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ECO401
ECO401
WHAT IS ECONOMICS?
Economics is not a natural science, i.e. it is not concerned with studying the physical world like chemistry,
biology. Social sciences are connected with the study of people in society. It is not possibleto conduct
laboratory experiments, nor is it possible to fully unravel the process of human decision- making.
“Economics is the study of how we the people engage ourselves in production, distribution and
consumption of goods and services in a society.”
The term economics came from the Greek for oikos (house) and nomos (custom or law), hence "rules of
the household.
Another definition is: “The science which studies human behavior as a relationship between ends and
scarce means which have alternative uses.”
BRANCHES OF ECONOMICS
Normative economics:
Normative economics is the branch of economics that incorporates value judgments about what the
economy should be like or what particular policy actions should be recommended to achieve a desirable
goal. Normative economics looks at the desirability of certain aspects of the economy. It underlies
expressions of support for particular economic policies. Normative economics is known as statements of
opinion which cannot be proved or disproved, and suggests what should be done to solve economic
problems, i-e unemployment should be reduced. Normative economics discusses "what ought to be".
Examples:
1-A normative economic theory not only describes how money-supply growth affects inflation, but it
also provides instructions that what policy should be followed.
2- A normative economic theory not only describes how interest rate affects inflation but it also
provides guidance that what policy should be followed.
Positive economics:
Positive economics, by contrast, is the analysis of facts and behavior in an economy or “the way things
are.” Positive statements can be proved or disproved, and which concern how an economy works, i-e
unemployment is increasing in our economy. Positive economics is sometimes defined as the economics
of "what is"
Examples:
1- A positive economic theory might describe how money-supply growth affects inflation, but it does
not provide any instruction on what policy should be followed.
2- A positive economic theory might describe how interest rate affects inflation but it does not provide
any guidance on whether what policy should be followed.
We the people: includes firms, households and the government.
Goods are the things which are produced to be sold.
Services involve doing something for the customers but not producing goods.
FACTORS OF PRODUCTION
Factors of production are inputs into the production process. They are the resources needed to produce
goods and services. The factors of production are:
Land includes the land used for agriculture or industrial purposes as well as natural resources
taken from above or below the soil.
Capital consists of durable producer goods (machines, plants etc.) that are in turn used for
production of other goods.
Labor consists of the manpower used in the process of production.
Entrepreneurship includes the managerial abilities that a person brings to the organization.
Entrepreneurs can be owners or managers of firms.
ECONOMIC SYSTEMS
There are different types of economic systems prevailing in the world.
Dictatorship:
Dictatorship is a system in which economic decisions are taken by the dictator which may be an
individual or a group of selected people.
Command or planned economy:
A command or planned economy is a mode of economic organization in which the key economic functions
– for whom, what, how to produce are principally determined by government directive. In a planned
economy, a planning committee usually government or some group determines the economy’s output of
goods and services. They decide about the optimal mix of resources in the economy. They also decide how
the factor of production needs to be employed to get optimal mix.
Free market/capitalist economy:
A free market/capitalist economy is a system in which the questions about what to produce, how to
produce and for whom to produce are decided primarily by the demand and supply interactions in the
market. In this economy what to produce is thereby determined by the market price of each good and
service in relation to the cost of producing each good and service.
In a free economy the only goods and services produced are those whose price in the market is at least
equal to the producer’s cost of producing output. When a price greater than the cost of producing that
good or service prevails, producers are induced to increase the production. If the product’s price falls
below the cost of production, producers reduce supply.
Islamic economic system:
This system is based on Islamic values and Islamic rules i-e zakat, ushr, etc. Islam forbids both the taking
and giving of interest. Modern economists, too, have slowly begun to realize the futility of interest. The
Islamic economic principles if strictly followed would eliminate the possibility of accumulation of wealth
in the hands of a few and would ensure the greater circulation of money as well as a wider distribution of
wealth. Broadly speaking these principles are (1) Zakat or compulsory alms giving (2) The Islamic law
of inheritance which splits the property of an individualinto a number of shares given to his relations
(3) The forbiddance of interest which checks accumulation of wealth and this strikes at the root of
capitalism.
Pakistan case: A mixed economy
In Pakistan, there is mixed economic system. Resources are governed by both government and
individuals. Some resources are in the hand of government and some are in the hand of public. Optimal
mix of resources is decided by the price mechanism i-e by the market forces of demand and supply.
Pakistan economy thus consists of the characteristics of both planned economy and free market economy.
People are free to make their decisions. They can make their properties. Government controls the Defense.
Macro Economics:
The branch of economics that studies– the entire economy, especially such topics as
aggregate production, unemployment, inflation, and business cycles. It can be thought of as the study of
the economic forest, as compared to microeconomics, which is the study of the economic trees.
Macroeconomics, involves the "total of economic activity, dealing with the issues of growth, inflation,
and unemployment and with national economic policies relating to these issues” and the effects of
government actions (e.g., changing taxation levels) on them.
Since net benefit of job A is greater so the rational choice is job A which is in Lahore.
OPPORTUNITY COST
The opportunity cost of a particular choice is the satisfaction that would have been derived from the
next best alternative foregone; in other words, it is what must be given up or sacrificed in making a certain
choice or decision.
Example:
Let’s take the decision to buy the book or not, if you will not buy the book then you will be involved in
many other activities. In the following table, opportunity Cost of buying the book and not giving charity
= 20 SU, which is the benefit derived from giving charity. You will buy the book if the benefit from
other alternatives is less than the benefit derived from buying of book.
Benefit Derived in
Cost
Satisfaction Unit
Book 200 10
Clothes 200 5
Charity 200 20
This table represents the alternative combinations of rice and cotton for a hypothetical economy which
is producing only 2 goods. At point A only cotton is produced, rice is not produced. In order to produce
one unit of rice, we have to give up one unit of cotton (10-9=1). So the opportunity cost is 1 at point B.
further in order to produce next unit of rice, we have to give up 2 units of cotton (9-7=2). So the
opportunity cost of next additional unit is 2 and so on. This table shows that opportunity cost is increasing
with each additional unit. It means we have to give up higher and higher units of cotton in order to produce
each additional unit of rice. This is the principle of increasing opportunity cost. If opportunity cost
decreases with each additional unit produced, then it is the principle of decreasing opportunity cost. And
if opportunity cost remains constant with each extra unit produced, it is the principle of constant
opportunity cost.
The law of increasing opportunity cost is what gives the curve its distinctive convex shape. Points on the
PPF show the efficient utilization of resources. Points inside the PPF show inefficient use of resources.
Points outside the PPF show that some of the resources are unemployed or not utilized. PPF curve shifts
upward due to technological advancements. If there is improvement in technology to produce the
output, then total output will increase and PPF will shift outward.
In the graph of PPF, Points within the PPF are inefficient and it is the rare possibility in the real world.
Inefficient means that it may not be using its available resources. May be some workers are unemployed
creating the macroeconomic problem of unemployment or may be capital is not using properly. Points
outside the PPF are unattainable since the PPF defines the maximum output produced at the given time
period so there is no possibility to produce output outside the PPF. Here in PPF, we are not concerned
with the combinations of goods which is a micro economic issue rather we are concerned with the overall
output produced which is a macroeconomic issue.
Economic growth is an increase in the total output of a country over time. It is the long-run expansion of
the economy's ability to produce output. When GDP of a country is increasing it means that countryis
growing economically. Economic growth is made possible by increasing the quantity or quality of the
economy's resources (labor, capital, land, and entrepreneurship).
Could production and consumption take place without money? If you think they could, give
examples.
Yes. People could produce things for their own consumption. For example, people could grow vegetables
in their garden or allotment; they could do their own painting and decorating. Alternatively people could
engage in barter: they could produce things and then swap them for goods that other people had produced.
Must goods be at least temporarily unattainable to be scarce?
Goods need not be unattainable to be scarce. Because people’s incomes are limited, they can not have
everything they want from shops, even though the shops are stocked full. If all items in shops were free,
the shelves would soon be emptied!
If we would all like more money, why does the government not print a lot more? Could it not thereby
solve the problem of scarcity ‘at a stroke’?
The problem of scarcity is one of a lack of production. Simply printing more money without producing
more goods and services will merely lead to inflation. To the extent that firms cannot meet the extra
demand (i.e. the extra consumer expenditure) by extra production, they will respond by putting up their
prices. Without extra production, consumers will be unable to buy any more than previously.
Which of the following are macroeconomic issues, which are microeconomic ones and which could
be either depending on the context?
a) Inflation.
b) Low wages in certain service industries.
c) The rate of exchange between the dollar and the rupee.
d) Why the price of cabbages fluctuates more than that of cars.
e) The rate of economic growth this year compared with last year.
f)The decline of traditional manufacturing industries.
a) Macro. It refers to a general rise in prices across the whole economy.
b) Micro. It refers to specific industries
c) Either. In a world context, it is a micro issue, since it refers to the price of one currency in terms
of one other. In a national context it is more of a macro issue, since it refers to the exchange rate
at which all Pakistanis goods are traded internationally. (This is certainly a less clear–cut division
that in (a) and (b) above.)
d) Micro. It refers to specific products.
e) Macro. It refers to the general growth in output of the economy as a whole.
f) Micro (macro in certain contexts). It is micro because it refers to specific industries. It could,
however, also help to explain the macroeconomic phenomena of high unemployment or balance
of payments problems.
Assume that you are looking for a job and are offered two. One is more unpleasant to do, but pays
more. How would you make a rational choice between the two jobs?
You should weigh up whether the extra pay (benefit) from the better paid job is worth the extra hardship
(cost) involved in doing it.
How would the principle of weighing up marginal costs and benefits apply to a worker deciding how
much overtime to work in a given week?
The worker would consider whether the extra pay (the marginal benefit) is worth the extra effort and loss
of leisure (the marginal cost).
Would it ever be desirable to have total equality in an economy?
The objective of total equality may be regarded as desirable in itself by many people. There are two
problems with this objective, however. The first is in defining equality. If there were total equality of
incomes then households with dependants would have a lower income per head than households where
everyone was working. In other words, equality of incomes would not mean equality in terms of standards
of living.
DEMAND ANALYSIS
Shortage:
A shortage is a situation in which demand exceeds supply, i.e. producers are unable to meet market
demand for the product. Shortages cause prices to raise prompting producers to produce more and
consumers to demand less.
Surplus:
A surplus is a situation of excess supply, in which market demand falls short of the quantity supplied;
i.e. the producers are unable to sell all the produced goods in the market. Surpluses cause prices to fall
prompting producers to supply less and consumers to demand more.
Price Mechanism:
The price mechanism is a signaling and rationing device which prompts consumers and producers to
adjust their demand and supply, respectively, in response to a shortage or surplus. Shortages cause
prices to rise, prompting producers to produce more and consumers to demand less. Surpluses cause prices
to fall prompting producers to supply less and consumers to demand more. In either case, the price
mechanism attempts to clear the shortage or surplus in the market.
Normal goods are goods whose quantity demanded goes up as consumer income increases.
Inferior goods are goods whose quantity demanded goes down as consumer income increases.
Giffen goods are the sub category of inferior good. It is a rare type of good seldom seen in the real world,
in which a change in price causes quantity demanded to change in the same direction (inviolation
of the law of demand). In other words, an increase in the price of Giffen good results in an increase in the
quantity demanded. The existence of a Giffen good requires the existence of special circumstances. First,
the good must be an inferior good. Second, the income effect is greater than the substitution effect. A
Giffen good is most likely to result when the good is a significant share of the consumer's budget.
Margarine is a Giffen good as compared to butter.
Substitution effect:
It is one of two reasons for law of demand and the negative slope of the market demand curve. The
substitution effect occurs because a change in the price of a good makes it relatively higher or lower
Price (P)
Demand Curve
SUPPLY
Supply is the quantity of a good that sellers wish to sell at each conceivable price.
Law of supply:
The law of supply states that the quantity supplied will go up as the price goes up and vice versa. As
output increases, cost will also increase. Higher prices means more profit so firms will produce more of
that product whose price has increased. New producers will also emerge in the market. And total supply
will also increase.
Supply schedule:
A supply schedule is a table (sometimes also referred to as a graph) which shows various combinations
of quantity supplied and price.
Supply curve:
A supply schedule is a table that shows various combinations of quantity supplied and price. GA graphical
illustration of this table gives us the supply curve.
Price (P)
Supply Curve
EQUILIBRIUM
Equilibrium is a state in which there are no shortages and surpluses; in other words the quantity
demanded is equal to the quantity supplied.
Equilibrium price is the price prevailing at the point of intersection of the demand and supply curves; in
other words, it is the price at which the quantity demanded is equal to the quantity supplied.
Equilibrium quantity is the quantity that clears the market; in other words, it is it is the quantity at which
the quantity demand is equal to the quantity supplied.
Demand Curve
Price (P) Supply Curve
Qd = Qs
Quantity (Q)
The symbol “” or “” shows increase and the symbol “” and “” shows a decrease while the
symbol “~” shows that the particular thing remains same.
NOTE: (Graphical illustration of all these possibilities is given in the video lecture)
Points to note in these 8 possibilities:
1. Whenever the demand curve shifts the new equilibrium is obtained by moving along the supply
curve.
2. Whenever supply curve shifts, the new equilibrium is obtained by moving along the demand
curve.
3. Whenever both demand and supply curves shifts, we will move first on the demand curve and
then along the supply curve.
PRICE CEILING:
A price ceiling is the maximum price limit that the government sets to ensure that prices don’t rise above
that limit (medicines for e.g.).
If a price ceiling is placed below the market-clearing price, as Pc, the market-clearing or equilibrium price
of Pe becomes illegal. At the ceiling price, buyers want to buy more than sellers will make available. In
the graph, buyers would like to buy amount Q4 at price Pc, but sellers will sell only Q1. Because they
cannot buy as much as they would like at the legal price, buyers will be out of equilibrium. The normal
adjustment that this disequilibrium would set into motion in a free market, an increase in price, is illegal;
and buyers or sellers or both will be penalized if transactions take place above Pc. Buyers are faced with
the problem that they want to buy more than is available. This is a rationing problem.
PRICE FLOOR:
A price floor is the minimum price that a Government sets to support a desired commodity or service in
a society (wages for e.g.).
Price ceilings are not the only sort of price controls governments have imposed. There have also been
many laws that establish minimum prices, or price floors. The graph illustrates a price floor with price Pf.
At this price, buyers are in equilibrium, but sellers are not. They would like to sell quantity Q2, but buyers
are only willing to take Q3. To prevent the adjustment process from causing price to fall, government may
buy the surplus, If it does not buy the surplus, government must penalize either buyers or sellers or both
who transact below the price floor, or else price will fall. Because there is no one else to absorb the surplus,
sellers will.
SOCIAL COST
Social cost is the cost of an economic decision, whether private or public, borne by the society as a
whole.
MARGINAL SOCIAL COST
Marginal social cost is the change in social costs caused by a unit change in output.
Asif and Aasia’s “monthly” demand schedules for potatoes are given. Roughly draw these demand
schedules on the same graph. Assume that there are 200 consumers in the market. Of these, 100
have schedules like Asif’s and 100 have schedules like Aasia’s. Complete the Total market demand
(“monthly”) column in the table below?
Price Asif Aasia Total
market
demand
(pence (Qd in (Qd in (kg)
per kg) kg) kg)
20 28 16 4400
40 15 11 2600
60 5 9 1400
80 1 7 800
100 0 6 600
100
90
80
70
60
Price in Rs/kg
50
40
Asif’s
30 demand
Aasia’s
20 demand
10
0
0 5 10 15 20 25 30
Quantity demanded (kg per month)
Assuming that demand does not change from month to month, how would you plot the annual
market demand for potatoes?
The amount demanded would be 12 times higher at each price. If the scale of the horizontal axis were
unaltered, the curve would shift way out to the right. A simple way of showing the new curve, therefore,
would be to compress the scale of the horizontal axis. (If each of the numbers on the axis were multiplied
by 12, the curve would remain in physically the same position.)
At what price is their demand the same?
The two curves cross at a price of Rs50 per kg and at a demand of 10 kg per month.
What explanations could there be for the quite different shapes of their two demand curves?
One explanation could be that Asif is quite happy to eat rice, pasta or bread instead of potatoes. Thus
when the price of potatoes goes up she switches to these other foods, and switches to potatoes when the
price of potatoes comes down. Aasia, by contrast, may not see these other foods as close substitutes and
thus her demand for potatoes will be less price sensitive.
100
90
80
70
Price (Rs per kg
60
50
40
30 demand
20
demand
10
0
0 100 200 300 400 500 600 700 800 900
Quantity demanded (kg per month)
The price of lamb meat rises and yet it is observed that the sales of lamb meat increase. Does this
mean that the demand curve for lamb meat is upward sloping? Explain.
No not necessarily. For example, the price of substitutes such as beef or chicken may have risen by a
larger amount. In such cases the demand curve for lamb meat will have shifted to the right. Thus although
a rise in the price of lamb meat will cause a movement up along this new demand curve, more lamb meat
will nevertheless be demanded because lamb meat is now relatively cheaper than thealternatives.
A demand function is given by Qd = 10000 – 200P. Draw this in P-Qd space. What is it about the
demand function equation that makes the demand curve in P- Qd space (a) downward sloping; (b) a
straight line?
a) The fact is that the 200P term has a negative sign attached to it. This means that as P rises, Qd
falls.
b) The fact is that there is no P to a power term. The demand curve thus has a constant slope of –
1/200.
A demand function is given by Qd = a + bY, where Y is total income. If the term “a” has a value of –
50 000 and the term “b” a value of 0.001, construct a demand schedule with respect to Y. Do this
for incomes between Rs100 million and Rs300 million at Rs50 million intervals.
100 50
150 100
200 150
250 200
300 250
Now use this schedule to plot a demand curve with respect to income. Comment on its shape.
The curve will be an upward-sloping straight line, crossing the horizontal axis at –50 000. It would rise by
100 000 units for each Rs100 million rise in income.
300
250
Income (Rs millions
200
150
100
50
0
0 50 100 150 200 250 300
Quantity demanded
Market demand (with respect to income)
What are the reasons which cause the market supply of potatoes to fall?
Examples include:
The cost of producing potatoes rises.
The profitability of alternative crops (e.g. carrots) rises.
A poor potato harvest.
Farmers expect the price of potatoes to rise (short-run supply falls).
For what reasons might the supply of leather rise?
Examples include:
The cost of producing leather falls.
The profitability of producing mutton and chicken decreases.
The price of beef rises (goods in joint supply).
A long-running industrial dispute involving leather workers is resolved.
Producers expect the price of leather to fall (short-run supply increases).
This question is concerned with the supply of gas for home and office heating in winters. In each
case consider whether there is a movement along the supply curve (and in which direction) or a shift
in it (left or right). (a) New gas fields start up in production. (b) The demand for home heating rises.
(c) The price of electric heating falls. (d) The demand for CNG for cars (produced in joint supply)
rises. (e) New technology decreases the costs of gas production.
(a) Shift right. (b) Movement up along (as a result of a rise in price). (c) Movement down along (as a result
of a fall in price resulting from a fall in demand as people switch to electric heating). (d) Shift right (more
of a good in joint supply is produced). (e) Shift right.
10
9
Supply
8
7
6
Price 5
4
3
2
1
0
0 2000 4000 6000 8000 10000
Quantity supplied
P (in Qs
Rs) (units)
1 1500
2 2500
3 3500
4 4500
5 5500
6 6500
7 7500
8 8500
9 9500
10 10500
The graph is an upward sloping straight line crossing the horizontal axis at 500 units. The slope is given
by the value of the d term: i.e. the slope is 1/1000 (for every Re1 increase in price, quantity supplied
increases by 1000 units).
Explain the process by which the price of houses would rise if there were a shortage.
People with houses to sell would ask a higher price than previous sellers of similar houses (probably with
the advice of an estate agent). Potential purchasers would be prepared to pay a higher price than previously
in order to obtain the type of house they wanted.
With a typical upward sloping market supply curve and downward sloping market demand curve,
what would happen to equilibrium price and quantity if the demand curve shifted to the left?
Both price and quantity will fall. You should be able to label two demand curves (e.g. D1 and D2), two
equilibrium points (e.g. e1 and e2) corresponding prices Pe2 and Pe1 (Pe2 < Pe1), and quantities Qe2 and Qe1
(Qe2 > Qe1).
What will happen to the equilibrium price and quantity of butter in each of the following cases?
You should state whether demand or supply (or both) have shifted and in which direction. (In each
case assume ceteris paribus.)
(a) A rise in the price of margarine; (b) A rise in the demand for yoghurt; (c) A rise in the price of
bread; (d) A rise in the demand for bread; (e) An expected rise in the price of butter in the near
future; (f) A tax on butter production; (g) The invention of a new, but expensive, process for
T h e p r i ce m e c h a n is m : th e e f f e c t o f th e d i s c o v e r y o f ra w m a te r i a l s
F ac to r M a rk e t
S i
S i s u rp lu s P i u n t il D i = S i
( S i > D i) D i
G o o d s M a rket
S g
Pi S g s u r p lu s P g until D g = S g
( S g > D g)
D g
The new discovery of raw material i means an increase in the supply i. This causes a surplus (excess
supply) in the market for i, causing the price of i to fall until the same is removed (lower Pi causes demand
to increase and supply to fall). The reduction in Pi also reduces the cost of producing good g (we can
assume good g uses the factor i intensively), causing the supply of good g to increase beyond demand. The
surplus in the market for good g drives the price of g down until the excess is cleared. The diagram
illustrates interdependence between goods and factor markets.
Can different factor markets be interdependent also? Give examples.
Yes. A rise in the price of one factor (e.g. oil) will encourage producers to switch to alternatives (e.g.
coal). This will create a shortage of coal and drive up its price. This will encourage increased production
of coal. Similarly an increase in the population (and consequently size of the labour force) of a country
will depress the price of labour (wages). This will cause producers to shift to more labour intensive
production and reduce production methods which are capital (or machine) intensive. As a result the
demand for capital will fall reducing its rental price.
Lesson 06
ELASTICITIES
ELASTICITY
Elasticity is a term widely used in economics to denote the “responsiveness of one variable to changes
in another.” In proper words, it is the relative response of one variable to changes in another variable. The
phrase "relative response" is best interpreted as the percentage change.
TYPES OF ELASTICITY
There are four major types of elasticity:
Price Elasticity of Demand
Price Elasticity of Supply
Income Elasticity of Demand
Cross-Price Elasticity of Demand
Price Elasticity of Demand:
Price elasticity of demand is the percentage change in quantity demanded with respect to the percentage
change in price.
Price elasticity of demand can be illustrated by the following formula:
If a 15% rise in the price of a product causes a 15% rise in the quantity supplied, the price elasticity of
supply will be:
PЄs = 15 % = 1
15 %
If a 2% rise in the consumer’s incomes causes an 8% rise in product’s demand, then the income
elasticity of demand for the product will be:
YЄd = 8% =4
2%
Cross-Price Elasticity of Demand:
Cross price elasticity of demand is the percentage change in quantity demanded of a specific good, with
respect to the percentage change in the price of another related good.
If, for example, the demand for butter rose by 2% when the price of margarine rose by 8%, then the
cross price elasticity of demand of butter with respect to the price of margarine will be.
PbЄda = 2% = 0.25
8%
If, on the other hand, the price of bread (a compliment) rose, the demand for butter would fall. If a 4%
rise in the price of bread led to a 3% fall in the demand for butter, the cross-price elasticity of demand
for butter with respect to bread would be:
PbЄda = - 3% = - 0.75
4%
1. By using percentage changes and proportions we can avoid the problem of comparison in two
different quantitative variables i-e Qd is measured in units and Price is measured in rupees. So by
calculating percentages we can avoid the problem of unit conversion into rupees.
2. It helps us avoid that of what size of units to be changed i-e A jump from Rs.2 to Rs.4 could be
described as a 100% increase or as an increase of Rs.2. but by using percentages we can avoid
this problem because both gives the same answer.
3. It also helps how to define big or small changes. By looking at Rs.2 or Rs.4, we can’t say that it
is a big change or a small change. But if we translate it in the form of percentages then it becomes
100% which is a big change.
EXAMPLE OF 2 FIRMS
Firm 1: (Inelastic demand curve)
For inelastic demand curve, firm increases its prices but quantity demanded does not change as much.
Increase in price is greater while the decrease in quantity is smaller. So firm will earn more revenues by
increasing prices. So TR increases as the price increases.
Price
10 F
Inelastic demand
curve
0 90 100 Quantity
Demanded
Є = percentage change in Qd
Percentage change in P
= 90 – 100 ÷ 10 – 6
100 6
= - 0.15
In the above figure, Elasticity for firm 1 is equal to -0.15; it is less than 1 (ignoring minus sign) which
shows that the demand curve is inelastic.
For elastic demand curve, firm does not increase its prices. Because as prices increases, quantity
demanded decreases much larger. Decrease in quantity demanded is greater than the increase in prices.
So firm will earn less revenue. So TR decreases as price increases.
Price
10
0 40 100 Quantity
Demanded
Є = percentage change in Qd
Percentage change in P
= 40 – 100 ÷ 7 – 6
100 6
= - 3. 6
In the above figure elasticity for firm 2 is -3.6; it is greater than 1 (ignoring minus sign) which shows
that the demand curve is elastic.
Price
10
8 K
0 8 16 Quantity
Demanded
Then draw a figure, plot prices on vertical axis and quantity on horizontal axis. The resulting curve will
be downward sloping curve.
7
6
5
4
3
2
1
0
0 20 40 60 80
To find the point elasticity of demand from this quadratic equation, differentiate it with respect to price,
Qd = 60 – 15P + P2
dQ/dP = -15 + 2P
IF P=3 then
Calculating elasticity’s between two points at the same curve involves arc elasticity method.
While calculating elasticity at a certain point involves point elasticity method.
YЄd = ∆ Q ÷ ∆ Y
Q Y
= 5 ÷ 2000
100 10000
= 0.25
The Good is normal (the sign is positive). But its demand is income inelastic o< | Є | < 1.
PbЄda = ∆ Qa ÷ ∆ Pb
Qa Pb
Table
Demand for A Price of B
100 10
140 12
PbЄda = ∆ Qa ÷ ∆ Pb
Qa Pb
= 40 ÷ 2
100 10
= 2
Goods are substitutes (sign is positive). Demand is cross price elastic | є | > 1.
INCIDENCE OF TAXATION
A tax results in a vertical shift of the supply curve as it increases the cost of producing the taxed
product.
RULE # 02
Normal good
Income elasticity
Inferior good
RULE # 03
+ Substitutes
Cross elasticity
- Complements
Why will the price elasticity of demand for a particular brand of a product (e.g. Shell) be greater
than that for the product in general (e.g. petrol)? Is this difference the result of a difference in the
size of the income effect or the substitution effect?
The price elasticity of demand for a particular brand is more elastic than that for a product in general
because people can switch to an alternative brand if the price of one brand goes up. No such switching
will take place if the price of the product in general (i.e. all brands) goes up. Thus the difference in
elasticity is the result of a difference in the size of the substitution effect.
Will a general item of expenditure like food (or clothing) have a price-elastic or inelastic demand?
Discuss in the context of income and substitution effects.
The income effect will be relatively large (making demand relatively elastic). The substitution effect will
be relatively small (making demand relatively inelastic). The actual elasticity will depend on the relative
size of these two effects.
Demand for oil might be relatively elastic over the longer term, and yet it could still be observed that
over time people consume more oil (or only very slightly less) despite rising oil prices. How can this
apparent contradiction be explained?
Because, there has been a rightward shift in the demand curve for oil. This is likely to be the result of
rising incomes. Car ownership and use increase as incomes increase. Also tastes may have changed so
that people want to drive more. There may also have been a decline in substitute modes of transport such
as rail transport and buses. Finally, people may travel longer distances to work as a result of a general
move to the suburbs.
Assume that demand for a product is inelastic. Will consumer expenditure go on increasing as price
rises? Would there be any limit?
So long as demand remains inelastic with respect to price, then consumer expenditure will go on rising as
price rises. However, if the price is raised high enough, demand always will become elastic.
Can you think of any examples of goods which have a totally inelastic demand (a) at all prices; (b)
over a particular price range?
a) No goods fit into this category, otherwise price could rise to infinity with no fall in demand – but
people do not have infinite incomes!
b) Over very small price ranges, the demand for goods with no close substitutes, oil, water (where it
is scarce) may be totally inelastic.
What will the demand curve corresponding to the following table look like?
If the curve had an elasticity of –1 throughout its length, what would be the quantity demanded (a)
at a price of £1; (b) at a price of 10p; (c) if the good were free?
P (£) Q Total
Expenditure
(£)
2.5 400 1000
5 200 1000
10 100 1000
20 50 1000
40 25 1000
The curve will be a ‘rectangular hyperbola’: it will be a smooth curve, concave to the origin which
never crosses either axis (Qd = 1000/P).
a. 1000 units.
b. 10 000 units.
c. There would be infinite demand!
Referring to the following table, use the mid-point (arc) formula to calculate the price elasticity of
demand between (a) P = 6 and P = 4; (b) P = 4 and P = 2. What do you conclude about the elasticity
As we consume more & more bottles of cokes, total utility increases & marginal utility remains positive
till units 4, after that total utility starts decreasing & marginal utility becomes negative. Total utility is
maximum at unit 5 & marginal utility is zero at this point.
Total & Marginal utility curves:
The marginal utility curve slopes downwards in a MU-Q graph showing the principle of diminishing
marginal utility. The MU curve is exactly equal to the demand curve.
The total utility curve starts at the origin and reaches the peak when marginal utility is zero. Marginal
utility can be derived from total utility. It is the slope of the lines joining two adjacent points on the TU
curve.
A At point A, TU
Utility is at maximum
& MU is zero
TU
Bottle of
coke MU
The problem of uncertainty is integral to consumption decisions especially in the matter of purchasing
durable goods. Uncertainty means assigning probabilities to the outcomes.
A consumer’s response to uncertainty depends upon her attitude to risk: whether she is:
a. Risk averse
b. Risk-loving
c. Risk neutral
RISK
Risk means to take a chance after the probabilities have been assigned. Risk is the possibility of gain or
loss. Risk the calculated probability of different events happening, is usually contrasted with uncertainty
the possibility that any number of things could happen. For example, uncertainty is the possibility that
you could win or lose $100 on the flip of a coin. You don't know which will happen, it could go either
way. Risk, in contrast, is the 50 percent chance of winning $100 and the 50 percent chance of losing
RISK HEDGING can be used to reduce the extent to which concerns about uncertainty affect our daily
lives.
Example: Insurance companies operate under the principle of law of large numbers. An insurance
company collects the premium from the people. They also diversify the risk.
In the presence of asymmetric information, an insurance company has to contend with the problems of
adverse selection (people who want to buy insurance are also the most risky customers; an ex-ante
problem) and moral hazard (once a person is insured his behavior might become more rash; an ex-post
problem).
Indifference
curve
Good X
The average slope of the indifference curve between any two points is given by the change in the quantity
of good Y divided by change in the quantity of good X. This is called the marginal rate of substitution
(MRS). MRS states how much unit of a good you have to give up in order get an additional unit of another
good.
A diminishing marginal rate of substitution (MRS) is related to the principle of diminishing marginal
utility. MRS is equal to the ratio of the marginal utility of X to the marginal utility of Y.
dY = MUX = MRS
dX MUY
The indifference curve for perfect substitutes is a straight line, while it is L-shaped for perfect
compliments.
Good
Y Indifference
Curve for
perfect
substitutes
Good X
cc
Good
Indifference
Y
Curve for perfect
compliments
Good X
An indifference map shows a number of indifference curves corresponding to different levels of utility.
A higher indifference curve corresponds to a higher level of utility. Indifference curves never intersect.
The Budget Line and Indifference curves:
The budget line shows various combinations of 2 goods X & Y that can be purchased. Its slope –Px/PY
is called input price ratio.
Good
Y
Budget Line
Good X
EQUATION OF THE BUDGET LINE
Budget line in terms of Y = a + bX
kX + lY = M
lY = – kX + M
Y= –kX + M
l l
Where,
M = total amount of money
k & l = Prices of two goods
M = intercept
l
- K = Px = slope
l Py
The budget line can shift due to changes in total budget and the relative price ratio –Px/PY. If money
income rises, the budget line will shift outwards (parallel to the initial budget line). If the relative price
ratio changes, the slope of the budget line changes.
THE OPTIMUM CONSUMPTION POINT FOR THE CONSUMER is where the budget line is
tangent to the highest possible indifference curve. At such a point, the slopes of the indifference curve
and the budget line are equal. In other words: vMRS = Px/Py = Y/X = MUx/MUy.
Just as we can use indifference analysis to show the combination of goods that maximizes utility for a
given budget, so too we can show the least-cost combination of goods that yields a given level of utility.
Good At point t,
Y Indifference curve is
tangent to the budget
line. This is the
optimal point of
consumption
t
Good X
LEAST COST COMBINATION can be derived also from the indifference curve & budget line.
Good Point t, is the least
Y cost combination
point.
Good X
Income
Engel curve
Good X
Engel curve shows the positive relationship between income & quantity demanded of normal good. As
income increases, quantity demanded for normal goods also increases.
Do you ever purchase things irrationally? If so, what are they and why is your behaviour
irrational?
A good example is things you purchase impulsively, when in fact you do have time to reflect on
whether you really want them. It is not a question of ignorance but a lack of care. Your behavior is
irrational because the marginal benefit of a bit of extra care would exceed the marginal effort involved.
Imagine that you are going out for the evening with a group of friends. How would you decide
where to go? Would this decision-making process be described as ‘rational’ behavior?
You would probably discuss it and try to reach a consensus view. The benefits to you (and to other group
members) would probably be maximized in this way. Whether these benefits would be seen as purely
‘selfish’ on the part of the members of the group, or whether people have more genuinely unselfish
approach, will depend on the individuals involved.
If you buy something in the shop on the corner when you know that the same item could have been
bought more cheaply two miles up the road from the wholesale market, is your behavior irrational?
Explain.
Not necessarily. If you could not have anticipated wanting the item and if it would cost you time, effort,
and maybe money (e.g. petrol) to go to the wholesale market, then your behavior is rational. Your behavior
a few days previously would have be irrational, however, if, when making out your weekly shopping list
for the wholesale market, a moment’s thought could have saved you having to make the subsequent trip
to the shop on the corner.
Are there any goods or services where consumers do not experience diminishing marginal utility?
Virtually none, if the time period is short enough. If, however, we are referring to a long time period,
such as a year, then initially as more of an item is consumed people may start ‘getting more of a taste for
it’ and thus experience increasing marginal utility. But even with such items, eventually, as
consumption increases, diminishing marginal utility will be experienced.
If Ammaar were to consume more and more crisps, would his total utility ever (a) fall to zero; (b)
become negative? Explain.
Yes, both. If he went on eating more and more, eventually he would feel more dissatisfied than if he
had never eaten any in the first place. He might actually be physically sick!
Complete this table to the level of consumption at which total utility (TU) is at a maximum, given
the utility function TU = Q + 60Q – 4Q2.
Q 60Q –4Q2 = TU
1 60 –4 = 56
2 120 –16 = 104
3 180 –36 = 144
4 240 –64 = 176
5 300 –100 = 200
6 360 –144 = 216
7 420 –196 = 224
8 480 –256 = 224
180
160
140
120
100
80
60
40
20
MU
0
-2 0
If a good were free, why would total consumer surplus equal total utility? What would be the level
of marginal utility?
Because there would be no expenditure. At the point of maximum consumer surplus, marginal utility
would be equal to zero, since if P = 0, and MU = P, then MU = 0.
Why do we get less consumer surplus from goods where our demand is relatively elastic?
Because we would not be prepared to pay such a high price for them. If price went up, we would more
readily switch to alternative products.
How would marginal utility and market demand be affected by a rise in the price of a
complementary good?
Marginal utility and market demand would fall (shift to the left). The rise in the price of the complement
would cause less of it to be consumed. This would therefore reduce the marginal utility of the other good.
For example, if the price of lettuce goes up and as a result we consume less lettuce, the marginal utility of
mayonnaise will fall.
The diagram illustrates a person’s MU curves of water and diamonds. Assume that diamonds are
more expensive than water. Show how the MU of diamonds will be greater than the MU of water.
Show also how the TU of diamonds will be less than the TU of water.
MU, P
Pd
Pw MU water
MU diamonds
Qd Qw
Substitution
B1a
a c
Income
1a
It is unlikely that any of the goods you consume are Giffen goods. One possible exception may
be goods where you have a specific budget for two or more items, where one item is much
cheaper: e.g. fruit bought from a greengrocer (or rehri waala on the street). If, say, apples are
initially much cheaper than bananas, you may be able to afford some of each. Then you find
that apples have gone up in price, but are still cheaper than bananas. What do you do? By
continuing to buy some of each fruit you may feel that you are not eating enough pieces of fruit
to keep you healthy and so you substitute apples for bananas, thereby purchasing more apples
than before (but probably less pieces of fruit than originally).
A firm is any organized form of production, in which someone or collections of individuals are involved
in the production of goods and services. An organization that combines resources for the production and
supply of goods and services. The firm is used by entrepreneurs to bring together otherwise unproductive
resources. The key role played by a firm is the production of output using the economy's scarce resources.
Firm's are the means through which society transforms less satisfying resources into more satisfying goods
and services. If firms did not do this deed, then something else would. And we would probably call those
something else’s firms.
A firm faced with three basic questions:
a. What should it produce?
b. How should it produce it and
c. How much profit/net benefit will the firm make?
ENTREPRENEURSHIP
Entrepreneurship refers to the management skills, or the personal initiative used to combine resources in
productive ways. It involves taking risks. It is the managerial function that combines land, labor, and
capital in a cost-effective way and uncovers new opportunities to earn profit; includes willingness to
take the risks associated with a business venture.
PRODUCTION FUNCTION
A mathematical relation between the production of a good or service and the inputs used. A production
function is usually expressed in this general form: Q = f(L, K), where Q = quantity of production output,
L = quantity of labor input, and K = quantity of capital input. A production function is simply the
relationship between inputs & outputs.
Mathematically it can be written as:
Q = f (K, L, N, E, T, P…)
Where,
Q = Output = Total product produced
K = Capital
L = Labor
N = Natural resources
E = Entrepreneurship
T = Technology
P = Power
0 0
1 3
2 10
3 24
4 36
5 40
6 42
7 42
8 40
Graphical illustration
45
TP P
40
35
30
25
20
15
10
8 10
No of farm workers
The total physical product (TPP) of a factor (F) is the latter’s total contribution to output measured in
units of output produced.
Average physical product (APP) is TPP per unit of the variable factor. APP can be represented by the
following formula,
APP = TPPF/QF
Marginal physical product (MPP) is the addition to TPP brought by employing an extra unit of the
variable factor. More generally,
MPPF = ∆TPPF/∆QF
• If the marginal physical product is above the average physical product, the average physical
product will rise.
• If the marginal physical product is below the average physical product, the average physical
product will fall.
It would be possible to reduce cost per unit of output by using a different combination of labor and capital
If MPPL> MPPK
PL PK
More labor should be used relative to capital, since the firm is getting a greater physical return for its
money from using extra workers than it is getting from using extra capital. However as more and more
labor is used, diminishing returns to labor set in. Thus MPPL will fall. Likewise, as less capital is used,
MPPK will rise. Until
MPPK = MPPL
PK PL
(Technical or productive
Efficiency point)
ISOQUANT
An isoquant represents different combinations of factors of production that a firm can employ to produce
the same level of output. Isoquant can be used to illustrate the concepts of returns to scale and returns to
factor.
Capital
Isoquant
curve
Labor
Isoquant Map:
Like an indifference map, an isoquant map consists of parallel isoquants that do not intersect. Thehigher
the output level the further to the right an isoquant will be.
∆ K = MPPL
∆ L MPPK
MRTS = MPPL
MPPK
Isoquant can be used to illustrate the concepts of returns to scale and returns to factor.
a. Constant returns to scale: equally spaced isoquants;
b. Increasing returns to scale: isoquants become closer and closer to each other;
c. Decreasing returns to scale: isoquants become further and further apart from each other.
d. Diminishing returns to factors can be illustrated by keeping one of the inputs constant (say
capital). Here if there are constant returns to scale, ever-increasing increments of labor will be
required to produce equal increments to output.
Labor
SUNK COST
In economics and in business decision-making, sunk costs are costs that have already been incurred and
which cannot be recovered to any significant degree. Sunk costs are sometimes contrasted with variable
costs, which are the costs that will change due to the proposed course of action. In microeconomic theory,
only variable costs are relevant to a decision. Economics proposes that a rational actor does not let sunk
costs influence one's decisions, because doing so would not be assessing a decision exclusively on its own
merits. It is important to note that the decision-maker may make rational decisions according to their own
incentives; these incentives may dictate different decisions than would be dictated by efficiency or
profitability, and this is considered an incentive problem and distinct from a sunk cost problem.
Economists argue that sunk cost should not be included in a rational person’s decision-making process
while opportunity cost should be included.
TC = TVC + TFC
Output ( Q ) TFC TVC TC
0 12 0 12
1 12 10 22
2 12 16 28
3 12 21 33
4 12 28 40
5 12 40 52
6 12 60 72
7 12 91 103
120 TC
100
TVC
80
Cost
60
40
TFC
20
0
0 2 4 6 8
Output
RELATIONSHIP BETWEEN AC AND AVC
Initially, AC falls more rapidly than AVC because AC is a summation of AFC & AVC and since both are
falling the effect of two falling curves is greater than the effect of one falling curve. After the turning point
in AVC, both AC and AVC rise but the gap between them narrows because of same reasoning as given
above.
There is an inverse relationship between costs and productivity, i.e. as productivity rises, costs fall and
vice versa.
The equivalent of constant, increasing and decreasing returns to scale in terms of costs are economies of
scale, diseconomies of scale and constant costs (or constant returns to scale).
i. In the case of economies of scale, long run total cost (LRTC) is an upward sloping curve
but with falling slope. Note that the slope can never become zero or negative, though.
ii. In diseconomies of scale, LRTC is an upward sloping curve with an increasing slope.
iii. In constant costs, LRTC is a positively sloped straight line.
Revenues are the sale proceeds that accrue to a firm when it sells the goods it produces; in other words,
they are the cash inflows that the firm received by way of selling its products.
Total Revenue (TR), Average Revenue (AR) and Marginal Revenue (MR):
Total revenue (TR), average revenue (AR) and marginal revenue (MR) concepts apply in the same way
as they did to TC, AC and MC.
i. TR = P x Q.
ii. AR = TR/Q; AR is usually equal to price unless the firm is engaged in price
discrimination.
iii. MR = TR/Q.
PRICE-TAKING FIRM
A firm that does not have the ability to influence market price is a price-taker. In perfect competition, the
firm is price taker. There are large number of buyers and sellers and firm can not influence on the market
price. Price is set by the forces of demand and supply.
PRICE-MAKING FIRM
A firm that influences the market price by how much it produces can be called a price-maker or price-
setter. In Monopoly, firm is price maker. A monopoly or a firm within monopolistic competition has the
power to influence the price it charges as the good it produces does not have perfect substitutes. A
monopoly is a price maker as it holds a large amount of power over the price it charges.
Price
AR=MR=P
Quantity
TR TR
Quantity
Q P = AR TR= P×Q MR
(ships) Rs. Crores Rs. Crores
1 8 8
2 7 14 6
3 6 18 4
4 5 20 2
5 4 20 0
6 3 18 -2
7 2 14 -4
A price maker faces a downward sloping demand (or AR) curve i.e., it cannot sell more without reducing
price. But this means lowering the price for all units, not just the extra units it hopes to sell. The demand
faced by a price maker is elastic, when MR is positive and therefore TR increases due to a decrease in
price. Demand is inelastic when MR is negative, and therefore TR falls due to a decrease in price.
Price
AR
Quantity
MR
TR
TR
Quantity
PROFIT MAXIMIZATION
Firms are interested in profit maximization. Profit is the difference between total revenue & total cost.
Higher the difference, higher is the level of profit. Economists say that when firms earn zero accounting
profits, they actually earn normal economic profits because TC already includes the normal profits that
owners of the firms need for themselves to stay in the business. Positive profits are, for this reason, called
supernormal profits as they are over and above what the owners normally require as a return for their
entrepreneurship.
Profit = TR – TC
TR & TC APPROACH
According to this approach, profit is maximized at that point where the difference between total revenue
& total cost is maximum. In this table, profit is maximized at quantity of 3, where profit is at its maximum
of 4.
Q(units) TR TC Tπ
0 0 6 -6
1 8 10 -2
2 14 12 2
3 18 14 4
4 20 18 2
5 20 25 -5
6 18 36 -18
7 14 56 -42
MR & MC APPROACH
According to this approach, profit is maximized at the point where MC=MR. In this table, profit is
maximized at quantity of 4 where MR=MC=2
Q P=AR TR MR TC AC MC Tπ Aπ
0 9 0 ----- 6 ---- ---- -6 ----
1 8 8 8 10 10 4 -2 -2
2 7 14 6 12 6 2 2 1
3 6 18 4 14 4 2/3 2 4 1 1/3
4 5 20 2 18 4 1/2 4 2 1/2
5 4 20 0 25 5 7 -5 -1
6 3 18 -2 36 ? 11 -18 -3
7 2 14 -4 56 8 20 -42 -6
If MR & AR remain same over the long run, then the profit maximizing output will be obtained where
MR intersects LRMC.
If AC is always above AR, then firms will never be able to make a profit. In this case, the point where
MR=MC, represents the loss-minimizing point.
When MC and MR intersect at two points, not one, then Firms should produce at that point of
intersection of MR and MC beyond which, MC exceeds MR.
If a firm’s AR is below its AVC, it will shut down since it is not covering any part of its fixed costs.
Note: Graphical illustration of these two approaches is discussed in detail in the video lectures.
How will the length of the short run for a shipping company depend on the state of the shipbuilding
industry?
If the shipbuilding industry is in recession, the short run (and the long run) may be shorter. It will take
less time to acquire a new ship if there is no waiting list, or if there are already ships available to purchase
(with perhaps only minimal modifications necessary).
Up to roughly how long is the short run in the following cases?
(a) A mobile ice-cream firm. (b) A small grocery. (c) Electricity power generation.
a) 2-3 days: the time necessary to acquire new bicycles, equipment and workers.
b) Several weeks: the time taken to acquire additional premises.
c) 3-5 years: the time taken to plan and build a new power station.
How would you advise the naanwaala (bread-maker) next door as to whether he should (a)
employ an extra assistant on a Sunday (which is a high demand day); (b) extend his shop, thereby
allowing more customers to be served on a Sunday?
a) If maximizing profit is the sole aim, then he should employ an additional assistant if the extra
revenue from the extra customers that the assistant can serve is greater than the costs of employing
the assistant.
b) Only if the extra revenue from the extra customers will more than cover the costs of the extension
plus the extra staffing.
Given that there is a fixed supply of land in the world, what implications can you draw from
about the effects of an increase in world population for food output per head?
Other things being equal, diminishing returns would cause food output per head to decline (a declining
MPP and APP of labour). This, however, would be offset (partly, completely or more than completely)
by improvements in agricultural technology and by increased amounts of capital devoted to agriculture:
this would have the effect of shifting the APP curve upwards.
The following are some costs incurred by a shoe manufacturer. Decide whether each one is a fixed
cost or a variable cost or has some element of both.
(a) The cost of leather. (b) The fee paid to an advertising agency. (c) Wear and tear on machinery.
(d) Business rates on the factory. (e) Electricity for heating and lighting. (f) Electricity for running
the machines. (g) Basic minimum wages agreed with the union. (h) Overtime pay. (i) Depreciation
of machines as a result purely of their age (irrespective of their condition).
(a) Variable. (b) Fixed (unless the fee negotiated depends on the success of the campaign). (c) Variable
(the more that is produced, the more the wear and tear). (d) Fixed. (e) Fixed if the factory will be heated
and lit to the same extent irrespective of output, but variable if the amount of heating and lighting depends
on the amount of the factory in operation, which in turn depends on output. (f) Variable. (g) Variable
(although the basic wage is fixed per worker, the cost will still be variable because the total cost will
increase with output if the number of workers is increased). (h) Variable. (i) Fixed (because it does not
depend on output).
Assume that a firm has 5 identical machines, each operating independently. Assume that with all
5 machines operating normally, 100 units of output are produced each day. Below what level of
output will AVC and MC rise?
20 units. Below this level, the one remaining machine left in operation will begin to operate at a level
below its optimum. (Note that with 5 machines producing 100 units of output, minimum AVC could be
achieved at 100, 80, 60, 40 and 20 units of output, but between these levels some machines may be
working at less than their optimum and some at more than their optimum. Thus if the optimum level for
a machine is critical, then the AVC curve may look ‘wavy’ rather than a smooth line.
Why is the minimum point of the AVC curve (y) at a lower level of output than the minimum point
of the AC curve (z)?
Because between points y and z marginal cost is above AVC (and thus AVC must be past the minimum
point) but below AC (and thus AC cannot yet have reached the minimum point). Even though AVC is
rising beyond point y, the fall in AFC initially more than offsets the rise in AVC and thus AC still falls.
What economies of scale is a large department store likely to experience?
1 8 10
2 7 12
3 6 14
4 5 18
5 4 25
6 3 36
7 2 56
Q P = AR TR MR TC AC MC Tπ Aπ
0 9 0 6 – –6 –
8 4
1 8 8 10 10 –2 –2
6 2
2 7 14 12 6 2 1
4 2
3 6 18 14 4.3 4 1.3
2 4
Why should the figures for MR and MC be entered in the spaces between the lines?
Because marginal revenue (or cost) is the extra revenue (or cost) from moving from one quantity
to another.
You are given the following information for a firm.
Q 0 1 2 3 4 5 6 7
P 12 11 10 9 8 7 6 5
TC 2 6 9 12 16 21 28 38
Construct a detailed table like the one you constructed in the earlier question with TR, AC, MR, TC,
AC, MC, T and A. Use your table to draw “two” diagrams (one with the marginal revenue and cost
curves, and one with the total (or average) revenue and cost curves) and use them to show the “profit-
maximizing output” and the “level of maximum profit”, respectively. Confirm your findings byreference
to the table you construct.
Q P = AR TR MR TC AC MC Tπ Aπ
0 12 0 2 – –2 –
11 4
1 11 11 6 6 5 5
9 3
2 10 20 9 4.5 11 5.5
7 3
3 9 27 12 4 15 5
5 4
4 8 32 16 4 16 4
3 5
5 7 35 21 4.2 14 2.8
1 7
6 6 36 28 4.7 8 1.3
–1 10
7 5 35 38 5.4 –3 –0.4
The curves will be a similar shape to those discussed in the lecture, and included in the slides handout. The
peak of the T curve will be at Q = 4. This will be the output where MR and MC intersect.
Will the size of normal ‘profit’ vary with the general state of the economy?
Yes. Normal profit is the rate of profit that can be earned elsewhere (in industries involving similar level
of risk). When the economy is booming, profits will normally be higher than when the economy is in
recession. Thus the ‘normal’ profit that must be earned in any one industry must be higher to prevent
capital being attracted to other industries.
Given the following equations:
TR = 72Q – 2Q²; TC = 10 + 12Q + 4Q²
Calculate the maximum profit output and the amount of profit at that output using both methods.
(a) T = 72Q – 2Q² – 10 – 12Q – 4Q