MANAGERIAL

ECONOMICS
Session 1
T A Pai Management Institute, Manipal
07/13/2024 2

Course outline
• Evaluation

My availability
• Office no. 221
Preliminaries • 8319725884
• 24*6

Outside ME
• RBI Policy challenge
• Res. work

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Evaluation

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Importance of
Microeconomics

Key takeaways
Things to note

Class slides

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 “economy is the art of making the most of

What is life.” Economics is the study of how we do
Economics? that.”
-Gary Becker (borrowed from G B Shaw)

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“Life is about trade-offs, and so is economics.”

the most of life  Consumption now against consumption in future
 Work vs. leisure

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Unlimited
Resources
the most of life
Goals

Limited
Constrained optimization
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What are you

trying to  Are you doing better than others?

maximize?

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 Consumers maximize satisfaction (What’s the constraint?)

 Producers maximize profits (What’s the constraint?)
Examples  What else?
 Do all parties in a transaction optimize their satisfaction?

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pe TAPMI
Demand Supply
T-shirt

DMA/ DMA/
Market
Consumer Producer
Max U Max π
Choice of Stc. Stc.

qe
Pckgd
meals
water
MBA seats

Market equilibrium; Foodgrains market, Market clearing

mechanism

MARKET ECONOMY/ LAISSEZ FAIRE Abhishek Rohit

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 The Theory Of Moral Sentiments, Part IV, Chapter I,

pp.184-5, para. 10.
ADAM SMITH (1723 – 1790)  Every individual... neither intends to promote the
public interest, nor knows how much he is
promoting it... he intends only his own security;
Market and by directing that industry in such a manner
economy as its produce may be of the greatest value, he
intends only his own gain, and he is in this, as in
many other cases, led by an invisible hand to
promote an end which was no part of his
intention.

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Market
economy

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Session 2
Managerial Economics
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• Constrained optimization

• Market economy
• Market equilibrium
Recap • Market clearing mechanism
• Equilibrium price, Equilibrium quantity

• Invisible hand

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Who feeds
Bangalore?

Invisible hand

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 Powerful force making our life better

 Prices to allocate scarce resources
Market  Markets are self correcting
economy
 Makes all parties better off
 Intervention maybe required

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“We have an obligation to ensure that the sale of our medicines provides us with the
resources necessary to invest in future research and development.”

To be more precise, after accounting for the costs of all research—about $80 billion a
year—drug companies had $40 billion more from the top 20 drugs alone, all of which
went straight to profits, not research. More excess profit comes from the next 100 or
200 brand-name drugs.

Abhishek Rohit
https://www.theatlantic.com/health/archive/2019/03/drug-prices-high-cost-research-and-development/585253/
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Limitations of Sale of Kidney

market Externalities (Private cost vs. social cost)

economy

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Non-market
economy

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 Central
07/13/2024
planning 25

 Failure of Soviet union

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Illinois delegates visit to Cuba
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“A Soviet woman is trying to buy a Lada, one of the cheap

automobiles made in the former Soviet Union. The dealer tells
her that there is a shortage of these cars, despite their reputation
for shoddy quality. Still, the woman insists on placing an order.
The dealer gets out a large, dusty ledger and adds the woman’s
name to the long waiting list. “Come back two years from now
on March 17th,” he says.

Central The woman consults her calendar. “Morning or afternoon?” she

asks.
planning “What difference does it make?” the surly dealer replies.
“That’s two years from now!”

“The plumber is coming that day,” she says.”

Failure of the Soviet union

Abhishek Rohit

Excerpt From: Wheelan, Charles. “Naked Economics”. Apple Books.

 07/13/2024

MICROECONOMICS
27
Funding for Inter- TAPMI
Demand
MBA temporal seats,
shifters/
allocation of Mobile
Supply shifters
resources phone

p
Demand Supply

Consumer Market Producer

Max U Max π
Stc. Stc.
q
Telecom service LPG,
provider Market MARKET ECONOMY Government Petrol
Structure intervention

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MICROECONOMICS MACROECONOMICS
p π

Qd, Qs National output/ GDP

Ld, Ls Unemployment rate

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p
Demand Supply

DMA/ DMA/
Market
Consumer Producer
Max U Max π
Stc. Stc.

q
MARKET ECONOMY/ LAISSEZ FAIRE

Unless specified, we will assume we are working in a competitive market economy.

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Session 3
Managerial Economics

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Amul paneer market

Demand Schedule
p 0 10 20 30 40 50 60
Qd 30 28 25 20 15 9 2

Supply Schedule
p 0 10 20 30 40 50 60
Qs NA NA 0 10 15 25 35

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p p

Qd Qs
DEMAND CURVE SUPPLY CURVE

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Why does it slope downwards (negative slope)?

p 1. Income effect
2. Substitution effect
a) Happen simultaneously

Demand function.
Qd = a –b(p)

Qd
DEMAND CURVE

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Why supply curve slopes upwards?

p

Supply function

Qs = a + b(p)

Qs
SUPPLY CURVE

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D S

Excess
supply
Ep

Shortage

Eq Q

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p
FACTORS:
Demand
1. Price of the good
2. Income
D 3. Promotion and advertisement
4. Reduction in taxes
5. Tastes & Preferences
6. Price of related goods
1. Complementary goods
2. Substitute goods

Qd

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Factors:
p 1. Price
S 2. Prices of factors of production
3. Technology
4. No. of sellers

Qs ∆ Supply

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Session4
Managerial Economics

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Excess supply for a commodity is ordinarily eliminated through market

forces by:

A. price rising, demand decreasing, and supply increasing.

B. price rising, quantity demanded decreasing, and quantity
supplied increasing.
C. price rising, demand increasing, and supply decreasing.
D. price rising, quantity demanded increasing, and quantity
supplied decreasing.
E. none of the above eliminate excess supply.

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New facts:
a) Narendra Modi, in an interview stated that he is a regular consumer of Amul milk,
and as per his sources, it is the best milk brand in the nation.
b) Milk suppliers to Amul plant are protesting against malpractices and have gone on
a strike.

How will this impact the market for Amul milk?

A. price would increase and quantity exchanged would decrease.
B. price and quantity exchanged would both decrease.
C. price would increase and quantity exchanged would be indeterminate.
D. price would be indeterminate and quantity exchanged would not change.
E. there is not enough information to determine either price or quantity.

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New facts:
a) Narendra Modi, in an interview stated that he is a regular consumer of Amul milk, and
as per his sources, it is the best milk brand in the nation.
b) Nandini, a popular milk brand in south India enters into new agreements with 2000
farmers of Karnataka to procure milk.
What is the effect on Price and Quantity in the market for Nandini milk?
A. quantity exchanged would decrease and price would be indeterminate.
B. price and quantity exchanged would both decrease.
D. price would decrease and quantity exchanged would be indeterminate.
E. there is not enough information to determine either price or quantity.

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1. Scenario1: Fall in the cost of RM

p

D S

2. Scenario2: Gov. increases T

Ep
Ep1
Ep2*
Ep2

Eq2

Eq Eq1 Q

Eq2*
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Session 5
Managerial Economics

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Q. Consider the demand for beer during the summer months. Let Qd = 30 – 5P + 0.01I - 2R.

Where Qd is measured in thousand of six-packs, P is the price per six-pack in dollars, I is income, and R is the
number of rainy days during the summer. The supply curve is given by Qs = -100 + 20P.
a. Plot the supply and demand curves if I = $20,000 and R = 15. What is the equilibrium P and Q?
b. If R reduces to 10, plot the new demand curve and find the new equilibrium. Compare this to the original
equilibrium. Does the change in market equilibrium make sense with the decline in the number of rainy
days from 15 to 10?
c. Suppose the supply curve is given by Qs = -100 + 20P – 0.2T, where, T is the monthly tax on raw materials.
Plot the demand and supply curves now and find the market equilibrium when T = $1000. (In the demand
curve, I = 20,000 and R = 15)
d. How will the market equilibrium be impacted if the monthly tax is lowered from $1000 to $500 and the no.
of rainy days reduce to 10.

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Session 6
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Elasticity

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SLOPE PROVIDES A CONSTANT MEASURE

 But degree of responsiveness changes as P changes.

Limitations of
slope
SLOPE IS DEPENDENT ON UNIT OF
MEASUREMENT
 Elasticity is independent of measurement units.

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 Responsiveness of one economic variable to a

change in another variable.
What is  Usually depicted as
elasticity?  % Economic variable1 divided by %
Economic variable2

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Three types wrt. Demand

PED (Price elasticity of demand)
IED (Income elasticity of demand)
CPED (Cross price elasticity of demand)

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Price elasticity of
demand

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PED = % change in Qd / % change in P

Always negative because of law of demand

Range : 0 to - ∞

0 < PED < 1  Relatively inelastic

PED = 1  Unit-elasticity
1 < PED  Relatively elastic

B
Figure 1
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PED and type of

demand

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Perfectly elastic
demand

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Perfectly
inelastic
demand

Ex. Essential goods. Ex. Salt, life

saving drugs

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Gradually sloping 58

Relatively
elastic demand

Presence of substitutes tends to

make demand elastic

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Rapidly sloping 59

Relatively
inelastic
demand

Absence of substitutes tends to

make demand inelastic

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 It assists in finalization of the price of a

product.
Why is PED
important?
 The question is how?

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PED and Total revenue

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 % change in quantity supplied / % change in

price
Price elasticity
 Range: 0 to ∞
of supply

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Point elasticity vs. Arc

elasticity(Mid-point
method)

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 IED: % change in Qd / % change in Income

 If
 IED > 0  Normal good
 IED < 1  Necessity good
 Foodgrains, Fuel, Milk

Income  IED > 1  Luxury good

 Air travel, Cars, Foreign trips
elasticity of  IED < 0  Inferior good
demand  Public transport, Loose oil, Chinese electronic items

 Usefulness
 IED > 0; Good prospect for the product when economy
grows
 IED < 0; The product will get replaced gradually as
income grows
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 CPED: % change in demand for X / % change

in price of Y
Cross price  Value of CPED and inference:
elasticity of  Zero: Unrelated. Ex: Motorbikes and books
demand  +ve: Substitutes. Ex: Cocacola and Pepsi
 -ve: Complements. Ex: Fuel and Car

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 Market demand is the sum of individual

demands….which could represent
Market demand demand from different regions or
demand from different market segments.

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Q1. The demand curve for frozen pizzas is given by Qd = 8 – 2P. What is the demand elasticity at P = 0, P = 2,
P = 4?

Q2. If the elasticity of demand is -6, at the current price of $12 and a quantity of 15,000, what is the equation of
demand curve? Similarly, if the elasticity of supply is equal to 4, at P = $12 and Q = 15,000, what is the
equation of the supply curve? Further, estimate the equilibrium P and Q. What will be the new equilibrium P
and Q, if supply increases by 20 percent at all prices?

Q3. MIT is located in Manipal. Currently, a student apartment rents for INR 5,000 a month in Manipal and
6000 apartments are rented. MIT is considering expanding enrolment by lowering its current academic
standards. A local economist estimates that at the current P and Q, the PED for apartments is -0.25 and the PES
is 0.5. Answer the following questions:
a. What are the equations of demand and supply?
b. Suppose there is a 20 percent increase in the demand for apartments as a result for increase in intake at
MIT. What would be the new equilibrium P and Q? Compute PED at new equilibrium point.

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Q.11. Suppose the demand curve for a product is given by Q =

10 - 2P + PS, where P is the price of the product and PS is the
price of a substitute good. The price of the substitute good is
$2.00.

a. Suppose P = $1.00. What is the price elasticity of demand?

What is the cross-price elasticity of demand?
b. Suppose the price of the good, P, goes to $2.00. Now what is
the price elasticity of demand? What is the cross-price
elasticity of demand?

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Nominal vs. Real price

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Cost of MBA education

IIM AHMEDABAD FEES:

Real vs. 2009 fees: 12.5 L
Nominal prices 2016 fees: 21 L

Constant prices vs. Current

prices
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Real Priceyear_z = (Nominal Priceyear_z ) x (CPIbase year / CPIyear_z)

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Q. The nominal price of a college education rose from $7619 in 1990

to $21,550 in 2010. The CPI was 82.4 in 1980, 130.7 in 1990, and
218.1 in 2010. What was the real price of a college education in 1990
in terms of 1980 dollars? In real terms, was college education more
expensive in 1990 or 2010 (use the 1983 base year when the CPI
equalled 100)?

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Q. The constant dollar price of a good:

a. Is the same as its real price

b. Is the same as its nominal price
c. Adjusts for inflation in the overall price level
d. b and c
e. a and c

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Q. If the real price of a college education has risen during a period of inflation:
a. Its nominal price has not changed
b. Its nominal price has risen slower than a general index of prices
c. Its nominal price has risen faster than a general index of prices
d. Its current dollar price has not changed
e. None of the above is correct.

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Positive vs. Normative

analysis

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 Positive analysis
 Costs and benefits of the potential action

 Normative analysis
 What the best policy is?

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State whether these questions are positive or normative.

a. If a freeze wipes out 15 percent of this year’s Florida orange crop, what
will be the impact on orange juice prices at the supermarket?
b. How much oil conservation (from switching to smaller cars, carpooling,
etc.) will a $0.50 per gallon tax on gasoline achieve?
c. To fund airport expansion, should the United States use a tax on airfares or
a tax on jet fuel combined with airport landing fees?
d. If all small businesses are required by law to provide health insurance to
their employees, will the number of small businesses decline?
e. Would higher gasoline prices (through taxes) or federal government
standards on automobile fuel economy be a better way to reduce gasoline
consumption?

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Session 9
CONSUMER PREFERENCES
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p
Demand Supply

DMA/ DMA/
Market
Consumer Producer
Max U Max π
Stc. Stc.

q
MARKET ECONOMY/ LAISSEZ FAIRE

Unless specified, we will assume we are working in a competitive market economy.

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CONSUMER CONSUMER
BUDGET CONSTRAINTS
CHOICES PREFERENCES

Max U

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 Market Baskets
List with specific quantities of one or more goods.

TABLE 3.1 ALTERNATIVE MARKET BASKETS

MARKET BASKET UNITS OF FOOD UNITS OF CLOTHING

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
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 Completeness

Preference  Transitivity
relations
 Non-satiation/Monotonicity

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 Indifference Curves
FIGURE 3.1
DESCRIBING INDIVIDUAL
PREFERENCES
FIGURE 3.2
AN INDIFFERENCE CURVE
The indifference curve U1 that
passes through market
basket A shows all baskets
that give the consumer the
same level of satisfaction as
does market basket A; these
include baskets B and D.
Our consumer prefers basket
E, which lies above U1, to A,
but prefers A to H or G, which
lie below U1.
 Indifference Maps

● indifference map Graph containing a set of indifference curves

showing the market baskets among which a consumer is indifferent.

FIGURE 3.3
AN INDIFFERENCE MAP
An indifference map is a set
of indifference curves that
describes a person's
preferences.
Any market basket on
indifference curve U3, such
as basket A, is preferred to
any basket on curve U2
(e.g., basket B), which in
turn is preferred to any
basket on U1, such as D.
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 Combination of consumption vectors providing

Indifference the same level of satisfaction/utility
curve

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 Why is it downward sloping and not upward

Indifference sloping?
curve

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 Why can’t IC intersect?

Indifference
curve

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FIGURE 3.4
INDIFFERENCE CURVES
CANNOT INTERSECT
If indifference curves U1 and
U2 intersect, one of the
assumptions of consumer
theory is violated.
According to this diagram, the
consumer should be
indifferent among market
baskets A, B, and D. Yet B
should be preferred to D
because B has more of both
goods.
The Shape of Indifference Curves

FIGURE 3.5
THE MARGINAL RATE OF
SUBSTITUTION
The magnitude of the slope of
an indifference curve
measures the consumer’s
marginal rate of substitution
(MRS) between two goods.
In this figure, the MRS
between clothing (C) and
food (F) falls from 6 (between
A and B) to 4 (between B and
D) to 2 (between D and E) to
1 (between E and G).

MRS of Food for Clothing

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 MRS of x for y is the maximum amount of y that a consumer

is willing to give up to obtain an additional unit of x.
 MRS = - (slope of IC)
Marginal rate of  MRS =
substitution  MRS falls as we increase the consumption of x.

LAW OF DIMINISHING MRS

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Why is an IC  Convexity assumption of consumer preferences

convex to the  Implies that a balanced basket is preferred to
the extremes.
origin and not
 MRS should fall and not rise.
concave?

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FIGURE 3.6
PERFECT SUBSTITUTES AND PERFECT COMPLEMENTS
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FLATTER

Slope of IC
STEEPER

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 EXAMPLE 3.1 DESIGNING NEW AUTOMOBILES (I)

Preferences for automobile attributes can be described by

indifference curves. Each curve shows the combination of
acceleration and interior space that give the same
satisfaction.

FIGURE 3.7
PREFERENCES FOR AUTOMOBILE ATTRIBUTES

Owners of Ford Mustang coupes (a) are The opposite is true for owners of
willing to give up considerable interior space Ford Explorers. They prefer interior
for additional acceleration. space to acceleration (b).
07/13/2024 101

 Income: W
 Price of good x: Px
 Price of good y: Py
Budget  No. of units of good x consumed: x
constraint  No. of units of good y consumed: y
 Budget line

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 W, Px,Py
 Impact of change in W:
 Will impact intercept but not slope.
 Thus, BL shifts parallelly when W changes

 Impact of change in P:
Determinants of  Either Px or Py:
 Slope changes with one of the intercepts
Budget line  Both Px and Py:

(BL)  If the change is proportionate; slope won’t change, but the intercepts
will.
 If the change is disproportionate, the slope will change along with
intercepts.

 Impact of change in W and P:

 When both W and {Px,Py} change proportionately, BL will not
change. When can this happen?
Abhishek Rohit
 The Effects of Changes in Income and Prices

FIGURE 3.11
EFFECTS OF A CHANGE IN
INCOME ON THE BUDGET
LINE
INCOME CHANGES
A change in income (with
prices unchanged) causes the
budget line to shift parallel to
the original line (L1).
When the income of $80 (on
L1) is increased to $160, the
budget line shifts outward to
L2.
If the income falls to $40, the
line shifts inward to L3.
FIGURE 3.12
EFFECTS OF A CHANGE IN
PRICE ON THE BUDGET
LINE
PRICE CHANGES
A change in the price of one
good (with income
unchanged) causes the
budget line to rotate about
one intercept.
When the price of food falls
from $1.00 to $0.50, the
budget line rotates outward
from L1 to L2.
However, when the price
increases from $1.00 to
$2.00, the line rotates inward
from L1 to L3.
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 Should lie on the budget line (exhaust the budget completely &
cannot overspend).

CONSUMER  Should be the most preferred one.

CHOICE THUS, THE MARKET BASKET TO BE CHOSEN SHOULD

LIE ON THE HIGHEST IC CROSSING THE BL

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THE MARKET BASKET TO BE CHOSEN SHOULD LIE ON THE HIGHEST IC

CROSSING THE BL

• At the utility maximizing point, the slope of IC is equal to the slope of BL.

• - =

• MRS =

• Satisfaction maximized when the marginal rate of substitution equals the price ratio.

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Implication of MRS = Px/Py

Q. Suppose two consumers purchase the same goods (x and y) and are maximizing their utilities. What can we
conclude from this statement?

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 UTILITY AND UTILITY FUNCTIONS
● utility Numerical score representing the satisfaction that a
consumer gets from a given market basket.
● utility function Formula that assigns a level of utility to individual
market baskets.

FIGURE 3.8
UTILITY FUNCTIONS AND
INDIFFERENCE CURVES
A utility function can be
represented by a set of
indifference curves, each with
a numerical indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50, and
100, respectively) associated
with the utility function:

u (F,C ) =
FC
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Total utility vs.

Marginal utility

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LAW OF DIMINISHING MARGINAL UTILITY
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Abhishek Rohit
EXAMPLE 3.2 CAN MONEY BUY HAPPINESS?

FIGURE 3.9
INCOME AND HAPPINESS
A cross-country comparison
shows that individuals living
in countries with higher GDP
per capita are on average
happier than those living in
countries with lower per-
capita GDP.
 Why do Diamonds demand a higher price than Water?
After all, it is water, not Diamonds that are essential to life.

The paradox of value

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𝑀𝑈𝑥 𝑀𝑈𝑦
Equi-marginal 𝑃𝑥
=
𝑃𝑦
principle

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 Utility functions
UTILITY  Cardinal vs. Ordinal utility

Abhishek Rohit
Corner Solutions

● corner solution Situation in which the marginal rate of substitution

for one good in a chosen market basket is not equal to the slope of the budget
line.

FIGURE 3.15
A CORNER SOLUTION
When a corner solution
arises, the consumer
maximizes satisfaction by
consuming only one of the
two goods.
Given budget line AB, the
highest level of satisfaction is
achieved at B on indifference
curve U1, where the MRS (of
ice cream for frozen yogurt) is
greater than the ratio of the
price of ice cream to the price
of frozen yogurt.
Q) Suppose that a market basket of two goods is changed by adding
more of one of the goods and subtracting one unit of the other. The
consumer will:

A) rank the market basket more highly after the change.

B) rank the market basket more highly before the change.
C) rank the market basket just as desirable as before.
D) any one of the above statements may be true.
Q) Which of the following is true about the indifference curve
where one commodity (such as pollution) is "bad"?

A) It has a negative slope.

B) It has a positive slope.
C) It is horizontal.
D) It is vertical.
Q. As an individual moves northwest along his or her indifference curve
substituting more and more Y for X, his or her MRS of X for Y

a. Increases
b. Decreases
c. Stays the same
d. Changes in a way that cannot be determined
Q) If a consumer is always indifferent between an additional
one grapefruit or an additional two oranges, then when
oranges are on the horizontal axis the indifference curves:

A) will be straight lines with a slope of -1/2.

B) will be straight lines with a slope of -1.
C) will be straight lines with a slope of +1/2.
D) will be right angles whose corners occur on a ray from the
origin with a slope of +2.
E) none of the above
Q) Envision a graph with meat on the horizontal axis and vegetables on the
vertical axis. A strict vegetarian who is neutral about meat would have
indifference curve that is:
A) vertical lines.
B) horizontal lines.
C) diagonal straight lines.
D) right angles.
E) upward sloping.
Q) Pencils sell for 10 cents and pens sell for 50 cents. Suppose Jack, whose
preferences satisfy all of the basic assumptions, buys 5 pens and one pencil
each semester. With this consumption bundle, his MRS of pencils for pens
is 3. Which of the following is true?

A) Jack could increase his utility by buying more pens and fewer pencils.
B) Jack could increase his utility by buying more pencils and fewer pens.
C) Jack could increase his utility by buying more pencils and more pens.
D) Jack could increase his utility by buying fewer pencils and fewer pens.
E) Jack is at a corner solution and is maximizing his utility.
Q. Abhyudaya only buys coffee and chips. Coffee costs INR 5/cup and
Chips cost INR 10/packet. He spends INR 100 on these two products. If
he is maximizing his Utility, his MRS of Coffee for Chips is:

a. 0.5
b. 2
c. 50
d. None of these
Q. Tejas spends exactly 1000 minutes a day studying Managerial economics (m)
and Financial accounting (f). His utility derived every day from studying these two
subjects can be given by
U = 2 ln m + 3 ln f

Each page of managerial economics takes 4 minutes to complete whereas each

page of financial accounting takes 10 minutes to complete. What is the optimum
consumption bundle in terms of no. pages of managerial economics (m) and
financial accounting (f) to be read by Tejas everyday?
Julio receives utility from consuming food (F) and clothing (C) as given by the utility
function U(F, C) = FC. In addition, the price of food is $2 per unit, the price of clothing
is $10 per unit, and Julio’s weekly income is $50.
a. What is Julio’s marginal rate of substitution of food for clothing when utility is
maximized? Explain.
b. Suppose instead that Julio is consuming a bundle with more food and less clothing
than his utility maximizing bundle. Would his marginal rate of substitution of food
for clothing be greater than or less than your answer in part a? Explain.
If Jane is currently willing to trade 4 movie tickets for 1
basketball ticket, then she must like basketball better than
movies. True or false? Explain.
Consumers in Georgia pay twice as much for avocados as
they do for peaches. However, avocados and peaches are
the same price in California. If consumers in both states
maximize utility, will the marginal rate of substitution of
peaches for avocados be the same for consumers in both
states? If not, which will be higher?
Upon merging with the West German economy, East German
consumers indicated a preference for Mercedes-Benz
automobiles over Volkswagens. However, when they converted
their savings into deutsche marks, they flocked to Volkswagen
dealerships. How can you explain this apparent paradox?
Jane receives utility from days spent traveling on vacation
domestically (D) and days spent traveling on vacation in
a foreign country (F), as given by the utility function
U(D,F) = 10DF. In addition, the price of a day spent
traveling domestically is $100, the price of a day spent
traveling in a foreign country is $400, and Jane’s annual
travel budget is $4000.
a. Illustrate the indifference curve associated with a
utility of 800 and the indifference curve associated
with a utility of 1200.
b. Graph Jane’s budget line on the same graph.
c. Can Jane afford any of the bundles that give her a
utility of 800? What about a utility
of 1200?
d. Find Jane’s utility maximizing choice of days spent
traveling domestically and days spent in a foreign
country.
abhishek.fpm2014@iimraipur.ac.in
Veblen goods and Giffen goods
07/13/2024 135

GIFFEN GOODS

 Sir Robert Giffen

 Low-paid British workers in the early 19th century.

Goods which do  Bread

not follow law of

demand VEBLEN GOODS

 Thorstein Veblen
 Status symbols, display of wealth
 Rolls Royce cars and Patek Phillipe watches
 Luxury watches, bags, paintings, cars
Abhishek Rohit
07/13/2024 136

Abhishek Rohit
SESSION-11

PRODUCTION
07/13/2024 139

p
Demand Supply

DMA/ DMA/
Market
Consumer Producer
Max U Max π
Stc. Stc.

q
MARKET ECONOMY/ LAISSEZ FAIRE

Unless specified, we will assume we are working in a competitive market economy.

Abhishek Rohit
07/13/2024 140

PRODUCTION
TECHNOLOGY

INPUT
MAX. RPOFIT CHOICES

COST
CONSTRAINTS
(COP)

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07/13/2024 141

 Y = f(K,L)
 As technology changes, it may change the
PRODUCTIO production function.
N  Short run vs long run
TECHNOLOG  Short run: Atleast one input (Fixed input) that
Y cannot be changed.
 Long run: All the inputs can be changed
 Example: Steel mfg.

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07/13/2024 142

 AVERAGE: Output per unit of a particular

SHORT RUN input.
PRODUCTIO  MARGINAL: Additional output produced as
N an input is increased by one unit.

Abhishek Rohit
Short run production with labor as variable input and capital as fixed input

TABLE 6.1 PRODUCTION WITH ONE VARIABLE INPUT

AMOUNT
AMOUNT OF TOTAL AVERAGE MARGINAL PRODUCT
OF LABOR
CAPITAL (K) OUTPUT (q) PRODUCT (q/L) (△q/△L)
(L)
0 10 0 — —

1 10 10 10 10

2 10 30 15 20

3 10 60 20 30

4 10 80 20 20

5 10 95 19 15

6 10 108 18 13

7 10 112 16 4

8 10 112 14 0

9 10 108 12 -4

10 10 100 10 -8
• Labor per year on x-axis
• Output per year on y-axis for the first graph
• Output per labor per year on y –axis for the
second graph
• MPL becomes negative when TP starts
declining.
• When MPL > AP, AP is rising.
• When MPL < AP, AP is falling.
• MPL = AP when AP reaches its maximum.
• Why does MP rise and then fall?
• AP = slope of the line drawn from the origin
to a point on the TP curve (L1)
• MP = slope of the TP at that point (First
derivative of TP)
• MP reaches its max at the inflection point of
the TP curve
07/13/2024 145

 As the use of one input is increased,

keeping other inputs fixed, after a point
Law of
the additional output(MP) starts Diminishing
decreasing. Marginal
 Results from the limitations of fixed Returns/La
input.
w of
 Doesn’t mean that marginal returns
become negative, they just start
variable
declining. proportions
Abhishek Rohit
07/13/2024 146

Malthus believed that the world’s limited amount of land would

not be able to supply enough food as the population grew. He
Malthus and the predicted that as both the marginal and average productivity of
food crisis labor fell and there were more mouths to feed, mass hunger and
starvation would result.

Abhishek Rohit
07/13/2024 147

Food
production

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07/13/2024 148

Abhishek Rohit
07/13/2024 149

Effect of
technological
improvement

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07/13/2024 150

Labor  Average product measures output per unit of labor input.

productivity  Total output divided by Total labor input

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07/13/2024 151

Labor  Capital stock

productivity  Technological change

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Three stages of
production

Abhishek Rohit
A certain production process employs two inputs ⎯labor (L) and raw materials (R). Output (Q) is a function of these
two inputs and is given by the following relationship:
Q = 6L2 R2 − .10L3 R3
Assume that raw materials (input R) are fixed at 10 units.

(a) Determine the total product function (TPL) for input L.

(b) Determine the marginal product function for input L.
(c) Determine the average product function for input L.
(d) Find the number of units of input L that maximizes the total product function.
(e) Find the number of units of input L that maximizes the marginal product function.
(f) Find the number of units of input L that maximizes the average product function.
(g) Determine the boundaries for the three stages of production.
07/13/2024 155

Long run  Both Labor and Capital vary

production

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07/13/2024 156

 Like IC in Consumer behavior

 A curve that shows all possible
Isoquant combinations of inputs that produce the
same level of output

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07/13/2024 157

Isoquant map

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07/13/2024 158

Diminishing
marginal
returns

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07/13/2024 159

 MRTS of Labor for Capital is the amount of capital that can be

reduced when Labor is increased by one unit.

Marginal rate of  MRTS = - for a particular output level

technical  Diminishing MRTS

substitution  Isoquants are convex to the origin.

(MRTS)  Can they be concave?

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07/13/2024 160

Concave
Isoquant
(Can’t happen)

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07/13/2024 161

Important  MRTS between two inputs is equal to the ratio

of the marginal products of the inputs
relationship

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07/13/2024 162

Special cases

Ex. Laundry shops, 6 Labor =

Ex. Kellogs corn flakes
1 washing machine

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07/13/2024 163

Change the scale of production by increasing all of the inputs

to production in the same proportion
Returns to scale 1. Constant returns to scale
2. Increasing returns to scale
3. Decreasing returns to scale

Abhishek Rohit
07/13/2024 164

Q.1 Do the following functions exhibit increasing, constant, or decreasing returns to scale? What
happens to the marginal product of each individual factor as that factor is increased and the other
factor held constant?

a. Y = 3L + 2K
b. Y=
c. Y = L0.5K0.5
d. Q.1.

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07/13/2024 165

Q.2. The production function for the personal

computers of DISK, Inc., is given by q = 10K0.5L0.5,
where q is the number of computers produced per day,
K is hours of machine time, and L is hours of labor
input. DISK’ s competitor, FLOPPY, Inc., is using the
production function q = 10K0.6L0.4.

a. If both companies use the same amounts of capital

and labor, which will generate more output?
Suppose, they use K > L, which will generate more
output?

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07/13/2024 166

Abhishek Rohit
07/13/2024 167

Abhishek Rohit
COST OF PRODUCTION
SESSION 16
07/13/2024 169

 OC: The next best alternative foregone.

 “what we give up” from “the road not
taken.”
 Should be included in decision making.
OPPORTUNIT  SC: Expenditure that cannot be
Y COST vs. recovered.
SUNK COST  Should be excluded from decision making.
 https://www.youtube.com/watch?v=8tHb2k
AB5OQ

Abhishek Rohit
07/13/2024 170

 Costs that do not change with the level of

output.
 Ex. Rent of factory, Salary of senior
Fixed cost vs. executives
Variable cost  Costs which are related to the level of output.
 Ex. Electricity for running machines, raw
materials, Wages of labors

Abhishek Rohit
07/13/2024 171

The total cost (TC) of producing computer software diskettes (Q) is given as: TC = 200 + 5Q. What is the
variable cost?

A) 200
B) 5Q
C) 5
D) 5 + (200/Q)

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07/13/2024 172

THE SHORT RUN

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07/13/2024 173

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07/13/2024 174

MC/AC

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07/13/2024 175

 MP follows diminishing returns/falls for an input factor as the

output is raised.
 MC rises with respect to an input factor as the output is raised.
 Inverse relationship between fall in MP and rise in MC.
Relationship  Mathematical relationship:
between MP
and MC  Low MP  High MC
 High MP  Low MC

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07/13/2024 176

Relationship  Example:
between MP
and MC

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07/13/2024 177

Shapes of cost
curves

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07/13/2024 178

1. FC does not vary with output

2. VC is zero when output is zero, increases when
Q increases.
3. TC = FC + VC
4. TC – VC = FC at all points.
5. AFC falls continuously.
6. AC falls when MC < AC.
7. AC rises when MC > AC.
Imp. Features of 8. The vertical gap between ATC and AVC
declines as output increases. Why?
cost curves 9. The AVC curve reaches its min. point at a lower
output than the ATC curve. Why?

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07/13/2024 179

THE LONG RUN

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07/13/2024 180

Price of capital = Depreciation rate + Interest rate

Price of capital (foregone interest)

Abhishek Rohit
 1. All possible combinations of factor inputs that can be purchased
07/13/2024 181
for the same cost.

2. C = wL + rK

3. Slope of Isocost line:

Isocost line

Abhishek Rohit
07/13/2024
Choosing 182

inputs

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07/13/2024 183

Mathematical
relationship
Last rupee spent on any factor of production should yield the
same amount of extra output.

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07/13/2024 184

Expansion path

Combination of Labor and Capital that the firm will choose to minimize
costs at each level.
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07/13/2024 185

Long run vs.

Short run
expansion path

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07/13/2024 186

EoS: AC falls as the scale of operation goes up.

DoS: AC rises as the scale of operations rise

Diff. between EoS and IRS?

Economies and IRS : Link between Quantities of input and output

Q increases more than the increase in inputs.
diseconomies of
EoS: Link between Cost of input and output
scale Q increases more than the rise in costs.

https://www.youtube.com/watch?v=_rk2hPrEnk8

Abhishek Rohit
07/13/2024 187

Economies of scope are present when the joint

output of a single firm is greater than the output
Economies of that could be achieved by two different firms
scope each producing a single product (with
equivalent production inputs allocated between
them).

Abhishek Rohit
07/13/2024 188

Degree of
Economies of
Scope

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07/13/2024 189

Long run AC
and MC

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07/13/2024 190

Economies of scale are often measured in terms of a cost-output

elasticity, EC. EC is the percentage change in the cost of
production resulting from a 1-percent increase in output:
EoS and cost-
output elasticity

Abhishek Rohit
07/13/2024 191

Use the following two statements to answer this question:

I. The average cost curve and the average variable cost curve
reach their minima at the same level of output.
II.The average cost curve and the marginal cost curve reach
their minima at the same level of output.
A) Both I and II are true.
B) I is true, and II is false.
C) I is false, and II is true.
D) Both I and II are false.

Abhishek Rohit
07/13/2024 192

41) Consider the following statements when answering this

question;
I. A firm's marginal cost curve does not depend on the level of
fixed costs.
II.As output increases the difference between a firm's average
total cost and average variable cost curves cannot rise.
A) I is true, and II is false.
B) I is false, and II is true.
C) I and II are both true.
D) I and II are both false.

Abhishek Rohit
07/13/2024 193

A firm has a fixed production cost of $5000 and a constant marginal cost of
production of $500 per unit produced.
a. What is the firm’s total cost function? Average cost?
b. If the firm wanted to minimize the average total cost, would it choose to be
very large or very small? Explain.

Abhishek Rohit
07/13/2024 194

In order for a taxicab to be operated in New York City, it must have a medallion on its hood. Medallions are
expensive, but can be resold, and are therefore an example of

A) a fixed cost.
B) a variable cost.
C) an implicit cost.
D) an opportunity cost.
E) a sunk cost.

Abhishek Rohit
07/13/2024 195

4) Which of the following statements is true regarding the

differences between economic and accounting costs?
A) Accounting costs include all implicit and explicit costs.
B) Economic costs include implied costs only.
C) Accountants consider only implicit costs when calculating
costs.
D) Accounting costs include only explicit costs.

Abhishek Rohit
07/13/2024 196

With its current levels of input use, a firm's MRTS is 3 (when capital
is on the vertical axis and labor is on the horizontal axis). This
implies
A) the firm could produce 3 more units of output if it increased its use
of capital by one unit (holding labor constant).
B) the firm could produce 3 more units of output if it increased its use
of labor by one unit (holding capital constant).
C) if the firm reduced its capital stock by one unit, it would have to
hire 3 more workers to maintain its current level of output.
D) if it used one more unit of both capital and labor, the firm could
produce 3 more units of output.
E) the marginal product of labor is 3 times the marginal product of
capital.
Abhishek Rohit
07/13/2024 197

You manage a plant that mass-produces engines by teams of workers using assembly machines. The
technology is summarized by the production function q = 5 KL, where q is the number of engines per week, K
is the number of assembly machines, and L is the number of labor teams. Each assembly machine rents for r =
$10,000 per week, and each team costs w = $5000 per week. Engine costs are given by the cost of labor teams
and machines, plus $2000 per engine for raw materials. Your plant has a fixed installation of 5 assembly
machines as part of its design.
a. What is the cost function for your plant—namely, how much would it cost to produce q engines? What are
average and marginal costs for producing q engines? How do average costs vary with output?
b. How many teams are required to produce 250 engines?What is the average cost per engine?
c. You are asked to make recommendations for the design of a new production facility.What capital/labor
(K/L) ratio should the new plant accommodate if it wants to minimize the total cost of producing at any
level of output q?

Abhishek Rohit
07/13/2024 198

Duane breeds parrots for a living. He has discovered that the production
function for parrot chicks (Q) is:
Q = K^1/2.L^1/2
where K is capital (for example nest boxes, cages and the like) and L is parrot
food. The marginal products of capital and labor are as follows:
MPK = ? MPL = ?
The price of K is $8 and the price of L is $2.

a. What type of production function is this?

b. Does this production function exhibit constant, increasing or
decreasing returns to scale? Explain.
c. What is the average product of capital?
d. Does capital obey the "law of diminishing returns?" Explain.
e. Suppose that Duane wants 144 parrot chicks, how much K and L
should be employed to minimize costs, and what is the cost of producing 144
parrot chicks?
f. Suppose that Duane is faced with the same problem as in (e) except
that he has a fixed amount of K. In fact, K = 16. How much L should be
employed to minimize costs, and what is the total cost?
Abhishek Rohit
07/13/2024 199

A fast food restaurant currently pays $5 per hour for servers and
$50 per hour to rent ovens and other kitchen machinery. The
restaurant uses seven hours of server time per unit of machinery
time. Determine whether the restaurant is minimizing its cost of
production when the ratio of marginal products (capital to labor)
is 12. If not, what adjustments are called for to improve the
efficiency in resource use?

Abhishek Rohit
07/13/2024 200

Abhishek Rohit
07/13/2024 201

Abhishek Rohit
07/13/2024 202

Abhishek Rohit
07/13/2024 203

Abhishek Rohit
 07/13/2024 204

Suppose your expected sales is 1000. Calculate optimal K and L choice.

Abhishek Rohit
PROFIT MAXIMIZATION
9/4/18 2

 Price t a k e r s
Perfectly  Homogenous products
competiti  F r e e e n t r y a n d exit
ve  Ex. Ve g e t a b l e m a r k e t
markets

A b h i s h e k Rohit
9/4/18 3

Objective of  Profit maximization

a firm

A b h i s h e k Rohit
07/13/2024 208

 MP follows diminishing returns/falls for an input factor as the

output is raised.
 MC rises with respect to an input factor as the output is raised.
 Inverse relationship between fall in MP and rise in MC.
Relationship  Mathematical relationship:
between MP
and MC  Low MP  High MC
 High MP  Low MC

Abhishek Rohit
9/4/18 4

Profit
maximization in
the short run
for all firms

MR = M C

A b h i s h e k Rohit
9/4/18 5

Because it is a price taker,

the demand curve d facing an individual competitive firm is given by a horizontal line.

Demand curve for

a competitive firm

Price is determined by the interaction of all firms and consumers in the

market,
A b h i s h e k Rohit
not by the output decision of a single firm.
9/4/18 6

MR = AR = p on the firm’s demand curve

Profit maximizing condition for a perfectly competitive firm:

MR = MC = P A b h i s h e k Rohit
9/4/18 7

D A

C
B

Equating MR = AR = p with MR = M C (profit maximizing condition), we get MC(q) = MR = p

Also, M C should be rising. Abhishek Rohit
 Should the firm shut down?
9/4/18 8

A
D

C B

SHUT D O W N RULE: When P < AV C and not when AV C < P < ATC
A b h i s h e k Rohit
9/4/18 9

A competitive firm only

supplies w h e r e MC >
AVC

PC short
run supply
curve is the
MC curve

A b h i s h e k Rohit
9/4/18 10

Short run
market
supply curve

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07/13/2024 216

Firm’s response
to input price
change

Abhishek Rohit
9/4/18 12

Producer
surplus in the
short run for a
firm

Abhishek Rohit
 9/4/18 12

Producer
surplus in the
short run for a
firm increments
Marginal cost reflects to
cost associated with increases in
output; because fixed cost does not
vary with output, the sum of all
marginal costs must equal the sum of
the firm’s variable costs

Abhishek Rohit
PS = Total revenue – Total variable cost = Area of rectangle ABCD
9/4/18 13

Producer
surplus vs.
profit

Abhishek Rohit
9/4/18 14

Producer
surplus in the
short run for a
market

Abhishek Rohit
9/4/18 16

Accounting profit vs. Economic Profit

Long run
competiti A firm earning zero economic profit is doing as well by
investing its money in capital as it could by investing elsewhere
ve —it is earning a competitive return on its money.

equilibrium
• Zero economic profit
• Normal return
• Positive economic profit
Abhishek Rohit
• Abnormal returns
9/4/18 17

Long run
competiti
ve
equilibrium
Zero economic
profit when LAC
tangent to P
Abhishek Rohit
9/4/18 18

1. A l l firms in the industry are maximizing profit.

Long run 2. No firm has an incentive either to enter or exit the

industry because all firms are earning zero economic
competiti profit.
ve 3. The price of the product is such that the quantity
equilibrium supplied b y the industry is equal to the
quantity demanded b y the consumers.

Abhishek Rohit
9/4/18 19

Amount that firms are willing to pay for an

Economic Rent input less the minimum amount necessary to
obtain it.

Abhishek Rohit
9/4/18

Zero economic profit in the long

run

Abhishek Rohit
 ANALYSIS OF
COMPETITIVE MARKETS
Session 16
 07/13/2024 227

Consumer surplus measures the

total net benefit to consumers

Consumer
surplus &
Producer
surplus
Producer surplus: The benefit
that lower-cost producers enjoy
by selling at the market price.
Abhishek Rohit
07/13/2024 228

Welfare effects
Gains and losses to consumers and
of Government producers.
intervention

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07/13/2024 229

Price controls:
Ceiling price

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07/13/2024 230

Changes in CS
and PS

Changes in CS: A-B

Changes in PS: -A-C
Abhishek Rohit
07/13/2024 231

Deadweight
loss

Net loss of total

(consumer plus producer)
surplus.
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Deadweight
loss

(A - B) + (-A - C) = -B - C

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The government sets the market price of a good

Price support above the free-market level and buys up whatever
output is needed to maintain that price.

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Price support

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Price support

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Case

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MONOPOLY
(Non-competitive market)A
9/12/18 2

• Ex. BSNL (previously)

• Pure monopoly doesn’t exist. Antitrust laws restrain
Monopoly it.
• No competition
• The monopolist is the market
• Decides the price and output
• Why doesn’t it charge any price?

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9/12/18 3

• AR curve for a monopolist is the market demand

curve

AR and MR
for a
monopolist

• MR curve is lower than the AR curve

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9/12/18 4

• If a monopolist wants to sell more, it must lower its

price. Price falls for all units sold

AR and MR
for a
monopolist

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9/12/18 5

Profit
maximization for C B

a monopolist

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Example

Identify the profit maximizing Q and P.

9/12/18 6

Pricing rule

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9/12/18
A Monopolist does not have a supply curve 7

Various shifts in the demand curve may cause different P’s for the same Q or different Q’s for theRohit
Abhishek same
P. Thus, a one to one relationship does not exist.
 For the competitive firm, price equals marginal cost;
9/12/18 9

for the firm with monopoly power, price exceeds marginal cost.

Measuring Lerner index of monopoly power:

Monopoly
power
Ed here is the elasticity of firm’s demand and not of the market.

The larger is L, the greater is the degree of monopoly power.

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07/13/2024 246
In 1995, a new drug developed by astra-Merck became available
for the long-term treatment of ulcers. the drug, Prilosec,
represented a new generation of antiulcer medication. Other
drugs to treat ulcer conditions were already on the market:
Tagamet had been introduced in 1977, Zantac in 1983, Pepcid in
1986, and axid in 1988. these four drugs worked in much the
same way to reduce the stomach’s secretion of acid. Prilosec,
however, was based on a very different biochemical mechanism
ASTRA- and was much more effective than these earlier drugs. By 1996,
it had become the best-selling drug in the world and faced no
MERCK PRICES major competitor. In 1995, astra-Merck was pricing Prilosec at
PRILOSEC about $3.50 per daily dose. (By contrast, the prices for Tagamet
and Zantac were about $1.50 to $2.25 per daily dose.) Is this
pricing consistent with the markup formula (10.1)? the marginal
cost of producing and packaging Prilosec is only about 30 to 40
cents per daily dose. this low marginal cost implies that the price
elasticity of demand, ED, should be in the range
Is the setting the price of Prilosec at
of roughly ?
a markup exceeding 400 percent over
marginal cost is consistent with our
rule of thumb for pricing?
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9/12/18 10

• The elasticity of market demand

• Lower elasticity higher monopoly
power
Sources • The number of firms
of • More firms, lower monopoly power
monopoly • The interaction among firms
power • More aggressive the competition,
lower the monopoly power.

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07/13/2024 248

A monopolist firm faces a demand with constant elasticity of

−2.0. It has a constant marginal cost of $20 per unit and sets
a price to maximize profit. If marginal cost should increase
by 25%, would the price charged also rise by 25%?

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07/13/2024 249

Suppose that an industry is characterized as follows:

C = 100 + 2q2 each firm’s total cost function
MC = 4q firm’s marginal cost function
P = 90 − 2Q industry demand curve
MR = 90 − 4Q industry marginal revenue curve

a. If there is only one firm in the industry, find the monopoly

price, quantity, and level of profit.

b. Find the price, quantity, and level of profit if the industry

is competitive.

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A monopolist faces the demand curve P = 11 − Q, where P is

measured in dollars per unit and Q in thousands of units.
The monopolist has a constant average cost of $6 per unit.

a. Draw the average and marginal revenue curves and the

average and marginal cost curves. What are the
monopolist’s profit-maximizing price and quantity?
What is the resulting profit? Calculate the firm’s degree
of monopoly power using the Lerner index.

b. A government regulatory agency sets a price ceiling of $7

per unit.What quantity will be produced, and what will the
firm’s profit be?What happens to the degree of monopoly
power?

c. What price ceiling yields the largest level of output?What

is that level of output? What is the firm’s degree of
monopoly power at this price?

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Types of market

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Perfect "Prefect competition is a market in which there are many

firms selling identical products with no firm large enough,

competition relative to the entire market, to be able to influence market

price".

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FEATURES:

Perfect 1.
2.
Large number of buyers and sellers
Homogenous goods
competition 3.
4.
No barrier to entry
Firms are price takers

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Monopolistic
competition

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•Large number of firms - each firm has an insignificantly small

share of the market.
•Independence - as a result of a large number of firms in the
market, each firm is unlikely to affect its rivals to any great
extent. In making decisions it does not have to think about how
its rivals will react.
•Freedom of entry - any firm can set up business in this
Monopolistic market.
•Product differentiation - This is the key difference from
competition perfect competition. Product differentiation involves creating
differences between products, either real or imagined, in
consumers minds and is likely to involve various forms of non-
price competition such as branding and advertising.
Examples of monopolistic competition
Restaurants, hairdressers, tuition centres

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Oligopoly

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 Interdependence in decisions
 Importance of Advertising

Features  Group Behaviour

 A Small number of Sellers
 Barriers to Entry of Firms
 Price War

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Kinked demand
curve under
Oligopoly
 The segment above the prevailing price level is highly elastic.
 The segment below the prevailing price level is inelastic.

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One buyer, many sellers.

For ex. A firm which is the sole buyer of a certain raw materials which are
produced by many.
Monopsony A firm with monopsony power can influence the market price to his
advantage.

Ex. Skilled/Specialized labor market in a particular region.

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An oligopsony is a situation when there are only a small

number of buyers in a market. This means that a limited
number of people have market power and are able to

Oligopsony lower the price they pay for a good or service due to the
lack of competition.

Ex. Agriculture-Few Commission agents many farmers,

Publishing houses-Few publishers, many authors

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Abhishek Rohit
9/12/18 11

Pricing with The objective is to capture consumer surplus and

market transfer it to the producer.
power

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9/12/18 11

How do you
capture
consumer
surplus?

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9/12/18 12

Price Charging different prices to consumers who have

discriminat different willingness to pay
ion

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9/12/18 13

First degree
price
discrimination
(Perfect PD)
Each consumer is charged
exactly what he or she is
willing to pay
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First degree
price
discrimination
(Imperfect PD)
Charging a few different prices based on
estimates of customers’ reservation
prices.
This practice is often used by
professionals, such as doctors, lawyers, Abhishek Rohit

accountants, or architects
9/12/18 14

Second
degree price
discrimination

Charging different prices

for different quantities of
the same good or service.
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Most prevalent form of price discrimination.

Third degree Some characteristic is used to divide consumers into distinct groups.

price Examples:
discrimination regular versus “special” airline fares;
premium versus nonpremium brands of liquor,
canned food or frozen vegetables;
discounts to students and senior citizens

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How should the firm 1. Total output should be divided between the groups of customers
decide so that marginal revenues for each group are equal, i.e., MR1=MR2
what price to charge 2. Total output must be such that the marginal revenue for
each group of each group of consumers is equal to the marginal cost of production.
consumers?
MR1=MR2=MC

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9/12/18 16

MR1 = MR2 = M C

Since, MR1 =
How to price MR2
MR1 = P1(1 + 1/E1) and MR2 = P2(1 + 1/E2)
in third
degree?
Higher price will be
charged to consumers Example, if the elasticity of demand for consumers in group 1 is -2
with the lower demand and the elasticity for consumers in group 2 is -4, how much price
elasticity should be charged for both the groups?
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Why do firms
issue coupons?

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 Sal’s satellite company broadcasts TV to subscribers in Los
07/13/2024
Angeles and New York. The demand functions for each of 275

these two groups are

QNY = 60 − 0.25PNY QLA = 100 − 0.50PLA

where Q is in thousands of subscriptions per year and P is

the subscription price per year. The cost of providing Q
units of service is given by
C = 1000 + 40Q
where Q = QNY + QLA.
a. What are the profit-maximizing prices and quantities for
the New York and Los Angeles markets?
b. b. As a consequence of a new satellite that the Pentagon
recently deployed, people in Los Angeles receive Sal’s
New York broadcasts, and people in New York receive
Sal’s Los Angeles broadcasts. As a result, anyone in New
York or Los Angeles can receive Sal’s broadcasts by
subscribing in either city. Thus Sal can charge only a
single price. What price should he charge, and what
quantities will he sell in New York and Los Angeles?

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Suppose that BMW can produce any quantity of cars at a

constant marginal cost equal to $20,000 and a fixed cost of
$10 billion. You are asked to advise the CEO as to what
prices and quantities BMW should set for sales in Europe
and in the United States. The demand for BMWs in each
market is given by:

QE = 4,000,000 − 100PE and QU = 1,000,000 − 20PU

where the subscript E denotes Europe and the subscript U
denotes the United States.

a. What quantity of BMWs should the firm sell in each

market, and what should the price be in each market?
What should the total profit be?

b. If BMW were forced to charge the same price in each

market, what would be the quantity sold in each market,
the equilibrium price, and the company’s profit?

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6. Elizabeth Airlines (EA) flies only one route: Chicago-Honolulu. The demand for each flight is Q = 500 − P. EA’s
cost of running each flight is $30,000 plus $100 per passenger.
a. What is the profit-maximizing price that EA will charge? How many people will be on each flight? What is EA’s
profit for each flight?
b. EA learns that the fixed costs per flight are in fact $41,000 instead of $30,000. Will the airline stay in business for
long? Illustrate your answer using a graph of the demand curve that EA faces, EA’s average cost curve when
fixed costs are $30,000, and EA’s average cost curve when fixed costs are $41,000.
c. Wait! EA finds out that two different types of people fly to Honolulu. Type A consists of business people with a
demand of QA = 260 − 0.4P. Type B consists of students whose total demand is QB = 240 − 0.6P. Because the
students are easy to spot, EA decides to charge them different prices. Graph each of these demand curves and
their horizontal sum. What price does EA charge the students? What price does it charge other customers? How
many of each type are on each flight?
d. What would EA’s profit be for each flight? Would the airline stay in business? Calculate the consumer surplus
of each consumer group. What is the total consumer surplus?
e. Before EA started price discriminating, how much consumer surplus was the Type A demand getting from air
travel to Honolulu? Type B? Why did total consumer surplus decline with price discrimination, even though
total quantity sold remained unchanged?

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Ans.
a. Q=200, P=300
c. P(A)=375, P(B)=250
d. CS(A)=15125, CS(B)=6750
e. CS(A)=24500, CS(B)=3000

Abhishek Rohit