Class XII - Introductory Microeconomics
Class XII - Introductory Microeconomics
Class XII - Introductory Microeconomics
Foreword iii
1. INTRODUCTION 1
1.1 A Simple Economy 1
1.2 Central Problems of an Economy 2
1.3 Organisation of Economic Activities 4
1.3.1 The Centrally Planned Economy 4
1.3.2 The Market Economy 5
1.4 Positive and Normative Economics 6
1.5 Microeconomics and Macroeconomics 6
1.6 Plan of the Book 6
2. THEORY OF CONSUMER BEHAVIOUR 8
2.1 The Consumer’s Budget 8
2.1.1 Budget Set 9
2.1.2 Budget Line 10
2.1.3 Changes in the Budget Set 12
2.2 Preferences of the Consumer 13
2.2.1 Monotonic Preferences 14
2.2.2 Substitution between Goods 14
2.2.3 Diminishing Rate of Substitution 15
2.2.4 Indifference Curve 15
2.2.5 Shape of the Indifference Curve 16
2.2.6 Indifference Map 17
2.2.7 Utility 17
2.3 Optimal Choice of the Consumer 18
2.4 Demand 20
2.4.1 Demand Curve and the Law of Demand 21
2.4.2 Normal and Inferior Goods 24
2.4.3 Substitutes and Complements 25
2.4.4 Shifts in the Demand Curve 25
2.4.5 Movements along the Demand Curve and Shifts 26
in the Demand Curve
2.5 Market Demand 27
2.6 Elasticity of Demand 27
2.6.1 Elasticity along a Linear Demand Curve 29
2.6.2 Factors Determining Price Elasticity of Demand for a Good 31
2.6.3 Elasticity and Expenditure 32
3. PRODUCTION AND COSTS 36
3.1 Production Function 36
3.2 The Short Run and the Long Run 38
3.3 Total Product, Average Product and Marginal Product 38
3.3.1 Total Product 38
3.3.2 Average Product 39
3.3.3 Marginal Product 39
3.4 The Law of Diminishing Marginal Product and the Law of 40
Variable Proportions
3.5 Shapes of Total Product, Marginal Product and Average Product Curves 41
3.6 Returns to Scale 42
3.7 Costs 42
3.7.1 Short Run Costs 43
3.7.2 Long Run Costs 47
4. THE THEORY OF THE FIRM UNDER PERFECT COMPETITION 52
4.1 Perfect competition: Defining Features 52
4.2 Revenue 53
4.3 Profit Maximisation 55
4.3.1 Condition 1 55
4.3.2 Condition 2 56
4.3.3 Condition 3 56
4.3.4 The Profit Maximisation Problem: Graphical Representation 57
4.4 Supply Curve of a Firm 58
4.4.1 Short Run Supply Curve of a Firm 58
4.4.2 Long Run Supply Curve of a Firm 59
4.4.3 The Shut Down Point 60
4.4.4 The Normal Profit and Break-even Point 60
4.5 Determinants of a Firm’s Supply Curve 61
4.5.1 Technological Progress 61
4.5.2 Input Prices 61
4.5.3 Unit Tax 62
4.6 Market Supply Curve 62
4.7 Price Elasticity of Supply 64
4.7.1 The Geometric Method 65
5. MARKET EQUILIBRIUM 69
5.1 Equilibrium, Excess Demand, Excess Supply 69
5.1.1 Market Equilibrium: Fixed Number of Firms 70
5.1.2 Market Equilibrium: Free Entry and Exit 78
5.2 Applications 82
5.2.1 Price Ceiling 82
5.2.2 Price Floor 83
6. NON-COMPETITIVE MARKETS 86
6.1 Simple Monopoly in the Commodity Market 86
6.1.1 Market Demand Curve is the Average Revenue Curve 87
6.1.2 Total, Average and Marginal Revenues 90
6.1.3 Marginal Revenue and Price Elasticity of Demand 91
6.1.4 Short Run Equilibrium of the Monopoly Firm 91
6.2 Other Non-perfectly Competitive Markets 95
6.2.1 Monopolistic Competition 95
6.2.2 How do Firms behave in Oligopoly? 96
Glossary 101
viii
Chapter 1
Introduction
1.1 A SIMPLE ECONOMY
Think of any society. People in the society need many goods and
services1 in their everyday life including food, clothing, shelter,
transport facilities like roads and railways, postal services and
various other services like that of teachers and doctors. In fact, the
list of goods and services that any individual2 needs is so large that
no individual in society, to begin with, has all the things she needs.
Every individual has some amount of only a few of the goods and
services that she would like to use. A family farm may own a plot of
land, some grains, farming implements, maybe a pair of bullocks
and also the labour services of the family members. A weaver may
have some yarn, some cotton and other instruments required for
weaving cloth. The teacher in the local school has the skills required
to impart education to the students. Some others in society may
not have any resource3 excepting their own labour services. Each of
these decision making units can produce some goods or services
by using the resources that it has and use part of the produce to
obtain the many other goods and services which it needs. For
example, the family farm can produce corn, use part of the produce
for consumption purposes and procure clothing, housing and
various services in exchange for the rest of the produce. Similarly,
the weaver can get the goods and services that she wants in exchange
for the cloth she produces in her yarn. The teacher can earn some
money by teaching students in the school and use the money for
obtaining the goods and services that she wants. The labourer also
can try to fulfill her needs by using whatever money she can earn by
working for someone else. Each individual can thus use her
resources to fulfill her needs. It goes without saying that no
individual has unlimited resources compared to her needs. The
amount of corn that the family farm can produce is limited by the
amount of resources it has, and hence, the amount of different goods
1
Goods means physical, tangible objects used to satisfy people’s wants and needs. The term
‘goods’ should be contrasted with the term ‘services’, which captures the intangible satisfaction of
wants and needs. As compared to food items and clothes, which are examples of goods, we can
think of the tasks that doctors and teachers perform for us as examples of services.
2
By individual, we mean an individual decision making unit. A decision making unit can be a
single person or a group like a household, a firm or any other organisation.
3
By resource, we mean those goods and services which are used to produce other goods and
services, e.g. land, labour, tools and machinery, etc.
and services that it can procure in exchange of corn is also limited. As a result, the
family is forced to make a choice between the different goods and services that are
available. It can have more of a good or service only by giving up some amounts of
other goods or services. For example, if the family wants to have a bigger house, it
may have to give up the idea of having a few more acres of arable land. If it wants
more and better education for the children, it may have to give up some of the
luxuries of life. The same is the case with all other individuals in society. Everyone
faces scarcity of resources, and therefore, has to use the limited resources in the
best possible way to fulfill her needs.
In general, every individual in society is engaged in the production of some
goods or services and she wants a combination of many goods and services not
all of which are produced by her. Needless to say that there has to be some
compatibility between what people in society collectively want to have and what
they produce4. For example, the total amount of corn produced by family farm
along with other farming units in a society must match the total amount of corn
that people in the society collectively want to consume. If people in the society
do not want as much corn as the farming units are capable of producing
collectively, a part of the resources of these units could have been used in the
production of some other good or services which is in high demand. On the
other hand, if people in the society want more corn compared to what the farming
units are producing collectively, the resources used in the production of some
other goods and services may be reallocated to the production of corn. Similar is
the case with all other goods or services. Just as the resources of an individual
are scarce, the resources of the society are also scarce in comparison to what the
people in the society might collectively want to have. The scarce resources of the
society have to be allocated properly in the production of different goods and
services in keeping with the likes and dislikes of the people of the society.
Any allocation5 of resources of the society would result in the production of a
particular combination of different goods and services. The goods and services
thus produced will have to be distributed among the individuals of the society.
2 The allocation of the limited resources and the distribution of the final mix of goods
Introductory Microeconomics
and services are two of the basic economic problems faced by the society.
In reality, any economy is much more complex compared to the society
discussed above. In the light of what we have learnt about the society, let us now
discuss the fundamental concerns of the discipline of economics some of which
we shall study throughout this book.
4
Here we assume that all the goods and services produced in a society are consumed by the people
in the society and that there is no scope of getting anything from outside the society. In reality, this
is not true. However, the general point that is being made here about the compatibility of production
and consumption of goods and services holds for any country or even for the entire world.
5
By an allocation of the resources, we mean how much of which resource is devoted to the
production of each of the goods and services.
What is produced and in what quantities?
Every society must decide on how much of each of the many possible goods and
services it will produce. Whether to produce more of food, clothing, housing or
to have more of luxury goods. Whether to have more agricultural goods or to
have industrial products and services. Whether to use more resources in education
and health or to use more resources in building military services. Whether to
have more of basic education or more of higher education. Whether to have
more of consumption goods or to have investment goods (like machine) which
will boost production and consumption tomorrow.
How are these goods produced?
Every society has to decide on how much of which of the resources to use in the
production of each of the different goods and services. Whether to use more
labour or more machines. Which of the available technologies to adopt in the
production of each of the goods?
For whom are these goods produced?
Who gets how much of the goods that are produced in the economy? How should
the produce of the economy be distributed among the individuals in the economy?
Who gets more and who gets less? Whether or not to ensure a minimum amount
of consumption for everyone in the economy. Whether or not elementary education
and basic health services should be available freely for everyone in the economy.
Thus, every economy faces the problem of allocating the scarce resources to
the production of different possible goods and services and of distributing the
produced goods and services among the individuals within the economy. The
allocation of scarce resources and the distribution of the final goods and
services are the central problems of any economy.
Introduction
usages and every society has to decide on how much of each of the resources
to use in the production of different goods and services. In other words,
every society has to determine how to allocate its scarce resources to different
goods and services.
An allocation of the scarce resource of the economy gives rise to a
particular combination of different goods and services. Given the total amount
of resources, it is possible to allocate the resources in many different ways
and, thereby achieving different mixes of all possible goods and services. The
collection of all possible combinations of the goods and services that can be
produced from a given amount of resources and a given stock of technological
knowledge is called the production possibility set of the economy.
a
Note that the concept of opportunity cost is applicable to the individual as well as the
society. The concept is very important and is widely used in economics. Because of its
importance in economics, sometimes, opportunity cost is also called the economic cost.
Introduction
agreed upon by the buyer and the sellers) at which the exchanges take place.
The price reflects, on an average, the society’s valuation of the good or service in
question. If the buyers demand more of a certain good, the price of that good
will rise. This will send a signal to the producer of that good to the effect that the
society as a whole wants more of that good than is currently being produced
and the producers of the good, in their turn, are likely to increase their production.
In this way, prices of good and services send important information to all the
individuals across the market and help achieve coordination in a market system.
Thus, in a market system, the central problems regarding how much and what
to produce are solved through the coordination of economic activities brought
about by the price signals.
In reality, all economies are mixed economies where some important
decisions are taken by the government and the economic activities are by and
large conducted through the market. The only difference is in terms of the
extent of the role of the government in deciding the course of economic activities.
In the United States of America, the role of the government is minimal. The
closest example of a centrally planned economy is the Soviet Union for the
major part of the twentieth century. In India, since Independence, the
government has played a major role in planning economic activities. However,
6
An institution is usually defined as an organisation with some purpose.
the role of the government in the Indian economy has been reduced considerably
in the last couple of decades.
?
Exercises
?
7. What do you understand by normative economic analysis?
8. Distinguish between microeconomics and macroeconomics.
Introduction
Chapter 2
Theor
Theoryy of
Consumer Behaviour
In this chapter, we will study the behaviour of an individual
consumer in a market for final goods1. The consumer has to decide
on how much of each of the different goods she would like to
consume. Our objective here is to study this choice problem in
some detail. As we see, the choice of the consumer depends on the
alternatives that are available to her and on her tastes and
preferences regarding those alternatives. To begin with, we will
try to figure out a precise and convenient way of describing the
available alternatives and also the tastes and preferences of the
consumer. We will then use these descriptions to find out the
consumer’s choice in the market.
1
We shall use the term goods to mean goods as well as services.
2
The assumption that there are only two goods simplifies the analysis considerably and allows us
to understand some important concepts by using simple diagrams.
Spoilt for Choice
income and the prices of the two goods, the consumer can afford to buy only
those bundles which cost her less than or equal to her income.
EXAMPLE 2.1
Consider, for example, a consumer who has Rs 20, and suppose, both the goods
are priced at Rs 5 and are available only in integral units. The bundles that this
consumer can afford to buy are: (0, 0), (0, 1), (0, 2), (0, 3), (0, 4), (1, 0), (1, 1),
(1, 2), (1, 3), (2, 0), (2, 1), (2, 2), (3, 0), (3, 1) and (4, 0). Among these bundles,
(0, 4), (1,3), (2, 2), (3, 1) and (4, 0) cost exactly Rs 20 and all the other bundles
cost less than Rs 20. The consumer cannot afford to buy bundles like (3, 3) and
(4, 5) because they cost more than Rs 20 at the prevailing prices.
3
Price of a good is the amount of money that the consumer has to pay per unit of the good she
wants to buy. If rupee is the unit of money and quantity of the good is measured in kilograms, the
price of goods 1 being p1 means the consumer has to pay p1 rupees per kilograms of good 1 that she
wants to buy.
2.1.2 Budget Line
If both the goods are perfectly
divisible4, the consumer’s budget set
would consist of all bundles (x1, x2)
such that x1 and x2 are any numbers
greater than or equal to 0 and p1x1 +
p2x 2 ≤ M. The budget set can be
represented in a diagram as in
Figure 2.1.
All bundles in the positive
quadrant which are on or below the
line are included in the budget set. Budget Set. Quantity of good 1 is measured
The equation of the line is along the horizontal axis and quantity of good 2
p1x1 + p2x2 = M (2.2) is measured along the vertical axis. Any point in
the diagram represents a bundle of the two
The line consists of all bundles which goods. The budget set consists of all points on
cost exactly equal to M. This line is or below the straight line having the equation
called the budget line. Points below p1x1 + p2x2 = M.
the budget line represent bundles which cost strictly less than M.
The equation (2.2) can also be written as5
p
x 2 = M − 1 x1 (2.3)
p2 p 2
M
The budget line is a straight line with horizontal intercept p and vertical
1
M
intercept p . The horizontal intercept represents the bundle that the consumer
2
can buy if she spends her entire income on good 1. Similarly, the vertical intercept
represents the bundle that the consumer can buy if she spends her entire income
p1
on good 2. The slope of the budget line is – p .
10 2
Introductory Microeconomics
4
The goods considered in Example 2.1 were not divisible and were available only in integer units.
There are many goods which are divisible in the sense that they are available in non-integer units
also. It is not possible to buy half an orange or one-fourth of a banana, but it is certainly possible to
buy half a kilogram of rice or one-fourth of a litre of milk.
5
In school mathematics, you have learnt the equation of a straight line as y = c + mx where c is the
vertical intercept and m is the slope of the straight line. Note that equation (2.3) has the same form.
Subtracting (2.4) from (2.5), we obtain
p1Δx1 + p2Δx2 = 0 (2.6)
p1
the consumer can substitute good 1 for good 2 at the rate p . The absolute
2
value6 of the slope of the budget line measures the rate at which the consumer is
able to substitute good 1 for good 2 when she spends her entire budget.
Points Below the Budget Line
Consider any point below the budget line. Such a point represents a bundle
11
which costs less than the consumer’s income. Thus, if the consumer buys such
6
The absolute value of a number x is equal to x if x ≥ 0 and is equal to – x if x < 0. The absolute
value of x is usually denoted by |x|.
1 as compared to point C. Point B contains more of good 1 and the same amount
of good 2 as compared to point C. Any other point on the line segment ‘AB’
represents a bundle which has more of both the goods compared to C.
12
Introductory Microeconomics
Changes in the Set of Available Bundles of Goods Resulting from Changes in the
Consumer’s Income. A decrease in income causes a parallel inward shift of the budget
line as in panel (a). An increase in income causes a parallel outward shift of the budget line
as in panel (b).
Now suppose the price of good 1 changes from p1 to p'1 but the price of good
2 and the consumer’s income remain unchanged. At the new price of good 1,
the consumer can afford to buy all bundles (x1,x2) such that p'1x1 + p2x2 ≤ M. The
equation of the budget line is
p'1x1 + p2x2 = M (2.10)
Equation (2.10) can also be written as
p'
x 2 = M – 1 x1 (2.11)
p2 p2
Note that the vertical intercept of the new budget line is the same as the
vertical intercept of the budget line prior to the change in the price of good 1.
However, the slope of the budget line has changed after the price change. If the
price of good 1 increases, ie if p'1> p1, the absolute value of the slope of the
budget line increases, and the budget line becomes steeper (it pivots inwards
around the vertical intercept). If the price of good 1 decreases,
i.e., p'1< p1, the absolute value of the slope of the budget line decreases and
hence, the budget line becomes flatter (it pivots outwards around the vertical
intercept). Changes in the set of available bundles resulting from changes in
the price of good 1 when the price of good 2 and the consumer’s income remain
unchanged are represented in Figure 2.4.
Changes in the Set of Available Bundles of Goods Resulting from Changes in the
Price of Good 1. An increase in the price of good 1 makes the budget line steeper as in 13
panel (a). A decrease in the price of good 1 makes the budget line flatter as in panel (b).
7
The simplest example of a ranking is the ranking of all students according to the marks obtained
by each in the last annual examination.
EXAMPLE 2.2
Consider the consumer of Example 2.1. Suppose the preferences of the consumer
over the set of bundles that are available to her are as follows:
The consumer’s most preferred bundle is (2, 2).
She is indifferent to (1, 3) and (3, 1). She prefers both these bundles compared
to any other bundle except (2, 2).
She is indifferent to (1, 2) and (2, 1). She prefers both these bundles compared
to any other bundle except (2, 2), (1, 3) and (3, 1).
The consumer is indifferent to any bundle which has only one of the goods
and the bundle (0, 0). A bundle having positive amounts of both goods is preferred
to a bundle having only one of the goods.
The bundles that are available to this consumer can be ranked from the best
to the least preferred according to her preferences. Any two (or more) indifferent
bundles obtain the same rank while the preferred bundles are ranked higher.
The ranking is presented in the Table 2.1.
Table 2.1: Ranking of the bundle available to the consumer in Example 2.1
Bundle Ranking
(2, 2) First
(1, 3), (3, 1) Second
(1, 2), (2, 1) Third
(1, 1) Fourth
(0, 0), (0, 1), (0, 2), (0, 3), (0, 4), (1, 0), (2, 0), (3, 0), (4, 0) Fifth
(x1, x2) and (y1, y2), if (x1, x2) has more of at least one of the goods and no less of
the other good as compared to (y1, y2), the consumer prefers (x1, x2) to (y1, y2).
Preferences of this kind are called monotonic preferences. Thus, a consumer’s
preferences are monotonic if and only if between any two bundles, the consumer
prefers the bundle which has more of at least one of the goods and no less of the
other good as compared to the other bundle.
EXAMPLE 2.3
For example, consider the bundle (2, 2). This bundle has more of both goods
compared to (1, 1); it has equal amount of good 1 but more of good 2 compared
to the bundle (2, 1) and compared to (1, 2), it has more of good 1 and equal
amount of good 2. If a consumer has monotonic preferences, she would prefer
the bundle (2, 2) to all the three bundles (1, 1), (2, 1) and (1, 2).
EXAMPLE 2.4
Suppose a consumer is indifferent to the bundles (1, 2) and (2, 1). At (1, 2), the
consumer is willing to give up 1 unit of good 2 if she gets 1 extra unit of good 1.
Thus, the rate of substitution between good 2 and good 1 is 1.
substitution of the consumer at that point. Usually, for small changes, the
rate of substitution between good 2 and good 1 is called the marginal rate
of substitution (MRS).
If the preferences are
monotonic, an increase in the
amount of good 1 along the
indifference is associated with a
decrease in the amount of good 2.
This implies that the slope of the
indifference curve is negative.
Thus, monotonicity of preferences
implies that the indifference
curves are downward sloping.
Figure 2.7 illustrates the negative
slope of an indifference curve.
Figure 2.8 illustrates an Slope of the Indifference Curve. The
indifference curve slopes downward. An
indifference curve with diminishing increase in the amount of good 1 along the
marginal rate of substitution. The indifference curve is associated with a
indifference curve is convex towards decrease in the amount of good 2. If Δx1 > 0
the origin. then Δx2 < 0.
Diminishing Rate of Substitution. Indifference Map . A family of
The amount of good 2 the consumer is willing indifference curves. The arrow indicates
to give up for an extra unit of good 1 declines that bundles on higher indifference curves
as the consumer has more and more of are preferred by the consumer to the
good 1. bundles on lower indifference curves.
2.2.7 Utility
Often it is possible to represent preferences by assigning numbers to bundles in
a way such that the ranking of bundles is preserved. Preserving the ranking
would require assigning the same number to indifferent bundles and higher
numbers to preferred bundles. The numbers thus assigned to the bundles are
17
called the utilities of the bundles; and the representation of preferences in terms
(2, 2) 5 40
(1, 3), (3, 1) 4 35
(1, 2), (2, 1) 3 28
(1, 1) 2 20
(0, 0), (0, 1), (0, 2), (0, 3), (0, 4), (1, 0), (2, 0), (3, 0), (4, 0) 1 10
2.3 OPTIMAL CHOICE OF THE CONSUMER
In the last two sections, we discussed the set of bundles available to the consumer
and also about her preferences to those bundles. Which bundle does she choose?
In economics, it is generally assumed that the consumer is a rational individual.
A rational individual clearly knows what is good or what is bad for her, and in
any given situation, she always tries to achieve the best for herself. Thus, not
only does a consumer have well-defined preferences to the set of available
bundles, she also acts according to her preferences. From the bundles which
are available to her, a rational consumer always chooses the one which she
prefers the most.
EXAMPLE 2.5
Consider the consumer in Example 2.2. Among the bundles that are available to
her, (2, 2) is her most preferred bundle. Therefore, as a rational consumer, she
would choose the bundle (2, 2).
In the earlier sections, it was observed that the budget set describes the
bundles that are available to the consumer and her preferences over the available
bundles can usually be represented by an indifference map. Therefore, the
consumer’s problem can also be stated as follows: The rational consumer’s
problem is to move to a point on the highest possible indifference curve given
her budget set.
If such a point exists, where would it be located? The optimum point would
be located on the budget line. A point below the budget line cannot be the
optimum. Compared to a point below the budget line, there is always some
point on the budget line which contains more of at least one of the goods and
no less of the other, and is, therefore, preferred by a consumer whose preferences
are monotonic. Therefore, if the consumer’s preferences are monotonic, for any
18 point below the budget line, there is some point on the budget line which is
preferred by the consumer. Points above the budget line are not available to
Introductory Microeconomics
the consumer. Therefore, the optimum (most preferred) bundle of the consumer
would be on the budget line.
Where on the budget line will the optimum bundle be located? The point at
which the budget line just touches (is tangent to), one of the indifference curves
would be the optimum.8 To see why this is so, note that any point on the budget
line other than the point at which it touches the indifference curve lies on a
lower indifference curve and hence is inferior. Therefore, such a point cannot be
the consumer’s optimum. The optimum bundle is located on the budget line at
the point where the budget line is tangent to an indifference curve.
Figure 2.10 illustrates the consumer’s optimum. At ( x1* , x 2* ) , the budget line
is tangent to the black coloured indifference curve. The first thing to note is that
the indifference curve just touching
the budget line is the highest
possible indifference curve given the
consumer’s budget set. Bundles
on the indifference curves above
this, like the grey one, are not
affordable. Points on the indifference
curves below this, like the blue
one, are certainly inferior to the
points on the indifference curve,
just touching the budget line.
Any other point on the budget line
lies on a lower indifference curve
Consumer’s Optimum. The point (x 1∗ , x ∗2 ), at
and hence, is inferior to ( x1* , x 2* ) . which the budget line is tangent to an
19
Therefore, ( x1* , x 2* ) is the consumer’s indifference curve represents the consumers
Problem of Choice
The problem of choice occurs in many different contexts in life. In any choice
problem, there is a feasible set of alternatives. The feasible set consists of the
alternatives which are available to the individual. The individual is assumed
to have well-defined preferences to the set of feasible alternatives. In other
words, the individual is clear in her mind about her likes and dislikes, and
hence, can compare any two alternatives in the feasible set. Based on her
preferences, the individual can rank the alternatives in the order of preferences
starting from the best. The feasible set and the preference relation defined
over the set of alternatives together constitute the basis of choice. Individuals
are generally assumed to be rational. They have well-defined preferences. In
any given situation, a rational individual tries to do the best for herself.
In the text we studied, the choice problem applied to the particular
context of the consumer’s choice. Here, the budget set is the feasible set
8
To be more precise, if the situation is as depicted in Figure 2.10 then the optimum would be
located at the point where the budget line is tangent to one of the indifference curves. However,
there are other situations in which the optimum is at a point where the consumer spends her entire
income on one of the goods only.
and the different bundles of the two goods which the consumer can buy at
the prevailing market prices are the alternatives. The consumer is assumed
to be rational. Her preference relation to the budget set is well-defined and
she chooses her most preferred bundle from the budget set. The consumer’s
optimum bundle is the choice she makes in the given situation.
2.4 DEMAND
In the previous section, we studied the choice problem of the consumer and
derived the consumer’s optimum bundle given the prices of the goods, the
consumer’s income and her preferences. It was observed that the amount of a
good that the consumer chooses optimally, depends on the price of the good
itself, the prices of other goods, the consumer’s income and her tastes and
preferences. Whenever one or more of these variables change, the quantity of the
good chosen by the consumer is likely to change as well. Here we shall change
one of these variables at a time and study how the amount of the good chosen
by the consumer is related to that variable.
Functions
Consider any two variables x and y. A function
y = f (x)
is a relation between the two variables x and y such that for each value of x,
there is an unique value of the variable y. In other words, f (x) is a rule
which assigns an unique value y for each value of x. As the value of y
depends on the value of x, y is called the dependent variable and x is called
the independent variable.
EXAMPLE 1
Consider, for example, a situation where x can take the values 0, 1, 2, 3 and
20
suppose corresponding values of y are 10, 15, 18 and 20, respectively.
Introductory Microeconomics
Here y and x are related by the function y = f (x) which is defined as follows:
f (0) = 10; f (1) = 15; f (2) = 18 and f (3) = 20.
EXAMPLE 2
Consider another situation where x can take the values 0, 5, 10 and 20.
And suppose corresponding values of y are 100, 90, 70 and 40, respectively.
Here, y and x are related by the function y = f (x) which is defined as follows:
f (0) = 100; f (10) = 90; f (15) = 70 and f (20) = 40.
Very often a functional relation between the two variables can be
expressed in algebraic form like
y = 5 + x and y = 50 – x
choice. In order to find out how the consumer would react to the change in the
relative price, let us suppose that her purchasing power is adjusted in a way
such that she can just afford to buy the bundle ( x1* , x 2* ) .
At the prices (p1– Δp1) and p2, the bundle ( x1* , x 2* ) costs (p1– Δp1) x1* + p2 x 2*
= p1x1* + p2 x 2* – Δp1x 1*
= M − Δp1x1* .
Therefore, if the consumer’s income is reduced by the amount Δp1x1* after
the fall in the price of good 1, her purchasing power is adjusted to the initial
level.9 Suppose, at prices (p1 – Δp1), p2 and income ( M – Δp1x1* ), the consumer’s
optimum bundle is ( x1** , x 2** ) . x1** must be greater than or equal to x1* . To see
why, consider the Figure 2.12.
The grey line in the diagram represents the budget line of the consumer
when her income is M and the prices of the two goods are p1 and p2. All points
9
Consider, for example, a consumer whose income is Rs 30. Suppose the price of good 1 is Rs 4
and that of good 2 is Rs 5, and at these prices, the consumer’s optimum bundle is (5,2). Now
suppose price of good 1 falls to Rs 3. After the fall in price, if the consumer’s income is reduced by
Rs 5, she can just buy the bundle (5, 2). Note that the change in the price of good 1 (Rs 1) times,
the amount of good 1 that she was buying prior to the price change (5 units) is equal to the
adjustment required in her income (Rs 5).
Substitution Effect. The grey line represents the consumer’s budget line prior to the price
change. The blue line in panel (a) represents the consumer’s budget line after the fall in price
of Good 1. The blue line in panel (b) represents the budget line when the consumer’s income
is adjusted.
on or below the budget line are available to the consumer. As the consumer’s
preferences are monotonic, the optimum bundle ( x1* , x 2* ) lies on the budget
line. The blue line represents the budget line after the fall in the price of Good 1.
If the consumer’s income is reduced by an amount Δp1x1* , there would be a
parallel leftward shift of blue budget line. Note that the shifted budget line
passes through ( x1* , x 2* ) . This is because the income is adjusted in a way
such that the consumer has just enough money to buy the bundle ( x1* , x 2* ) .
If the consumer’s income is thus adjusted after the price change, which
bundle is she going to choose? Certainly, the optimum bundle would lie on
the shifted budget line. But can she choose any bundle to the left of the point
( x1* , x 2* ) ? Certainly not. Note that all points on this budget line which are to
23
the left of ( x1* , x 2* ) lie below the grey budget line, and therefore, were available
10
As we shall shortly discuss, a rise in the purchasing power (income) of the consumer can
sometimes induce the consumer to reduce the consumption of a good. In such a case, the substitution
effect and the income effect will work in opposite directions. The demand for such a good can be
inversely or positively related to its price depending on the relative strengths of these two opposing
effects. If the substitution effect is stronger than the income effect, the demand for the good and
the price of the good would still be inversely related. However, if the income effect is stronger than
the substitution effect, the demand for the good would be positively related to its price. Such a good
is called a Giffen good.
consumer’s income decreases. Such goods are called normal goods. Thus,
a consumer’s demand for a normal good moves in the same direction as the
income of the consumer. However, there are some goods the demands for
which move in the opposite direction of the income of the consumer. Such
goods are called inferior goods. As the income of the consumer increases,
the demand for an inferior good falls, and as the income decreases, the demand
for an inferior good rises. Examples of inferior goods include low quality food
items like coarse cereals.
A good can be a normal good for the consumer at some levels of income and
an inferior good for her at other levels of income. At very low levels of income, a
consumer’s demand for low quality cereals can increase with income. But, beyond
a level, any increase in income of the consumer is likely to reduce her
consumption of such food items.
Shifts in Demand. The demand curve in panel (a) shifts leftward and that in panel
(b) shifts rightward.
is more. Thus, any change in the price leads to movements along the demand
curve. On the other hand, changes in any of the other things lead to a shift in
the demand curve. Figure 2.15 illustrates a movement along the demand
curve and a shift in the demand curve.
Movement along a Demand Curve and Shift of a Demand Curve. Panel (a) depicts a
movement along the demand curve and panel (b) depicts a shift of the demand curve.
2.5 MARKET DEMAND
In the last section, we studied the choice problem of the individual consumer
and derived the demand curve of the consumer. However, in the market for a
good, there are many consumers. It is important to find out the market demand
for the good. The market demand for a good at a particular price is the total
demand of all consumers taken together. The market demand for a good can be
derived from the individual demand curves. Suppose there are only two
consumers in the market for a good. Suppose at price p′, the demand of consumer
1 is q′1 and that of consumer 2 is q ′2. Then, the market demand of the good at p′
is q′1 + q′2. Similarly, at price p̂ , if the demand of consumer 1 is q̂1 and that of
consumer 2 is q̂ 2 , the market demand of the good at p̂ is qˆ1 + qˆ 2 . Thus, the
market demand for the good at each price can be derived by adding up the
demands of the two consumers at that price. If there are more than two consumers
in the market for a good, the market demand can be derived similarly.
The market demand curve of a good can also be derived from the individual
demand curves graphically by adding up the individual demand curves
horizontally as shown in Figure 2.16. This method of adding two curves is called
horizontal summation.
27
Consider the demand curve of a good. Suppose at price p0, the demand for
the good is q0 and at price p1, the demand for the good is q1. If price changes
from p0 to p1, the change in the price of the good is, Δp = p1 – p0, and the change
in the quantity of the good is, Δq = q1 – q0. The percentage change in price is,
+p p1 − p 0
p 0 × 100 = p0
× 100, and the percentage change in quantity,
Δq q1 − q 0
0
× 100 = × 100
q q0
Thus
( Δq / q 0 ) ×100 Δq / q 0 (q1 – q 0 )/ q 0
eD = = = (2.16)
( Δp / p 0 ) × 100 Δp / p 0 ( p1 – p 0 )/ p 0
price- elasticity of demand for the good. If at some price, the percentage change
in demand for a good is less than the percentage change in the price, then
|eD|< 1 and demand for the good is said to be inelastic at that price. If at some
price, the percentage change in demand for a good is equal to the percentage
change in the price, |eD|= 1, and demand for the good is said to be unitary-
elastic at that price. If at some price, the percentage change in demand for a
good is greater than the percentage change in the price, then |eD|> 1, and
demand for the good is said to be elastic at that price.
Figure 2.18(b) depicts a demand curve which has the shape of a rectangular
hyperbola. This demand curve has the nice property that a percentage change
in price along the demand curve always leads to equal percentage change in
quantity. Therefore, |eD| = 1 at every point on this demand curve. This demand
curve is called the unitary elastic demand curve.
31
Note that
if eD < –1, then q (1 + eD ) < 0, and hence, ΔE has the opposite sign as Δp,
if eD > –1, then q (1 + eD ) > 0, and hence, ΔE has the same sign as Δp,
if eD = –1, then q (1 + eD ) = 0, and hence, ΔE = 0.
Now consider a decline in the price of the good. If the percentage increase in
quantity is greater than the percentage decline in the price, the expenditure on
the good will go up. On the other hand, if the percentage increase in quantity is
less than the percentage decline in the price, the expenditure on the good will go
down. And if the percentage increase in quantity is equal to the percentage decline
in the price, the expenditure on the good will remain unchanged.
The expenditure on the good would change in the opposite direction as the
price change if and only if the percentage change in quantity is greater than the
percentage change in price, ie if the good is price-elastic. The expenditure on the
good would change in the same direction as the price change if and only if the
percentage change in quantity is less than the percentage change in price, i.e., if
the good is price inelastic. The expenditure on the good would remain unchanged
if and only if the percentage change in quantity is equal to the percentage change
in price, i.e., if the good is unit-elastic.
Rectangular Hyperbola
An equation of the form
xy = c
where x and y are two variables and c
is a constant, giving us a curve called
rectangular hyperbola. It is a
downward sloping curve in the x-y
plane as shown in the diagram. For
any two points p and q on the curve,
the areas of the two rectangles Oy1px1
and Oy2qx2 are same and equal to c.
If the equation of a demand curve
takes the form pq = e, where e is a constant, it will be a rectangular
hyperbola, where price (p) times quantity (q) is a constant. With such a
demand curve, no matter at what point the consumer consumes, her
expenditures are always the same and equal to e.
Summary
• The budget set is the collection of all bundles of goods that a consumer can buy
with her income at the prevailing market prices.
• The budget line represents all bundles which cost the consumer her entire income.
The budget line is negatively sloping.
• The budget set changes if either of the two prices or the income changes.
• The consumer has well-defined preferences over the collection of all possible 33
bundles. She can rank the available bundles according to her preferences
Preference Indifference
Indifference curve Rate of substitution
Monotonic preferences Diminishing rate of substitution
Indifference map,Utility function Consumer’s optimum
Demand Law of demand
Demand curve Substitution effect
Income effect Normal good
Inferior good Substitute
Complement Price elasticity of demand
that good?
(iv) What is the slope of the budget line?
Questions 5, 6 and 7 are related to question 4.
5. How does the budget line change if the consumer’s income increases to Rs 40
but the prices remain unchanged?
6. How does the budget line change if the price of good 2 decreases by a rupee
but the price of good 1 and the consumer’s income remain unchanged?
7. What happens to the budget set if both the prices as well as the income double?
8. Suppose a consumer can afford to buy 6 units of good 1 and 8 units of good 2
if she spends her entire income. The prices of the two goods are Rs 6 and Rs 8
respectively. How much is the consumer’s income?
9. Suppose a consumer wants to consume two goods which are available only in
integer units. The two goods are equally priced at Rs 10 and the consumer’s
income is Rs 40.
(i) Write down all the bundles that are available to the consumer.
(ii) Among the bundles that are available to the consumer, identify those which
cost her exactly Rs 40.
10. What do you mean by ‘monotonic preferences’?
11. If a consumer has monotonic preferences, can she be indifferent between the
bundles (10, 8) and (8, 6)?
12. Suppose a consumer’s preferences are monotonic. What can you say about
her preference ranking over the bundles (10, 10), (10, 9) and (9, 9)?
13. Suppose your friend is indifferent to the bundles (5, 6) and (6, 6). Are the
preferences of your friend monotonic?
14. Suppose there are two consumers in the market for a good and their demand
functions are as follows:
d1(p) = 20 – p for any price less than or equal to 15, and d1(p) = 0 at any price
greater than 15.
d2(p) = 30 – 2p for any price less than or equal to 15 and d1(p) = 0 at any price
greater than 15.
Find out the market demand function.
15. Suppose there are 20 consumers for a good and they have identical demand
functions:
10
d(p) = 10 – 3p for any price less than or equal to
3 and d1(p) = 0 at any price
10
greater than
3 .
What is the market demand function?
16. Consider a market where there are just two
p d1 d2
consumers and suppose their demands for the
good are given as follows: 1 9 24
Calculate the market demand for the good. 2 8 20
3 7 18
4 6 16
5 5 14
6 4 12
Isoquant
In Chapter 2, we have learnt about indifference curves. Here, we introduce a
similar concept known as isoquant. It is just an alternative way of
representing the production function. Consider a production function with
two inputs factor 1 and factor 2. An isoquant is the set of all possible
combinations of the two inputs that yield the same maximum possible level
of output. Each isoquant represents a particular level of output and is
labelled with that amount of output.
In the diagram, we have
three isoquants for the three Factor 2
output levels, namely q = q1,
q = q 2 and q = q 3 in the
inputs plane. Two input 2x¢¢
combinations (x′1, x′′2 ) and
(x′′1
, x 2′ ) give us the same level
of output q1. If we fix factor 2
at x 2′ and increase factor 1 to 2x¢ q=q 3
In our example, both the inputs are necessary for the production. If any of
the inputs becomes zero, there will be no production. With both inputs positive,
output will be positive. As we increase the amount of any input, output increases.
Consider the example represented through Table 3.1. Suppose, in the short
run, factor 2 remains fixed at 5 units. Then the corresponding column shows
the different levels of output that the firm may produce using different quantities
of factor 1 in the short run.
In the long run, all factors of production can be varied. A firm in order to
produce different levels of output in the long run may vary both the inputs
simultaneously. So, in the long run, there is no fixed input.
For any particular production process, long run generally refers to a longer
time period than the short run. For different production processes, the long run
periods may be different. It is not advisable to define short run and long run in
terms of say, days, months or years. We define a period as long run or short run
simply by looking at whether all the inputs can be varied or not.
0 0 - -
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5
after which the resulting addition to output (i.e., marginal product of that input)
will start falling.
A somewhat related concept with the law of diminishing marginal product
is the law of variable proportions. It says that the marginal product of a
factor input initially rises with its employment level. But after reaching a certain
level of employment, it starts falling.
The reason behind the law of diminishing returns or the law of variable
proportion is the following. As we hold one factor input fixed and keep increasing
the other, the factor proportions change. Initially, as we increase the amount of
the variable input, the factor proportions become more and more suitable for
the production and marginal product increases. But after a certain level of
employment, the production process becomes too crowded with the variable
input and the factor proportions become less and less suitable for the production.
It is from this point that the marginal product of the variable input starts falling.
Let us look at Table 3.2 again. With factor 2 fixed at 4 units, the table shows
us the TP, MP1 and AP1 for different values of factor 1. We see that up to the
employment level of 3 units of factor 1, its marginal product increases. Then it
starts falling.
3.5 SHAPES OF TOTAL PRODUCT, MARGINAL PRODUCT
AND AVERAGE PRODUCT CURVES
An increase in the amount of one of the inputs keeping all other inputs constant
generally results in an increase in output. Table 3.2 shows how the total product
changes as the amount of factor 1 increases. The total product curve in the
input-output plane is a positively sloped curve. Figure 3.1 shows the shape of
the total product curve for a typical firm.
We measure units of factor 1 along the horizontal axis and output along
the vertical axis. With x1 units of factor 1, the firm can at most produce q 1
units of output.
According to the law of variable proportions, the marginal product of an
input initially rises and then after a certain level of employment, it starts falling.
The MP curve in the input-output plane, therefore, looks like an inverse
‘U’-shaped curve.
Let us now see what the AP
curve looks like. For the first unit Output
of the variable input, one can TP
easily check that the MP and the q 1
firm.
The AP of factor 1 is maximum
O x 1 Factor 1
at x1. To the left of x1, AP is rising
and MP is greater than AP. To the Fig. 3.2
right of x1, AP is falling and MP is Average and Marginal Product. These are
less than AP. average and marginal product curves of factor 1.
3.6 RETURNS TO SCALE
So far we looked at various aspects of production function when a single
input varied and others remained fixed. Now we shall see what happens when
all inputs vary simultaneously.
Constant returns to scale (CRS) is a property of production function
that holds when a proportional increase in all inputs results in an increase
in output by the same proportion.
Increasing returns to scale (IRS) holds when a proportional increase in
all inputs results in an increase in output by more than the proportion.
Decreasing returns to scale (DRS) holds when a proportional increase
in all inputs results in an increase in output by less than the proportion.
For example, suppose in a production process, all inputs get doubled.
As a result, if the output gets doubled, the production function exhibits CRS.
If output is less than doubled, the DRS holds, and if it is more than doubled,
the IRS holds.
Returns to Scale
Consider a production function
q = f (x1, x2)
where the firm produces q amount of output using x 1 amount of factor 1
and x 2 amount of factor 2. Now suppose the firm decides to increase the
employment level of both the factors t (t > 1) times. Mathematically, we
can say that the production function exhibits constant returns to scale if
we have,
f (tx1, tx2) = t.f (x1, x2)
42 ie the new output level f (tx1, tx2) is exactly t times the previous output level
f (x1, x2).
Introductory Microeconomics
3.7 COSTS
In order to produce output, the firm needs to employ inputs. But a given level
of output, typically, can be produced in many ways. There can be more than
one input combinations with which a firm can produce a desired level of output.
In Table 3.1, we can see that 50 units of output can be produced by three
different input combinations – (x1 = 6, x2 = 3), (x1 = 4, x2 = 4) and (x1 = 3, x2 = 6).
The question is which input combination will the firm choose? With the input
prices given, it will choose that combination of inputs which is least expensive.
So, for every level of output, the firm chooses the least cost input combination.
This output-cost relationship is the cost function of the firm.
Cobb-Douglas Production Function
Consider a production function
q = x 1α x 2β
where α and β are constants. The firm produces q amount of output
using x1 amount of factor 1 and x2 amount of factor 2. This is called a
Cobb-Douglas production function. Suppose with x1 = x1 and x2 = x 2 , we
have q0 units of output, i.e.
q0 = x 1 α x 2 β
If we increase both the inputs t (t > 1) times, we get the new output
q1 = (t x1 )α (t x 2 )β
= t α + β x1 α x 2 β
When α + β = 1, we have q1 = tq0. That is, the output increases t times. So the
production function exhibits CRS. Similarly, when α + β > 1, the production
function exhibits IRS. When α + β < 1 the production function exhibits DRS.
In Table 3.3, we get the SAC-column by dividing the values of the fourth
column by the corresponding values of the first column. At zero output, SAC is
undefined. For the first unit, SAC is Rs 30; for 2 units of output, SAC is Rs 19
and so on.
Similarly, the average variable cost (AVC) is defined as the total variable
cost per unit of output. We calculate it as
TVC
AVC = q (3.8)
Clearly,
SAC = AVC + AFC (3.10)
In Table 3.3, we get the AFC-column by dividing the values of the second
column by the corresponding values of the first column. Similarly, we get the
AVC-column by dividing the values of the third column by the corresponding
values of the first column. At zero level of output, both AFC and AVC are
undefined. For the first unit of output, AFC is Rs 20 and AVC is Rs 10. Adding
them, we get the SAC equal to Rs 30.
The short run marginal cost (SMC) is defined as the change in total cost
per unit of change in output
change in total cos t ΔTC
SMC = change in output = Δq (3.11)
where Δ represents the change of the variable.
If output changes in discrete units, we may define the marginal cost in the
following way. Let the cost of production for q1 units and q1 – 1 units of output
be Rs 20 and Rs 15 respectively. Then the marginal cost that the firm incurs for
producing q1th unit of output is
MC = (TC at q1) – (TC at q1 – 1) (3.12)
= Rs 20 – Rs 15 = Rs 5
44 Just like the case of marginal product, marginal cost also is undefined at
zero level of output. It is important to note here that in the short run, fixed cost
Introductory Microeconomics
cannot be changed. When we change the level of output, whatever change occurs
to total cost is entirely due to the change in total variable cost. So in the short
SMC starts rising. AVC, however, continues to fall as long as the value of SMC
remains less than the prevailing value of AVC. Once the SMC has risen sufficiently,
its value becomes greater than the value of AVC. The AVC then starts rising. The
AVC curve is therefore ‘U’-shaped.
As long as AVC is falling, SMC Cost
must be less than the AVC and as
AVC
AVC, rises, SMC must be greater
than the AVC. So the SMC curve cuts
the AVC curve from below at the
minimum point of AVC.
In Figure 3.6 we measure output B
V
along the horizontal axis and AVC
along the vertical axis. At q0 level of
output, AVC is equal to OV . The
total variable cost at q0 is O q
0
Output
TVC = AVC × quantity
Fig. 3.6
= OV × Oq0
The Average Variable Cost Curve. The area
= the area of the of the rectangle OVBq0 gives us the total
rectangle OV Bq0. variable cost at q0.
In Figure 3.7, we measure output
Cost
along the horizontal axis and TVC
along the vertical axis. At q0 level TVC
Let us check how the LRMC curve looks like. For the first unit of output,
both LRMC and LRAC are the same. Then, as output increases, LRAC initially
falls, and then, after a certain point, it rises. As long as average cost is falling,
marginal cost must be less than the average cost. When the average cost is rising,
marginal cost must be greater
than the average cost. LRMC LRMC
Cost
curve is therefore a ‘U’-shaped
curve. It cuts the LRAC curve from
below at the minimum point of the LRAC
LRAC. Figure 3.9 shows the
shapes of the long run marginal
M
cost and the long run average cost
curves for a typical firm.
LRAC reaches its minimum
at q1. To the left of q 1, LRAC is
falling and LRMC is less than the
O 1q
Output
LRAC curve. To the right of q1,
LRAC is rising and LRMC is Fig. 3.9
higher than LRAC. Long Run Costs. Long run marginal cost and
average cost curves.
Summary
• For different combinations of inputs, the production function shows the maximum
quantity of output that can be produced.
• In the short run, some inputs cannot be varied. In the long run, all inputs can be
varied.
• Total product is the relationship between a variable input and output when all
other inputs are held constant.
• For any level of employment of an input, the sum of marginal products of every
unit of that input up to that level gives the total product of that input at that
employment level.
• Both the marginal product and the average product curves are inverse ‘U’-shaped.
The marginal product curve cuts the average product curve from above at the
maximum point of average product curve.
• In order to produce output, the firm chooses least cost input combinations.
• Total cost is the sum of total variable cost and the total fixed cost.
• Average cost is the sum of average variable cost and average fixed cost.
• Average fixed cost curve is downward sloping.
• Short run marginal cost, average variable cost and short run average cost curves
are ‘U’-shaped.
• SMC curve cuts the AVC curve from below at the minimum point of AVC.
• SMC curve cuts the SAC curve from below at the minimum point of SAC.
• In the short run, for any level of output, sum of marginal costs up to that level
gives us the total variable cost. The area under the SMC curve up to any level of
output gives us the total variable cost up to that level.
• Both LRAC and LRMC curves are ‘U’ shaped.
• LRMC curve cuts the LRAC curve from below at the minimum point of LRAC.
Key Concepts
5 4
6 3.5
Q TC
25. The following table shows the total cost schedule of a
firm. What is the total fixed cost schedule of this firm? 0 10
Calculate the TVC, AFC, AVC, SAC and SMC 1 30
schedules of the firm. 2 45
3 55
4 70
5 90
6 120
26. The following table gives the total cost schedule of
Q TC
a firm. It is also given that the average fixed cost at
4 units of output is Rs 5. Find the TVC, TFC, AVC, 1 50
AFC, SAC and SMC schedules of the firm for the 2 65
corresponding values of output. 3 75
4 95
5 130
6 185
4.2 REVENUE
We have indicated that in a perfectly competitive market, a firm believes that
it can sell as many units of the good as it wants by setting a price less than or
equal to the market price. But, if this is the case, surely there is no reason to
set a price lower than the market price. In other words, should the firm desire
to sell some amount of the good, the price that it sets is exactly equal to the
market price.
A firm earns revenue by selling the good that it produces in the market. Let
the market price of a unit of the good be p. Let q be the quantity of the good
produced, and therefore sold, by the firm at price p. Then, total revenue (TR) of
the firm is defined as the market price of the good (p) multiplied by the firm’s
output (q). Hence, 53
TR = p × q
4.3.1 Condition 1
Consider condition 1. We show that condition 1 is true by arguing that a profit-
maximising firm will not produce at an output level where market price exceeds
marginal cost or marginal cost exceeds market price. We check both the cases.
Case 1: Price greater than MC is ruled out
Consider Figure 4.3 and note that at the output level q2, the market price, p,
exceeds the marginal cost. We claim that q2 cannot be a profit-maximising output
level. Why?
Observe that for all output levels slightly to the right of q2, the market price
continues to exceed the marginal cost. So, pick an output level q3 slightly to the
right of q2 such that the market price exceeds the marginal cost for all output
levels between q2 and q3.
55
Suppose, now, that the firm increases its output level from q 2 to q 3. The
4.3.3 Condition 3
SAC
Consider the third condition that
must hold when the profit- AVC
maximising output level is
positive. Notice that the third E B
condition has two parts: one part p
applies in the short run while the A
other applies in the long run.
O q1 Output
Case 1: Price must be greater
than or equal to AVC in the Fig. 4.4
short run Price-AVC Relationship with Profit
We will show that the statement of Maximisation (Short Run). The figure is used
Case 1 (see above) is true by to demonstrate that a profit-maximising firm
produces zero output in the short run when the
arguing that a profit-maximising
market price, p, is less than the minimum of its
firm, in the short run, will not average variable cost (AVC). If the firm’s output
produce at an output level wherein level is q1, the firm’s total variable cost exceeds
the market price is lower than its revenue by an amount equal to the area of
the AVC. rectangle pEBA.
Let us turn to Figure 4.4. Observe that at the output level q1, the market
price p is lower than the AVC. We claim that q1 cannot be a profit-maximising
output level. Why?
Notice that the firm’s total revenue at q1 is as follows
TR = Price × Quantity
= Vertical height Op × width Oq1
= The area of rectangle OpAq1
Similarly, the firm’s total variable cost at q1 is as follows
TVC = Average variable cost × Quantity
= Vertical height OE × Width Oq1
= The area of rectangle OEBq1
Now recall that the firm’s profit at q1 is TR – (TVC + TFC); that is, [the area of
rectangle OpAq1] – [the area of rectangle OEBq1] – TFC. What happens if the
firm produces zero output? Since output is zero, TR and TVC are zero as well.
Hence, the firm’s profit at zero output is equal to – TFC. But, the area of rectangle
OpAq1 is strictly less than the area of rectangle OEBq1. Hence, the firm’s profit
at q1 is strictly less than what it obtains by not producing at all. This means, of
course, that q1 cannot be a profit-maximising output level.
Case 2: Price must be greater than or equal to AC in the long run
We will show that the statement of Case 2 (see above) is true by arguing that a
profit-maximising firm, in the long run, will not produce at an output level
wherein the market price is lower than the AC.
Let us turn to Figure 4.5.
Observe that at the output level
Price, LRMC
q1, the market price p is lower than costs
the (long run) AC. We claim that
q1 cannot be a profit-maximising 57
output level. Why? LRAC
down, the last price-output combination at which the firm produces positive
output is the point of minimum AVC where the SMC curve cuts the AVC curve.
Below this, there will be no production. This point is called the short run shut
down point of the firm. In the long run, however, the shut down point is the
minimum of LRAC curve.
Opportunity cost
In economics, one often encounters the concept of opportunity cost.
Opportunity cost of some activity is the gain foregone from the second best
activity. Suppose you have Rs 1,000 which you decide to invest in your
family business. What is the opportunity cost of your action? If you do not
invest this money, you can either keep it in the house-safe which will give
you zero return or you can deposit it in either bank-1 or
bank-2 in which case you get an interest at the rate of 10 per cent or 5 per
cent respectively. So the maximum benefit that you may get from other
alternative activities is the interest from the bank-1. But this opportunity
will no longer be there once you invest the money in your family business.
The opportunity cost of investing the money in your family business is
therefore the amount of forgone interest from the bank-1.
Sm
p3
p2
p1
O q3 O q4 O q5 Output
(a) (b) (c)
Fig. 4.13
The Market Supply Curve Panel. (a) shows the supply curve of firm 1. Panel (b) shows the
supply curve of firm 2. Panel (c) shows the market supply curve, which is obtained by taking
a horizontal summation of the supply curves of the two firms.
Notice that S1(p) indicates that (1) firm 1 produces an output of 0 if the market
price, p, is strictly less than 10, and (2) firm 1 produces an output of (p – 10) if
the market price, p, is greater than or equal to 10. Let the supply curve of firm 2
be as follows
⎧0 : p < 15
S2(p) = ⎨ p – 15 : p ≥ 15
⎩
The interpretation of S2(p) is identical to that of S1(p), and is, hence, omitted.
Now, the market supply curve, Sm(p), simply sums up the supply curves of the
two firms; in other words
Sm(p) = S1(p) + S2(p)
But, this means that Sm(p) is as follows
⎧0 : p < 10
⎪
Sm(p) = ⎨ p – 10 : p ≥ 10 and p < 15
⎪( p – 10) + ( p – 15) = 2 p – 25 : p ≥ 15
⎩
Given the market supply curve of a good (that is, Sm(p)), let q0 be the quantity
of the good supplied to the market when its market price is p0. For some reason,
the market price of the good changes from p0 to p1. Let q1 be the quantity of
the good supplied to the market when the market price is p1. Notice that
64 when the market price moves from p0 to p1, the percentage change in price is
Introductory Microeconomics
1 0
100 × ( p – p ) ; similarly, when the quantity supplied moves from q0 to q1,
p0
1 0
the percentage change in quantity supplied is 100 × (q – q ) . So
q0
100 × (q1 – q 0 )/ q 0 q1 / q 0 – 1
eS = =
100 × ( p1 – p 0 )/ p 0 p1 / p 0 –1
To make matters concrete, consider the following numerical example. Suppose
the market for cricket balls is perfectly competitive. When the price of a cricket ball
is Rs10, let us assume that 200 cricket balls are produced in aggregate by the firms
in the market. When the price of a cricket ball rises to Rs 30, let us assume that 1,000
cricket balls are produced in aggregate by the firms in the market. Then
q1
1. ( ) = (1,000/200 – 1) = 4,
q −1
0
p1
2. ( ) = (30/10 – 1) = 2,
p −10
4
3. eS = = 2.
2
When the supply curve is vertical, supply is completely insensitive to price
and the elasticity of supply is zero. In other cases, when supply curve is
positively sloped, with a rise in price, supply rises and hence, the elasticity of
supply is positive. Like the price elasticity of demand, the price elasticity of
supply is also independent of units.
S S S
p0 p0 p0
65
• The total revenue of a firm is the market price of the good multiplied by the firm’s
output of the good.
• For a price-taking firm, average revenue is equal to market price.
• For a price-taking firm, marginal revenue is equal to market price.
• The demand curve that a firm faces in a perfectly competitive market is perfectly
elastic; it is a horizontal straight line at the market price.
• The profit of a firm is the difference between total revenue earned and total cost
incurred.
• If there is a positive level of output at which a firm’s profit is maximised in the
short run, three conditions must hold at that output level
(i) p = SMC
(ii) SMC is non-decreasing
(iii) p ≥ AV C.
• If there is a positive level of output at which a firm’s profit is maximised in the
long run, three conditions must hold at that output level
(i) p = LRMC
(ii) LRMC is non-decreasing
(iii) p ≥ LRAC.
• The short run supply curve of a firm is the rising part of the SMC curve from and
above minimum AVC together with 0 output for all prices less than the minimum
AVC.
• The long run supply curve of a firm is the rising part of the LRMC curve from and
above minimum LRAC together with 0 output for all prices less than the minimum
LRAC.
• Technological progress is expected to shift the supply curve of a firm to the right.
• An increase (decrease) in input prices is expected to shift the supply curve of a
firm to the left (right).
• The imposition of a unit tax shifts the supply curve of a firm to the left.
• The market supply curve is obtained by the horizontal summation of the supply
curves of individual firms.
• The price elasticity of supply of a good is the percentage change in quantity
supplied due to one per cent change in the market price of the good.
Key Concepts
Exercises
21. The following table shows the total cost Price (Rs) TC (Rs)
schedule of a competitive firm. It is given that
the price of the good is Rs 10. Calculate the 0 5
profit at each output level. Find the profit 1 15
maximising level of output. 2 22
3 27
4 31
5 38
6 49
7 63
8 81
9 101
10 123
22. Consider a market with two Price (Rs) SS1 (units) SS2 (units)
firms. The following table
shows the supply schedules 0 0 0
of the two firms: the SS 1 1 0 0
column gives the supply 2 0 0
schedule of firm 1 and the 3 1 1
SS2 column gives the supply
4 2 2
schedule of firm 2. Compute
the market supply schedule. 5 3 3
6 4 4
23. Consider a market with two Price (Rs) SS1 (kg) SS2 (kg)
firms. In the following table,
columns labelled as SS 1 0 0 0
and SS 2 give the supply 1 0 0
schedules of firm 1 and firm 2 0 0
2 respectively. Compute the
3 1 0
market supply schedule.
4 2 0.5
5 3 1
6 4 1.5
7 5 2
8 6 2.5
6 10
7 12
8 14
25. A firm earns a revenue of Rs 50 when the market price of a good is Rs 10. The
market price increases to Rs 15 and the firm now earns a revenue of Rs 150.
What is the price elasticity of the firm’s supply curve?
26. The market price of a good changes from Rs 5 to Rs 20. As a result, the quantity
supplied by a firm increases by 15 units. The price elasticity of the firm’s supply
curve is 0.5. Find the initial and final output levels of the firm.
27. At the market price of Rs 10, a firm supplies 4 units of output. The market price
increases to Rs 30. The price elasticity of the firm’s supply is 1.25. What quantity
will the firm supply at the new price?
Chapter 5
Price
Market Equilibrium
Market SS
pf
p*
This chapter will be built on the foundation laid down in Chapters p1
DD
2 and 4 where we studied the consumer and firm behaviour when
they are price takers. In Chapter 2, we have seen that an O q'1 q'1 q* q2 q1
individual’s demand curve for a commodity tells us what quantity Quantity
a consumer is willing to buy at different prices when he takes price
as given. The market demand curve in turn tells us how much of
the commodity all the consumers taken together are willing to
purchase at different prices when everyone takes price as given.
In Chapter 4, we have seen that an individual firm’s supply curve
tells us the quantity of the commodity that a profit-maximising
firm would wish to sell at different prices when it takes price as
given and the market supply curve tells us how much of the
commodity all the firms taken together would wish to supply at
different prices when each firm takes price as given.
In this chapter, we combine both consumers’ and firms’
behaviour to study market equilibrium through demand-supply
analysis and determine at what price equilibrium will be attained.
We also examine the effects of demand and supply shifts on
equilibrium. At the end of the chapter, we will look at some of the
applications of demand-supply analysis.
Out-of-equilibrium Behaviour
From the time of Adam Smith (1723-1790), it has been maintained that in
a perfectly competitive market an ‘Invisible Hand’ is at play which changes
price whenever there is imbalance in the market. Our intuition also tells us
that this ‘Invisible Hand’ should raise the prices in case of ‘excess demand’
and lower the prices in case of ‘excess supply’. Throughout our analysis we
shall maintain that the ‘Invisible Hand’ plays this very important role.
Moreover, we shall take it that the ‘Invisible Hand’ by following this process
is able to reach the equilibrium. This assumption will be taken to hold in all
that we discuss in the text.
EXAMPLE 5.1
Let us consider the example of a market consisting of identical1 farms producing
same quality of wheat. Suppose the market demand curve and the market supply
curve for wheat are given by:
qD = 200 – p for 0 ≤ p ≤ 200
=0 for p > 200 71
q = 120 + p for p ≥ 10
S
Market Equilibrium
=0 for 0 ≤ p < 10
where qD and qS denote the demand for and supply of wheat (in kg) respectively
and p denotes the price of wheat per kg in rupees.
Since at equilibrium price market clears, we find the equilibrium price
(denoted by p*) by equating market demand and supply and solve for p*.
qD(p*) = qS(p*)
200 – p* = 120 + p*
Rearranging terms,
2p* = 80
p* = 40
Therefore, the equilibrium price of wheat is Rs 40 per kg. The equilibrium
quantity (denoted by q* ) is obtained by substituting the equilibrium price into
either the demand or the supply curve’s equation since in equilibrium quantity
demanded and supplied are equal.
1
Here, by identical we mean that all farms have same cost structure.
qD = q* = 200 – 40 = 160
Alternatively,
qS = q* = 120 + 40 = 160
Thus, the equilibrium quantity is 160 kg.
At a price less than p*, say p1 = 25
qD = 200 – 25 = 175
qS = 120 + 25 = 145
Therefore, at p1 = 25, qD > qS which implies that there is excess demand at
this price.
Algebraically, excess demand (ED) can be expressed as
ED(p) = qD – qS
= 200 – p – (120 + p)
= 80 – 2p
Notice from the above expression that for any price less than p*(= 40), excess
demand will be positive.
Similarly, at a price greater than p*, say p2 = 45
qD = 200 – 45 = 155
qS = 120 + 45 = 165
Therefore, there is excess supply at this price since qS > qD. Algebraically,
excess supply (ES) can be expressed as
ES(p) = qS – qD
= 120 + p – (200 – p)
= 2p – 80
Notice from the above expression that for any price greater than p*(= 40),
72 excess supply will be positive.
Therefore, at any price greater than p*, there will be excess supply, and at
Introductory Microeconomics
Market Equilibrium
if MPL increases which in turn Wage
implies that less labour S L
a
Recall from Chapter 4 that for a perfectly competitive firm, marginal revenue equals price.
b
Since the firm under consideration is perfectly competitive, it believes it cannot influence
the price of the commodity.
Having explored the demand side, we now turn to the supply side.
As already mentioned, it is the households which determine how much
labour to supply at a given wage rate. Their supply decision is essentially
a choice between income and leisure. On the one hand, individuals enjoy
leisure and find work irksome and on the other, they value income for
which they must work.
So there is a trade-off between enjoying leisure and spending more
hours for work. To derive the labour demand curve for a single individual,
let us assume at some wage rate w1, the individual supplies l1 units of
labour. Now suppose the wage rises to w2. This increase in wage rate will
have two effects: First, due to the increase in wage rate, the opportunity
cost of leisure increases which makes leisure costlier. Therefore, the
individual will want to enjoy less leisure. As a result, they will work for
longer hours. Second, because of the increase in wage rate to w2, the
purchasing power of the individual increases. So, she would want to
spend more on leisure activities. The final effect of the increase in wage
rate will depend on which of the two effects predominates. At low wage
rates, the first effect dominates the second and so the individual will be
willing to supply more labour with an increase in wage rate. But at high
wage rates, the second effect dominates the first and the individual will
be willing to supply less labour for every increase in wage rate. Thus, we
get a backward bending individual labour supply curve which shows
that up to a certain wage rate for every increase in wage rate, there is an
increased supply of labour. Beyond this wage rate for every increase in
wage rate, labour supply will decrease. Nevertheless, the market supply
curve of labour, which we obtain by aggregating individuals’ supply at
different wages, will be upward sloping because though at higher wages
some individuals may be willing to work less, many more individuals
will be attracted to supply more labour.
With an upward sloping supply curve and downward sloping demand
curve, the equilibrium wage rate is determined at the point where these two
74 curves intersect; in other words, where the labour that the households wish
to supply is equal to the labour that the firms wish to hire. This is shown in
Introductory Microeconomics
the diagram.
G E
p2 p0
F
p0 p1
E
DD2 DD0
DD0 DD1
O q0 q2 q¢¢0 Quantity O q10 q1 q0 Quantity
Fig. 5.2 (a) (b)
Shifts in Demand. Initially, the market equilibrium is at E. Due to the shift in demand to the
right, the new equilibrium is at G as shown in panel (a) and due to the leftward shift, the new
equilibrium is at F, as shown in panel (b). With rightward shift the equilibrium quantity and price
increase whereas with leftward shift, equilibrium quantity and price decrease.
Now suppose the market demand curve shifts rightward to DD2 with supply
curve remaining unchanged at SS0, as shown in panel (a). This shift indicates
that at any price the quantity demanded is more than before. Therefore, at price
p0 now there is excess demand in the market equal to q0q''0 . In response to this
excess demand some individuals will be willing to pay higher price and the price
would tend to rise. The new equilibrium is attained at G where the equilibrium
quantity q2 is greater than q0 and the equilibrium price p2 is greater than p0.
Similarly if the demand curve shifts leftward to DD1, as shown in panel (b), at
any price the quantity demanded will be less than what it was before the shift.
Therefore, at the initial equilibrium price p0 now there will be excess supply in
the market equal to q'0 q0 in response to which some firms will reduce the price
of their commodity so that they can sell their desired quantity. The new 75
equilibrium is attained at the point F at which the demand curve DD1 and the
Market Equilibrium
supply curve SS0 intersect and the resulting equilibrium price p1 is less than p0
and quantity q1 is less than q0. Notice that the direction of change in equilibrium
price and quantity is same whenever there is a shift in demand curve.
Having developed the general theory, we now consider some examples to
understand how demand curve and the equilibrium quantity and price are
affected in response to a change in some of the aforementioned factors which
are also enlisted in Chapter 2. More specifically, we would analyse the impact
of increase in consumers’ income and an increase in the number of consumers
on equilibrium.
Suppose due to a hike in the salaries of the consumers, their incomes increase.
How would it affect equilibrium? With an increase in income, consumers are able
to spend more money on some goods. But recall from Chapter 2 that the consumers
will spend less on an inferior good with increase in income whereas for a normal
good, with prices of all commodities and tastes and preferences of the consumers
held constant, we would expect the demand for the good to increase at each price
as a result of which the market demand curve will shift rightward. Here we consider
the example of a normal good like clothes, the demand for which increases
with increase in income of consumers, thereby causing a rightward shift in the
demand curve. However, this income increase does not have any impact on
the supply curve, which shifts only due to some changes in the factors relating to
technology or cost of production of the firms. Thus, the supply curve remains
unchanged. In the Figure 5.2 (a), this is shown by a shift in the demand curve
from DD0 to DD2 but the supply curve remains unchanged at SS0. From the figure,
it is clear that at the new equilibrium, the price of clothes is higher and the quantity
demanded and sold is also higher.
Now let us turn to another example. Suppose due to some reason, there is
increase in the number of consumers in the market for clothes. As the number
of consumers increases, other factors remaining unchanged, at each price, more
clothes will be demanded. Thus, the demand curve will shift rightwards. But
this increase in the number of consumers does not have any impact on the
supply curve since the supply curve may shift only due to changes in the
parameters relating to firms’ behaviour or with an increase in the number of
firms, as stated in Chapter 4. This case again can be illustrated through Figure
5.2(a) in which the demand curve DD0 shifts rightward to DD2, the supply curve
remaining unchanged at SS0. The figure clearly shows that compared to the old
equilibrium point E, at point G which is the new equilibrium point, there is an
increase in both price and quantity demanded and supplied.
Supply Shift
In Figure 5.3, we show the impact of a shift in supply curve on the equilibrium
price and quantity. Suppose, initially, the market is in equilibrium at point E
where the market demand curve DD0 intersects the market supply curve SS0
such that the equilibrium price is p0 and the equilibrium quantity is q0.
76
Introductory Microeconomics
Shifts in Supply. Initially, the market equilibrium is at E. Due to the shift in supply curve to the
left, the new equilibrium point is G as shown in panel (a) and due to the rightward shift the new
equilibrium point is F, as shown in panel (b). With rightward shift, the equilibrium quantity
increases and price decreases whereas with leftward shift,equilibrium quantity decreases and
price increases.
Now, suppose due to some reason, the market supply curve shifts leftward to
SS2 with the demand curve remaining unchanged, as shown in panel (a). Because
of the shift, at the prevailing price, p0, there will be excess demand equal to q0'' qo in
the market. Some consumers who are unable to obtain the good will be willing to
pay higher prices and the market price tends to increase. The new equilibrium is
attained at point G where the supply curve SS2 intersects the demand curve DD0
such that q2 quantity will be bought and sold at price p2. Similarly, when supply
curve shifts rightward, as shown in panel (b), at p0 there will be supply excess of
goods equal to q0 q 0' . In response to this excess supply, some firms will reduce
their price and the new equilibrium will be attained at F where the supply curve
SS1 intersects the demand curve DD0 such that the new market prices is p1 at
which q1 quantity is bought and sold. Notice the directions of change in price and
quantity are opposite whenever there is a shift in supply curve.
Now with this understanding, we can analyse the behaviour of equilibrium
price and quantity when various aspects of the market change. Here, we will
consider the effect of an increase in input price and an increase in number of
firms on equilibrium.
Let us consider a situation where all other things remaining constant, there
is an increase in the price of an input used in the production of a commodity.
This will increase the marginal cost of production of the firms using this input.
Therefore, at each price, the market supply will be less than before. Hence, the
supply curve shifts leftward. In the Figure 5.3(a), this is shown by a shift in the
supply curve from SS0 to SS2. But this increase in input price has no impact on
the demand of the consumers since it does not depend on the input prices
directly. Therefore, the demand curve remains unchanged. In Figure 5.3(a), this
is shown by the demand curve remaining unchanged at DD0. As a result,
compared to the old equilibrium, now the market price rises and quantity
produced decreases.
Let us discuss the impact of an increase in the number of firms. Since at
each price now more firms will supply the commodity, the supply curve shifts to
the right but it does not have any effect on the demand curve. This example can
be illustrated by Figure 5.3(b) where the supply curve shifts from SS0 to SS1
whereas the demand curve remains unchanged at DD0. From the figure, we can
say that there will be a decrease in price of the commodity and increase in the
quantity produced compared to the initial situation.
Simultaneous Shifts of Demand and Supply
What happens when both demand and supply curves shift simultaneously?
The simultaneous shifts can happen in four possible ways: 77
(i) Both supply and demand curves shift rightwards.
Market Equilibrium
(ii) Both supply and demand curves shift leftwards.
(iii) Supply curve shifts leftward and demand curve shifts rightward.
(iv) Supply curve shifts rightward and demand curve shifts leftward.
The impact on equilibrium price and quantity in all the four cases are
given in Table 5.1. Each row of the table describes the direction in which the
equilibrium price and quantity will change for each possible combination of
the simultaneous shifts in demand and supply curves. For instance, from the
second row of the table, we see that due to a rightward shift in both demand
and supply curves, the equilibrium quantity increases invariably but the
equilibrium price may either increase, decrease or remain unchanged. The
actual direction in which the price will change will depend on the
magnitude of the shifts. Check this yourself by varying the magnitude
of shifts for this particular case.
In the first two cases which are shown in the first two rows of the table, the
impact on equilibrium quantity is unambiguous but the equilibrium price may
change, if at all, in either direction depending on the magnitudes of shifts. In the
next two cases, shown in the last two rows of the table, the effect on price is
unambiguous whereas effect on quantity depends on the magnitude of shifts in
the two curves.
Table 5.1: Impact of Simultaneous Shifts on Equilibrium
Here we give diagrammatic representations for case (ii) and case (iii) in Figure
5.4 and leave the rest as exercises for the readers.
78
Introductory Microeconomics
In the Figure 5.4(a), it can be seen that due to rightward shifts in both demand
and supply curves, the equilibrium quantity increases whereas the equilibrium
price remains unchanged, and in Figure 5.4(b), equilibrium quantity remains
the same whereas price decreases due to a leftward shift in demand curve and a
rightward shift in supply curve.
Market Equilibrium
p = min AC
From the above, it follows
that the equilibrium price will be
equal to the minimum average
cost of the firms. In equilibrium,
the quantity supplied will be
determined by the market
demand at that price so that they
are equal. Graphically, this is
shown in Figure 5.5 where the
market will be in equilibrium at
point E at which the demand
curve DD intersects the p0 = min
AC line such that the market
price is p0 and the total quantity
Price Determination with Free Entry and
demanded and supplied is Exit. With free entry and exit in a perfectly
equal to q0. competitive market, the equilibrium price is always
At p 0 = min AC each firm equal to min AC and the equilibrium quantity is
supplies same amount of output, determined at the intersection of the market
say q0f . Therefore, the equilibrium demand curve DD with the price line p = min AC.
number of firms in the market is equal to the number of firms required to supply
q0 output at p0, each in turn supplying q0f amount at that price. If we denote the
equilibrium number of firms by n0, then
q0
n0 = q
0f
EXAMPLE 5.2
Consider the example of a market for wheat such that the demand curve for
wheat is given as follows
qD = 200 – p for 0 ≤ p ≤ 200
=0 for p > 200
Assume that the market consists of identical farms. The supply curve of a
single farm is given by
s
q f = 10 + p for p ≥ 20
=0 for 0 ≤ p < 20
The free entry and exit of farms would mean that the farms will never produce
below minimum average cost because otherwise they will incur loss from
production in which case they will exit the market.
As we know, with free entry and exit, the market will be in equilibrium at a
price which equals the minimum average cost of the farms. Therefore, the
equilibrium price is
p0 = 20
At this price, market will supply that quantity which is equal to the market
demand. Therefore, from the demand curve, we get the equilibrium quantity:
80
q0 = 200 – 20 = 180
Introductory Microeconomics
Shifts in Demand
Let us examine the impact of shift in demand on equilibrium price and quantity
when the firms can freely enter and exit the market. From the previous section,
we know that free entry and exit of the firms would imply that under all
circumstances equilibrium price will be equal to the minimum average cost of
the existing firms. Under this condition, even if the market demand curve shifts
in either direction, at the new equilibrium, the market will supply the desired
quantity at the same price.
In Figure 5.6, DD0 is the market demand curve which tells us how much
quantity will be demanded by the consumers at different prices and p0 denotes
the price which is equal to the minimum average cost of the firms. The initial
equilibrium is at point E where the demand curve DD0 cuts the p0 = minAC line
and the total quantity demanded and supplied is q0. The equilibrium number of
firms is n0 in this situation.
Now suppose the demand curve shifts to the right for some reason. At p0
there will be excess demand for the commodity. Some dissatisfied consumers
will be willing to pay higher price for the commodity, so the price tends to
rise. This gives rise to a possibility of earning supernormal profit which will
attract new firms to the market. The entry of these new firms will eventually
wipe out the supernormal profit and the price will again reach p0. Now higher
quantity will be supplied at the same price. From the panel (a), we can see
that the new demand curve DD1 intersects the p0 = minAC line at point F such
that the new equilibrium will be (p0, q 1) where q1 is greater than q 0. The new
equilibrium number of firms n1 is greater than n0 because of the entry of new
firms. Similarly, for a leftward shift of the demand curve to DD2, there will be
Shifts in Demand. Initially, the demand curve was DD0, the equilibrium quantity and price 81
were q0 and p0 respectively. With rightward shift of the demand curve to DD1, as shown in
Market Equilibrium
panel (a), the equilibrium quantity increases and with leftward shift of the demand curve to
DD2, as shown in panel (b), the equilibrium quantity decreases. In both the cases, the equilibrium
price remains unchanged at p0.
excess supply at the price p0. In response to this excess supply, some firms,
which will be unable to sell their desired quantity at p0, will wish to lower
their price. The price tends to decrease which will lead to the exit of some of
the existing firms and the price will again reach p 0. Therefore, in the new
equilibrium, less quantity will be supplied which will be equal to the reduced
demand at that price. This is shown in panel (b) where due to the shift of
demand curve from DD0 to DD2, quantity demanded and supplied will
decrease to q 2 whereas the price will remain unchanged at p 0. Here, the
equilibrium number of firms, n2 is less than n0 due to the exit of some existing
firms. Thus, due to a shift in demand rightwards (leftwards), the equilibrium
quantity and number of firms will increase (decrease) whereas the
equilibrium price will remain unchanged.
Here, we should note that with free entry and exit, shift in demand has a
larger effect on quantity than it does with the fixed number of firms. But
unlike with fixed number of firms, here, we do not have any effect on
equilibrium price at all.
5.2 APPLICATIONS
In this section, we try to understand how the supply-demand analysis can be
applied. In particular, we look at two examples of government intervention in
the form of price control. Often, it becomes necessary for the government to
regulate the prices of certain goods and services when their prices are either too
high or too low in comparison to the
desired levels. We will analyse these
issues within the framework of perfect
competition to look at what impact
these regulations have on the market for
these goods.
Market Equilibrium
Figure 5.8 shows the market supply and the market demand curve for a
commodity on which price floor is imposed. The market equilibrium here would
occur at price p* and quantity q*. But when the government imposes a floor higher
than the equilibrium price at pf , the market demand is qf whereas the firms want
to supply q f′ , thereby leading to an excess supply in the market equal to q f′ qf .
In the case of agricultural support, to prevent price from falling because of
excess supply, government needs to buy the surplus at the predetermined price.
Equilibrium
Key Concepts
Excess demand
Excess supply
Marginal revenue product of labour
Value of marginal product of labour
Price ceiling, Price floor
84
Exercises
Market Equilibrium
consists of identical firms producing commodity X. Let the supply curve of a
single firm be explained as
qSf = 8 + 3p for p ≥ 20
=0 for 0 ≤ p < 20
(a) What is the significance of p = 20?
(b) At what price will the market for X be in equilibrium? State the reason for
your answer.
(c) Calculate the equilibrium quantity and number of firms.
24. Suppose the demand and supply curves of salt are given by:
qD = 1,000 – p qS = 700 + 2p
(a) Find the equilibrium price and quantity.
(b) Now suppose that the price of an input used to produce salt has increased
so that the new supply curve is
qS = 400 + 2p
How does the equilibrium price and quantity change? Does the change
conform to your expectation?
(c) Suppose the government has imposed a tax of Rs 3 per unit of sale of salt.
How does it affect the equilibrium price and quantity?
25. Suppose the market determined rent for apartments is too high for common people
to afford. If the government comes forward to help those seeking apartments on rent
by imposing control on rent, what impact will it have on the market for apartments?
Chapter 6
Non-competitive Mark ets
Markets
We recall that perfect competition was theorised as a market
structure where both consumers and firms were price takers.
The behaviour of the firm in such circumstances was described
in the Chapter 4. We discussed that the perfect competition
market structure is approximated by a market satisfying the
following conditions:
(i) there exist a very large number of firms and consumers of the
commodity, such that the output sold by each firm is negligibly
small compared to the total output of all the firms combined,
and similarly, the amount purchased by each consumer is
extremely small in comparison to the quantity purchased by
all consumers together;
(ii) firms are free to start producing the commodity or to stop
production;
(iii) the output produced by each firm in the industry is
indistinguishable from the others and the output of any other
industry cannot substitute this output; and
(iv) consumers and firms have perfect knowledge of the output,
inputs and their prices.
In this chapter, we shall discuss situations where one or more
of these conditions are not satisfied. If assumptions (i) and (ii) are
dropped, we get market structures called monopoly and oligopoly.
If assumption (iii) is dropped, we obtain a market structure called
monopolistic competition. Dropping of assumption (iv) is dealt with
as ‘economics of risk’. This chapter will examine the market
structures of monopoly, monopolistic competition and oligopoly.
Non-competitive Markets
monopoly in a single commodity market.
As seen earlier, the p values represent the market demand curve as shown
in Figure 6.2. The AR curve will therefore lie exactly on the market demand
curve. This is expressed by the statement that the market demand curve is 89
the average revenue curve for the
Non-competitive Markets
monopoly firm.
Graphically, the value of AR
can be found from the TR curve
for any level of quantity sold
through a simple construction
given in Figure 6.3. When quantity
is of 6 units, draw a vertical line
passing through the value 6 on
the horizontal axis. This line will
cut the TR curve at the point
marked ‘a’ at a height equal to 42.
Draw a straight line joining the
origin O and point ‘a’. The slope
of this ray from the origin to a
Relation between Average Revenue and
point on the TR provides the value
Total Revenue Curves. The average revenue
of AR. The slope of this ray is equal at any level of output is given by the slope of the
to 7. Therefore, AR has the value line joining the origin and the point on the total
7. The same can be verified from revenue curve corresponding to the output level
Table 6.1. under consideration.
6.1.2 Total, Average and Marginal Revenues
A more careful glance at Table 6.1 reveals that TR does not increase by the
same amount for every unit increase in quantity. Sale of the first unit leads to
a change in TR from Rs 0 when quantity is of 0 unit to Rs 9.50 when quantity
is 1 unit, i.e., a rise of Rs 9.50. As the quantity increases further, the rise in TR
is smaller. For example, for the 5th unit of the commodity, the rise in TR is
Rs 5.50 (Rs 37.50 for 5 units minus Rs 32 for 4 units). As mentioned earlier,
after 10 units of output, TR starts declining. This implies that bringing more
than 10 units for sale leads to a level of TR less than Rs 50. Thus, the rise in TR
due to the 12th unit is: 48 – 49.50 = –1.5, ie a fall of Rs 1.50.
This change in TR due to the sale of an additional unit is termed Marginal
Revenue (MR). In Table 6.1, this is depicted in the last column. The values in
every row of the MR column after the first equal the TR value in that row minus
the TR value in the previous row. In the last paragraph, it was shown that TR
increases more slowly as quantity sold increases and falls after quantity reaches
10 units. The same can be viewed through the MR values which fall as q
increases. After the quantity reaches 10 units, MR has negative values. In Figure
6.2, MR is depicted by the dotted line.
Graphically, the values of
the MR curve are given by the
TR,
slope of the TR curve. The slope MR c
of any smooth curve is defined
L d
as the slope of the tangent to the 2
b
curve at that point. This is TR
depicted in Figure 6.4. At point
L1
‘a’ on the TR curve, the value of a
MR is given by the slope of the
line L1, and at point ‘b’ by the
line L2. It can be seen that both
O 10 Output
90 lines have positive slope, but the
MR
line L2 is flatter than line L1, ie
Introductory Microeconomics
AR
AR
O O
Output Output
MR MR
(a) (b)
Fig. 6.5
Relation between Average Revenue and Marginal Revenue curves. If the AR curve is
steeper, then the MR curve is far below the AR curve.
Non-competitive Markets
6.1.4 Short Run Equilibrium of the Table 6.2: MR and Price Elasticity
Monopoly Firm q p MR Elasticity
As in the case of perfect competition, we
continue to regard the monopoly firm as 0 10 - -
one which maximises profit. In this section, 1 9.5 9.5 19
we analyse this profit maximising 2 9 8.5 9
behaviour to determine the quantity 3 8.5 7.5 5.67
produced by a monopoly firm and price at 4 8 6.5 4
which it is sold. We shall assume that a firm 5 7.5 5.5 3
does not maintain stocks of the quantity
6 7 4.5 2.33
produced and that the entire quantity
produced is put up for sale. 7 6.5 3.5 1.86
8 6 2.5 1.5
The Simple Case of Zero Cost
9 5.5 1.5 1.22
Suppose there exists a village situated
10 5 0.5 1
sufficiently far away from other villages. In
this village, there is exactly one well from 11 4.5 -0.5 0.82
which water is available. All residents are 12 4 -1.5 0.67
completely dependent for their water 13 3.5 -2.5 0.54
requirements on this well. The well is owned by one person who is able to prevent
others from drawing water from it except through purchase of water. The person
who purchases the water has to draw the water out of the well. The well owner is
thus a monopolist firm which bears zero cost in producing the good.
We shall analyse this simple case of a monopolist bearing zero costs to determine
the amount of water sold and the price at which it is sold.
Figure 6.6 depicts the same
TR, AR and MR curves, as in TR,
AR,
Figure 6.2. The profit received by
MR,
the firm equals the revenue Price
a
received by the firm minus the cost
incurred, that is, Profit = TR – TC.
TR
Since in this case TC is zero, profit
is maximum when TR is
maximum. This, as we have seen
earlier, occurs when output is of
10 units. This is also the level 5 AR = D
market structure. Let us assume that there is an infinite number of such wells.
If one well owner charges Rs 5 per unit of water to get a profit of Rs 50, another
well owner realising there are still consumers willing to buy water at a lower
rate, will fix the price lower than Rs 5, say at Rs 4. Consumers will decide to
purchase from the second water seller and demand a larger quantity of 12 units
creating a total revenue of Rs 48. In similar fashion, another water seller, in
order to obtain the revenue, would offer a still lower price, say Rs 3, and selling
14 units earning a revenue of Rs 42. Since there is an infinite number of firms,
price would continue to move down infinitely till it reaches zero. At this output,
20 units of water would be sold and profit would become zero.
Through this comparison, we can see that a perfectly competitive equilibrium
results in a larger quantity being sold at a lower price. We can now proceed to
the general case involving positive costs of production.
Introducing Positive Costs
Analysing using Total curves
In Chapter 3, we have discussed the concept of cost and the shape of the total
cost curve having been depicted as shown by TC in Figure 6.7. The TR curve is
also drawn in the same diagram. The profit received by the firm equals the total
revenue minus the total cost. In the figure, we can see that if quantity q1 is
produced, the total revenue is TR1 and total cost is TC1. The difference, TR1 – TC1,
is the profit received. The same is depicted by the length of the line segment AB,
i.e., the vertical distance between the TR and TC curves at q1 level of output. It
should be clear that this vertical distance changes for diferent levels of output.
When output level is less than q2, the TC curve lies above the TR curve, i.e., TC is
greater than TR, and therefore profit is negative and the firm makes losses.
The same situation exists for
output levels greater than q 3.
Revenue,
Hence, the firm can make positive TC
a
Profit
Cost,
profits only at output levels
between q2 and q3, where TR curve A
lies above the TC curve. The TR 1 TR
monopoly firm will choose that
level of output which maximises TC 1
B
its profit. This would be the level
of output for which the vertical
distance between the TR and TC
is maximum and TR is above the O q 2q 1 q 0 q Output
3
TC, i.e., TR – TC is maximum. This
Profit
occurs at the level of output q0.
If the difference TR – TC is Fig. 6.7
calculated and drawn as a graph,
Equilibrium of the Monopolist in terms of the
it will look as in the curve marked Total Curves. The monopolist’s profit is maximised
‘Profit’ in Figure 6.7. It should be at the level of output for which the vertical distance
noticed that the Profit curve has between the TR and TC is a maximum and TR is
its maximum value at the level of above the TC.
output q0.
The price at which this output is sold is the price consumers are willing to pay
for this q0 quantity of the commodity. So the monopoly firm will charge the price
corresponding to the quantity level q0 on the demand curve.
Using Average and Marginal curves 93
Non-competitive Markets
The analysis shown above can also be conducted using Average and Marginal
Revenue and Average and Marginal Cost. Though a bit more complex, this
method is able to exhibit the process in greater light.
In Figure 6.8, the Average
Cost (AC), Average Variable Cost Price
(AVC) and Marginal Cost (MC) MC
curves are drawn along with the
Demand (Average Revenue) Curve
and Marginal Revenue crve. AC
It may be seen that at quantity
a
level below q0, the level of MR is b
p C
f
higher than the level of MC. This c
d
e D = AR
means that the increase in total
revenue from selling an extra unit
of the commodity is greater than O
the increase in total cost for q q 0 C Output
producing the additional unit. This Fig. 6.8 MR
Non-competitive Markets
commodities using new technologies are always coming up, which are close
substitutes for the commodity produced by the monopoly firm. Hence, the
monopoly firm always has competition in the long run. Even in the short run,
the threat of competition is always present and the monopoly firm is unable to
behave in the manner we have described above.
Still another view argues that the existence of monopolies may be beneficial
to society. Since monopoly firms earn large profits, they possess sufficient funds
to take up research and development work, something which the small perfectly
competitive firm is unable to do. By doing such research, monopoly firms are
able to produce better quality goods. Also, because of the more modern
technologies which such firms are able to use, their marginal cost may be so
much lower that the equilibrium level of output, where MC = MR, may be even
larger than that in the case of perfect competition.
the short run, some firms would stop producing (exit from the market) the
commodity and the fall in total quantity produced would lead to a higher price.
Entry or exit would halt once profits become zero and this would serve as the
long run equilibrium.
Since the demand of the output of each firm continues to increase with a
fall in the price of its brand, the long run equilibrium continues to be
associated with a lower level of total output and a higher price as compared
to perfect competition.
Non-competitive Markets
1 B 0
1 20
2 A × 20 =
2 2
1 1 20 20
3 B (20 – × 20) = –
2 2 2 4
1 1 1 20 20 20
4 A (20 – (20 – × 20)) = – +
2 2 2 2 4 8
1 1 1 1 20 20 20 20
5 B (20 – (20 – (20 – × 20))) = – + –
2 2 2 2 2 4 8 16
And so on.
Therefore both the firms would finally supply an output equal to
20 20 20 20 20 20 20 20
– + – + – + ... =
2 4 8 16 32 64 128 3
The total quantity supplied in the market equals the sum of the quantity
supplied by the two firms is
20 20 20
+ =2×
3 3 3
which is greater than the quantity supplied under a monopoly market structure
and less than the quantity supplied under a perfectly competitive structure.
Since price depends on the quantity supplied by the formula
40 20
p = 10 – 0.5q, for q = , price is 10 – = Rs 3.33. This is lower than the price
3 3
under monopoly and higher than under perfect competition.
Even in the case where there are positive costs, the mathematics only
becomes more complex, but the results are similar. That through a very large
number of moves and countermoves, the two firm reach an equilibrium
quantity of total output. The quantity produced by both firms together is more
than what a pure monopoly would have produced and lesser than that
produced if the market structure was perfectly competitive. The equilibrium
market price is naturally lower than in the case of pure monopoly and higher
than under perfect competition.
Thirdly, some economists argue that oligopoly market structure makes the
market price of the commodity rigid, i.e. the market price does not move freely
in response to changes in demand. The reason for this lies in the way in which
oligopoly firms react to a change in price initiated by any firm. If one firm feels
that a price increase would generate higher profits, and therefore increases the
price at which it sells its output, other firms do not follow. The price increase
would therefore lead to a huge fall in the quantity sold by the firm leading to a
fall in its revenue and profit. It is therefore not rational for any firm to increase
the price. On the other hand, a firm may estimate that it could earn a larger
revenue and profit by selling a larger quantity of output and therefore lowers
the price at which it sells the commodity. Other firms would perceive this action
as a threat and therefore follow the first firm and lower their price as well. The
increase in the total quantity sold due to the lowering of price is therefore shared
by all the firms, and the firm that had initially lowered the price is able to achieve
only a small increase in the quantity it sells. A relatively large lowering of price
98 by the first firm leads to a relatively small increase in the quantity sold. Thus,
this firm experiences an inelastic demand curve and its decision to lower price
Introductory Microeconomics
leads to a lowering of its revenue and profit. Any firm therefore finds it irrational
to change the prevailing price, leading to prices that are more rigid compared to
perfect competition.
Summary
• The market structure called monopoly exists where there is exactly one seller
in any market.
• A commodity market has a monopoly structure, if there is one seller of the
commodity, the commodity has no substitute, and entry into the industry
by another firm is prevented.
• The market price of the commodity depends on the amount supplied by the
monopoly firm. The market demand curve is the average revenue curve for
the monopoly firm.
• The shape of the total revenue curve depends on the shape of the average
revenue curve. In the case of a negatively sloping straight line demand curve,
the total revenue curve is an inverted vertical parabola.
• Average revenue for any quantity level can be measured by the slope of the
line from the origin to the relevant point on the total revenue curve.
• Marginal revenue for any quantity level can be measured by the slope of the
tangent at the relevant point on the total revenue curve.
• The average revenue is a declining curve if and only if the value of the marginal
revenue is lesser than the average revenue.
• The steeper is the negatively sloped demand curve, the further below is the
marginal revenue curve.
• The demand curve is elastic when marginal revenue has a positive value, and
inelastic when the marginal revenue has a negative value.
• If the monopoly firm has zero costs or only has fixed cost, the quantity supplied
in equilibrium is given by the point where marginal revenue is zero. In
contrast, perfect competition would supply an equilibrium quantity given by
the point where average revenue is zero.
• Equilibrium of a monopoly firm is defined as the point where MR = MC
and MC is rising. This point provides the equilibrium quantity produced.
The equilibrium price is provided by the demand curve given the
equilibrium quantity.
• Positive short run profit to a monopoly firm continue in the long run.
• Monopolistic competition in a commodity market arises due to the commodity
being non-homogenous.
• In monopolistic competition, the short run equilibrium results in quantity
produced being lesser and prices being higher compared to perfect
competition. This situation persists in the long run, but long run profits
are zero.
• Oligopoly in a commodity market occurs when there are a small number of
firms producing a homogenous commodity.
Monopoly
Key Concepts
Monopolistic Competition
Oligopoly.
99
Non-competitive Markets
1. What would be the shape of the demand curve so that the total revenue curve is
Exercises
Quantity 0 1 2 3 4 5 6 7 8
Total Cost 10 60 90 100 102 105 109 115 125
find the quantity supplied by each firm in equilibrium and the equilibrium
market price.
13. What is meant by prices being rigid? How can oligopoly behaviour lead to such
an outcome?
Average cost Total cost per unit of output.
Average fixed cost Total fixed cost per unit of output.
Average product Output per unit of the variable input.
Average revenue Total revenue per unit of output.
Average variable cost Total variable cost per unit of output.
Break-even point is the point on the supply curve at which a firm
earns normal profit.
Budget line consists of all bundles which cost exactly equal to the
consumer’s income.
Budget set is the collection of all bundles that the consumer can
buy with her income at the prevailing market prices.
Constant returns to scale is a property of production function that
holds when a proportional increase in all inputs results in an increase
in output by the same proportion.
Cost function For every level of output, it shows the minimum cost
for the firm.
Decreasing returns to scale is a property of production function
that holds when a proportional increase in all inputs results in an
increase in output by less than the proportion.
Demand curve is a graphical representation of the demand function.
It gives the quantity demanded by the consumer at each price.
Demand function A consumer’s demand function for a good gives
the amount of the good that the consumer chooses at different levels
of its price when the other things remain unchanged.
Duopoly is a market with just two firms.
Equilibrium is a situation where the plans of all consumers and
firms in the market match.
Excess demand If at a price market, demand exceeds market supply,
it is said that excess demand exists in the market at that price.
Excess supply If at a price market, supply is greater than market
demand, it is said that there is excess supply in the market at that
price.
Firm’s supply curve shows the levels of output that a profit-
maximising firm will choose to produce at different values of the
market price.
Fixed input An input which cannot be varied in the short run is
called a fixed input.
Income effect The change in the optimal quantity of a good when the purchasing
power changes consequent upon a change in the price of the good is called the
income effect.
Increasing returns to scale is a property of production function that holds when a
proportional increase in all inputs results in an increase in output by more than
the proportion.
Indifference curve is the locus of all points among which the consumer is indifferent.
Inferior good A good for which the demand decreases with increase in the income
of the consumer is called an inferior good.
Isoquant is the set of all possible combinations of the two inputs that yield the
same maximum possible level of output.
Law of demand If a consumer’s demand for a good moves in the same direction as
the consumer’s income, the consumer’s demand for that good must be inversely
related to the price of the good.
Law of diminishing marginal product If we keep increasing the employment of an
input with other inputs fixed then eventually a point will be reached after which the
marginal product of that input will start falling.
Law of variable proportions The marginal product of a factor input initially rises
with its employment level when the level of employment of the input is low. But after
reaching a certain level of employment, it starts falling.
Long run refers to a time period in which all factors of production can
be varied.
Marginal cost Change in total cost per unit of change in output.
Marginal product Change in output per unit of change in the input when all other
inputs are held constant.
Marginal revenue Change in total revenue per unit change in sale of output.
Marginal revenue product(MRP) of a factor Marginal Revenue times Marginal
Product of the factor.
Market supply curve shows the output levels that firms in the market produce in
102 aggregate corresponding to different values of the market price.
Monopolistic competition is a market structure where there exit a very large
Introductory Microeconomics
Glossary
Total variable cost The cost that a firm incurs to employ variable inputs is called
the total variable cost.
Value of marginal product (VMP) of a factor Price times Marginal Product of
the factor.
Variable input An input the amount of which can be varied.