Q1 + Q2 is the total output of the firm.
All output, whether they are produced in plant 1 or in plant2 will be sold at uniform
market price, Say P then the total profit of the monopolist is 6
 = P. QT – C1 – C2
 = PQ1 + PQ2 – C1 –C2,
d d
To maximize profit and must be equal to zero
dQ1 dQ2

115
 = TR – C1 – C2 , because PQ1 + PQ2 = TR the condition of equilibrium is:
d dTR dC1 dC 2
    0  MR1 - MC1 = 0
dQ1 dQ1 dQ1 dQ 2

d dTR dC1 dC 2
    0  MR2 - MC2 = 0
dQ 2 dQ 2 dQ 2 dQ 2
Note that:
dC 2
 0 because C2 = f (Q2) and
dQ1
dC1
 0 because C1 = f (Q1)
dQ 2
The equilibrium condition is, thus
MR1 = MC1
MR2 = MC2
But MR1 = MR2 because all outputs whether they are produced in plant1 or plant 2
are sold at the same market price.
Let MR1 = MR2 = MR
Then the above equilibrium condition can be written as:
MR = MC1 and
MR = MC2
Equivalently, it can be written as MR = MC1 = MC2

Now let us see one numerical example

Suppose Ethiopian Electric Light and Power Corporation (EELPC) is a multi plant
monopolist having two plants, Tekeze plant (plant1) and Fincha plant (Plant2). The
operating costs of the two plants are given as follows:
Tekeze Plant: TC1 = 10 Q 12 and where Q1 - Amount of electric power
produced in Tekeze
Fincha plant: TC2 = 20 Q22 Q2 – amount of electric power produced in
Fincha

116
EELPC estimates the demand for electric power by the following function

P= 700 – 5Q where P - is price (total in million birr) per Giga watt and
Q – is the total amount of Giga watt sold and Q = Q1 + Q2
Note that a Giga watt of electric power, whether it comes from Fincha or Tekeze plant
worth equal price
a) What level of output (electric power) should EELPC produce and what price per
Kilowatt should it charge to maximize its profit?
b) How much of the total output should be produced in each plant?
c) Suppose that recently the Tekeze plant is suffering from siltation problem (which
leads to additional cost of cleaning the dum), but Fincha plant is not. How should
EELPC adjust Q1, Q2 and QT and P to maximize its profit?
Solution
a) The equilibrium condition is:
MR = MC1
MR = MC2
TR = P.Q
= (700 – 5Q) Q = 700Q-5Q2
dTR
MR = = 700- 10Q, where Q = Q1+Q2
dQ
Thus, MR = 700 – 10 Q1 – 10 Q2

dTC1
MC1 =  20Q1
dQ 2

dTC 2
MC2 = = 40 Q2
dQ 2
Now the equilibrium occurs when:
700 – 10Q1- 10Q2 = 20Q1 and
700 – 10Q1 – 10Q2 = 40Q2

117
 Re-arranging the above equations we get the following simultaneous equation.
30Q1 + 10Q2 = 700
10Q1 + 50Q2 = 700
Solving the above equations simultaneously, we get
Q1 = 20 giga watts
Q2 = 10 giga watts
The profit maximizing level of output is, thus, Q1+Q2
= 30 giga watt
To determine the equilibrium price we substitute the total output (30) in the demand
function:
Accordingly, P = 700 – B (30)
= 550 mill birr
b) The Tekeze plant should produce 20 giga watts and the Fincha plant should
produce 10 giga watts
c) To answer this question let us graphically present the problem. In the following
figure suppose MC1, MC2 and MCm denote the initial marginal cost of Tekeze,
Fincha and the multi-plant (EELPC), and MCm denote the new marginal costs. Note
that the silt problem will increase the MC1 to MC1’ and as a result MCM will
increase to MCM’.

MC2
MC1’

MC1 MCm’

PT
MCm

550

E2

E1

D=AR
MR

Fig.6.5 118
 10 Q2 Q1 20 20 QT 30

Initially, the total output was 30 giga watts. out of which, 20 gw is produced in Tekeze
and 10gw in Fincha.
Due to siltation problem MC1 shifts up ward to MC1' and MCm shifts up ward to
MCm'. The new equilibrium takes place at E 2 i.e. the total output decreases from 30 to
QT, output of Tekeze plant decreases from 20 to Q1.
And that of Fincha increases from 10 to Q2. Hence the firm will re allocate some of its
output from Tekeze to Fincha and will decrease the total output from Tekeze to Fincha
And will decrease the total output. As to equilibrium price is concerned, it increases
from 550 to PT.
5.9 Price Discrimination
Price discrimination refers to the charging of different prices for the same good. But
not all price differences are price discrimination. If the costs of offering a certain
uniform commodity (service) to different group of customers are different (say due to
difference in transport costs), price of the commodity may differ for each group owing
to this cost difference. But this can not be considered as price discrimination. A firm is
said to be price discriminating if it is charging different prices for the same
commodity with out any justification of cost differences.
By practicing price discrimination, the monopolist can increase its total revenue and
profits.
Necessary conditions for price discrimination
For a firm to effectively practice price discrimination the following necessary
conditions should be fulfilled.
1-There should be effective separation of markets for different classes of
consumers, so that buyers of low price market can not resale the commodity in high
price market.
A market is said to be effectively separated if one of the following points is met:

119
- Geographical variation with high transport cost so that the inter market price margin
is unable to cover the transport expense.
E.g. Domestic Vs international markets.
- Exclusive use of the commodity. For some services resale is inherently difficult. For
example you can not resale Doctor’s services, Entertainment shows.
- Lack of distribution channels
2. The second necessary condition to successfully practice price discrimination is
that the price elasticity of demand should be different in each sub market.
For example, a movie theatre knows that college students and old people differ in
their willingness to pay for a ticket and can exercise discrimination by charging the
college students a higher price. This condition can be justified by using the markup
formula. Suppose the firm has a marginal cost of MC and the price elasticity’s of
demand for its product into different markets are ed1 and ed2
Then the price in each market is
MC MC
P1  , and .P 2 
1 1
1 1
ed1 ed 2
If ed1= ed2, P1 will be automatically equal to P2.
Hence, ed1 = ed2 for the prices to differ.
3- Lastly, the market should be imperfectly competitive. In other words, the seller of
the product should have some monopoly power (it should not be price taker) to
practice price discrimination.
5.10 Degrees (types) of price discrimination

The degree of price discrimination refers to the extent to which a seller can divide the
market and can take advantage of it in extracting the consumer Surplus. In economics
literature, there are three degrees of price discrimination. These are discussed one by
one here under.
1-First degree price discrimination (Perfect price discrimination)
This is a price discrimination in which the monopolist attempts to entirely take away
the consumers surplus. Ideally, a firm would like to charge each customer the

120
maximum price that the customer is writing to pay for each unit bought. We call this
maximum price the consumer’s reservation price and obviously, the consumers’
reservation prices are different due to the differences in their economic status or the
value they attach to a commodity. The practice of charging each customer his/her
reservation price is called first degree price discrimination. Note that the consumer’s
willingness to pay reservation price for a given commodity varies with the quantities
of the commodity the consumers own. The law of diminishing marginal utility implies
that a consumer’s willingness to pay for successive units of a commodity declines
because the marginal utilities of these successive units decline. Hence, in the first
degree price discrimination prices differ across customers, and a given customer may
pay more for the initial units than for others (successive units).
First degree price discrimination is the limiting case of price discrimination, the
monopolist, in this case, individually negotiate with each buyer and sell each unit of
the out put at the corresponding price given on the demand curve of the consumer,
then receiving the entire of consumer’s surplus.
For example, a doctor who knows his patients’ paying capacity charges high price
for the richest patients’ and low price for the poor patients for identical services.
This is practiced to increase revenue. If the doctor fixes the price at the richest
patients’ level, no poor will afford to pay and the doctor will not get revenue
from the poor. On the other hand, the doctor would not fix the price at the
poorest patients’ level for all patients because he knows that the rich can pay
more and he will exploit the rich. Lawyers also practice the same
discrimination for identical legal service.

Perfect price discrimination is efficient as it maximizes the total welfare, where

welfare is defined as the sum of consumer surplus and producer surplus. That is, there
is no welfare loss associated with first degree price discrimination equilibrium. The
problem with perfect price discrimination is that it hurts consumers because the
monopolist will take the entire of the consumer surplus. The other problem with
perfect discrimination is that it involves high transaction costs; it is too difficult and
costly to gather information about each customer’s price sensitively.
2-Second degree price discrimination (block pricing)

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Many firms are unable to determine which customers have the highest reservation
prices. Such firms may know, how ever, that most customers are willing to pay more
for the first unit than for successive units. This is due to the fact the typical customer’s
demand curve is down ward sloping. Such a firm can price discriminate by letting the
price each customer pays vary with the number of units the customer buys. The act of
charging different prices for different quantities of purchases is called second degree
price discrimination or some times called quantity discrimination. In second degree
price discrimination the price various only with quantity: all customers pay the same
price for a given quantity.
In second degree price discrimination, the monopolist attempts to take the major part
of the consumer surplus instead of the entire of it.
Block pricing can feasibly be implemented where:
-the number of consumers is large and price rationing can be effective e.g.
electricity and telephone services.
-the demand curves of all customers are identical and
-a single rate is applicable for a large number of buyers.
Graphically, block pricing can be explained as follows:
A monopolist that practices second degree price discrimination charges the price OP1,
for the first OQ, units, OP2 for the next Q1 Q2 units and OP3 for Q2 Q3 units. By
doing so, the monopolist will increase its total revenue by extracting the major part
the consumer surplus.

P1

P2

122
 P3
DD

Q1 Q2 Q3
Fig.6.7 Second price degree price discrimination. The monopolist receives a price OP1, for
each unit sold to a given customer for the first OQ, units, OP2 for the next Q1 Q2 units and
OP3 for the next Q2 Q3 units. By so doing, the monopolist will receive total revenue of OP, A
B C D E. If the monopolist charges a uniform price of OP3, its total revenue will only be OP3
EQ3. Hence, block pricing will enable him receive large total revenue than uniform pricing.
Note that not all quantity discounts are a form of price discrimination. Some times
selling in large quantities may reduce the unit costs of sales and as a result a firm may
charge a relatively lower per unit price for large sales than small sales. Such an action
can not be regarded as price discrimination.
3-Third degree price discrimination (multi-market price discrimination)
Typically, a firm does not know the reservation price for each of its customers. But,
the firm may know which groups of customers are likely to have higher reservation
prices than others. In such a situation the firm may divide potential customers in to
two or more groups and set a different price for each group. Such an action of
charging different prices in different markets is called third degree price
discrimination. All units of the good sold to customer with in a group (in one market)
are sold at a single price, but prices will differ among the different groups or markets.

For simplicity, let us assume that there are only two markets. To maximize profits, the
monopolist must produce the level of out put (defined by MC=MR) and sell that out
put in the two markets in such away that the marginal revenue of the last unit sold in
each market is the same. This will require the monopolist to sell the commodity at
higher p rice in the market with the less elastic demand.
For example, suppose that a monopolist has 100 units of a commodity to be sold in
one or both of two sub markets. How should the monopolist allocate the 100 units

123
between the two markets to maximize its profit? Suppose, initially, that the
monopolist simply sold 50 units in each market and also assume that the marginal
revenue of the last unit sold in market 1 is 5 and the marginal revenue of the last unit
sold in market 2 is 3.
In this case, the monopolist can increase its total revenue by decreasing the number of
units sold in market 2 and increasing the number of units sold in market 1. Hence, if
one less unit is sold in market 2, total revenue falls by $3. But by selling this unit in
market 1 total revenue increases by $5.So, by reallocating it sales from market 2 to
market 1 the monopolist can increase its total revenue by $2 ($5-3$). Obviously,
reallocation of sales will increase the firm’s total revenue until the marginal revenue
of the last unit sold in each market gets equal.
Thus we can conclude that to maximize the total revenue received from the sale of a
given quantity a commodity, the monopolist should allocate the total quantity in each
sub market in such away that the marginal revenue of the last unit sold in each sub
market is the same. Symbolically, the equilibrium condition for a third degree price
discriminating monopolist is: MC=MR1=MR2.
Now let us drive this equilibrium condition algebraically.
Assume that the firm sells its product in two markets and the demand functions of the
segmented markets are given as:
P1= f1 (Q1) and p2= f2 (Q2)
And suppose that cost function of the firm is
TC = f (Q), where Q=Q1+Q2
Q1 is the amount of the commodity sold in market 1
Q2 is the amount sold in market 2.
The total profits of the monopolist (∏) are equal to the total revenue it receives from
selling the commodity in the two markets (i.e., TR1 + TR2)minus the total cost of
producing the total out put (TC),that is,
п=TR1+TR2-TC---------------------------- (1)
But TR1=P1.Q1 and TR2 =P2. Q2

124
For ∏ to be maximized, the first derivatives of the ∏ function with respect to Q1 and
Q2 should be equal to zero. That is,
 
 0 -------------------------- --------------- (2)
Q1 Q2

 TR1 TR 2 TC

But, 0    0 -------------------- (3)
Q1 Q1 Q 2 Q1

MR1- MC1=0 or MR1 = MC1

 TR1 TR 2 TC
and 0    0 -------------------- (4)
Q 2 Q 2 Q 2 Q 2
 MR2 – MC2 = O or MR2 = MC2
Note that:
TR 2
 0 in equation (3) because TR2 is only a function of Q2.
Q1
TR1
and  0 in equation (4) because TR1 is only a function of Q1.
Q1
Now the equilibrium condition equation (2) & (4) can be summarized as.
MR1==MC1
MR2==MC2--------------------------------------------- (5)
But, note that the monopolist produce its commodity in one plant, and the fact that the
commodity is sold in market 1 or market 2 has no impact on the marginal cost of the
commodity (i.e., MC1==MC2)
Suppose—that MC1 =MC2 =MC
The equilibrium condition equation (5) can be reduced
in to MR1= MC
MR2=MC
Or MR1= MR2 =MC------------------------------------------- (6)
Thus, the equilibrium condition of a third degree price discriminating monopolist is
MR=MR2 =MC.
Numerical example

125
Suppose a monopolist sells its commodity in U.S.A and Ethiopian markets. The
demand function for the monopolist’s product in U.S.A market is given as Pu=100-Qu
and in Ethiopian market the demand function is Pe=80-2Qe, where Pu and Qu denote
price and quantity demanded in U.S A and Pe and Qe denote price and quantity
demanded in Ethiopia.
The monopolist has 55 units of the commodity.
a) How many units should be sold in Ethiopia and U.S.A?
b) In which country should the firm charge larger price? Why?
Solutions
a) the monopolist allocates its product in such a why that MRu= MRe
TRu T Re
MRu = , and , M Re 
Qu Qe

But, TRu = Pu.Qu

=(100-Qu) Qu = 100 Qu- Qu2 and
TRe = Pe. Qe
=(80-2Qe)Qe =80Qe-2Qe2

MRu 

d 100Qu  Qu 2 
=100-2Qu and
dQu

M Re 

d 100Qe  Qe 2 
)= 80 - 4Qe
dQe
The Firm maximizes its revenue when the condition MRu=MRe is fulfilled. That is, it
maximizes its revenue when:
100 -2 Qu =80-4Qe or
2Qu – 4 Qe =20--------------------------- (1
More over, we know that Qu + Qe = 55------------------ (2)
Solving equations (1) and (2) simultaneously, we obtain Qu= 40 units and Qe =15
units.

126
Thus, the monopolist should sell 40 units in U.S.A and 15 units in Ethiopia to
maximize its TR, the demand functions in each country.
Pu = 100 –Qu
Substituting 15 for Qe, we get Pe =$ 50
Hence, the firm should charge higher price in U.S.A. the reason is that the price
elasticity of demand for the firm’s commodity is lower in U.S.A than Ethiopia.
That is,
Price elasticity of demand in U.S.A (Eu) is

dQu Pu
Eu  .
dPu Qu

= -1* 60/40 = /-3/2/ = 1.5

and price elasticity of demand in Ethiopia (i.e.)is
dQe Pe
Ee  .
dPe Qe
= -1 . 50/2 = / -50/2/ =1. 67
Eu < Ee which implies that a one percent increase in price of the
commodity reduces the amount of sales by a lower percent(1.5%) in U.S.A than in
Ethiopia (1.67%).In other words, U.S.A.citizens are less sensitive to a price change
than Ethiopians so that the firm can charge higher price in U.S.A.
The fact that the firm should charge a higher price in the market having lower price
elasticity of demand can be shown algebraically as follows:
You know that the marginal revenues in two markets (market1 and 2) having price
elastic ties of demand, Ed1 and Ed2 respectively are given as:

 1 
MR1  P11   Where MR1 and P1 are marginal revenue and price in market 1
 Ed1 
 1 
MR 2  P 21   Where MR2 and P2 are marginal revenue and price in market2
 Ed 2 

127
For optimal allocation of the commodity between the two markets, Mr, = MR2 i.e.,

 1   1 
P11    P 21  
 Ed1   Ed 2 
or
1
1
P1 Ed 2

P2 1
1
Ed1
1
1
Ed 2
If /ed2/ > /ed,/the ratio will be greater than one (i.e 1+1ed2>1), which
1
1
Ed1
implies that P1/P2will be greater than one (i.e, P1/P2>1)
There fore, if /Ed2/>/Ed1/, P1>P2

Hence, the larger the price elasticity of demanded, the lower the price to be charged.
Numerical example
Suppose Ethiopian Air lines (EAL) flies only one route: from Addis Ababa to Dubai.
EAL knows that two different types of people fly to Dubai. Type A consists of rich
merchants flying to Dubai for business purposes with demand for flight of
QA = 260-0.4PA. Type B consists of poor ladies flying to Dubai in search of jobs
( such as house maid) whose total demand is QB = 240-0.6PB.
Assume that EAL has a running cost of $30,000 plus $100 per passenger and it has
decided to charge different prices for the two groups of passengers.
a. How many tickets should EAL sell to each group?
b. How much price should EAL charge each group?
c. Suppose now that EAL is prohibited by the Ethiopian government to exercise such
discrimination. How many tickets should the EAL sell to maximize its profit and at
what price?
Solution
Given

128
TC = 30,000 + 100Q
Where Q = QA+QB
QA = 260 – 0.4PA ……………………………. Merchants demand function:

PA = 650 – 2.5QA
QB = 240 – 0.6 PB………………………….. Ladies demand function
5
PB  400  QB
3
a) The equilibrium condition is that
MC=MRA = MRB
dTC
But MC =  100
dQ
dTRA
MRA = , and TRA = QA.PA = 650QA – 2.5 Q 2A
dQA
Thus, MRA = 650 – 5QA
10
Like wise MRB = 400 - QB
3
The equilibrium condition is thus presented as:
100 = 650 – 5QA
10
100 = 400 - QB
3
Solving the above equations simultaneously, we get
QA = 110 and
QB = 90
Therefore, EAL should sell 110 tickets of A type and 90 tickets of B type passengers.
b) Substituting the above quantities in their respective demand functions, we get
PA = 650 – 2.5 QA
= 650 – 2.5 (110)
= $ 375
5
PB = 400 - QB
3

129
 5
= 400 - (90) = $ 250
3
Hence, the EAL should charge $ 375for the A type passengers and $ 250 for the B
type passengers.
c) If EAL decides to charge a uniform price, the equilibrium price will be obtained
first by deriving the market demand function and then by using the usual method (MC
= MR)
Market demand (Q) = QA + QB
Q = 260 – 0.4 PA + 240 – 0.6 PB
Since prices are uniform PB = PA = P
Thus the market demand equation becomes = 500 – P or
P = 500 – Q
TR = P.Q = 500 Q – Q2
MR = 500 – 2Q
Given MC = 100, Equilibrium occurs when MC = MR, i.e.
100 = 500 – 2Q
Q = 200, and P = 500 – Q = $300
That is, EAL should sell 200 tickets at a price of $ 300 each to maximize its profit.
5.11 Social costs of monopoly: the dead weight loss
In a competitive market, price equals marginal cost of production. Monopoly power,
on the other hand, implies that price exceeds marginal cost. Because monopoly power
results in higher prices and lower quantities produced, we would expect it to make
consumers worse off and the firm better off. But suppose we value the welfare of
consumers the same as that of producers. In aggregate, does monopoly power make
consumers and producers better off or worse off?
To answer this question, suppose an industry operating under perfectly competitive
situation is suddenly monopolized. We can answer the questions by comparing the
consumer and producer surplus that results when a competitive industry produces a
good with the surplus that results when a monopolist supplies the entire market.

130
 Referring to the following figure, suppose DD represents the market demand curve,
MR represents the corresponding marginal revenue.

F
Dead
41 = pm D
weight
MC
A B Ec
Em
25 = pc
C
DD= Price = MR (for perfect competitor)
G Em
MR

0 Qm Qc Q
6 10
Fig.6.8
Here, we use consumers’ and producers’ surplus as a measure of welfare of each.
Consumer surplus is the area between the demand curve and equilibrium price and
producer surplus is the area between the equilibrium price and marginal cost curve.
- A perfect competitor’s equilibrium occurs when MC equal price or marginal
revenue at Ec and the equilibrium price and quantity are PC &QC
respectively. Here the consumer’s surplus is the area above the dropped line Pc
Ec and below the demand curve i.e. area of  Pc F Ec. On the other hand the
producer surplus is the area below the dropped line PcEc and above the MC
curve.
- A monopolist equilibrium occurs when MC = MR i.e. at Em and the
equilibrium price and quantity become Pm and Qm respectively. Hence, in
monopoly lower quantity is sold at higher price. The new consumers’ welfare
is the area above the dropped line PmD and below the demand curve (i.e. area
of  PmFD) where as the producers surplus becomes the area below the
dropped line PmD and above MC curve to the left of Qm (i.e. the area GPm
DEm)

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 - Thus monopoly power reduces the consumers’ surplus by the amount which
equals area A+B. But increases the producers’ surplus by the area A-C. The net
welfare effect (loss) is obtained by deducting the welfare loss of consumers
from the welfare gain of producers i.e.,

Net welfare = Welfare gain by producers – Welfare loss by consumers

= A-C – (A+B)
= A-C – A-B
= -C –B or – (C +B)
Thus monopoly results in a welfare loss which is given by the area ( C+B)
This area is called dead weight loss. It is gained neither by producers nor by
consumers.

The other disadvantage (Social cost) of monopoly is that is discourages innovations.

Monopolist may feel secure and have no incentive to innovate new product
(technology) since there are no competitors.

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 CHAPTER SIX
MONOPOLISTIC COMPETITION
Monopolistic competition is a market structure with many buyers and sellers in which
product differentiation exists and there are elements of both monopoly and perfect
competition.
6.1 Assumptions of Monopolistic Competition
Chamberlin’s model of monopolistic competition works under many of the assumptions of pure
competition.
1. There are large number of sellers and buyers in the group
2. The products of the sellers are differentiated, but they are close substitutes of one
another.
3. There is free entry and exit of firms in the group.
4. The goal of the firm is profit maximization.
5. The prices of factors and technology are given.
6. The firm is assumed to behave as if it knows its demand and cost curves with
certainty.
7. The long run consists of a number of identical short run periods, which are
assumed to be independent of one another, in the sense that decisions in one
period do not affect future periods and will not be affected by past decisions. The
optimum decision for one period is the optimum decision for any other period,
Thus by assumption, maximization of short run profit implies long run profit
maximization.

133
8. Heroic Assumptions – Both demand and cost curves of all products are
uniform throughout the group. This requires that consumer’s preference be evenly
distributed among the different sellers, and that differences between the products be
such as not to give rise to differences in costs. This assumption is made in order to be
able to show the equilibrium of the firm and the group on the same diagram. But this
assumption leads to a model that is very restrictive, because it excludes the inclusion
of the firm in the group which has similar products but different cost of production.
Chamberlin himself recognized that the ‘heroic’ assumptions are unrealistic and he relaxes them at a
later stage.
6.2 Product Differentiation and the Demand Curve
Product differentiation is any feature of a product of sellers that makes buyers to
prefer one product or sellers to that of another. It leads to different consumer’s
preference. It is also the basis for establishing a downward sloping demand curve.
Chamberlin suggested that the demand for a product is not only determined by the
price – but also by the style of the product, the services associated with it and the
selling activities of the firm. Thus, Chamberlin introduced two additional policy
variables in the theory of the firm: the product itself and selling costs. Hence, the
demand curve shifts if:
1. The style, services, or the selling strategy of the firm changes,
2. Competitors change their price, output, services or selling policies of a product;
3. Tastes, incomes, prices or selling policies of products from other industries change.
Product differentiation is intended to distinguish the product of one producer from
that of the other producer in the ‘industry’ (in the group). It can be real differentiation
or fancied (artificial) differentiation. Real differentiation: exists when the inherent
characteristics of the products have slight differences (slight difference in quality,
durability), in the specification of products (terms of credit, transportation, guarantee,
location of the firm), which determine the convenience with which a product is
accessible to the consumer. Example: chemical differences existing in shampoos or
conditioners. On the other hand, fancied differentiation is established by advertising
or differences in packaging or differences in design (color or shape) or simply by
brand name.

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In any case, the aim of product differentiation is to make the product unique in the
mind of the consumers. And the effect of product differentiation leaves firms under
monopolistic competition with some degree of monopoly power. Because of this the
firm is not a price – taker.

Monopolistic competition has less power than pure monopoly and more power than
perfectly competitive market structure over the price of its product. The power of the
firm over price is limited because of the existence of other competitors. Product
differentiation creates brand loyalty and gives rise to a negatively sloped demand
curve.
Cost of the Firm:
Cost structure of a firm under monopolistic competition is similar to that of any other
firm (perfectly competitive and monopoly firm). The AVC, MC, ATC are all U-
shaped implying that there is only single level of output which can be optimally
produced.
There is another cost, the cost of selling activities, which is introduced in the theory of
the firm by chamberlin. The recognition of product differentiation provides the
rationale for the selling expenses incurred by the firm. With advertising and other
selling activities the firm seeks to differentiate more his product from the products of
other firms in the group. Chamberlin assumes that advertising will shift the demand
and will make the demand less elastic.
Total cost = Production cost + Selling cost.
Like any other costs the average selling cost is U-shaped. That means there are
economies and diseconomies of selling cost as output increases.

Average Selling Cost

Average Selling Cost Curve

Q
Initially, expansion
o of output will not require an equi-proportional increase in selling
costs, and this leads to a fall in the average selling expenditure. However, beyond a

135
certain level of output, the firm will have to spend more per unit in order to attract
customers from other firms. The U shaped average selling cost, added to U shaped
average production cost, yields a U shaped ATC curve.
6.3 The Concept of Industry and Product Group
In perfectly competitive market, firms included in an industry are easy to determine
because they all produce same product. But product differentiation creates difficulty
in the analytical treatment of the industry. Firms under monopolistic competition do
not constitute an industry because they produce differentiated products. Hence, for
this market structure, the concept of industry needs redefinition. Chamberlin uses the
concept of ‘product group’, which includes products which are ‘closely related’. The
products should be close technological and economic substitutes. Technological
substitutes are products which can technically cover the same want. For example,
Motor cars are all used for transportation, all powder soaps are used for washing
purpose. On the other hand, Economic substitutes are products which cover same
want and have similar prices. Products with different cost structure are not economic
substitutes.
An operational definition of the ‘product group’ is the demand of each single product
be highly elastic and that it shifts appreciably when the price of other products in the group
changes. In other words, products forming the group or ‘industry’ should have high price and
cross-elasticities. But, ‘how much high the elasticities should be?’ is not indicated.
Product differentiation allows each firm to charge different prices and practically there will
not be unique equilibrium price but an equilibrium cluster of prices, reflecting the preferences
of consumers for the products of the various firms in the group. When the market demand
shifts or cost conditions change in a way affecting all firms, then the entire cluster of prices
will rise or fall simultaneously. This more realistic market situation emerges from
Chamberlin’s analysis after the relaxation of his ‘heroic assumptions’ .
6.4. Equilibrium of the Firm The product differentiation gives rise to a negatively sloped
demand curve. The demand curve is more elastic because of the assumption of large number
of firms. Since the firm is one of the very large numbers of sellers if it reduces its price, the
increase in its sales will produce loss of sales distributed more or less equally over all the
other firms, so that each one of them will suffer a negligible loss in customers, not sufficient

136
to induce them to change their own price. Therefore, the individual demand curve, DD. is a
planned sales curve, drawn on the assumption that the competitors will not react to changes in
the particular firm’s price.
D Planned sale

D Q

In order to be able to analyze the equilibrium of the firm and of the industry on the same
diagram Chamberlin made two ‘heroic assumption’, namely that firms have identical costs,
and consumers’ preferences are evenly distributed among the different products. That is,
although the products are differentiated, all firms have identical demand and cost curves.
Under these assumptions the price in the market will be unique.
Chamberlin develops three models of equilibrium.
Model 1: Equilibrium with new firms entering the industry
Assumption: Each firm is in short run equilibrium with excess profit.

LMC

dE

C
Pm LAC

Pe E
B
A

d|E d|

Qe Qm Q

137
 MR2 MR1

The firm in the short run is in equilibrium at point C where MC = MR. At

equilibrium point a given firm attains abnormal profit, area of PmCBA. The excess
profit attracts firms to come in to the market with competing brands. The result of
new entry is a downward shift of the demand curve dd’, since the market is shared by
a larger number of sellers. The process will continue until the dd curve is tangent to
the average cost curve at its equilibrium. i.e. until the abnormal profit is eliminated
and excess profit is wiped out. In the final equilibrium of the firm, the price will be Pe
and the ultimate demand curve will be dd|E. In the long run the equilibrium occurs at
P=LAC, at this point there will be neither entry nor exit, and the equilibrium is stable.
Model 2: Equilibrium with price competition
In this model, the number of firms in the industry is assumed to be compatible with
long run equilibrium, so that neither entry nor exit will take place. But the ruling
price in the short run is assumed to be higher than the equilibrium price.

Actual Sales curve or share of the Market Curve

d D
LMC
P0
d|1

P1
d||1 LAC

P2
d|2 d

e d|1
Pe

d||1
D
d|e

138
 X0 X1X2Xe MR Xol
The analysis of this case is done by the introduction of a second demand curve,
labeled DD’, which shows the actual sales of the firm at each price after accounting
for the adjustments of the prices of other firms in the group. DD’ is sometimes called
actual sales curve or share of the market curve. It is a locus of points of shifting dd
curves as competitors change their price.
Assume the firm is at a non-equilibrium position Po and Xo. The firm, in an attempt

to maximize its profit, lower the price to P1 expecting to sell X 'o . This level of sales is
not actually realized because all other firms faced by the same demand and cost
condition have an incentive to act in the same way simultaneously. Thus, all firms
acting independently reduce their price simultaneously to P1. As a result, the dd curve

shifts downward and the firm instead of selling expected quantity X 'o sales actual
quantity X1 (whish is less than the expected quantity)on the shifted dd curve dd’ along
the share curve DD’.
According to Chamberlin, the firm suffers from myopia and does not learn from pas
experience and may further reduce price expecting that the others will not react. Thus
the firm lowers its price again in an attempt to reach equilibrium, but instead of the
expected sales Xo the firm achieves actual sales of X 2, because all other firms act
identically, though independently. The process stops when the dd’ curve has shifted
so far to the left as to be tangent to the LAC curve. Equilibrium is determined by the
tangency of dd’ and the LAC. At the point of tangency the DD| curve cuts the dd|
curve. Obviously it will pay no one firm to cut the price beyond that point, because
its costs of producing the larger output would exceed the price at which this output
could be sold in the market.
Model 3: Equilibrium through Entry and Price Competition.
Chamberlin suggests that in the real world adjustment towards long run equilibrium
takes place through both entry/exit and price competition. Price adjustments are
shown along the dd| curve while entry/exit cause shifts in the DD’ curve. Equilibrium

139
is stable if the dd| curve is tangent to the AC curve and expected sales are equal to
actual sales, i..e, DD| curve cuts dd| curve at the point of tangency of dd’ & LAC.

D|
D* D LMC

d
e2
P

C d| A

LAC
P1 B
d* e1

d||
E d
P*
d|
|
D D* D

d*

d||

X X1 X2 X* MR*

Let’s start from e1 where there is an abnormal profit. This excess profit attracts other
firms to enter into the market. When they enter in to the market, the market will be
shared by larger number of firms then DD (market share curve) keeps on shifting left
ward until it becomes tangent to LAC, DD|.
Although, firms earn normal profit, e2 does not constitute stable equilibrium, because
the firm believes that dd is its demand curve. By taking dd as its sales planning
function the firm will feel that it can expand sales and earn excess profit by reducing
price to P1. But all the firms will be doing the same thing simultaneously. As price is

140
reduced by all firms dd shifts down to dd| and each firm realizes a loss of area CABP1
instead of positive profit.
The firm is still in myopia assumption, now also he believes that he can obtain
positive profit by cutting its price. However, all the firms do the same. One might
think that the process would stop when dd becomes tangent to the LAC, dd*. This
would be so if the firm could produce X*. However, there are so many firms and the
share of the firm is only X2. The firm still on the myopia assumption believes that it
can reach X* if he reduces to P*. However, all firms do the same and dd* falls below
the LAC with ever increasing losses. At this time, the financially weakest firms will
leave the market. So that the surviving firms will have a higher market share then
DD| will move to the right with dd | . Exit will continue until the dd becomes tangent
to the LAC curve and the market share curve, DD, cuts the dd curve at the point of
tangency, point E.
Equilibrium is then stable at point E with normal profits earned by all firms and no
entry or exit taking place. The equilibrium price is P*, which is unique and each firm
have a share equal to OX* at E, expected share is equal to actual sale.
Criticism of Chamberlin’s Large Group Model

1. The assumption of product differentiation is incompatible with the assumption

of independent action and free entry.
2. It is hard to accept the myopic behavior of business men implied by the model.
For sure some firms learn from their past mistakes.
3. The concept of industry was destroyed by the recognition of product
differentiation. Heterogeneous products can not be added to give industry.
4. The model assumes large number of firms & high cross price elasticities
among the products in the industry but the model does not objectively define
the number of firms and the magnitude of elasticity required to have
monopolistic market structure.
Despite his critics chamberlin’s contribution to the theory of pricing are:
a) Introduction of product differentiation and selling strategy as two additional
policy variables in the decision process of the firm. These factors are the

141
 basis for the non price competition which is a typical form of competition in
the real world.
b) Introduction of the share of the market demand curve as a tool of analysis.
2.6 Excess Capacity and Welfare Loss
Under perfectly competitive firm MC = MR = LAC = P = AC at the minimum point
of LAC and resources are efficiently allocated. On the other hand, under monopolistic
competition MC = MR and P = AC, but P > MC (because P > MR). As a result price
will be higher and output will be lower in monopolistic competition as compared to
the perfectly competitive market.
In monopolistically competitive market structure there are too many firms in the
industry each producing less than the optimal (at a higher cost) because of:

1. The tangency of the long run average cost and demand occurs at the falling
point of the average cost curve.
2. Firms incur selling cost which is not presented in perfectly competitive market
structure. Therefore, firms in monopolistically competitive market structure
have an excess capacity measured by the difference between the ideal output
(YF) corresponding to the minimum cost level on the LAC curve and the
output actually obtained in the long run (YE).

P
LMC
d

Excess
Capacity

PE LAC
PF

142
 YE YF Y
MR
Chamberlin argues that the excess capacity and misallocation of resources is valid
only if one assumes that the demand curve of each individual firm is horizontal. If
demand is downward sloping and firms enter into active price competition and entry
is free in the industry. YF cannot be considered as a socially optimal level of output.
Consumers desire a variety of products. And product differentiation reflects the desire
of consumers to pay higher price for differentiated product. Therefore, the difference
between the actual output YE and the minimum cost output YF is not a measure of
excess capacity but rather a measure of the “social cost of producing and offering the
consumers a greater variety of output.”

P D| D
LAC
d
P

d
|
D
D

Y YE YF Y
Excess Capacity Social Cost

Chamberlin’s argument is based on the assumption of active price competition and

free entry. He argues that the equilibrium output will be very close to the minimum
cost output, because firms will be competing along their individual dd curves which
are very elastic.

Chamberlin divides the competition into two, price and non-price competition. If
firms avoid price competition and instead enter into a non price competition there will
be an excess capacity in each firm and inefficient product capacity in the industry and

143
that is an inexhaustible economy of scale for the firms in the industry. Chamberlin
argues “excess capacity in monopolistically competitive market structure comes
because of the non-price competition coupled with free entry” . Excess capacity
is the difference between YE and Y.

In summary, if the market is monopolistically competitive the output is lower than

society would ideally like it to be (that is, price is higher than MC, but the socially
desired P = MC cannot be achieved without destroying the whole private enterprise
system.

144
 CHAPTER THREE:
OLIGOPOLY

 OLIGOPOLY is a market organization in which there are few firms that produce
identical or closely substituted products (identical or differentiated). Oligopoly is said to
exist when there are more than one seller in the market, but their number is not so large
so as to make the contribution of each firm negligible. Firms thus, are situated
mutually interdependence. That is they behave as if any one firm’s action directly affect
other rivals and is affected by the action of others.
 In oligopoly market barrier to entry is difficult or impossible for new firms to enter the
market. Barrier to entry may arise as a result of
1. Scale of economics and large capital
requirement than other markets except
monopoly
2. Patents or access to technology or raw
materials may exclude potential competitors.
Generally, the underlying reasons for the
evolution of oligopoly are economic of scale
and the advance of mergers.
 DUOPOLY is a special case of oligopoly in which there are only two firms in the
industry. The duopoly case allows as to capture many of the important features of firms
engaging in strategic interaction without the notational complication involved in models
with a large number of firms. Also, we will limit ourselves investigation of the case in
which each firm is producing an identical product. This allows us to avoid the problems
of product differentiation and focus only on strategic interaction.
 If one firm reduces its price it will attract consumers and increases its sells, leading to a
substantial loss of sales by other firms in the industry. The other firms may or may not
reduce their price, but the firm that reduces price can no longer assume other firms do

145
 not notice his/her action. The outcome of his/her decision depends on the reaction of
other firms.
 The outcomes (consequences) of price changes by the firm under consideration are
uncertain. Firm under oligopoly market may
1. Spend a lot of time to guess each others action or reaction
2. Be bitter rivals of each other, competing by price changes (price
war may be started)
3. Tacitly1 (informally or implicitly) agree to compete by
advertising but not by price changes
4. Form a collusion or cooperation (some kind of agreement) rather
than competing. Therefore, there are many solutions to oligopoly problem. This
means that there is no unique solution like that of perfect competition. Monopoly,
and monopolistic competition.
 In general, oligopoly market is divided in to two. These are
I. Non collusive oligopoly
II. Collusive oligopoly. Following we will discuss
models for oligopoly problems under these two kinds of oligopoly.

3.1. NON-COLLUSIVE OLIGOPOLY: This implies that firms do not enter in to collusive
agreement. There are a number of non-collusive oligopoly models that give us stable
solution to the oligopoly problem that may arise. Example
1. The Cournot’s model (1838)
2. The Kinked demand (Sweezy’s) model
(1839)
3. The Stackelberg’s model (1920)
4. The Bertrand’s model (1883)
5. The Chamberlain’s model (1883). For this
course we will discuss only some of them.

3.1.1. COURNOT’S DUOPOLY MODEL

Augustine Cournot (1838) assumed that there are only two firms each having (owning) a
mineral water well and operating at zero cost. Let one of the firms A and the other B.
Both sell their output in a market with a down wars sloping DD curve. Each firm acts
on the assumption that its competitors will not change its output and decides its own
output so as to maximize profit.
Assume that firm A is the first to start producing and selling mineral water to maximize
profit. A will produce OA amount (1/2 of AD) and sell it at a price P A, where profits are
at maximum because at this point MR = MC = 0.
1
Tacitly means understood without being expressed directly 9formally)

146
 P D’’

C=d=1
PA

F
PB k

O
MC
A B D’

MRA MRB

In the first period

 The equilibrium output level of firm A is at point A (OA amount) where MR A=MC.
Firm A faces DD curve denoted by D’D’. At the midpoint of D’D’ that is at point C, the
elasticity of DD at this level of output is unity and TR of the firm is the maximum. With
zero cost and hence MC, maximum TR implies maximum profit. That is, the area given
by OACPA.
 Further let us assume that B enters into the market and faces the DD curve given by
CD’. It is this time that the Cournot assumption comes into picture. Now firm B
assumes that firm A will keep its output fixed at OA and hence considers that its own
DD curve as CD’. Hence, firm B will produce AB amount where MRB=MC (i.e. ½ of
AD’, which is not supplied by firm A, or 1/4 th of the total market DD, OD’), and will
sell it at price PB. Clearly, at the midpoint of firm B’s DD curve that is at point F the
elasticity of DD is unity and therefore TR of firm B is the maximum. The profit of firm
B is given by area OBFPB.

In the second period

 Firm A who faced a competitor that is firm B will assume that firm B will keep on
producing that constant amount AB in the next period. Therefore, A will decide to
produce ½ of BD’ (which is not supplied by firm B). That is, since B covered 1/4 th of
the total market, A will supply in the second period ½ (1-1/4) = 3/8= 0.375 of the total
market DD (OD’).

147
  Assuming A will keep on producing 3/8 of the market, firm B will react to the latest
decision made by firm A by producing ½ of the unsupplied section of the market. That
is, ½(1-3/8)= 5/16=0.3125.

In the third period

 Once again firm A continues to assume that firm B will keep on (not change) its
quantity supply at 5/16 and thus will decide to produce ½ of the remainder of the
market in the third period. That is, ½ (1-5/16) = 11/32 = 0.34375. Similarly, firm B will
assume as firm A and will supply ½ of the remainder of the market. That is ½(1-11/32)
= 21/64 = 0.3125.
 This action-reaction pattern continues because firms have naïve behaviour
(assumption)2 of never learning from their past pattern of reaction from their rival.
Thus, gradually A’s sales decreases while that of B’s increases. However, eventually
equilibrium is reached where each firm supply (produce) 1/3 of the total market DD.
Thus, the action-reaction ends (settles) and together they supply 2/3 (1/3+1/3) of the
total DD.
 Each firm maximizes its profit in each period but the industry profit is not maximized.
That is, each firm’s profit and hence their joint profit would have been higher if they
have recognised their interdependence after their failure in forecasting the correct
reaction of their rival. Recognising their interdependence or forming open collusion
would lead them to act as a monopolist, produce ½ of the market DD jointly, sell that
output at a profit maximizing P, and sharing the market equally. That is, each can
produce ¼ of the market instead of 1/3.
 SUMMERY
Firm A Firm B
st
 1 period=1/2 1//2(1-1/2)=1/4
nd
 2 period=1/2(1-1/4)=(1/2-1/8)=3/8 ½(1-3/8) or (1/4+1/16)=5/6
rd
 3 period= ½(1-5/16) or (1/2-1/8-1/32)=11/32 ½(1-11/32) or
(1/4+1/16+1/64)=21/64
 4th period=1/2(1-21/64) or (1/2-1/8-1/32-1/128) ½(1-43/128) or
(1/4+1/16+1/64+1/256)

=43/128 … = 58/256 …
 We observe that the output of A declines while that of B increases gradually.
Therefore, for n period we have
=1/2-1/8-1/32-1/128 … =1/4+1/16+1/64+1/256 …

2
Naïve assumption is disproved trust (believe) that someone is telling the truth (doing good) or
people’s intention in general and that life is simple and fair.

148
 =1/2-(1/8+1/8(1/4)+1/8(1/4)2+1/8(1/4)3+…)
=(1/4+1/4(1/4)+1/4(1/4)2+1/4(1/4)3+…)

a r a r

 Applying the summation formula for an infinite geometric series:

S = a where, s is sum, a is 1st term, and r is ratio.
1- r
 For A = ½ - ⅛ => For B= 1/4
1-1/4 1-1/4
=½ - ⅛ = 1/4
¾ 3/4
=½ - ⅛ (4/3) = ¼ (3/4)
= ½ - 4/24 = 4/12
=½ - 1/6=1/3 = 1/3
 Each firm in the long run (during n period) supplies 1/3 of the market (together they will
supply 2/3 of the output under perfect competition) and sell at a common price, which is
2/3 of the monopoly price. In other word, output OD’ is under perfect competition, half of
OD’ (i.e.OA) is under monopoly, and 2/3 of OD’ is output under duopoly using the
Cournot’s model.
 Thus, the Cournot’s case is stable and is one possible solution to the duopoly problem.
However, it is based on an extraordinary naïve assumption that each firm believes the
other firm will not change its output even after repeatedly observing changes.
 Observe that if there are three firms in the industry, each will supply ¼ of the market (¾
of the output under perfect competition) according the Cournot’s model. If there are four
firms, each 1/5 of the market (4/5 of the output under perfect competition) and so on. In
general, if there are n firms in the industry, each will supply 1/n +1 of the market and
together n/n+1 of the output that would have been supplied under perfect competition.
 Mathematical version of the Cournot model. It is based on the following
assumptions
1. Each firm maximizes profit by assuming the output of the other is constant
(ignoring their interdependence or naïve assumption).
2. The duopolies face the same demand function (curve).
3. The MRs of the duopolies need not be the same. This is because if the
duopolies are of unequal size, the one with the larger output or smaller MC
will have smaller MR. This implies that in the short run the duopolies will
supply different output levels but sell at the same price since they supply
identical products it is the total output that determines price.

149
 4. The duopolies have different cost function.
5. In the long run, however, each firm will supply 1/3 of the market

 Example: Assume that the market demand and cost functions of the duopolies are
P =100 - 0.5Q, where Q = q1+q2
TC1= 5q1
TC2 = 0.5q22. Given these answer the questions that follow
A. Determine the short run equilibrium output of each duopoly ignoring their
interdependence (with naive assumption)
B. What is the short run market price?
C. Find the demand functions of the duopolies (the reaction curves or graphic
solution of Cournot’ model and draw) and show the short run output
levels.
D. Calculate the short run profits of each duopoly and the industry profit.
E. Verify the economic profit of each duopoly graphically
F. Explain the relationship between output and MR in the short run.
G. Calculate the long run equilibrium output of each duopoly, market price,
and economic profits of each firm and the industry profit as a whole
 Solution:
st
A. 1 find TR1 = Pq1
= (100 – 0.5 (q1+q2)) q1
= 100q1 –0.5q12 – 0.5q1q2
2nd find MR1 = ∂TR1 = 100 –q1 – 0.5q2
∂q1
rd
3 find MR1 = ∂TC1 = 5
∂q1
th
4 equate MR1 = MC1
100 – q1 – 0.5q2 = 5
100 – 5 - q1 – 0.5q2 = 0
95 – q1 – 0.5q2 = 0
95 = q1 + 0.5q2 -------------------------------------------- (1)
th
5 find TR2 = Pq2
= (100 – 0.5 (q1+q2)) q2
= 100q2 – 0.5q22 – 0.5q2q1
6th find MR2 = ∂TR2 = 100 – q2 – 0.5q1
∂q2
th
7 find MC2 = ∂TC2 = q2
∂q2

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 8th equate MR2 = MC2
100 – q2 – 0.5q1 = q2
100 – q2 – q2 – 0.5q1 = 0
100 – 2q2 – 0.5q1 = 0
100 = 2q2 +0.5q1 --------------------------------------- (2)
th
9 The profit maximizing (loss minimizing) output of q1 and q2 can be solved
from the two equations using simultaneous equation method. That is
q1 + 0.5q2 = 95
(0.5q1 + 2q2 = 100) (–2)
q1 + 0.5q2 = 95
-q1 – 4q2 = -200
-3.5q2 = -105
q2 = 105/3.5 = 30, substituting this in any on of the above equation gives
the value of q1. That is
q1 + 0.5q2 = 95
q1 + 0.5 (30) = 95
q1 = 95 – 15 = 80
Q = q1 + q2 = 80 +30 = 110
B. Market price: P = 100 – 0.5Q, where q1 + q2
= 100 – 0.5 (80 + 30)
= 100 – 0.5 (110)
= 100 – 55 = 45
C. The demand functions (reaction curves) of the duopolies are obtained by solving
for q1 and q2 from the two equations as follows.
95 = q1 + 0.5q2
q1 = 95 – 0.5q2, is the demand function for firm 1. Hence,
 If q2 = 0, then q1 = 95 and if q1 = 0, then q2 = 190
100 = 2q2 + 0.5q1
2q2 = 100 – 0.5q1
q2 = 50 – 0.25q1, is the demand function for firm 2. Hence,
 If q1 = 0, then q2 = 50 and if q2 = 0, then q1 = 200. The reaction curves (graphic
solution of Cournot’s model) is
q2

190
Firm 1’s reaction curve

50 Equilibrium

30 Firm 2’s reaction curve

151
 q1
80 95 200

 At the equilibrium each firm maximizes their own profit. But the industry profit is not
maximized. Why firms choose these sub optimal output? The reason is that, the Cournot
pattern of behaviour implies that the firms do not learn from past experience, each
expects the other to remain at a given position. Each firm acts independently. That is,
each does not know (recognise) the other will behave (hold) the same assumption.
D. The economic profits of each duopoly
Π1 = Pq1 – TC1 Π2 = Pq2 – TC2
= 45(80) – 5(80) = 45 (30) – 0.5 (30) 2
= 3600 – 400 = 3200 =1350 – 450 = 900
Π= 3200 + 900 = 4100 is the total industry profit due to naïve assumption
E. The relevant curves to show profits graphically are
-The market DD curve
-The MR curve derived from the market DD curve
-Each firm’s MC and ATC curves
P P MC2

100 MC1 100 ATC2

ATC1

45 45

30

5 15

Q 30 100 200
80 100 200
Q

Π1 = q1 (P – ATC1) Π2 = q2 (P – ATC2)
= 80 (45 – 5) = 30 (45 – 15)

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 = 80 (40) = 30 (30)
= 3200 = 900
F. Firm 1 has lower MR than firm 2 because q1 > q2 (80 > 30)
MR1 = 100 – q1 – 0.5q2 MR2 = 100 – q2 – 0.5q1
= 100 – 80 – 0.5 (30) = 100 – 30 – 0.5(80)
= 100 – 80 – 15 = 100 – 30 – 40
=5 = 30
MR1 < MR2 because MC1 < MC2 and q1 >q2
G. The long run equilibrium output and price are calculated from the MR functions
using simultaneous equation method. That is
q1 + 0.5q2 = 100
(0.5q1 + q2 = 100) (-2)
q1 + 0.5q2 = 100
-q1 – 2q2 = -200
-1.5q2 = -100
q2 = 100/1.5 = 66.7, substituting this in any of the above MR will give us q 1
in the long run. That is
q1 + 0.5q2 = 100
q1 = 100 –0.5 (66.7)
q1 = 100 – 33.3 = 66.7
=> P = 100 – 0.5Q
P = 100 – 0.5 (66.7 +66.7)
P = 100 – 66.7 = 33.3
=> Π1 = Pq1 – TC1 Π2 = Pq2 – TC2
= 33.3 (66.7) – 5(66.7) = 33.3 (66.7) – 0.5 (66.7) 2
= 2221.11 – 333.5 = 2221.11 – 2224.45
= 1887.61 = -3.34
Π = Π1 + Π2 = 1887.61 + (-3.34) = 1884.27 is total industry profit in
the long run. Note that, each firm’s and industry profits are higher in
the short run than in the long run.

 Exercise: Given, (1) P = 140 – 0.6Q, TC1 = 7q1, TC2 = 0.6q22 and
(2) P = 150 – 8Q, TC1 = 10q1, TC2 = 4q22 answer the questions A to G
as done in the example. Note that Q = q1 + q2
 Answer: For the first
(A) q2 = 35 and q1 = 93.333
(B) P = 63
(C) q1 = 110.8 – 0.5q2. Then if q2 = 0, q1 =110.8, if q1 = 0, q2 = 221.6 and

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 q2 = 58.333 – 0.25q1. Then, if q1 = 0, q2 = 58.33, if q2 = 0, q1 =233.33.
Draw the graph plotting the values of q1 and q2 for the above DD
functions.
(D) Π1= 5224.8, Π2 = 1470, and Π = 6694.8
(E) From the graphs you will get Π1 = q1 (P – ATC1) = 93.33 (63 – 7) =
5224.8 and Π2 = q2 (P – ATC2) = 35 (63 – 21) = 1470
(F) MR1 = 140 - 1.2q1 – 0.6q2 = 140 – 1.2 (93.33) – 0.6 (35) = 7
MR2 = 140 – 0.6q1 – 1.2q2 = 140 – 0.6 (93.33) – 1.2 (35) = 42
Since MC1 (7) < MC2 (42) and MR1 (7) < MR2 (42), then q1 (93.33) > q2
(35)
(G) MR1 = 1.2q1 + 0.6q2 = 140
(MR2 = 0.6q1 + 1.2q2 = 140) (-2)
1.2q1 + 0.6q2 =140
-1.2q1 – 2.4q2 = -280
q2 = -140/ -1.8 = 77.77 and q1 = 77.77, P = 46.76
Π1= 3092.5, Π2= 5.3, and Π= 3097.8
 For the second
(A) q2 = 4 and q1 = 6.75
(B) P = 64
(C) q1 = 8.75 – 0.5q2 .Then, if q2 = 0, q1 = 8.75, if q1 = 0, q2 = 17.5 and
q2 = 6.25 – 0.33q1. Then, if q1 = 0, q2 = 6.25, if q2 =0, q1 = 18.75. Draw
the graph plotting the values of q1 and q2 for the above DD functions.
(D) Π1 =364.5, Π2 = 192, and Π =556.5
(E) From the graphs we will get Π1= q1 (P – ATC1) = 6.75 (64 – 10) = 364.5
and Π2= q2 (P – ATC2) = 4 (64 – 16) = 192
(F) MR1 = 150 – 16q1 –8q2 = 150 – 16 (6.75) – 8 (4) = 10
MR2 = 150 –8q1 –16q2 = 150 – 8(6.75) – 16(4) = 32
Since MC1 < MC2 and MR1 < MR2, then q1 > q2
(G) 16q1 + 8q2 = 150
(8q1 + 16q2 = 150) (-2)
16q1 + 8q2 = 150
–16q1 – 16q2 = -300
q2 and q1 are = -150/-8 = 6.25, Q = 12.5, P = 50
Π1= 250, Π2= 156.25, and Π= 406.25

8.1.2. THE STACKELBERG MODEL (Quantity leadership)

 This model often used to describe industries in which there is a dominant firm or a
natural leader. For example, IBM is often considered to be a dominant firm in the
computer industry. A commonly observed pattern of behaviour is for the smaller firms

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 in the computer industry to wait for IBM’s announcements of new products and then
adjust their own product decisions accordingly. In this case we might want to model the
computer industry with IBM playing the role of a Stackelberg leader and the other firms
in the industry being Stackelberg follower.
 Suppose that firm 1 is the leader and that it chooses to produce q 1. Firm 2 responds by
choosing a quantity q2. Each firm knows that the equilibrium price in the market
depends on the total output produced. That is by substituting Q (q 1 +q2) in the inverse
demand function (curve).
 What output should the leader choose to produce to maximize profits? The answer
depends on how the leader thinks the followers will react to its choice. Presumably, the
leader should expect that the follower will also attempt to maximize profits as well,
given the choice made by the leader. In order for the leader to make a sensible decision
about its own product, it has to consider the follower’s profit maximization problem as
its own.
 Numerical example: Consider the example we have used to describe Cournot’s model.
That is, P = 100 – 0.5Q, where Q=q1 + q2, TC1 = 5q1, and TC2 = 0.5q22. Given this,
(A) Find the equilibrium q1, q2, market price, Π1, and Π2
- Firm 1 being Stackelbrg’s sophisticated leader and firm 2 the
follower
- Firm 2 being Stacklberg’s sophisticated leader and 1 the follower
(B) From the view point of profit obtained is it better for the firms to be a
leader or a follower?
 Solution:
A. The reaction (DD) functions or curves are found by taking the partial derivatives
w.r.t. q1 and q2 and equating to zero.
Π1= Pq1 – TC1= (100 –0.5 (q1+q2)) q1 –5q1
= 100q1 – 0.5q12 – 0.5q1q2 – 5q1
= 95q1 – 0.5q12 - 0.5q1q2
Π2 = Pq2 – TC2 = (100 – 0.5 (q1+q2) q2 –0.5q22
= 100q2 – 0.5q1q2 – 0.5q22 – 0.5q22
= 100q2 – 0.5q1q2 – q22
 The partial derivatives w.r.t. q1 and q2
 ∂ Π1= 95 – 0.5q2 – q1
 ∂q1
 ∂ Π1= 100 – 0.5q1 – 2q2
 ∂q1
 The reaction (DD) function are
 q1= 95 – 0.5q2 --- firm 1 reaction (DD) function
 q2= 50 – 0.25q1 --- firm 2 reaction (DD) function

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 Stakelberg’s solution with firm 1 being the sophisticated leader. Firm 1 will
substitute firm 2’s reaction (DD) function in its own profit equation to
produce an output that will maximize profit as if it were a monopoly. That is
Π1= Pq1 – TC1
= 95q1 – 0.5q12 – 0.5q1q2, substituting firm 2’s DD function
= 95q1 – 0.5q12 – 0.5q1 (50 – 0.25q1)
= 95q1 – 0.5q12 – 25q1 + 0.125q12
= 70q1 – 0.375q12
 The first order condition of the profit function w.r.t. q1
 ∂Π1= 70 – 0.75q1
∂q1
= 70= 0.75q1
= q1 = 70/0.75 = 93.333
Π1= 70q1 – 0.375q12
= 70 (93.333) – 0.375 (93.333) 2
= 6533.333 – 3266.666 = 3266.66
 Firm 2 will substitute firm 1’s output in its own DD as a follower. That is
 q2 = 50 – 0.25q1
= 50 – 0.25 (93.333)
= 50 – 23.333 = 26.666
Π2 = 100q2 – q22 – 0.5q1q2
= 100 (26.666) – 26.6662 – 0.5 (93.333) (26.666)
= 2666.66 – 711.1 – 0.5 (2488.8)
= 2666.7 – 711.1 – 1244.4 = 711.1
 P = 100 – 0.5 Q
= 100 – 0.5 (93.33 + 26.666)
= 100 – 0.5 (120)
= 100 – 60 = 40
 Stakelberg’s solution with firm 2 being the sophisticated leader. It will
substitute firm 1’s DD function in its own profit function to produce an
output that will maximize its profit as it were a monopoly. That is
 Π2 =Pq2 – TC2
 Π2 = 100q2 – q22 – 0.5q1q2, substituting firm 1’s DD function
= 100q2 – q22 – 0.5q2 (95 – 0.5q2)
= 100q2 – q22 – 47.5q2 + 0.25 q22
= 52.5q2 – 0.75q22
 The first order condition of Π2 w.r.t.q2 gives
 ∂ Π2 = 52.5 – 1.5q2
∂q2

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 = 52.5 = 1.5q2
= q2 = 52.5/1.5 = 35
Π2 = 52.2q2 – 0.75q22
= 52.2 (35) – 0.75 (35) 2
= 1837.5 – 0.75 (1225)
= 1837.5 – 918.75 = 918.75
 As a follower firm 1 will substitute the output produced by firm 2 on its DD
function. That is
 q1 = 95 – 0.5 q2
= 95 – 0.5 (35)
= 95 – 17.5 = 77.5
 Π1 = 95q1 – 0.5q12 – 0.5q1q2
= 95 (77.5) – 0.5 (77.5) 2 – 0.5 (35) (77.5)
= 7362.5 – 3003.125 –1356.25
= 3003.125
 P = 100 – 0.5 (35 + 77.5)
= 100 – 0.5 (112.5)
= 100 – 56.25 = 43.75
B. As can be seen from the profits as a leader and
follower, both are better off as a leader.

8.1.3. THE “KINKED DEMAND” MODEL: SWEEZY’S NON-COLLUSIVE

STABLE EQUILIBRIUM
 Consider a firm in an oligopolistic market structure which behaves that
1. If it raises price above the ongoing market price, none of its rivals will follow suit.
But, the firm will lose a considerable part of its consumers. Hence, the demand
curve confronting the firm is very elastic above the ongoing price. The relevant
curve for decision-making is the perceived demand curve (d). It is assumed that the
other firms will not change their price when one firm changes (increases) its price.
2. If it reduces its price, its competitors will follow suit, matching the price cut. That is
to say all rivals will reduce their prices. So the share of the competitors in the
market demand remains unchanged. Therefore, for price reduction below the
ongoing market price, the relevant curve for decision marking is the proportional
demand curve (D).
 In short, oligopolies rivals will ignore a price rise and follow a price cut. This in turn
cause
1. The oligopoly’s DD curve to be kinked. That is CED.
2. His/her MR curve to have a vertical break or gap. That is due to the kink in the DD
curve the MR curve becomes discontinuous at the level of output corresponding to

157
 the kink. The discontinuous segment AB in the graph below shows this. Thus, the
MR curve will be CABF. Where, CA corresponds to the upper part of the perceived
DD curve (i.e. CA) and BF corresponds to the lower part of the proportional curve
(i.e. ED).
3. Furthermore, since any shift in MC between MC1 and MC2 will cut the vertical
segment (dashes) of the MR curve, no change in either Pk or Qk will occur.

MC1
E MC2
Pk

A d

B D
MRd

MRD
Q
Qk
 The equilibrium of the firm is defined by the kink because at any point to the left
of the kink MC lies below MR implying output must increase while to the right of
the kink MC lies above MR implying output must decrease. Thus, total profit is
maximised at the point of the kink by the intersection of d and D curves at point E.
 The discontinuous segment AB on the MR curve implies that there is a range
within which cost may change without affecting the equilibrium price (Pk) and
output (Qk) of the firm. So long as the MC passes through the segment AB the
firm maximizes profits by producing Qk and selling at Pk. Hence, oligopoly price
is said to be very sticky, changing only infrequently (rarely). This is because the
equilibrium price and output change only as a result of significant change in costs
of production. Example, a rise in costs due to the imposition of substantial sales
tax and affects all firms equally.
 The kinked demand model has two limitations. These are
1. The model implies that price rigidity (stickiness) coincides with quantity
rigidity (stickiness). In reality this may not be the case. For example, in our
country the price of Coca Cola and Pepsi are rigid for the last many years
but the SS of the products has been increasing from time to time due to
aggressive promotion. In other word, the model ignores the impact of non-

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 price competition (advertising and sales promotion) in increasing output
sold.
2. The analysis does not explain how the ongoing price gets to be Pk or why
firms in oligopoly market are reluctant to deviate from this existing price
to other price that yields them higher (substantial) profits.

8.1.4. THE BERTRAND’S MODEL (simultaneous price setting): This model assumed a
model of competitive bidding and hence is the opposite of the Cournot’ model.
 The Cournot’s model described that firms were choosing their quantities and letting
the market determines the price. Another approach is to think of firms as setting their
prices and letting the market determines the quantity sold. This model is known as the
Bertrand model.
 What does the Bertrand model looks like? The answer is that when firms are selling
identical (homogenous) products and have significant effect on the price, the Bertrand
equilibrium is a competitive equilibrium for they engaged in strategic interaction.
That is the Bertrand equilibrium is where price equals MC. How?
 First, we note that price can never be less than MC. As a result, either firm would
increase its profits by producing less output. So let us consider the case where P >MC.
Suppose that both firms are selling at some P >MC. Consider the position of firm 1.
If it lowers its price by any small amount ε and if the other firm keeps it price at P ,
all the consumers will prefer to purchase from firm 1. By cutting its price by an
arbitrary small amount, form 1 can steel all the consumers from firm 2.
 If firm 1 really believes that firm 2 will charge a price P that is greater than MC, it
will always pay firm 1 to cut its price to P - ε. But firm 2 can reason the same way.
Thus, any price higher than MC cannot be equilibrium. The only equilibrium is then
the competitive equilibrium.
 This result seems paradoxical when you first encounter it. You may wonder how can
we get a competitive price if there are only two firms that produce identical products
in the market? If we think of the Bertrand model as a model of competitive bidding it
makes more sense. Suppose that one firm “bids” for the consumers’ business by
quoting a price above MC. Then the other firm can always make a profit by
undercutting this price with a lower price. It follows that the only price that each firm
cannot rationally expects to be undercut is a price equal to MC. Thus, it is often
observed that competitive bidding among firms that are unable to collude can result in
prices that are much lower than it can be achieved by other means. This phenomenon
is simply an example of Bertrand competition.
 Numerical Example: Given P = 100 – 0.5Q, where Q = q1+q2, TC1= 5q1, TC2 = 0.5q22
find the Bertrand’s equilibrium.
 Solution:

159
 Firm 1 Firm 2
P = MC1 P = MC2
P=5 P = q2
5 = 100 – 0.5Q
-95 = -0.5Q
Q = 95/0.5 = 190
 Check that P = MC1 = MC2
100 – 0.5 (q1 + q2) = 5 100 – 0.5 (q1 + q2) = q2
95 – 0.5q1 – 0.5q2 100 – 0.5q1 –1.5q2
95 = 0.5q1 + 0.5q2 100 = 0.5q1 + 1.5q2
 Solving the two equations simultaneously
 95 = 0.5q1 + 0.5q2
(100 = 0.5q1 +1.5q2) –1
95 = 0.5q1 + 0.5q2
-100 = -0.5q1 – 1.5q2
-5 = -q2, q2 = 5
95 = 0.5q1 + 0.5 (5)
95 = 0.5q1 + 2.5
0.5q1 = 95 – 2.5
0.5q1 = 92.5, q1 = 92.5/0.5 = 185 and Q = 5+185 = 190
 P = 100 – 0.5Q
= 100 – 0.5 (5 + 185)
= 100 – 0.5 (190)
= 100 – 95 = 5, is the price which cannot be undercut because it is equal to
MC1 and MC2.
8.2. COLLUSIVE OLIGOPOLY: One way of avoiding the uncertainty that may arise
from interdependence of firms in oligopoly market is to enter in to collusive
agreement (that is to adopt more strategic cooperation). There are two main types of
collusive oligopoly. These are
1. Cartels
2. Price leadership. They have been
exclusively analysed by W. Fellner.

8.2.1.CARTELS: A cartel is a cooperation of firms whose objective is to limit (reduce) the

scope of competitive environment that arises due to mutual interdependence of firms
within the market and act as a monopoly. There are two forms of cartel. These are
a) Cartel aiming at joint profit maximization
b) Cartel aiming at sharing the market

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A. CARTEL AIMING AT JOINT PROFIT MAXIMIZATION: As the name of the
cartel entails, the aim of this particular form of cartel is to set prices and outputs
together so as to maximize total industry (joint) profit not profit of individual firms. In
this cartel solution the firms act together to restrict output so as no to “spoil” the
market. They recognize the effect on joint profits from producing more output in
either firm. This situation is similar to the multi plant monopoly case that seeks
(wants) the maximization of his profit.
 For simplicity we will consider two oligopoly firms (firm A and B) producing
identical (homogenous) products. The firms appoint a central agency (cartel) to which
they delegate the authority to decide
1) The total quantity and the price level at which each quantity should be sold so as
to attain maximum group (joint) profit
2) The allocation of production among the members of the cartel and
3) The distribution of the maximized joint profits among the participating members.

 The authority of the central cartel agency is complete. The central agency has access
to the cost figures of individual members (firms). Besides, it calculates the market
demand and the corresponding MR. Given the market demand, the cartel (monopoly)
solution-output and price levels- that maximizes joint industry profit is determined by
equating MR = MC.
 Next the central agency allocates the production among firm A and B by equating the
MR to individual firm’s MC. That is MR = MC A and MR = MCB. In short, the
optimality condition implies that the MR of the extra unit of output must be the same
no matter where it is produced. It follows that MC A = MCB. So the two MCs will be
equal in equilibrium. Thus, firm A will produce q A and firm B, qB,. Note that if one
firm has lower cost (cost advantage) its MC curve always lies below that of the other
firm, and then it will necessarily produce more output in equilibrium in the cartel
solution. However, this does not mean that the firm with lower cost will take the
larger share of the attained joint profit. This is because the total industry (joint) profit
is distributed by the central agency of the cartel according to some agreed upon
criteria.

MCA MC
MCB
ATC
P P

D
C MR

q1 q2
Q = q1 + q2
Firm A Firm B Central Cartel

161
 Theoretically it is easy to derive the monopoly solution of the cartel aiming at
joint profit maximization. However, maximum joint profit is rarely achieved due
to the following reasons.
1. Mistake in the estimation of the market demand which leads to mistake in
the derivation of MR and hence to a price that is higher or lower than
monopoly price
2. Mistake in the estimation of MC, may be due to reporting low cost figures
by a firm/s, leading to an equilibrium Q which differs from the monopoly
solution.
3. The temptation to cheat when there is no effective way (means) to detect
and punish cheating. This arise because at the output levels that maximize
joint profits, it will always be profitable for each firm to unilaterally
increase its output if each firm expects the other firm will keep its output
fixed.
 Numerical example: Given P = 100 – 0.5Q, where Q = q1 +q2, TC1 = 5q1, and TC2
= 0.5q22 determine Q, q1, q2, P, and joint profit.
 Solution: First the central agency of the cartel compute the joint profit function as
П = П1 + П2
= TR1 – TC1 + TR2 – TC2
= (Pq1+Pq2) – (TC1 + TC2)
= P (q1+q2) – (TC1+TC2)
= 100 – 0.5 (q1+q2) (q1+q2) – (5q1+0.5q22)
= 100q1+100q2 – 0.5q12 – 0.5q1q2 – 0.5q1q2 – 0.5q22 – 5q1 – 0.5q22
= 95q1+100q2 – 0.5q12 – q1q2 – q22
 Find the partial derivative of the profit function w.r.t q1 and q2 and equate them to
zero.
∂ П = 0 = 95 – q1 – q2 = 0 ∂ П = 100 – q1 – 2q2 = 0
∂ q1 ∂ q2
= q1+q2 = 95 -------- (1) = q1+2q2 = 100 --------- (2)
 To obtain the level of output and price that maximizes joint profit, the central
agency of the cartel solves q1 and q2 using the above two equations
simultaneously as follows
q1+q2 = 95
(q1+2q2 = 100) –1
q1+q2 = 95
-q1 – 2q2 = -100

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 -q2 = -5, q2 = 5. Substituting this in one of the two equations above will
give us
q1+q2 = 95
q1+ 5 = 95
q1 = 95 – 5
q1 = 90. Thus Q = q1+q2 = 90+5 = 95. Then joint profit maximizing price is
P = 100 – 0.5Q
= 100 – 0.5 (95)
= 100 – 47.5 = 52.5. Finally, the joint profit will be obtained by
substituting the values of q1 and q2 in the above П function or
alternatively as follows

П = TR1+TR2 – TC1 – TC2

= Pq1+Pq2 – TC1 – TC2
= 52.5 (90) + 52.5 (5) – 5 (90) – 0.5 (5) 2
= 4725 + 262.5 – 450 – 12.5
= 4525. Check that at the output level (Q = 95) that maximizes joint profit,
MR = MC1 = MC2.
TR = PQ
= (100 –0.5Q) Q
= 100Q – 0.5Q2
∂ TR = 100 – Q = 100 – 95 = 5, ∂ TC1 = 5, ∂ TC2 = q2 = 5.
∂Q ∂ q1 ∂q2
 Thus, Q = 95 and P = 52.5 are the output and price levels that maximizes joint
profit.

B. CARTEL AIMING AT SHARING THE MARKET: This is the most common type
of cartel. The two methods of sharing the market are through
I. Non price competition
II. The determination of quotas

I. NON-PRICE COMPETITION (Price matching and competition): Under

this cartel members agree on a common price informally not by bargaining. This
implies that firms agree not to sell below the cartel price; but they can vary the style
of their products and their selling activities. For example
- Doctors charge the same price
- Barbers charge the same price
- Gasoline stations charge the same price

163
 - Cinema halls charge the same price etc. These prices are not the
result of perfect competition in the market. Rather, they result from tacit agreement
upon price. Hence, sellers compete one another through advertising but not by price
changes.
 Due to cost difference among manufacturing firms, this type of cartel is loose or
unstable than the complete cartel aiming at joint profit maximization. In other words,
the cartel is inherently unstable for there is a temptation to cheat by low cost firm.
Hence, there is a strong incentive to break away from the cartel and charge lower
price (give price concession to buyers). However, other members from the cartel will
soon discover such a cheating when they loose consumers.
 Another method (way) to acquire information as to whether other firms keep
track of the price is to use your customers to spy on the other firms. When firms are
not sure that the other firm is not cheating on their agreement and selling at the
implicitly agreed price, price war (instability) may develop and the cartel splits.
II. SHARING THE MARKET BY AGREEMENT ON QUOTAS: Here, cartel
members agree explicitly on the common price and quantity each member may sell in
the market (national or international). The best example of this cartel is OPEC and
ICO.
 If all firms have identical cost, a monopoly solution will emerge with the
market being shared equally. That is equal quotas will be allocated. This will happen
if and only if firms have identical costs. However, if costs are different, the quotas
(shares) of the market will differ. Again, allocation of quotas on the basis of cost is
unstable. Therefore, the quotas will be decided by bargaining. During the bargaining
process to decide the quotas of members of the cartel, two main criterions are often
considered. These are
a) Past level (historical) sells
b) The production capacity of the firm. Both criterions, however, are influenced
by the bargaining power and skills of cartel members.
 Though it is not main criterion, defining the region in which each cartel member is
allowed to sell (spheres of influence) is another criterion of sharing the market. The
best example of this kind of agreement is what the Japanese, Malaysian, and Chinese
companies producing Sony products have agreed.
 Note that cartel models of collusive oligopoly are closed models. That is they assume
no entry. However, if entry is free, the inherent instability of cartel will be intensified.
This is because new entrant firms may charge lower prices in order to secure a
considerable share of the market. Besides, if either firm are not sure the other firm
keeps track on prices and production levels, price war and eventually the dissolution
of the cartel is inevitable. A successful cartel will only be maintained if they found a
means to police members’ and new entrants’ behaviour.

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8.2.2. PRICE LEADERSHIP: The collusion among the oligopolies also entails that one
firm will set the market price and others followed (adopt) it. Followers usually prefer to
avoid the uncertainty that might occur because of their competitor’s reaction for their action
even if this implies departure from profit maximizing point.
 Price leadership is more widespread than cartel. The two most common types of price
leadership are
 Price leadership by low cost firm
 Price leadership by the dominant (large) firm

1. Low Cost Price Leadership:- Consider a situation where there are only two firms
(duopoly) that produce identical (homogenous) products at different costs but sell their
products at the same market price. However, firms may have equal (the high cost firm
also to produce the same level of output to that of the low cost firm and sell at the same
price) or unequal share.
 Assuming firm 2 is the low cost firm and firm 1 is the high cost firm, the graphic solution is given as
follows.

P
MC1

P1 MC2
P2
D
E

q1 q2 MR q2+q2
Q=

Q = 2(q2)
 Firm 2 has lower cost and hence it charges lower price, p 2, and produce q2 to

maximize profits. Firm 1, with the highest cost, on the other hand would like to
charge p1 and produce q1. However, firm 1 prefers to follow the leader because if it
charges p1 its sells will be zero implying no one will pay a higher price for identical
products. Therefore, the high cost firm 1 must be willing (satisfied) to accept the
price decision of the low cost firm. Thus, it changes P 2 and produces the same
quantity as firm 2, q2.
 The two together then produce output level, which is equal to q 2 + q2 = 2Q2. It is only

in this case the antitrust monopoly legislation, which forbid monopoly production
will work. In short the high cost firm must tolerate to the price and output level

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 equal to the low cost firm to avoid the uncertainty that may arise when firm 2,
reduces price lower than p2.
2
 Numerical example: Given P = 24 – 0.1Q, where Q = q 1+q2 and q1 = q2, TC1 = 0.1q1 ,

TC2 = 0.05q22,
a) Determine the output and price of low cost firm
b) Calculate the profit of the low cost firm
c) What is the profit maximizing price level the high firm would like to charge
but that doesn’t realise in the market
d) Compare the profits of the price taker at its own profit maximizing output
and low cost firm’s output
e) Show the results a to d graphically
 Solution
a) Since q1 = q2, 0.075q12 > 0.05q22. This implies that firm 2 is a low cost price
leader. Hence,
П2 = Pq2 – TC2 P = 24 – 0.1Q, where q1 = q2
2
= (24 – 0.1(q1+q2)) q2 – 0.05q2 P = 24 – 0.1 (2q2)
= (24 – 0.1 (q2+q2)) q2 – 0.05q22 = 24 – 0.2q2
= (24 – 0.1 (2q2)) q2 – 0.05q22 = 24 – 0.2 (48)
2
= (24 – 0.2q2) q2 – 0.05q2 = 24 – 9.6 = 14.4
2 2
= 24q2 – 0.2q2 – 0.05q2 b) П2 = Pq2 –TC2
2
= 24q2 – 0.25q2
dП2 = 0 = 24 – 0.5q2 = 0 = 14.4 (48) – 0.05 (48) 2
dq2
= q2 = 24/0.5 = 48 = 691.2 –115.2 = 576
c) П1 = Pq1 – TC1 d) П1= Pq1 – TC1
2
= (24 – 0.1(q1+q2)) q1 – 0.075q1 = 14.4 (43.63) – 0.075
2
(43.63)
= (24 – 0.1 (q1+q1)) q1 – 0.075q12 = 628.36 –142.77= 485.59
and
= (24 – 0.1 (2q1) q1 – 0.075q12 П1= Pq1 – TC1
2
= (24 – 0.2q1) q1 – 0.075q1 = 14.4 (48) – 0.1 (48) 2
= 24q1 –0.2q12 – 0.075q12 = 691.2 – 230.4 = 460.8
2
= 24q1 – 0.275q1 though, 485.59>460.8 firm 1
will produce 48 than 43.63
dП1 = 0 = 24 –0.55q1 = 0
dq1
q1= 24/0.55 = 43.63

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  Exercise: Given P = 300 – 5X, where X = x 1+x2, TC1= 0.5x12, TC2 = 3x22 answer
the questions above.
 Answer: x1 = 14.29, P1 = 157.96, x2 =11.54, and P2 = 184.62

2) The Dominant – Firm Price Leadership (Partial Monopoly)

 This type of duopoly assumes that there is a dominant firm, which has considerable
share of the market and smaller firms, each of them having a smaller market share.
 The dominant firm is assumed
 To know the market demand curve
 The MC of smaller firms. Hence, firm the horizontal summation of the
MCs of smaller firms the dominant firms found the total SS by the smaller
firms at each price.
 Knowing the market DD and the SS of the smaller firms the dominant firm
calculates its DD curve as follows. At each price the dominant firm will be able to
SS that section of the total market DD not supplied by the smaller forms. That is,
the DD for the product of the firm will be the difference between the total dd (D)
and the total SS of the smaller firms.

P S small
MCL

PS D1
SSsm
B C
PL1
SSsm SSL1
P2 A D2
SSsm SSL2
D3
P3 dL
SSL3 DD MRL
Q qL q2 q3
Smaller firms Dominant firm

 At ps, market DD is equal to the market SS of smaller firms. This is equal to P SD1
amount. The dd for the product of the leader will be zero.
 As price falls below PS, the dd for the leader increases, for instance, at P 2, total market
dd is P2D2 amount of which P2A is supplied by the smaller firms. The share of the
dominant is AD2.

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 At P3, total market dd is P3D3 of which the share of smaller firms is zero, while P 3D3
(all) is the share of the dominant firm. Below P s the market dd coincides with the
leader dd curve.
 Having derived the dd curve of the leader (dL) and given its MC, the dominant firm
will set the price p at which MRL = MCL and output is qL. At price PL1 the total
market dd is PL1C of which PLA is the share of smaller firms while AC is the share of
the dominant firm. The dominant firm maximizes its profit be equating its MR to
MC, but the smaller firms or price taker may or may not attain the point where MR S =
MCS.
 Numerical example: Given Q = 120 – 0.2P, SSsm = 4.8P, and TCL = 4qL determine
the supply, price, and profit of the dominant (large) firm. Finally, the supply of
smaller (followers) firms.
 Solution:
qL (dL ) = Q – SSsm)
qL= 120 – 0.2P – 4.8P
qL = 120 – 5P
qL – 120 = -5P
 P = 24 - 0.2qL
 TRL = (24 – 0.2 q2) q2
 ПL = TRL – TCL
= (24 – 0.2qL) qL – 4qL
= 24qL – 0.2qL2 – 4qL
= 20qL - 0.2qL2
d ПL= 20 – 0.4qL = 0
dqL
= 20 = 0.4qL
qL = 20/0.4 = 50
 P = 24 – 0.2 qL
 P = 24 – 0.2 (50)
= 24 – 10 = 14, this is the equilibrium price both the dominant and smaller
firms will adopt.
ПL = PqL – TCL
= 14 (50) – 4 (50)
= 700 – 200 = 500
 The supply of smaller firms will then be Q – dL. That is
SSsm = (120 – 0.2P) – 50 or SSsm = 4.8P
= (120 – 0.2 (14)) – 50 = 4.8(14)
= (120 – 2.8) – 50
= 67.2

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= 117.82– 50 = 67.2

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