II.

Microeconomics
2.1. Supply and Demand
2.1.1 Demand and supply functions, schedules and curves.
In economics, a desire for goods and services backed by the ability and willingness to buy those
goods and services in a given period of time is generally referred to as Demand.
Definition: Demand indicates the different quantities of a product that buyers are willing and
able to buy at various prices in a given period of time, other things remaining unchanged
(Ceteris Paribus). The definition stresses that:
1) The consumer is willing to have that product
2) The consumer should have the ability to buy the product and
3) Demand is time specific
Note that quantity demanded and demand are two different concepts. Quantity demanded refers
to a specific quantity that a consumer is willing and able to buy at a specific price. But demand
refers to the relationship between various possible prices of a product and the corresponding
quantities demanded for the product, other things remain unchanged.
A. Demand schedule, curve and function
The demand schedule is a table, which represents the relationship between the various prices of a
product and the corresponding quantities demanded, other factors remaining constant. See Table
2 below.
From the table below, we notice that as price continues to fall, the respective quantity demanded
increases, and vice versa. This inverse or negative relationship between price and quantity
demanded, holding other things constant, is called the law of demand.
Table 2: An individual household’s weekly demand for orange

Price Quantity demanded

per Kg per week
A 6 2
B 5 3
C 4 4
D 3 5
E 2 6
F 1 7

The law of demand states that all other things remain unchanged, as price of a product increases,
quantity demanded decreases, and as price decreases quantity demanded increases.

1
When the data presented in the demand schedule is depicted graphically, it is called a demand
curve. It shows how the quantity of a product varies as the price of the product changes.
By agreement, price is depicted on the Y-axis and quantity is depicted on the X-axis. The
negative slope of the demand curve reflects the law of demand.

The individual household’s demand for orange can also be expressed in the form of
mathematical equation, which is called the demand function.

1
Or P  f (Qd ) , which is known as inverse demand function

For example,

or P  8  Qd

B. Individual and market demand

The market demand is the total demand of all buyers of a product. The market demand schedule
or curve for a product is derived by horizontally adding the quantity demanded for the product
by all buyers at each price.

P P P P

3 + 3 + 3 = 3

2
5 Q 3 Q 5 Q 13 Q
Consumer 1 Consumer 2 Consumer 3
C. Determinants of Demand
The demand for a product is determined by
i) Price of the product
ii) Taste or preference of consumers
iii) Income of the consumers
iv) Price of related goods (substitutes and complements)
v) Consumer’s expectation of income and price
vi) Number of buyers in the market
The first determinant, price of the product, is known as own-price determinant of demand. The
remaining determinants (ii) – (vi), are known as non-own price determinants or demand shifters.
Change in quantity demanded and change in demand
For each price of a product, there is a corresponding quantity demanded. When the price of the
product changes, the corresponding quantity demanded the product also changes. Hence, a
change in quantity demanded as a result of change in the price of the product is represented as a
movement along a fixed demand curve.
A change in demand, on the other hand, refers to a change in the demand schedule or a shift of
the entire demand curve to a new location. This happens due to changes in one or more of the
non-own price determinants of demand like changes in income, taste, etc.
Effects of non-own price determinants of demand
1. Effects of changes in taste or preference
A favorable change in consumers’ taste causes an increase in demand, which is
represented by a right ward shift of the demand curve. The favorable change can be a
result of fashion change, or intensive advertisement. Unfavorable changes in taste, such
as scientific report about the negative impact of a product on health, on the other hand,
will reduce the demand for that product and cause the demand curve for the product to
shift to the left. (e.g. Queen Burger; lost its market because people got sick after eating
the burgers)
2. Effects of change in income
How changes in income affect demand depends on the nature of the product. For most
products, a rise in income causes an increase in demand and vice versa. Products whose
demand varies directly with income are called superior goods or normal goods. On the
other hand, there are some products whose demand decreases as consumers’ income
increases and vice versa. Such goods whose demand varies inversely with income are
called inferior goods. For example, cabbage, second hand shoes, etc

3
 3. Prices of related goods
A change in the price of a related good may either increase or decrease the demand for a
product depending on whether the related good is a substitute or a compliment.

 A substitute good is one that can be used in place of another good. If X and Y are
substitutes, an increase in the price of X leads to an increase in demand for Y, and
vice versa, other things being constant (e.g. Coke and Pepsi).

 A complementary good is one that is used together with another good like sugar
and tea. If X and Y are complements, then an increase in the price of X leads to a
decrease in the demand for Y and vice versa, other things being constant. For
example, a car and its tire,

 Unrelated goods are goods that are neither substitutes nor complements e.g.
automobiles and bananas.
4. Effects of change in consumers’ expectation of price and income
When consumers expect higher future price of a product, e.g. due to poor harvest in the
past rainy season, they would buy more today to avoid unnecessary expenditure in the
future. This causes an increase in current demand for the product and shifts the demand
curve to the right.
A change in the expectations concerning future income may also prompt consumers to
change their current spending, but its impact would depend on the nature of the product.
Expectation of higher income will induce consumers to buy more of a normal good but
less of an inferior good.
5. Effects of change in number of buyers
When number of buyers increases in a market, then the demand will increase. For
example, improvements in communications have increased the demand for stocks and
bonds due to an increase in the number of participants internationally. Population growth
in a country also increases the demand for food stuffs.
D. Supply schedule, curve and function
Supply indicates the various quantities of a product that sellers (producers) are willing and able
to provide at each of a series of possible prices in a given period of time, other things remain
unchanged. Like demand, supply can be represented by a schedule, curve or a function.
As opposed to demand, as price rises, the respective quantity supplied also rises and vice versa.
This direct (positive) relationship between the price of a product and quantity supplied, ceteris
paribus, is called the law of supply.

4
The law of supply states that, ceteris paribus, as price of a product increases, quantity supplied
of the product increases and as price decreases, quantity supplied also decreases. Price is an
obstacle from the standpoint of the consumer, who is on the paying end. The higher the price the
less the consumer will buy. But the supplier is on the receiving end of the product’s price. To a
supplier, price represents revenue which serves as an incentive to produce and sell a product. The
higher the price, the greater this incentive and the greater the quantity supplied.
i. Individual and market supply
The market supply schedule or curve indicates the total market supply of a product that all sellers
in the market are willing and able to provide in a given period of time. It is derived by
horizontally adding the quantity supplied of the product by all sellers at each price.
ii. Determinants of supply
The supply curve is drawn on the assumption that all factors except own price are fixed and do
not change. If one of them does change, a change in supply will occur and so the entire supply
curve will shift.
Basic non-own price determinants of supply are or supply shifters are:
1. Prices of inputs (resources)
2. Technology
3. Taxes and subsidies
4. Prices of related goods
5. Price expectations of sellers
6. Number of sellers in the market
7. Weather

5
1) Resource prices
Higher resource prices will raise production costs, and assuming a fixed product price, high
production cost squeezes profits. This reduction in profits reduces the incentive for firms to
supply output at each product price so that resource prices and supply are inversely related.
2) Technology
Improvements in technology enable firms to produce more units of output with fewer resources.
Because resources are costly, using fewer of them will lower production costs and increases
supply. Thus, if there happens to be technological progress, sellers would be willing and able to
produce and provide more of their product at each price than before. Therefore, technological
advancement shifts the supply curve outwards (to the right).
3) Taxes and subsidies
Businesses treat most taxes as costs. An increase in sales or property taxes will increase
production costs, hence will reduce supply. In contrast, subsidies are taxes in reverse. If the
government subsidizes the production of a good, it in effect lowers the producers’ costs and
increases supply.
4) Prices of related goods
Firms that produce a particular product, say, leather jackets, can sometimes use their plant and
equipment to produce alternative goods like leather shoes. The higher prices of these alternative
goods like leather shoes may induce leather jacket producers to switch production in order to
increase profits. This substitution in production results in a decline in the supply of leather
jackets.
5) Price expectations of sellers (expected selling price)
Changes in expectations about the future price of a product may affect the producers’ current
willingness to supply of the product. It is difficult, however, to generalize about how a new
expectation of higher prices affects the present supply of a product. Farmers expecting a higher
teff price in the future might withhold some of their current teff harvest from the market, thereby
“causing a decrease in the current supply of teff”. In contrast, in many types of manufacturing
industries, newly formed expectation that price will increase may induce firms to add another
shift of workers to expand their production capabilities, “causing current supply to increase”.
6) Number of sellers
Other things being equal, the larger the number of suppliers, the greater the market supply. As
more firms enter an industry, the supply curve shifts to the right and vice versa.
7) Weather conditions
A change in weather condition will have an impact on the supply of a number of products,
especially agricultural products. Other things being equal, good weather condition will increase
the supply of maize and so the curve shifts outward. That is, at each price, sellers are willing and
able to provide more maize than before. Bad weather will have the opposite effect.

6
2.1.2. Market equilibrium
Market brings supply and demand together to decide how the buying decisions of households
and the selling decisions of businesses interact to determine the price of a product and the
quantity actually bought and sold. We assume a competitive market – neither buyers nor sellers
can set the price.

The market demand and supply of maize per week

Market demand Price Market supply Surplus (+),

(in quintal) (per quintal) (in quintal) shortage (-)
400 120 1200 (+) 800
600 100 1000 (+) 400
800 80 800 0
1000 60 600 (-) 400
1200 40 400 (-) 800

Surpluses (+) or (Qs > Qd): Buyers can buy whatever amount they want to buy but sellers cannot
sell all they want to. For example, at the price of Birr 120 per quintal, sellers are willing and able
to supply 1,200 quintals per week but buyers are willing to purchase only 400 quintals leading to
a surplus of 800 quintals. Surplus is the excess of supply over demand. Surplus or unsold output
in the hands of the sellers increases the competition among sellers and this pushes the price
down.
Shortages (-) or (Qd > Qs): Buyers cannot buy what they want to buy, but sellers sell all they
want to sell. Hence buyers are dissatisfied, but sellers are satisfied. Let’s jump to Birr 40 per
quintal. This lower price encourages buyers to buy more but discourages sellers of maize. Buyers
are willing and able to purchase 1200 quintals while sellers are ready to sale only 400 quintals.
This results in a shortage of 800 quintals. Shortage is the result of excess demand over supply.
The existing level of shortage creates competition among buyers and this pushes the price up.
Equilibrium price and quantity (Qs = Qd): Competition between buyers and sellers drives price
to be equal at birr 80, where total quantity demanded is equal to total quantity supplied i.e. the
total market demand equals the total market supply. At this price, there is neither shortage nor
excess supply. Economists call this price the market clearing or equilibrium price, where
“equilibrium” means “in balance” or “at rest”. At birr 80, quantity supplied and quantity
demanded are in balance at the equilibrium quantity of 800. Equilibrium quantity is the quantity
which is actually bought and sold at the equilibrium price.

7
The equilibrium price and equilibrium quantity can also be shown graphically.
S
Surplus

100 •

80 •

60 •
Shortage
40 •
D
20 •
• • •

600 800 1000

Graphically, the intersection of the supply curve and the demand curve indicates the market
equilibrium for that product.
Mathematically:
Assume that there are 200 identical buyers of wheat in a market with an individual demand
function of Qdw  8  Pw , ceteris paribus, where Qdw is quantity demanded for wheat by
individual buyer and Pw is price of wheat. There are also 100 identical sellers of wheat with an
individual supply function of Qsw  2 Pw , other things being constant, where Qsw is quantity
supplied of wheat by individual seller and Pw is price of wheat.

Question: Formulate the market demand and supply functions and calculate the equilibrium price
and quantity.

Changes in Supply, Demand and Equilibrium

i. When demand changes while supply remaining unchanged

a. When demand increases

 Demand curve shifts to the right

 Equilibrium price increases
 Equilibrium quantity increases

b. When demand decreases

 Demand curve shifts to the left

 Equilibrium price decreases
 Equilibrium
8 quantity decreases
 ii. When Supply changes while demand remaining constant
a. When supply increases

 Supply curve shifts to the right

 Equilibrium price decreases
 Equilibrium quantity increases

b. When supply decreases

 Supply curve shifts to the left

 Equilibrium price increases
 Equilibrium quantity decreases

iii. When both demand and supply change

a. When Demand increases and supply decreases

In all cases, equilibrium price increases. But the impact on equilibrium quantity is indeterminate.
i.e. it is determined by the extent of changes (shifts) in demand and supply.
b. When demand decreases and supply increases
In this case equilibrium price will decrease and that of quantity remains indeterminate. (Show)
c. When both supply and demand increase
Equilibrium price will be indeterminate while equilibrium quantity increases. (Show)
d. When both demand and supply decreases
Equilibrium price will be indeterminate while equilibrium quantity decreases. (Show)

9
1 Summary of the analysis:

Supply
Increase
No change
Decrease
Increase
P? Q 
P Q
P  Q?

2.1.3. Elasticity of Demand and Supply

Price elasticity of demand (ed):

a good.

Mathematically,

=
Demand
No change
P Q
P Q
P Q

Where, Q and P are original quantity demanded and price respectively.

Decrease
P  Q?
P Q
P? Q 

The law of demand simply states that quantity demanded decreases (increases) as price of goods
and services increases (decreases). It, however, says nothing about the magnitude of change in
quantity demanded. The extent of change in quantity demanded is embedded in the concept of
elasticity.

Elasticity is a measure of responsiveness of quantity demanded to changes in the price of a good.

It is simply the percentage change in quantity demanded for a one percent change in the price of

When elasticity is computed, changes in quantity and prices are expressed as percentages. Hence,
the elasticity value is unit free, i.e., it doesn’t depend on unit of measurement.

Example: When price of wheat falls from 4 birr to 2 birr, the quantity demanded rose from 6 to 8
quintals. Find elasticity.

10
Ans:

N.B. – Price elasticity of demand is negative because of the law of demand.

- Conventionally, we ignore the sign by taking in absolute terms

Classification of price elasticity of demand

Price elasticity of demand can be classified into elastic, inelastic and unitary elastic.

1. Elastic demand ( demand is said to be price elastic if the price elasticity

of demand is greater than unity (one). That is, the percentage change in quantity
demanded exceeds the percentage change in price. In other words, if the price elasticity
of a good is greater than one, then demand is termed as price elastic,

This implies that change in price of a good has greater effect on quantity demanded. Quantity is
sensitive to changes in price. e.g. luxurious goods have elastic demand

The demand for a product may be perfectly elastic. This means that a minute change in price of a
good will result in an infinitely large change in quantity demanded. The demand curve for such
goods is horizontal implying that a small change in price will lead to an infinitely large change in
quantity demanded.

A small change in price will lead to larger (infinite) changes in quantity demanded

2. Inelastic demand ( : If the price elasticity of demand has been zero and one
(zero included), then demand is said to be price inelastic.
Formally,

11
When demand is inelastic, a change in price has little impact on quantity demanded. That is,
demand is weakly responsive to changes in price.

Price elasticity of demand may be perfectly inelastic. Under such situation, the demand curve
would be vertical. Demand is completely non-sensitive to changes in price.

The vertical demand curve indicates that if price changes, there will be no change in quantity
demanded. That is, no matter what the change in price, demand remains the same.

Example: demand for insulin

3. Unitarily elastic demand ( ): If the price elasticity of demand is equal to one,

then demand for a good is said to be unitary elastic.
Formally,

In other words, the percentage change in quantity demanded equals the percentage change in
price.

Example: If 200% increase in price of a good decrease the quantity demanded by 200%, demand
will be unitary elastic.

Summary

Elasticity Classification Interpretation

Inelastic (
Unitary elastic (

12
 Elastic

Determinants of Price Elasticity of Demand

What determines the price elasticity of demand for a product?
a) Availability of substitutes:
In general, the more and better substitutes exist for an item, the more elastic its
demand will be. A perfectly elastic demand has many perfect substitutes. On the
contrary, a perfectly inelastic demand has virtually no substitutes.
Example, demand for taxi service (of one driver).
b) Proportion of income consumers spend on a commodity:
If consumers spend a large proportion of their income on a given item, then that item
has price elastic demand.
e.g. Food in large family (with so many children), i-pod, etc.

On the other hand, if consumers spend less of their income on a particular item, then
the demand for that item is inelastic. Example, Matches, salt, etc.
c) Adjustment time
Demand tends to be more elastic with longer time over long periods; consumers will
have more time to adjust their consumption patterns in response to price changes,
that, is, find substitutes.
Example, A permanent increase in price of gasoline leads to development of
substitutes (solar, thermal, etc.) energy sources. But in shorter period, it is difficult to
develop substitutes.
d) General Vs Specified
The more narrowly defined the product, the greater the number of substitutes and the
higher the elasticity of demand. Example, Pepsi Vs soft drinks, Chevrolets Vs
automobile, taxi Vs transport service, etc.

Calculating Price Elasticity of Demand

Price elasticity of demand can be measured at a point or between two points.
a) Point elasticity: is elasticity measured at a single point or for arbitrarily small
changes.

with both distances measured along the demand curve.

Example
P
A

C 13
=

E
=
O F B Q
 Q P
d  .
P Q
Q EC OF
but  
P AE AE
P OE

Q OF
OF OE OE CF
d  .  
AE OF AE AE
But the triangles AEC and CFB are similar
CF CB
 
AE AC
CB
 d  This is applicable if you have the demand function for some good X or at
AC
least the demand curve for some given level of price and quantity, i.e.
1 P
d  . 
Slope  Q 
b) Arc elasticity: It is an elasticity measured between two points on a demand curve.
Elasticity is defined as:

The quantities are easy to define (as and

. But the question arises as to what values of Q and P we use. Are

we supposed to take the beginning or final values or some average?
The most convenient way is to use the average of the initial and final values.
Example 1: Let the initial point be ( and final point ( , then

This is the formula to find arc elasticity of demand between 2 points.

14
Geometrically:

Q2  Q1  P1  P2 
Arc _  d  . 
P2  P2  Q1  Q2  A
P2
N.B. As the gap between point A and B approaches
P1 B
zero, arc elasticity becomes closer to point
elasticity.
Example 2: Suppose that the price of a quintal ofQwheat
Q1 rises from 200 BirrQto 300 Birr and as a
2
result the quantity of wheat demanded declined from 100 to 90 quintals.

Given: (Q1, P1) = (100, 200) and (Q2, P2) = (90, 300)
Q P 90  100 200  300 10 500 5
Arc  d  
P Q

300  200

100  90
 
100 190

9 (show for what would be if we
use initial or final price and quantity).
Price Elasticity of Demand and Slope

The slope of the linear demand curve is constant from point to point, with Slope  P Q .

However, since Q is not constant, the demand elasticity will be different at different points on
P
the non-linear demand curve.
Example: The quantity demanded is related to price by the following equation:
Q d  a  bP For all a, b > 0

1
Slope  P  1 
Q Q b
P

1 P  P   bP
d     b 
Slope Q  a  bP  a  bP

Exercise: Q d  10  2 P. Calculate price elasticity of demand at prices of 2 and 4, and show that
the above formula holds.
Price Elasticity of Demand along the Demand Curve

15
Price elasticity of demand varies continuously along a linear demand curve. It will be higher at
higher price (lower output), equal to one at the mid point of a demand curve and it will be lower
at lower price (higher output) levels.

E
Graphically:

N.B Elasticity is the ratio of the distance

M
from point F to Qc (point on the demand
curve) to the distance between E and the
point on the curve.

Price Elasticity of Demand and Total Revenue and Expenditure

Total expenditure (TE): is the product of the amount of goods and services purchased and their
price during a given time period. i.e.
TE  P  Q

Total revenue (TR): is the amount sold multiplied by the price over a given time period. i.e.,
TR  P  Q

Note: Expenditure by buyers represents revenue for sellers.

Example:

Price Quantity TE=TR Change in

TR (=MR)
A 12 1 12
B 10 2 20 8
C 8 3 24 4
D 6 4 24 0
E 4 5 20 -4

The Effect of Price Change on Total Expenditure and Total Revenue

What will happen to TR/TE when price changes? The increase in price increases total consumer
expenditure by increasing the P component of PQ. But the law of demand indicates that as price
increases, quantity demanded will decrease, i.e. the Q component of PQ declines as P increases.
Hence, we have two opposing forces acting on TR/TE (= PQ) as price increases. The net effect
of price increase on PQ depends on price elasticity of demand, which tells us about the relative
magnitude of the two effects.

16
 a) Inelastic Demand: When demand is price inelastic, the percentage reduction in quantity
demanded lowered by the price increase would be smaller than percentage increase in
price (%ΔQ < %ΔP). This shows that the upward influence of price increase on total
expenditure is stronger than the downward pressure of the reduction in quantity
demanded on revenue/expenditure.
 P   TR/TE (= PQ) 

 P   TR/TE (= PQ) 

i.e. the net effect of price increase on TR/TE is increase and the net effect of price
decrease on TR/TE is a decline.
b) Unit Elasticity of Demand: When demand is unitary elastic, any given percentage
increase in price will result in exactly an equal percentage reduction in quantity
demanded. In other words, the upward force equals the downward force and the net effect
would be no change in total revenue/total expenditure (as %ΔQ = %ΔP)
 P  or P   no change/effect on TR/TE
c) Elastic Demand: When demand is price elastic, the percentage reduction in quantity
demanded caused by price increase would be greater than the percentage increase in price
(%ΔQ > %ΔP). This implies that the upward pressures on total revenue/total expenditure
caused by price increase would be more than off-set by the downward pressure on total
revenue/total expenditure resulting from the reduction in quantity demanded.
 P   TR/TE (= PQ) 

 P   TR/TE (= PQ) 

In summary, the net effect of price increase and decrease is:

Price elasticity Implication Effects on TR/TE

of demand Price increase Price Decrease

Elastic %ΔQ> %ΔP (-) (+)

Unitary elastic %ΔQ= %ΔP (0) (0)
Inelastic %ΔQ< %ΔP (+) (-)

Marginal Revenue (MR) is a change in total revenue when the quantity sold changes by a small
amount. That is:
TR
MR 
Q

17
 dTR d ( P.Q )
 
dQ dQ
QdP  PdQ

dQ
dP
 P Q
dQ

dQ Q Q dQ dP P
But we know that   dP P   . P  dP  dQ   .Q

Using this result in the above analysis will give us:

 P 
MR  P  Q 
  .Q 

 1 
MR  P1 
  

We can establish the relationship between total revenue and elasticity of demand as:

1. If  d
> 1 (elastic), MR > 0 and total revenue will be increasing

2. If  d
< 1 (inelastic), MR < 0 and total revenue will be decreasing

3. If  d
= 1 (unitary elastic), MR = 0 and total revenue will not change.

Other Elasticity Concepts

Elasticity can be defined with respect to any two related variables. There are two more important
elasticities of demand, namely, income elasticity of demand and cross-price elasticity of demand.

a) Income elasticity of demand (  y ): It measures the sensitivity of consumer purchases for

a given percentage change in income, ceteris paribus. It can be defined as:
Q Y
y   , where Y = income and Q = quantity demanded.
Y Q

 y measures the percentage change in the number of units of a good demanded, when
income changes by one percent, ceteris paribus.

Example:  y = 2.3 implies a 1% increase in income leads to a 2.3% increase in quantity

demanded, ceteris paribus.

When computing  y , we don’t take it in absolute term since its sign is of interest. Income
elasticity of demand could be positive or negative.

18
 i. Positive income elasticity: Positive income elasticity indicates that increases in
income are associated with increase in the quantity of goods purchased. Those
goods with  y > 0 are normal/superior goods.

Normal goods are also further classified into necessities and luxuries. A good is said to be
necessity if its income elasticity is positive and less than one, i.e.

0< y <1

e.g. the demand for injera

This means that the quantity demanded for a product increases when income increases,
but less than proportionately. People will spend a similar fraction of their additional
income on such goods.

If income elasticity of demand exceeds one, the good is called luxury good, i.e. if  y >
1, then this means people will spend a larger fraction of their income on luxury items.
ii. Negative income elasticity: A negative income elasticity of demand indicates an
inverse relationship between income and the amount of the good purchased.
Goods that have negative income elasticity of demand are called inferior goods.

b) Cross-Price Elasticity of Demand (  y. P ): X

It is used to measure the sensitivity of consumer purchase of one good to changes in the
price of another good.
Example: The elasticity of demand for good Y with respect to the prices of good X
measures the responsiveness of demand for Y to a change in the price of X and
is defined as:
QY PX
 y.P  
X
PX Q y

Example: A cross-price elasticity of  y. P = -1.4 means that a 1% increase in the price

X

of good X leads to a 1.4% reduction in the demand for good Y.

Again the sign of the elasticity is important. A positive cross-price elasticity of demand means
that an increase in PX leads to an increase in the demand of good Y (or decrease in quantity
demanded of good X), ceteris paribus. Hence, the two goods are substitutes.
A negative cross-price elasticity of demand, on the other hand, implies that an increase in PX
causes a reduction in quantity demanded of good Y. Hence, the two goods are complements. (e.g.
tea and sugar, shoe and socks, etc.)
Note: Two goods (X and Y) have two cross-price elasticities;

i)  y p x - elasticity of demand for Y with respect to PX

19
 QY PX
 y px  
PX Q y

ii)  x. p y - elasticity of demand for X with respect to PY

Q X PY
 x. p y  
PY Q X

These two elasticities need not be equal. If cross-price elasticities are zero (  y p x =  x. p y = 0),
then the two goods are independent/unrelated.

Price Elasticity of Supply (  S )

The law of supply simply tells us that as price increases or decreases, the quantity supplied will
increase or decrease, respectively. But the law doesn’t tell us anything about how much does
quantity supplied increase or decrease as price increase or decrease by a given amount. Supply
elasticity tells us about the magnitude of change in quantity supplied as price changes.
Definition: The price elasticity of supply is a number used to measure the sensitivity of change in
quantity supplied to a given percentage change in the price of a good. Alternatively, it can be
defined as the percentage change in quantity supplied resulting from a 1% change in price,
ceteris paribus. That is:

%Q s Q s P
s   
%P P Q s

 s is always positive  no need for absolute value sign.

Classification of Price Elasticity of Supply: it can be classified into elastic, inelastic or unitary
elastic.

i) Elastic supply: If  s is greater than one, then supply of an item is said to be elastic
(i.e.,  s >1).

Supply of an item may be perfectly elastic. The shape of elastic supply curve is
horizontal.
 s → ∞ i.e. a small change in price will lead to an infinite change of quantity supplied by
firms.
P

20
ii) Inelastic supply: If the price elasticity of supply is equal or greater than zero but less than one,
then supply is said to be price inelastic (i.e., 0 ≤  s < 1).

Price elasticity of supply may be perfectly inelastic, i.e.  s = 0, which is completely

unresponsive to price change.
P

iii) Unitary Elasticity of Supply: If the price elasticity of supply is equal to one (  s = 1), then
supply is said to be unitary elastic.
Q

Determinants of Elasticity of Supply:

i. Time
ii. Availability of factors of production (resources)
iii. Possibility of switching production to other products

2.2. Utility and Consumer Equilibrium

2.2.1. Utility and Equilibrium in Consumption
A consumer buys goods and services because it has utility to him/her. Utility is the amount of
satisfaction to be obtained from a good or service at a particular time. Utility has nothing to do
with usefulness nor does it have any ethical connotation. Moreover, utility of a good varies from
person to person.
There two approaches to the measurement of utility: the cardinal and ordinal approaches.
According to the cardinal approach, utility can be measured and its unit of measurement is ‘util’.
In the ordinal approach, on the other hand, utility cannot be measured but it can be compared.
Following the cardinal approach and assuming that the consumer consumes different goods and
services, the total utility (U) is the sum of utilities obtained by consuming the various units of
goods and services. i.e.

U  U 1  U 2  ...  U n
where q is quantity purchased.
 f 1 (q1 )  f 2 (q 2 )  ...  f n (q n ) ,

The additional satisfaction received over a given time period by consuming one more unit of a
good is known as marginal utility (MU).
A rational and utility maximizing consumer consumes goods and services in order of their
utilities. Consumer equilibrium is established when the marginal utilities per money spent are
equal on each good purchased and his/her money income available for the purchase of the goods
has been used up completely. That is:

21
 MU A MU B
  ...
PA PB

Provided that:
PA Q A  PB Q B  ...  Y

Where, MUA – marginal utility of good A and MUB – marginal utility of good B
PA – price of A and PB – price of B
QA – quantity of A and QB – quantity of B
Y – Consumer income.
Law of Diminishing Marginal Utility
The law of diminishing marginal utility states that the marginal utility of a good declines as more
of it is consumed, over any given period. For example, if a consumer drinks five bottles of cock,
the amount of utility obtained from drinking the second bottle is less than that of the first; the 3 rd
is less than that of the 2nd and so on.

Total Utility Marginal utility

TU

Q Q
MU

2.2.2. Indifference Curves: An introduction

In the indifference curve analysis the emphasis is on comparing different utility levels
instead of measuring them through cardinal scale. An indifference curve is a locus of points
each showing a different combination of two goods which yield the same satisfaction to the
consumer. For example the table below shows combination of two goods, good A and good
B, between which a consumer is indifferent.

Combination Units of good A Units of good B

A 24 4
B 12 8
C 8 12
D 6 16

22
 E 5 20

Moving from one combination to another, the consumer is substituting one good for the other but
maintaining a constant level of utility derived from them. The rate at which the consumer
substitutes one good for the other so as to remain equally satisfied is the slop of the indifference
curve. It is known as the marginal rate of substitution:

Q A
MRS BA   , Marginal rate of substitution of B for A.
Q B

Characteristics of indifference curves

a. An indifference curve slopes downward from left to right
b. An indifference curve is convex to the origin
c. Indifference curves do not intersect nor they are tangent to one another

QB
Indifference curves by themselves cannot tell us which combination is to be chosen. In addition
to his/her desire, the consumer must have the capacity to pay for the goods. The consumer’s
capacity which is indicated by the budget lineI is determined by his/her income and the prices of
the goods. 3
I2
I
Budget line: Y  PA Q A  PB QB . The 1budget line divides the area between quantity of A and
QA
quantity of B axes into feasibility area and non-feasibility area.

 E Budget line

QB

The utility maximization rule

23
I
QA
Consumer equilibrium is established on the highest attainable indifference curve. For example, in
the figure above consumer equilibrium is at point E. At this point, the slope of the highest
attainable indifference curve is equal to the slope of the budget line. This is so because the
indifference curve and the budget line are tangent to each other.

MU B PB
 
MU A PA

Consumer Surplus
Consumer surplus is the difference between what a consumer pays for some good or service and
what s/he would have been willing to pay. The price a consumer pays for a good measures only
the MU but not the total utility. Only for the marginal unit which a consumer is just ready to pay
a price is exactly equal to the satisfaction that s/he expects to get for that unit.
2.3. Theory of Production and Costs
2.3.1. Theory of Production
Theory of production shows how economic resources are combined to produce commodities. In
economics, the process by which inputs or factors of production (such as labour, capital, etc.) are
combined, transformed and turned into outputs is called Production.
An input is any good or service, such as labour, capital, land and entrepreneurial ability that
contributes to the production of a product. The produced product is called output.
Output can be produced in different ways:
i) Labour intensive technology: a technology that relies heavily on human labor rather than
capital. e.g. large number of farmers using small shovels to cultivate five hectares of land.
ii) Capital intensive technology: a technology that heavily relies on capital than human
labor. e.g. three farmers cultivating five hectares of land using different machines.
In production activity there is a certain kind of relationship between inputs and outputs. And the
relationship between any combination of inputs and the maximum output obtainable from that
combination, expressed mathematically, is called a Production Function. It is a technical
relationship that summarizes the land of technology for producing an output.

Mathematically: y  f ( L, K ) where y = output, L = labour and K = capital.

Tabular representation of production function:

Labour units Total product Average product

0 0
1 10 10
2 25 12.5

24
 3 35 11.67
4 40 10
5 42 8.4
6 42 7

The Short Run and the Long Run

A firm uses various inputs (factors of production) in a production process. And depending on the
duration of the time considered, inputs are categorized as fixed and variable inputs.

 Fixed Inputs: are those factors of production for which the supply can not be changed
over a short period. Thus, fixed inputs are inputs which do not change in quantity when
output changes in a given short period. (e.g. Buildings, machineries, etc.)

 Variable Inputs: are inputs for which the supply can change in response to the desired
change in output in a short time. These inputs change in quantity to achieve change in
output. (e.g. labour)
The distinction between the two inputs is the time that is under consideration. We have two
different periods:
 Short Run: is a period of time for which the firm is operating under a fixed factor of
production. During this period, at least one input is fixed. In the short run, production can
be changed by changing only variable inputs, but not fixed inputs. The firm’s plant
capacity is fixed in the short run, but output can be varied by applying larger or smaller
amounts of variable inputs. In the short run, there is a limit to production because there is
only limited plant capacity available.
 Long Run: is a period extensive enough for firms to change the quantities of all
resources or inputs employed, including plant capacity. It is a period of time for which
there are no fixed factors of production.
Note: the short run and the long run are conceptual rather than specific calendar time periods.
The actual period of time encompassing the long run is likely to vary from industry to industry.
e.g. some producers might be able to increase all of their inputs in a month and some might take
years to increase the capital inputs required to produce more output.

Production in the Sort Run

Production in the short-run is characterized by the use of some variable inputs and some fixed
inputs. Based on the assumption that some inputs, like capital, are fixed in the short run, the
relationship between inputs like labour and total output can easily be established.
Total product (TP): is defined as the total quantity of product produced during some period of
time by all factors of production employed over that period of time.

25
Total product curve describes the relationship between the variable input and output, with fixed
amount of the other inputs and under current technology.

L
Average Product (AP) is the average amount of output produced by each unit of the variable
input.
Total _ Pr oduct TP
APL  
Total _ Labor L

Average product curve shows the relationship between the average product and the variable
input.

It indicates the productivity of labour

(workers). APL initially increases, reaches
maximum and then decreases but it
never reaches zero.

Marginal Product (MP) is the increase in total output resulting from employment of small
amount of the variable input.

Change _ in _ total _ product TP

MPL  
Change _ in _ amount _ of _ labor L
Marginal product curve:

26
 MPL initially increasing reaches a
maximum and declines to zero, even to
negative values.

Consider the information in the table below.

Total product increases at an increasing rate up to three units of labour (Stage I), in Stage II (i.e.
for labor units 4 to 9) total product increases at a decreasing rate and finally output declines in
Stage III. When the 9th labor is employed, the rate of increase in output is zero and total product
is at its maximum.

Unit of TPL APL MPL Stages of

labour production
0 0 - -
1 8 8 8
2 20 10 12 Stage I
3 39 13 19
4 52 13 13
5 60 12 8
6 66 11 6
Stage II

7 69 9.9 3
8 71 8.9 2
9 71 7.9 0
10 68 6.8 -3
Stage III

Relationship between Total Product and Marginal Product

MP is the change in TP divided by change in labor. This means that MP is the slope of TP curve.
The TP first increases, reaches maximum and then declines. This is called the law of diminishing
returns or the law of diminishing marginal productivity. (This law starts to effect from the
maximum point of MP, i.e. the law applies for the decreasing portion of the MP curve)
This law states that, holding other inputs constant, as variable input is in increased with equal
amount, eventually, the addition to total product will decline.
Additional workers will have less of the other inputs, like machines, than earlier workers who
had access to ample quantities of the other inputs.

27
1 The relationship between TP and MP is:
 If MP > 0, TP will be rising as labor rises. The additional worker adds something to the

APL 
total output.
 If MP = 0, TP will be constant as labor increases. The additional worker does not affect
output.
 If MP < 0, TP will be falling as labor increases. The additional worker actually reduces
total output.
The point where MP stops increasing and starts decreasing is called inflection point, because the
curvature of the TP curve changes at this point. It is here that diminishing returns starts.
AP curve and its relation to MP and TP curves
Total Pr oduct TP
Total Labor

L

Average product of a variable input is represented by the slope of a ray drawn from the origin to
a point on the total product curve, corresponding to the given amount of the variable input.

As we increase labor use from 0 units to a, to b and to c units, the lines from the origin to the
corresponding points on the TP curve first become steeper, i.e. AP increases, and eventually
flatter, meaning AP will be decreasing. The maximum point on the AP curve corresponds to the
slope of the ray from the origin which is tangent to the TP curve.
Remember that marginal product of a variable input is measured by the slope of the tangent line
to the total product curve corresponding to the given amount of the variable input. This is
because; by definition the marginal product of a given amount of input is the change in output as
the variable input changes by a small amount.
So, when AP is maximum, then it is equal to the MP. Then the AP declines as we employ more
and more variable inputs beyond this tangency point (MP = AP).
Stages of Production
Based on the behaviors of MP and AP, production can be classified into three stages:

28
 Stage I: MP > 0, AP is rising. Thus MP > AP
Stage II: MP > 0 but AP is falling. MP < AP but still TP is increasing due to MP > 0.
Stage III: MP < 0, TP is falling.
No profit maximizing producer would produce in stages I and III. In stage I, by adding more
units of labor, the producer can increase the average productivity of all the units. Thus it would
be unwise on the part of the producers to stop production at this stage.

 Point A is inflection point

where MP is maximized

 Point B is where AP is
maximized, hence AP = MP

 At point C, TP is maximum
and MP = 0

In stage III, it does not pay for the producers to be in this region because by reducing the labour
unit, a producer can increase total output and save the cost of production. Hence, the
economically meaningful range is Stage II.

2.3.2. Theory of Costs

Economic Cost is the monetary value of all inputs used in a particular activity or enterprise over
a given period to make goods or services available to users.
The idea behind economic cost of any resource in producing a good is that it must reflect the
value of those resources in their best alternative uses i.e. opportunity cost.
Economic cost can be either explicit or implicit.

29
Economic cost = Explicit cost + Implicit cost
Implicit costs are the values of inputs which are owned by the businessmen.
Explicit costs are the monetary payments or cash expenditures that a firm makes to outsiders
who supply inputs.
Accounting Costs are the explicit costs of operating a business (the actual payments that are
made).
Due to the different explanation of costs, economists and accountants use the term profit
differently.
Accounting profit = Total revenue – explicit cost
= Total revenue – Accounting cost
Economic/pure Profit = Total revenue – Economic cost
= Total revenue - Opportunity cost of all inputs (implicit and explicit)

Costs in the Short-run

In the short-run some resources are fixed and others are variable. This implies that in the short
run, costs can be classified as either fixed or variable.
Fixed costs are costs that do not vary with changes in output.
Suppose you are earning 22,000 birr a year as a sale representative for a T-shirt manufacturing.
At some point you decided to open a retail store to sell T-shirts on your own. You must invest
20,000 birr of your saving that has been earning an interest of 1000 birr per year. And you
decided to pay 18,000 birr for a clerk.
A year after you open the store, you total up your account and find the following.
Total sales revenue -------------------120,000
Cost of T-shirt --------------------- 40,000
Clerk’s salary --------------------- 18,000
Utilities --------------------------- 5,000
Total (explicit) cost ---------------- 63,000
Accounting profit ------------------ 57,000
Question: Calculate the economic profit assuming that your entrepreneurial talent is worth 5,000
birr.

30
Normal Profit Vs Economic Profit (Pure Profit)
The 5,000 birr is implicit cost of your entrepreneurial talent in the above example, called a
normal profit. The payment you could otherwise receive for performing entrepreneurial function
is called a normal profit and is an implicit cost. To the accountant, profit is the firm’s total
revenue less its explicit costs.
To the economist, economic profit is total revenue less economic costs including the normal
profit. If a firm’s total revenue exceeds all its economic costs, any residual goes to the
entrepreneur. The residual is called economic profit or pure profit.
Total fixed cost is the same both at zero level of output and all other levels of output.
e.g. building
Fixed costs can not be avoided or changed in the short run.
Firms have no control over fixed costs in the short run and hence they are some times called sunk
costs.
Variable costs are costs that change with the level of output in the short run.
The total variable cost is the market value of the minimum quantity of the variable inputs
consistent with the prevailing technology and factor prices required to produce the various
quantities of output.
Various costs can be controlled or altered in the short run by changing production levels.
Therefore, in the short run fixed costs and variable costs together make up total costs.
TC = TFC + TVC
The total cost function: TC = TFC + V (Q)
Cost function expresses the relationship between cost and the corresponding output.

Total Fixed, Total Variable and Total Cost Curves

Total fixed cost curve: is a graph that shows the relationship between total fixed cost and the
firm’s output.
Since total fixed cost is constant in the short run, it is always a horizontal, straight line.
Total variable cost curve: is a graph which shows the relationship between total variable cost
and the level of a firm’s output.
Since more output costs more in total than less output, total variable cost curve has a positive
slope.
Total Variable Cost always starts at the origin and rises to the right first at a decreasing rate and
then at an increasing rate. This is due to the law of diminishing returns in the short run, as the
firm increases production larger and larger amounts of variable input are needed to produce each
successive units of output.
31
Total cost curve: is a graph that shows the relationship between total cost and the level of a
firm’s output.
 At zero units of output total cost is equal to the firm’s fixed cost. And then for each unit of
output total cost varies by the same amount as variable cost. As a result the total cost curve
begins from the level of the fixed cost and moves parallel with the total variable cost curve.

32
 Output FC VC TC
TC
0 200 0 200
Cost
TVC 1 200 50 250

2 200 90 290

3 200 120 320

4 200 140 340

5 200 150 350

TFC 6 200 156 356

7 200 175 375

Output 8 200 208 408

Average costs
Average costs are important as we may make comparisons with product price, which is always
stated on per unit basis.
Average fixed cost (AFC): is found by dividing total fixed cost by the level of output.
TFC
AFC 
Q

Since total fixed costs are constant or independent of output, average fixed cost will continuously
decline as long as output increases.
Average variable cost (AVC): is obtained by dividing total variable cost by the level of output.
TVC
AVC 
Q

Since total variable cost reflects the law of diminishing returns, so must the average variable cost
because average variable cost is derived from total variable cost.
Due to increasing returns, initially it takes fewer and fewer additional variable resources to
produce each of the first few units of output.
After AVC hits minimum it will start to rise as diminishing returns require more and more
variable resources to produce each additional unit of output.

AVC is U-shaped.

33
Average total cost (ATC): is total cost divided by total output.
TC
ATC 
Q

TC TVC TFC
ATC = AVC + AFC   
Q Q Q

ATC
Average AVC
cost

Diminishing returns
The reason behind the shape of ATC and AVC lies in the shape of the marginal product curve.
At first, marginal product is increasing, i.e. smaller and smaller increase in the amounts of
variable resources is needed to produce successive units of output. Hence, the variable cost of
successive units of output decreases.
But as diminishing returns are encountered, marginal product begins to decline, larger and larger
additional amounts of variable resources are needed to produce successive units of output. Total
variable cost increases by increasing amounts. AFC

The shape of ATC, AFC and AVC Unit of

output
Output (Q) AFC AVC ATC

1 200 50 250
2 100 45 145
 As AFC = TFC/Q and TFC is fixed, AFC
3 66.7 40 106.7 declines continuously as output expands.
 ATC always exceeds AVC due to the fact that
4 50 35 85
ATC = AVC + AFC and AFC is always
5 40 30 70 positive. However, since AFC falls
ATC as output
Averageincreases, AVC and ATC get closer asAVC output
6 33.3 26 59.3 cost rises.
 AVC first declines, reaches a minimum and
7 28.6 25 53.6 then starts increasing.
8 25 26 51
The Relationship among MC, AVC and ATC

34 AFC
Unit of output
MC is the extra cost of producing one more unit of output.
 The MC curve intersects both the AVC and ATC curves at their minimum points.
This relationship is a mathematical necessity. If the MC is below ATC, ATC will decline
towards MC.
If MC is above ATC, ATC will increase, i.e. ATC, always moves towards MC. As a result, MC
intersects ATC at ATC’s minimum point. By the same reason MC intersects AVC at AVC’S
minimum point.
No such relationship exists for the MC and the AFC curves because the two are not related. MC
includes only those costs which change with output, and FC and output are independent.
 The average variable cost reaches its minimum before the average total cost because of
the inclusion of average fixed cost.

MC
ATC
AC, MC AVC

TC
MC 
Q

Note that TC = TFC + TVC

∆ TC = ∆TFC + ∆TVC
AFC
TC TFC TVC
MC    Unit of output
Q Q Q

TVC
MC  (Because ∆TFC/∆Q = 0, since ∆TFC = 0)
Q

 If MC < ATC, then ATC is falling

 If MC > ATC, then ATC is rising, i.e. ATC = MC at minimum ATC
 If MC < AVC, then AVC is falling
 If MC > AVC, then AVC is rising, i.e. AVC = MC at minimum AVC
This implies that MC intersects both ATC and AVC at their minimum points.

35
Relationship between cost and production

 Average total cost and marginal cost curves are U-shaped.

 Average product and marginal product curves have inverted U-shape.
 The additional cost of production of a good is lowest at the output level where the
additional product of the variable input is maximum, MPmax  MC min
 Similarly, the average variable cost is minimum when the average product of the
variable input is maximum, APmax  AVC min
 Thus, MC and AVC curves are mirror images of the MP and AP curves, respectively.

TP

AP
L
MP
C

MC AC

Q
Consider a single variable factor; labor (L) and all other factors are fixed. The wage rate is given
by ‘w’ and it is constant.
TVC = w.L
AVC = TVC/Q
= w.L/Q (since TVC = w.L)
AVC = w (L/Q)
This shows that AVC and APL are inversely related. As AP increases (decreases), AVC decreases
(increases).

36
Remember that APL = Q/L and L/Q = 1/APL
AVC= w/ APL
Again note that: ∆ TC = ∆TVC, since ∆TFC = 0
∆TC = ∆(w.L)
∆TC = w. ∆L
TC TVC w.L
MC   
Q Q Q

Q L 1
But L  MPL  Q  MP
L

w
 MC 
MPL

This also implies that MC and MP are negatively related. As MP increases (decreases) MC
decreases (increases).

2.4. An overview of Market Structures

Market structures are classified into: Pure competition, pure monopoly, Monopolistic
competition and Oligopoly.
This division of markets is based on:
1) The number of firms in the industry;
2) Product differentiation/standardization;
3) Ease of entering and exit into the market.
Definitions of the different market structures:
a) Pure competition: it involves large number of small firms producing standardized
product. Entry and exit are free
b) Pure monopoly: is where a single seller is the sole supplier of goods and services. Entry
is blocked and there is no product differentiation.
c) Monopolistic competition: is characterized by a relatively large number of sellers
producing differentiated products. There is non-price competition through product
differentiation. Entry and exit is quite easy.
d) Oligopoly: involves only a few sellers of the same or similar product and hence there is
interdependence in decision making.

37
 Pure/perfect competition
The characteristics of this market include:
1. Very large sellers: The distinguishing feature of this market is that there exists a large
number of independently acting sellers- selling at national or international markets. A
good example can be retail cigarette sellers in Ethiopia.
2. Standardized product: The firms produce standardized/identical/homogenous
products. Consumers will be indifferent to buy from any sellers, as long as the price is
the same. The firms don’t try to differentiate their products – no non-price
competition, only price competition exists. (e.g. Photocopy services, they give more
or less the same service).
3. “Price Takers”: In pure competition individual firms don’t exert any control over
price because each firm produces only a small fraction of total supply to the market.
Hence, every firm is price taker i.e. it cannot change market price but simply adjust to
it. If one of the firms increases price greater than the market, consumers will not buy
from it. Conversely, it can sell as much as it wants at market price. Therefore, there is
no reason to charge lower than market price.
4. Free entry and exit: new firms can freely enter and incompetent firms can exit freely.
No significant legal, technological, financial or other obstacles prohibit new firms
from selling their product in the market.
N.B.: Although pure competition is rare in the real world, this market model is highly
relevant because:

 Pure competition is a meaningful starting point for any discussion of price

and output determination

 Pure competition is a standard against which efficiency is evaluated.

38
 Comparison of markets

Pure/perfectly Pure monopoly Monopolistic Oligopoly

competitive Competition
Number of Many One Large Few
firms/sellers
Types of Standardized No Differentiated Similar
products differentiation
and substitute
Ease of entry Free Blocked Quite easy Difficult
Price No Yes Yes Yes
discrimination

2.5 Profit Maximization in Perfect and Imperfect Markets

A competitive firm is one which sells its products in a perfectly competitive market. The price of
a product is uniform through out the market and each seller is small in relation to the total market
sales, and hence can not affect the price of a product.
Thus, each seller is a "price taker". Each seller sees the market demand curve for its demand as
perfectly elastic, i.e. the demand curve facing a perfectly competitive firm is horizontal.

P P Market Demand
Firm’s supply

P* S

Q Q
The demand curve facing a perfectly competitive firm is similarly a horizontal line at a market
equilibrium price.

S P
Firm’s demand
P*

P* D
D
Q
Q*
Q

39
Total, Average and Marginal Revenues
Total Revenue (TR) is the total amount that a firm takes in the form of revenue of its product.
Total revenue is then, the price per unit times the quantity of output that the firm sold.
Total Revenue = price x quality
TR = P x Q
Average Revenue (AR) is the quotient of total revenue and quantity that is sold in the market.
Total  revenue TR PQ
Average revenue = Quantity sold  Q  Q
P

Marginal Revenue (MR) is the additional revenue that a firm takes in, when it increases out put
by a small amount (by one additional unit for practical purpose).
TR  ( P.Q ) P.Q
MR    P
Q Q Q

Thus, MR curve facing a Competitive firm is upward sloping straight line which starts form the
origin and rises by a fixed amount for each additional unit of the product sold.
Example

Price Quantity TR AR MR TC

15 0 0 - - 10
15 1 15 15 15 15
15 2 30 15 15 25
15 3 45 15 15 30
15 4 60 15 15 40
15 5 75 15 15 60
15 6 90 15 15 90

Profit Maximization of a perfectly competitive firm

There are two ways to determine the level of output at which a competitive firm will realize
maximum profit.
Comparing TR and TC (TR and TC Approach)

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 Comparing MR and MC (MR and MC Approach)
1. TR and TC Approach
A firm’s short run profit is maximized when the difference between total revenue and total cost
is the highest.

TR
TC
TC
TR
Break even point
TR-TC is maximum

Q
0

TC > TR > TVC, the firm will produce by covering TVC and part of its total fixed cost, because
the fixed cost is the cost that the firm used to pay even at zero level of output.
Case of shut down
When TR < TVC, the firm has to stop producing.
2. MR-MC Approach

P = MR

a
Q
It seems seasonable to pick output at which MC is at its minimum point.
At ‘a’ the difference between MR and MC is maximum. But at this point, the MR > MC,
indicating that profit is not being maximized. That is the additional revenue that the seller has got
is greater than the additional cost he has incurred.
 The profit maximizing perfectly competitive firm will produce up to the point where the
price, or the marginal revenue, of its output is just equal to the short -run marginal cost.

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 d
At Maximum profit, slope = 0 = dQ

d dTR  dTC
 0
dQ dQ

MR - MC = 0

MR = MC

So at the maximum profit (minimum loss), MR equals MC.

Note: Although output level where MC = P* is a profit maximizing level of output for the
competitive firm, it may or may not result in a positive economic profit, i.e., it may take positive,
zero, or negative economic profits for a given cost function. The level of profit actually depends
upon the market price.
 When P* > AC at an output level where MC = P*, the firm earns positive profit
 The firm provides positive output and continue production at output level where MC = P*
if P* > min. AVC because, at this level the firm will cover all of its variable and part of its
fixed cost.
 When P* = min. AC at the output level where MC = P*, the firm earns zero economic
profit (normal profit). Then, the firm in this case is said to break even.
 In this case, the firm will be indifferent as whether or not to produce at an output level
where P* = MC if P* = min AVC. Because at this level it covers its TVC and faces a loss
of TFC, which could have been incurred even at zero output.
 When P < min. AC at output level where MC = P*, the firm incurs loss since TC < TR.

P Profit MC
P Indifferent MC P Loss
P* < min. AVC at the profit
MC maximizing level of output result in a loss of the variable cost,
AC
which the firm can avoid by ceasing
AC production. AC
P*
Hence, the minimum AVC is called the shut down point. MR

Q 42 Q Q
Pure monopoly
A market is said to be monopoly when there exists only one supplier of a product for which there
is no close substitute.

 Features of pure monopoly

i. Single seller
ii. The products have no close substitutes e.g. public sector monopoly in water supply
iii. Price maker: A monopolist can set/control the price at which it sells the output. In
essence, the monopolist is the price maker. (e.g. ETC’s mobile subscription and air-
time tariffs)
iv. Huge barrier to entry: Legal, financial and/or technological barriers makes it
difficult. The following entry barriers have been associated with the existence of
monopoly;
- Control of input: A firm may own the total supply of raw material, which
is essential in the production of the product.
- Patent: this is an exclusive right to produce the product granted to the
inventor of the product. Monopolist may also have unique access to a
technique that is useful in the production of some good or could have the
sole right to produce the good (patent).
- Economies of scale: because of the level of technology used by the
monopoly, the cost may be lower than the small firms sharing or (trying to
share) the market. This blocks entry.
- License: government sometimes blocks entry into a particular market by
requiring firms to have governmentally provided license as a condition for
operating in such market.
- Entry lag: entry to some market takes time. This gives the firms temporary
monopoly time.
o Monopoly market is characterized by absence of competition. Hence, it is the most
inefficient market structure.
o Monopolists also practice price discrimination, i.e., the same good is sold at different
prices to different buyers in different markets.

Monopolists Demand, Marginal Revenue and Total Revenue Curve

Since the monopoly is the only seller of the product, its demand curve is the same as the market
(industry) demand curve. As such, the monopolist demand curve is down ward sloping. A
monopolist is price maker. Since a monopolist faces a negatively sloped demand curve, as price
increases the quantity demanded decreases.
P

D
Q
This negatively sloped demand curve shows that the monopolist must decrease price in order to
sell more output.
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 o Monopolist’s total revenue (TR) is:
TR = P.Q (This is no more linear because P is not constant.)
o Marginal revenue (MR): is the additional revenue attributed to the sale of one or more
unit(s) of output.
TR dR d ( P.Q ) dP
MR     P  Q. (because both P and Q are variable)
Q dQ dQ dQ
MR is a fixed amount but varied with the quantities sold.

 Q.dP   1 
MR  P1    P1  , MR = 0 or TR is maximum at  d = 1 and MR < P.
P.dQ    d 
 

D and MR start at the same point on the vertical axis because the MR of the first unit sold equals
the price of the good.

 Show this using the inverse demand function: P = a + bQ

 Also show that TR is maximum at output where MR = 0 or εd = 1
- At mid point of the demand curve, (|εd| =1), MR is zero; TR is maximum
 1 
MR  P1   0 at | εd| = 1
  d 

- When demand is inelastic (|εd | < 1), MR < 0; TR is decreasing with output increase.
- When demand is elastic (|εd | > 1), MR > 0; TR is increasing with output.

Tabular example:

P P Q TR MR AR = P

11 0 0 - -
10 1 10 10 10
D 9 2 18 8 9
Q
8 3 24 6 8

7 4 28 4 7
MR 6 5 30 2 6
P
5 6 30 0 5

4 7 28 -2 4
TR
3 8 24 -4 3

Q
AR = R/Q = (P.Q)/Q = P
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 - N.B. MR = P = 10 for the first unit of output, but for all other unit of output sold,
MR is less than P (MR < P)
- TR is maximum (30) when MR = 0

Profit Maximizing under Monopoly

The objective of a monopolist is to maximize profit. There are two approaches to profit
maximization under monopoly.
a. TR-TC Approach
In this approach monopolists profit is said to be maximized when the difference between TR
and TC is the highest.
i.e. ∏ = TR - TC is highest
= Q*(P- ATC)
Graphically, profit is maximized when the vertical distance between TR and TC is highest.
Q* is the monopolist’s profit maximizing level of output.

b. Marginal Approach
In this approach, profit is maximized when MR = MC

 1 
Remember that MR  P1  

 d 

 1 
Hence, profit is maximized when MR  P1   = MC

 d 

Graphically, the profit maximization level of output occurs when MR intersects MC (while it
is rising):
The profit maximizing level of output occurs when MC = MR < P
- Since competitive firms produce when MC = P, a monopolized industry charges
higher price and produces smaller output than a competitive industry.

P MC

P* ATC

Q
Q*
MR

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