‫بسم هللا الرحمن الرحيم‬

Principles of Microeconomics

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The course marks plan
• Course work (home works and seminars) = 10 marks.
• Test (2 tests) . 15 marks = 30 marks
• Final exam =. 60 marks
• Total. = 100 marks

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• All the notes taken from the book

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 • The Subject Matter of microeconomic
• What is economics?
• Economics: is the study of how societies choose to use scarce productive resources that
have alternative uses, to produce commodities of various kinds, and to distribute them
among different groups.
• why we study economics?
1. to understand the world we live in,as well as the many potential worlds that reformers
are constantly proposing to us.
Goods are scarce because people desire much more than the economy can produce.
Economic goods are scarce, not free, and society must choose among the limited goods that
can be produced with its available resources.
• Economics major subfields:
1. Microeconomics
2. macroeconomics.
Adam Smith is usually considered the founder of microeconomics.

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• Definition of microeconomics.

the branch of economics which today is concerned with the behaviour of individual entities such as markets,
firms, and households.

Variations between Microeconomics Vs Macroeconomics:

Historically it concerns on:

- how individual prices are set, studied the determination of prices of land, labor, and capital, and inquired into
the strengths and weaknesses of the market mechanism.

- efficiency properties of markets and explained how the self- interest of individuals working through the
competitive market can produce a societal economic benefit. (Smith (1776), The Wealth of Nations considered)

Microeconomics today:

moved to include the study of monopoly, the role of international trade, finance, and many other vital subjects.

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The Concerns of Macroeconomics: the overall performance of the economy.

• The modern modern form Macroeconomics created by John Maynard Keynes (1936),
on his revolutionary General Theory of Employment, Interest and Money.

- theory developed an analysis of what causes business cycles, with alternating spells of
high unemployment and high inflation.

Today, macroeconomics: examines a wide variety of areas, such as:

- how total investment and consumption are determined,

- - how central banks manage money and interest rates,

- what causes international financial crises,

- and why some nations grow rapidly while others stagnate.

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 The Basic Principle of Economics:
• Positive and Normative Economics; Considering economic issues, we have two types
of: questions of fact from questions of fairness.
Positive economics: describes the facts of an economy it claims that attempt to
describe the world as it is
. It deals with questions such as:
- Why do doctors earn more than janitors?
- Did the policies adopted by the country raise or lower the incomes of most the its
Citizens?
- Do higher interest rates slow the economy and lower inflation?
Although these may be difficult questions to answer, they can all be resolved by reference
to analysis and empirical evidence. That puts them in the realm of positive economics.
Normative economics: involves value judgments or ethical precepts and norms of
fairness. claims that attempt to prescribe how the world should be
Questions like;
- Should unemployment be raised to ensure that price inflation does not become too
rapid?
- Has the distribution of income in the country become too unequal?
Note that: There are no right or wrong answers to these questions because they involve
ethics and values rather than facts.
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An Economic problem;

• The summary of the Basic Economic Problem is Unlimited human

wants and the limit supply of resources (scarcity).  
• Unlimited wants mean that there is no end to the quantity of goods and
services people would like to consume.
• the scarcity, is the fundamental issue of economic problem.
• Scarcity means that society has limited resources and therefore cannot
produce all the goods and services people wish to have.
• Therefore because of scarcity, economics is concerned with the economic
three fundamental:
Every human society—whether it is an advanced industrial nation, a
centrally planned economy, or an isolated tribal nation—must confront and
resolve three fundamental economic problems. Every society must have a
way of determining what commodities are produced, how these goods are
made, and for whom they are produced.

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Choice: The act of selecting among alternatives.

• A great deal of economics is about how people choose when the alternatives open to them are
restricted.

• EXAMPLES OF Choices :

- The family shopper are restricted by the household budget. - The business decision-maker
are restricted by competition from other firms, the cost of productive resources, and technology.

• The selection of one alternative generally necessitates the foregoing of others:

if you choose to spend an evening watching a movie, you must forego spending the evening
playing ping pong (or participating in some other activity) . You cannot have your cake and eat it,
too.

• Each day, we alJ make hundreds of economic choices, although we are not normally aware of
doing so.

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 •
Meaning: The production-possibility frontier (or PPF )
shows the maximum quantity of goods that can be
Production efficiently produced by an economy, given its
Possibility technological knowledge and the quantity of available
Frontier (PPF) inputs.

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• A schedule of
possibilities is given in
Table 1-1. Combination
F shows the extreme,
where all butter and no
guns are produced, while
A depicts the opposite
extreme, where all
resources go into guns.
In between—at E, D, C,
and B—increasing
amounts of butter are
given up in return for
more guns.

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Price theory:

• his is concerned with the study of prices and is regarded as the basis of economic
theory.
• It is concerned with the economic behaviour of individual consumers, producers
and resource owners.
• It explains the production, allocation and pricing of goods and services.
• Price: is the exchange value of a commodity in terms of money.
OR: The amount of money that has to be given up in order to obtain a good or
service or a factor input.

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THE MARKET MECHANISM

• A market is a mechanism through which buyers and sellers interact to

determine prices and exchange goods, services, and assets.
• The central role of markets is to determine the price of goods. A price
is the value of the good in terms of money.
• Prices coordinate the decisions of producers and consumers in a market.
Higher prices tend to reduce consumer purchases and encourage
production. Lower prices encourage consumption and discourage
production. Prices are the balance wheel of the market mechanism.
• How Markets Solve the Three Economic Problems :
• By matching sellers and buyers (supply and demand) in each market, a
market economy simultaneously solves the three problems of what, how,
and for whom.

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1. What goods and services will be produced is determined by the dollar
votes of consumers in their daily purchase decisions.
2. How things are produced is determined by the competition among different
producers. The best way for producers to meet price competition and
maximize profits is to keep costs at a minimum by adopting the most
efficient methods of production.
3. For whom things are produced—who is consuming and how much—
depends, in large part, on the supply and demand in the markets for factors of
production. Factor markets
(i.e., markets for factors of production) determine wage rates, land rents,
interest rates, and profits. Such prices are called factor prices.
The distribution of income among the population is thus determined by the
quantity of factor services (person-hours, acres, etc.) and the prices of the
factors (wage rates, land rents, etc.).
Interact between supply and demand leads to equilibrium
invisible hand: Smith saw the harmony between private profit and public
interest;
that private interest can lead to public gain when it takes place in a well-
functioning market mechanism.

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• Adam Smith discovered a remarkable property of a competitive
market economy. Under perfect competition and with no market
failures, markets will squeeze as many useful goods and services out of
the available resources as is possible.
But where monopolies or pollution or similar market failures become
pervasive, the remarkable efficiency properties of the invisible hand may
be destroyed.

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the circular flow of economic life

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 • 2.1 Demand and Supply 
• 2.2 Determinants of Demand
• 2.3 Determinants of supply
• 2.4 The slope of the demand Curve vs supply curve
 Surpluses and shortages; Market equilibrium (price and output); and
•  
 Price ceiling Vs Price Floor
• 2.5 Demand and Supply: Elasticities and Applications

Theory of • 2.6
and cross)
Price elasticity of demand (point. arch, income

Demand •  
 Determinants of price elasticity of demand
and Supply  Some practical applications
 Price elasticity of supply
 Point elasticity
 Cross and income elasticity of demand
•  
 Elasticity of Supply

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2.1 Demand and Supply 

• This theory shows how consumer preferences determine consumer demand for
commodities, while business costs are the foundation of the supply of commodities .

• Defntions:

- The terms supply and demand refer to the behavior of people as they interact
with one another in markets.

- A market: is a group of buyers and sellers of a particular good or service. The

buyers as a group determine the demand for the product, and the sellers as a group
determine the supply of the product.

- Types of markets:

• competitive market:

a market in which there are many buyers and many sellers so that each has a negligible
impact on the market price .

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 Types of Markets :

• A) Perfectly competitive markets:

are defined by two primary characteristics:

(1) the goods being offered for sale are all the same, and

(2) the buyers and sellers are price takers: no single buyer or seller can influence
the market price. Because they must accept the price the market determines. Eg.
wheat market, for example, there are thousands of farmers who sell wheat and millions of consumers who use wheat and wheat
products. Be- cause no single buyer or seller can influence the price of wheat, each takes the price as given.

B) The Monopoly Market:

Its a market with only one seller, and this seller sets the price.

Eg. electricity company, for instance, may be a monopoly if only one company
from which to buy this service.

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• Oligopoly market:

It has a few sellers that do not always compete aggressively.

Communication companies are an example. If it serviced by only two or
three companies, it may avoid rigorous competition to keep prices high.

• Monopolistically competitive market:

it contains many sellers, each offering a slightly different product.

Because the products are not exactly the same, each seller has some ability
to set the price for its own product. An example is the software industry.

Note that,

Our analysis based on the Perfectly competitive markets.

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 DEMAND

•quantity demanded means:

the amount of a good that buyers are willing and able to purchase.
Determines of the Quantity an Individual Demands:
Consider your own demand for rice. How do you decide how much rice to buy
each month, and what factors affect your decision?
1.Price: the quantity demanded is negatively related to the price.
law of demand: the claim that, other things equal, the quantity demanded of a
good falls when the price of the good rises.
2. Income:
2-1) normal good: a good for which, other things equal, an increase in income
leads to an increase in demand.
2-2) inferior good a good for which, other things equal, an increase in income
leads to a decrease in demand.

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3. Price of related goods:
3-1) substitutes: two goods for which an increase in the price
of one leads to an increase in the demand for the other .
3-2) complements: two goods for which an increase in the
price of one leads to a decrease in the demand for the other

4. Tastes: The most obvious determinant of your demand is

your tastes. If you like the good, you buy more of it and
conversely.

5. Expectations: consumer expectations about the future

may affect his demand for a good or service today. (earn a
higher income next month, or the price will fall tomorrow).
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 Determinants of supply

• Quantity Supplied: means the amount of a good that sellers are willing and able to sell.

• Determines of the Quantity an Individual supplies:

1. Price: quantity supplied is positively related to the price of the good.

• law of supply: the claim that, other things equal, the quantity supplied of a good rises
when the price of the good rises.

2. Input Prices: When the price of one or more of the inputs rises, the firm supplies less
products. Thus, the supply of a good is negatively related to the price of the inputs used
to make the good.

3. Technology: The advance in technology raised the supply of the products.

4. Expectations: The amount of a good you supply today may depend on your
expectations of the future.

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 The Demand Schedule and the Demand Curve:

• demand schedule: a table that shows the relationship between the price of a
good and the quantity demanded.

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• demand curve: a graph of the relationship between the price of a good and the quantity
demanded , the demand curve slopes downward.

• ceteris paribus a Latin phrase, translated as “other things being equal,” used as a reminder
that all variables other than the ones being studied are assumed to be constant , literally
means “other things being equal.”

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The Market Demand: the sum of all the individual demands for a particular good or
service.

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 Shifts in the Demand :
• Movements along Curves versus Shifts of Curves:
1. A change in the quantity demanded: moving along, or moving to a different point, on the
same demand curve after a price change.

2. shifts of a demand curve: Any change that raises the quantity that buyers wish to
purchase at a given price shifts the demand curve to the right. Any change that lowers
the quantity that buyers wish to purchase at a given price shifts the demand curve to the
left

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 QUICK QUIZ:
• List the determinants of the quantity of pizza you demand?.
• Make up an example of a demand schedule for pizza, and graph
the implied demand curve?.
• Give an example of something that would shift this demand
curve?.
• Would a change in the price of pizza shift this demand curve?

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 The Supply Schedule and the Supply Curve:

• supply schedule: a table that shows the relationship between the price of a good and the
quantity supplied .
• supply curve: a graph of the relationship between the price of a good and the quantity
supplied .

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MARKET SUPPLY VERSUS INDIVIDUAL SUPPLY

• market supply is the sum of the supplies of all sellers.

• Table 4-5 shows the supply schedules for two ice cream producers Ben and Jerry.
At any price, Ben’s supply schedule tells us the quantity of ice cream Ben supplies,
and Jerry’s supply schedule tells us the quantity of ice cream Jerry supplies.
• Market supply depends on all those factors that influence the supply of individual
sellers, [prices of inputs, technology, expectations and the number of sellers].
• The supply schedules in Table 4-5 show what happens to quantity supplied as the
price varies while all the other variables that determine quantity supplied are held
constant.

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• supply curves: the supply curve shows what happens to the quantity supplied of
a good when its price varies, holding constant all other determinants of quantity
supplied. When one of these other determinants changes, the supply curve shifts.
[Figure 4-6]
• we sum the individual supply curves horizontally to obtain the market supply
curve.
• That is, to find the total quantity supplied at any price, we add the individual
quantities found on the horizontal axis of the individual supply curves.
• The market supply curve shows how the total quantity supplied varies as the
price of the good varies.

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 SHIFTS IN THE SUPPLY CURVE

• If the price of in puts falls, This raises the supply, at any given
price, sellers are now willing to produce a larger quantity. Thus,
the supply curve shifts to the right.
• any change that reduces the quantity supplied at every price shifts
the supply curve to the left.
• Whenever there is a change in any determinant of supply, other
than the good’s price, the supply curve shifts.

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 • As Figure 4-7 shows, shifts of the supply curve.

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• QUICK QUIZ:
• List the determinants of the quantity of pizza supplied?.
• Make up an example of a supply schedule for pizza, and graph the
implied supply curve?.
• Give an example of something that would shift this supply curve?.
• Would a change in the price of pizza shift this supply curve?

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SUPPLY AND DEMAND TOGETHER: market equilibrium
• combine supply and demand to see how they determine the quantity of a good sold
in a market and its price.
• equilibrium : a situation in which supply and demand have been brought into
balance [market’s equilibrium: a situation in which various forces are in balance].
• equilibrium price : the price that balances supply and demand[market-clearing
price].
• equilibrium quantity: the quantity supplied and the quantity demanded when the
price has adjusted to balance supply and demand

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How can Market towards the equilibrium?

• if the market price is above the equilibrium price, There is a surplus of the
good: Suppliers are unable to sell all they want at the going price. They respond
to the surplus by cutting their prices. Prices continue to fall until the market
reaches the equilibrium.
• surplus supply: a situation in which quantity supplied is greater than quantity demanded.
• If the market price is below the equilibrium price, There is a shortage of the
good: Demanders are unable to buy all they want at the going price. With too
many buyers chasing too few goods, sellers can respond to the shortage by
raising their prices without losing sales. As prices rise, the market once again
moves toward the equilibrium.
• shortage: a situation in which quantity demanded is greater than quantity
supplied.
• the activities of the many buyers and sellers automatically push the market price
toward the equilibrium price. Once the market reaches its equilibrium, all
buyers and sellers are satisfied, and there is no upward or downward pressure
on the price.
• law of supply and demand: the claim that the price of any good adjusts to
bring the supply and demand for that good into balance
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 Home work
• Starting from the equilibruim point, using the scatter digrams expalin how
market adjust towards equlibirum if:
1. There is a change in demand?
2. There is a change in supply?
3. There is a change in both of supply and demand?
Note that, youbcan use the book

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 CONTROLS ON PRICES : Price ceiling Vs Price Floor
:

• price ceiling: a legal maximum on the price at which a good can be

sold. “price is not allowed to rise above this level, the legislated maximum”

• price floor: a legal minimum on the price at which a good can be sold
“the price cannot fall below this level”.
• When the government, imposes a price ceiling on the market, two outcomes are
possible:

• (a) the government imposes a price ceiling higher than the equilibrium price the price
ceiling is not binding. Market forces naturally move the economy to the equilibrium,
and the price ceiling has no effect.

• (b) the price ceiling less than the equilibrium price: When the government imposes a
binding price ceiling on a competitive market, a shortage of the good arises, and sellers must
ration the scarce goods among the large number of potential buyers
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• When there is a shortage some mechanism for rationing will
naturally develop.
• The mechanism could be long lines: Buyers who are willing to
arrive early and wait in line get a cone, while those unwilling to
wait do not.
• Alternatively, sellers could ration their salles according to their
own personal biases, selling it only to friends, relatives, or
members of their own racial or ethnic group.
• Notice not all buyers benefit from the price ceiling policy. Some
buyers do get to pay a lower price, although they may have to
wait in line to do so, but other buyers cannot get any thing at all.

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HOW PRICE FLOORS AFFECT MARKET OUTCOMES

• It’s a kind of government price control, a price floor places a legal minimum.

• (a) if the equilibrium price is above the floor, the price floor is not binding. Market forces
naturally move the economy to the equilibrium, and the price floor has no effect.

• if the equilibrium price is below the floor, the price floor is a binding constraint on the market.
The forces of supply and demand tend to move the price toward the equilibrium price, but when
the market price hits the floor, it can fall no further. The market price equals the price floor. At

this floor, the quantity supplied exceeds the quantity demanded . Thus, a binding
price floor causes a surplus.
• price floors and surpluses can lead to undesirable rationing mechanisms. some sellers are
unable to sell all they want at the market price. The sellers who appeal to the personal biases of
the buyers, perhaps due to racial or familial ties, are better able to sell their goods than those
who do not.

• By contrast, in a free market, the price serves as the rationing mechanism, and sellers can sell
all they want at the equilibrium price.
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 Elasticity and its Application

• elasticity: a measure of the responsiveness of quantity demanded or quantity

supplied to one of its determinants .

• THE ELASTICITY OF DEMAND

• To measure how much demand responds to changes in its determinants,
economists use the concept of elasticity.
• price elasticity of demand: a measure of how much the quantity demanded of a good
responds to a change in the price of that good, computed as the percentage change in
quantity demanded divided by the percentage change in price .

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The Determinates of the Price Elasticity of Demand.

• Demand for a good is said to be elastic if the quantity demanded responds substantially to
changes in the price. Demand is said to be inelastic if the quantity demanded responds only
slightly to changes in the price.

• What determines whether the demand for a good is elastic or inelastic?

1. Necessities versus Luxuries: Necessities tend to have inelastic demands, whereas

luxuries have elastic demands.

2. Availability of Close Substitutes Goods with close substitutes tend to have more
elastic demand because it is easier for consumers to switch from that good to
others.

3. Definition of the Market The elasticity of demand in any market depends on how
we draw the boundaries of the market. Narrowly markets more elastic demand
than broadly markets.

4. Time Horizon: Goods tend to have more elastic demand over longer time horizons.
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COMPUTING THE PRICE ELASTICITY OF DEMAND

Example:
• suppose that a 10 -percent increase in the price of an ice-cream cone causes the
amount of ice cream you buy to fall by 20 percent. We calculate your elasticity of
demand as
• Price elasticity of demand = 2.
• the elasticity is 2, reflecting that the change in the quantity demanded is
proportionately twice as large as the change in the price.

• PROBLEM: If you try calculating the price elasticity of demand between

two points on a demand curve, you will quickly notice an annoying
problem: The elasticity from point A to point B seems different from the
elasticity from point B to point A.
• SOLUTION: MIDPOINT

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Midpoint elasticity:

Point A: Price = $4. Quantity = 120 Point B: Price = $6 Quantity =80

Midpoint: Price = $5 Quantity = 100

The price elasticity of demand equal = 1

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Explanation of elasticity values

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THE VARIETY OF DEMAND CURVES

• Economists classify demand curves according to their elasticity.

• Demand is elastic when the elasticity is greater than 1, so that
quantity moves proportionately more than the price.
• Demand is inelastic when the elasticity is less than 1, so that
quantity moves proportionately less than the price.
• If the elasticity is exactly 1, so that quantity moves the same
amount proportionately as price, demand is said to have unit
elasticity.
• Because the price elasticity of demand measures how much
quantity demanded responds to changes in the price, it is closely
related to the slope of the demand curve.
• The following rule of thumb is a useful guide:
1. The flatter is the demand curve that passes through a given point,
the greater is the price elasticity of demand.
2. The steeper is the demand curve that passes through a given
point, the smaller is the price elasticity of demand.
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TOTAL REVENUE AND THE PRICE ELASTICITY OF DEMAND

• total revenue: the amount paid by buyers and received by sellers of a good,
computed as the price of the good times the quantity sold.
• In any market, total revenue = P x Q,
• Given P = $4 and Q = 100, total revenue is $4 x 100, or $400.
• How does total revenue change as one moves along the demand curve?
• The answer depends on the price elasticity of demand.

• a general rule:
• When a demand curve is inelastic (a price elasticity less than 1), a
price increase raises total revenue, and a price decrease reduces
total revenue.
• When a demand curve is elastic (a price elasticity greater than 1), a
price increase reduces total revenue, and a price decrease raises
total revenue.
• In the special case of unit elastic demand (a price elasticity exactly
equal to 1), a change in the price does not affect total revenue.
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OTHER DEMAND ELASTICITIES: The Income Elasticity of Demand

• income elasticity of demand: a measure of how much the quantity demanded of a

good responds to a change in consumers’ income, computed as the percentage
change in quantity demanded divided by the percentage change in income.

• Normal goods: Higher income raises quantity demanded. normal goods have
positive income elasticities. [Necessities, tend to have small income elasticities,
Luxuries, tend to have large income elasticities]

• Inferior goods: Higher income lowers the quantity demanded. Because quantity
demanded and income move in opposite directions, inferior goods have negative
income elasticities.

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 cross-price elasticity of demand
• cross-price elasticity of demand: a measure of how much the quantity demanded
of one good responds to a change in the price of another good, computed as the
percentage change in quantity demanded of the first good divided by the percentage
change in the price of the second good.

• Whether the cross-price elasticity is a positive or negative number depends on

whether the two goods are substitutes or complements.

• QUICK QUIZ: Define the price elasticity of demand?.

• HOW to calculate the price elasticity of demand?.
• Why we use mid point and how? .
• Explain the relationship between total revenue and the price elasticity of demand?.
•

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THE ELASTICITY OF SUPPLY

• price elasticity of supply: a measure of how much the quantity

supplied of a good responds to a change in the price of that good,
computed as the percentage change in quantity supplied divided by
the percentage change in price.
• Determinates of price elasticity of supply :
1. the flexibility of sellers to change the amount of the good they produce.
2. a key determinant of the price elasticity of supply is the time period being
considered.

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• For example:
suppose that an increase in the price of milk from $2.85 to
$3.15 a gallon raises the amount that dairy farmers produce
from 9,000 to 11,000 gallons per month. Using the midpoint
method, we calculate the percentage change in price as
• Percentage change in price = (3.15 - 2.85)/3.00 x 100 = 10
percent.
• Percentage change in quantity supplied = (11,000 -
9,000)/10,000 = 100 = 20 percent.
• In this case, the price elasticity of supply is = 0.20/ 0.10 = 2.0
• In this example, the elasticity of 2 reflects the fact that the
quantity supplied moves proportionately twice as much as
the price.

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Explanations:
1.In the extreme case of a zero elasticity, supply is perfectly inelastic, e
= 0. the quantity supplied is the same regardless of the price.
2. supply is perfectly elastic= the price elasticity of supply = infinity,
meaning that very small changes in the price lead to very large changes
in the quantity supplied. meaning that very small changes in the price
lead to very large changes in the quantity supplied.
3. the supply elasticity greater than 1, the quantity supplied moves
proportionately more than the price.
4. the elasticity is less than 1, quantity supplied moves proportionately
less than the price.

QUICK QUIZ:
Define the price elasticity of supply.
Explain why the the price elasticity of supply might be different in the
long run than in the short run.
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applications : home work from the book p., 108

• What happens to wheat farmers and the market for wheat

when university agronomists dis- cover a new wheat hybrid
that is more productive than existing varieties?
• WHY DID OPEC FAIL TO KEEP THE PRICE OF OIL HIGH?
• DOES DRUG INTERDICTION INCREASE OR DECREASE
DRUG-RELATED CRIME?

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 Theory Consumer Behavior
ALL THE NOTES TAKEN FROM:

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• It explores the basic principles of consumer choice and behavior, while making decisions
every day about how to allocate scarce money and time, and how we balance competing
demands and desires, and make the choices that define our lives.

• 1. Choice and utility theory 2. the theory of indifference curve.

• Choice and utility theory:

• utility defined as the satisfaction. Often, it is convenient to think of utility as the subjective
pleasure or usefulness that a person derives from consuming a good or service.

• Or “property in any object . . . to produce pleasure, good or happiness or to prevent . . . pain,

evil or unhappiness.”

• More precisely, it refers to how consumers rank different goods and services.

• If basket A has higher utility than basket B for a consumer, this ranking indicates that
consumer prefers A over B.

• Rather, utility is a scientific construct that economists use to understand how rational
consumers make decisions.
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• Basic assumptions:
• Consumer are rational: make decisions that give them the greatest
satisfaction or utility.
• people maximize their utility, which means that they choose the
bundle of consumption goods that they most prefer.
• Types of utility:
• 1. marginal utility 2. marginal utility.
• “Marginal” is a key term in economics and always means
“additional” or “extra.” Marginal utility denotes the additional
utility you get from the consumption of an additional unit of a
commodity.
• Total utility of consuming a certain amount is equal to the sum of
the marginal utilities up to that point.
• Law of Diminishing Marginal Utility: states that, as the amount
of a good consumed increases, the marginal utility of that good
tends to decline. [ Total utility increase by a decreasing rate].
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• A Numerical Example:

• By the law of diminishing marginal utility, the marginal utility

falls with increasing levels of consumption.
•

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• DERIVATION OF DEMAND CURVES

• apply the utility theory to explain consumer demand and to

understand the nature of demand curves.
• Assumptions:
- each consumer maximizes utility, by chooses the most
preferred bundle of goods from what is available.
- consumers have a certain income.
- market prices for goods are given.
satisfactory rule :
If good A costs twice as much as good B, then buy good A
only when its marginal utility is at least twice as great as good
B’s marginal utility.
Equimarginal principle:
It states that a consumer will achieve maximum satisfaction or utility when the
marginal utility of the last dollar spent on a good is exactly the same as the
marginal utility of the last dollar spent on any other good.
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This fundamental
condition of consumer
equilibrium can be written
in terms of the marginal
utilities (MUs) and prices
(Ps) of the different goods
in the following compact
way

marginal utility of
income: The common
marginal utility per dollar of
all commodities in consumer
equilibrium. .

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• Why Demand Curves Slope Downward?
- Starting from the fundamental rule for consumer behavior, we can easily
see why demand curves slope downward.
- For simplicity, hold the common marginal utility per dollar of income
constant.
- Then increase the price of good 1. With no change in quantity consumed,
the first ratio (i.e., MU good 1 /P1) will be below the MU per dollar of all
other goods.
- The consumer will lowering the consumption of good 1, then raising the
MU of good 1, until the new marginal utility per dollar spent on good 1 is
again equal to the MU per dollar spent on other goods.
- Thus:

A higher price for a good reduces the consumer’s desired consumption of that
commodity; this shows why demand curves slope downward.

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GEOMETRICAL ANALYSIS OF CONSUMER EQUILIBRIUM

• The tow theories of analyzing the comsumer behaviro are marhinal

utility(cardinal) theory and an indiffeince curves theory (ordinal).
• Assumptions:
- a consumer buys different combinations of two commodities, say, food and
clothing.
- There are a given set of prices.
- For each combination of the two goods, the consumer might prefer one to the
other or are indifferent between the pair.
• For example, when asked to choose between combination A of 1 unit of food
and 6 units of clothing and combination B of 2 units of food and 3 of clothing,
you might (1) prefer A to B, (2) prefer B to A, or (3) be indifferent between A
and B.
• Indifference curve: a curve that shows consumption bundles that give the
consumer the same level of satisfaction.

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• FOUR PROPERTIES OF INDIFFERENCE CURVES :
1. Higher indifference curves are preferred to lower ones.
2. Indifference curves are downward sloping
3. Indifference curves do not cross.
4. Indifference curves are bowed inward “convexe to the original point”

MRS

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01/18/2023 78
• Indifference map:

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• The budget line (The Budget
Constraint): the limit on the
consumption bundles that a
consumer can afford.

• is the set of bundles that cost

exactly m:
p1x1 + p2x2 = m (2.3)
• These are the bundles of goods
that just exhaust the consumer’s
income. The budget set is
depicted in Figure 2.1. The heavy
line is the budget line—the
bundles that cost exactly m—and
the bundles below this line are
those that cost strictly less than
m.

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• Consumer equilibrium: is
attained at the point where the
budget line is tangent to the
highest indifference curve. At that
point, the consumer’s substitution
ratio is just equal to the slope of
the budget line.
- The optimum point: at which this
indifference curve and the budget
constraint touch.
- at the optimum, the slope of the
indifference curve equals the slope
of the budget constraint.
- The slope of the indifference curve
is the marginal rate of substitution
between the two goods.
- and the slope of the budget
constraint is the relative price of
the two goods
- the marginal rate of substitution
equals the relative price.

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• At equilibrium point

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 CHANGES IN INCOME AND PRICE

• Assume, first, that the

consumer’s daily income
is halved while the two
prices remain unchanged.

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 Single Price Change

• Assume that:
• the consumer’s income
constant,
• one price changed
• the other price is
unchanged.
• Again we must examine
the change in the budget
line. This time we find
that it has pivoted on
point N and is now NM’,
as illustrated in Figure
5A-6.

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 DERIVING THE DEMAND CURVE

Assumptions:
Ceteris money
based on Figure
5A-6. Paribus: Tastes, income,

At a price of $1.50, if the price rises to $3, at a price of $6 , we have derived a neat
downward-sloping
food = 2 units, food =1 unit, food=0.45 equilibrium demand curve from
equilibrium point B. equilibrium point B‘’. point B’’’ . indifference curves.

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 HOME WORK
Briefly write about the followings:

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 Topic 4: Theory of Production
and Cost

4.1 What is a firm?

4.2 Objectives of Production

4.3 Factors of Production

4.4 Production functions

4.5 Cost curves

4.6 Short run supply curves

4.7 Long run supply curves

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What is a firm?

-Business firms: are specialized organizations

devoted to managing the process of production.

Firms are institutions which exist to produce goods

and services for the market. 

The definition of a ‘firm’ in the field of economics is any company that

seeks to make a profit by manufacturing or selling products or services –
or both – to consumers.

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 1. Exploiting economies of mass production,
raising funds, and organizing factors of
Production: production is organized in firms
because of economies of specialization, there
fore Efficient production requires specialized
labor and machinery, coordinated production,
Firm and the division of production into many small
operations.
Functions: 2. Raising resources for large-scale production:
Manage and coordinate the production
process: efficient production by private
enterprise would be virtually unthinkable if
corporations could not raise billions of dollars
each year for new projects.
3. manage and coordinate the production
process: such as purchasing or renting land,
capital, labor, and materials.

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 1. The Individual Proprietorship : A small store might do a few
hundred dollars of business per day and barely provide a minimum
wage for the owners’ efforts.
These businesses are large in number but small in total sales. The self-
employed often work 50 or 60 hours per week and take no vacations,
yet the average lifetime of a small business is only a year.

Types of 2. The Partnership: Any two or more people can get together and
form a partnership. Each agrees to provide a fraction of the work and
capital and to share a percentage of the profits and losses. Today,

production partnerships account for only a small fraction of total economic

activity, because they imposed unlimited liability. Under unlimited
liability, partners are liable without limit for all debts contracted by the
firms: partnership.

3. The Corporation: a corporation is a form of business organization

owned by a number of individual stockholders. The corporation has a
separate legal identity, and indeed is a legal “person” that may on its
own behalf buy, sell, borrow money, produce goods and services, and
enter into contracts. In addition, the corporation enjoys the right of
limited liability, whereby each owner’s investment and financial
exposure in the corporation is strictly limited to a specified amount.

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 1. The ownership: determined by the
ownership of the company’s common stock.
[10 % corporation’s shares, = 10 %
The central ownership]. Publicly owned corporations are
features of a valued on stock exchanges.
modern 2. In principle, the shareholders control the
companies they own. They collect
corporation: dividends in proportion to the fraction of the
shares they own, and they elect directors and
vote on many important issues.
3. The corporation’s managers and directors
have the legal power to make decisions for
the corporation. [what to produce, how to
produce it, negotiate with labor unions and
decide whether to sell the firm if another
firm wishes to take it over]. The shareholders
91 own the corporation, but the man- agers run
it.

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Objectives
of • Firms always strive to produce efficiently, In other
words, they always attempt to produce the
Production maximum level of output for a given dose of inputs.
In order to maximize the profit.
• To reduce the cost.

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 • Inputs or factors of production defined as are commodities or
services that are used to produce goods and services.

Factors of • Outputs or production: are the various useful goods or services

that result from the production process and are either consumed or
Production employed in further production.
• Factors of production: can be classified into three broad
[Inputs categories:
1. Land [natural resources]: represents the gift of nature to our
and societies. It consists of the land used for farming or for under-
pinning houses, factories, and roads; the energy resources that
Outputs] fuel our cars and heat our homes; and the nonenergy resources
like copper and iron ore and sand in addition to environmental
resources, such as clean air and drinkable water.
2. Labor: consists of the human time spent in production -
working in automobile factories, writing software, teaching
school, or baking pizzas. Thousands of occupations and tasks, at
all skill levels, are performed by labor.
3. Capital: resources form the durable goods of an economy,
produced in order to produce yet other goods. Capital goods
include machines, roads, computers, software, trucks, steel

93
mills, automobiles, washing machines, and buildings.

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 • production function: The relationship between the
amount of input required and the amount of output
that can be obtained.

Production • The production function specifies the maximum

output that can be produced with a given quantity of
functions inputs. It is defined for a given state of engineering
and technical knowledge.
• the concept of a production function is a useful way
of describing the productive capabilities of a firm.
• Assumptions: the firms always strive to produce
efficiently. In other words, they always attempt to
produce the maximum level of output for a given
dose of inputs.
• Types of production functions:
1.Capital - intensive
2. Labor - intensive

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 • Total physical product, or total product: which
designates the total amount of output produced, in
Important physical units such as bushels of wheat or number
of sneakers. they show how total product responds
production as the amount of labor applied is increased. The
total product starts at zero for zero labor and then
concepts: increases as additional units of labor are applied,
reaching a maximum level.
• The marginal product: of an input is the extra
output produced by 1 additional unit of that input
while other inputs are held constant. For example,
assume that we are holding land, machinery, and
all other inputs constant. Then labor’s marginal
product is the extra output obtained by adding 1
unit of labor. The third col
95 • The average product: which equals total output
divided by total units of input.

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Total,
Marginal,
and Average
Product

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01/18/2023 97
 • a firm will get less and less extra output
when it adds additional units of an input
while holding other inputs fixed.
The Law of • In other words, the marginal product of
Diminishing each unit of input will decline as the amount
Returns: of that input increases, holding all other
inputs constant.
• The law of diminishing returns expresses a
very basic relationship. As more of an input
such as labor is added to a fixed amount of
land, machinery, and other inputs, the labor
has less and less of the other factors to work
with. The land gets more crowded, the
98 machinery is overworked, and the marginal
product of labor declines.

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 • the returns to scale: refers to the effects of scale increases
of all inputs on the quantity produced.
1. Constant returns to scale: denote a case where a change in
all inputs leads to a proportional change in output. For
example, if labor, land, capital, and other inputs are doubled,
then under constant returns to scale output would also double.

RETURNS 2. Increasing returns to scale (also called economies of

scale): arise when an increase in all inputs leads to a more-
TO than-proportional increase in the level of output. For example,
increasing the inputs of labor, capital, and materials by 10
SCALE percent will increase the total output by more than 10 percent.
3. Decreasing returns to scale: occur when a balanced
increase of all inputs leads to a less-than- proportional
increase in total output. In many processes, scaling up may
eventually reach a point beyond which inefficiencies set in.
These might arise because the costs of management or control
become large.
All in all Production shows increasing, decreasing, or constant
returns to scale when a balanced increase in all inputs leads to
a more-than-proportional, less- than-proportional, or just-
proportional increase in output.

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 Everywhere that production goes, costs follow close
behind like a shadow. Firms must pay for their
inputs.

Profitable businesses are acutely aware of this

simple fact as they determine their production
Analysis strategies, since every dollar of unnecessary costs
reduces the firm’s profits by that same dollar.
of Costs In addition, the role of costs affect input choices,
investment decisions, and even the decision of
whether to stay in business.

Is it cheaper to hire a new worker or to pay

overtime? To open a new factory or expand an old
one? To invest in new machinery domestically or to
outsource production abroad?
Businesses want to choose those methods of production that
are most efficient and produce output at the lowest cost.
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 Types of cost: TOTAL COST, FIXED AND VARIABLE

• consider a firm that produces a quantity of output (denoted by q) using inputs of capital,
labor, and materials. The firm’s accountants have the task of calculating the total dollar
costs incurred to produce out- put level q.
• Total cost represents the lowest total dollar expense needed to produce each level of
output q. TC rises as q rises.
• Fixed cost represents the total dollar expense that is paid out even when no output is
produced; fixed cost is unaffected by any variation in the quantity of output.
• Variable cost represents expenses that vary with the level of output—such as raw
materials, wages, and fuel—and includes all costs that are not fixed.
• Always, by definition:
TC = FC + VC
Marginal cost (MC ): denotes the extra or additional cost of producing 1 extra unit of
output.
Average cost is the total cost divided by the total number of units produced.
Minimum Attainable Costs:

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01/18/2023 102
Calculation
of Marginal
Cost

01/18/2023 103
AVERAGE COST(or Unit Cost)

• Average cost: is the total cost divided by the total number of units
produced.

• Average fixed cost: (AFC) is defined as FC/q.

• Average variable cost (AVC ) equals variable cost divided by output, or AVC
= VC/q.

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AVERAGE
COST(or Unit
Cost)

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Cost curves
Cost

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01/18/2023 107
To summarize:
In terms of cost curves, if the:
- MC curve is below the AC curve, the AC curve must be
falling.
- By contrast, if MC is above AC, AC is rising.
- Finally, when MC is just equal to AC, the AC curve is flat.
The AC curve is always pierced at its minimum point by a
rising MC curve.

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 • It is important to understand the link between average
cost and marginal cost. We begin with three closely
related rules:
1.When marginal cost is below average cost, it is
The pulling average cost down.
2.When MC is above AC, it is pulling up AC.
Relation 3.When MC just equals AC, AC is constant. At the
between bottom of a U-shaped AC, MC = AC = minimum AC.
Average To understand these rules, begin with the first one.
Cost and If MC < AC,
this means that the last unit produced costs less than the
Marginal average cost of all the previous units produced. This
Cost implies that the new AC (i.e., the AC including the last
unit) must be less than the old AC, so AC must be falling.

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