MGEC Slides Lecture 4

Managerial Economics
Aditya Kuvalekar
Essex
Lecture 4: Foundations of Consumer & Producer Behavior.

What we have seen so far
▶ Buyers or consumers: Demand curve.
▶ Sellers or producers: Supply curve.
▶ Ancilliary concepts such as elasticity.
▶ But where do the demand and supply curves come from?

▶ Buyers: maximize utility subject to a budget constraint.
▶ Sellers: maximize profits given the prices of inputs.
▶ Today: See an overarching principle underlying both these problems.

A closer look at two problems
Problem 1: Anita has |100 with her. With that, she can buy√ avocados and loafs of
bread. Her utility from a avocados and b loafs of bread is ab. Suppose that an
avocado costs |20 and a loaf of bread costs |10. What is the combination of a and b she
should use to maximize her utility?
A closer look at two problems
Problem 1: Anita has |100 with her. With that, she can buy√ avocados and loafs of
bread. Her utility from a avocados and b loafs of bread is ab. Suppose that an
avocado costs |20 and a loaf of bread costs |10. What is the combination of a and b she
should use to maximize her utility?
Problem 2: Anita runs a glass factory. √

She has to produce 10 units of glass. Her
production function is Q = f (K, L) = KL, where K (capital) is the number of
machines she can use, and L is the amount of labor she can use. She has to produce 10
units of glass. The cost of running a machine, denoted by PK , is |10, while the cost of
hiring one worker, denoted by PL , is |5. What is the combination of K and L that she
should use to minimize her cost of production?
Start with problem 2
▶ Anita solves the following problem:
min 10K + 5L
K,L
√
subject to KL = 10
▶ K costs more than L. So why not use L only?

√
▶ If K = 0, then KL = 0.
▶ Let us focus on the combinations of K and L that produce the same output. These
are called as isoquants.
Isoquants: Economic trade-offs in production
Capital ▶ We can represent the production

function in terms of isoquants.
▶ Isoquant: A curve that shows all

possible combinations of inputs
Higher production that yield the same level of
output.
√
KL = 20
√
KL = 10
√
KL = 5
Labor
Isoquants
Flexibility of production
▶ Captures degree of flexibility in production.

▶ Wine can be produced in a more labor intensive way using many workers or in a capital
intensive way using more machines.
▶ Operating an assembly line at a higher speed may require more labor, even more
material (higher waste) but less assembly line capital.
▶ While baking a cake, options for substituting flour for more labor is limited.
Isoquants
Flexibility of production
▶ Captures degree of flexibility in production.

▶ Wine can be produced in a more labor intensive way using many workers or in a capital
intensive way using more machines.
▶ Operating an assembly line at a higher speed may require more labor, even more
material (higher waste) but less assembly line capital.
▶ While baking a cake, options for substituting flour for more labor is limited.
▶ The more “L-shaped,” the harder is substitution.

▶ Extreme example: “Fixed proportions production function”
▶ Straight line shows perfect substitutability.
▶ Returns to scale: Constant, increasing and decreasing.

Slope of Isoquants
Marginal rate of technical substitution
▶ The slope of the isoquant has meaning: Indicates how the quantity of one input
can be traded off against the quantity of the other, while keeping the output
constant.
▶ So called the marginal rate of technical substitution.

Slope of Isoquants
constant.
▶ Slope of an isoquant is the ratio of the marginal products.

Slope of Isoquants
constant.

q = f (K, L)
∂F ∂F
dq = dK + dL
∂K ∂L
Slope of Isoquants
constant.

q = f (K, L)
∂F ∂F
dq = dK + dL
∂K ∂L
Along an isoquant, we know q is constant.
∂F ∂F
0= dK + dL
∂K ∂L
dK MPL
=⇒ − = .
dL MPK
Using isoquants: Choosing optimal mix of inputs
If isoquants tell us how to trade off inputs, can we use them to identify the optimal mix
of inputs for a given output?
▶ What is the optimal mix of inputs (here, labor and capital)?

▶ Depends not just on productivity of inputs, but also on costs.


▶ The most cost-effective way of making the desired output?
1. Given the price per unit of input, we can conbemph a set of straight line isocost lines
representing the different combinations of labor and capital we can get for a fixed
budget.
2. Cost minimization then involves finding the tangency of the lowest isocost line with the
isoquant associated with the desired quantity.
Cost-minimizing input choice
▶ Suppose you want to produce 10
Capital
semiconductor chips.
▶ Given prices of L and K, you can

draw isocost lines.
√
KL = 10
C1 = 100 C2 = 150
Labor
Capital

draw isocost lines.
▶ Suppose your budget is C1 .
√
KL = 10
C1 = 100 C2 = 150
Labor
Capital

draw isocost lines.
▶ Suppose your budget is C1 .
▶ What if it was C2 ? Best input

combination?
▶ Have you chosen the cheapest way

of making 10 chips?
√
KL = 10
C1 = 100 C2 = 150
Labor
▶ At the optimal choice, the production function (isoquant) is tangent to the isocost
line. So their slopes must be equal.
▶ What is the slope of the isocost line? Ratio of input prices.
PL
− .
PK
PL
− .
PK
▶ What is the slope of the isoquant? Ratio of marginal products.
MPL
− .
MPK
PL
− .
PK
MPL
− .
MPK
▶ If the slopes are equal,
MPL MPK
= .
PL PK
PL
− .
PK
MPL
− .
MPK
▶ If the slopes are equal,
MPL MPK
= .
PL PK
▶ What does this mean? At the optimum, the firm chooses quantities of inputs so
that the last dollar worth of any input yields the same amount of extra output.
Applying our learnings
▶ Let us return to the example
√ √
q= L K
with PK = 10, PL = 5.
▶ We wish to solve the following problem.
min 10K + 5L
K,L
√
subject to KL = Q.
√ √
q= L K
with PK = 10, PL = 5.
min 10K + 5L
K,L
√
subject to KL = Q.
▶ MPK /MPL = L PK 10
K
= PL
= 5
= 2.
√ √
q= L K
with PK = 10, PL = 5.
min 10K + 5L
K,L
√
subject to KL = Q.
▶ MPK /MPL = L PK 10
K
= PL
= 2.
= 5
√
▶ =⇒ L = 2K. Substituting in KL = q gives,
√ q
2K = Q =⇒ K = √ .
2
▶ Therefore, the cost of producing Q units is,

√
10K + 5L = 20K = 10 2Q.
▶ This is the Cost function of a firm: the cheapest cost to produce Q units.
▶ Notice, even if L is cheaper, we don’t use only L.
Utility maximization
Context: How can a consumer decide which goods and services to buy, given her
income or budget?
▶ How do these consumer decisions in turn determine the aggregate demand for
goods and services?
Concepts: Utility, Preferences, Indifference curves, Budget constraint

Consumer preferences
▶ Consumers can buy a vast array of goods / services.

▶ Buy a basket / bundle D e.g. a pair of jeans, a shirt, a hamburger and a manicure.
▶ Consumer preferences tell us how an individual ranks different bundles.
▶ What do we assume about preferences?

▶ Preferences are complete.
▶ Preferences are transitive.
▶ More is better.

▶ Preferences are complete.
▶ Preferences are transitive.
▶ More is better.
▶ Can represent preferences with a utility function: Measures the level of
satisfaction that an individual receives from any basket of goods.
Indifference curves
▶ We can represent a consumer’s preferences graphically using indifference curves.

▶ An indifference curve represents all combinations of baskets that provide the
consumer with the same level of satisfaction or utility.
▶ A consumer is indifferent between all baskets (points) on the same indifference curve.
Indifference Curves
Broccoli per lb
Higher utility
U3
U2
U1
Chicken per lb
Indifference Curves
Broccoli per lb ▶ More is better!

▶ As you move northeast in the
figure, utility rises.
▶ Indifference curves have a
negative slope.
Higher utility
U3
U2
U1
Chicken per lb
Indifference Curves

negative slope.
▶ IC cannot intersect.
Higher utility
U3
U2
U1
Chicken per lb
Indifference Curves

negative slope.
▶ IC cannot intersect.
Higher utility
▶ Shape tells you the marginal rate
of substitution (MRS).
▶ Slope = How many lbs of broccoli
you are willing to give up for 1
lb of chicken.
U3 ▶ Principle of diminishing MRS:
leads to convex shape.
▶ The closer substitutes the goods
are, the straighter the indifferent
U2 curves. Examples?
U1
Chicken per lb
Utility
Broccoli per lb
Higher utility
U3
U2
U1
Chicken per lb
Utility
Broccoli per lb ▶ Our theory of consumer behavior

relies on relative rankings of
baskets of goods.
Higher utility
U3
U2
U1
Chicken per lb
Utility

baskets of goods.
▶ Sometimes, useful to assign
numerical values to baskets:
Higher utility ▶ Concept of utility
U3
U2
U1
Chicken per lb
Utility

baskets of goods.
▶ Sometimes, useful to assign
numerical values to baskets:
Higher utility ▶ Concept of utility
▶ A utility function assigns a
numerical level of utility to each
basket.
▶ Indifference curve is a iso-utility
U3 curve.
So far, talked only of

U2 preferences...But, what can you
afford?
U1
Chicken per lb
But, which bundles can a consumer afford?
Broccoli per lb ▶ Suppose you have a budget of $24

per week. Broccoli cost $3 per lb.
Chicken costs $4 per lb. What
baskets can you afford?
Chicken per lb

8 ▶ At most 8lb of only broccoli or at

most 6 lbs of only chicken.
Combinations thereof.
Chicken per lb
6


▶ Any point in the feasible set is

Budget line
affordable. Points on the budget
line fully use up the budget.
Feasible budget set ▶ Slope of budget line is − Pchicken .

P broccoli
Chicken per lb
6


▶ Any point in the feasible set is

Budget line
affordable. Points on the budget
line fully use up the budget.
Feasible budget set ▶ Slope of budget line is − Pchicken .

P broccoli
What is your optimal choice?
Chicken per lb
6
Given a budget and preferences, which bundle will a consumer choose?
Broccoli per lb ▶ The consumer’s chosen bundle

depends on
▶ His preferences
▶ His budget
▶ The prices of broccoli and chicken
Chicken per lb
6

depends on
▶ His preferences
▶ His budget
8
▶ The consumer wants to maximize
his utility given his budget
constraint.
Chicken per lb
6

depends on
▶ His preferences
▶ His budget
8
▶ The consumer wants to maximize
his utility given his budget
constraint.
6
▶ So, choose the combination of

broccoli and chicken that hits the
highest indifference curve.
Chicken per lb
2 6
The consumer’s utility maximizing choice, subject to his budget
constraint
Broccoli per lb ▶ The consumer chooses a point

where the budget line and IC are
tangent.
▶ At point A, the slope of the IC is
the same as that of the budget
8 line.
P
MRS = chicken .
Pbroccoli
6 i.e. MRS= ratio of prices
▶ What do you think happens
if...the price of chicken falls?
Chicken per lb
2 6
Linking optimal choice to the demand curve
Broccoli per lb ▶ What happens if the price of

chicken falls to $3? $2?
▶ Consumer’s optimal bundle
changes.
8
16/3
4.8
4.4
2 16 5.4 6 8 12 Chicken per lb

5

changes.
8 ▶ This can help us trace the
consumer’s demand curve for
chicken!
16/3
4.8
4.4

5

changes.
8 ▶ This can help us trace the
consumer’s demand curve for
chicken!
▶ All else equal, demand for
16/3 chicken rises as prices fall.
4.8
4.4

5
Back to firms’ costs
More definitions
We saw how the cost function is derived from the production function and prices.
Some related definitions . . .
▶ Cost function:
▶ Fixed cost (FC):
▶ Variable cost (VC):
▶ Average cost (AC):
▶ Marginal cost (MC):

Back to firms’ costs
More definitions
We saw how the cost function is derived from the production function and prices.
Some related definitions . . .
▶ Cost function: Total cost of inputs the firm needs to produce output q. Denoted
by C(q).
▶ Fixed cost (FC): The cost that does not depend on the output level, C(0).
▶ Variable cost (VC): The part of costs that depends on output level, i.e.,
C(q) − C(0).
▶ Average cost (AC): Total cost divided by output level, C(q)

q
.
▶ Marginal cost (MC): The unit cost of a small increase in output. Derivative of cost
with respect to output, dC
dq
, or approximately C(q) − C(q − 1).
Cost Curves
Cost
MC
AVC
ATC
Quantity
Cost Curves
Cost
MC
Quantity
Let’s start with the Marginal cost

▶ At first Marginal cost decreases due to gains from specialization
▶ Then it increases, because of too much labor(variable inputs) with respect to fixed
inputs.
Cost Curves
Cost
MC
AVC
Quantity
Adding in the Average Variable cost

▶ The total variable cost of producing q units divided by q
▶ VC(q) = MC(1)+MC(2)+...+MC(q) = Area under MC. And AVC(q) = VC(q)/q
Cost Curves
Cost
MC
AVC
ATC
Quantity
Adding in the Average Total cost

▶ TC(q)=VC(q)+Fixed Costs
▶ ATC(q) = AVC(q)+ FC/q
Relationship between MC and AC
▶ Relationship between MC and AC, i.e., marginal cost and average cost
MC = AC at minimum AC
If MC < AC , AC is falling
If MC > AC , AC is rising
▶ Firms always produce in the region where MC is increasing

▶ At any quantity q where MC is decreasing:
▶ the firm can decrease its average cost by producing more
▶ therefore, not an efficient use of resources to be producing where MC is decreasing
▶ ⇒the MC of producing each successive unit is greater than the last one
⇒each successive unit must be sold at a higher price to cover the higher cost of
production
⇒gives rise to the upward sloping supply curve!
Market Supply and Competitive Equilibrium
Context: A cost curve describes the minimum cost at which a firm can produce various
levels of output. Now we ask the fundamental question: How much should be
produced?
▶ How much should a firm produce in order to maximize profit?
▶ What does this imply for a profit maximizing firm in a competitive market?
▶ How does a firm’s output choice change as its costs change? Is there a connection
between a firm’s costs and the supply curve?
Concepts: Profit maximization, short-run and long-run supply curves, Competitive

market
Perfect Competition
Competitive Equilibrium
A perfectly competitive market: What does this mean?

Competitive Equilibrium
A perfectly competitive market: What does this mean?

▶ Price takers
▶ Homogeneous product
▶ Free entry and exit
Profit Maximization
▶ We assume that firms maximize profit.

▶ Why this assumption?
Profit Maximization

▶ Why this assumption? Predicts business behavior quite accurately.
Profit Maximization

▶ Why this assumption? Predicts business behavior quite accurately.
▶ Not always true. Examples?
In this class, we focus on profit maximization.

Profit
▶ Profit Π = Revenue - Costs.

▶ Total revenue TR = PQ.
▶ Marginal revenue MR = dTR .
dQ
▶ Average revenue AR = TR PQ
Q
= Q
= P.
Taking stock
The story so far...

▶ Consumer behavior, utility, and the demand for goods
▶ The production process, costs, and the supply of goods
▶ The interaction of demand and supply to arrive at equilibrium prices and
quantities
Taking stock
The story so far...

quantities
The road ahead...

▶ The context in which these interactions happen has key implications for how
prices and quantities are set
Taking stock
The story so far...

quantities
The road ahead...

▶ The context in which these interactions happen has key implications for how
prices and quantities are set
▶ “market structure”: determines the degree of pricing power that a supplier has
▶ 2 extreme cases:
▶ perfect competition: no market power, managers take prices as given and adjust quantities alone
▶ monopoly: single seller with complete discretion over price and quantity
Perfect competition
Characteristics of perfectly competitive markets

▶ Large number of buyers and sellers
▶ each buyer and seller is small
▶ individual actions have imperceptible influence on market dynamics
Perfect competition

▶ No product differentiation
▶ each firm’s product is the same from a consumer’s perspective
▶ consumers pick on the basis of price alone
Perfect competition

▶ Perfect information
▶ information about prevailing prices easily available and costless for both suppliers and
buyers
Perfect competition

▶ Perfect information
▶ information about prevailing prices easily available and costless for both suppliers and
buyers
▶ Equal access to resources
▶ Current as well as prospective firms have same access to inputs (labor, skills, capital,
technology, raw material etc.)
▶ i.e., no single firm has greater market power in any regard as compared to any other firm
▶ Can access and release at will through well-functioning markets
Perfect competition
Implications for perfectly competitive markets

▶ no regulatory barriers to entry such as patents, licenses or government fiats
▶ no economic barriers to entry such as first mover advantage or network effects
▶ low fixed costs (capital requirements, skills etc)
Perfect competition

▶ Firms are price takers
▶ No firm can individually influence market supply (atomistically small firms)
▶ Each firm can sell as much as it wants at the prevailing market price
Perfect competition

▶ Firms are price takers
▶ No firm can individually influence market supply (atomistically small firms)
▶ Each firm can sell as much as it wants at the prevailing market price
▶ Law of one price
▶ each firm’s offering is the same from the consumer’s perspective
▶ consumers pick on the basis of price alone, leading to the prevalance of a single price in
the market
Economic Profit
All costs curves represent the Opportunity cost of firms (owners of the firm).
So, the profit that is generated goes to the owners/share holders of the firm.
So what does it mean to say that Economic profit is positive?

▶ After paying the owners/shareholders their Opportunity cost, (next best return,
say market return), whatever is left over is your Economic profit.
So what does it mean to say that Economic profit is zero?

▶ After paying the owners/shareholders their Opportunity cost, (next best return,
say market return), nothing is left over.
▶ Owners/Shareholders of firms are making as much returns as their next best
alternative!
Perfect Competition: Demand Faced by a Firm
Price Price
Market Supply
P∗ P∗
Market Demand Demand faced by a firm
Quantity Quantity
Q∗
Demand faced by an individual firm is perfectly
Market price(P∗ ) and market quantity(Q∗ ) in a elastic at the market price (P∗ ). The firm is a
competitive equilibrium price taker in competitive markets.
Perfect Competition: Profit maximization by firms
Price Price/Cost
Market Supply
MC
P∗ P∗
Market Demand Demand = MR
Quantity Quantity
Q∗ q∗
Market price(P∗ ) and market quantity(Q∗ ) in a To maximise profits, an individual firm produces
competitive equilibrium a quantity q∗ where MR = P∗ = MC(q∗ )
Perfect Competition: Equilibrium
Our study of Equilibrium in perfectly competitive markets will comprise of two

time-scales:
▶ Short run: Time interval is short enough that firms’ fixed inputs have not expired.
That is, the firm does not need to acquire fixed inputs for production again in this
interval.
▶ Think of this as how long fixed inputs last. Life of a factory, life of a license acquired etc.
▶ Recall that all the cost curves that we have seen are short run cost curves, keeping the
fixed inputs constant.
▶ Long run: Time interval is long enough that firms can adjust all factors of
production, including fixed inputs.
Perfect Competition: Short Run
In the analysis of short run, we will need two particular prices:
▶ PT : This is the minimum value of the ATC curve.

▶ PV : This is the minimum value of the AVC curve.
▶ Note that PT > PV .
Perfect Competition: Short Run
In the analysis of short run, we will need two particular prices:
▶ PT : This is the minimum value of the ATC curve.

▶ PV : This is the minimum value of the AVC curve.
▶ Note that PT > PV .
It turns out the behaviour of a firm is different depending on three cases of potential
market price P∗ .
▶ P∗ > PT
▶ PV < P∗ < PT
▶ P∗ < PV
We will consider all of these three cases, one by one...

Short Run Cost Curves
Price/Cost
MC
ATC
AVC
PT
PV
Quantity
Perfect Competition: Short Run (P∗ > PT )
Price/Cost
MC
ATC
P∗
AVC
PT
PV
Quantity
Suppose the market price P∗ is above the minimum ATC given by PT .

Question: How much should a firm produce?
Price/Cost
MC
ATC
P∗
AVC
PT
PV
Quantity
q∗

Question: How much should a firm produce? Answer: Where P∗ = MC(q∗ )
Price/Cost
MC
ATC
P∗
Total Profit AVC
PT ATC(q∗ )
PV
Quantity
q∗

What is the Profit? Difference between P∗ and ATC(q∗ ) is the per unit profit. Total
profit is shaded in yellow. Firms make positive profits!
Summary when P∗ > PT
▶ P∗ is always above ATC(q∗ ) because MC is above ATC curve in this region.

▶ This means that per unit revenue is higher than per unit total cost.
▶ Therefore firms make positive Economic profits!
▶ Firms are doing great in this market and there is no question of exiting the market.
Perfect Competition: Short Run (PV < P∗ < PT )
Price/Cost
MC
ATC
AVC
PT
P∗
PV
Quantity
Suppose the market price P∗ is below the minimum ATC given by PT but above the
minimum AVC given by PV . Question: How much should a firm produce?
Price/Cost
MC
ATC
AVC
PT
P∗
PV
Quantity
q∗
Suppose the market price P∗ is below the minimum ATC given by PT but above the
minimum AVC given by PV .
Price/Cost
MC
ATC
AVC
ATC(q∗ )
PT
Total Loss
P∗
PV
Quantity
q∗
Suppose the market price P∗ is below the minimum ATC given by PT but above
minimum AVC given PV .
What is the Profit? Difference between P∗ and ATC(q∗ ) is the per unit loss in this case.
Total loss is shaded in red.
Summary when PV < P∗ < PT
▶ P∗ is below ATC(q∗ ) but above AVC(q∗ ) because MC is below ATC and above
AVC in this region.
▶ This means that per unit revenue is lower than per unit total cost.
▶ Therefore firms make Economic loss!
AVC in this region.
Should firms exit this market?

AVC in this region.

Answer is complicated. Depends on the short run vs. long run.
▶ Short run: Note that P∗ > AVC(q∗ ). This means that while firms are unable to
cover all costs, they are able to cover variable costs, i.e., producer surplus is
positive. Because fixed costs are already paid for and unrecoverable, firms should
continue producing in the short run.
▶ Long run: In the long run, you get to adjust your fixed inputs. Clearly a firm
should exit this market as a loss is being made.
Perfect Competition: Short Run (P∗ < PV )
Price/Cost
MC
ATC
AVC
PT
PV
P∗
Quantity
Suppose the market price P∗ is below the minimum AVC given by PV .

Question: How much should a firm produce?
Price/Cost
MC
ATC
AVC
PT
PV
P∗
Quantity
q∗
Suppose the market price P∗ is below the minimum AVC given by PV . Question: How
much should a firm produce? Answer: Where P∗ = MC(q∗ ). If P∗ = MC(q∗ ) at
multiple quantities then choose the higher quantity. Why?
Price/Cost
MC
ATC
ATC(q∗ )
AVC
PT
Total Loss
PV
P∗
Quantity
q∗
Suppose the market price P∗ is below the minimum ATC given by PT but above
minimum AVC given PV .
What is the Profit? Difference between P∗ and ATC(q∗ ) is the per unit loss in this case.
Total loss is shaded in red. Note that total loss is greater than the fixed cost. The firm
stops production and exits from the market immediately.
Summary when P∗ < PV
▶ P∗ is below AVC(q∗ ) because MC is below AVC in this region.

▶ This means that per unit revenue is lower than per unit variable cost (and
therefore per unit total cost).




Note that P∗ < AVC(q∗ ). This means that firms are unable to cover even their variable
costs, i.e., producer surplus is negative. This means that not selling anything is better
than selling any positive quantity. Clearly a firm should stop selling, i.e., exit the
market right away!
Aside: Supply Curve of a firm
▶ The preceding discussion tells us that a firm never produces when price in the
market P∗ is less than PV
▶ This means that the supply curve of a firm is the part of the MC curve that lies
above the AVC curve.
▶ When P∗ ≥ PV , MC is always increasing, and therefore the supply curve of a firm
is always increasing.
Price/Cost
MC= Supply
AVC
PV
Quantity
Perfect Competition: Short Run Summary
If Market Equilibrium price is P∗
▶ P∗ > PT : Firms make economic profit and are happy to stay put in the market.
▶ PV < P∗ < PT : Firms make economic loss and are happy to stay in the market in
the short run, but exit in the long run.
▶ P∗ < PV : Firms make economic loss and exit the market immediately.
Perfect Competition: From Short Run to Long Run Equilibrium
What happens in the long run? If Market Equilibrium price is P∗
▶ Other firms, lured by economic profits, enter the market =⇒ Supply in the market
increases =⇒ P∗ falls!
▶ Entry continues until P∗ falls to PT
▶ Some firms exit the market =⇒ Supply in the market decreases =⇒ P∗ rises!
▶ Exit continues until P∗ rises to PT
▶ P∗ < PV : Same as the previous case.

Important Observations:
▶ Long run price is the minimum of ATC= PT !
▶ =⇒ Firms make zero economic profit!
▶ Long run price does not depend on the demand!
▶ Long run price does not depend on the demand!
▶ Key idea: Through free entry and exit, supply adjusts in the long run to bring
prices back to PT , if price is not already equal to PT .
Perfect Competition: Long Run Equilibrium
Price/Cost
MC
ATC
AVC
P∗ = PT
PV
Quantity
q∗
At the long run equilibrium, P∗ = minimum of ATC. Long run price does not depend
on demand at all! It only depends on min ATC and therefore only on the costs of
production! How remarkable!
Key Idea: In the long run, supply adjusts to demand changes to brings price back to
PT .
Demand and MR for a Competitive Firm
▶ A firm’s quantity choice cannot influence the price.

▶ What does the demand curve facing a firm look like then?
▶ What are AR and MR?
Demand and MR for a Competitive Firm
▶ A firm’s quantity choice cannot influence the price.

▶ What does the demand curve facing a firm look like then?
▶ What are AR and MR?
▶ For a firm in a perfectly competitive market, AR = MR = P. Firm can sell as much

as it can at a given price.

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MGEC Slides Lecture 4

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Managerial Economics

Lecture 4: Foundations of Consumer & Producer Behavior.

▶ Buyers or consumers: Demand curve.

▶ Sellers or producers: Supply curve.

▶ Ancilliary concepts such as elasticity.

▶ But where do the demand and supply curves come from?

▶ Sellers: maximize profits given the prices of inputs.

▶ Today: See an overarching principle underlying both these problems.

Problem 2: Anita runs a glass factory. √

▶ Anita solves the following problem:

▶ K costs more than L. So why not use L only?

Capital ▶ We can represent the production

▶ Isoquant: A curve that shows all

▶ Captures degree of flexibility in production.

▶ Captures degree of flexibility in production.

▶ The more “L-shaped,” the harder is substitution.

▶ Returns to scale: Constant, increasing and decreasing.

▶ So called the marginal rate of technical substitution.

▶ So called the marginal rate of technical substitution.

▶ Slope of an isoquant is the ratio of the marginal products.

▶ So called the marginal rate of technical substitution.

▶ Slope of an isoquant is the ratio of the marginal products.

▶ So called the marginal rate of technical substitution.

▶ Slope of an isoquant is the ratio of the marginal products.

▶ What is the optimal mix of inputs (here, labor and capital)?

▶ What is the optimal mix of inputs (here, labor and capital)?

▶ What is the optimal mix of inputs (here, labor and capital)?

▶ Given prices of L and K, you can

▶ Given prices of L and K, you can

▶ Suppose your budget is C1 .

▶ Given prices of L and K, you can

▶ Suppose your budget is C1 .

▶ What if it was C2 ? Best input

▶ Have you chosen the cheapest way

▶ Therefore, the cost of producing Q units is,

Concepts: Utility, Preferences, Indifference curves, Budget constraint

▶ Consumers can buy a vast array of goods / services.

▶ Consumers can buy a vast array of goods / services.

▶ Consumers can buy a vast array of goods / services.

▶ We can represent a consumer’s preferences graphically using indifference curves.

Broccoli per lb ▶ More is better!

Broccoli per lb ▶ More is better!

Broccoli per lb ▶ More is better!

Broccoli per lb ▶ Our theory of consumer behavior

Broccoli per lb ▶ Our theory of consumer behavior

Broccoli per lb ▶ Our theory of consumer behavior

So far, talked only of

Broccoli per lb ▶ Suppose you have a budget of $24

Broccoli per lb ▶ Suppose you have a budget of $24

8 ▶ At most 8lb of only broccoli or at

Broccoli per lb ▶ Suppose you have a budget of $24

8 ▶ At most 8lb of only broccoli or at

▶ Any point in the feasible set is

Feasible budget set ▶ Slope of budget line is − Pchicken .

Broccoli per lb ▶ Suppose you have a budget of $24

8 ▶ At most 8lb of only broccoli or at

▶ Any point in the feasible set is

Feasible budget set ▶ Slope of budget line is − Pchicken .

Broccoli per lb ▶ The consumer’s chosen bundle