Republic of the Philippines

BATANGAS STATE UNIVERSITY

Batangas City
College of Accountancy Business Economics and
International Hospitality Management

BUSINESS AND ENTREPRENUERSHIP DEPARTMENT

Module: Basic Microeconomics (ECO 101)

Prerequisite: None
Credit hours: 3
Professor: Inesio H. Sadiangcolor
Dr. Gemar Perez
Glen Ferdinand C Magadia

Module Synopsis
The module provides a basic analytical framework for understanding the functioning of
markets. The module begins by examining the laws of demand and supply, and price
determination in individual markets, consumer behaviour, and the concepts of elasticity,
production cost and profit.
We also discuss the economics of firms in different types of market structures (perfect and
imperfect competition), and strategic interaction between economic agents and basic issues
in the economics of labor market.
Module Teaching Objectives
The teaching objectives of the module are:
1. Introduce the various economic theories and models necessary for real-world
understanding
and applications.
2. Understand the two (2) important laws in economics (i.e., law of demand and supply).
3. Understand market forces and consumer behaviour.
4. Identify the different production costs, revenues and profit maximization.
5. Analyse and compare the different types of firm competition in a market.

Module Learning Outcomes

Upon successful completion of the module, students will be able to:
1. Define the terminologies and concepts used in the study of microeconomics.
2. Generalize about economic behaviour or economic data.
3. Explain the laws of demand and supply and their interaction with each other.
4. Explain and analyse the cost and profit-maximizing behaviour of firms in the short and long
run.
5. Compare and analyse the characteristics of different types of market structures (e.g.,
perfect
and imperfect competition).

Modes of Delivery
This is a 3 credit hour conducted over a period of 18 weeks. The modes of delivery will be in
the form of lectures through online strategies and even self-directed study.
The following topics will be discussed throughout the duration of online class

TOPIC 1 - Introduction
Demand and Supply analysis
TOPIC 2 - Elasticity and its Uses
TOPIC 3 - Consumer Choice & Demand
TOPIC 4 - Theory of Production
TOPIC 5 - Cost and Profit Theory
TOPIC 6 - Perfect Competition
TOPIC 7 - Imperfect Competition

ECO 101 BASIC MICROECONOMICS

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Module 1

INTRODUCTION

Introduction to Economics, Microeconomics and Economic Models

Week 1-2

INTRODUCTION

You may be wondering why we need to study economics especially our course (i.e.
microeconomics. The answer is very simple- we use it everyday. We often hear news reports
on fuel prices going up and down. We have encountered transport strikes where drivers
demand for rollback in gasoline prices or a fare increase. In our daily trip to work or school,
we experience heavy traffic. We might think that roads are not wide enough, or there are just
too many vehicles plying the streets. We regularly go to grocery stores even there is a
pandemic to shop for our daily needs. There are times when we observe several items on
sale and feel that either those items are near expiration or the store had overstocked. It is
difficult to miss these daily experiences, and we cannot deny their relation to economics. It is
possible that there’s an increase in fuel prices as a consequence of an oil price increase in
the world market. Heavy traffic is a result of an unregulated increase in the volume of vehicles
and the government’s insufficient resources to finance the construction of new roads. The
discounted prices of goods can be levelled-off by new stocks of products at regular prices.
So think about it: is it a waste of time to learn economics?

INTENDED LEARNING OUTCOMES

After studying this module, the students will be able to:

1. Define economics and explain the role in business and to the economy as a whole.
2. Differentiate microeconomics from macroeconomics by citing an examples.
3. Describe the different economic models and find how it is applied to the various types of
businesses.
4. Differentiate and identify economic theories from economic models.

DEFINITION OF TERMS

• Economics defined as the study of the proper allocation and efficient utilization of
scarce productive resources to produce commodities for the maximum satisfaction of
unlimited wants and needs.

• Microeconomics deals with the behaviour of individual components such as

household, firm, and individual owner of production. It focuses on the behaviour of a particular
unit of the economy such as consumers, producers, and specific markets. In microeconomics,
you will often encounter terms like consumer’s behaviour, production theory, cost and profit,
and the market structures.

• Macroeconomics deals with the behaviour of economy as a whole with the view of
understanding the interaction between economic aggregates such as unemployment, inflation
and national income. In macroeconomics, the initial discussions begin with how growth and
output are measured and how multipliers work. Labor, employment, and inflation are included
for long-term effects, as well as monetary, fiscal and trade policies.

• Economic theory is a preposition about certain related variables that scientifically

explain a certain phenomenon. It tries to explain economic phenomena, to interpret why and
how the economy behaves and what is the best to solution-how to influence or to solve these
economic phenomena.

• Economic model is essentially a simplified framework for describing the working of

the economy. It is used to illustrate, demonstrate, and represent a theory or parts of it. It
simplifies an explanation or description of a certain phenomenon, often employing graphs,
diagrams, or mathematical formulae.

• Circular Flow Diagram pictures the economy as consisting of two groups-

households and firms-that interact in two market; goods and services market in which firms
sell and households buy and the labor market in households sell labor to business firms or
other employees.

• Production Possibility Frontier (PPF), Production Possibility Curve (PPC), or a

Production Possibility Boundary (PPB) is a curve which shows various combinations of
the amounts of two goods which can be produces within the giver resources and technology/
a graphical representation showing all the possible options of output for two products that can
be produced using all factors of production, where the given resources are fully and efficiently
utilized per unit time.

Methodologies of Economics

The difference between microeconomics and macroeconomics is based on the degree

of details considered. Another valuable feature is the reason in examining a problem.
 • Positive economics relates to what is. It is an economic analysis that explains what
happens in the economy and why, without making any recommendations to economic policy,
or in simple idea, it deals with how should be verified by facts.

• Normative economics concerns itself with what should be. It is an economic

statement that makes recommendation to economic policy. This economic statement is
employed to make value judgments about the economy and suggests solutions to economic
problems. Instead of restricting its involvement on facts, it extends to the specific actions that
we should do to address the issues that depend on our values.

Figure 1
Circular Flow Diagram

A depiction of how money and products are exchanged within an economy. A circular flow
diagram might be used by a business to show how a specific series of exchanges of goods,
services and payments make up the building blocks of a given economic system of interest.

The economy can be thought of as two cycles moving in opposite directions. In one
direction, we see goods and services flowing from individuals to businesses and bac k
again. This represents the idea that, as laborers, we go to work to make things or provide
services that people want.

In the opposite direction, we see money flowing from businesses to households and back
again. This represents the income we generate from the work we do, which we use to pay
for the things we want.

Both of these cycles are necessary to make the economy work. When we buy things, we
pay money for them. When we go to work, we make things in exchange for money.

The circular flow model of the economy distills the idea outlined above and shows the flow
of money and goods and services in a capitalist economy.

What Are Circular Flow Diagrams?

We all need to buy goods. Sometimes those goods are groceries, while other times those
goods are clothing for an important event. Whatever the goods might be, purchasing them
forms a crucial piece in a functioning economy.
Simply put, each time we buy a good we are contributing to the economy. In this lesson, we'll
look at how those purchases are just part of a bigger piece of the economic puzzle. You see,
the economy works in a circular motion known as the circular flow diagram in economics.
The circular flow diagram is a basic model used in economics to show how an economy
functions. Primarily, it looks at the way money, goods, and services move throughout the
economy. In the diagram, there are two main characters, known as firms and households,
where households represent consumers and firms represent producers.

The Role of Households

Let's take a look at the role of the consumer, or the households. In a circular flow diagram,
households consume the goods offered by the firms. However, households also offer firms
factors so that the firms can produce products for the household to later consume.
For example, households may supply land to produce goods or they may offer themselves in
the form of labor. Households also offer capital, which is a monetary form of investing that
helps firms create products for consumption. All three forms (land, labor, and capital) are
offered to firms so that they can make products that households need and consume.

The Role of Firms

Now let's look at the role of firms. The main function of the firms is to offer goods. In order to
do this, firms take the factors (land, labor, and capital) from households and convert products
into goods and services that consumers need and want. The role of firms makes up the
second part of the circular flow diagram.

Figure 2
What is the Production Possibilities Frontier (PPF)?

Definition: Production possibilities frontier (PPF), also known as production possibility curve,
indicates the maximum output combinations of two goods or services an economy can
achieve by fully using all available resources efficiently.

What Does Production Possibilities Frontier Mean?

What is the definition of production possibilities frontier? The production possibility

frontier indicates the maximum production possibilities of two goods or services, assuming a
fixed level of technology and only one choice between the two.
Producing one good always creates a trade-off over producing another good. In other words,
if more of good A is produced, less of good B can be produced given the resources and
production technology remain constant.

Hence, the production of one good or service increases when the production of the other good
or service decreases. The PPF measures the efficiency in which the two goods or services
are produced together. In that way, it helps managers to determine the most beneficial mix of
commodities for the business.

Let’s look at an example.

Example

Typically, opportunity cost occurs when a manager chooses between two alternative ways of
allocating business resources. In other words, if one action is chosen, the other action is
foregone or given up. There is a trade-off. Hence, the production possibility frontier provides
an accurate tool to illustrate the effects of making an economic choice.

At any given point of a PPF, the company produces at maximum efficiency by fully using its
resources. At an economic level, this is known as the Pareto efficiency, which suggests that,
when allocating resources, the choice of one will worse off the other. Also, any point inside
the PPF is inefficient because at that point the output is greater than the output that the
existing resources can produce.
For example, a country produces pizza and sugar. If the country decides to ramp up its sugar
production, using the existing fixed resources, it has to lower its pizza production. Hence, at
points A, B, and C, the economy achieves the maximum production possibilities between
pizza and sugar. Points D and E are inside the PPF line and is inefficient because all the
resources are not being used properly. Point F is simply beyond the amount of production
attainable with the current level of resources.

Summary Definition

Define Production Possibilities Frontier: PPF means a graphical representation of the

possible production combinations a company could produce if it used all of its resources to
produce only two goods or services.
 Figure 3

Definition of Market Equilibrium

**It is a situation where for a particular good supply = demand. When the market is in
equilibrium, there is no tendency for prices to change. We say the market-clearing price has
been achieved. A market occurs where buyers and sellers meet to exchange money for
goods.

Figure 4

Equilibrium Using Demand and Supply Curves

 Let us examine the behaviour of demand and supply presented in Figure 4 in a
graphical form.

In Figure 4, equilibrium exists at point E were equilibrium price is USD 3 and equilibrium
quantity is 7,000 bushels of corn. It is at this point that forces of demand and supply are
balanced, that is, the amount of goods being demanded equals the amount being supplied at
a given price. Say the price is too high, assuming that the price of USD 4 per unit of corn is
applied. At this price, suppliers tend to offer more than the consumer demand, thus creating
a surplus, a condition where quantity supplied is greater than quantity demanded. Hence, the
price is greater than the equilibrium price. A surplus situation creates forces among suppliers
which cause a downward pressure on price. On the other hand, shortage occurs when the
price is set below the equilibrium price. It is a condition where quantity demanded is greater
than the quantity supplied. Hence, competitions among consumers for limited goods cause
prices to rise.

Exercises/Activities

1. The following is a Production Possibilities table for good X and good Y.

Good Production
Alternatives
A B C D E
X 0 3 6 9 12
Y 33 30 25 15 0

a. Plot the Production Possibilities Frontier of the data with good X on the horizontal axis
and
Good Y on the vertical axis.(10 pts).

b. What do the points on the curve indicate? (5 pts).

2. What does it mean for an economy to be on its production possibilities frontier? Why is it
not recommended to be outside (or to the northeast) of the frontier? (10 pts).

3. From the following data, plot the supply and the demand curves and determine the
equilibrium
price and quantity. Likewise, identify for each price whether surplus or shortage is
derived. Please use graphing paper for a single graph and label properly. (15 pts).

Price Quantity Demanded Quantity Supplied

(Per Siomai)
30 5 60
25 15 50
20 20 20
15 45 15
10 75 10
5 100 5
 TOPIC 2 : DEMAND AND ANALYSIS

Learning Objectives:

1. Use demand and supply to explain how equilibrium price and quantity are determined in a
market.

2. Understand the concepts of surpluses and shortages and the pressures on price they generate.

3. Explain the impact of a change in demand or supply on equilibrium price and quantity.

4. Explain how the circular flow model provides an overview of demand and supply in product
and factor markets and how the model suggests ways in which these markets are linked.

In this topic we combine the demand and supply curves we have just studied into a new model.
The model of demand and supply uses demand and supply curves to explain the
determination of price and quantity in a market.

INTRODUCTION
The model of demand and supply that we shall develop in this chapter is one of the most
powerful tools in all of economic analysis. You will be using it throughout your study of
economics. We will first look at the variables that influence demand. Then we will turn to
supply, and finally we will put demand and supply together to explore how the model of
demand and supply operates. As we examine the model, bear in mind that demand is a
representation of the behavior of buyers and that supply is a representation of the behavior of
sellers. Buyers may be consumers purchasing groceries or producers purchasing iron ore to
make steel. Sellers may be firms selling cars or households selling their labor services. We
shall see that the ideas of demand and supply apply, whatever the identity of the buyers or
sellers and whatever the good or service being exchanged in the market. In this chapter, we
shall focus on buyers and sellers of goods and services.

The Determination of Price and Quantity

The logic of the model of demand and supply is simple. The demand curve shows the quantities
of a particular good or service that buyers will be willing and able to purchase at each price
during a specified period. The supply curve shows the quantities that sellers will offer for sale
at each price during that same period. By putting the two curves together, we should be able
to find a price at which the quantity buyers are willing and able to purchase equals the quantity
sellers will offer for sale.

Figure 3.14 “The Determination of Equilibrium Price and Quantity” combines the demand and
supply data introduced in Figure 3.1 “A Demand Schedule and a Demand Curve” and Figure
3.8 “A Supply Schedule and a Supply Curve” Notice that the two curves intersect at a price of
$6 per pound—at this price the quantities demanded and supplied are equal. Buyers want to
purchase, and sellers are willing to offer for sale, 25 million pounds of coffee per month. The
market for coffee is in equilibrium. Unless the demand or supply curve shifts, there will be no
tendency for price to change. The equilibrium price in any market is the price at which
quantity demanded equals quantity supplied. The equilibrium price in the market for coffee is
thus $6 per pound. The equilibrium quantity is the quantity demanded and supplied at the
equilibrium price.
Figure 3.14 The Determination of Equilibrium Price and Quantity

When we combine the demand and supply curves for a good in a single graph, the point at
which they intersect identifies the equilibrium price and equilibrium quantity. Here, the
equilibrium price is $6 per pound. Consumers demand, and suppliers supply, 25 million
pounds of coffee per month at this price.

With an upward-sloping supply curve and a downward-sloping demand curve, there is only a
single price at which the two curves intersect. This means there is only one price at which
equilibrium is achieved. It follows that at any price other than the equilibrium price, the market
will not be in equilibrium. We next examine what happens at prices other than the equilibrium
price.

Surpluses

Figure 3.15 “A Surplus in the Market for Coffee” shows the same demand and supply curves
we have just examined, but this time the initial price is $8 per pound of coffee. Because we no
longer have a balance between quantity demanded and quantity supplied, this price is not the
equilibrium price. At a price of $8, we read over to the demand curve to determine the quantity
of coffee consumers will be willing to buy—15 million pounds per month. The supply curve
tells us what sellers will offer for sale—35 million pounds per month. The difference, 20
million pounds of coffee per month, is called a surplus. More generally, a surplus is the
amount by which the quantity supplied exceeds the quantity demanded at the current price.
There is, of course, no surplus at the equilibrium price; a surplus occurs only if the current
price exceeds the equilibrium price.
Figure 3.15 A Surplus in the Market for Coffee

At a price of $8, the quantity supplied is 35 million pounds of coffee per month and the quantity
demanded is 15 million pounds per month; there is a surplus of 20 million pounds of coffee
per month. Given a surplus, the price will fall quickly toward the equilibrium level of $6.

A surplus in the market for coffee will not last long. With unsold coffee on the market, sellers
will begin to reduce their prices to clear out unsold coffee. As the price of coffee begins to fall,
the quantity of coffee supplied begins to decline. At the same time, the quantity of coffee
demanded begins to rise. Remember that the reduction in quantity supplied is a
movement along the supply curve—the curve itself does not shift in response to a reduction in
price. Similarly, the increase in quantity demanded is a movement along the demand curve—
the demand curve does not shift in response to a reduction in price. Price will continue to fall
until it reaches its equilibrium level, at which the demand and supply curves intersect. At that
point, there will be no tendency for price to fall further. In general, surpluses in the marketplace
are short-lived. The prices of most goods and services adjust quickly, eliminating the surplus.
Later on, we will discuss some markets in which adjustment of price to equilibrium may occur
only very slowly or not at all.

Shortages

Just as a price above the equilibrium price will cause a surplus, a price below equilibrium will
cause a shortage. A shortage is the amount by which the quantity demanded exceeds the
quantity supplied at the current price.

Figure 3.16 “A Shortage in the Market for Coffee” shows a shortage in the market for coffee.
Suppose the price is $4 per pound. At that price, 15 million pounds of coffee would be supplied
per month, and 35 million pounds would be demanded per month. When more coffee is
demanded than supplied, there is a shortage.
Figure 3.16 A Shortage in the Market for Coffee

At a price of $4 per pound, the quantity of coffee demanded is 35 million pounds per month
and the quantity supplied is 15 million pounds per month. The result is a shortage of 20 million
pounds of coffee per month.

In the face of a shortage, sellers are likely to begin to raise their prices. As the price rises, there
will be an increase in the quantity supplied (but not a change in supply) and a reduction in the
quantity demanded (but not a change in demand) until the equilibrium price is achieved.

Shifts in Demand and Supply

Figure 3.17 Changes in Demand and Supply

A change in demand or in supply changes the equilibrium solution in the model. Panels (a)
and (b) show an increase and a decrease in demand, respectively; Panels (c) and (d) show an
increase and a decrease in supply, respectively.

A change in one of the variables (shifters) held constant in any model of demand and supply
will create a change in demand or supply. A shift in a demand or supply curve changes the
equilibrium price and equilibrium quantity for a good or service. Figure 3.17 “Changes in
Demand and Supply” combines the information about changes in the demand and supply of
coffee presented in Figure 3.2 “An Increase in Demand” Figure 3.3 “A Reduction in
Demand” Figure 3.9 “An Increase in Supply” and Figure 3.10 “A Reduction in Supply” In
each case, the original equilibrium price is $6 per pound, and the corresponding equilibrium
quantity is 25 million pounds of coffee per month. Figure 3.17 “Changes in Demand and
Supply” shows what happens with an increase in demand, a reduction in demand, an increase
in supply, and a reduction in supply. We then look at what happens if both curves shift
simultaneously. Each of these possibilities is discussed in turn below.

An Increase in Demand
An increase in demand for coffee shifts the demand curve to the right, as shown in Panel (a)
of Figure 3.17 “Changes in Demand and Supply”. The equilibrium price rises to $7 per pound.
As the price rises to the new equilibrium level, the quantity supplied increases to 30 million
pounds of coffee per month. Notice that the supply curve does not shift; rather, there is a
movement along the supply curve.

Demand shifters that could cause an increase in demand include a shift in preferences that
leads to greater coffee consumption; a lower price for a complement to coffee, such as
doughnuts; a higher price for a substitute for coffee, such as tea; an increase in income; and an
increase in population. A change in buyer expectations, perhaps due to predictions of bad
weather lowering expected yields on coffee plants and increasing future coffee prices, could
also increase current demand.

A Decrease in Demand

Panel (b) of Figure 3.17 “Changes in Demand and Supply” shows that a decrease in demand
shifts the demand curve to the left. The equilibrium price falls to $5 per pound. As the price
falls to the new equilibrium level, the quantity supplied decreases to 20 million pounds of
coffee per month.

Demand shifters that could reduce the demand for coffee include a shift in preferences that
makes people want to consume less coffee; an increase in the price of a complement, such as
doughnuts; a reduction in the price of a substitute, such as tea; a reduction in income; a
reduction in population; and a change in buyer expectations that leads people to expect lower
prices for coffee in the future.

An Increase in Supply

An increase in the supply of coffee shifts the supply curve to the right, as shown in Panel (c)
of Figure 3.17 “Changes in Demand and Supply”. The equilibrium price falls to $5 per pound.
As the price falls to the new equilibrium level, the quantity of coffee demanded increases to
30 million pounds of coffee per month. Notice that the demand curve does not shift; rather,
there is movement along the demand curve.

Possible supply shifters that could increase supply include a reduction in the price of an input
such as labor, a decline in the returns available from alternative uses of the inputs that produce
coffee, an improvement in the technology of coffee production, good weather, and an increase
in the number of coffee-producing firms.

A Decrease in Supply

Panel (d) of Figure 3.17 “Changes in Demand and Supply” shows that a decrease in supply
shifts the supply curve to the left. The equilibrium price rises to $7 per pound. As the price
rises to the new equilibrium level, the quantity demanded decreases to 20 million pounds of
coffee per month.

Possible supply shifters that could reduce supply include an increase in the prices of inputs
used in the production of coffee, an increase in the returns available from alternative uses of
these inputs, a decline in production because of problems in technology (perhaps caused by a
restriction on pesticides used to protect coffee beans), a reduction in the number of coffee-
producing firms, or a natural event, such as excessive rain.

Heads Up!

Figure 3.18

You are likely to be given problems in which you will have to shift a demand or supply curve.

Suppose you are told that an invasion of pod-crunching insects has gobbled up half the crop
of fresh peas, and you are asked to use demand and supply analysis to predict what will happen
to the price and quantity of peas demanded and supplied. Here are some suggestions.

Put the quantity of the good you are asked to analyze on the horizontal axis and its price on
the vertical axis. Draw a downward-sloping line for demand and an upward-sloping line for
supply. The initial equilibrium price is determined by the intersection of the two curves. Label
the equilibrium solution. You may find it helpful to use a number for the equilibrium price
instead of the letter “P.” Pick a price that seems plausible, say, 79¢ per pound. Do not worry
about the precise positions of the demand and supply curves; you cannot be expected to know
what they are.

Step 2 can be the most difficult step; the problem is to decide which curve to shift. The key is
to remember the difference between a change in demand or supply and a change in quantity
demanded or supplied. At each price, ask yourself whether the given event would change the
quantity demanded. Would the fact that a bug has attacked the pea crop change the quantity
demanded at a price of, say, 79¢ per pound? Clearly not; none of the demand shifters have
changed. The event would, however, reduce the quantity supplied at this price, and the supply
curve would shift to the left. There is a change in supply and a reduction in the quantity
demanded. There is no change in demand.

Next check to see whether the result you have obtained makes sense. The graph in Step 2
makes sense; it shows price rising and quantity demanded falling.

It is easy to make a mistake such as the one shown in the third figure of this Heads Up! One
might, for example, reason that when fewer peas are available, fewer will be demanded, and
therefore the demand curve will shift to the left. This suggests the price of peas will fall—but
that does not make sense. If only half as many fresh peas were available, their price would
surely rise. The error here lies in confusing a change in quantity demanded with a change in
demand. Yes, buyers will end up buying fewer peas. But no, they will not demand fewer peas
at each price than before; the demand curve does not shift.

Simultaneous Shifts

As we have seen, when either the demand or the supply curve shifts, the results are
unambiguous; that is, we know what will happen to both equilibrium price and equilibrium
quantity, so long as we know whether demand or supply increased or decreased. However, in
practice, several events may occur at around the same time that cause both the demand and
supply curves to shift. To figure out what happens to equilibrium price and equilibrium
quantity, we must know not only in which direction the demand and supply curves have shifted
but also the relative amount by which each curve shifts. Of course, the demand and supply
curves could shift in the same direction or in opposite directions, depending on the specific
events causing them to shift.

For example, all three panels of Figure 3.19 “Simultaneous Decreases in Demand and
Supply” show a decrease in demand for coffee (caused perhaps by a decrease in the price of a
substitute good, such as tea) and a simultaneous decrease in the supply of coffee (caused
perhaps by bad weather). Since reductions in demand and supply, considered separately, each
cause the equilibrium quantity to fall, the impact of both curves shifting simultaneously to the
left means that the new equilibrium quantity of coffee is less than the old equilibrium quantity.
The effect on the equilibrium price, though, is ambiguous. Whether the equilibrium price is
higher, lower, or unchanged depends on the extent to which each curve shifts.

Figure 3.19 Simultaneous Decreases in Demand and Supply

Both the demand and the supply of coffee decrease. Since decreases in demand and supply,
considered separately, each cause equilibrium quantity to fall, the impact of both decreasing
simultaneously means that a new equilibrium quantity of coffee must be less than the old
equilibrium quantity. In Panel (a), the demand curve shifts farther to the left than does the
supply curve, so equilibrium price falls. In Panel (b), the supply curve shifts farther to the left
than does the demand curve, so the equilibrium price rises. In Panel (c), both curves shift to
the left by the same amount, so equilibrium price stays the same.

If the demand curve shifts farther to the left than does the supply curve, as shown in Panel (a)
of Figure 3.19 “Simultaneous Decreases in Demand and Supply”, then the equilibrium price
will be lower than it was before the curves shifted. In this case the new equilibrium price falls
from $6 per pound to $5 per pound. If the shift to the left of the supply curve is greater than
that of the demand curve, the equilibrium price will be higher than it was before, as shown in
Panel (b). In this case, the new equilibrium price rises to $7 per pound. In Panel (c), since both
curves shift to the left by the same amount, equilibrium price does not change; it remains $6
per pound.

Regardless of the scenario, changes in equilibrium price and equilibrium quantity resulting
from two different events need to be considered separately. If both events cause equilibrium
price or quantity to move in the same direction, then clearly price or quantity can be expected
to move in that direction. If one event causes price or quantity to rise while the other causes it
to fall, the extent by which each curve shifts is critical to figuring out what happens. Figure
3.20 “Simultaneous Shifts in Demand and Supply” summarizes what may happen to
equilibrium price and quantity when demand and supply both shift.
Figure 3.20 Simultaneous Shifts in Demand and Supply

If simultaneous shifts in demand and supply cause equilibrium price or quantity to move in
the same direction, then equilibrium price or quantity clearly moves in that direction. If the
shift in one of the curves causes equilibrium price or quantity to rise while the shift in the other
curve causes equilibrium price or quantity to fall, then the relative amount by which each curve
shifts is critical to figuring out what happens to that variable.

As demand and supply curves shift, prices adjust to maintain a balance between the quantity
of a good demanded and the quantity supplied. If prices did not adjust, this balance could not
be maintained.

Notice that the demand and supply curves that we have examined in this chapter have all been
drawn as linear. This simplification of the real world makes the graphs a bit easier to read
without sacrificing the essential point: whether the curves are linear or nonlinear, demand
curves are downward sloping and supply curves are generally upward sloping. As
circumstances that shift the demand curve or the supply curve change, we can analyze what
will happen to price and what will happen to quantity.

An Overview of Demand and Supply: The Circular Flow Model

Implicit in the concepts of demand and supply is a constant interaction and adjustment that
economists illustrate with the circular flow model. The circular flow model provides a look
at how markets work and how they are related to each other. It shows flows of spending and
income through the economy.

A great deal of economic activity can be thought of as a process of exchange between

households and firms. Firms supply goods and services to households. Households buy these
goods and services from firms. Households supply factors of production—labor, capital, and
natural resources—that firms require. The payments firms make in exchange for these factors
represent the incomes households earn.

The flow of goods and services, factors of production, and the payments they generate is
illustrated in Figure 3.21 “The Circular Flow of Economic Activity”. This circular flow model
of the economy shows the interaction of households and firms as they exchange goods and
services and factors of production. For simplicity, the model here shows only the private
domestic economy; it omits the government and foreign sectors.
Figure 3.21 The Circular Flow of Economic Activity

This simplified circular flow model shows flows of spending between households and firms
through product and factor markets. The inner arrows show goods and services flowing from
firms to households and factors of production flowing from households to firms. The outer
flows show the payments for goods, services, and factors of production. These flows, in turn,
represent millions of individual markets for products and factors of production.

The circular flow model shows that goods and services that households demand are supplied
by firms in product markets. The exchange for goods and services is shown in the top half
of Figure 3.21 “The Circular Flow of Economic Activity”. The bottom half of the exhibit
illustrates the exchanges that take place in factor markets. factor markets are markets in
which households supply factors of production—labor, capital, and natural resources—
demanded by firms.
 Our model is called a circular flow model because households use the income they receive
from their supply of factors of production to buy goods and services from firms. Firms, in turn,
use the payments they receive from households to pay for their factors of production.

The demand and supply model developed in this chapter gives us a basic tool for understanding
what is happening in each of these product or factor markets and also allows us to see how
these markets are interrelated. In Figure 3.21 “The Circular Flow of Economic Activity”,
markets for three goods and services that households want—blue jeans, haircuts, and
apartments—create demands by firms for textile workers, barbers, and apartment buildings.
The equilibrium of supply and demand in each market determines the price and quantity of
that item. Moreover, a change in equilibrium in one market will affect equilibrium in related
markets. For example, an increase in the demand for haircuts would lead to an increase in
demand for barbers. Equilibrium price and quantity could rise in both markets. For some
purposes, it will be adequate to simply look at a single market, whereas at other times we will
want to look at what happens in related markets as well.

In either case, the model of demand and supply is one of the most widely used tools of
economic analysis. That widespread use is no accident. The model yields results that are, in
fact, broadly consistent with what we observe in the marketplace. Your mastery of this model
will pay big dividends in your study of economics.

Key Takeaways

• The equilibrium price is the price at which the quantity demanded equals the quantity
supplied. It is determined by the intersection of the demand and supply curves.

• A surplus exists if the quantity of a good or service supplied exceeds the quantity demanded
at the current price; it causes downward pressure on price. A shortage exists if the quantity
of a good or service demanded exceeds the quantity supplied at the current price; it causes
upward pressure on price.

• An increase in demand, all other things unchanged, will cause the equilibrium price to rise;
quantity supplied will increase. A decrease in demand will cause the equilibrium price to
fall; quantity supplied will decrease.

• An increase in supply, all other things unchanged, will cause the equilibrium price to fall;
quantity demanded will increase. A decrease in supply will cause the equilibrium price to
rise; quantity demanded will decrease.

• To determine what happens to equilibrium price and equilibrium quantity when both the
supply and demand curves shift, you must know in which direction each of the curves shifts
and the extent to which each curve shifts.

• The circular flow model provides an overview of demand and supply in product and factor
markets and suggests how these markets are linked to one another.

Try It!
What happens to the equilibrium price and the equilibrium quantity of DVD rentals if the price
of movie theater tickets increases and wages paid to DVD rental store clerks increase, all other
things unchanged? Be sure to show all possible scenarios, as was done in Figure 3.19
“Simultaneous Decreases in Demand and Supply”. Again, you do not need actual numbers to
arrive at an answer. Just focus on the general position of the curve(s) before and after events
occurred.

Case in Point: Demand, Supply, and Obesity

Figure 3.22

Why are so many Americans fat? Put so crudely, the question may seem rude, but, indeed, the
number of obese Americans has increased by more than 50% over the last generation, and
obesity may now be the nation’s number one health problem. According to Sturm Roland in a
recent RAND Corporation study, “Obesity appears to have a stronger association with the
occurrence of chronic medical conditions, reduced physical health-related quality of life and
increased health care and medication expenditures than smoking or problem drinking.”
Many explanations of rising obesity suggest higher demand for food. What more apt picture
of our sedentary life style is there than spending the afternoon watching a ballgame on TV,
while eating chips and salsa, followed by a dinner of a lavishly topped, take-out pizza? Higher
income has also undoubtedly contributed to a rightward shift in the demand curve for food.
Plus, any additional food intake translates into more weight increase because we spend so few
calories preparing it, either directly or in the process of earning the income to buy it. A study
by economists Darius Lakdawalla and Tomas Philipson suggests that about 60% of the recent
growth in weight may be explained in this way—that is, demand has shifted to the right,
leading to an increase in the equilibrium quantity of food consumed and, given our less
strenuous life styles, even more weight gain than can be explained simply by the increased
amount we are eating.

What accounts for the remaining 40% of the weight gain? Lakdawalla and Philipson further
reason that a rightward shift in demand would by itself lead to an increase in the quantity of
food as well as an increase in the price of food. The problem they have with this explanation
is that over the post-World War II period, the relative price of food has declined by an average
of 0.2 percentage points per year. They explain the fall in the price of food by arguing that
agricultural innovation has led to a substantial rightward shift in the supply curve of food. As
shown, lower food prices and a higher equilibrium quantity of food have resulted from
simultaneous rightward shifts in demand and supply and that the rightward shift in the supply
of food from S1 to S2 has been substantially larger than the rightward shift in the demand
curve from D1 to D2.
Figure 3.23
 Sources: Roland, Sturm, “The Effects of Obesity, Smoking, and Problem Drinking on Chronic
Medical Problems and Health Care Costs,” Health Affairs, 2002; 21(2): 245–253. Lakdawalla,
Darius and Tomas Philipson, “The Growth of Obesity and Technological Change: A
Theoretical and Empirical Examination,” National Bureau of Economic Research Working
Paper no. w8946, May 2002.

Answer to Try It! Problem

An increase in the price of movie theater tickets (a substitute for DVD rentals) will cause the
demand curve for DVD rentals to shift to the right. An increase in the wages paid to DVD
rental store clerks (an increase in the cost of a factor of production) shifts the supply curve to
the left. Each event taken separately causes equilibrium price to rise. Whether equilibrium
quantity will be higher or lower depends on which curve shifted more.

If the demand curve shifted more, then the equilibrium quantity of DVD rentals will rise [Panel
(a)].

If the supply curve shifted more, then the equilibrium quantity of DVD rentals will fall [Panel
(b)].

If the curves shifted by the same amount, then the equilibrium quantity of DVD rentals would
not change [Panel (c)].
Figure 3.24
 TOPIC 3 : The Price Elasticity of Demand

Learning Objectives

1. Explain the concept of price elasticity of demand and its calculation.

2. Explain what it means for demand to be price inelastic, unit price elastic, price elastic,
perfectly price inelastic, and perfectly price elastic.

3. Explain how and why the value of the price elasticity of demand changes along a linear
demand curve.

4. Understand the relationship between total revenue and price elasticity of demand.

5. Discuss the determinants of price elasticity of demand.

INTRODUCTION

We know from the law of demand how the quantity demanded will respond to a price change:
it will change in the opposite direction. But how much will it change? It seems reasonable to
expect, for example, that a 10% change in the price charged for a visit to the doctor would
yield a different percentage change in quantity demanded than a 10% change in the price of a
Ford Mustang. But how much is this difference?

To show how responsive quantity demanded is to a change in price, we apply the concept of
elasticity. The price elasticity of demand for a good or service, eD, is the percentage change
in quantity demanded of a particular good or service divided by the percentage change in the
price of that good or service, all other things unchanged. Thus we can write:

Equation 5.2

eD=% change in quantity demanded% change in priceeD=% change in quantity demanded%

change in price

Because the price elasticity of demand shows the responsiveness of quantity demanded to a
price change, assuming that other factors that influence demand are unchanged, it reflects
movements along a demand curve. With a downward-sloping demand curve, price and
quantity demanded move in opposite directions, so the price elasticity of demand is always
negative. A positive percentage change in price implies a negative percentage change in
quantity demanded, and vice versa. Sometimes you will see the absolute value of the price
elasticity measure reported. In essence, the minus sign is ignored because it is expected that
there will be a negative (inverse) relationship between quantity demanded and price. In this
text, however, we will retain the minus sign in reporting price elasticity of demand and will
say “the absolute value of the price elasticity of demand” when that is what we are describing.
Heads Up!

Be careful not to confuse elasticity with slope. The slope of a line is the change in the value of
the variable on the vertical axis divided by the change in the value of the variable on the
horizontal axis between two points. Elasticity is the ratio of the percentage changes. The slope
of a demand curve, for example, is the ratio of the change in price to the change in quantity
between two points on the curve. The price elasticity of demand is the ratio of the percentage
change in quantity to the percentage change in price. As we will see, when computing elasticity
at different points on a linear demand curve, the slope is constant—that is, it does not change—
but the value for elasticity will change.

Computing the Price Elasticity of Demand

Finding the price elasticity of demand requires that we first compute percentage changes in
price and in quantity demanded. We calculate those changes between two points on a demand
curve.

Figure 5.1 “Responsiveness and Demand” shows a particular demand curve, a linear demand
curve for public transit rides. Suppose the initial price is $0.80, and the quantity demanded is
40,000 rides per day; we are at point A on the curve. Now suppose the price falls to $0.70, and
we want to report the responsiveness of the quantity demanded. We see that at the new price,
the quantity demanded rises to 60,000 rides per day (point B). To compute the elasticity, we
need to compute the percentage changes in price and in quantity demanded between points A
and B.
Figure 5.1 Responsiveness and Demand

The demand curve shows how changes in price lead to changes in the quantity demanded. A
movement from point A to point B shows that a $0.10 reduction in price increases the number
of rides per day by 20,000. A movement from B to A is a $0.10 increase in price, which reduces
quantity demanded by 20,000 rides per day.

We measure the percentage change between two points as the change in the variable divided
by the average value of the variable between the two points. Thus, the percentage change in
quantity between points A and B in Figure 5.1 “Responsiveness and Demand” is computed
relative to the average of the quantity values at points A and B: (60,000 + 40,000)/2 = 50,000.
The percentage change in quantity, then, is 20,000/50,000, or 40%. Likewise, the percentage
change in price between points A and B is based on the average of the two prices: ($0.80 +
$0.70)/2 = $0.75, and so we have a percentage change of −0.10/0.75, or −13.33%. The price
elasticity of demand between points A and B is thus 40%/(−13.33%) = −3.00.

This measure of elasticity, which is based on percentage changes relative to the average value
of each variable between two points, is called arc elasticity. The arc elasticity method has the
advantage that it yields the same elasticity whether we go from point A to point B or from
point B to point A. It is the method we shall use to compute elasticity.

For the arc elasticity method, we calculate the price elasticity of demand using the average
value of price,¯PP¯, and the average value of quantity demanded,¯QQ¯. We shall use the
Greek letter Δ to mean “change in,” so the change in quantity between two points is ΔQ and
the change in price is ΔP. Now we can write the formula for the price elasticity of demand as
Equation 5.3

eD=ΔQ/¯QΔP/¯PeD=ΔQ/Q¯ΔP/P¯

The price elasticity of demand between points A and B is thus:

eD=20,000(40,000+60,000)/2−$0.10($0.80+$0.70)/2=40%−13.33%=−3.00eD=20,000(40,00
0+60,000)/2−$0.10($0.80+$0.70)/2=40%−13.33%=−3.00

With the arc elasticity formula, the elasticity is the same whether we move from point A to
point B or from point B to point A. If we start at point B and move to point A, we have:

eD=−20,000(60,000+40,000)/2$0.10($0.80+$0.70)/2=−40%13.33%=−3.00eD=−20,000(60,0
00+40,000)/2$0.10($0.80+$0.70)/2=−40%13.33%=−3.00

The arc elasticity method gives us an estimate of elasticity. It gives the value of elasticity at
the midpoint over a range of change, such as the movement between points A and B. For a
precise computation of elasticity, we would need to consider the response of a dependent
variable to an extremely small change in an independent variable. The fact that arc elasticities
are approximate suggests an important practical rule in calculating arc elasticities: we should
consider only small changes in independent variables. We cannot apply the concept of arc
elasticity to large changes.

Another argument for considering only small changes in computing price elasticities of
demand will become evident in the next section. We will investigate what happens to price
elasticities as we move from one point to another along a linear demand curve.

Heads Up!

Notice that in the arc elasticity formula, the method for computing a percentage change differs
from the standard method with which you may be familiar. That method measures the
percentage change in a variable relative to its original value. For example, using the standard
method, when we go from point A to point B, we would compute the percentage change in
quantity as 20,000/40,000 = 50%. The percentage change in price would be −$0.10/$0.80 =
−12.5%. The price elasticity of demand would then be 50%/(−12.5%) = −4.00. Going from
point B to point A, however, would yield a different elasticity. The percentage change in
quantity would be −20,000/60,000, or −33.33%. The percentage change in price would be
$0.10/$0.70 = 14.29%. The price elasticity of demand would thus be −33.33%/14.29% =
−2.33. By using the average quantity and average price to calculate percentage changes, the
arc elasticity approach avoids the necessity to specify the direction of the change and, thereby,
gives us the same answer whether we go from A to B or from B to A.

Price Elasticities Along a Linear Demand Curve

What happens to the price elasticity of demand when we travel along the demand curve? The
answer depends on the nature of the demand curve itself. On a linear demand curve, such as
the one in Figure 5.2 “Price Elasticities of Demand for a Linear Demand Curve”, elasticity
becomes smaller (in absolute value) as we travel downward and to the right.
Figure 5.2 Price Elasticities of Demand for a Linear Demand Curve

The price elasticity of demand varies between different pairs of points along a linear demand
curve. The lower the price and the greater the quantity demanded, the lower the absolute value
of the price elasticity of demand.

Figure 5.2 “Price Elasticities of Demand for a Linear Demand Curve” shows the same demand
curve we saw in Figure 5.1 “Responsiveness and Demand”. We have already calculated the
price elasticity of demand between points A and B; it equals −3.00. Notice, however, that when
we use the same method to compute the price elasticity of demand between other sets of points,
our answer varies. For each of the pairs of points shown, the changes in price and quantity
demanded are the same (a $0.10 decrease in price and 20,000 additional rides per day,
respectively). But at the high prices and low quantities on the upper part of the demand curve,
the percentage change in quantity is relatively large, whereas the percentage change in price
is relatively small. The absolute value of the price elasticity of demand is thus relatively large.
As we move down the demand curve, equal changes in quantity represent smaller and smaller
percentage changes, whereas equal changes in price represent larger and larger percentage
changes, and the absolute value of the elasticity measure declines. Between points C and D,
for example, the price elasticity of demand is −1.00, and between points E and F the price
elasticity of demand is −0.33.

On a linear demand curve, the price elasticity of demand varies depending on the interval over
which we are measuring it. For any linear demand curve, the absolute value of the price
elasticity of demand will fall as we move down and to the right along the curve.

The Price Elasticity of Demand and Changes in Total Revenue

Suppose the public transit authority is considering raising fares. Will its total revenues go up
or down? Total revenue is the price per unit times the number of units sold1. In this case, it
is the fare times the number of riders. The transit authority will certainly want to know whether
a price increase will cause its total revenue to rise or fall. In fact, determining the impact of a
price change on total revenue is crucial to the analysis of many problems in economics.

We will do two quick calculations before generalizing the principle involved. Given the
demand curve shown in Figure 5.2 “Price Elasticities of Demand for a Linear Demand Curve”,
we see that at a price of $0.80, the transit authority will sell 40,000 rides per day. Total revenue
would be $32,000 per day ($0.80 times 40,000). If the price were lowered by $0.10 to $0.70,
quantity demanded would increase to 60,000 rides and total revenue would increase to $42,000
($0.70 times 60,000). The reduction in fare increases total revenue. However, if the initial
price had been $0.30 and the transit authority reduced it by $0.10 to $0.20, total revenue
would decrease from $42,000 ($0.30 times 140,000) to $32,000 ($0.20 times 160,000). So it
appears that the impact of a price change on total revenue depends on the initial price and, by
implication, the original elasticity. We generalize this point in the remainder of this section.

The problem in assessing the impact of a price change on total revenue of a good or service is
that a change in price always changes the quantity demanded in the opposite direction. An
increase in price reduces the quantity demanded, and a reduction in price increases the quantity
demanded. The question is how much. Because total revenue is found by multiplying the price
per unit times the quantity demanded, it is not clear whether a change in price will cause total
revenue to rise or fall.

We have already made this point in the context of the transit authority. Consider the following
three examples of price increases for gasoline, pizza, and diet cola.

Suppose that 1,000 gallons of gasoline per day are demanded at a price of $4.00 per gallon.
Total revenue for gasoline thus equals $4,000 per day (=1,000 gallons per day times $4.00 per
gallon). If an increase in the price of gasoline to $4.25 reduces the quantity demanded to 950
gallons per day, total revenue rises to $4,037.50 per day (=950 gallons per day times $4.25 per
gallon). Even though people consume less gasoline at $4.25 than at $4.00, total revenue rises
because the higher price more than makes up for the drop in consumption.

Next consider pizza. Suppose 1,000 pizzas per week are demanded at a price of $9 per pizza.
Total revenue for pizza equals $9,000 per week (=1,000 pizzas per week times $9 per pizza).
If an increase in the price of pizza to $10 per pizza reduces quantity demanded to 900 pizzas
per week, total revenue will still be $9,000 per week (=900 pizzas per week times $10 per
pizza). Again, when price goes up, consumers buy less, but this time there is no change in total
revenue.

Now consider diet cola. Suppose 1,000 cans of diet cola per day are demanded at a price of
$0.50 per can. Total revenue for diet cola equals $500 per day (=1,000 cans per day times
$0.50 per can). If an increase in the price of diet cola to $0.55 per can reduces quantity
demanded to 880 cans per month, total revenue for diet cola falls to $484 per day (=880 cans
per day times $0.55 per can). As in the case of gasoline, people will buy less diet cola when
the price rises from $0.50 to $0.55, but in this example total revenue drops.

In our first example, an increase in price increased total revenue. In the second, a price increase
left total revenue unchanged. In the third example, the price rise reduced total revenue. Is there
a way to predict how a price change will affect total revenue? There is; the effect depends on
the price elasticity of demand.
Elastic, Unit Elastic, and Inelastic Demand

To determine how a price change will affect total revenue, economists place price elasticities
of demand in three categories, based on their absolute value. If the absolute value of the price
elasticity of demand is greater than 1, demand is termed price elastic. If it is equal to 1,
demand is unit price elastic. And if it is less than 1, demand is price inelastic.

Relating Elasticity to Changes in Total Revenue

When the price of a good or service changes, the quantity demanded changes in the opposite
direction. Total revenue will move in the direction of the variable that changes by the larger
percentage. If the variables move by the same percentage, total revenue stays the same. If
quantity demanded changes by a larger percentage than price (i.e., if demand is price elastic),
total revenue will change in the direction of the quantity change. If price changes by a larger
percentage than quantity demanded (i.e., if demand is price inelastic), total revenue will move
in the direction of the price change. If price and quantity demanded change by the same
percentage (i.e., if demand is unit price elastic), then total revenue does not change.

When demand is price inelastic, a given percentage change in price results in a smaller
percentage change in quantity demanded. That implies that total revenue will move in the
direction of the price change: a reduction in price will reduce total revenue, and an increase in
price will increase it.

Consider the price elasticity of demand for gasoline. In the example above, 1,000 gallons of
gasoline were purchased each day at a price of $4.00 per gallon; an increase in price to $4.25
per gallon reduced the quantity demanded to 950 gallons per day. We thus had an average
quantity of 975 gallons per day and an average price of $4.125. We can thus calculate the arc
price elasticity of demand for gasoline:
Percentage change in quantity demanded = -
50/975 = -5.1%

Percentage change in price=0.25/4.125=6.06%

Price elasticity of demand = -5.1%/6.06% =

-.084

The demand for gasoline is price inelastic, and total revenue moves in the direction of the price
change. When price rises, total revenue rises. Recall that in our example above, total spending
on gasoline (which equals total revenues to sellers) rose from $4,000 per day (=1,000 gallons
per day times $4.00) to $4037.50 per day (=950 gallons per day times $4.25 per gallon).

When demand is price inelastic, a given percentage change in price results in a smaller
percentage change in quantity demanded. That implies that total revenue will move in the
direction of the price change: an increase in price will increase total revenue, and a reduction
in price will reduce it.

Consider again the example of pizza that we examined above. At a price of $9 per pizza, 1,000
pizzas per week were demanded. Total revenue was $9,000 per week (=1,000 pizzas per week
times $9 per pizza). When the price rose to $10, the quantity demanded fell to 900 pizzas per
week. Total revenue remained $9,000 per week (=900 pizzas per week times $10 per pizza).
Again, we have an average quantity of 950 pizzas per week and an average price of $9.50.
Using the arc elasticity method, we can compute:
Percentage change in quantity demanded = -100/950 = -10.5%

Percentage change in price = $1.00/$9.50 = 10.5%

Price elasticity of demand = -10.5%/10.5% = -1.0

Demand is unit price elastic, and total revenue remains unchanged. Quantity demanded falls
by the same percentage by which price increases.

Consider next the example of diet cola demand. At a price of $0.50 per can, 1,000 cans of diet
cola were purchased each day. Total revenue was thus $500 per day (=$0.50 per can times
1,000 cans per day). An increase in price to $0.55 reduced the quantity demanded to 880 cans
per day. We thus have an average quantity of 940 cans per day and an average price of $0.525
per can. Computing the price elasticity of demand for diet cola in this example, we have:
Percentage change in quantity demanded = -120/940 = -12.8%

Percentage change in price = $0.05/$0.525 = 9.5%

Price elasticity of demand = -12.8%/9.5% = -1.3

The demand for diet cola is price elastic, so total revenue moves in the direction of the quantity
change. It falls from $500 per day before the price increase to $484 per day after the price
increase.

A demand curve can also be used to show changes in total revenue. Figure 5.3 “Changes in
Total Revenue and a Linear Demand Curve” shows the demand curve from Figure 5.1
“Responsiveness and Demand” and Figure 5.2 “Price Elasticities of Demand for a Linear
Demand Curve”. At point A, total revenue from public transit rides is given by the area of a
rectangle drawn with point A in the upper right-hand corner and the origin in the lower left-
hand corner. The height of the rectangle is price; its width is quantity. We have already seen
that total revenue at point A is $32,000 ($0.80 × 40,000). When we reduce the price and move
to point B, the rectangle showing total revenue becomes shorter and wider. Notice that the area
gained in moving to the rectangle at B is greater than the area lost; total revenue rises to
$42,000 ($0.70 × 60,000). Recall from Figure 5.2 “Price Elasticities of Demand for a Linear
Demand Curve” that demand is elastic between points A and B. In general, demand is elastic
in the upper half of any linear demand curve, so total revenue moves in the direction of the
quantity change.
Figure 5.3 Changes in Total Revenue and a Linear Demand Curve
Moving from point A to point B implies a reduction in price and an increase in the quantity
demanded. Demand is elastic between these two points. Total revenue, shown by the areas of
the rectangles drawn from points A and B to the origin, rises. When we move from point E to
point F, which is in the inelastic region of the demand curve, total revenue falls.

A movement from point E to point F also shows a reduction in price and an increase in quantity
demanded. This time, however, we are in an inelastic region of the demand curve. Total
revenue now moves in the direction of the price change—it falls. Notice that the rectangle
drawn from point F is smaller in area than the rectangle drawn from point E, once again
confirming our earlier calculation.
Figure 5.4
We have noted that a linear demand curve is more elastic where prices are relatively high and
quantities relatively low and less elastic where prices are relatively low and quantities
relatively high. We can be even more specific. For any linear demand curve, demand will be
price elastic in the upper half of the curve and price inelastic in its lower half. At the midpoint
of a linear demand curve, demand is unit price elastic.

Constant Price Elasticity of Demand Curves

Figure 5.5 “Demand Curves with Constant Price Elasticities” shows four demand curves over
which price elasticity of demand is the same at all points. The demand curve in Panel (a) is
vertical. This means that price changes have no effect on quantity demanded. The numerator
of the formula given in Equation 5.2 for the price elasticity of demand (percentage change in
quantity demanded) is zero. The price elasticity of demand in this case is therefore zero, and
the demand curve is said to be perfectly inelastic. This is a theoretically extreme case, and no
good that has been studied empirically exactly fits it. A good that comes close, at least over a
specific price range, is insulin. A diabetic will not consume more insulin as its price falls but,
over some price range, will consume the amount needed to control the disease.
Figure 5.5 Demand Curves with Constant Price Elasticities
The demand curve in Panel (a) is perfectly inelastic. The demand curve in Panel (b) is perfectly
elastic. Price elasticity of demand is −1.00 all along the demand curve in Panel (c), whereas it
is −0.50 all along the demand curve in Panel (d).

As illustrated in Figure 5.5 “Demand Curves with Constant Price Elasticities”, several other
types of demand curves have the same elasticity at every point on them. The demand curve in
Panel (b) is horizontal. This means that even the smallest price changes have enormous effects
on quantity demanded. The denominator of the formula given in Equation 5.2 for the price
elasticity of demand (percentage change in price) approaches zero. The price elasticity of
demand in this case is therefore infinite, and the demand curve is said to be perfectly elastic.
This is the type of demand curve faced by producers of standardized products such as wheat.
If the wheat of other farms is selling at $4 per bushel, a typical farm can sell as much wheat as
it wants to at $4 but nothing at a higher price and would have no reason to offer its wheat at a
lower price.

The nonlinear demand curves in Panels (c) and (d) have price elasticities of demand that are
negative; but, unlike the linear demand curve discussed above, the value of the price elasticity
is constant all along each demand curve. The demand curve in Panel (c) has price elasticity of
demand equal to −1.00 throughout its range; in Panel (d) the price elasticity of demand is equal
to −0.50 throughout its range. Empirical estimates of demand often show curves like those in
Panels (c) and (d) that have the same elasticity at every point on the curve.
Heads Up!

Do not confuse price inelastic demand and perfectly inelastic demand. Perfectly inelastic
demand means that the change in quantity is zero for any percentage change in price; the
demand curve in this case is vertical. Price inelastic demand means only that the percentage
change in quantity is less than the percentage change in price, not that the change in quantity
is zero. With price inelastic (as opposed to perfectly inelastic) demand, the demand curve itself
is still downward sloping.

Determinants of the Price Elasticity of Demand

The greater the absolute value of the price elasticity of demand, the greater the responsiveness
of quantity demanded to a price change. What determines whether demand is more or less
price elastic? The most important determinants of the price elasticity of demand for a good or
service are the availability of substitutes, the importance of the item in household budgets, and
time.

Availability of Substitutes

The price elasticity of demand for a good or service will be greater in absolute value if many
close substitutes are available for it. If there are lots of substitutes for a particular good or
service, then it is easy for consumers to switch to those substitutes when there is a price
increase for that good or service. Suppose, for example, that the price of Ford automobiles
goes up. There are many close substitutes for Fords—Chevrolets, Chryslers, Toyotas, and so
on. The availability of close substitutes tends to make the demand for Fords more price elastic.

If a good has no close substitutes, its demand is likely to be somewhat less price elastic. There
are no close substitutes for gasoline, for example. The price elasticity of demand for gasoline
in the intermediate term of, say, three–nine months is generally estimated to be about −0.5.
Since the absolute value of price elasticity is less than 1, it is price inelastic. We would expect,
though, that the demand for a particular brand of gasoline will be much more price elastic than
the demand for gasoline in general.

Importance in Household Budgets

One reason price changes affect quantity demanded is that they change how much a consumer
can buy; a change in the price of a good or service affects the purchasing power of a
consumer’s income and thus affects the amount of a good the consumer will buy. This effect
is stronger when a good or service is important in a typical household’s budget.

A change in the price of jeans, for example, is probably more important in your budget than a
change in the price of pencils. Suppose the prices of both were to double. You had planned to
buy four pairs of jeans this year, but now you might decide to make do with two new pairs. A
change in pencil prices, in contrast, might lead to very little reduction in quantity demanded
simply because pencils are not likely to loom large in household budgets. The greater the
importance of an item in household budgets, the greater the absolute value of the price
elasticity of demand is likely to be.

Time
 Suppose the price of electricity rises tomorrow morning. What will happen to the quantity
demanded?

The answer depends in large part on how much time we allow for a response. If we are
interested in the reduction in quantity demanded by tomorrow afternoon, we can expect that
the response will be very small. But if we give consumers a year to respond to the price change,
we can expect the response to be much greater. We expect that the absolute value of the price
elasticity of demand will be greater when more time is allowed for consumer responses.

Consider the price elasticity of crude oil demand. Economist John C. B. Cooper estimated
short- and long-run price elasticities of demand for crude oil for 23 industrialized nations for
the period 1971–2000. Professor Cooper found that for virtually every country, the price
elasticities were negative, and the long-run price elasticities were generally much greater (in
absolute value) than were the short-run price elasticities. His results are reported in Table 5.1
“Short- and Long-Run Price Elasticities of the Demand for Crude Oil in 23 Countries”. As
you can see, the research was reported in a journal published by OPEC (Organization of
Petroleum Exporting Countries), an organization whose members have profited greatly from
the inelasticity of demand for their product. By restricting supply, OPEC, which produces
about 45% of the world’s crude oil, is able to put upward pressure on the price of crude. That
increases OPEC’s (and all other oil producers’) total revenues and reduces total costs.

Key Takeaways

• The price elasticity of demand measures the responsiveness of quantity demanded to changes
in price; it is calculated by dividing the percentage change in quantity demanded by the
percentage change in price.

• Demand is price inelastic if the absolute value of the price elasticity of demand is less than
1; it is unit price elastic if the absolute value is equal to 1; and it is price elastic if the absolute
value is greater than 1.

• Demand is price elastic in the upper half of any linear demand curve and price inelastic in
the lower half. It is unit price elastic at the midpoint.

• When demand is price inelastic, total revenue moves in the direction of a price change. When
demand is unit price elastic, total revenue does not change in response to a price change.
When demand is price elastic, total revenue moves in the direction of a quantity change.

• The absolute value of the price elasticity of demand is greater when substitutes are available,
when the good is important in household budgets, and when buyers have more time to adjust
to changes in the price of the good.

Try It!

You are now ready to play the part of the manager of the public transit system. Your finance
officer has just advised you that the system faces a deficit. Your board does not want you to
cut service, which means that you cannot cut costs. Your only hope is to increase revenue.
Would a fare increase boost revenue?
 You consult the economist on your staff who has researched studies on public transportation
elasticities. She reports that the estimated price elasticity of demand for the first few months
after a price change is about −0.3, but that after several years, it will be about −1.5.
1. Explain why the estimated values for price elasticity of demand differ.

2. Compute what will happen to ridership and revenue over the next few months if you decide
to raise fares by 5%.

3. Compute what will happen to ridership and revenue over the next few years if you decide to
raise fares by 5%.

4. What happens to total revenue now and after several years if you choose to raise fares?

Case in Point: Elasticity and Stop Lights

We all face the situation every day. You are approaching an intersection. The yellow light
comes on. You know that you are supposed to slow down, but you are in a bit of a hurry. So,
you speed up a little to try to make the light. But the red light flashes on just before you get to
the intersection. Should you risk it and go through?

Many people faced with that situation take the risky choice. In 1998, 2,000 people in the United
States died as a result of drivers running red lights at intersections. In an effort to reduce the
number of drivers who make such choices, many areas have installed cameras at intersections.
Drivers who run red lights have their pictures taken and receive citations in the mail. This
enforcement method, together with recent increases in the fines for driving through red lights
at intersections, has led to an intriguing application of the concept of elasticity. Economists
Avner Bar-Ilan of the University of Haifa in Israel and Bruce Sacerdote of Dartmouth
University have estimated what is, in effect, the price elasticity for driving through stoplights
with respect to traffic fines at intersections in Israel and in San Francisco.

In December 1996, Israel sharply increased the fine for driving through a red light. The old
fine of 400 shekels (this was equal at that time to $122 in the United States) was increased to
1,000 shekels ($305). In January 1998, California raised its fine for the offense from $104 to
$271. The country of Israel and the city of San Francisco installed cameras at several
intersections. Drivers who ignored stoplights got their pictures taken and automatically
received citations imposing the new higher fines.

We can think of driving through red lights as an activity for which there is a demand—after
all, ignoring a red light speeds up one’s trip. It may also generate satisfaction to people who
enjoy disobeying traffic laws. The concept of elasticity gives us a way to show just how
responsive drivers were to the increase in fines.

Professors Bar-Ilan and Sacerdote obtained information on all the drivers cited at 73
intersections in Israel and eight intersections in San Francisco. For Israel, for example, they
defined the period January 1992 to June 1996 as the “before” period. They compared the
number of violations during the before period to the number of violations from July 1996 to
December 1999—the “after” period—and found there was a reduction in tickets per driver of
31.5 per cent. Specifically, the average number of tickets per driver was 0.073 during the
period before the increase; it fell to 0.050 after the increase. The increase in the fine was 150
per cent. (Note that, because they were making a “before” and “after” calculation, the authors
 used the standard method described in the Heads Up! on computing a percentage change—
i.e., they computed the percentage changes in comparison to the original values instead of the
average value of the variables.) The elasticity of citations with respect to the fine was thus
−0.21 (= −31.5%/150%).

The economists estimated elasticities for particular groups of people. For example, young
people (age 17–30) had an elasticity of −0.36; people over the age of 30 had an elasticity of
−0.16. In general, elasticities fell in absolute value as income rose. For San Francisco and
Israel combined, the elasticity was between −0.26 and −0.33.

In general, the results showed that people responded rationally to the increases in fines.
Increasing the price of a particular behavior reduced the frequency of that behavior. The study
also points out the effectiveness of cameras as an enforcement technique. With cameras,
violators can be certain they will be cited if they ignore a red light. And reducing the number
of people running red lights clearly saves lives.
Source: Avner Bar-Ilan and Bruce Sacerdote. “The Response of Criminals and Non-Criminals
to Fines.” Journal of Law and Economics, 47:1 (April 2004): 1–17.

Answers to Try It! Problems

1. The absolute value of price elasticity of demand tends to be greater when more time is allowed
for consumers to respond. Over time, riders of the commuter rail system can organize car pools,
move, or otherwise adjust to the fare increase.

2. Using the formula for price elasticity of demand and plugging in values for the estimate of
price elasticity (−0.5) and the percentage change in price (5%) and then rearranging terms, we
can solve for the percentage change in quantity demanded as: eD = %Δ in Q/%Δ in P; −0.5 =
%Δ in Q/5%; (−0.5)(5%) = %Δ in Q = −2.5%. Ridership falls by 2.5% in the first few months.

3. Using the formula for price elasticity of demand and plugging in values for the estimate of
price elasticity over a few years (−1.5) and the percentage change in price (5%), we can solve
for the percentage change in quantity demanded as eD = %Δ in Q/%Δ in P; −1.5 = %Δ
in Q/5%; (−1.5)(5%) = %Δ in Q = −7.5%. Ridership falls by 7.5% over a few years.

4. Total revenue rises immediately after the fare increase, since demand over the immediate
period is price inelastic. Total revenue falls after a few years, since demand changes and becomes
price elastic.

Notice that since the number of units sold of a good is the same as the number of units bought,
the definition for total revenue could also be used to define total spending. Which term we use
depends on the question at hand. If we are trying to determine what happens to revenues of
sellers, then we are asking about total revenue. If we are trying to determine how much
consumers spend, then we are asking about total spending.

Division by zero results in an undefined solution. Saying that the price elasticity of demand is
infinite requires that we say the denominator “approaches” zero.
TOPIC 4 : CONSUMER CHOICE AND DEMAND

Learning Objectives:

1. Derive an individual demand curve from utility-maximizing adjustments to changes in price.

2. Derive the market demand curve from the demand curves of individuals.

3. Explain the substitution and income effects of a price change.

4. Explain the concepts of normal and inferior goods in terms of the income effect.

INTRODUCTION

You are in the checkout line at the grocery store when your eyes wander over to the ice cream
display. It is a hot day and you could use something to cool you down before you get into your
hot car. The problem is that you have left your checkbook and credit and debit cards at home—
on purpose, actually, because you have decided that you only want to spend $20 today at the
grocery store. You are uncertain whether or not you have brought enough cash with you to pay
for the items that are already in your cart. You put the ice cream bar into your cart and tell the
clerk to let you know if you go over $20 because that is all you have. He rings it up and it comes
to $22. You have to make a choice. You decide to keep the ice cream and ask the clerk if he
would mind returning a box of cookies to the shelf.

We all engage in these kinds of choices every day. We have budgets and must decide how to
spend them. The model of utility theory that economists have constructed to explain consumer
choice assumes that consumers will try to maximize their utility. For example, when you decided
to keep the ice cream bar and return the cookies, you, consciously or not, applied the marginal
decision rule to the problem of maximizing your utility: You bought the ice cream because you
expect that eating it will give you greater satisfaction than would consuming the box of cookies.

Utility theory provides insights into demand. It lets us look behind demand curves to see how
utility-maximizing consumers can be expected to respond to price changes. While the focus of
this chapter is on consumers making decisions about what goods and services to buy, the same
model can be used to understand how individuals make other types of decisions, such as how
much to work and how much of their incomes to spend now or to sock away for the future.

We can approach the analysis of utility maximization in two ways. The first two sections of the
chapter cover the marginal utility concept, while the final section examines an alternative
approach using indifference curves.

Choices that maximize utility—that is, choices that follow the marginal decision rule—
generally produce downward-sloping demand curves. This section shows how an individual’s
utility-maximizing choices can lead to a demand curve.

Deriving an Individual’s Demand Curve

Suppose, for simplicity, that Mary Andrews consumes only apples, denoted by the letter A,
and oranges, denoted by the letter O. Apples cost $2 per pound and oranges cost $1 per pound,
and her budget allows her to spend $20 per month on the two goods. We assume that Ms.
Andrews will adjust her consumption so that the utility-maximizing condition holds for the
two goods: The ratio of marginal utility to price is the same for apples and oranges. That is,
Equation 7.4

MUA$2=MUO$1MUA$2=MUO$1

Here MUA and MUO are the marginal utilities of apples and oranges, respectively. Her
spending equals her budget of $20 per month; suppose she buys 5 pounds of apples and 10 of
oranges.

Now suppose that an unusually large harvest of apples lowers their price to $1 per pound. The
lower price of apples increases the marginal utility of each $1 Ms. Andrews spends on apples,
so that at her current level of consumption of apples and oranges
Equation 7.5

MUA$1>MUO$1MUA$1>MUO$1

Ms. Andrews will respond by purchasing more apples. As she does so, the marginal utility she
receives from apples will decline. If she regards apples and oranges as substitutes, she will
also buy fewer oranges. That will cause the marginal utility of oranges to rise. She will
continue to adjust her spending until the marginal utility per $1 spent is equal for both goods:
Equation 7.6

MUA$1=MUO$1MUA$1=MUO$1

Suppose that at this new solution, she purchases 12 pounds of apples and 8 pounds of oranges.
She is still spending all of her budget of $20 on the two goods [(12 x $1)+(8 x $1)=$20].
Figure 7.3 Utility Maximization and an Individual’s Demand Curve
Mary Andrews’s demand curve for apples, d, can be derived by determining the quantities of
apples she will buy at each price. Those quantities are determined by the application of the
marginal decision rule to utility maximization. At a price of $2 per pound, Ms. Andrews
maximizes utility by purchasing 5 pounds of apples per month. When the price of apples falls
to $1 per pound, the quantity of apples at which she maximizes utility increases to 12 pounds
per month.

It is through a consumer’s reaction to different prices that we trace the consumer’s demand
curve for a good. When the price of apples was $2 per pound, Ms. Andrews maximized her
utility by purchasing 5 pounds of apples, as illustrated in Figure 7.3 “Utility Maximization and
an Individual’s Demand Curve”. When the price of apples fell, she increased the quantity of
apples she purchased to 12 pounds.

Heads Up!

Notice that, in this example, Ms. Andrews maximizes utility where not only the ratios of
marginal utilities to price are equal, but also the marginal utilities of both goods are equal. But,
the equal-marginal-utility outcome is only true here because the prices of the two goods are
the same: each good is priced at $1 in this case. If the prices of apples and oranges were
different, the marginal utilities at the utility maximizing solution would have been different.
The condition for maximizing utility—consume where the ratios of marginal utility to price
are equal—holds regardless. The utility-maximizing condition is not that consumers maximize
utility by equating marginal utilities.
Figure 7.4

Utility maximizing condition is: MUXPX=MUXPYMUXPX=MUXPY

Utility maximizing condition is not: MUX=MUYMUX=MUY

From Individual to Market Demand

The market demand curves we studied in previous chapters are derived from individual
demand curves such as the one depicted in Figure 7.3 “Utility Maximization and an
Individual’s Demand Curve”. Suppose that in addition to Ms. Andrews, there are two other
consumers in the market for apples—Ellen Smith and Koy Keino. The quantities each
consumes at various prices are given in Figure 7.5 “Deriving a Market Demand Curve”, along
with the quantities that Ms. Andrews consumes at each price. The demand curves for each are
shown in Panel (a). The market demand curve for all three consumers, shown in Panel (b), is
then found by adding the quantities demanded at each price for all three consumers. At a price
of $2 per pound, for example, Ms. Andrews demands 5 pounds of apples per month, Ms. Smith
demands 3 pounds, and Mr. Keino demands 8 pounds. A total of 16 pounds of apples are
demanded per month at this price. Adding the individual quantities demanded at $1 per pound
yields market demand of 40 pounds per month. This method of adding amounts along the
horizontal axis of a graph is referred to as summing horizontally. The market demand curve is
thus the horizontal summation of all the individual demand curves.
Figure 7.5 Deriving a Market Demand Curve

The demand schedules for Mary Andrews, Ellen Smith, and Koy Keino are given in the table.
Their individual demand curves are plotted in Panel (a). The market demand curve for all three
is shown in Panel (b).

Individual demand curves, then, reflect utility-maximizing adjustment by consumers to

various market prices. Once again, we see that as the price falls, consumers tend to buy more
of a good. Demand curves are downward-sloping as the law of demand asserts.
Substitution and Income Effects

We saw that when the price of apples fell from $2 to $1 per pound, Mary Andrews increased
the quantity of apples she demanded. Behind that adjustment, however, lie two distinct effects:
the substitution effect and the income effect. It is important to distinguish these effects,
because they can have quite different implications for the elasticity of the demand curve.

First, the reduction in the price of apples made them cheaper relative to oranges. Before the
price change, it cost the same amount to buy 2 pounds of oranges or 1 pound of apples. After
the price change, it cost the same amount to buy 1 pound of either oranges or apples. In effect,
2 pounds of oranges would exchange for 1 pound of apples before the price change, and 1
pound of oranges would exchange for 1 pound of apples after the price change.

Second, the price reduction essentially made consumers of apples richer. Before the price
change, Ms. Andrews was purchasing 5 pounds of apples and 10 pounds of oranges at a total
cost to her of $20. At the new lower price of apples, she could purchase this same combination
for $15. In effect, the price reduction for apples was equivalent to handing her a $5 bill, thereby
increasing her purchasing power. Purchasing power refers to the quantity of goods and services
that can be purchased with a given budget.

To distinguish between the substitution and income effects, economists consider first the
impact of a price change with no change in the consumer’s ability to purchase goods and
services. An income-compensated price changeAn imaginary exercise in which we assume
that when the price of a good or service changes, the consumers income is adjusted so that he
or she has just enough to purchase the original combination of goods and services at the new
set of prices. is an imaginary exercise in which we assume that when the price of a good or
service changes, the consumer’s income is adjusted so that he or she has just enough to
purchase the original combination of goods and services at the new set of prices. Ms. Andrews
was purchasing 5 pounds of apples and 10 pounds of oranges before the price change. Buying
that same combination after the price change would cost $15. The income-compensated price
change thus requires us to take $5 from Ms. Andrews when the price of apples falls to $1 per
pound. She can still buy 5 pounds of apples and 10 pounds of oranges. If, instead, the price of
apples increased, we would give Ms. Andrews more money (i.e., we would “compensate” her)
so that she could purchase the same combination of goods.

With $15 and cheaper apples, Ms. Andrews could buy 5 pounds of apples and 10 pounds of
oranges. But would she? The answer lies in comparing the marginal benefit of spending
another $1 on apples to the marginal benefit of spending another $1 on oranges, as expressed
in Equation 7.5. It shows that the extra utility per $1 she could obtain from apples now exceeds
the extra utility per $1 from oranges. She will thus increase her consumption of apples. If she
had only $15, any increase in her consumption of apples would require a reduction in her
consumption of oranges. In effect, she responds to the income-compensated price change for
apples by substituting apples for oranges. The change in a consumer’s consumption of a good
in response to an income-compensated price change is called the substitution effectThe
change in a consumers consumption of a good in response to an income-compensated price
change..

Suppose that with an income-compensated reduction in the price of apples to $1 per pound,
Ms. Andrews would increase her consumption of apples to 9 pounds per month and reduce her
consumption of oranges to 6 pounds per month. The substitution effect of the price reduction
is an increase in apple consumption of 4 pounds per month.
The substitution effect always involves a change in consumption in a direction opposite that
of the price change. When a consumer is maximizing utility, the ratio of marginal utility to
price is the same for all goods. An income-compensated price reduction increases the extra
utility per dollar available from the good whose price has fallen; a consumer will thus purchase
more of it. An income-compensated price increase reduces the extra utility per dollar from the
good; the consumer will purchase less of it.

In other words, when the price of a good falls, people react to the lower price by substituting
or switching toward that good, buying more of it and less of other goods, if we artificially hold
the consumer’s ability to buy goods constant. When the price of a good goes up, people react
to the higher price by substituting or switching away from that good, buying less of it and
instead buying more of other goods. By examining the impact of consumer purchases of an
income-compensated price change, we are looking at just the change in relative prices of goods
and eliminating any impact on consumer buying that comes from the effective change in the
consumer’s ability to purchase goods and services (that is, we hold the consumer’s purchasing
power constant).

To complete our analysis of the impact of the price change, we must now consider the $5 that
Ms. Andrews effectively gained from it. After the price reduction, it cost her just $15 to buy
what cost her $20 before. She has, in effect, $5 more than she did before. Her additional income
may also have an effect on the number of apples she consumes. The change in consumption
of a good resulting from the implicit change in income because of a price change is called
the income effectThe change in consumption of a good resulting from the implicit change in
income because of a price change. of a price change. When the price of a good rises, there is
an implicit reduction in income. When the price of a good falls, there is an implicit increase.
When the price of apples fell, Ms. Andrews (who was consuming 5 pounds of apples per
month) received an implicit increase in income of $5.

Suppose Ms. Andrews uses her implicit increase in income to purchase 3 more pounds of
apples and 2 more pounds of oranges per month. She has already increased her apple
consumption to 9 pounds per month because of the substitution effect, so the added 3 pounds
brings her consumption level to 12 pounds per month. That is precisely what we observed
when we derived her demand curve; it is the change we would observe in the marketplace. We
see now, however, that her increase in quantity demanded consists of a substitution effect and
an income effect. Figure 7.6 “The Substitution and Income Effects of a Price Change” shows
the combined effects of the price change.
Figure 7.6 The Substitution and Income Effects of a Price Change
This demand curve for Ms. Andrews was presented in Figure 7.5 “Deriving a Market Demand
Curve”. It shows that a reduction in the price of apples from $2 to $1 per pound increases the
quantity Ms. Andrews demands from 5 pounds of apples to 12. This graph shows that this
change consists of a substitution effect and an income effect. The substitution effect increases
the quantity demanded by 4 pounds, the income effect by 3, for a total increase in quantity
demanded of 7 pounds.

The size of the substitution effect depends on the rate at which the marginal utilities of goods
change as the consumer adjusts consumption to a price change. As Ms. Andrews buys more
apples and fewer oranges, the marginal utility of apples will fall and the marginal utility of
oranges will rise. If relatively small changes in quantities consumed produce large changes in
marginal utilities, the substitution effect that is required to restore the equality of marginal-
utility-to-price ratios will be small. If much larger changes in quantities consumed are needed
to produce equivalent changes in marginal utilities, then the substitution effect will be large.

The magnitude of the income effect of a price change depends on how responsive the demand
for a good is to a change in income and on how important the good is in a consumer’s budget.
When the price changes for a good that makes up a substantial fraction of a consumer’s budget,
the change in the consumer’s ability to buy things is substantial. A change in the price of a
good that makes up a trivial fraction of a consumer’s budget, however, has little effect on his
or her purchasing power; the income effect of such a price change is small.

Because each consumer’s response to a price change depends on the sizes of the substitution
and income effects, these effects play a role in determining the price elasticity of demand. All
other things unchanged, the larger the substitution effect, the greater the absolute value of the
price elasticity of demand. When the income effect moves in the same direction as the
substitution effect, a greater income effect contributes to a greater price elasticity of demand
 as well. There are, however, cases in which the substitution and income effects move in
opposite directions. We shall explore these ideas in the next section.

Normal and Inferior Goods

The nature of the income effect of a price change depends on whether the good is normal or
inferior. The income effect reinforces the substitution effect in the case of normal goods; it
works in the opposite direction for inferior goods.

Normal Goods

A normal good is one whose consumption increases with an increase in income. When the
price of a normal good falls, there are two identifying effects:

1. The substitution effect contributes to an increase in the quantity demanded because consumers
substitute more of the good for other goods.
2. The reduction in price increases the consumer’s ability to buy goods. Because the good is
normal, this increase in purchasing power further increases the quantity of the good demanded
through the income effect.

In the case of a normal good, then, the substitution and income effects reinforce each other.
Ms. Andrews’s response to a price reduction for apples is a typical response to a lower price
for a normal good.

An increase in the price of a normal good works in an equivalent fashion. The higher price
causes consumers to substitute more of other goods, whose prices are now relatively lower.
The substitution effect thus reduces the quantity demanded. The higher price also reduces
purchasing power, causing consumers to reduce consumption of the good via the income
effect.

Inferior Goods

In the chapter that introduced the model of demand and supply, we saw that an inferior good
is one for which demand falls when income rises. It is likely to be a good that people do not
really like very much. When incomes are low, people consume the inferior good because it is
what they can afford. As their incomes rise and they can afford something they like better,
they consume less of the inferior good. When the price of an inferior good falls, two things
happen:

1. Consumers will substitute more of the inferior good for other goods because its price has fallen
relative to those goods. The quantity demanded increases as a result of the substitution effect.
2. The lower price effectively makes consumers richer. But, because the good is inferior, this
reduces quantity demanded.

The case of inferior goods is thus quite different from that of normal goods. The income effect
of a price change works in a direction opposite to that of the substitution effect in the case of
an inferior good, whereas it reinforces the substitution effect in the case of a normal good.
Figure 7.7 Substitution and Income Effects for Inferior Goods
 The substitution and income effects work against each other in the case of inferior goods. The
consumer begins at point A, consuming q1 units of the good at a price P1. When the price falls
to P2, the consumer moves to point B, increasing quantity demanded to q2. The substitution
effect increases quantity demanded to qs, but the income effect reduces it from qs to q2.

Figure 7.7 “Substitution and Income Effects for Inferior Goods” illustrates the substitution and
income effects of a price reduction for an inferior good. When the price falls from P1 to P2,
the quantity demanded by a consumer increases from q1 to q2. The substitution effect
increases quantity demanded from q1 to qs. But the income effect reduces quantity demanded
from qs to q2; the substitution effect is stronger than the income effect. The result is consistent
with the law of demand: A reduction in price increases the quantity demanded. The quantity
demanded is smaller, however, than it would be if the good were normal. Inferior goods are
therefore likely to have less elastic demand than normal goods.

Key Takeaways

• Individual demand curves reflect utility-maximizing adjustment by consumers to changes in

price.

• Market demand curves are found by summing horizontally the demand curves of all the
consumers in the market.

• The substitution effect of a price change changes consumption in a direction opposite to the
price change.
• The income effect of a price change reinforces the substitution effect if the good is normal;
it moves consumption in the opposite direction if the good is inferior.

Try It!

Ilana Drakulic has an entertainment budget of $200 per semester, which she divides among
purchasing CDs, going to concerts, eating in restaurants, and so forth. When the price of CDs
fell from $20 to $10, her purchases rose from 5 per semester to 10 per semester. When asked
how many she would have bought if her budget constraint were $150 (since with $150 she
could continue to buy 5 CDs and as before still have $100 for spending on other items), she
said she would have bought 8 CDs. What is the size of her substitution effect? Her income
effect? Are CDs normal or inferior for her? Which exhibit, Figure 7.6 “The Substitution and
Income Effects of a Price Change” or Figure 7.7 “Substitution and Income Effects for Inferior
Goods”, depicts more accurately her demand curve for CDs?

Case in Point: Found! An Upward-Sloping Demand Curve

Figure 7.8

Charles Haynes – rice – CC BY-SA 2.0.

The fact that income and substitution effects move in opposite directions in the case of inferior
goods raises a tantalizing possibility: What if the income effect were the stronger of the two?
Could demand curves be upward sloping?

The answer, from a theoretical point of view, is yes. If the income effect in Figure 7.7
“Substitution and Income Effects for Inferior Goods” were larger than the substitution effect,
the decrease in price would reduce the quantity demanded below q1. The result would be a
reduction in quantity demanded in response to a reduction in price. The demand curve would
be upward sloping!
The suggestion that a good could have an upward-sloping demand curve is generally attributed
to Robert Giffen, a British journalist who wrote widely on economic matters late in the
nineteenth century. Such goods are thus called Giffen goods. To qualify as a Giffen good, a
good must be inferior and must have an income effect strong enough to overcome the
substitution effect. The example often cited of a possible Giffen good is the potato during the
Irish famine of 1845–1849. Empirical analysis by economists using available data, however,
has refuted the notion of the upward-sloping demand curve for potatoes at that time. The most
convincing parts of the refutation were to point out that (a) given the famine, there were not
more potatoes available for purchase then and (b) the price of potatoes may not have even
increased during the period!

A recent study by Robert Jensen and Nolan Miller, though, suggests the possible discovery of
a pair of Giffen goods. They began their search by thinking about the type of good that would
be likely to exhibit Giffen behavior and argued that, like potatoes for the poor Irish, it would
be a main dietary staple of a poor population. In such a situation, purchases of the item are
such a large percentage of the diet of the poor that when the item’s price rises, the implicit
income of the poor falls drastically. In order to subsist, the poor reduce consumption of other
goods so they can buy more of the staple. In so doing, they are able to reach a caloric intake
that is higher than what can be achieved by buying more of other preferred foods that
unfortunately supply fewer calories.

Their preliminary empirical work shows that in southern China rice is a Giffen good for poor
consumers while in northern China noodles are a Giffen good. In both cases, the basic good
(rice or noodles) provides calories at a relatively low cost and dominates the diet, while meat
is considered the tastier but higher cost-per-calorie food. Using detailed household data, they
estimate that among the poor in southern China a 10% increase in the price of rice leads to a
10.4% increase in rice consumption. For wealthier households in the region, rice is inferior but
not Giffen. For both groups of households, the income effect of a price change moves
consumption in the opposite direction of the substitution effect. Only in the poorest
households, however, does it swamp the substitution effect, leading to an upward-sloping
demand curve for rice for poor households. In northern China, the net effect of a price increase
on quantity demanded of noodles is smaller, though it still leads to higher noodle consumption
in the poorest households of that region.

In a similar study, David McKenzie tested whether tortillas were a Giffen good for poor
Mexicans. He found, however, that they were an inferior good but not a Giffen good. He
speculated that the different result may stem from poor Mexicans having a wider range of
substitutes available to them than do the poor in China.

Because the Jensen/Miller study is the first vindication of the existence of a Giffen good
despite a very long search, the authors have avoided rushing to publication of their results.
Rather, they have made available a preliminary version of the study reported on here while
continuing to refine their estimation.
Sources: Robert Jensen and Nolan Miller, “Giffen Behavior: Theory and Evidence,” KSG
Faculty Research Working Papers Series RWP02-014, 2002 available
at ksghome.harvard.edu/~nmiller/giffen.html or http://ssrn.com/abstract=310863. At the
authors’ request we include the following note on the preliminary version: “Because we have
received numerous requests for this paper, we are making this early draft available. The results
presented in this version, while strongly suggestive of Giffen behavior, are preliminary. In the
near future we expect to acquire additional data that will allow us to revise our estimation
 technique. In particular, monthly temperature, precipitation, and other weather data will enable
us to use an instrumental variables approach to address the possibility that the observed
variation in prices is not exogenous. Once available, the instrumental variables results will be
incorporated into future versions of the paper.” ; David McKenzie, “Are Tortillas a Giffen
Good in Mexico?” Economics Bulletin 15:1 (2002): 1–7.

Answer to Try It! Problem

One hundred fifty dollars is the income that allows Ms. Drakulic to purchase the same items
as before, and thus can be used to measure the substitution effect. Looking only at the
income-compensated price change (that is, holding her to the same purchasing power as in
the original relative price situation), we find that the substitution effect is 3 more CDs (from
5 to 8). The CDs that she buys beyond 8 constitute her income effect; it is 2 CDs. Because
the income effect reinforces the substitution effect, CDs are a normal good for her and her
demand curve is similar to that shown in Figure 7.6 “The Substitution and Income Effects of
a Price Change”
______________________________________

Module 5

THEORY OF PRODUCTION

Week 10-11

INTRODUCTION

Basically, goods and services cannot be produced without utilizing the factors of
production such as land, labor, capital, and entrepreneurship. It is the fundamental decision
of the firm to determine the amount of goods and services to produce and how much factors
of production to apply together with other inputs to generate an output with the highest level
of efficiency.
This module focuses with the general discussion of production theory, with the
specific case where there is one variable input depicting the law of diminishing marginal
returns, three stages of production, and the return to scale. An in-depth discussion on the
two variable inputs such as isocost and isoquant concepts also follows, extending to the
condition for attaining the producer’s equilibrium.

INTENDED LEARNING OUTCOMES

After studying this module, students will be able to:

1. Describe the three stages of production.
2. Explain the relationship between Marginal Product (MP) and Average Product (AP).
3. Explain the difference between short-run and long-run analysis of production.
4. Explain the Law of Diminishing Marginal Returns and give numerical example.
Theory of Production

It explains the principles in which the business/firm has to take decisions on how much of
each commodity it sells and how much it produces and also how much of raw material i.e.,
fixed capital and labor it employs and how much it will use. It defines the relationships between
the prices of the commodities and productive factors on one hand and the quantities of these
commodities and productive factors that are produced on the other hand.

What is Production?

• Production is the transformation of inputs into outputs.

• The process of transforming inputs into outputs can be any of the following kinds:
* Change in the Form (Raw material transformed to finished goods )
* Change in Place ( Supply chain, Factory to Retailer)
• Production takes inputs and uses them to create an output which is fit for
consumption of a good or product which has value to an end-user or customer.

• Also, it defined as a process of combining various inputs to produce an output for

consumption. It is the act of creating output in the form of a commodity or a service which
contributes to the utility of individuals. In other words, it is a process in which the inputs are
converted into outputs.

Understanding Important Terms in Production

• Inputs are the factors of production or resources.

• Output is the result that has been created by the inputs (in this case, when labor
and
capital are combined).

There are two types of output:

• Goods - are materials that satisfy human wants and provide utility, for example, to
a consumer making a purchase of a satisfying product. A common distinction is made
between goods that are tangible property, and services, which are non-physical.

• Services - is a transaction in which no physical goods are transferred from the seller
to the buyer. The benefits of such a service are held to be demonstrated by the buyer's
willingness to make the exchange.

Factors of Production

• Factors of production are the inputs needed for the creation of a good or service. The factors
of production include land, labor, entrepreneurship, and capital.

• Land has a broad definition as a factor of production and can take on various forms,
from agricultural land to commercial real estate to the resources available from a particular
piece of land. Natural resources, such as oil and gold, can be extracted and refined for human
consumption from the land.

• Capital typically refers to money. But money is not a factor of production because it
is not directly involved in producing a good or service. Instead, it facilitates the processes
used in production by enabling entrepreneurs and company owners to purchase capital goods
or land or pay wages. As a factor of production, capital refers to the purchase of goods made
with money in production. For example, a tractor purchased for farming is capital. Along the
same lines, desks and chairs used in an office are also capital.

• Labor actually means any type of physical or mental exertion. In economic terms,
labor is the efforts exerted to produce any goods or services. It includes all types of human
efforts – physical exertion, mental exercise, use of intellect, etc. done in exchange for an
economic reward.

• Entrepreneurship is the secret sauce that combines all the other factors of
production into a product or service for the consumer market.

Concept of Production

The theory involves some of the most fundamental principles of economics. These include
the relationship between the prices of commodities and the prices of the productive factors
used to produce them and also the relationships between the prices of commodities and
productive factors, on the one hand, and the quantities of these commodities and productive
factors that are produced or used, on the other.

Production Function

The production function shows the relationship between quantities of various inputs used and
the maximum (technically feasible) output can be produced with those inputs used per unit of
time expressed in a table, graph or an equation.

• A tool of analysis used in explaining the input-output relationship. It describes the technical
relationship between inputs and output in physical terms. In its general form, it holds that
production of a given commodity depends on certain specific inputs.

• In its specific form, it presents the quantitative relationships between inputs and outputs. A
production function may take the form of a schedule, a graph line or a curve, an algebraic
equation or a mathematical model. The production function represents the technology of a
firm.

Long-run production

• An empirical production function is generally so complex to include a wide range of

inputs: land, labour, capital, raw materials, time, and technology. These variables form the
independent variables in a firm’s actual production function.

• A firm’s long-run production function is of the form: Q = f(Ld, L, K, M, T, t) where Ld

= land and building; L = labour; K = capital; M = materials; T = technology; and, t = time.

• For sake of convenience, economists have reduced the number of variables used in
a production function to only two: capital (K) and labor (L). Therefore, in the analysis of input-
output relations, the production function is expressed as: Q = f(K, L)

• Increasing production, Q, will require K and L, and whether the firm can increase
both K and L or only L will depend on the time period it takes into account for increasing
production, that is, whether the firm is thinking in terms of the short run or in terms of the long
run.
 • Economists believe that the supply of capital (K) is inelastic in the short run and
elastic in the long run.

• Thus, in the short run firms can increase production only by increasing labor, since
the supply of capital is fixed in the short run. In the long run, the firm can employ more of both
capital and labor, as the supply of capital becomes elastic over time.

Short Run Production

• In the short run, capital is fixed – Only changes in the variable labor input can change the
level
of output
• Short run production function Q = f ( L,K ) = f ( L )

The Short-run Vs. Long-run Analysis of Production

All production in real time occurs in the short run. In the short run, a profit-maximizing firm
will:

• Increase production if marginal cost is less than marginal revenue (added revenue
per
additional unit of output)

• Decrease production if marginal cost is greater than marginal value

• Continue producing if marginal variable cost is less than price per unit, even if
average
total cost is greater than price

• Shut down if average variable cost is greater that price at each level of output

Table 1 Hypothetical Data of Production with One Variable

Production with One Variable Input

• Average Product (AP) is the quantity of total output produced per unit of a variable
input, holding all other inputs fixed. Average product, usually abbreviated AP, is found by
dividing total product by the quantity of the variable input. Average product is generally
considered less important than total product and marginal product in the analysis of short-run
production.
Average Product = Total Product/ Units of Variable Factor Input

• Marginal Product (MP) is the additional output produced as a result of employing

an additional unit of the variable factor input. Thus, we can say that marginal product is the
addition to Total Product when an extra factor input is used.
Marginal Product = Change in Output/ Change in Input
Thus, it can also be said that Total Product is the summation of Marginal products at different
input levels.

Total Product = Ʃ Marginal Product

Important Relationship between MP and AP

Marginal product focuses on the changes between production totals and the quantity of
resources. Average product shows output at a specific level of input. The peak of the average
product curve is the point at which the marginal product curve and average product curve
intersect.

• MP > AP, AP rises as the variable input increases

• MP = AP, AP is constant; In some books it is stated that it is when AP reaches its maximum.
• MP < AP, AP falls as the variable input increases

Law of Diminishing Marginal Returns

• It states that as one input variable is increased, there is a point at which the marginal
increase
in output begins to decrease, holding all other inputs constant.

*The law of diminishing marginal returns describes a pattern in most production

portion in the short run. By holding one of the inputs constant except for one (it may be
capital or labor) and continually increasing the other input, a certain point will be arrived
at wherein the rate in the increase of output will fall. It says that output will decrease even
if there is an increase in one of the inputs.

It is also called as the Law of Variable Proportion. It states that as units of one input are added
with all other inputs held constant, a point will be reached where the resulting additions to
output will begin to decrease or the marginal product will decline. Simply put, it says that
output will decrease even if there is an increase in one of the inputs.

The law of diminishing marginal returns is a theory in economics that predicts that after some
optimal level of capacity is reached; adding an additional factor of production will actually
result in smaller increases in output. This law affirms that the addition of a larger amount of
one factor of production, ceteris paribus, inevitably yields decreased per-unit incremental
returns. This law only applies in the short run because, in the long run, all factors are variable.

Examples of diminishing returns

 • Use of chemical fertilizers. A good example of diminishing returns includes the use
of chemical fertilizers- a small quantity leads to a big increase in output. However, increasing
its use further may lead to declining Marginal Product (MP) as the efficacy of the chemical
declines.

• Revising into early hours of the morning. If you revise economics for six hours a day,
you will improve your knowledge quite a bit. However, if you continue to revise into the early
hours of the morning, the amount that you learn increases by only a small amount because
you are tired.

• Employing extra workers. A cafe may wish to serve more customers during the busy
summer months. However, employing extra workers may be difficult because of a lack of
space in the cafe.

Three Stages of Production (***Explaination for Table 1 above)

Take note: It is important to describe the three stages of production because these will help
us define the quantity of labor (or any other input) that a profit maximizing firm will employ.
Stage I of production starts at the origin until the highest portion of AP of labor. The TP
increases at an increasing rate whereas both AP of labor and MP of labor increase.

Stage II goes from the highest portion of AP of labor until MP of labor is zero. The TP
increases at a decreasing rate and the AP of labor and the MP of labor decrease.

Stage III of production begins where MP of labor is zero until its negative range. The TP
decreases and the AP of labor is also decreasing but still positive while MP of labor is already
negative.

Therefore, State II of production is the most favourable stage because the MP of labor and
AP of labor are both positive though declining.

Stage I: Stage of Increasing Returns

Starts at the origin until the highest portion of AP. MP and AP both are rising, and the MP is
more than AP. As more of the variable input is added to the fixed input, the marginal product
of the variable input increases. Most importantly, marginal product is greater than average
product, which causes average product to increase. The producer is not making the best
possible use of the fixed factor. A particular portion of fixed factor remains unutilized.
The total product curve has a positive slope. Average product is positive and the average
product curve has a positive slope.

Stage II: Stage of Decreasing Returns

It goes from the highest portion of the AP until MP is zero. MP and AP both are falling and
MP through positive is less than AP. In Stage II, short-run production is characterized by
decreasing, but positive marginal returns. As more of the variable input is added to the fixed
input, the marginal product of the variable input decreases. Most important of all, Stage II is
driven by the law of diminishing marginal returns. The stage where there is less than
proportionate change in output due to change in labor force. Hence at this stage the producer
will employ the variable factor in such a manner that the utilization of fixed factor is most
efficient.
The three product curves reveal the following patterns in Stage II. The total product curve has
a decreasing positive slope. In other words, the slope becomes flatter with each additional
unit of variable input. Marginal product is positive and the marginal product curve has a
negative slope. The marginal product curve intersects the horizontal quantity axis at the end
of Stage II. Average product is positive and the average product curve has a negative slope.
The average product curve is at its a peak at the onset of Stage II. At this peak, average
product is equal to marginal product.

Stage III: Stage of Negative Returns

It begins where MP is zero until its negative range. TP is diminishing and the MP is negative.
In this stage of short-run production, the law of diminishing marginal returns causes marginal
product to decrease so much that it becomes negative.
The total product curve has a negative slope. It has passed its peak and is heading down.
Marginal product is negative and the marginal product curve has a negative slope. The
marginal product curve has intersected the horizontal axis and is moving down. Average
product remains positive but the average product curve has a negative slope.
These three distinct stages of short-run production are not equally important. Stage I, and
with largely increasing marginal returns, is a great place to visit, but most firms move through
it quickly. Because each variable input is increasingly more productive, firms employ as many
as they can, as quickly as they can. Stage III, with negative marginal returns, is not particularly
attractive to firms. Production is less than it would be in Stage II, but the cost of production is
greater due to the employment of the variable input. Not a lot of benefits are to be had with
Stage III.
In Stage II even though production cost rises with additional employment, there are benefits
to be gained from extra production. It tends to be the choice of firms for short-run production;
it is often referred to as the "economic region." Firms quickly move from Stage I to Stage II,
and do all they can to avoid moving into Stage III. Firms can comfortably, and profitably,
produce forever and ever in Stage II.
 Table 2 Return to Scale

Law of Returns to Scale

What is Returns to Scale?

In the long run, factors of production are variable. No factor is fixed. Accordingly, the scale of
production can be changed by changing the quantity of all factors of production. Returns to
scale relates the behaviour of total output as all inputs are varied and is a long-run concept.
The law of returns to scale describes the relationship between variable inputs and output
when all the inputs or factors are increased in the same proportion. Here we find out in what
proportions the output changes when there is proportionate change in the quantities of all
inputs. The answer to this question helps a firm to determine its scale or size in the long run.

This law assumes that:

(1) All factors (inputs) are variable but enterprise is fixed.

(2) A worker works with given tools and implements.
(3) Technological changes are absent.
(4) There is perfect competition.
(5) The product is measured in quantities.
Assumptions Explanation:

Given these assumptions, when all inputs are increased in unchanged proportions and the
scale of production is expanded, the effect on output shows three stages. It has been
observed that when there is a proportionate change in the amounts of inputs, the behavior of
output varies. The output may increase by a great proportion, by in the same proportion or in
a smaller proportion to its inputs. This behavior of output with the increase in scale of
operation is termed as increasing returns to scale, constant returns to scale and diminishing
returns to scale. These three laws of returns to scale are now explained, in brief, under
separate heads and with the help of this Table.

Table 2. Returns to Scale

We should define Total Returns and Marginal Returns first:
Total Returns- the total income gained from an investment, including capital gains, over a
specified period of time. Mainly, that time frame is one year worth of investment activity.
Marginal Returns- the rate of return for a marginal increase in investment; roughly, this is
the additional output resulting from a one-unit increase in the use of a variable input, while
other inputs are constant.
Now, we will briefly discuss the three stages of returns to scale:

1. Increasing Returns to Scale

The table reveals that in the beginning with the scale of production of (1 worker + 2 acres of
land), total output is 8. To increase output when the scale of production is doubled (2 workers
+ 4 acres of land), total returns are more than doubled. They become 17. Now if the scale is
trebled (3 workers + о acres of land), returns become more than three-fold, i.e., 27. It shows
increasing returns to scale. If the output of a firm increases more than in proportion to an
equal percentage increase in all inputs, the production is said to exhibit increasing returns to
scale. 12

Returns to scale increase due to the following reasons:

a. Indivisibility of Factors

Returns to scale increase because of the indivisibility of the factors of production. Indivisibility
means that machines, management, labour, finance, etc. cannot be available in very small
sizes. They are available only in certain minimum sizes. When a business unit expands, the
returns to scale increase because the indivisible factors are employed to their maximum
capacity.

b. Specialisation and Division of Labour

Increasing returns to scale also result from specialisation and division of labour. When the
scale of the firm is expanded there is wide scope of specialization and division of labour. Work
can be divided into small tasks and workers can be concentrated to narrower range of
processes. For this, specialised equipment can be installed. Thus with specialisation,
efficiency increases and increasing returns to scale follow.

c. Internal Economies

As the firm expands, it enjoys internal economies of production. It may be able to install better
machines, sell its products more easily, borrow money cheaply, procure the services of more
efficient manager and workers, etc. All these economies help in increasing the returns to scale
more than proportionately.

d. External Economies

A firm also enjoys increasing returns to scale due to external economies. When the industry
itself expands to meet the increased long-run demand for its product, external economies
appear which are shared by all the firms in the industry. When a large number of firms are
concentrated at one place, skilled labour, credit and transport facilities are easily available.
Subsidiary industries crop up to help the main industry. Trade journals, research and training
centres appear which help in increasing the productive efficiency of the firms. Thus these
external economies are also the cause of increasing returns to scale.

2. Constant Returns to Scale

In the table, for the 4th and 5th units of the scale of production, marginal returns are 11, i.e.,
returns to scale are constant. When all inputs are increased by a certain percentage, the
output increases by the same percentage, the production function is said to exhibit constant
returns to scale. For example, if a firm doubles inputs, it doubles output. In case, it triples 13
output. The constant scale of production has no effect on average cost per unit produced.
The following causes Constant Returns to Scale:

a. Internal Economies and Diseconomies

Increasing returns to scale do not continue indefinitely. As the firm expands further, internal
economies are counterbalanced by internal diseconomies. Returns increase in the same
proportion so that there are constant returns to scale over a large range of output.

• Internal economies are those economies in production which occur to the firm itself
when it expands its output or enlarge its scale of production. An internal economy of scale
measures a company's efficiency of production. That efficiency is attained as the company
improves output when the average cost per product drops. This type of economy of scale is
a consequence of a company's size and is controlled by its management teams such as
workforce, production measures, and machinery. The factors, therefore, are independent of
the entire industry.

• Internal diseconomies implies to all those factors which raise the cost of production
of a particular firm when its output increases beyond the certain limit. These factors may be
of the following types:

• Inefficient Management

The main cause of the internal diseconomies is the lack of efficient or skilled management.
When a firm expands beyond a certain limit, it becomes difficult for the manager to manage
it efficiently or to co-ordinate the process of production. Moreover, it becomes very difficult to
supervise the work spread all over, which adversely affects the operational efficiency.

• Technical Difficulties

Another major reason for the onset of internal diseconomies is the emergence of technical
difficulties. In every firm, there is an optimum point of technical economies. If a firm operates
beyond these limits technical diseconomies will emerge out.
For instance, if an electricity generating plant has the optimum capacity of 1 million Kilowatts
of power; it will have lowest cost per unit when it produces 1 million Kilowatts. Beyond, this
optimum point, technical economies will stop and technical diseconomies will result.

• Production Diseconomies

The diseconomies of production manifest themselves when the expansion of a firm’s

production leads to rise in the cost per unit of 14 output. It may be due to the use of inferior
or less efficient factors as the efficient factors are in scarcity. It happens when the size of the
firm surpasses the optimum size.

• Marketing Diseconomies

After an optimum scale, the further rise in the scale of production is accompanied by selling
diseconomies. It is due to many reasons. Firstly, the advertisement expenditure is bound to
increase more than proportionately with scale. Secondly, the overheads of marketing increase
more than proportionately with the scale

• Financial Diseconomies

If the scale of production increases beyond the optimum scale, the cost of financial capital
rises. It may be due to relatively more dependence on external finances. To conclude,
diseconomies emerge beyond an optimum scale. The internal diseconomies lead to rise in
the average cost of production in contrast to the internal economies which lower the average
cost of production.

• Marketing Diseconomies

After an optimum scale, the further rise in the scale of production is accompanied by selling
diseconomies. It is due to many reasons. Firstly, the advertisement expenditure is bound to
increase more than proportionately with scale. Secondly, the overheads of marketing increase
more than proportionately with the scale.

• Financial Diseconomies

If the scale of production increases beyond the optimum scale, the cost of financial capital
rises. It may be due to relatively more dependence on external finances. To conclude,
diseconomies emerge beyond an optimum scale. The internal diseconomies lead to rise in
the average cost of production in contrast to the internal economies which lower the average
cost of production.

b. External Economies and Diseconomies

The returns to scale are constant when external diseconomies and economies are neutralised
and output increases in the same proportion.

• External economies of scale occur when a whole industry grows larger and firms
benefit from lower long-run average costs. External economies of scale can also be referred
to as positive external benefits of industrial expansion.
 • External diseconomies are not suffered by a single firm but by the firms operating
in a given industry. These diseconomies arise due to much concentration and localization of
industries beyond a certain stage. Localization leads to increased demand for transport and,
therefore, transport costs rise. Similarly, as the industry expands, there is competition among
firms for the factors of production and the raw-materials. This raises the prices of raw-
materials and other factors of production. As a result of all these factors, external
diseconomies become more powerful.

Some of the external diseconomies are as under:

• Diseconomies of Pollution
The localization of an industry in a particular place or region pollutes the environment. The
polluted environment acts as health hazard for the labourers. Thus, the social cost of
production rises.

• Diseconomies of Strains on Infrastructure

The localisation of an industry puts excessive pressure on transportation facilities in the

region. As a result of this, the transportation of raw materials and finished goods gets delayed.
The communication system in the region is also overtaxed. As a result of the strains on
infrastructure, monetary, as well as the real costs of production rise.

c. Divisible Factors

When factors of production are perfectly divisible, substitutable, and homogeneous with
perfectly elastic supplies at given prices, returns to scale are constant. Constant returns to
scale may occur in certain productive activities where the factors of production are perfectly
divisible. For example, we may double the output by setting up two plants (factories) which
use the same quantity and the same type of workers, machinery, raw materials and other
inputs.

3. Diminishing Returns to Scale

The table shows that when output is increased from the 6th, 7th and 8th units, the total returns
increase at a lower rate than before so that the marginal returns start diminishing successively
to 10, 9 and 8. The term 'diminishing' returns to scale refers to scale where output increases
in a smaller proportion than the increase in all inputs. For example, if a firm increases inputs
by 100% but the output decreases by less than 100%, the firm is said to exhibit decreasing
returns to scale. In case of decreasing returns to scale, the firm faces diseconomies of scale.
The firm's scale of production leads to higher average cost per unit produced.

The following are reasons of Diminishing Returns to Scale:

A constant return to scale is only a passing phase, for ultimately returns to scale start
diminishing. Indivisible factors may become inefficient and less productive. Business may
become unwieldy and produce problems of supervision and coordination. Large management
creates difficulties of control and rigidities. To these internal diseconomies are added external
diseconomies of scale.
These arise from higher factor prices or from diminishing productivities of the factors. As the
industry continues to expand, the demand for skilled labour, land, capital, etc. rises. There
being perfect competition, intensive bidding raises wages, rent and interest. Prices of raw
materials also go up. Transport and marketing difficulties emerge. All these factors tend to
raise costs and the expansion of the firms leads to diminishing returns to scale so that
doubling the scale would not lead to doubling the output.
In conclusion, for the management, increasing, decreasing or constant returns to scale reflect
changes in production efficiency that result from scaling up productive inputs. But returns to
scale is strictly a production and cost concept. Management’s decision on what to produce
and how much to produce must be based upon the demand for the product. Therefore,
demand and other factors must also be considered in decision making.
After the discussion of the key concepts of Returns to Scale, we will now go to the Production
with Two Variable Inputs.

Production with Two Variable Inputs

When more than one input level is free to be altered, a firm faces the question of what is the
best input combination to use. This section examines the various alternative the firm faces
when deciding how to produce each particular level of output.
The first topic in this section is the Isocost.

Isocost

This shows the different combinations of capital (K) and labor (L) that produces can purchase
or hire given their total outlay and the factor prices. The following example and figure shows
what an Isocost line is.

Suppose the price of capital is 2 pesos, the price of labor is 1 peso, the total outlay of the
producer is 20 pesos per time period and all is spent in both inputs. The isocost line is given
by the line CD in Figure 1. If the producer spends all his outlay on purchasing or hiring capital,
he could purchase 10 units of it (₽20/₽2 = ₽10). This is shown in point C. On the other hand,
if total outlay is spent on purchasing or hiring labor, he could purchase 20 units of it (₽20/₽1
= 20). This is shown in point D. By joining both points, we can now define the isocost line CD.

Figure 1. Isocost Line

If you plot the initial isocost line, as long as long as production continues, it may shift in two
directions. An isocost that shifts to the right indicates an increase in total outlay, while a
leftward shift denotes a decrease in total outlay. As shown in Figure 2.
 Figure 2. Shifting of Isocost

• Isocost line pertains to cost-minimization in production, as opposed to utility-

maximization. For the two production inputs labour and capital, with fixed unit costs of the
inputs, the equation of the isocost line is where w represents the wage rate of labour, r
represents the rental rate of capital, K is the amount of capital used, L is the amount of labour
used, and C is the total cost of acquiring those quantities of the two inputs. The absolute value
of the slope of the isocost line, with capital plotted vertically and labour plotted horizontally,
equals the ratio of unit costs of labour and capital.
The slope is: The isocost line is combined with the isoquant map to determine the optimal
production point at any given level of output. Specifically, the point of tangency between any
isoquant and an isocost line gives the lowest-cost combination of inputs that can produce
the level of output associated with that isoquant. Equivalently, it gives the maximum level of
output that can be produced for a given total cost of inputs. A line joining tangency points of
isoquants and is costs is called the expansion path.

We will now discuss the highlighted words comprehensively.

Isoquant

An isoquant is a curve which shows the different combinations of capital (K) and labor (L),
which yield the same level of output. An isoquant is a firm’s counterpart of the consumer’s
indifference curve. ‘Iso’ means equal and ‘quant’ means quantity. Therefore, an isoquant
represents a constant quantity of output.
 Figure 3 Isoquant

The isoquants show the combinations of labor and capital that produce various levels of
output. Isoquants farther from the origin correspond to higher levels of output. Points a, b, c
and d are various combinations of labor and capital the firm can use to produce 24 units of
output. A shift of an isoquant to the right means that there is an increase in production, while
a shift to the left denotes a decline in production. We will now proceed to the characteristics
of isoquant.

Characteristics of Isoquant

1. Negatively Sloped,
2. Convex to the origin, and
3. Do not intersect;

The negatively sloped isoquant can be explained through the diminishing marginal rate of
technical substitution (MRTS). Marginal Rate of Technical Substitution is the amount of
capital that a producer is willing to give up in exchange of labor and still lies on the same
isoquant.
We can say that MRTS is the slope of isoquant. This is shown in this equation:

MRTS is also equal to the ratio of the marginal product of labor to marginal product of
capital, or:
An isoquant is convex to the origin because of the diminishing MRTS, meaning, a
producer is willing to give up less and less of capital to gain additional amount of labor.
The less remaining capital makes it more valuable than additional labor.

Figure 4: Why Isoquants do not intersect

This figure illustrates why isoquants do not intersect. In Isoquant I, points H and I
create the same level of production. In isoquant II, point H and J also produce the same level
of production. It follows that points I and J have equal level of production even though the
producer is using different level of capital and labor. If they intersect each other, there would
be a contradiction and we will get inconsistent results.

To further elaborate, we have this Example:

Table 3. Levels of Isoquant Schedule

 The table shows points on three different isoquants. Plotting three points on the
same set of axes and joining them by smooth curves, we get a map of isoquants shown in
the next figure.

Figure 5: Maps of Isoquant

• Isoquant Map can be defined as the set of isoquant curves that show technically
efficient combinations of inputs that can produce different levels of output.
Isoquant I, II and III are three isoquants showing different levels of output produced by
combining 2 factors of production.

Now, we will compute for the Marginal Rate of Technical Substitution.

Table 4. MRTS of Isoquants

In the table, from points C to D, to be able to gain an additional unit of labor, the producer
must reduce the use of capital by 4 units which is the MRTS. Let’s put it in the equation:
Point C: Labor (L)= 2, Capital (K) = 10
Point D: Labor (L)= 3, Capital (K) = 6
The change in K from point C to D is equal to 10 minus 6 while change in L is equal to 2 minus
3. To simply put,
MRTS = 10-6
2-3
=- 4
-1
= 4 units of capital to be reduced in order to gain 1 additional
labor

After the computation for MRTS, we will now proceed to……

Finding the Producer’s Equilibrium

Economic production is the result of the output we produce by employing factors like land,
labour, capital, and entrepreneurship. It is possible to determine the optimum amount of
production possible considering different combinations of these inputs. Such a determination
is called the producer’s equilibrium. A producer is in equilibrium graphically when given his
total outlay and the factor prices, the producer maximizes the production. This is shown by
the point of tangency between the isocost and isoquant.

Refer to the Example:

Suppose that total outlay increases from 12 pesos to 20 pesos and 28 pesos, where the price
of capital is 1 peso and the price of labor is 2 pesos.We can now derive the producer’s
equilibrium in Figure 6.

Figure 6. Producer’s Equilibrium

At the points of tangency, the absolute slopes of the isoquant and isocost are equal.
 Since MRTS= MPL/ MPK , at equilibrium:

After finding the producer’s equilibrium, it is much safe to check it through the use of this
formula:

Refer to Figure 6, at Isoquant I, the optimal combination is in point a where capital = 6 and
labor = 3. To check we multiply 6 to the price of capital which is 1 peso and we add the factor
of 3 multiplied by the price of labor which is 2. We will get 6 in both. Then we will add it
together so we can get 12. The optimum combination of capital and labor to get the total
outlay of 12 pesos is in point a. The following table shows the same with Isoquants II and III.

Table 5. Optimum Combination

The least cost combination of factors or producer's equilibrium is now explained with the
help of isoquant and isocosts. The optimum combination or the least cost combination
refers to the combination of factors with which a firm can produce a specific quantity of
output at the lowest possible cost.

Lastly, we will discuss the Expansion Path.

What is Expansion Path?

 Figure 7. Expansion Path

This shows the collection of a producer’s equilibrium caused by varying total outlay while
keeping factor prices unchanged. An expansion path provides a long-run view of a firm's
production decision and can be used to create its long-run cost curves. A producer seeks to
produce the most units of a product in the cheapest possible attempts to increase production
along the expansion path.
Exercises/Activities

1. The following is the production schedule of Glennsky Enterprises. Fill the missing value
for
Average Product (AP) and Marginal Product (MP). (18 pts).

Land Labor Total Product Average Marginal

Product Product
1 0 0
1 1 6
1 2 16
1 3 24
1 4 30
1 5 34
1 6 34
1 7 32
1 8 26

2. Using the following data on the table below, at what points do diminishing returns begin?
Please show your computation. (22 pts).

Points Units of Labor (L) Total Product

(Quantity/day
A 0 0
B 1 27
C 2 62
D 3 95
 E 4 122
F 5 126
G 6 125

References:

1. Gabay, Kristoffer . et al. (Second Edition, 2012). Concepts and Principles of Economics,
Rex
Book Store, Inc.
2. https://owlcation.com/social-sciences/Law-of-Returns-to-Scale
3. https://www.economicsdiscussion.net/production/production-in-the-short-run-with-one-
variable-input/
4. https://www.yourarticlelibrary.com/economics/production-function-law-of-variable-
proportions-
and-law-of-returns-to-scale/28602
5. https://www.investopedia.com/ask/answers/013015/what-are-differences-between-
internal-
and-external-economies-scale.asp
6. https://www.economicshelp.org/microessays/costs/diminishing-returns/
7. https://www.economicsdiscussion.net/production/diseconomies-of-scale-of-production-
internal-and-external/6912
8. https://business.inquirer.net/272034/manufacturing-slump-continues
9. https://www.slideshare.net/IbrahimIsmail8/three-stages-of-production-and-law-of-
diminishing
10. https://www.economicsdiscussion.net/production-function/production-function-meaning-
definitions-and-features/6892
11. https://www.jandkicai.org/pdf/16792Theory_of_Production.pdf
Prepared by: Inesio H. Sadiangcolor (ECO 101 Asst. Prof.)
ECO 101 BASIC MICROECONOMICS
_________________________________________________________________________
__

Module 6

THEORY OF COST AND PROFIT

Week 12-13

INTRODUCTION

The production and sale of goods and services are always profit-motivated. However,
production depends on certain factors like the law of diminishing marginal returns and
marginal productivity.
Cost is the most important consideration in production. A producer will not just jump
into a particular investment by simply looking at the potential revenue of the business.
Revenue may be substantial but the producer will think twice because of the
implication on the pricing of the commodity. Consumers will not be so enthusiastic in
patronizing the offered product if the price is quite high. Inefficiency in the production process
has a direct impact on cost, because it takes away the incentives being rewarded by the
market for producers that are not wasteful. The market forces the producer to manage cost
of production by finding the least cost in expanding output.
 In this module, we will study how cost and profit affect market behavior. Likewise, we
will look into the nature and types of cost, and the basis for a firm in leaving the market.
Different cost concepts are used to answer questions important to the firm.

INTENDED LEARNING OUTCOMES

After studying this module, students will be able to:

1. Define Cost and Profit.
2. Differentiate Economic Cost from Accounting Cost.
3. Explain the Different Types of Cost.
4. Construct a Graph of the Different Types of Cost.
5. Differentiate Total Revenue from Marginal Revenue.
6. Distinguish between Economic and Accounting Profit.
7. Identify Profit Maximization and Loss Maximization.
8. Identify the classification of Profit.
9. Identify the types of Economic Cost.
10. Discuss and explain decision to operate or shut down.

What is Cost?

• Costs are the necessary expenditures that must be made in order to run a business.
Every factor of production has an associated cost. The cost of labor, for example, used in the
production of goods and services is measured in terms of wages and benefits. The cost of a
fixed asset used in production is measured in terms of depreciation. The cost of capital used
to purchase fixed assets is measured in terms of the interest expense associated with raising
the capital.

It is usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities
consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good
or service.

Costs can have different relationships to output. Costs also are used in different
business applications, such as financial accounting, cost accounting, budgeting,
capital budgeting, and valuation. Consequently, there are different ways of
categorizing costs according to their relationship to output as well as according to the
context in which they are used.

Following this summary of the different types of costs are some examples of how
costs are used in different business applications.

Economic Costs versus Accounting Costs

• Economic costs are forward looking costs (i.e., economists are in tune with future
costs). These costs have repercussions on the potential profitability of the firm.

• Accounting costs tend to be retrospective; they recognize costs only when these are
made and properly recorded. They do not adjust these costs even if opportunity cost change.

• Therefore, the difference between economic costs and accounting cost is the
opportunity cost.
TWO TYPES OF ECONOMIC COST

• Explicit Costs are the monetary payments it makes to those from whom it must
purchase resources that it does not own.
Explicit costs refer to the actual expenses of the firm in purchasing or hiring the
inputs it needs, such as, when the firm purchases a machine worth Php 1 M or rents a
building worth Php 100,000.00 per month.

• Implicit Costs are the opportunity costs of using the resources that it already owns
to make the firm’s own product rather than selling those resources to outsiders for cash.
Implicit costs refer to the value of inputs being owned by the firm and used in its own
production process.

ECONOMIC COST = EXPLICIT COST + IMPLICIT COST

WHAT ARE THE DIFFERENT TYPES OF COST?

Short-Run Cost Analysis

Short run for a firm is a time horizon when one input is held constant. To analyse the short-
run costs, it is essential to fix the level of capital and study the changes in the quantity of labor
hired. The following are the types of short-run costs:

The two basic types of costs incurred by businesses are fixed and variable. Fixed costs do
not vary with output, while variable costs do. Fixed costs are sometimes called overhead
costs.

1. Fixed cost are expenses that do not change in proportion to the activity of a
business, within the relevant period or scale of production. For example, a retailer must pay
rent and utility bills irrespective of sales. They are incurred whether a firm manufactures 100
widgets or 1,000 widgets. In preparing a budget, fixed costs may include rent, depreciation,
and supervisors' salaries. Manufacturing overhead may include such items as property taxes
and insurance. These fixed costs remain constant in spite of changes in output. It stays the
same no matter how much output changes.
A cost that does not change with an increase or decrease in the amount of goods or
services produced or sold. It is an expense that must be paid by a company, independent of
any specific business activities. Fixed cost does not change with the volume of production.

*** Examples are rent, salaries of top management, interest payments on borrowed capital,
insurance premiums, interest payments and most of the depreciation allowances of plant and
equipment.

2. Variable costs fluctuate in direct proportion to changes in output. In a

production facility, labor and material costs are usually variable costs that increase as
the volume of production increases. It takes more labor and material to produce more
output, so the cost of labor and material varies in direct proportion to the volume of output. It
varies with output and when output rises, variable cost rises; when output falls,
variable cost falls.
***Examples are payment for raw materials, utilities, fuel, shipping/freight
costs, wages, tax payments and the like.
Other types of cost

1. Total Cost is the sum of variable cost and fixed cost. It increases in total cost is
due to the increase in variable cost.

2. Marginal Cost is the cost of producing one additional unit of output. It can be found
by calculating the change in total cost when output is increased by one unit.

3. Average Fixed Cost (AFC). It is the fixed cost per unit of output. As the total
number of units of the good produced increases, the average fixed cost decreases because
the same amount of fixed costs is being spread over a larger number of units of output.
Average Fixed Cost (AFC) = TFC/Q where TFC is Total Fixed Cost, Q is total number
of units produced. Unit fixed costs decline along with volume, following a rectangular
hyperbola. As a result, the total unit cost of a product will decline as volume increases.

4. Average Variable Cost (AVC). It is a firm's variable costs (labor, electricity, etc.)
divided by the quantity of output produced.
Average Variable Cost (AVC) is the TVC of a firm divided by the total units of output
(Q).
AVC = TVC/Q where TVC is Total Variable Cost, and total number of units produced.

5. Average Cost/Average Total Cost (AC/ATC). Average Cost (AC) is the TC of a

firm divided by the total units of output (Q). AC = TC/Q = AFC + AVC
6. Marginal Cost is the change in total cost that arises when the quantity produced
changes by one unit. In general terms, marginal cost at each level of production includes any
additional costs required to produce the next unit. The additional cost incurred to produce one
additional unit of output is called the Marginal Cost (MC). MC = dC/dQ. It is the change in the
total cost when the quantity produced changes by one unit. It is the cost of producing one
more unit of a good. Marginal cost is not related to fixed costs.

Example:

In Table 1, the first four columns are hypothetical costs schedules (TFC, TVC, and
TC) and are plotted in Figure 1. We see that TFC is 30 pesos regardless of the level of output
represented by the straight line. TVC has zero value when output is also zero, but it increases
with the level of output. The curve of the TVC is caused by the diminishing returns. The area
between the TC curve and the TVC curve is the TFC curve. Figure 1.1 shows the graph of
the next four costs schedule which is AFC, AVC, ATC, and MC. In Figure 1.1, the AFC curve
is continuously declining as output expands but does not touch the axis, while the area
between ATC and AVC is the AFC. Notice that the MC curve is graphed between two points
because it is derived between successive points. Observe that AFC, AVC, and ATC are
U=shaped and the MC cuts at the lowest point of AVC and AC.
Table 1. Hypothetical Cost Schedules

Figure 1
 Figure 2

Why does the MC Curve pass through the AVC and ATC curves at their minimum
points?

The Marginal Cost (MC) curve intersects the average total cost (ATC) curve at its
lowest point because once the marginal cost exceeds the average cost, the average cost
starts to increase. When marginal cost is less than average cost, the average cost falls as
production increases. The minimum average cost is reached when the average cost falls to
the same level as the marginal cost. As marginal cost increases above the minimum average
cost, the average cost begins to rise.

Average Total Cost and Marginal Cost are connected because they are derived from
the same basic numerical cost data. The general rules governing the relationship are:
1. Marginal Cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling,
and when marginal cost is above average total cost, average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also
where Average Total Cost (ATC) = Marginal Cost (MC).

Why are the AVC and ATC curved-U Shaped?

Average Total Cost starts off relatively high, because at low levels of output total costs
are dominated by the fixed cost; mathematically, the denominator is so small that average
total cost is large. Average total cost then declines, as the fixed costs are spread over an
increasing quantity of output. In the average cost calculation, the rise in the numerator of total
costs is relatively small compared to the rise in the denominator of quantity produced. But as
output expands still further, the average cost begins to rise. At the right side of the average
cost curve, total costs begin rising more rapidly as diminishing returns kick in.
The nature ‘U’ shaped short-run Average Cost curve can be attributed to the law of
variable proportions. This law tells that when the quantity of one variable factor is changed
while keeping the quantities of other factors fixed, the total output increases with an increasing
rate and then declines with more than proportionate.
Thus, the Average Costs of the firms continue to fall as output increases because it
operates under the increasing returns due to various internal economies. Due to the operation
of the law of increasing returns the firm is able to work with the machines to their optimum
capacity and as a consequence the Average Cost is minimum.
 The average variable cost curve is U-shaped. Average variable cost is relatively high
at small quantities of output, then as production increases, it declines, reaches a minimum
value, then rises. This shape of the average variable cost curve is indirectly attributable to
increasing, then decreasing marginal returns (and the law of diminishing marginal returns).

Why does the AVC curve begin to rise?

The average variable cost (AVC) curve will at first slope down from left to right, then
reach a minimum point, and rise again. AVC is ‘U’ shaped because of the principle of variable
proportions, which explains the three phases of the curve:

1. Increasing returns to the variable factors, which cause average costs to fall, followed by:
2. Constant returns, followed by:
3. Diminishing returns, which cause costs to rise

What is Profit?

According to Merriam Webster Dictionary it defines profit as a valuable return or gain.

It is the excess of returns over expenditure in a transaction or series of transactions.•
According to Professor Hawley “Profits is the reward of bearing risk”. The term profit
has distinct meaning for different people, such as businessmen, accountants, policymakers,
workers and economists.

• Profit simply means a positive gain generated from business operations or

investment after subtracting all expenses or costs.

In economic terms profit is defined as a reward received by an entrepreneur by

combining all the factors of production to serve the need of individuals in the economy faced
with uncertainties. In a layman language, profit refers to an income that flow to investor. In
accountancy, profit implies excess of revenue over all paid-out costs.
Profit in economics is termed as a pure profit or economic profit or just profit. Profit
differs from the return in three respects namely:

a. Profit is a residual income, while return is a total revenue

b. Profits may be negative, whereas returns, such as wages and interest are always positive
c. Profits have greater fluctuations than returns

To modern economists, profits are the rewards of purely entrepreneurial functions.

On the basis of fields, profit can be classified into two types, which are explained as follows:
• Accounting Profit refers to the total earnings of an organization. It is a return that
is calculated as a difference between revenue and costs, including both manufacturing and
overhead expenses. The costs are generally explicit costs, which refer to cash payments
made by the organization to outsiders for its goods and services. In other words, explicit costs
can be defined as payments incurred by an organization in return for labor, material, plant,
advertisements, and machinery.

The accounting profit is calculated as:

Accounting Profit = TR-(W + R + I + M) = TR- Explicit Costs

TR = Total Revenue
W = Wages and Salaries
R = Rent
I = Interest

AP=Revenue – Explicit Cost

M = Cost of Materials

The accounting profit is used for determining the taxable income of an organization and
assessing its financial stability. Let us take an example of accounting profit. Suppose that the
Total Revenue earned by an organization is Php250,000. Its explicit costs are equal to Php10,
000. The accounting profit equals = Php250,000 – Php10,000 = Php240,000. It is to be noted
that the accounting profit is also called gross profit. When depreciation and government taxes
are deducted from the gross profit, we get the net profit.
• Economic Profit

Takes into account both explicit costs and implicit costs or imputed costs. Implicit that is
foregone which an entrepreneur can gain from the next best alternative use of resources.
Thus, implicit costs are also known as opportunity cost. The examples of implicit costs are
rents on own land, salary of proprietor, and interest on entrepreneur’s own investment. Let us
understand the concept of economic profit. Suppose an individual A is undertaking his own
business manager in an organization. In such a case, he sacrifices his salary as a manager
because of his business. This loss of salary will opportunity cost for him from his own
business.

The economic profit is calculated as:

Economic profit = Total revenue-(Explicit costs + implicit costs)

Alternatively, economic profit can be defined as follows:

Pure profit = Accounting profit-(opportunity cost + unauthorized payments, such as bribes)

Economic profit is not always positive; it can also be negative, which is called economic loss.
Economic profit indicates that resources of a business are efficiently utilized, whereas
economic
loss indicates that business resources can be better employed elsewhere.

TOTAL AND MARGINAL REVENUE

• Total Revenue. In economics refers to the total receipts from sales of a given
quantity of goods or services. It is the total income of a business and is calculated by
multiplying the quantity of goods sold by the price of the goods. For example, if company A
produces 100 notebooks and sells them for Php50 each, the total revenue would be 100 *
Php50 = Php5, 000. In economics, total revenue is often represented in a table or as a curve
on a graph.

• Marginal Revenue is the additional revenue generated from the sale of an additional
unit of output. In other words, it's the change in total revenue from the sale of one more unit
of a good. For example, if Company A sold one more notebook and their revenue increased
from Php5, 000 to Php5, 050, the marginal revenue would be equal to Php50.
 • Total Revenue is price times total output sold.
• Marginal Revenue is the increase in total revenue when output sold goes up by one
unit. It is the additional revenue derived from selling one more unit of output.

To illustrate the concept, let us assume that the price of a good is PHP 16.00. If the
firm produces various amounts of Good X given in column 2 of Table 7, the TR in column 4
is by multiplying Php16.00 and each quantity of goods produced. Given the firm’s TC shown
in column 3, the firm’s profit represented in column 5 is computed by deducting the TC
(column 3) from the TR (column 4).

Table 2

Likewise, using the same hypothetical data presented in Table 2, the firm icurs losses
during the span of its operation from points A to C, a situation in which a negative profit occurs
after deducting TC in column 3 to TR in column 4. The firm is in equilibrium level at points D
and I where, after subtracting TC from TR, we calculate a zero total profit. From point E to H,
the firm incurs profit. This produces a positive result after deducting TC from TR. In symbols:

TR › TC = Profit
TR ‹ TC = Loss
TR =TC = Breakeven

PROFIT MAXIMIZATION AND LOSS MINIMIZATION

A firm will maximize its profit or minimize its loss at the output where MARGINAL COST is
equal to MARGINAL REVENUE.
 Table 3

THE DECISION TO OPERATE OR SHUT DOWN

*A firm will operate in the short run when prospective sales exceed variable costs.
Operational decisions or Operating decisions are decisions made to manage day to day
business. Any firm which is into any kind of business is faced with 100 decisions they have to
take in a day. These will be as mundane as refilling the water cooler, to as stressful as fulfilling
a customer’s order within minutes. Naturally, operational decisions have to be taken care of
by a manager in charge of the operations.

However, it is not as easy as it sounds because the number of operations can be mind
boggling.

On any normal day, McDonald’s sells 75 burgers a second, or 64 million burgers a day across
the world. Thing about the number of simple operational decisions that, if not taken properly,
can destroy the experiences of customers visiting the McDonald’s stores.
Typically, operational decisions in any business are of the following types:
1) Pricing – Go to any retail store and you will find customers haggling on price. Now, if the
owner was himself involved in such operational decisions, the firm would go down the drain
soon. Instead, the owner or the manager gives price levels and margin levels which are to be
maintained and hence the decision is made by the employee.

2) Discounts – In channel sales or in network marketing, the daily sale as well as daily
purchase is so high in quantity, that discounts play a major role on which brand the dealer will
push in the market. And hence, managers should have all information on current discount
levels in the market and what discounts to be given to dealers which are ultimately given by
executives. In short, channel level operations have to be managed properly.
3) Promotions – Promotions involve a lot of operating decisions, like how to promote the
product, and which areas or mediums will give the best ROI after promotions. Similarly, getting
the promotional material ready and ensuring that the promotions are done properly in the
market are all operational decisions which are to be taken from time to time.

4) Collecting information – Now this is a task which is huge and can make a big impact in
the altogether running of an organization. If you look at it from the bottom up level, there is a
lot of operational information also collected, which has to be summarized at the manager level
and finally submitted at the director level.
Above 4 are the major operational decisions which have to be taken everyday and hence are
mostly outsourced or are managed via a chain of command in between. Besides the above,
there are other operational decisions also which are made in the day to day running of a
business.

• Maintaining Inventory
• Logistics decisions
• Sales and outreach
• Employee management
• Customer management

Overall, calculating the time spent on operations is important for any organization as you don’t
want to waste your resources. And hence, MBA’s generally have a subject known as
operations management, which emphasizes the importance of time and how to achieve a
task in as less steps as possible.

As a business grows, the operational decisions needed to manage the day to day activities
increases. Hence the business needs to hire employees, or an organization needs to hire
managers to manage such operational decisions.

Shutdown

*A firm will shut down in the sort run when variable costs exceed prospective sales.
A firm will implement a production shutdown if the revenue from the sale of goods produced
cannot cover the variable costs of production.

• Economic shutdown occurs within a firm when the marginal revenue is below
average variable cost at the profit -maximizing output.

• When a shutdown is required the firm failed to achieve a primary goal of production
by not operating at the level of output where marginal revenue equals marginal cost.

• If the variable cost is greater than the revenue being made (VC>R) then the firm is
not even covering production costs and it should be shutdown.
 • The decision to shutdown production is usually temporary. If the market conditions
improve, due to prices increasing or production costs falling, then the firm can resume
production.

• When a shutdown last for an extended period of time, a firm has to decide whether
to
continue to business or leave the industry.

THE DECISION TO OPERATE OR SHUTDOWN

Therefore:

• A firm will operate in the short-run when prospective firm sales exceed
variable costs.

Example: If the firm has fixed costs of 5 million, variable costs of 6 million, and total
revenue of 7 million, what must it do in the short run?
The firm must operate.

• A firm will shut down in the short-run when variable costs exceed
prospective sales.

Example: If the firm has fixed costs of 10 million, variable costs of 9 million, and total
revenue of 8 million, what must it do in the short run?
The firm must shut down.

Price is greater than Average Total Cost (P › ATC).

In Figure 4, below, the optimum output of the firm in the short-run is given by Qo,
where P = MC. We use ATC to find the total cost in order to compute for the profit. In this
case, the firm is earning profits because Price is greater than the cost (ATC) given by the
shaded region.
 Figure 4. Optimum Output in the Short-run

Figure 5. Price is equal to Average Total Cost (P=ATC)

Figure 5, above shows the case where a firm is either experiencing profits or losses.
As shown in the graph, Price is equal to Marginal Cost denoting the best level of output. But
since Price equals ATC, the firm is at a breakeven (TR = TC).

In Figure 6, below shows that P ‹ AVC, the decision is to shut down because Total
Revenue is insufficient to pay variable costs.
 Figure 6. Profits are negative and P ‹ AVC (shutdown point).
References:

1. Gabay, Kristoffer . et al. (Second Edition, 2012). Concepts and Principles of Economics,
Rex
Book Store, Inc.
2. Pindyck, Robert S. and Rubinfeld, Daniel L. (Fifth Edition). Microeconomics Printice-Hall
Inc
Upper Saddle River, New Jersey.

Exercises/Activities

1. Based on the following cost information below: (10 pts).

Quantity (Q) Fixed Cost (FC) Variable Cost VC)

1 5 8
2 5 15
3 5 23
4 5 32
5 5 42

1.1 What is the Total Cost of producing 3 units?

1.2 What is the Average Total Cost of producing 3 units?

1.3 What is the Marginal Cost of producing the 4th unit of output?
2. Using the following data below, compute the following: TC, MC, AFC, AVC, and ATC.(40
pts)

Output Total Total Total Marginal Average Average Total

Fixed Variable Cost Cost Fixed Variable Average
Cost Cost Cost Cost Cost
1 100 50
2 100 80
3 100 100
4 100 110
5 100 150
6 100 220
7 100 350
8 100 640

Prepared by:

Inesio H. Sadiangcolor
ECO 101 Asst Prof

Topic 7

PERFECT COMPETITION

Week 14

INTRODUCTION
 All businesses face two realities: no one is required to buy their products, and even
customers who might want those products may buy from other businesses instead. Firms that
operate in perfectly competitive markets face this reality. In this chapter we will learn how
such firms make decisions about how much to produce, how much profit they make, whether
to stay in business or not, and many others. Industries differ from one another in terms of how
many sellers there are in a specific market, how easy or difficult it is for a new firm to enter,
and the type of products that are sold. This is referred to as the market structure of the
industry.

INTENDED LEARNING OUTCOMES:

After studying this module, students will be able to:

1. Define and explain what “perfect competition’ is.
2. Identify and explain the assumptions/conditions/characteristics of perfect compitition.
3. Discuss the determination of short-run and long-run periods.
4. Identify the profit maximization, shutdown and loss.

DEFINITION

• Perfect competition/market is a market structure which consists of a very large

number of buyers and sellers offering a homogeneous product. Under such condition, no firm
can affect the market price. Price is determined through the market demand and supply of
the particular product, since no single buyer or seller has a real control over price.

Firms are said to be in perfect competition when the following conditions occur: (1)
many firms produce identical products; (2) many buyers are available to buy the product, and
many sellers are available to sell the product; (3) sellers and buyers have all relevant
information to make rational decisions about the product being bought and sold; and (4) firms
can enter and leave the market without any restrictions—in other words, there is free entry
and exit into and out of the market.

Perfect competition: Conditions

• A large number of sellers, each acting independently and not colliding with any
other.
• Selling a homogeneous product
• No artificial restrictions placed upon price or quantity
• Easy entry and exit
• All buyers and sellers have perfect knowledge of market conditions and any changes
that occur in the market
• Firms are “price takers”
A perfectly competitive firm is known as a price taker, because the pressure of
competing firms forces them to accept the prevailing equilibrium price in the market. If a firm
in a perfectly competitive market raises the price of its product by so much as a penny, it will
lose all of its sales to competitors. When a wheat grower wants to know what the going price
of wheat is, he or she has to go to the computer or listen to the radio to check. The market
price is determined solely by supply and demand in the entire market and not the individual
farmer. Also, a perfectly competitive firm must be a very small player in the overall market, so
that it can increase or decrease output without noticeably affecting the overall quantity
supplied and price in the market.

THE REVENUE OF A COMPETITIVE FIRM

 A firm in a competitive market tries to maximize profit, which equals total revenue
minus total cost.
The average revenue is total revenue divided by the quantity sold (amount of output). Average
revenue tells us how much revenue a firm for the typical unit sold. (total revenue is P x Q ,
price times quantity).
The marginal revenue is the change in total revenue from the sale of each additional
unit of output. Total revenue is P x Q and P is fixed for a competitive firm. Therefore, when Q
rises by 1 unit, total revenue rises by P euros. For competitive firms, marginal revenue equals
the price f the good (attention: ONLY FOR COMPETITIVE MARKETS).

Formula:

• Total Revenue (TR = P X Q)

• Average Revenue (AR = TR / Q)

• Marginal Revenue (MR = ΔTR / Δ Q)

PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE

A simple example of profit maximization

If marginal revenue is greater than marginal cost the firm should increase the
production. If marginal revenue is less than marginal cost, the firm should decrease
production. If the firms think at the margin and make incremental adjustments to the level of
production, they are naturally led to produce the profit maximizing quantity.

THE MARGINAL COST CURVE AND THE FIRM’S SUPPLY DECISION

In general, we use the rule that at the profit-maximizing level of output, marginal
revenue and marginal cost are exactly equal. Because a competitive firm is a price taker, its
marginal revenue equals the market price. For any given price, the competitive firm’s profit-
maximizing quantity of output is found by looking at the intersection of the price with the
marginal cost curve. When the price rises, the firm finds that marginal revenue is now higher
than marginal cost that the previous level of output, so that the firm increases production.
THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN

In some circumstances the firm will decide to shut down and not produce anything at
all. Here we should distinguish between a temporary shutdown of a firm and the permanent
exit from the market. A shutdown refers to a short-run decision. Exit refers to a long-run
decision. These decisions differ because most firms cannot avoid their fixed costs in the short
run but can do so in the long run.

If the firm shuts down, it loses all revenue from the sale of its product. At the same
time, it saves the variable cost of making its product. Thus the firm shuts down if the revenue
that it would get from producing is less than its variable cost of production. Mathematics:

If the price doesn’t cover the average variable cost, the firm is better off stopping
producing altogether. The firm might reopen it the conditions change. If the firm produces
anything, it produces the quantity at which marginal cost equals the price of the good. Yet it
the price is less than average variable cost at the quantity, the firm is better off shutting down.
SPILT MILK AND OTHER SUNK COSTS

Economists say that a cost is a sunk cost when it has already been committed and
cannot be recovered. Sunk costs cannot be avoided regardless of the choices you make. (If
you cannot erase the cost; if something has already been invested like in infrastructure or if I
want to go to the cinema, buy a ticket and lose it). Because nothing can be done about sunk
cost, you can ignore them when making decisions.

THE FIRM’S LONG RUN DECISION TO EXIT OR ENTER A MARKET

If the firm exits a market, it will lose all revenue from the sale of its product, but now it
saves both fixed and variable costs of production. Thus, the firm exits the market if the
revenue it would get from producing is less than its total costs. Mathematics:

The firm will enter the market if such an action would be profitable, which occurs if the
price of the good exceeds the average total cost of production. The entry criterion is:
Enter P > ATC

MEASURING PROFIT IN OUR GRAPH FOR THE COMPETITIVE FIRM

The profit equals total revenue (TR) minus total cost (TC):
THE SUPPLY CURVE IN A COMPETITIVE MARKET

Over short periods of time it is often difficult for firms to enter an exit, so the assumption
of a fixed number of firms is appropriate. But over long periods of time, the number of firms
can adjust to changing market conditions.

THE SHORT RUN: MARKET SUPPLY WITH A FIXED NUMBER OF FIRMS

For any given price each firm supplies a quantity of output so that its marginal cost
equals the price. That is, as long as price is above average variable costs, each firm’s
marginal cost curve is its supply curve. The quantity supplied to the market is the quantity
supplied by each firm times the number of firms.

THE LONG RUN: MARKET SUPPLY WITH ENTRY AND EXIT

 Now consider what happens if the firms are able to enter or exit the market. Let’s
suppose that everyone has access to the same technology for producing the good and access
to the same markets to buy the inputs into production. Therefore, all firms and all potential
firms have the same cost curves.

If firms already in the market are profitable, then new firms will have an incentive to
enter the market. This entry will expand the number of firms, increase the quantity of the good
supplied, and drive down prices and profits. Conversely, if firms in the market are making
losses, then some existing firms will exit the market. Their exit will reduce the number of firms,
decrease the quantity of the good supplied and drive up prices and profits. At the end of this
process firms that remain in the market must be making zero economic profit (Profit=(P-ATC)
x Q) An operating firm has zero profit if and only if the price of the good equals the average
total cost of producing that good.

The long-run equilibrium of a competitive market with free entry and exit must have
firms operating at their efficient scale. (price = marginal cost in competitive markets M free
entry and exit forces price to equal average total cost; price equal marginal and average total
cost; marginal and average total cost equals each other = efficient scale).

WHY DO COMPETITIVE FIRMS STAY IN BUSINESS IF THEY MAKE ZERO

PROFIT?

To answer this question, we must keep in mind that profit equals total revenue minus
total cost, and that total cost includes all the opportunity costs of the firm. In particular, total
cost includes the opportunity cost of the time and money that firm owners devote to the
business.

Exercises/Activities

MULTIPLE CHOICE: (10 pts).

Choose the one alternative that best completes the statement or answers the question.

1) Perfect competition is an industry with

A) a few firms producing identical goods.
B) many firms producing goods that differ somewhat.
C) a few firms producing goods that differ somewhat in quality.
D) many firms producing identical goods.
2) In a perfectly competitive industry, there are
A) many buyers and many sellers.
B) many sellers, but there might be only one or two buyers.
C) many buyers, but there might be only one or two sellers.
D) one firm that sets the price for the others to follow.
3) In perfect competition, the product of a single firm
A) is sold to different customers at different prices.
B) has many perfect complements produced by other firms.
C) has many perfect substitutes produced by other firms.
D) is sold under many differing brand names.
4) In perfect competition, restrictions on entry into an industry
A) do not exist.
B) apply to labor but not to capital.
C) apply to both capital and labor.
D) apply to capital but not to labor.
5) In perfect competition,
A) there are significant restrictions on entry.
B) each firm can influence the price of the good.
C) there are few buyers.
D) all firms in the market sell their product at the same price.
6) In perfect competition, a firm that maximizes its economic profit will sell its good
A) below the market price.
B) above the market price.
C) below the market price if its supply curve is inelastic and above the market
price
if its supply curve is elastic.
D) at the market price
7) Economists assume that a perfectly competitive firm's objective is to maximize its
A) revenue.
B) economic profit.
C) output price.
D) quantity sold
8) The break-even point is the output level at which
A) average cost equals average revenue.
B) average fixed cost equals average variable cost.
C) marginal cost equals marginal revenue.
D) total cost equals total revenue

9) Economic profit is maximized when

A) marginal revenue equals marginal cost.
B) marginal revenue is greater than marginal cost.
C) marginal revenue is less than marginal cost.
D) total revenue equals total cost.
10) A firm shuts down if price falls below the minimum of
 A) average total cost.
B) average fixed cost.
C) average variable cost.
D) marginal cost.

TOPIC 8 - IMPERFECT COMPETITION

MONOPOLY and OLIGOPOLY

MONOPOLISTIC COMPETITION
Monopolistic Competition is a market structure which combines elements of monopoly
and competitive markets. Essentially a monopolistic competitive market is one with freedom
of entry and exit, but firms can differentiate their products. Therefore, they have an inelastic
demand curve and so they can set prices. However, because there is freedom of entry,
supernormal profits will encourage more firms to enter the market leading to normal profits in
the long term.
Main Features of Monopolistic Competition
A monopolistic competitive industry has the following features:
• Many firms.
• Freedom of entry and exit.
• Firms produce differentiated products.

• Firms have price inelastic demand; they are price makers because the good is highly
differentiated

• Firms make normal profits in the long run but could make supernormal profits in the short
term

• Firms are allocative and productively inefficient.

Diagram Monopolistic Competition (Short run/ Long run)

In the short run, the diagram for monopolistic competition is the same as for a monopoly.
The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading
to supernormal profit For Monopolistic competition long run demand curve shifts to the left
due to new firms entering the market.
In the long-run, supernormal profit encourages new firms to enter. This reduces demand for
existing firms and leads to normal profit.
Efficiency of firms in monopolistic competition
• Allocative inefficient. The above diagrams show a price set above marginal cost
• Productive inefficiency. The above diagram shows a firm not producing on the lowest point
of
AC curve
• Dynamic efficiency. This is possible as firms have profit to invest in research and
development.
• X-efficiency. This is possible as the firm does face competitive pressures to cut cost and
provide
better products.
Examples of Monopolistic Competition
• Restaurants – restaurants compete on quality of food as much as price. Product
differentiation
is a key element of the business. There are relatively low barriers to entry in setting up a new
restaurant.
• Hairdressers. A service which will give firms a reputation for the quality of their hair-cutting.
• Clothing. Designer label clothes are about the brand and product differentiation
• TV programmes – globalisation has increased the diversity of TV programmes from
networks
around the world. Consumers can choose between domestic channels but also imports
from
other countries and new services, such as Netflix.

Limitations of the model of Monopolistic Competition

• Some firms will be better at brand differentiation and therefore, in the real world, they will be
able to make supernormal profit.

• New firms will not be seen as a close substitute.

• There is considerable overlap with oligopoly – except the model of monopolistic competition
assumes no barriers to entry. In the real world, there are likely to be at least some barriers
to
entry
• If a firm has strong brand loyalty and product differentiation – this it becomes a barrier to
entry.
A new firm can’t easily capture the brand loyalty.
• Many industries, we may describe as monopolistically competitive are very profitable, so the
assumption of normal profits is too simplistic.

Key difference with Monopoly

In Monopolistic competition there are no barriers to entry. Therefore in long run,
the market will be competitive, with firms making normal profit.
Key difference with perfect competition
In Monopolistic Competition, firms do produce differentiated products, therefore, they
are not price takers (perfectly elastic demand). They have inelastic demand.
New trade theory and Monopolistic Competition
New trade theory places importance on the model of monopolistic competition for
explaining trends in trade patterns. New trade theory suggests that a key element of product
development is the drive for product differentiation – creating strong brands and new features
for products. Therefore, specialization doesn’t need to be based on traditional theories of
comparative advantage, but we can have countries both importing and exporting the same
good. For example, we import Italian fashion labels and export
British fashion labels. To consumers, the importance is the choice of goods.

OLIGOPOLY
The term Oligopoly derives from the Latin ‘olígoi’ – meaning “few”, and ‘pōléō’ – meaning “to
sell”. So, translated, it means ‘few sellers’.
In fact, this is a key characteristic of an oligopoly, where a few firms dominate the market.
In economics, an Oligopoly is a type of market structure where two or more firms have
market control. Combined, they are able to dictate prices and supply. Yet, they are unable to
influence the market on their own.
It does not mean there are just two, three or four competitors. In fact, there could be dozens
of them. However, there are only few dominant ones.
The following are the examples :
1. Google/Microsoft/Apple – In journalism to refer to the largest and most
dominant companies in
the information technology industry.
2. Samsung, Iphone &amp; Huawei are dominating mobile phones brands in the Philippines
3. Sony BMG, EMI Music , Warner Music &amp; UMI – are consortium of music labels
popularly
known globally
4. Coca-Cola &amp; Pepsi – soft drink brands dominating the soda industry The World
Oligopolies
do not exist just within countries but also in whole continents and across the globe.
 Globally, there are 3 dominant computer operating systems – Linux, Mac OS &amp;
Windows. They control virtually the whole desktop computer market.
In the smartphone and tablet markets, Google Android and Apple IOS together have more
than 90% global market share.
Characteristics:
Interdependence – If one oligopoly firm changes its price or its marketing strategy, it will
significantly impact the rival firm(s). For instance, if Pepsi lowers its price by 20 cents per
bottle, Coke will be affected. If Coke does not respond, it will lose significant market share.
Therefore, Coke will most likely lower its price too. Interdependence on decision- making.
Barriers to entry – It is difficult to enter an oligopoly industry and compete as a small start-
up company. Oligopoly firms are large and benefit from economies of scale. It takes
considerable know-how and capital to compete in this industry.
Oligopoly, a firm can earn super-normal profits in the long run as there are barriers to
entry like patents, licenses, control over crucial raw materials, etc. These barriers prevent the
entry of new firms into the industry.
Few Sellers - there are just several sellers who control all or most of the sales in the industry.
Under Oligopoly, there are a few large firms although the exact number of firms is undefined.
Also, there is severe competition since each firm produces a significant portion of the total
output.
Prevalent advertising – advertising is a powerful instrument in the hands of an oligopolistic.
A firm under oligopoly can start an aggressive advertising campaign with the intention of
capturing a large part of the market. Other firms in the industry will obviously resist its
defensive advertising.
Oligopoly firms frequently advertise on a national scale. Many world series, World cup finals
, NBA, NCAA finals advertisements are done by oligopoly forms.
Oligopoly models
Collusion model – a group of firms that gets together and make price and output decisions
to maximize join profits is called a cartel. Collusion occurs when price and quantity fixing
agreements are explicit.
Price Leadership Model - is a form of oligopoly in which one dominate firm sets prices and
all the small firms in the industry follow its pricing policy.
Game Theory – analyzes oligopolistic behavior as a complex series of strategic moves and
reactive countermoves among rival firms.

References:
 1. Gabay, Kristofer . et al. (Second Edition, 2012). Concepts and Principles of Economics,
Rex
Book Store, Inc.
2. Pindyck, Robert S. and Rubinfeld, Daniel L. (Fifth Edition). Microeconomics Printice-Hall
Inc
Upper Saddle River, New Jersey.
3. https://open.lib.umn.edu/principleseconomics/part/chapter-7-the-analysis-
of-consumer-choice/

4. https://www.unf.edu/~traynham/ch10lecture.pdf

5. https://www.nr.edu/eco202/author_pps/pdf/econ2_micro_ch06.pdf