P.O.

Box 342
THIKA, KENYA
Email: info@mku.ac.ke
Web: www.mku.ac.ke

Department of Business and Social studies

sciences

Course code: BBM 216

Course title: INTERMEDIATE MICRO-ECONOMIC THEORY

Instructional materials for distance learning students

 TABLE CONTENTS
CHAPTER ONE: INTRODUCTION TO MICROECONOMIC THEORY............................... 1
1.1.1 MODERN ECONOMICS AND ECONOMIC THEORY.................................................... 2
1.1.2 KEY ASSUMPTIONS AND DESIRED PROPERTIES COMMONLY USED
ECONOMICS ...................................................................................................................................... 4
1.1.3 THE BASIC ANALYTICAL FRAMEWORK OF MODERN ECONOMICS................... 4
1.1.4 METHODOLOGIES FOR STUDYING MODERN ECONOMICS.................................. 7
1.1.5 ROLES, GENERALITY, AND LIMITATION OF ECONOMIC THEORY ..................... 9
1.1.6 LIMITATION OF ECONOMIC THEORY .......................................................................... 10
1.1.7 ROLES OF MATHEMATICS IN MODERN ECONOMICS ........................................... 11
1.1.8 CONVERSION BETWEEN ECONOMIC AND MATHEMATICAL LANGUAGES ...... 12
1.1.9 DISTINGUISH BETWEEN NECESSARY AND SUFFICIENT CONDITIONS AS
WELL NORMATIVE AND POSITIVE STATEMENTS............................................................ 13
REVISION QUESTIONS ................................................................................................................ 14
QUESTION FOUR............................................................................................................................ 16
REFERENCE....................................................................................................................................... 16
CHAPTER TWO: CONSUMER THEORY ................................................................................... 18
2.1 THE BUDGET CONSTRAINT................................................................................................. 18
2.2 CONSUMER PREFERENCES .................................................................................................. 20
2.2.1 ASSUMPTION ABOUT PREFERENCES............................................................................ 21
2.2.2 INDIFFERENCE CURVES ..................................................................................................... 21
2.2.3 SHAPES OF INDIFFERENT CURVES ................................................................................ 22
2.2.4 THE MARGINAL RATE OF SUBSTITUTION ................................................................. 25
2.2. 5 BEHAVIOR PF THE MARGINAL RATE OF SUBSTITUTION.................................... 26
REVISION QUESTIONS ................................................................................................................ 27
REFERENCE....................................................................................................................................... 28
CHAPTER THREE: UTILITY.......................................................................................................... 29
3.3.1 THE UTILITY FUNCTION .................................................................................................... 29
3.3.3 CONSUMER EQUILIBRIUM................................................................................................ 33
REFERENCE....................................................................................................................................... 39
CHAPTER FOUR: THEORY OF DEMAND ................................................................................ 40
4.1 THE CONSUMER DEMAND FUNCTIONS......................................................................... 40
4.2 REVEALED PREFERENCE ....................................................................................................... 42

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4.3 THE WEAK AXIOM OF REVEALED PREFERENCE .......................................................... 45
4.5 THE HICKS SUBSTITUTION EFFECT.................................................................................. 58
REFERENCE....................................................................................................................................... 58
CHAPTER FIVE: THEORY OF PRODUCTION ......................................................................... 60
5.0 PRODUCTION TECHNOLOGY ............................................................................................. 60
5.1 DESCRIBING TECHNOLOGICAL CONSTRAINTS......................................................... 60
5.3 THE TECHNICAL RATE OF SUBSTITUTION.................................................................... 65
5.4 DIMINISHING TECHNICAL RATE OF SUBSTITUTION............................................... 66
5.5 THE LONG RUN AND THE SHORT RUN .......................................................................... 66
REFERENCE....................................................................................................................................... 67
CHAPTER SIX; THEORY OF MARKETS.................................................................................... 68
6.1 PERFECT COMPETITION........................................................................................................ 68
6.2 MONOPOLY AND MONOPOLISTIC COMPETITION.................................................... 75
MONOPOLY...................................................................................................................................... 76
6.3 MONOPOLISTIC COMPETITION ........................................................................................ 97
OPTIMAL ADVERTISING .......................................................................................................... 101
6.4 OLIGOPOLY.............................................................................................................................. 101
REFERENCE..................................................................................................................................... 109
CHAPTER SEVEN: GENERAL EQUILIBRIUM....................................................................... 110
LEARNING OBJECTIVES ............................................................................................................ 110
7.1 THE EDGEWORTH BOX DIAGRAM.................................................................................. 110
REVISON QUESTIONS................................................................................................................ 114
REFERENCE..................................................................................................................................... 117
CHAPTER EIGHT: EXTERNALITIES ........................................................................................ 118
8.1 WHAT IS AN EXTERNALITY?.............................................................................................. 118
8.2 PRIVATE SOLUTION TO EXTERNALITIES..................................................................... 120
8.3 FAILURES OF PRIVATE REMEDIES FOR EXTERNALITIES ....................................... 121
8.4 PUBLIC SECTOR SOLUTIONS TO EXTERNALITIES .................................................... 122
REVISION QUESTIONS .............................................................................................................. 124
SAMPLE QUESTIONS .................................................................................................................... 127

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 COURSE OUTLINE
BBM 216: INTERMEDIATE MICROECONOMICS
Contact hours: 42
Pre-requisites: BBM 115

Purpose: To understand and appreciate the importance of the various economics

activities and equip learners with skills that help them actively play a practical role in
economic activities thus enhancing economic development.

Expected Learning Outcomes of the Course:

By the end of the course unit the learners should be able to:-
i) Discuss economics problems faced by different types of economic systems
ii) Discuss intermediate welfare economics, economic efficiency, welfare efficiency
and compensation
iii) Explain causes and methods of dealing with externalities

Course Content
Extension of equilibrium and disequilibrium models in microeconomic theory;
Application of equilibrium analysis and disequilibrium analysis; Intermediate welfare
economics; economic efficiency, welfare, welfare criteria and compensation tests;
Intermediate theory of the firm, perfect competition, monopolistic competition,
monopoly, oligopoly, and game theory; Alternative to profit maximization; Public goods
and externalities; Methods of dealing with externalities; Factor markets ; theories and
distribution, rent interest and profit

Teaching / Learning Methodologies: Lectures and tutorials; group discussion;

demonstration; Individual assignment; Case studies

Instructional Materials and Equipment: Projector; test books; design catalogues;

computer laboratory; design software; simulators

Course Assessment
Examination - 70%; Continuous Assessment Test (CATS) - 20%; Assignments - 10%;
Total - 100%

Recommended Text Books:

i) Nicholson W. (1990) Intermediate Micro-economics and Its Applications London:
Dryden Press
ii) Hal R. Varian, (1999), Intermediate Microeconomics, 5th edition W. W. Norton &
Company

Text Books for further Reading:

i) Left and Eckrert (1984) The Price System and Resources Allocation London: Dryden
Press, (3rd Edition)

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CHAPTER ONE: INTRODUCTION TO MICROECONOMIC THEORY

LEARNING OBJECTIVES

At the end of the Lecture the student should be able to:

 Explain the nature of modern economics.
 Explain the relationship between mathematics and micro-economics.
 Outline Key Assumptions and Desired Properties Commonly Used Economics
 Explain The Basic Analytical Framework of Modern Economics
 Understand Methodologies for Studying Modern Economics
 Discuss Roles, Generality, and Limitation of Economic Theory
 Outline Limitation of Economic Theory
 Conversion between Economic and Mathematical Languages
 Distinguish between Necessary and Sufficient Conditions as well Normative and

In this chapter, we first set out some basic terminologies and key assumptions imposed in
modern economics in general and in the lecture notes in particular. We will discuss the
standard analytical framework usually used in modern economics. We will also discuss
methodologies for studying modern economics as well as some key points one should
pay attention. The methodologies for studying modern economics and key points include:
providing studying platforms, establishing reference/benchmark systems, developing
analytical tools, noting generality and limitation of an economic theory, the role of
mathematics, distinguishing necessary and sufficient conditions for a statement, and
conversion between economic and mathematical language

1.1 Nature of Modern Economics

1.1.1 Modern Economics and Economic Theory
What is economics about?
Economics is a social science that studies individuals' economic behavior, economic
phenomena, as well as how individual agents, such as consumers, firms, and government
agencies, make trade-off choices that allocate limited resources among competing uses.

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People's desires are unlimited, but resources are limited, therefore individuals must make
trade-offs. We need economics to study this fundamental conflict and how these trade-
offs are best made.
Four basic questions must be answered by any economic institution:

(1) What goods and services should be produced and in what quantity?
(2) How should the product be produced?
(3) For whom should it be produced and how should it be distributed?
(4) Who makes the decision?
The answers depend on the use of economic institutions. There are two basic economic
institutions that have been so far used in the real world:
(1) Market economic institution (the price mechanism): Most decisions on economic
activities are made by individuals. This primarily decentralized decision system is the
most important economic institution discovered for reaching cooperation amongst
individuals and solving the conflicts that occur between them. The market economy has
been proven to be only economic institution, so far, that can keep sustainable
development and growth within an economy.
(2) Planed economic institution: Most decisions on economic activities are made by
governments, which are mainly centralized decision systems.

What is Modern Economics?

Modern economics, mainly developed in last sixty years, systematically studies
individuals' economic behavior and economic phenomena by a scientific studying
method {observation} and through the use of various analytical approaches.
What is Economic Theory?
An economic theory, which can be considered an axiomatic approach, consists of a set of
assumptions and conditions, an analytical framework, and conclusions (explanations
and/or predications) that are derived from the assumptions and the analytical framework.
Like any science, economics is concerned with the explanation of observed phenomena
and also makes economic predictions and assessments based on economic theories.

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Economic theories are developed to explain the observed phenomena in terms of a set of
basic assumptions and rules.
Microeconomic theory
Microeconomic theory aims to model economic activities as the interaction of individual
economic agents pursuing their private interests.

1.1.2 Key Assumptions and Desired Properties Commonly Used Economics

Economists usually make all or some of the following key assumptions and conditions
when they study economic problems:
(1) Individuals are (bounded) rational: self-interested behavior assumption;
(2) Scarcity of resources: individuals confront scarce resources;
(3) Economic freedom: voluntary cooperation and voluntary exchange;
(4) Decentralized decision makings: One prefers to use the way of decentralized decision
making. Why? This is because most economic information is incomplete or asymmetric
to a decision marker;
(5) Incentive compatibility of parties: the system or economic mechanism should solve
the problem of interest conflicts among individuals or economic units;
(6) Well-defined property rights;
(7) Equity in opportunity;
(8) Allocative efficiency of resources;
Relaxing any of these assumptions may result in different conclusions.

1.1.3 The Basic Analytical Framework of Modern Economics

The basic analytical framework for an economic theory consists of five aspects or steps:
(1) Specification of economic environments,
(2) Imposition of behavioral assumptions,
(3) Adoption of economic institutional arrangements,
(4) Determination of equilibria, and
(5) Evaluation of outcomes resulting from a undertaken institution. The framework is a
framework that uses to deal with daily activities and is used to study particular economic
issues and questions that economists are interested in. Almost of all theoretical

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economics papers adopt this framework. As such, to have a solid training in economics
and doing research, it is very important to master this basic analytical framework,
specifically, these five steps. It can helpful at least in the following three aspects:
(1) Help to understand economic theories and their arguments relatively easily. (2) Help
to find research topics.
(3) How to write standard scientific economics papers.
Understanding this basic analytical framework can help people classify possible
misunderstandings about modern economics and can also help them use the basic
economic principles or develop new economic theories to solve economic problems in
various economic environments, with different human behavior and institutional
arrangements.

1. Specification of Economic Environments

The first step for studying an economic issue is to specify the economic environment.
The specification on economic environment can be divided into two levels: 1) description
of the economic environment, and
2) Characterization of the economic environment.

To perform these well, the description is a job of science, and the characterization is a job
of art. The more clear and accurate the description of the economic environment is, the
higher the possibility is of the correctness of the theoretical conclusions. The more
refined the characterization of the economic environment is, the simpler and easier the
arguments and conclusions will obtain.
Modern economics provides various perspectives or angles to look at real world
economic issues. An economic phenomenon or issue may be very complicated and be
affected by many factors. The approach of characterizing the economic environment can
grasp the most essential factors of the issue and take our attention to the most key and
core characteristics of an issue so that we can avoid unimportant details. An economic
environment usually consists of
(1) A number of individuals,
(2) The individuals' characteristics, such

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as preferences, technologies, endowments, etc.
(3) Informational structures, and
(4) Institutional economic environments that include fundamental rules for establishing
the basis for production, exchange, and distribution.
2. Imposition of Behavior Assumptions
The second step for studying an economic issue is to make assumptions on individuals'
behavior. Making appropriate assumptions is of fundamental importance for obtaining a
valuable economic theory or assessment. A key assumption modern economics makes
about an individual's behavior is that an individual is self-interested. This is a main
difference between individuals and other subjects. The self-interested behavior
assumption is not only reasonable and realistic, but also has a minimum risk. Even this
assumption is not suitable to an economic environment; it does not cause a big trouble to
the economy even if it is applied to the economy. A rule of a game designed for self-
interested individuals is likely also suitable for altruists, but the reverse is likely not true.

3. Adoption of Economic Institutional Arrangement

The third step for studying an economic issue is to adopt the economic institutional
arrangements, which are also called economic mechanisms, which can be regarded as the
rules of the game. Depending on the problem under consideration, an economic
institutional arrangement could be exogenously given or endogenously determined. For
instance, when studying individuals' decisions in the theories of consumers and
producers, one implicitly assumes that the undertaken mechanism is a competitive market
mechanism takes it as given. However, when considering the choice of economic
institutions and arguing the optimality of the market mechanism, the market institution is
endogenously determined. The alternative mechanisms that are designed to solve the
problem of market failure are also endogenously determined. Economic arrangements
should be designed differently for different economic environments and behavior
assumptions.

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4. Determination of Equilibria

The fourth step for studying an economic issue is to make trade-off choices and
determine the "best" one. Once given an economic environment, institutional
arrangement, and other constraints, such as technical, resource, and budget constraints,
individuals will react, based on their incentives and own behavior, and choose an
outcome from among the available or feasible outcomes. Such a state is called
equilibrium and the outcome an equilibrium outcome. This is the most general definition
an economic \equilibrium".

5. Evaluations
The fifth step in studying an economic issue is to evaluate outcomes resulting from the
undertaken institutional arrangement and to make value judgments of the chosen
equilibrium outcome and economic mechanism based on certain criterion. The most
important criterion adopted in modern economics is the notion of efficiency or the \first
best". If an outcome is not efficient, there is room for improvement. The other criterions
include equity, fairness, incentive-compatibility, informational efficiency, and operation
costs for running an economic mechanism. In summary, in studying an economic issue,
one should start by specifying economic environments and then study how individuals
interact under the self-interested motion of the individuals within an exogenously given
or endogenously determined mechanism. Economists usually use \equilibrium,"
\efficiency", \information", and \incentive-compatibility" as focal points, and investigate
the effects of various economic mechanisms on the behavior of agents and economic
units, show how individuals reach equilibria, and evaluate the status at equilibrium.
Analyzing an economic problem using such a basic analytical framework has not only
consistence in methodology, but also in getting surprising (but logically consistent)
conclusions.

1.1.4 Methodologies for Studying Modern Economics

As discussed above, any economic theory usually consists of five aspects. Discussions on
these five steps will naturally amplify into how to combine these five aspects organically.

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To do so, economists usually integrate various studying methods into their analysis. Two
methods used in modern economics are providing various levels and aspects studying
platforms and establishing reference/benchmark systems.
Studying Platform
A studying platform in modern economics consists of some basic economic theories or
principles. It provides a basis for extending the existing theories and analyzing more deep
economic issues. Examples of studying platforms are:
(1) Consumer and producer theories provide a bedrock platform for studying individuals'
independent decision choices.
(2) The general equilibrium theory is based on the theories of consumers and producers
and is a higher level platform. It provides a basis for studying interactions of individuals
within a market institution and how the market equilibrium is reached in each market.
(3) The mechanism design theory provides an even higher level of studying platform and
can be used to study or design an economic institution. It can be used to compare various
economic institutions or mechanisms, as well as to identify which one may be an
\optima".

Reference Systems/Benchmark
Modern economics provides various reference/benchmark systems for comparison and to
see how far a real world is from an ideal status. A reference system is a standard
economic model/theory that results in desired or ideal results, such as efficiency/the \first
best".
The importance of a reference system does not rely on whether or not it describes the real
world correctly or precisely, but instead gives a criterion for understanding the real
world.
It is a mirror that lets us see the distance between various theoretical models/realistic
economic mechanisms and the one given by the reference system. For instance, the
general equilibrium theory we will study in the notes is such a reference system. With
this reference system, we can study and compare equilibrium outcomes under various
market structures with the ideal case of the perfectly competitive mechanism. The first-

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best results in a complete information economic environment in information economics.
Other examples include the Coarse Theorem in property rights theory and economic law,
and the Modigliani-Miller Theorem in corporate finance theory.

Although those economic theories or economic models as reference systems may impose
some unrealistic assumptions, they are still very useful, and can be used to make further
analysis. They establish criterions to evaluate various theoretical models or economic
mechanisms used in the real world. A reference system is not required, in most cases it is
actually not needed, to predicate the real world well, but it is used to provide a
benchmark to see how far a reality is from the ideal status given by a reference system.

The value of a reference system is not that it can directly explain the world, but that it
provides a benchmark for developing new theories to explain the world. In fact, the
establishment of a reference system is very important for any scientific subject, including
modern economics. Anyone can talk about an economic issue but the main difference is
that a person with systematic training in modern economics has a few reference systems
in her mind while a person without training in modern economics does not so he cannot
grasp essential parts of the issue and cannot provide deep analysis and insights.

Analytical Tools
Modern economics also provides various powerful analytical tools that are usually given
by geometrical or mathematical models. Advantages of such tools can help us to analyze
complicated economic behavior and phenomena through a simple diagram or
mathematical structure in a model. Examples include (1) the demand-supply curve
model, (2) Samuelson's overlapping generation model, (3) the principal-agent model, and
(4) the game theoretical model.

1.1.5 Roles, Generality, and Limitation of Economic Theory

Roles of Economic Theory
An economic theory has three possible roles: (1) It can be used to explain economic
behavior and economic phenomena in the real world. (2) It can make scientific

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predictions or deductions about possible outcomes and consequences of adopted
economic mechanisms when economic environments and individuals' behavior are
appropriately described. (3) It can be used to refute faulty goals or projects before they
are actually undertaken. If a conclusion is not possible in theory, then it is not possible in
a real world setting, as long as the assumptions were approximated realistically.

Generality of Economic Theory

An economic theory is based on assumptions imposed on economic environments,
individuals' behavior, and economic institutions. The more general these assumptions are,
the more powerful, useful, or meaningful the theory that comes from them is. The general
equilibrium theory is considered such a theory.

1.1.6 Limitation of Economic Theory

When examining the generality of an economic theory, one should realize any theory or
assumption has a boundary, limitation, and applicable range of economic theory. Thus,
two common misunderstandings in economic theory should be avoided. One
misunderstanding is to over-evaluate the role of an economic theory. Every theory is
based on some imposed assumptions. Therefore, it is important to keep in mind that every
theory is not universal, cannot explain everything, but has its limitation and boundary of
suitability. When applying a theory to make an economic conclusion and discuss an
economic problem, it is important to notice the boundary, limitation, and applicable range
of the theory. It cannot be applied arbitrarily, or a wrong conclusion will be the result.

The other misunderstanding is to under-evaluate the role of an economic theory. Some

people consider an economic theory useless because they think assumptions imposed in
the theory are unrealistic. In fact, no theory, whether in economics, physics, or any other
science, is perfectly correct. The validity of a theory depends on whether or not it
succeeds in explaining and predicting the set of phenomena that it is intended to explain
and predict. Theories, therefore, are continually tested against observations. As a result of
this testing, they are often modified, refined, and even discarded.

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The process of testing and refining theories is central to the development of modern
economics as a science. One example is the assumption of perfect competition. In reality,
no competition is perfect. Real world markets seldom achieve this ideal status. The
question is then not whether any particular market is perfectly competitive, almost no one
is. The appropriate question is to what degree models of perfect competition can generate
insights about real-world markets. We think this assumption is approximately correct in
certain situations. Just like frictionless models in physics, such as in free falling body
movement (no air resistance), ideal gas (molecules do not collide), and ideal fluids,
frictionless models of perfect competition generate useful insights in the economic world.
It is often heard that someone is claiming they have toppled an existing theory or
conclusion, or that it has been overthrown, when some condition or assumption behind it
is criticized. This is usually needless claim, because any formal rigorous theory can be
criticized at anytime because no assumption can coincide fully with reality or cover
everything. So, as long as there are no logic errors or inconsistency in a theory, we cannot
say that the theory is wrong. We can only criticize it for being too limited or unrealistic.
What economists should do is to weaken or relax the assumptions, and obtain new
theories based on old theories. We cannot say though that the new theory topples the old
one, but instead that the new theory extends the old theory to cover more general
situations and different economic environments.

1.1.7 Roles of Mathematics in Modern Economics

Mathematics has become an important tool in modern economics. Almost every field in
modern economics uses mathematics and statistics. The mathematical approach to
economic analysis is used when economists make use of mathematical symbols in the
statement of a problem and also draw upon known mathematical theorems to aid in
reasoning. It is not difficult to understand why the mathematical approach has become a
dominant approach since finding the boundary of a theory, developing an analytical
framework of a theory, establishing reference systems, and providing analytical tools all
need mathematics. If we apply a theoretical result to real world without knowing the

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boundary of a theory, we may get a very bad consequence and hurt an economy
seriously.

Some of the advantages of using mathematics are that (1)the \language" used and the
descriptions of assumptions are clearer, more accurate, and more precise, (2) the logical
process of analysis is more rigorous and clearly sets the boundaries and limitations of a
statement, (3) it can give a new result that may not be easily obtained through observation
alone, and (4) it can reduce unnecessary debates and improve or extend existing results.

It should be remarked that, although mathematics is of critical importance in modern

economics, economics is not mathematics. Economics uses mathematics as a tool in order
to model and analyze various economic problems. Statistics and econometrics are used to
test or measure the accuracy of our predication, and identify causalities among economic
variables.

1.1.8 Conversion between Economic and Mathematical Languages

The result of economics research is an economic conclusion. A valuable economics paper
usually consists of three parts: (1) It raises important economic questions and answering
these questions become the objectives of a paper. (2) It establishes the economic models
and draws and proves the conclusions obtained from the model. (3) It uses non-technical
language to explain the results and, if relevant, provides policy suggestions.

Thus, the production of an economic conclusion usually goes in three stages:

Stage 1:
(non-mathematical language stage) Produce preliminary outputs, propose economic
ideas, intuitions, and conjectures.

(2) Stage 2:
(Mathematical language stage) Produce intermediate outputs, give a formal and rigorous
result through mathematical modeling that specifies the boundary of a theory.
Stage 3:

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(Non-technical language stage) Produce final outputs, conclusions, insights, and
statements that can be understood by non specialists.

1.1.9 Distinguish between Necessary and Sufficient Conditions as well Normative

and Positive Statements
When discussing an economic issue, it is very important to distinguish between: (1) two
types of conditions: necessary and sufficient conditions for a statement to be true and (2)
two types of statements: positive analysis and normative analysis. It is easy to confuse the
distinction between necessary conditions and sufficient conditions, a problem that results
often in incorrect conclusions.

For instance, it is often heard that the market institution should not be used based on the
fact that some countries are market economies but remain poor. The reason this logic
results in a wrong conclusion is that they did not realize the adoption of a market
mechanism is just a necessary condition for a country to be rich, but is not a sufficient
condition. Becoming a rich country also depends on other factors such as political
system, social infrastructures, and culture. Additionally, no example of a country can be
found so far that it is rich in the long run, that is not a market economy. A positive
statement states facts while normative statements give opinions or value judgments.
Distinguishing these two statements can void many unnecessary debates.

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REVISION QUESTIONS

QUESTION ONE

Evans Hall society is composed of a large poor class and a minority wealthy class. Each
consumer in this society buys only two goods: new economic books and used economics
books (plus coffee to keep awake while trying to read them, but we’ll ignore that). For
each poorer consumer, the income effect of a change in the price of used books reinforces
the substitution effect. For each wealthy consumer, the income effect opposes and
outweighs the substitution effects.

a) For which classes are used books a Giffen good? a normal good? an inferior good?
b) Illustrate graphically the effect of a decrease in the price of used books on an
individual’s consumption in each class. Label the substitution and income effects for used
books.
c) Think about what could cause the income effects of the two classes to be different.
2) Consider a government subsidy program that lowers the price of food to poor
consumers from $3 per unit to $2. Assume:
 diminishing MRS between food and all other goods (AOG)
 price of AOG is $1
 good and AOG are normal goods
a) Graphically show the change in food consumption that results from the program.
b) Graphically show the change in consumption attributable to the income and
substitution effects.
c) Show graphically how much the program costs the government.
d) An economist claims that she can make these poor consumers better off without
costing the government any more money. How is this possible? (This can be shown
graphically).

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QUESTION TWO

If the marginal product of labor is decreasing as more labor is used, must the average
product of labor also be decreasing? Can a firm be producing efficiently when the
marginal product of labor is negative?
2. Suppose the demand for corn oil is Q = 1,000 - 10p + 10Y, where Y = income, p =
price, and Q =quantity. Write a formula for the price elasticity of demand for corn oil.
3. An hour-long exam consists of two problems, each worth a maximum of 50 points. A
student doesn’t have enough time to get full-credit on both questions. How should this
student allocate his or her time spent on each problem to maximize the total score?
Illustrate your answer using a figure. #
4. The United States imposes a binding quota of Q* on steel imports. Suppose the U.S.
supply curve is relatively inelastic while the supply curve of foreign supplier is very
elastic. Use a figure to show the effect of the quota on the U.S. price of steel, the quantity
of steel sold by U.S. firms, and the total quantity sold in the United States.

QUESTION THREE
The government is considering either setting (i) a binding electricity price ceiling or (ii)
providing a per unit subsidy to consumers so that they would pay the same price as they
would with a price ceiling.
(A) Contrast the effects of these two policies (discuss prices for firms and
consumers, quantities,...).
(B) What determines the incidence of the subsidy on consumers? (7)
b) 6. A manufacturing firm uses only capital (K) and labor (L) to produce its
product, using a production function of Q = 10KL. It pays its workers w = $15 per
hour and has a rental cost of capital of r = $5 per hour.
(A) Does this firm’s production function exhibit decreasing, constant, or
increasing returns to scale?
(B) The firm wants to produce 480 units of output. Find the optimal bundle of
inputs (L*,K*) it should use to minimize its cost of production. (Note:
MPL = 10K and MPK = 10L.)

15
 c) At the original wage w1, Janice chose to work 4 hours a day.
Her boss now tells her that all employees must work at least 8 hours a day. Use a figure
to show Janice’s new budget constraint. Show how Janice responds to this new budget
constraint: How many hours does she work? (If there are several possibilities, explain
why.) Now her boss says that she must work at least 8 hours, but offers her a higher wage
(w2 > w1), which is high enough that she is as well off as before the boss imposed the
full-time restriction. Use a figure to show how many hours she is willing to w

QUESTION FOUR

A firm produces candles. The market for candles is highly competitive, with candles
currently selling for $10. The firm's short-run total cost function is C = 200 + 0.2q2, so its
marginal cost is MC = 0.4q.

A. What is the firm's profit-maximizing quantity? (5 pts)

B. Is the firm earning a profit? (6 pts)

C. What is the short-run shutdown price? (6 pts)

QUESTION FIVE

3. In the short run, will a competitive firm ever produce in A) the downward-sloping
section of its average cost curve, B) in the downward-sloping section of its average
variable cost curve? Why (17 pts)?

Reference
Border, K. C., Fixed Point Theorems with Applications to Economics and Game The-
ory, Cambridge: Cambridge University Press, 1985.
Luenberger, D., Microeconomic Theory, McGraw-Hill, 1995, Appendixes A-D.
Takayama, A. Mathematical Economics, the second edition, Cambridge: Cambridge
University Press, 1985, Chapters 1-3.

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Tian, G., The Basic Analytical Framework and Methodologies in Modern Economics,
2004 (in Chinese). http://econweb.tamu.edu/tian/chinese.htm.
Tian, G., \Fixed Points Theorems for Mappings with Non-Compact and Non-Convex
Domains," Journal of Mathematical Analysis and Applications, 158 (1991), 161-167.

17
CHAPTER TWO: CONSUMER THEORY

LEARNING OBJECTIVES

At the end of the Lecture the student should be able to:

 Explain the concept of Budget Constraint
 Explain the concept of consumer Preferences
 Outline assumptions about preferences
 Define Indifference curves
 Explain and illustrate the shapes of Indifferent Curves
 Explain the concept of Marginal Rate of Substitution
In your elementary microeconomics, the basic principles of consumer behavior were
introduced by laying a strong foundation on the theory of demand on which premise the
consumer behavior is build upon. The consumer behavior is introduced as a utility
maximizing behavior but subject to consumer’s ability to purchase. A consumer is
portrayed as an agent who goes for the best that he/she can afford.

In the intermediate level we describe more precisely what we mean by ‘best’ and I can
afford’, In the first section, we will examine how to describe what a consumer can afford;
the next section will focus on the concept of how the consumer determines what is best.
We will then be able to undertake a detailed study of the implications of this simple mode
of consumer behavior.

2.1 The Budget Constraint

Suppose that there is some set of goods from which the consumer can choose. In real life
there are many goods to consume but we will consider two.

Let the consumer’s consumption bundle be ( X 1 X 2 ) where X 1 ,represents the number of

units the consumer chooses of good I and X 2 is the number of units of good to be chosen
by the consumer.

18
Let P 1 and P 2 represent the unit prices for the two goods respectively; and M to represent
the amount of money the consumer has to spend.

The budget constraint of the consumer can be written as:

p1 x1  p2 x2  M

Where P 1 X 1 is expenditure for good I and P 1 X 1 is expenditure on good 2

The budget constraint of the consumer requires that the amount of money spent on the
two good is no more than the total amount the consumer has to spend. The consumer’s
affordable consumption bundles are those that do not costs any more than m. The set of
affordable consumption bundles at prices P 1 P 2 income M is called the budget set of the
consumer.
The set of bundles that cost exactly M is called the budget line.

p1 x1  p2 x2  M

These are the bundles of goods that are affordable at the given prices and income.

X2

M
P2

Budget Line
Slope =  Pp21

Budget set
M
P1 X1

The budget set consists of all bundles that are affordable at the given prices and income.

19
Re- arranging equations ( 2)

x2 MP2 Pp11 x2……………………………………(3)

M
This is an equation for a straight line with a vertical intercept of and a slope of
P2
p1
 P1

The example tells how many units of good 2 the consumer needs to consume in order to
just satisfy the budget constraint, if she is consuming X 1 units of good 1.

The slope of the budget line measures the rate at which the market is willing to substitute
good 1 for good 2

 x2 p
 1
 x1 p2
The slope of the budget line is also said to be an opportunity cost of consuming good 1.
In order to consume more of good1, one has to give up some consumption of good 2.
Giving up the opportunity of consume good 2 is the true economic cost of more of good
1 consumption, and that cost is measured by the slope of the budget line.

2.2 Consumer Preferences

This section is devoted to clarifying the economic concept of “best thins” now that the
meaning of “can afford” is clear.
The objects of consumer choice are consumption bundles. This is a complete list of the
goods and services that are involved in the choice problem faced by a consumer.

20
Suppose there are two consumption bundles (X 1 X 2 ) and (Y 1 Y 2 ).The consumer can rank
them as to their desirability. That is, the consumer can determine that one of the bundles
is strictly better than the other, or decide that she is indifferent between the two bundles.
2.2.1 Assumption about preferences

1. Completeness: It is assumed that any two bundles can be compared. That is,
given any X bundle and Y bundle, then (X 1 X 2 ) > (Y 1 Y 2 ) or (Y 1 Y 2 ) > (X 1 X 2 ) or
both, in which case the consumer is indifferent between two bundles. This is to
say that the consumer can make a choice.
2. Reflexive: We assume that any bundle is at least as good as itself.
(X 1 X 2 ) > (X 1 X 2 )
Transitive: If (X 1 X 2 ) > ( Y 1 Y 2 ) and ( Y 1 Y 2 ) > ( Z 1 Z 2 ) then we assume that consumer
thinks that X is at least as good as Y and that Y is at least as good as Z, then the
consumer thinks that X is at least as Z.

2.2.2 Indifference curves

The whole theory of consumer choice can be formulated in terms of preferences that
satisfy the three axioms above. However, it is convenient to describe preferences
graphically using indifference curves.

21
 Consider a consumer’s consumption of goods 1 and 2
X2

X2

0
X1 X1

If (X 1 X 2 ) is a certain consumption bundle, the consumption bundle in the shaded region

are weakly preferred to (X 1 X 2 ). It is called the weakly preferred set. The bundles on the
boundary of this set for which the consumer is just different to (X 1 X 2 ) from the
indifference curve. It consists of all bundles of goods that leave consume indifferent to
the given bundle.

2.2.3 Shapes of Indifferent Curves

If no further assumptions about preferences are made. ICs can take very peculiar shapes.

1. Perfect Substitutes
Two goods are perfect substitutes if the consumer is willing to substitute one good
for the other at a constant rate. The simplest care of perfect substitutes occurs
when the consumer is willing to substitute the goods on alone to one basis. ICs
for such a consumer are all parallel straight lines.

22
 X2
IC s
Linear ICs, Perfect Substitution

0 X1

Perfect Complements
Perfect complements are goods that are always consumed together in fixed proportions,
e.g shoes ( left and right ). The ICs L shaped. with the vertex of the L occurring where the
number of one good equals the number of the other good

X2

0 X1

3. Bad goods
A bad is c commodity that the consumer doesn’t like. Suppose that the two commodities
are meat and pepper, the consumer loves meat bud dislike pepper. But suppose there is
some trade of possible between meat and pepper i.e there would be some amount of meat

23
in samosa that could compensate the consumer for having to consume a given amount of
pepper, If more pepper is given in the samosa ,more meat has to be given to compensate
for having to put up with the pepper. Thus this consumer will have indifference curves
that slope up and to the right.
X2
(bad)

ICs

X1
(Good)
3. Neutral Goods
A good is a neutral good if the consumer doesn’t care about it one way or the
other. Suppose in the above case the consumer is just neutral about pepper (X 2 ).
The IC would be vertical lines as depicted below. The consumer only cares about
the amount of X 1 and doesn’t care at all a bout how much of X 2 he/she has. The
more of X 1 the better but adding more X 2 doesn’t affect him.

X2 IC

Adding X 1

0 X1
5. Imperfect Substitutes
If the rate at which one good is substituted for another is not constant, but diminishing,
then the two goods are imperfect substitutes. As more and note of one good is given up
successively larger units of the other good are consumer to compensate the consumer

24
 for the loss. Such goods will have indifference curves that are rounded, i.e The ICs are
strictly convex.

X2

X1
2.2.4 The Marginal Rate of Substitution

The slope of the IC is known as the Mrs. It measures the rate at which the consumer is
just willing to substitute one good for another.
Suppose that we take a little of good 1; ∆X 1 away from the consumer. Then we give him
∆ X 2 an amount i.e. just sufficient to put him back on his/her IC, so that he is just as well
off after this substitution of X 2 for X 1 as he was before.

The ration ∆X 2 is thought as being the rate at which the consumer is willing to ∆X 1
substitute good 1 for good 1 and is called the MRS.

The MRS measures an interesting measure of consumer behavior. Suppose that the
consumer has well behaved preferences, i.e. preferences which are monotonic and
convex, and currently consuming some bundle (X 1 X 2 ). The consumer is now offered a
trade: to exchange good I for 2 or good 2 for I in any amount at a “rate of exchange” of E.
i.e. If the consumer gives up ∆X 1 units of good1, he can get E∆X 1 units of good 2 in
exchange or conversely, if he gives up ∆ X 2 , units of good 2, he can get ∆X 2 units of
good 1.

25
  x2
MRS  E
 x1

 x2  E  x1

 x2
 x1  
E
Geometrically, we are offering the consumer an opportunity to move to any point along a
line with a slop E that passes through X 1 X 2 as depicted.
 x2 p
 1 1 IC
 x1 p2

y
X2 E
x
X1 X1

Moving up and to the left from X 1 to X 2 involves exchange of good I for good 2,and
moving down to the right involves exchanging good 2 for good 1. In either movement the
exchange rate is E. Since exchange always involves giving up one good in exchange for
another, the exchange rate E corresponds to slope at E. The point of tangency between
the budget line and the indifference curve is referred to as the consumer equilibrium.

2.2. 5 Behavior pf the marginal Rate of substitution

Perfect substitute’s indifference curves are characterized by the fact that the MRS is
constant at – 1 .The neutral case is characterized by the fact that the MRS is everywhere
infinite .The preference for perfect complements are characterized by the fact that the
MRS is either ) or infinite and nothing is between.

26
The assumption of monotomity implies that ICs must have a negative slope, so the MRS
always involves reducing the consumption of one good in order to get mote of another for
monotonic preferences.

The case of convex ICs exhibits yet another kind of behaviour for the MRS. For Convex
ICs, the MRS decreases as more of X 1 is consumer. Thus the IC exhibits a diminishing
Mrs. Convexity of ICs implies that the more of a good consumed, the more willing is a
consumer is to give some of it u- in exchange for the other goods. This seems very
natural for a consumer and hence convexity if ICs becomes both necessary and sufficient
conditions for consumer equilibrium besides just having a point of tangency between the
consumer’s budget line and the IC.

REVISION QUESTIONS

QUESTION ONE
Consider a model with two periods, each with one composite consumption good. Prices
are the stable and normalized to 1. Suppose a consumer is endowed with income 20 in the
first period and 60 in the second period. The consumer receives a 10% interest rate on
savings and is subject to a 20% interest rate on borrowing. Regulations prohibit the
consumer from borrowing more than 20.
(a) Find this consumer’s budget constraint.
(b) Carefully graph the budget set. Label all intercepts.

QUESTION TWO

Suppose a consumer's preferences are represented by the utility function u(x; y) = x + 2y.
The price for good x is px, the price for good y is py, and the consumer has m to spend.
(a) Graph indifference curves given by these preferences.
(b) Derive the consumer's demand for good x as a function of px, py, and m.
(c) Derive the consumer's demand for good y as a function of px, py, and m.

27
QUESTION THREE

a) What is perfect competition? Explain the assumptions of perfect competition.

b) With the help of a diagram distinguish between the substitution effect and income
effect of a price change with respect to a normal good
QUESTION four
a) Define the concept of externalities and explain four remedies to negative
externalities
b) Define monopoly and explain the sources of monopoly power

Reference
1. Border, K. C., Fixed Point Theorems with Applications to Economics and Game The-
ory, Cambridge: Cambridge University Press, 1985.

2. Luenberger, D., Microeconomic Theory, McGraw-Hill, 1995, Appendixes A-D.

3. Takayama, A. Mathematical Economics, the second edition, Cambridge: Cambridge

University Press, 1985, Chapters 1-3.

4. Tian, G., The Basic Analytical Framework and Methodologies in Modern Economics,
2004

5. Tian, G., \Fixed Points Theorems for Mappings with Non-Compact and Non-Convex
Domains," Journal of Mathematical Analysis and Applications

28
CHAPTER THREE: UTILITY

The theory of consumer behavior has been formulated with an objective of utility
maximization .Utility refers to the ability of in a good to satisfy the consumer.

There are several approaches to the study of utility with one theory attaching significance
to the magnitude utility and is know as the cardinal utility theory. In this theory the size
of the utility difference between the bundles of goods is supposed to have some sort of
significance.
Another theory formulates the consumer behavior entirely in terms of consumer
preferences and utility is seen only as a way to describe preferences by ranking bundles
according to utility derived from each bundle. The proponents of this theory recognized
that all that mattered about utility as far as choice behavior was concerned was whether
one bundle had a higher utility than another but how much higher didn’t matter ( ranking
was the only matter). Because of this emphasis on ordering bundles of goods, this kind of
utility is refereed ordinal utility.

3.3.1 The Utility Function

A utility function is a way of assigning a number to every possible consumption bundle
such that more preferred bundles get assigned larger numbers that less preferred bundles.
A utility function is a way of to label indifference curves. Since every bundle of an IC
must have the same utility, a utility function is a way to assign number to the different
indifference curves in a way tat higher ICs get assigned larger numbers. As long as ICs
containing more preferred bundles get a larger label than indifference curves containing
less preferred bundles, the labeling will represent the different preferences.
However, not all kinds of preferences can be represented by a utility function for
example, suppose a consumer had intransitive preferences so that A > B > C > A. Then a
utility function for these preferences would have to consist of numbers U(A), U(B) and
U(C) such that U(A) >U(B) > U (C) U(A), which is impossible.

29
Examples of Utility Functions
1. Perfect Substitutes goods
Preferences for perfect substitutes are represented by linear utility functions of the
form.
U(X 1 X 2 ) = α X 1 = βX 2

Where∞ α, β>0,numbers that measure the value of goods 1 and 2 to the consumer, by
plotting all the points (X 1 X 2 ) such that U(X 1 X 2 ) equals a constant, yields a linear

indifference curve with a slope  . For every different value of a constant, there is a


different IC, but having a similar slope of  .Each represents utility functions which

are monotonic transformations to each other.

X2

a
ICs with a slope =
b

X1

2. Complementary goods
These goods used together. The preferences for complementary goods take utility
functions of the form.

U (X 1 X 2 ) = min ( X 1 X 2 ) = Min (α X 1 , βX 2 )

30
 Where a and β are positive numbers that indicate the proportion in which the
goods are consumed
e.g αx 1 < β X 2 , then U ( X 1 X 2 = αX 1 ) if α X 1 > β X 2 then U (X 1 X 2 ) = bX 2

Any monotonic transformation of this utility function will describe the same
preferences which are presented by L – shaped ICs
x2

Good X 1 and X 2 are perfect

Complements

0 x1
3. Imperfect Substitutes

Perfect substitutes have an additive utility function which implies that a consumer will
yield some level of utility even by consuming only one of the goods.

However, many cases are such that some level of utility is only possible when a
combination of the goods is consumes, i.e no amount of utility is achievable from
consuming zero amount of one good. Such goods are said to be imperfect substitutes and
their preferences take multiplicative form of utility functions.

 ( X 1 X 2 )= X 1 a X b 2


This kind of a function is refereed to as a Cobb – Douglas utility function. It yields a

convex monotonic indifference curve and are said to be well behaved.

31
It is the most useful preference in presenting algebraic examples of the economic ideas. A
monotonic transformation of the Cobb – Douglas utility function above will represent
exactly the same preferences as.
X2

Convex ICs

U4
U3
U2
U1
X1

3.3.2 Marginal utility and Marginal Rate of Substitution

Consider a consumer consuming bundle ( X 1 X 2 ). The amount by which the total utility
changes U ( X 1 X 2 ) when an extra unit of a good is consumed is the marginal u utility
with respect to the good.

Suppose an extra unit of good is consumed such that total utility changes from U( X1X2)
to U ( X1 + ∆X1 ,X2) the MU of good 1 is written as:

u u(x1 x1, x2 )  u(x1x2

mu1  
x1 x1

It measures the rate of change in utility (∆U) associated with a small change in the
amount of good 1 ( ∆X 1 ) . Therefore to calculate the change in utility associated with a
small change in consumption of good 1, we can multiply the change in consumption by
the MU of the good.

32
∆U = ∆MU 1 ∆X 1

Similarly

u u(x1 x1, x2 )  u(x1x2

mu2  
x2 x2

∆ U = MU 2 ∆X 2

Recall that the MRS measures the slope of the IC at a given bundle of goods.
Consider now a change in the consumption of each good ( ∆ X 1 ∆X 2 ) that keeps utility
constant, i.e a change in consumption that moves us along IC, then
MU 1 ∆X 1 + MU ∆X 2 = ∆ U =
Solving for the slope of the IC we have,

x2 Mu
MRTs   1
x1 Mu2
But ∂U = 0 since utility does not change along the indifference curve.

MU x1 ∆X 1 = -MUX 2 ∆X 2
 x2 M u x1
 
 x1 M u x2

The slope is negative since to get more of one good, lesser units of the other good must
be consumed in order to keep the same level of utility. For example if

x2 Mu
  1  2 Give up 2 units of good 2 to consume extra unit of good 1.
x1 Mu2
3.3.3 Consumer Equilibrium
This section concentrates with putting together the budget line and the theory of
preference in order to examine the optimal choice of consumers. We have noted that the

33
economic model of consumer choice is that consumers choose the best bundle they can
afford, i.e the consumers choose the most preferred bundle from their budget set.Suppose
the budget set and the well behaved consumer preferences are drawn on the same
diagram as:
x2

The consumer equilibrium

x2

x2

x1
The bundle of goods that is associated with the highest indifference curve and is
affordable is (X 1 X2).Any bundle above this one is unaffordable, such a bundle that
appears on a point of tangency between the consumers optimal choice and also referred to
as the consumer' equilibrium choice. The point of tangency is called the consumer
equilibrium point. Since a solution as is represented above is an interior solution, where
the consumers optimal choice involves both goods. A situation where optimal
consumption involves consuming ) units of one good and some units of another is called
a boundary solution/optimum. For example;

34
x2

IC
Budget line

x1

0 x1
Boundary optimum: the optimum consumption involves consuming 0 units of good 2
and the indifference curve is not tangent to the budget line.
The tangency condition is only a necessary to have as optimal choice but not a sufficient
condition. However, there is one important case where it is sufficient, the case of convex
preferences. The case of convex preferences, any point that satisfies the tangency
condition must be an optimal point. Generally there may be more than one optimal
bundle that satisfies the MRS condition as show below:

X2 Optimal bundle

Non - optimal bundle

0 X1
In such a case, there are three tangencies but only two optimal points, so the tangency
condition is necessary but not sufficient. However, again convexity implies a restriction.
If the indifference curves are strictly convex, then there will be only one optimal choice

35
in each budget line.

Recall that the marginal rate of substitution is the rate of exchange at which the consumer
is just willing to stay put. On the other hand, the market is offering a rate of exchange to
the consumer of - P 1 ( the slope of the budget line).
P2
If the consumer is at a consumption bundle where he/she is willing to stay put, it must be
one where the MRS is equal to this rate of exchange.

P1
M RS  
P2

MU1 MU
 2

P1 P2

Hence

MU 1 P
MRS    1
MU 2 P2
Or simply

MU 1 P
 1 Consumer equilibrium condition
MU 2 P2

The equilibrium point (optimal choice) has this characteristic that the slope of the IC
(MRS) is equal to the slope of the budget line. The consumer's choice model can be used
to find the optimal choices for other preferences. Some examples include:

1. Perfect Substitutes
Recall that perfect substitutes have linear indifference curves, just similar to a budget
line. If P 2 > P 1 , then the slope of the budget line is flatter the slope of the indifference

36
curves. In such a case, the optimal bundle is where the consumer spends all income on
good 1.

If P 1 > P 2 , then the consumer purchases only good 2. If P 1 = P 2 , there is a whole range
of optimal choices and any amounts of goods 1 and 2 that satisfies the budget constraints
is optimal.

The graph below illustrates an optimal choice with perfect substitutes which provide a
boundary solution.

X2
Indifference curve
Budget line

Optimal choice

M
X1  X1
P1
In summary

M
 P if P1  P2
 1
 M
X1  any number between 0 and ifP1  P2
 P1
0 if P1  P2



37
2. Perfect complements

in this case, the optimal choice must always lie on the diagonal, where the consumer is
purchasing equal amounts of both goods, no matter what prices are. The optimal choice
can be illustrated as;

X2
Indifference curves

Optimal choice

Budget line

0 X1 X1

3. Concave preferences
X2
Indifference curve
Non optimal choice

X Budget line

Optimal choice

Z X1

The optimal choice is always going to be a boundary choice/solution such bundle Z

The optimal choice is the boundary point Z, not the interior tangency point X because Z
lies on a higher indifference curve.

38
Uses of Indifference Curve Analysis

Indifference curve analysis is useful when studying welfare economics as follows:

They are used to indicate the amount of income and leisure combination that can yield a
given level of satisfaction allowing for the measure of trade off between leisure and
income.

Since each indifference curve represents a given level of welfare, in an indifference map,
the curve to the right represents a higher level of welfare. This is useful in analysing the
effect taxation on the standard of living in an economy. A tax level may reduce the
economic standard of the people and vice versa.

Employees use indifference curve analysis to decide whether to give employees housing
facility in kind or in money allowance in a manner not to affect their welfare.

Reference
1. Border, K. C., Fixed Point Theorems with Applications to Economics and Game
Theory, Cambridge: Cambridge University Press, 1985

2. Luenberger, D., Microeconomic Theory, McGraw-Hill, 1995, Appendixes A-D.

3. Takayama, A. Mathematical Economics, the second edition, Cambridge:

Cambridge University Press, 1985, Chapters 1-3.

4. Tian, G., The Basic Analytical Framework and Methodologies in Modern

Economics,2004

5. Tian, G., \Fixed Points Theorems for Mappings with Non-Compact and Non-
Convex Domains," Journal of Mathematical Analysis and Applications

39
CHAPTER FOUR: THEORY OF DEMAND

LEARNING OBJECTIVES

At the end of the Lecture the student should be able to:

 Distinguish between demand, desire, need and want.
 Know the factors that affect the quantity demanded of a commodity by a
household and the total market demand.
 Explain consumer demand Functions
 Explain Revealed Preference
 Explain the Slutsky Equation
 Outline the Use of the Slutsky Equation
 Explain the The Hicks Substitution Effect
 Income and Substitution Effects for other preferences

4.1 The consumer demand Functions

The consumer’s demand functions give the optimal amounts of each of the goods as a
function of the prices and income faced by the consumer. The demand functions are
written as:

X 1 = X 1 (P 1 P 2 M)

X 2 - X 2 (P 1 P 2 M)

in elementary microeconomics clear distinction is made between the normal, inferior and
giffen goods. When the consumer income changes, the optimal choice for the goods
changes yielding an income expansion path. The income consumption path is used to
derive and Engel curve. On the other hand, a change in price also changes the optimal
choice of the consumer yielding a price offer curve which is used to derive the demand

40
curve.

In this level we give it a mathematical approach where we seek to determine the demand
functions for the optimal choice bundles of the consumer.

The consumer problem is stated as;

MaxU ( X 1 X 2 ) ............................................... i
st
P 1 X 1 + P 2 X 2 = M ...................................... ....ii

introducing a langrangian multiplier and converting (1) and (2) into a composite function
we have:
L = U ( X 1 X2) - λ ( P 1 X 1 + P 2 X 2 - M)

Obtaining the first order conditions

L u
   p1 ----------------------------------iii
X1 X1

L u
   p2 .................................................iv
X2 X2
L
 p x  p x M0 ....................................v
 1 1 2 2
Re - writing equations (4) and (5) and dividing them yields:

41
  u
 x 1 P1

 u P 2
 x 2

MUx1 P1

MUx2 P2

This is a similar concept to what was earlier called the consumer equilibrium condition. It
corresponds to a point of tangency between an indifference curve and the budget line fro
the graphical approach discussed in the previous sections.

4.2 Revealed Preference

We have seen how we can use information about the consumer's preferences and the
budget constraints to determine his/her demand. However, in real life, preferences are not
directly observable. We discover people's preferences form observing their behavior. The
revealed preference theory shows how we can use information about the consumers
demand to discover information about his/her preferences.

Consider the figure below, where we have depicted a consumer's demanded bundle
(X 1 X 2 ) and another arbitrary bundle (Y 1 Y 2 ) i.e beneath the consumer's budget line.

good 2

*.X 1 X 2
*Y 1 Y 2

good 1

42
Bundle (Y 1 Y 2 ) is certainly an affordable purchase at the given budget. The consumer
could have bought it if he/she wanted to and even had money over. Since ( X 1 X 2 ) it the
optimal bundle it must be better than anything else that the consumer could afford.
Hence it must be better than (Y 1 Y 2 ) or any other bundle on or beneath the budget line.

Let (X 1 X 2 ) be the bundle purchased at prices (P 1 P 1 ) when the consumer has income M.
Since (Y 1 Y 2 ) is affordable at these prices and income, the,

P1Y1 = P2 Y2 < M

Since X 1 X 2 is actually bought at the given budget, then

P1 Y1 + P2Y2 = M

Putting these two equations

P1Y1 + P2Y2 > P1Y1 + P2Y2

If the above inequality satisfied and (Y 1 Y 2 ) is actually a different bundle from (X 1 X 2 ) is

said to be directly revealed preferred to (Y 1 Y 2 ).This revealed preference is a relation that
holds between the bundle that is actually demanded at some budget and the bundles that
could been demanded at that budget. The principle of revealed preference is therefore
stated as;

Let (X 1 X 2 ) be the chosen bundle when the prices are (P 1 P 1 ) and let (Y 1 Y2) be some other
bundle such as that:
P 1 Y 1 = P 2 Y 2 >P 1 Y 1 + P 2 Y 2 . Then if the consumer is choosing the most preferred
bundle ,he can afford, we must have (X 1 X 2 ) > (Y 1 Y 2 ).

Suppose further that (Y 1 Y 2 ) is a demanded bundle at prices (Q 1 Q2) and that (Y 2 Y 2 ) is

itself revealed preferred to some other bundle (Z 1 Z 2 ). That is:

43
q 1 y 1 + q2 y 2 > q 1 z 1 + q 1 z 2.

Then (X 1 X 2 ) > (Y 1 Y 2 ) and (Y 1 Y 1 )> ( Z 1 Z 2 ).From the transitivity assumption, we can

conclude that (X 1 X 2 ) > (Z 1 Z 2 ).

This is illustrated:

Good 2

* X1 X2
*
Y1Y2 Budget line

Z 1Z2
Good 1

Revealed preference and transitivity assumption tell us that (X 1 X 2 ) must be better than
(Z 1 Z 2 ) for the consumer who made the illustrated choices. In this case (X 1 X 2 ) is said to
be indirectly revealed proffered to (Z 1 Z 2 ).The chain of direct comparisons can be of any
length such that if bundle A is directly revealed to B, and B to C, C to D .........all the way
to Z, then bundle A is still indirectly revealed to Z.

If a bundle is either directly or indirectly revealed preferred to another bundle, we will

say that the first bundle is revealed preferred to the second .

From the figure below, since (X 1 X 2 ) is revealed preferred, either directly, to all of the
bundles below (shaded area) either budget lines) (X 1 X 2 ) it is fact preferred to those
bundles by the consumer. That is, the true indifference curve through (X 1 X 2 ), whatever it
is, must lie above the shaded region. It therefore also follows that, the true indifference
curve through (Y 1 Y 2 ) must lie above the flatter budget line.

44
4.3 The Weak Axiom of revealed preference

We have so far supposed that the consumer has preferences and that he/she is always
choosing the best bundle of goods affordable. If the consumer is not behaving this way,
the estimated of the indifference curves that we have constructed are meaningfulness.

Consider:
Good 2

*
X1X2 Budget line

* Y1Y2

Good 1
According to the logic of revealed preference, the diagram allows us to conclude two
things.

(i) (X 1 X 2 ) is preferred to (Y 1 Y 2 ) and

(ii) (Y 1 Y 2 ) is preferred to (X 1 X 2 )

That is, the consumer has apparently chosen (X 1 X 2 ) when she /he could have (Y1Y 2 )
indicating that (X 1 X 2 ) was preferred to (Y 2 ) indicating that (X 1 X 2 ) was preferred to
(Y 1 Y 2 ) but then he/she indicating the opposite. This situation absurd and violates the
weak Axiom of Revealed Preference.

Clearly this consumer cannot be a maximizing consumer. Either the consumer is not
choosing the best bundle he/she can afford or there is some other aspect of the choice
problem that has changed that we have not observed. If consumers are choosing the best
bundles that are affordable, but not chosen must be worse than what is choosen

45
.Economics have therefore formulated this simple point in a basic axiom of consumer
theory referred to as the weak axiom of revealed preference (WARP) it states that if
(X 1 X 2 ) is directly revealed preferred to (Y 1 Y 2 ) and the two bundles are not the same, then
it cannot happen that (Y 1 Y 2 ) is directly revealed [referred to (X 1 X 2 ) .

In other words, if a bundle (X 1 X 2 ) is purchased at prices (P 1 P 2 ) and a different bundle

(Y 1 Y 2 ) is purchased at prices q 1 q 2 then if.

P1X1 + P2 X2 > P1Y1 + P2Y2

It must not be the case that
q1Y1 + q2Y2 > q1X1 + q2 X2

That is, if the Y bundle is affordable when the x – bundle is purchased, then when the Y –
bundle is purchased the X bundle must not be affordable.
The consumer is (immediate diagram) has violated the WARP and therefore this
consumers behavior could not have been maximizing behavior. There is no set of
indifference curves that could make both bundles maximizing bundles.
On the other hand, a consumer who satisfies WARP is said to have a maximizing or
optimal behavior and for such, it is possible to find indifference curves for which his/her
behavior is optimal. One possible choice of indifference curves is illustrated below.

46
 Good 2

Budget line
*X 1 X 2

X
*1X2
Good 1

The Strong axiom of revealed Preference

The weak axiom of revealed preference requires that if X is directly to Y, then we
should never observe Y being directly revealed to X. The strong Axiom of revealed
preference requires that the same sort of condition hold for indirect revealed preference.
The strong Axiom of revealed Preference. The strong Axiom of revealed Preference
(SARP) states that:
If (X 1 X 2 ) is revealed preferred to (Y 1 Y 2 ) either directly of indirectly and (Y 1 Y 2 ) is
different from (X 1 X 2 ) is revealed preferred to (Y 1 Y 2 ).

It is therefore clear that if the observed behavior is optimizing behaviour, then it must
satisfy the strong axiom. For if the consumer optimizing and (X 1 X 2 ) is revealed preferred
to, either directly or indirectly, then it must be case that (X 1 X 2 ) > (Y 1 Y 2 ) and (Y 1 Y 2 ) >
(X 1 X 2 ),which is a contradiction . We can conclude that either the consumer must not be
optimizing or some other aspect of the consumer’s environment such as tastes, other
prices e.t.c must have changed.

47
While WARP is a necessary condition for optimizing behavior .SARP is both necessary
and sufficient in the sense that, if the observed choices satisfy SARP, we can always find
well behaved preferences that could have generated the observed choices. It ensures both
consistency and transitivity of consumer preferences.

4.4 The Slutsky Equation

Economists are concerned with how consumer’s behavior changes in response to changes
in the economic environment. So far, the price of the goods and the income are the
common variables in the consumer economic environment.

The AEO 100 an exposure is one on how the optimal choice by a consumer changes
prices and income. In this case , we consider a detailed analysis of how a consumer’s
choice of a good responds to changes in its price.

When the price of a good changes, there are two types of effects. The rate at which one
can exchange one good for another changes, and the total purchasing power of income
changes. These two causes changes in the consumer demand for the goods .

The change in demand due to the change in the rate of exchange between the goods is
called the substitution effect. While the change in demand due to changes in the
purchasing power is called income effect. To give a more precise definition, let us
consider the two effects separately and in details.

The substitution effect

To capture the SE, we let the relative prices to change due to a price change and adjust
money income so as to hold purchasing power constant.

Using diagram:

48
 Good 2

M
P2 Original BL
Original choice

Final choice
X1 Pivot
Pivot Shift Final Budget line

0 X1 M Good 1
P1

Suppose the price of good 1 falls, this means that the budget line rotates around the
vertical intercept M and becomes flatter .This movement of the budget line can be broken
P2
Into two steps:
1. Pivots the budget line around the original demanded bundle and then,
2. Shift the pivoted line out to the new demanded bundle.

The pivot is a movement gives a convenient way to decompose the change in demand
into two places. This decomposition is only hypothetical and the consumer simply
observes a change in price and chooses a new bundle of goods response. In analyzing
how the consumers choice changes it is useful to think of the budget line changing in two
stages (i) pivot and (ii) shift.

Considering the pivot, the pivoted budget line has the same slop and thus the same
relative prices as the final budget line. However, the money income associated with this
budget lines is different since the vertical intercept are different.

49
Since the original consumption bundle ( X 1 X 2 ) lies on the pivoted Bl, that consumption
is
just affordable .In this sense, the purchasing power of the consumer has remained
constant in the sense that the original bundle of goods is just affordable at the new
pivoted line. That is after the price of good 1 falls, income must have been adjusted so
as to make the original bundle just affordable at a change in relative prices.

Suppose the original prices for goods 1 and 2 are P1 and P2 respectively and M is the
original income. Let M1 be the amount of money income that will just make the original
consumption bundle affordable this will be the amount of money income associated
with the pivoted budget line.

Since ( X 1 X 2 ) is affordable at both ( P 1 P 2 M) and (P 1 P 2 M)

Where P1 is the new fallen price of good1, then we have

M1 = P 1 X 1 + P 2 X 2
M= P 1 X 1 + P 2 X 2

Subtracting the two equations

M1 – M= X 1 ( P1 – P1)
That is the change in money income necessary to make the old bundle affordable at the
new prices is just th original amount of consumption of good 1 times the change in
prices.

Let ∆P1-P1 represent the change in price

∆M = M-M represent the change in income necessary to make the old bundle just
affordable.

Then:
∆M = X1∆P1

50
NOTE: The change in income and the change in price will always move in the same
direction: if the price goes up, then we have to raise income to keep the same bundle
affordable.
Although (X 1 X 2 ) is still affordable, it is not generally the optimal purchase at the pivoted
budget line. The optimal purchase on the pivoted budget line is
Good 2

X
Z
Y

Pivot shift
Good 1
SE IE

Bundle Y is the optimal one, when we change the price and adjust income so as to keep
the old bundle of goods just affordable. The movement from X and Y is known as SE. it
indicates how the consumer substitutes one good for the other. When the price changes
while adjusting income to retain the consumer’s purchasing power.

More precisely, the SE ∆X1 is the change in the demand for good 1, when the price of
good I changes to P1from P1 and at the same time, money income changes from M to M.

∆XS 1 = X 1 (P 1 M) – X 1 (P 1 M)

THE SE is sometimes called the change in compensated demand. The idea is that the
consumer is being compensated for a price change by having his/her income adjusted

51
accordingly, if the price rises “compensation: is done by giving the consumer some more
income to make the same amount of a good affordable at a higher price and vice versa.

For example:
Mathematically
Suppose that the consumer has a demand function for good X of the form.

X = 10 + M
10P

Let his original income be kshs, 120 per day and let the price of good X be ksh. 3 per
unit. Thus the demand for good X per day is:

X(P,M) =X(3,20) = 10 + (120/ 10(3)) = 14 units per day

Suppose the price of good X falls to ksh. 2 per unit. His new demand at his new price
would be

X (P,M) = X(2,120) = 10 +120/10(2)

= 16 units per day

The total change in demand is increased by 2 units of good X per day. In order to
calculate the SE, we must first calculate by now much income would have to change in
order to make the original demand of 14 units just affordable when the price is Ksh. 2 per
unit.

Recall that:

∆M = X 1 ∆P 1

52
 = 14(2-3)
= - 14

The level of income necessary to keep purchasing power constant is:

M=M+∆M
=120-14
= 106 shillings

The consumer demand at the new price of Kshs. 2 and the new income level of ksh.106
is.

X(P 1 M) = X(2,106) = 10 + 106 = 15.3

10(2)

Thus the SE is

∆XS 1 = X(P 1 M) – X (P 1 M)

The income effect

We have so far considered the pivot of the budget line, the second stage of the price
adjustment is the shift movement.

A parallel shift of the budget line is the movement that occurs when income changes
while relative prices remain constant. Thus the second stage of the price adjustment is
called the income effect. It is a change of the consumers income from M1 back to M1
keeping the prices constant at (P 1 P 2 ). In the last diagram this changes moves from the
point Y to Z. It is natural to call this last movement in the income effect since all we are
doing is changing income while keeping the prices fixed at the new prices.

53
Precisely, the income effect ∆Xn1 is the change in the demand for god 1 when the
income changes from M to M holding the price of good 1 fixed at p1

∆Xn 1 = X 1 (P 1 M) – X 1 (P 1 M)

Recall from EC 100, that income effect of a price change can operate either way. It will
tend to increase or decrease the demand for good 1 depending on whether good 1 is
normal or inferior.

When the price of a good decrease, the income also decreases in order to keep purchasing
power constant. If the good is normal, then this decreases in income will lead to a
decrease in demand. If the good is inferior, then the decrease in income will lead to an
increase in demand.

For example

X(P 1 M) = X(2,120) = 16
X(P 1 M) = X(2,106) = 15.3
Thus
∆Xn 1 =X 1 (2,120) – X 1 (2,106)
= 16 – 15.3
= 0.7
Since the demand for good X here increases when income increases, then good X is
normal.
The Sign of the Substitution Effect

Consider (last diag) the point on pivoted budgetline where the amount of good 1
consumed is less than that at the bundle X. these bundles were all affordable at the prices
(P1P2) but they were not purchased. Instead, the bundle X was purchased. if the
consumer is always choosing the best bundle he/she can afford, then X must be preferred

54
to all of the bundles on the part of the pivoted budgetline that lies inside the original
budget set.

That is, the optimal choice on the pivoted budgetline must not be one of the bundles that
lies underneath the original budgetline. The optimal choice on the pivoted line would
have to b either X or some point to the right of X. But this means that the new optimal
choice must involve consuming at least as much as good 1 as originally just as we wanted
to show. In the (diag) the optimal choice at the pivoted budgetline is the bundle Y, which
certainly involves consuming more of good 1 than at the original consumption point X.

The substitution effect always moves opposite to the price movement. it is said to be
always negative, since the change in demand due to the SE is opposite to the change in
price. If the price increases, the demand for the good due to the Se decreases.

The Total Change

The total change in demand is ∆X1, is the change in demand due to the change in price,
holding income constant:
∆X 1 =X 1 (P 1 M) – X 1 (P 1 M)

We have already seen that, this total change can be split into two effects, the substitution
effect and ∆XS 1 and the income effect ∆Xn 1

∆X 1 =∆XS 1 +∆XN 1

Hence

X 1 (P 1 M) – X1(P 1 M) =[ X 1 (LM)-X 1 (P 1 M)]+[X 1 (P 1 M) – X 1 (P 1 M)]

This equation says that the total change in demand equals the substitution effects plus the
income effect. This equation is called the slutsky’s identity. it is true for all values of

55
P1P1, M and M. the first and the forth terms on the RHS cancel out, so the RHs is
identically equal to the LHS.

Use of the Slutsky’s Equation

The Slutsky’s identity is not just the algebraic identity. the content comes in the
interpretation of the two terms on the RHS. the substitution effect and the income effect.
in particular, the signs of the income and substitution effect can be used to determine the
sign of the total effect, which in turn reveals the type of a good in question. that is, he
total effect reveals whether a good is normal, inferior or giffen.

when the Se must always be negative (opposite to the change in price) the income effect
can go either way. Thus the total effect maybe positive or negative.

Normal Good.

If a good is normal, the substitution effect and the income effect work in the same
direction. An increase in the price will mean that demand will go down due to the Se. if
the price goes up, i.e. a decrease in income which for a normal good means a decrease
demand. Both effects reinforce each other. In terms of our notations, the change in
demand due to price increase means that

∆X 1 = ∆XS 1 + ∆Xn 1

on the other hand, if we have an inferior good, the income effect is positive. a fall in
price for example is like an increase in income. an increase in income would reduce the
demand for an inferior good.

∆X 1 = ∆XS 1 + ∆Xn 1

56
However, the second term on the RHS – the income effect < the first term of right hand
side. The total change is therefore negative. This would mean that a fall in price results to
an increase in demand.

Giffen good, for giffen good, the second term on the RHS- income effect is positive but
large enough that the total change could be positive. This would mean that a fall in price
would result to a fall in demand.
b) Perfect substitutes
in this case, when the budgetline tilts, the demand bundle moves from the vertical axis to
the horizontal axis. There is no shifting and the entire change in demand is due to the
substitution effect. This is show as:

Indifference curves

Final budget line

original
choice Final choice

original budget
line

57
4.5 The Hicks Substitution Effect

The substitution effect is the name that economists give to the change in demand when
prices change but a consumer’s purchasing power is held constant so that the original
bundle remains affordable. This definition is called the slutsky’s substitution effect.

Suppose that instead of pivoting the budgetline around the original consumption bundle,
the budgetline is rolled around the indifference curve through the original consumption
bundle as shown.

∆X +1 = ∆Xs -1 + ∆Xn +1

A fall in price has increased consumer purchasing power such that, the consumer has
reduced his/her consumption of the inferior good. The slutskys identify shoes that his
kind of perverse effect van only occur for inferior goods. If the good is normal, then the
income and substitution effect reinforce each other, so that the total change in demand is
always in the ‘right’ directions. Thus a giffen good must be inferior. But an inferior good
is not necessarily a giffen good. The income effect not only has to be large enough of the
‘wrong’ sign it also has to be large enough to outweigh the right sing of the substitution
effect. This is why giffen goods are so rarely observed in real life; they would not only
have to be inferior goods, but they would have to be too inferior.

Reference
Border, K. C., Fixed Point Theorems with Applications to Economics and Game The-
ory, Cambridge: Cambridge University Press, 1985.

Luenberger, D., Microeconomic Theory, McGraw-Hill, 1995, Appendixes A-D

Takayama, A. Mathematical Economics, the second edition, Cambridge: Cambridge

University Press, 1985, Chapters 1-3.

58
Tian, G., The Basic Analytical Framework and Methodologies in Modern Economics,
2004
Tian, G., \Fixed Points Theorems for Mappings with Non-Compact and Non-Convex
Domains," Journal of Mathematical Analysis and Applications

59
CHAPTER FIVE: THEORY OF PRODUCTION

LEARNING OBJECTIVES

At the end of the Lecture the student should be able to:

 Identify and categorize the factors of production
 Analyze the relationship between the input of factors and the output of goods and
services in the short-run and in the long-run
 Define fixed and variable costs and show, that in the short-run, average and
marginal costs will eventually rise as ‘diminishing returns’ come into operation
 Explain the role of economics and diseconomies of scale in determining the shape
of a firm’s long-run average cost curve
 Show that a firm’s profits will be maximized at the point where the marginal cost
cuts the marginal revenue curve from below

5.0 Production Technology

We examine the constraints on a firm’s behaviour. When a firm makes choices it faces
many constraints Nature imposes the constraints that are only certain feasible ways to
produce outputs from the inputs; there are only certain kinds of technological choices that
are possible.

Inputs and outputs

Inputs to production are called factors of production (classified into broad categories such
as land, labour, capital and raw materials). Capital goods are those inputs to production
that are themselves produced goods. Basically capital goods are machines of one sort or
another

Money used up or maintain a business is called financial capital and capital goods or
physical capital used for produced factors of production.

5.1 Describing Technological Constraints

60
Nature imposes technological constraints on firms, only certain combinations of inputs
are feasible was to produce a given amount of output and the firm must limit itself to
technologically feasible production plans.

The set of all combinations of inputs and outputs that comprise a technologically feasible
way to produce is called a production set.
For example, one input (x) and one output (y) the production set may have the shape

Y=output Y=f(x)

Production set

X= output

The production set shows the possible technological choices facing a firm. As long as the
inputs to the firm are costly it makes sense to limit ourselves to examining the maximum
possible output for a production set depicted. The function depicting the boundary set is
known as the production function. It measures the maximum possible output that you can
get from a given amount of input.

In a two input case f(x 1 x 2 ) a convenient way to depict production is by use of isoquant.
An isoquant is the set of all possible combinations of inputs 1 and 2 that are just
sufficient to produce a given amount of output. Isoquants are similar to indifferent
curves, but one difference is that isoquants are labeled with the amount of output they can
produce, not with a utility level. Thus the labeling of isoquants is fixed by the technology
and does not have the kind of arbitrary nature that the utility labeling has.

61
Examples of technology
(i) fixed proportions

eg. Producing hiles, hence one man shovel. Extra shovels are not worth anything. Thus
the total number of holes that you can produce will be the minimum of the number of
men and the number of shovels that you have.

f(x 1 x 2 ) =min x 1 , x2

X2 case of perfect complement s

Isoquant
0 X1

(ii) perfect substitutes

suppose now that we are producing homework and the inputs are red pencils and blue
pencils. The amount of homework produced depends only on the total number of pencils,
the production function is written as:

62
 X2

Case of perfect substitute s

0 X1

Cobb – Douglas
A CD production function is given as:

f (x1x2) = Ax 1 ax 2 b

measures the scale of production – hoe much, output we would get if we used one unit
of each input. The parameters a and b measure law the amount of output responds to
change in the inputs.
Properties of technology
1. Technologies are monotonic- if you increase the amount of at least one inputs, it
should be possible to produce at least as much output as you were producing
originally. This is sometimes referred to as property of free disposal; if the firms
can costless dispose of any inputs, having extra inputs around can hurt it.

2. Technology is convert- this means that if you have two ways to produce y units of
output, (x 1 x 2 ) and (z 1 z 2 ) then their weighted average will produce at least units of
output. Two ways of producing output is called production techniques.

63
 X2

100a 2
(100a 1 +100a 2 )

(25a 1 +75b 1 ,25a 1 +75b 2 )

100b 2 (100b 2 + 100b) 1 Y = 100
100a 1 100b 1 X1

Convexity, if you can operate production activities independently then weighted

averages of production plans will also be feasible. Thus the isoquent will have a convex
shape.

The Marginal Product

Suppose that we are operating as some point, (x1x2) and that we consider using a little bit
more of factor 1 while keeping factor 2 fixed at the level x2. how much more output will
we get per additional unit of factor 1?

y f ( x 1   x 1  x 2 )  f ( x 1, x 2 )

x  x1

This is called the marginal product of factor 1. Marginal product is a rate; the extra
amount of output per unit extra input.

64
5.3 The Technical Rate of Substitution

Suppose that we are operating at some point (x 1 x 2 ) and that we consider giving up a little
bit of factor 1 and using just enough more of factor to produce the same amount of output
y. how much extra of factor 2, ∆x 2 do we need if we are going to give up a little bit of
factor 1, ∆x 1 ? This is just the slope of the isoquant referred to a technical rate of
substitution rate of substitution (TRS) denomination by TRS(x 1 x 2 ).

TRS measures the trade off between two inputs in production. It measures the rate at
which the firm will have to substitute one input for another in order to keep output
constant.

Consider a change in our use of factors 1 and 2 that keeps output fixed . then:

∆y = MP 1 (x 1 x 2 )∆x 1 + MP 2 (x 1 x 2 )∆x 2 = 0

Which we can solve to get:

M P1  x 1 x 2 
T R S (x1x 2 ) 
M P2  x 1 x 2 

Diminishing Marginal Product

As long as we have a monotonic technology, we know that the total output will go up as
we increase the amount of factor one. But it is natural to expect that it will go up at a
decreasing rate. We would typically expect that the marginal product of factor of a factor

65
that will diminish as we get more and more of that factor. Thia is called the law of
diminishing marginal product.

It only holds when other inputs are fixed.

5.4 Diminishing Technical Rate of Substitution

This assumption says that as we increase the amount of factor 1, and adjust factor 2 so as
to stay on the same isoquant, the technical rate of substitution declines.. this assumption
of diminishing TRS means that the slope of an isoquant must decrease in absolute value
as we move along the isoquant in the direction of increasing x 1 ( convex isoquant)

5.5 The long run and the short run

In the short run, there will be some factors of production that are fixed at predetermined
levels, e.g.. land. In the long run all the factors of production can be varied. There is no
specific time interval implied here. The long run and the short run periods depend on
what kinds of choices we are examining.

Let us suppose that factor 2 is fixed at x 2 in the short run. Then the relevant production
function for the short run is f(x 1 x 2 ).

Return to scale
Instead of increasing the amount of one input while holding the other input fixed, input
fixed, let us scale the amount of all inputs up by some constant factors if we twice as
much output, its referred to as constant returns to scale.

2f(x 1 x 1 ) = f(2x 1 2x 2 )

66
In general, if we scale all of the inputs by some amount tg, constant returns to scale
implies that we should get t times as much output;

Tf(x 1 x 2 )=f(tx 1 ,tx 2 )

Returns to scale describes what happens when you increase all inputs, while diminishing
marginal product describes what happens when you increase one of the inputs and hold
the others fixed (explained)

If we scale up both inputs by some factor t we get more than t times as much as output.
This is called increasing returns to scale i.e.

f(tx 1 ,tx 2 ) >tf(x 1 x 1 ) for all t>1 in some instances , we get less than twice as much output
from having twice as much of each input. This is called decreasing returns to scale.

f(tx 1 ,tx 2 )<tf(x 1 ,x 2 )for all t>1

Reference
Border, K. C., Fixed Point Theorems with Applications to Economics and Game The-
ory, Cambridge: Cambridge University Press, 1985.
Luenberger, D., Microeconomic Theory, McGraw-Hill, 1995, Appendixes A-D.
Takayama, A. Mathematical Economics, the second edition, Cambridge: Cambridge
University Press, 1985, Chapters 1-3.
Tian, G., The Basic Analytical Framework and Methodologies in Modern Economics,
2004
Tian, G., \Fixed Points Theorems for Mappings with Non-Compact and Non-Convex
Domains," Journal of Mathematical Analysis and Applications

67
CHAPTER SIX; THEORY OF MARKETS
LEARNING OBJECTIVES
The following concepts will be explored in this Topic:
 Perfect competition
 Assumptions
 Types of monopoly
 Monopoly pricing
 Short-run and long-run equilibrium analysis of a monopoly
 Pricing policy of a multi-plant monopoly
 Dominant firm
 Relationship among product differentiation, perceived and actual demand curves
in monopolistic competition
 Short-run and long-run equilibrium analysis of monopolistic competition
 Optimal advertising in monopolistic competition
 Oligopoly

6.1 PERFECT COMPETITION

The model of perfect competition describes a market situation in which there are:

 Many buyers and sellers to the extent that the supply of one firm makes a very
insignificant contribution on the total supply. Both the sellers and buyers take the
price as given. This implies that a firm in a perfectly competitive market can sell
any quantity at the market price of its product and so faces a perfectly price elastic
demand curve.
 The product sold is homogenous so that a consumer is indifferent as to whom to
buy from.
 There is free entry into the industry and exit out of the industry.
 Each firm aims at maximizing profit.
 There is free mobility of resources i.e. Perfect market for the resources.
 There is perfect knowledge about the market.

68
  There is no government regulation and only the invisible hand of the price
allocates the resources.

 There are no transport costs, or if there are, they are the same for all the
producers.

SHORT RUN EQUILIBRIUM OF THE FIRM

A firm is in equilibrium when it is maximizing its profits, and can’t make bigger profits
by altering the price and output level for its product or service. In Short-run the firm may
make super-normal profits as shown below:

AC MC
C
MC
MR
AR

P R = MR

C q OUTPUT

The firm will produce output q where Marginal Revenue is equal Marginal Cost. At this
level of output, the average cost is C. Hence the firm will make super-normal profits
shown by the shaded area.

In the Short-Run however the firm does not necessarily need to make profits or cover all
its cost. It may only need to cover Total Variable Cost.

69
 MR 4

MR 3

MR 2

MR 1

OUTPUT

The firm’s short-run supply curve will be represented by the part of the Marginal Cost
curve that lie above the AVC. The firm shall not produce unless the price is equal to P1.
Below the price P1 the firm minimizes its cost by shutting down.

NORMAL AND SUPERNORMAL PROFITS

Normal profit refers to the payment necessary to keep an entrepreneur in a particular line
of production.

In economics, it is generally believed that any capital invested in business has an

opportunity cost. The business must offer the investor a prospective return on capital at
least equal to the return available on the next best alternative.

70
The minimum return required to keep an entrepreneur in a particular line of production is
what economists call Normal Profits. Since it represents the opportunity cost of risk
capital to the business it is treated as part of the firm’s fixed cost which have to be paid if
the firm is first to come into existence and then survive in the long run. Normal profits,
therefore are included in the calculations which produce the AC curve. Therefore, when
price exceeds average cost, the firm is said to be earning abnormal /supernormal profits –
it is earning a surplus over and above what is necessary to keep it in that business (the
surplus is often referred to in economics as Economic rent).

LONG RUN EQUILIBRIUM FOR THE FIRM

Since there is freedom of entry into the industry the surplus profits will attract new firms
into the industry. As a result the supply of the product will increase and the price will
fall. The individual firm will face a falling perfectly elastic demand curve, and the
surplus profits will be reduced.

INDUSTRY FIRM

P
D S1
S2

P1
P2 D2 S1 S2 D q q

This will go on until the firm is no longer making surplus profits, i.e. when it is just
covering its production costs. At this stage no more firms will be attracted to the
industry. This will happen when the price is equal to the average cost and the demand
curve is tangent to the average cost curve at the minimum point. The firm is said to be
making normal profits.

71
Advantages of Perfect Market

It achieves, subject to certain conditions, an allocation of resources which is: socially

optimal” or “economically efficient” or “pareto efficient”.

Perfectly competitive firms are technically efficient in the long run, in that they produce
that level of output, which minimizes their average costs, given their small capacity.

Perfect competition achieves an automatic allocation of resources in response to changes

in demand. The consumer is not exploited. The price of goods, in the long run will be as
low as possible. Producers can only earn a normal profit, which are the minimum levels
of profits necessary to retain firms in the industry, due to the existence of free entry into
the markets.

Disadvantages of Perfect Competition

There is a great deal of duplication of production and distribution facilities amongst firms
and consequent waste.

Economies of scale cannot be taken advantage of because firms are operating on such a
small scale. Therefore although the firms may be highly competitive and their prices
may be as low as is possible, given their scale of production, nevertheless it is a higher
price that could take advantage of economies of scale.

There may be lack of innovation in a situation of perfect competition. Two reasons

account for this:

i) The small size and low profits of the firm limit the availability of funds for
research and development

72
 ii) The assumption of free flow of information, and no barriers to entry, implies
that innovations will immediately be copied by all competitors, so that
ultimately individual firms will not find it worthwhile to innovate.

REALISM OF PERFECT COMPETITION

The assumptions of perfect competition are obviously at variance with the conditions
which actually exist in real world markets. Some markets approximately conform to
individual assumptions, for example, the stock exchange is characterized by a fairly free-
flow of information but the information requires expertise to grasp. However no markets
exactly conform to the assumption of the model, with peasant agriculture probably the
nearest to the mark.

We however study the model of perfect competition to enable us to see:

How competition operates in the real world situation, within a highly simplified model.

The advantageous features of perfect competition which governments may wish to

encourage in real world markets.

The disadvantageous features of perfect competition which the governments may wish to
avoid.A standard against which to oil the degree of competition prevailing in a given
market. We can discuss how closely a specific market resembles the perfectly
competitive ideal

OUTPUT AND REVENUE IN COMPETITIVE MARKETS

Since the firm is a place taker, the total revenue depends on the amount sold.

73
TR = P.Q

MR= ∂TR =P
∂Q

AR =TR = P
Q

P = AR = MR
P

_
P P = MR = AR

The SMC curve cuts the ATC at its minimum

At equilibrium
MR = MC
Slope of MC > slope of MR
SATC
P,C
SMC

P P = AR =MR

Q Q

74
π = TR – Tc
F.O.C for Π max
∂π = 0
∂Q
∂π = ∂ TR - ∂TC = 0
∂Q ∂Q ∂Q

∂ TR - ∂TC
∂Q ∂Q
MR – MC

But MR = P for competitive market. At Equilibrium P = MC

The S.O.C for profit maximization requires that

∂2π < 0
∂Q2
∂2π = ∂2 TR - ∂2TC < 0
∂Q2 ∂2 Q ∂Q2
∂ 2TR < ∂2TC
∂Q2 ∂Q2
Slope of MR = slope of MC
The MC must be steeper than MR curve hence MC rising.

6.2 Monopoly and Monopolistic Competition

Monopoly is the other extreme case in the market structure spectrum. While market
conditions facing a monopolist are much different from those of perfectly competitive
firms, both types of firms have at least one thing in common - they do not have to have a
competitor.

75
Monopolistic competition is like a cross between perfect competition and monopoly.
There are many firms in the market but they all produce slightly different products so
they all have some degree of market power. In perfect competition, the demand curve of
a firm is horizontal. In monopolistic competition, the demand curve of a firm is
downward sloping but not as steep as that of the monopoly.

Monopoly

Monopoly is the sole seller in a market.

Characteristics of Monopoly

The characteristics that define a monopoly are:

 There is only one seller and large numbers of infinitely small buyers in the
market. This means the demand curve faced by the monopolist is the downward
demand curve for the market. Therefore, the monopolist is a price setter.

 The product produced by the monopolist must be highly differentiated from other
products. The inability of the buyers to substitute for other products gives rise to
the firm’s monopolistic status.

 To maintain its monopoly status in the long run, the monopolist must be able
prevent entry into its market.

Types of Monopoly

There are many types of monopoly and the following four are the most common ones:

 Monopoly on Inputs

One of the most important bases for monopoly lies in the control of inputs.

76
 Example: Prior to the Second World War, Aluminium Company of America
(Alcoa) owned almost every sources of bauxite, a necessary
ingredient in the production of aluminium, in the US.

 Natural Monopoly

Natural monopoly arises from huge economies of scale. It comes into place when
the MES is sufficiently large to satisfy the market demand. It is called natural
monopoly in the sense that it is the natural result of market forces.

Example: Most public utilities.

 Market Franchise

A market franchise is actually a contract entered into by a governmental

organisation and a business firm providing the firm with an exclusive right to
market a good or services within its jurisdiction.

Example: Oakland Raiders has the franchise granted by the National Football
League for operating a football team in the city of Oakland.

 Technical Superiority

A firm whose technical expertise vastly exceeds that of potential competitors can
maintain a monopoly position.

Example: Intel in computer chip making.

Monopoly Pricing and Short-Run Equilibrium

In a monopolistic market, the market demand curve is the monopoly demand curve.
Consequently, the pricing behaviour of a monopoly is different from perfectly
competitive firms. A monopolist is a price setter rather than a price taker.

77
The objective of a monopolist is no different from a competitive firm. It maximises its
profit :

 = pQ – C(Q)

Where p = price,

Q = output,

C(Q) = the total cost function, which is a cubic function.

The important distinction between the monopolist and a perfectly competitive firm is that
the monopolist has the power to set output and price simultaneously. We can write the
monopoly price as a function of output and the profit function is rewritten as:

 = p(Q)Q – C(Q)

Applying the decision rule that the profit-maximising output occurs at the point where
MR = MC, we have

 1 
P 1    MC
 E d 

Where MR = p(1+1/E D ),

E D = the price elasticity of demand,

MC = a function of output Q.

78
If the monopoly demand curve is linear, then the rate of decline of MR is twice the rate of
decline of price, that is, the MR curve is halfway between the demand curve and the
vertical axis.

Example:

Suppose the linear demand curve is given by the following equation:

p = a - bQ

Where a and b are constants. The total revenue TR of the monopolist is

TR = pQ = aQ – bQ2

And the MR is

T R
MR   a  2b
Q

In short run, the monopolist maximises its profit if

 MR = MC

 the slope of the MC curve is greater than the slope of the MR curve at the point of
intersection.

A typical case is depicted in Figure 7.1. The short-run equilibrium occurs at point E
where MC is equal to MR. The monopoly sets the price at p* (read the price off the
demand curve at Q*) and sells Q* units of output. Average cost at Q* is denoted by AC*.
The short-run profit is indicated by area p*ABAC*.

79
 p AC
MC

p* A

B
AC*
E
D = AR
MR
Q
Q*

Figure 5.1: Short-run equilibrium of monopoly

Exercise 5.1

Given the monopoly demand curve is:

p = 100 – 5Q

Calculate the equation of and plot the TR and MR curves.

Answer

The equation of the TR curve is TR = 100Q – 5Q2. The equation of the MR curve is MR =
100 – 10Q.

Exercise 7.2

Suppose the short-run total cost function and demand function of a monopoly are:

TC = 1/3Q3 – 10Q2 + 120Q + 1,000

and p = 600 – 8Q, respectively. Calculate the profit-maximising output, the

price, and the profit.

80
Answer

The profit-maximising output, the price, and the profit are Q = 24 units, p = $408
and  = $7,064, respectively.

MC = Q2  20Q + 120
TR = 600Q  8Q2
MR = 600  16Q
Q2  20Q + 120 = 600  16Q

Q2  4Q  480 = 0
(Q  24)(Q + 20) = 0
Q = 24
p = 600  8(24) = 408

 = 408(24)  [(1/3)(24)3  10(24)2 + 120(24) + 1,000]

= 7,064

Long-Run Equilibrium

Long-run equilibrium occurs where long-run marginal cost LMC is equal to marginal
revenue MR. The pricing mechanism is the same as in short-run except the average cost
LAC* is achieved by choosing the scale of operation that results in the corresponding
short-run MC and AC curves. Note that the AC* incurred at Q* is greater than the
minimum LAC. This means that monopoly does not produce at minimum LAC in the long
run and long-run profit for a monopoly is extra-normal.

81
 LMC
p
LAC
SAC*
SMC*
p*

AC*

D = AR
MR
Q
Q*

Figure5. 2: Long-run equilibrium of monopoly

Multi-plant Monopoly

We shall now examine the case of a monopolist who produces products in different
production facilities. Suppose the monopolist operates two plants, 1 and 2, with different
cost structures. The monopoly has to make two decisions:

 How much to produce altogether? What price to charge to maximise its profit?

 How to allocate the production of the optimal output between the two plants?

Mathematically, the profit function is:

 = p(Q)Q – C 1 (Q 1 ) – C 2 (Q 2 ),

where Q = Q1 + Q2,

C 1 (Q 1 ) is the total cost of producing Q 1 units of output in plant 1.

C 2 (Q 2 ) is the total cost of producing Q 2 units of output in plant 2.

82
The condition for profit maximisation turns out to be:

MR = MC 1 = MC 2

Exercise 7.3

Suppose the monopolist’s demand curve, the total cost of plant 1, and the total
cost of plant 2 are:

p = 100 – 0.5Q

C 1 = 10Q 1

and C 2 = 0.25Q 2 2,respectively.

a) Calculate the profit-maximising output for each plant.

b) Calculate the profit and the price.

Answer

a) The profit maximising output for plants 1 and 2 are Q 1 = 70 and Q 2 = 20,
respectively;

Q = Q1 + Q2
p = 100 – 0.5(Q 1 + Q 2 )
TR = 100(Q 1 + Q 2 )  0.5(Q 1 + Q 2 )2
MR 1 = MR 2 = 100  Q 1  Q 2
MC 1 = 10
MC 2 = 0.5Q 2
100  Q 1  Q 2 = 10
Q 1 = 90  Q 2
100  Q 1  Q 2 = 0.5Q 2
100  (90  Q 2 )  Q 2 = 0.5Q 2

83
 Q 2 = 20
Q 1 = 90  20 = 70

a) The firm’s profit and price are  = $4,150 and p = $55, respectively.

p = 100 – 0.5(70 + 20) = 55

 = 55(70 + 20) – 10(70) – 0.5(20)2 = 4150

DEMAND AND PRICE OF A MONOPOLIST

He sets the price hence the amount he sells depend on price ,i.e the demand is a
decreasing function of price i.e
Q = f (p) f
Specifically
Q = b0 – b1p
The demand curve is assumed to be linear with changing elastics at every one point.

ℓp = ∞

ℓp = 1
A ℓp = 0
0 Q

OQ
 b1
OP
OQ
ℓp =
OP

P
At point B, ℓ p = -b 1 = ∞
O

84
 0
At point C, ℓ p = -b 1 = 0
O
At point A, ℓ p = 1

Now

TR = P.Q

But Q = b 0 – b 1 p

bo b
P  Q
b1 b1
TR = P.Q

b b 
  o  QQ
 b1 b1 

bo 1
= Q  Q2
b1 b1

bo 1
AR   Q
b1 b1

bo 2
MR   Q
b1 b1

The MR is a straight line with the same interrupt as the demand curve but twice as steep
as:

85
 P

MR AR = D Q

The AR is the demand curve for a monopolist

Equilibrium requires that MR = MC and slope of MC scope of MC slope of slope of MP

at intersection.

SATC
SMCP

Qm MR AR = D Q

86
Π (Q) = TR (Q) – TC (Q)

 TR TC
  0
Q Q Q
MR = MC

∂2π = ∂2TR - ∂2TC < 0

∂Q2 ∂Q2 ∂Q2
Slope of MR < slope of MC
e.g
Q = 50 – 0.5,C= 50 + 40Q

P = 100 – 2Q

TR = PQ = (100 – 2 Q) Q

= 100Q – 2 Q2

MR = ∂ TR = 100 – 4Q
∂
FOC MR – MC
100 – 4Q = 40
60 – 40
60 = 4Q
Q = 15
P = 100 – 2 (15)
= 100 – 30
= 70 units
SOC

87
∂ MR = -4 , ∂MC = 0
∂Q ∂Q

- 4<0

THE MULTIPLANT MONOPOLIST

- A monopolist who produces a homogenous product in different plants

- For simplicity we shall assume two plants.

Assume the monopolist operates two plants A & B with a difference cost structure. He
has to make two decisions.

(i) How much output to produce altogether and at what price to sell it so as to
maximize profit.
(ii) How to allocate the proportion of the optimal output between the two plants.

The monopolist is assumed to know his market demand and the corresponding MR curve
and the cost structure of the different plants.
The total MC curve is a horizontal summation of the MC curve of the individual plants.
MC = MC 1 + MC 2

The monopolist maximizes his profit by utilizing each plant up to the level at which the
marginal cost are equal to each other and to the common Mr. This is *,if the MC of the
one plant say plant A is lower than the MC of plant B, the monopolist wound increase his
profit by increasing the production in A and decreasing it in B until.

MC 1 = MC 2 = MR

Given that the market demand

88
P = f ( Q) = f (Q 1 + Q 2 )

And the cost structure of the plant

C1 = f ( Q1)

C2 = f ( Q2)

The monopolist aims at the allocation of his production between plant 1 and 2.

To maximize profits

Π = TR – ( TC 1 + TC 2 )

f.o.c

∂π = 0 and ∂π = 0
∂Q 1 ∂ Q2

∂π = ∂TR - ∂TC = 0
∂Q 1 ∂Q 1 ∂Q 1
MR 1 = MC 1

∂2π = ∂TR - ∂TC < 0

∂Q2 ∂Q 2 ∂Q 2
MR 2 = MC 2

But MR1 = MR2 = MR given that each unit of the homogenous output will be sold at the
same price P and will yield the same MR1 irrespective of the plant

89
MR = MC 1
MR = MC 1 = MC 2
MR = MC 2
S.O.C

∂2TR < ∂2TC and ∂2TR < ∂2TC

∂Q2 ∂Q2 1 ∂Q2 ∂Q2

Q = 200 – 2P

P = 100 – 0.5Q

C 1 = 10 Q 1

C 2 = 0.25 Q 2 2

π = TR –TC 1 – TC 2

TR = PQ

= 100Q – 0.5Q2

MR = 100- (Q 1 + Q 2 )

MC 1 = 10

MC 2 = 0.5Q 2

90
MR = MC 1

100 – Q 1 – Q 2 = 10

100 – Q 1 – Q 2 = 0.5 Q 2

Q 1 + Q 2 = 90

Q 1 + Q 2 = 100

-0.50 2 = - 10

Q 2 = -10
- 0.5

Q 2 = 20

Q 1 = 70

Q = 20 + 70
= 90

P = 100 – 0.5 (90) = 5

Obtain profit.

91
PRICE DISCRIMINATING MONOPOLIST

Exist when the same product is sold at different prices to different buyers.

The conditions necessary which must be fulfilled for the implementation of price
discrimination are:
(i) The market must be divided into sub market
(ii) Different submarkets must have different prices elasticities.
(iii) There must be effective separation of sub markets, so that no reselling
can take place from a low price market to a high price market.. This
condition explains why price discrimination is easier to apply with
commodities like electricity or gas or services e.g. Doctor which are
consumed by the buyer and cannot be resold.

The reason for a monopolist to apply price discrimination is to obtain an increase in his
total revenue and his profit. By selling the quantity defined by the equation of his
marginal cost and marginal revenue at different prices the monopolist realize higher total
revenue and hence higher profits as compared with the revenue he would receive by
charging a uniform price. Taking a simple case of a monopolist who sells his product at
two different prices. In the first market profit is maximized when MR1 =MC. In the
second market profit is maximized when MR2 =MC. Clearly the total profit is
maximized when the monopolist equates the common MC to individual revenues. MC
=MR1 =MR2

If Mr is one market were larger, the monopolist would sell more in that market and less in
the other, until the above condition is restored.

Illustration: assume that the total demand is X = 50-5P and the total demand functions for
the segmented markets are X1 =32-0.4P1,X2= 18-0.1p2. you are required to find Xs,
prices and profits.

92
MR Vs price elasticity

TR =PQ

MR=∂TR =P ∂Q + Q ∂P
∂Q ∂Q ∂Q

MR = P+ Q ∂P
∂Q

But ℓ p = - ∂Q P
∂P Q

1 = - ∂P Q
ℓp ∂Q P

∂P = 1 P
∂Q ℓ p Q

5. The Impact of Taxes on a Monopolist

For simplicity let us consider a firm with constant MC. When a quantity tax is imposed
the Mc will go up by the amount of the tax. What happens to the price?

We consider a linear demand curve

P = a by
Where p is price
Y is output

93
TR = py = (a-by)
= ay – by2
MR = a – 2by

After a quantity tax t, the MC shifts up to the MC + t

After tax
p
p before tax MC + t

MC =C AR =P
0 Q Q Quantity
MR

The equilibrium moves to the left after the tax. Since the demand curve is half as steep as
the MR curve, the price goes up by half the amount of the tax.

Equilibrium before tax

MR = MC
But after the tax the MC increases by the text sush that:

MR=MC + t
But MC=C
a – 2by = c +t
a- c –t= 2by
2by = a-c-t
y = a-c-t

94
 2b
∆y = -1
∆t = 2b

Recall that equal price is

P= a – by
∆p = - b
∆y

∆p = ∆p ∆y
∆t ∆y ∆t chain rule

= -b – 1 b = 1
2 2

Hence the price changes by less than tax. Specifically for the linear dd, the price rise by
½ the tax.

Generally: in general, a tax may increase the prise by more or less than the amount of tax.
Since the monopolistic will always operate where the demand is lastic then he passes on
more than the amount of the tax.

Inefficiency of Monopoly
Recall, in a competitive market, P=MC

In a monopoly, P>MC

The price will be higher and the output lower, if a firm behaves monopolistically rather
than competitively. For this reason, customers will typically be worse off in an industry
organized monopolistically.

95
However, the firm will be better off by the same taken into considerations monopoly
situation below.

MC

p
p

AR =P
Y Y out put
MR

Alternatively, if the firm recognized its influence on the market price and chose its level
of output so as to maximize profit, we would see the monopoly price and output P m Y m.

Recall that an economic arrangement is Pareto efficient if there is no way to make anyone
better off without somebody worse off.

Therefore is the monopoly level of output Pareto efficient?

Recall the invest dd curve p(y) measures how much people are waiting to pay for an
additional unit of the good. Since (y) is greater than MC(Y) for all the output levels
between Ym and Yc, there is a whole range of output where people are willing to pay
more for a unit of output than it costs to produce it. Clearly there is a potential for pareto
improvement her. Hence a monopoly would be inefficient.

96
But just how inefficient is he? Can we measure the total loss in efficiency due to
monopoly?

The consumers surplus in the monopoly structure is P m e m A which would go up by area

A +B if the monopolist behaves competitively.

On the other hand, the area a would just be a transfer from the monopolist to the
consumer.

Under competition, the producer surplus would include area C. however due to the
monopoly charging the price Pm, he denies the customer surplus (A+B). out of this
surplus, only A benefits the producer while B is lost. Area C is also lost since the
producer sells Y m instead of Y c.

The area B+C is known as the dead weight loss due to the monopoly. If provides a
measure of how much worse off people are paying the monopoly price than paying the
competitive price.

It measures the value of the lost output by valuing each unit of the lost output at the price
that people are willing to pay for that unit.

6.3 Monopolistic Competition

The characteristic that firms compete in the same market produce a homogenous product
does not fit the real world. Furthermore, the model of perfect competition cannot explain
advertising and other marketing strategies practised widely by businesses. In reality, there
is a wide range of products offered in the same market, yet they are often close
substitutes of each other. The model of monopolistic competition was advanced in the
1930s to explain these anomalies.

Characteristics of Monopolistic Competition

97
The two major characteristics that define a monopolistically competitive market are:

 There are large numbers of infinitely small sellers and buyers.

 All the firms produce slightly differentiated (heterogenous) products, yet they are
close substitutes to each other. The aim of product differentiation is to make the
product unique in the minds of the consumers. Yet the product differentiation
must leave the product closely related if they are to be included in the same
product group.

Demand Curves in Monopolistic Competition

The major effect of product differentiation is on the demand curve of a monopolistically

competitive firm. Product differentiation makes the product of a firm unique in the minds
of its consumers to create customer loyalty. It is this uniqueness and customer loyalty that
give rise to market power and negatively sloping demand curve. However, a monopolistic
competitive firm still faces keen competition because of close substitutes offered by other
firms. This means the positions of all demand curves are somewhat dependent on the
interactions between the firms. There are in fact two demand curves for each firm, one
perceived and one actual, as illustrated in Figure 5.3.

p
E
p*
d

D
q
Q*

Figure 6.3: Demand curves of a monopolistically competitive firm

98
The perceived demand curve d is the demand curve that a monopolistically competitive
firm anticipated. This perceived demand curve is highly price elastic because of the fact
that there are a large number of firms in the market and the assumption that rival firms
will not react to changes in this particular firm’s price. In fact, rival firms do react to
changes in this particular firm’s price. The actual demand curve D faced by this firm
when the actions of all the firms in the same product group are the same. The actual
demand curve is also known as the “share-of-the-market” demand curve.

Short-Run Equilibrium

There is virtually no difference between the short-run analysis of monopoly and

monopolistic competition. Short-run profit maximisation occurs at the intersection of the
MR and MC curves, as shown in Figure 7.4. The only difference between the two market
structures is that you expect the demand curve under monopolistic competition to be
much flatter.

MC AC
A
p*
B
AC*
d
E
D
MR
q
Q*

Figure6. 4: Short-run equilibrium of monopolistic competition

99
Long-Run Equilibrium

The long-run equilibrium of monopolistic competition, like perfect competition, is

achieved by both price adjustments and new entry. In Figure 5.5, the initial equilibrium is
at point A with extra-normal profit. This attracts new entry to the market and the actual
demand curve D shift from D 1 to D 2 with point B being the intermediate equilibrium
point. With normal profit, some firms may attempt to increase their competitiveness by
lowering their prices, thus depressing the profitability of all firms. Some financially
weaker firms will leave the market and the actual demand curve D shift to the right and
eventually settle at position D 3 . The final equilibrium is point E where the perceived
demand curve d 3 tangents the long-run average cost curve LAC and normal profit
prevails.

p
LMC
A
LAC
B

d1
E
p*
d2 D1
D3
D2 d3 Q
MR

Figure 6.5: Long-run equilibrium of monopolistic competition

It is again important to point out that monopolistic competition does not produce at the
minimum of the LAC, which means monopolistic competition produces less and charges
a higher price than perfect competition.

100
Optimal Advertising

In addition to product differentiation, firms in monopolistic competition also engage in

advertising and other marketing activities. The most important model that shed light on
profit-maximising advertising is Dorfman-Steiner condition, which suggests that profit-
maximising advertising occurs when the ratio of the advertising expenditure to sales
equal the ratio of advertising elasticity to price elasticity of demand. Mathematically,

Ak EA
 
Pq ED

Where A is the per unit cost of advertising,

k is the number of advertising messages,

E A is the advertising elasticity of demand.

6.4 Oligopoly
Oligopoly is the study of market interactions with a small number of firms. Such an
industry usually does not exhibit the characteristics of perfect competition, since
individual firms' actions can in fact influence market price and the actions of other firms.
The modern study of this subject is grounded almost entirely in the theory of games
discussed in the last chapter. Many of the specifications of strategic market interactions
have been clarified by the concepts of game theory. We now investigate oligopoly theory
primarily from this perspective by introducing four models.

Definition 1 (Oligopoly). Oligopoly is a market where a small number of firms act

independently but are aware of each other’s actions.
6.4.1. Typical assumptions for oligopolistic markets.
 Consumers are price takers.
 All firms produce homogeneous products.

101
  There is no entry into the industry.
 Firms collectively have market power: they can set price above marginal cost.
 Each firm sets only its price or output (not other variables such as advertising).
6.4.2 Summary of results on oligopolistic markets.
 The equilibrium price lies between that of monopoly and perfect competition.
 Firms maximize profits based on their beliefs about actions of other firms.
 The firm’s expected profits are maximized when expected marginal revenue
equals marginal cost.
 Marginal revenue for a firm depends on its residual demand curve (market
demand minus the
 output supplied by other firms)
6.4.3. OLIGOPOLY MODELS AND GAME THEORY
Definition 2 (Game Theory). A game is a formal representation of a situation in which a
number of decision makers (players) interact in a setting of strategic interdependence.
By that, we mean that the welfare of each decision maker depends not only on her own
actions, but also on the actions of the other players.
Moreover, the actions that are best for her to take may depend on what she expects the
other players to do.
We say that game theory analyzes interactions between rational, decision-making
individuals who may not
be able to predict fully the outcomes of their actions.
Definition 3 (Nash equilibrium). A set of strategies is called a Nash equilibrium if,
holding the strategies of all other players constant, no player can obtain a higher payoff
by choosing a different strategy. In Nash equilibrium, no player wants to change its
strategy.

6.4.4 Behavior of firms in oligopolistic games.

 Firms are rational.
 Firms reason strategically.
6.4.5. Elements of typical oligopolistic games.
 There are two or more firms (not a monopoly).

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  The number of firms is small enough that the output of an individual firm has a
measurable impact
 on price (not perfect competition). We say each firm has a few, but only a few,
rivals.
 Each firm attempts to maximize its expected profit (payoff).
 Each firm is aware that other firm’s actions can affect its profit.
 Equilibrium payoffs are determined by the number of firms, the rules of the
games and the length
 of the game.
6.4.6. Comparison of oligopoly with competition. In competition each firm does not
take into account the actions of other firms. In effect they are playing a game against an
impersonal market mechanism that gives them a price that is independent of their own
actions. In oligopoly, each firm explicitly takes account of other firm’s expected actions
in making decisions.

6..4.7 Single period models.

Definition 4 (Single period or static games). Firms or players “meet only once” in a
single period model. The market then clears one and for all. There is no repetition of the
interaction and hence, no opportunity for the firms to learn about each other over time.
Such models are appropriate for markets that last only a brief period of time.
There are three main types of static oligopoly models.
 Cournot
 Bertrand
 Stackelberg
6.4.7.1 THE COURNOT MODEL
Historical background. Augustin Cournot was a French mathematician. His original
model was published in 1838. He started with a duopoly model. His idea was that there
was one incumbent firm producing at constant unit cost of production and there was one
rival firm considering entering the market. Since the incumbent was a monopolist, p >
MC, and there was potential for a rival to enter and to make a profit.

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Cournot postulated that the rival firm would take into account the output of the
incumbent in choosing a level of production. Similarly he postulated that the monopolist
would consider the potential output of the rival in choosing output.

General assumptions of the Cournot model.

 Two firms with no additional entry.
 Homogeneous product such that q1 + q2 = Q where Q is industry output and qi is
the output of the ith firm.
 Single period of production and sales (consider a perishable crop such as
cantaloupe or zucchini).
 Market and inverse market demand is a linear function of price. We write this
linear inverse demand as follows
p = A − BQ = A − B (q1 + q2)= A − B q1 − B q2 ) Q = A B −pB = A − pB

 5. Each firm has constant and equal marginal cost equal to c. With constant
marginal cost, average cost is also constant and equal to c.
 6. The decision variable in the quantity of output to produce and market.

Example Model

. Assume market demand is given by

Q(p) = 1000 − 1000p
This implies that inverse demand is given by
Q(p) = 1000 − 1000p) 1000 p = 1000 − Q) p = 1 − 0.001Q
= 1 − .001 (q1 + q2)
= 1 − 0.001q1 − 0.001q2.

With this demand function, when p = $1.00, Q = 0 and when p = 0, Q = 1000. Also
notice that for p = A -BQ to have a positive price with A > 0 and B > 0 it must be that AB
> Q.
For this example, assume that

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AC = MC = $0.28.

Residual demand curves in oligopoly models. Assume that there are two firms: Firm 1
and Firm 2. If Firm 2 believes that Firm 1 will sell q1 units of output, then its residual
inverse demand curve is given byp = A − B q1 − B q2 = (A − B q1) − q2
In equation 5 we view (A - Bq1) as a constant. We can also write this in quantity
dependent form as q2(p) = Q(p) − q1
We obtain equation 6 by shifting the market demand curve to the left by q1 units. For
example if q1 = 300 then the residual demand curve will hit the horizontal axis at 700
units. Thus q2(p) =Q(p) − q1
= (1000− 1000p) − 300, q1 = 300
= 700 − 1000p
Now if p = 0 then q2(p) = 700. The residual inverse demand curve is given by
substituting 300 in equation above to obtain
p = 1 − 0.001q1 − 0.001q2
= 1 − (0.001)(300) − 0.001q2
= 0.70 − .001q2.
We find residual marginal revenue by taking the derivative of the residual revenue
function. With residual demand given by p = A - Bq1 - Bq2, revenue for the second firm
is given by
R2 = (A − Bq1 − B q2) q2
= Aq2 − Bq1 q2 − B q2 while residual marginal revenue is given by the derivative of
residual revenueR2 = Aq2 − Bq1 q2 − B q2

MR2 = A − B q1 − 2B q2
For the example with residual demand given by p = .70 - .001q2, revenue for the second
firm is given by R2 = (.70 - .001q2)q2 = .70 q2 - .001q2
2. Residual marginal revenue is given by the derivative of residual revenue
R2 = .70q2 − .001q2) MR2 = dR2/dq2
= .70 − .002q2

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6.4.7.2 THE BERTRAND MODEL
Introduction to the Bertrand Model. In the Cournot model each firm independently
chooses its output. The price then adjusts so that the market clears and the total output
produced is bought. Yet, upon reflection, this phrase “the price adjusts so that the market
clears” appears either vague or incomplete. What exactly does it mean? In the context of
perfectly competitive markets, the issue of price adjustment is perhaps less pressing. A
perfectly competitive firm is so small that its output has no effect on the industry price.
From the standpoint of the individual competitive firm, prices are given i.e., it is a “price-
taker.”

Hence, for analyzing competitive firm behavior, the price adjustment issue does not arise.
The issue of price adjustment does arise, however, from the perspective of an entire
competitive industry. That is, we are obliged to say something about where the price,
which each individual firm takes as given, comes from.

We usually make some assumption about the “invisible hand” or the “Walrasian
auctioneer”. This mechanism is assumed to work impersonally to insure that the price is
set at its market clearing level. But in the Cournot model, especially when the number of
firms is small, reliance upon the fictional auctioneer of competitive markets seems
strained. After all, the firms clearly recognize their interdependence. Far from being a
price-taker, each firm is keenly aware that the decisions it makes will affect the industry
price. In such a setting, calling upon the auctioneer to set the price is a bit inconsistent
with the development of the underlying model. Indeed, in many circumstances, it is more
natural “to cut to the chase” directly and assumes that firms compete by setting prices and
not quantities. Consumers then decide how much to buy at those prices.

The Cournot duopoly model, recast in terms of price strategies rather than quantity
strategies, is referred to as the Bertrand model. Joseph Bertrand was a French
mathematician who reviewed and critiqued Cournot’s work nearly fifty years after its
publication in 1883, in an article in the Journal des Savants. Acentral point in Bertrand’s

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review was that the change from quantity to price competition in the Cournot duopoly
model led to dramatically different results.

The Basic Bertrand Model.

4.2.1. Assumptions of the basic Bertrand Model.
 Two firms with no additional entry.
 Homogeneous product such that q1 + q2 = Q where Q is industry output and qi is
the output of the ith firm.
 Single period of production and sales
 Market and inverse market demand is a linear function of price.
p = A − BQ = A − B (q1 + q2)
Q = AB −pB= A − pB
 Each firm has constant and equal marginal cost equal to c. With constant marginal
cost, average cost is also constant and equal to c.
 The decision variable is the price to charge for the product.

Residual demand curves in the Bertrand model. If Firm 2 believes that Firm 1 will sell q1
units of output, then its residual inverse demand curve is given by p = A − B q1 − B q2 =
(A − B q1) − q2 while residual demand is given by Q = AB −pB= a − bp where a =
ABand b =1B
In order to determine its best price choice, Firm 2 must first work out the demand for its
product conditional on both its own price, p2, and Firm 1’s price, p1. Firm 2’s reasoning
then proceeds as follows. If p2 >p1, Firm 2 will sell no output. The product is
homogenous and consumers always buy from the cheapest source. Setting a price above
that of Firm 1, means Firm 2 serves no customers. The opposite is true if p2 <p1. When
Firm 2 sets the lower price, it will supply the entire market, and Firm 1 will sell nothing.
Finally,we assume that if p2 = p1, the two firms split the market. The foregoing implies
that the demand for Firm 2’s output, q2, may be described as follows:
q2 = 0 if p2 > p1
q2 = a − bp2 if p2 < p1

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q2 =(a − bp2) if p2 = p1

Equilibrium in the Bertrand model. We are now in a position to determine the Nash
equilibrium for the duopoly when played in prices. We know that a Nash equilibrium is
one in which each firm’s expectation regarding the action of its rival is precisely the
rival’s best response to the strategy chosen by the firm in question in anticipation of that
response. For example, the strategy combination, [p1 = a+bc 2b , p2 = a+bc2b -"] cannot
be an equilibrium. This is because in that combination, Firm 2 is choosing to undercut
Firm 1 on the expectation that Firm 1 chooses the monopoly price. But Firm 1 would
only choose the monopoly price if it thought that Firm 2 was going to price above that
level. In other words, for the suggested candidate equilibrium, Firm 1’s strategy is not a
best response to Firm 2’s choice. Hence, this strategy combination cannot be Nash
equilibrium.
There is, essentially, only one Nash equilibrium for the Bertrand duopoly game where
both firms are producing. It is the price pair, (p_1 = c, p_2 = c) . If Firm 1 sets this price
in the expectation that Firm 2 will do so, and if Firm 2 acts in precisely the same manner,
neither will be disappointed. Hence, the outcome of the Bertrand duopoly game is that the
market price equals marginal cost. This is, of course, exactly what occurs under perfect
competition. The only difference is that here, instead of many small firms, we have
just two, large ones.

Criticisms of the Bertrand model.

1. Small changes in price lead to dramatic changes in quantity
The chief criticism of the Bertrand model is its assumption that any price deviation
between the two firms leads to an immediate and total loss of demand for the firm
charging the higher price. It is this assumption that gives rise to the discontinuity in either
firm’s demand or profit functions.
It is also this assumption that underlies the derivation of each firm’s best response
function. There are two reasons why one firm’s decision to charge a price somewhat
higher than its rival may not cause it to lose all its customers. One of these factors is the
existence of capacity constraints.

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1 The other is that the two goods may not be identical.
2. Capacity constraints

Reference
Border, K. C., Fixed Point Theorems with Applications to Economics and Game The-
ory, Cambridge: Cambridge University Press, 1985.
Luenberger, D., Microeconomic Theory, McGraw-Hill, 1995, Appendixes A-D.
Takayama, A. Mathematical Economics, the second edition, Cambridge: Cambridge
University Press, 1985, Chapters 1-3.
Tian, G., The Basic Analytical Framework and Methodologies in Modern Economics,
2004 (in Chinese). http://econweb.tamu.edu/tian/chinese.htm.
Tian, G., \Fixed Points Theorems for Mappings with Non-Compact and Non-Convex
Domains," Journal of Mathematical Analysis and Applications, 158 (1991), 161-167.

109
CHAPTER SEVEN: GENERAL EQUILIBRIUM
Learning Objectives
 By the end of this topic, the learner should be able to:
 Explain the concept of general equilibrium
 Illustrate the concept of Edgeworth Box Diagram and its application

The state of efficiency in exchange /consumption i.e. how we can exchange one good for
another but maintaining the same level of utility.

We shall assume two people A& B two goods 1& 2

equation reference goes here MRS12A = MRS12B Efficiency in exchange

Efficiency in production where we assume two goods 1 and 2 two inputs L and K, such
that MRTS12L = MRTS12K Efficiency in production

7.1 The Edgeworth Box Diagram

This is a convenient graphical tool known as the edgeworth box that can be used to
analyze the exchange of two goods between two people. It allows us to depict the
endowments and preferences of two individuals in one convenient diagram.

Let us assume two people involved A&B and two goods 1&2

Let persons A’s consumption bundle be X A = X 1

A X A2  where X 1A represents to A’s

consumption of good 1 and X A2 represents As consumption of good 2.

B’s consumption bundle of the two goods is X B =  X B1 X B2 

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A pair of consumption bundles X A and X B is called an allocation. An allocation is
specific allocation if the total amount of each good consumed is equal to the total amount
available.i.e.

X 1A  X B1  WA1  WB1

X A2  X B2  WA2  WB2

Where WA1 for instance is the total availability of good 1 to person A and WB1 WB is the
availability to person B

WB1 X B1

Good 2 Person B

X B2

X A2

WB2

WA2

Person A

x1 A w1 A Good 1

The width of the box measures the total amount of good 1 in the economy and the height
measures. The total amount of good 2. persons A’s consumption choices are measured
from the lower left hand corner while person B’s choices are measured from the upper
right.

111
The bundles in this box indicate the amount of goods that each person can hold. If for
example there are 10 units of good 1 and 20 units of good 2, then if A holds (7,12), then
B must be holding (3,8).

For instance at point M, if person A holds X 1A if good 1, then B holds X B1 of good 1. if A

holds X A2 of good 2, then B holds X B2 of good 2.

Consider point W
Movement from point W for example puts person A to a higher 1C IAM from IAW.
Hence making person A better off without necessarily making person B worse off. To
move to point M person A have to forego ( WA1  X 1A ) amount of good 1 and have

( X A2  WA2 ) amount more of good 2 on the other hand person B has to forego ( WB1  X B1 )

amount of good 2 I order to have more good 1 i.e.( X B1  WB1 )

All the same , this movement makes person A better off by putting him on a higher IC.
Similarly, movement from point W to point N will make person B better off without
making person A worse off.

At a pareto efficient allocation each person is on his highest possible IC given the IC of
the other person. A pareto optimal state is therefore a state such that changing the state
will at least make one person off at the expense of the other. One is made better off while
the other is made worse off.

A line connecting all such points in consumption contract curve. It is a locus of all
efficient allocation in consumption.
Along the c.c.c the MRS for both persons is the same. When this condition is met, then
the first condition for social welfare maximization has been achieved i.e.

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MRSA 12 = MRSB 12
Generally
MRSA 12 =MRSB 12 = MRSC 12 = …=MRSn 12
By definition, a pareto efficient allocation makes each agent as well-off as possible given
he utility of the other agent. Let u be the utility level for agent B, so how can agent A be
made as well –off as possible?
The maximization problem is:

Max UA (X1 A , X2 A )
st
UB(X1 B ,X2 B ) = U
X1 A +X1 B =w1
X2 Z +X2 B =W2

Where.
W1 =W1 A +W1 B is the total amount of good 1 available and W 2 =W2 A +W2 B is the total
availability of good 2.
We then seek to find (X1 A X2 A X1 B X2 B ) i.e.X A and X B that makes person B’s utility and
given that the total amount of each good used is equal to the amounts available.

We can write the langrangian for this problem as:

L=UA(X1 A X2 A ) - λ{UB(X1 B X2 B ) – U} - µ(X1 A + X1 B – W1) -µ(X2 A +X2 B –W2)

Λ is the language multiplier on the utility constraints and µ’s are the language multiplers
of the resources constraints.

Getting the FOC’s.

∂L = ∂UA - µ 1 = 0………………………………… (I)
∂X1 A ∂X1 A
∂L = ∂UA - µ 1 = 0………………………………….. (II)

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∂X1 A ∂X1 A

∂L = ∂UB - µ 1 = 0…………………………………..(III)
∂X1 B ∂X1 B

∂L = ∂UB - µ 2 = 0………………………………….(IV)
∂X2 B ∂X2 B
If we divide the first equation by the second and the third equation by the fourth we
have:
∂UA ∂UA = µ1 MRS12 A = µ 1
∂X1 A ∂X2 A µ2 µ2

∂UB ∂UB = µ1 MRS12 B = µ1

∂X1 B ∂X1 B µ2 µ2

At a Pareto efficient allocation the MRS between the two goods must be the same.

REVISON QUESTIONS

QUESTION ONE

(i) List as many conditions as you can that lead to a cartel being successful (in
raising price and not falling apart).
(ii) Using a graph, show how a price floor can be used to get a perfectly
competitive market to produce the socially optimal amount of output when
there is a negative externality of production (pollution).
(iii) What happens to firm profits and the number of firms in a monopolistically
competitive market if a lump-sum tax (collected annually) is placed on the
firms in the short-run and in the long-run? [Student suggested]

114
 (iv) Cigarette manufacturers may not advertise on television. How does imposing
this restriction affect the equilibrium price and quantity in that market?
Explain.
(v) The more output a firm produces the greater the externality damage from
pollution. Determine if the following statement is true or false, and explain
your answer with a graph: A tax equal to the marginal externality damage
placed on the polluting firm always will lead to a welfare improvement.
(vi) Davies Symphony Hall has a fixed capacity. The Symphony may set a price
per concert, sell only season tickets, use two-part tariffs, or use other pricing
schemes. Discuss how the Symphony may price its tickets to capture all the
consumer surplus if it cannot perfectly price discriminate? Explain your
answer. [Student suggested]

QUESTION TWO

(i) B1 A monopoly can imperfectly discriminate between two groups of

customers. Its marginal cost of production is 2. Group A's (constant) elasticity
of demand is -4 and Group B's is -2. What prices does the monopoly charge
the two groups?
(ii) B2 A homeowner has an opportunity to switch to fluorescent light bulbs for a
one-time price of $300. The fluorescent light bulbs would save her $20 per
year in electricity bills from now on (you may assume she makes these
savings forever and there is no inflation). Her discount rate is 5%.

A. Would she choose to switch to fluorescent light bulbs? (5 pts)

B. At what discount rate would she be indifferent about switching? (4 pts)

C. Suppose she could instead use the $300 to make a different one-year investment that
would return a gross of $400 next year. What would she choose to do? (5 pts)

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Question three

C1 Two firms are in the chocolate market. Each can choose to go for the high end of the
market (high quality) or the low end (low quality). The resulting profits are given by the
following payoff matrix:

Firm 2 (top)
Low High
Low -30 600

-20 900

Firm 1 High 800 50

(bottom) 100 50

A. Nash: The firms move simultaneously. What outcomes, if any, are Nash equilibria? (3
pts) Explain why these outcomes are Nash. (3 pts)

B. Stackelberg: Draw the game tree if Firm 1 goes first. (3 pts) Show Firm 2's best
response on the game tree. (1 pt) What is the outcome if Firm 1 can pick its quality level
first? Explain. (4 pts)

C2 An incumbent firm can get the legislature to raise its marginal cost and that of a
potential entrant by $50. There is no cost to lobbying. If the incumbent lobbies and gets
the higher marginal cost and the other firm later enters, both firms lose $10. If the other
firm does not enter it makes $0 and the incumbent makes $50. If the incumbent does not
get the legislature to raise costs and the other firm enters, both firms make $40. If the
other firm does not enter, it makes $0 and the incumbent makes $100.

A. Illustrate this game using a game tree. (5 pts)

B. What actions do the incumbent and entrant take and why? (9 pts)

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Question four

D1 Market demand is p = 26 - Q. Two identical firms have cost functions C = 64 + 2q,

where q is each firm's individual output. (So MC = 2.) The firms produce identical
products.

A. What is the Cournot-Nash equilibrium market price and output? (8 pts)

B. Would a third identical firm want to enter? (5 pts)

C. What is the equilibrium (market price and quantity of each firm) if the firms collude
and split the market equally? (5 pts)

Reference
Border, K. C., Fixed Point Theorems with Applications to Economics and Game The-
ory, Cambridge: Cambridge University Press, 1985.

Luenberger, D., Microeconomic Theory, McGraw-Hill, 1995, Appendixes A-D.

Takayama, A. Mathematical Economics, the second edition, Cambridge: Cambridge

University Press, 1985, Chapters 1-3.

Tian, G., The Basic Analytical Framework and Methodologies in Modern Economics,
2004

Tian, G., \Fixed Points Theorems for Mappings with Non-Compact and Non-Convex
Domains," Journal of Mathematical Analysis and Applications.

117
CHAPTER EIGHT: EXTERNALITIES
LEARNING OBJECTIVES

At the end of the Lecture the student should be able to:

 Explain the concept of externalities in economics
 Explain the various types of externalities
 Discuss the private and public remedies for externalities

8.1 What is an externality?

Externality is a cost or benefit from production or consumption activities that affect

people who are not part of the original activity. Externalities may be negative or positive.

 External cost (negative externality) - cost of producing a good/service not borne

by consumers but by others. Consumers can create externalities when they
purchase and consume goods and services.
 Pollution from cars and motorbikes
 Litter on streets and in public places
 Noise pollution from using car stereos or ghetto-blasters
 Negative externalities created by smoking and alcohol abuse
 Externalities created through the mis-treatment of animals
 Vandalism of public property
 Negative externalities arising from crime
Externalities create market failure (allocative inefficiency). Markets overproduce
goods/services with external cost and overproduce goods/services with external benefits.

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 Figure 1 Excessive Production of Goods Yielding Negative Externalities

Marginal social cost

Supply curve
(Marginal private cost)

Demand curve
(Marginal benefit)
Qe Qm

Quantity of Steel

The level of production of negative externality generating commodity will be excessive.

Figure 1 show a conventional demand and supply curves. The absence of externalities
will result the market equilibrium efficient. The demand curve reflected the individual’s
marginal benefits from the production of an extra unit of the commodity, and the supply
curve reflected the marginal costs of producing an extra unit of commodity. At the
intersection of the two curves the marginal benefits just equal the marginal costs. Now,
with externalities, the industry’s supply curve will not reflect marginal social costs, only
marginal private costs, those borne privately by the producers. If the expansion of steel
production increases the level of pollution, there is a real cost to that expansion in
addition to the costs of the iron, ore, labor, coke and limestone that go into the production
of steel. But the steel industry fails to take the cost of pollution into account. Figure 1
also shows the marginal social cost curve, giving the total extra costs (private and social)
of producing an extra unit of steel. This cost curve lies above the industry supply curve.
Efficiency requires that marginal social cost equal the marginal benefit of increasing
output: production should occur at Q e , the intersection of the marginal social cost and the

119
demand curve. The efficient level of production is lower than the market equilibrium
level.
 External benefit (positive externality) – benefit from consuming a good/ service
going not to consumers but to others. In some cases, the actions of an individual
or firm confer (uncompensated) benefits on others, like for example a homeowner
who maintains his property; including planting attractive flowers in front, and
provide a positive externality

The issue of external benefits is related to that of public goods, which are goods where it
is difficult if not impossible to exclude people from benefits. The production of public
goods has beneficial externalities for all or almost all, of the public. As with external
costs, there is a problem here of societal communication and coordination to balance
benefits and costs. This also implies that pollution is not something solved by competitive
markets.

Example of positive externalities includes:

Knowledge spillover of inventions and information (most other forms of practical

information) is discovered or made more easily accessible, others benefit by exploiting
the invention or information. Copyright and intellectual property law is mechanisms to
allow the inventor or creator to benefit from a temporary, state-protected monopoly in
return for “sharing” the information through publication or other means

8.2 Private Solution to Externalities

Sometimes economic efficiency can be attained without resort to government

intervention.
 By establishing sufficiently large economic organizations, the externalities can be
internalized.
 By establishing clear property rights, private parties can bargain toward an
efficient solution, as suggested by Coase.
COASE THEOREM- if the property rights are established and transaction costs are low,
there will be efficiency. The costs imposed on people who are not part of the original

120
activity can be recovered through the legal process and thus be paid by those involved in
the activity. The costs will become internal (private).
Coase theorem suggests that we may be able to do even better. If property
rights are fully assigned, then the regulatory body should not, in theory,
have to be involved. Instead, parties will negotiate among themselves to
and the lowest cost solution to correcting the externalities.
 By using the legal system, imposers of externalities can be forced to compensate
victims.
 The legal system can provide protections against externalities. Our system
of common law does not allow one party to injure another, and “injury”
has been interpreted to include a variety of economic costs imposed on
others.

8.3 Failures of Private Remedies for Externalities

 Public Good (free rider) problems

Many externalities involve the provision of a public good, such as clean air or clean
water: in particular, it may be very costly to exclude anyone from enjoying the
benefits of these goods.

 Compounded by imperfect information problems

The problem of arriving voluntarily at an efficient solution is exacerbated by the

presence of imperfect information. Take for example the smokers will try to persuade
nonsmokers that they require a lot of compensation to induce them not to smoke. In
such bargaining situation, one party may risk the possibility of not arriving at a
mutually advantageous agreement in order to get more out of any bargain that might
be made.

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  Transactions costs

Transaction costs are a major disadvantage of dealing with externalities through

judicial processes. For many externalities, the losses involved may simply be too
small to justify undertaking litigation. Since those generating externalities know that
litigation is expensive, they may be inclined to generate their externality just up to the
point where it pays the injured party to sue—giving rise to considerable
inefficiencies. Uncertainty about the extent of the injury frequently compounds the
problem of transaction costs, and there is also some ambiguity about the outcome of
most suits.

 Additional problems with litigation

If litigation costs are large, the uncertainty acts as a further deterrent to individuals
contemplating using the court system to deal with externalities. The high litigation
costs and uncertain outcome of the litigation process imply that there is, in effect,
differential access to legal remedies—poor people may not be able or willing to bear
the risks of litigation—a situation which conflict with our usual notion of justice in
democracy.

8.4 Public Sector Solutions to Externalities

MARKET-BASED SOLUTIONS

1. Fines and Taxes- In general, whenever there is an externality, there is a difference

between the social cost and the private cost, and between the social benefit and
private benefit. A properly calculated fine or tax presents the individual or firm
with the true social costs and benefits of its actions. Fine of this sort—designed to
make marginal private costs equal marginal social costs, and marginal private
benefits equal to marginal social benefits- are called corrective taxes, or
sometimes Pigouvian taxes.

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2. Subsidizing pollution abatement- Rather than taxing pollution, the government
could subsidize pollution abatement expenditures. By providing a subsidy equal
to the difference between the marginal social benefit of pollution abatement and
firm’s marginal private benefit, the efficient level of pollution abatement
expenditures can be attained.

3. Marketable Permits- An increasingly popular market-based solution involves

marketable permits. These limit the amount of pollution that any firm can emit.
Under this system, firms will be willing to sell permits so long as the market price
of the permit is greater than the marginal cost of reducing pollution, and firms
will be willing to buy permits so as long as the marginal cost of reducing
pollution is greater than the market price of the permit. Thus in equilibrium, each
firm will reduce pollution to a level such that the marginal cost of pollution
reduction is equal to the market price of the permit. Marketable permits have one
advantage over fines. With fines, the government may not be sure about the level
of emissions that the firms will choose to produce.

 REGULATION
Most economists believe that market-based solutions provide the most promise for
curbing environmental externalities, but government traditionally has replied upon
direct regulation. It has set emission standards for automobiles; put forth detailed
regulations relating to the disposal of toxic chemicals; outlawed smoking on domestic
airline flights; imposed laws requiring oil companies with wells in the same oil pool
to unitize their production; imposed restrictions on fishing and hunting to reduce the
inefficiencies associated with excessive utilization of these common resources.

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REVISION QUESTIONS

QUESTION ONE

A firm has a U-shaped average cost curve. The market demand is a downward-sloping
straight line.

A. Can this firm ever be a natural monopoly? If not, why not? If so, what conditions must
be met for it to be a natural monopoly? (10 pts)

B. Show the equilibrium price, quantity, and profit for this monopoly equilibrium. (7
pts)Firm 1 is initially a monopoly. Then, a competitive fringe enters the market. The
fringe supply is horizontal at p* (a price that is above Firm 1's minimum average cost).
Show that the dominant firm-competitive fringe equilibrium price, p*, is less than the
original monopoly equilibrium price, p (10 pts). Also show how much the dominant
produces, Q d , and how much the fringe produces, Q f , in the new equilibrium (7 pts).

QUESTION TWO

A monopoly produces a life-saving medicine at a constant cost of $10 per dose. The
demand for this medicine is perfectly inelastic so long as price is less than the $100 (per
day) income of the 100 patients who need to take this drug once a day.

A. Show the equilibrium price and quantity and the consumer and producer surplus in a
graph. (8 pts)

B. The government imposes a price ceiling of $30. Show the new equilibrium. What is
the change in consumer and producer surplus? What is the deadweight loss (if any) from
this price control? (9 pts)

QUESTION THREE

Initially, a firm uses L* units of labor and K* units of capital to produce q* units of
output. The firm has the usual smooth-shaped isoquants (labor and capital are imperfect

124
substitutes). To encourage additional employment, the government starts paying 25% of
the firm's wage payments (the rate offered by the U. S. government in the late 1970s
under the New Jobs Tax Credit program).

A. If the firm continues to produce q* units, show in a graph how its choice of inputs
changes. (6 pts)

B. Does the government program achieve its objective of increasing employment? (3 pts)

C. In a graph, show the firm's original output-expansion path and its new path. (6 pts)

QUESTION FOUR
Steve's utility function is U = BC, where B = beer cans per week and C = pack of
cigarettes per week. As a result, his marginal rate of substitution is MRS = -B/C, where
beer is on the vertical axis and cigarettes are on the horizontal axis. Steve's income is
$120, the price of a can of beer is $2 and that of a pack of cigarettes is $1. [In answering
the following, use graphs and math.]

A. How many cans of beer and packs of cigarette does Steve consume? (12)

B. Due to a new tax, the price to Steve of a can of beer rises to $3. Now how much beer
and how many packs of cigarettes does Steve consume? (13)

QUESTION FIVE

Bill has an income of $200. He may buy up to $100 worth of food stamps, where a food
stamp can be used to purchase $1 worth of food costs him 25¢. [Assume there is no black
market for food stamps.]

A. Under what conditions would he prefer receiving $75 cash instead of being able to buy
up to $100 worth of food stamps? Explain using a graph. (15)

125
B. If Bill got $100 worth of food stamps for free (instead of having to buy them at a
discount), would he be more or less likely to prefer in cash ($100) to food stamps than in
(A)? (10)

References:

Aronson, Richard J. Public Finance, USA, New York: Mc Graw Hill Book Co.,1985

Rosen, Harvey S., Public Finance, 5th edition, USA, New York: Mc Graw Hill Book Co.,
1999.

Stiglitz, Joseph E., Economics of the Public Sector, 3rd edition, W.W. Norton & Co.,
New York, 2000

Border, K. C., Fixed Point Theorems with Applications to Economics and Game The-
ory, Cambridge: Cambridge University Press, 1985.

Luenberger, D., Microeconomic Theory, McGraw-Hill, 1995, Appendixes A-D.

Takayama, A. Mathematical Economics, the second edition, Cambridge: Cambridge

University Press, 1985, Chapters 1-3.
Tian, G., The Basic Analytical Framework and Methodologies in Modern Economics,
2004
Tian, G., \Fixed Points Theorems for Mappings with Non-Compact and Non-Convex
Domains," Journal of Mathematical Analysis and Applications

126
SAMPLE QUESTIONS
MOUNT KENYA UNIVERSITY

INTERMEDIATE MICRO-ECONOMIC THEORY SAMPLE PAPER

TIME: 2HRS

INSTRUCTIONS
1. THIS PAPER CONTAINS TWO SECTIONS
2. QUESTION ONE IS COMPULSORY
3. ANSWER ANY OTHER TWO QUESTIONS FROM SECTION B

SECTION A (COMPULSORY) 30MKS

a) THE GOVERNMENT OF KENYA IMPOSES A BINDING QUOTA OF Q* ON STEEL

IMPORTS. SUPPOSE THE SUPPLY CURVE IS RELATIVELY INELASTIC WHILE THE

SUPPLY CURVE OF FOREIGN SUPPLIER IS VERY ELASTIC. USE A FIGURE TO SHOW THE

EFFECT OF THE QUOTA ON THE KENYA PRICE OF STEEL, THE QUANTITY OF STEEL

SOLD BY KENYAN FIRMS, AND THE TOTAL QUANTITY SOLD WITHIN THE COUNTRY

5 MKS
b) WHAT IS CONSUMER PREFERENCES? OUTLINE THE ASSUMPTIONS OF CONSUMER

PREFERENCE 8 MKS
c) WHAT ARE INDIFFERENCE CURVES? ILLUSTRATE ANY THREE PECULIAR SHAPES

THAT CAN BE TAKEN BY INDIFFERENCE CURVES 8 MKS

d) EXPLAIN THE CONCEPT OF BUDGET CONSTRAINT 4MKS
e) EXPLAIN FIVE STEPS OF A BASIC ANALYTICAL FRAMEWORK FOR AN ECONOMIC

THEORY 5 MKS

QUESTION TWO

A) EXPLAIN THE FOLLOWING TERMS 12 MKS

(i) THE MARGINAL PRODUCT
(ii) THE TECHNICAL RATE OF SUBSTITUTION

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 (iii) DIMINISHING MARGINAL PRODUCT
(iv) DIMINISHING TECHNICAL RATE OF SUBSTITUTION
(v) RETURN TO SCALE
(vi) MONOPOLISTIC MARKET

B) DISCUSS ANY FOUR TYPES OF MONOPOLY 8 MKS

QUESTION THREE
a) EXPLAIN THE COURNOT MODEL AND STATE ITS ASSUMPTIONS 10 MKS
b) WHAT IS PRICE DISCRIMINATION? 2 MKS
c) EXPLAIN THE CONDITIONS WHICH MUST BE FULFILLED FOR THE IMPLEMENTATION OF

PRICE DISCRIMINATION 8 MKS

QUESTION FOUR

A FIRM’S MARKET DEMAND IS P = 26 - Q. TWO IDENTICAL FIRMS HAVE COST FUNCTIONS C

= 64 + 2Q, WHERE Q IS EACH FIRM'S INDIVIDUAL OUTPUT. (SO MC = 2.) THE FIRMS
PRODUCE IDENTICAL PRODUCTS.

A. WHAT IS THE COURNOT-NASH EQUILIBRIUM MARKET PRICE AND OUTPUT? (8 PTS)

B. WOULD A THIRD IDENTICAL FIRM WANT TO ENTER? (6 PTS)

C. WHAT IS THE EQUILIBRIUM (MARKET PRICE AND QUANTITY OF EACH FIRM) IF THE FIRMS
COLLUDE AND SPLIT THE MARKET EQUALLY? (6 PTS)

QUESTION FIVE

a) WHAT IS AN EXTERNALITY? 2 MKS

b) EXPLAIN THE COASE THEOREM AND OUTLINE THREE PRIVATE SOLUTIONS

TO EXTERNALITIES 12 MKS

c) DISCUSS THE ROLES OF ECONOMIC THEORY 6MKS

128
 MOUNT KENYA UNIVERSITY

INTERMEDIATE MICRO-ECONOMIC THEORY Sample paper

TIME:2hrs

INSTRUCTIONS
4. This paper contains two sections
5. Question ONE is compulsory
6. Answer any other TWO questions from section B

Section A (compulsory) 30mks

QUESTION ONE

a) What is Economic Theory?. Outline the limitations of economic theory 6 mks

b) What is oligopoly? Explain the assumptions of an oligopolistic market 12 mks
c) If the marginal product of labor is decreasing as more labor is used, must the
average product of labor also be decreasing? Can a firm be producing efficiently
when the marginal product of labor is negative? 6 mks
f) Suppose the demand for corn oil is Q = 1,000 - 10p + 10Y, where Y = income, p
= price, and Q =quantity. Write a formula for the price elasticity of demand for
corn oil. 4 mks
g) An hour-long exam consists of two problems, each worth a maximum of 50
points. A student doesn’t have enough time to get full-credit on both questions.
How should this student allocate his or her time spent on each problem to
maximize the total score? Illustrate your answer using a figure. 6 mks

QUESTION TWO
a) Explain three properties of technology 2 mks
b) Illustrate the concept of Edgeworth Box Diagram and its application 8 mks

129
 c) Using a graph, show how a price floor can be used to get a perfectly competitive
market to produce the socially optimal amount of output when there is a negative
externality of production (pollution).10 mks

QUESTION THREE

c) What is perfect competition? Explain the assumptions of perfect competition.

d) With the help of a diagram distinguish between the substitution effect and income
effect of a price change with respect to a normal good
QUESTION FOUR
c) Define the concept of externalities and explain four remedies to negative
externalities
d) Define monopoly and explain the sources of monopoly power

QUESTION FIVE

A firm produces candles. The market for candles is highly competitive, with candles
currently selling for $10. The firm's short-run total cost function is C = 200 + 0.2q2, so its
marginal cost is MC = 0.4q.

A. What is the firm's profit-maximizing quantity? (6 mks)

B. Is the firm earning a profit? (7 mks)

C. What is the short-run shutdown price? (7 mks)

130