Basic Microeconomics

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 Basic Microeconomics

Table of Contents

Chapter Title Page

Introduction to Economics, Microeconomics and Economic
1
Models 3
2 Demand, Supply and Market Equilibrium 11
3 Elasticity of Demand and Supply 32
4 Consumer Choice and Demand 44
5 Theory of Production 54
6 Theory of Cost and Profit 69
7 Perfectly Competitive Market 80
8 Imperfect Competitive Market 88

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Chapter I
Introduction to Economics, Microeconomics and Economic Models

INTRODUCTION
You may be wondering why we need to study economics especially our course (i.e.
microeconomics. The answer is very simple- we use it every day. We often hear newa
reports on fuel prices going up and down. We have encountered transport strikes where
drivers demand for rollback in gasoline prices or a fare increase. In our daily trip to work or
school, we experience heavy traffic. We might think that roads are nt wide enough, or there
are just too many vehicles plying the streets. We regularly go to grocery stores even there is
a pandemic to shop for our daily needs. There are times when we observe several items on
sale and feel that either those items are near expiration or the store had overstocked. It is
difficult to miss these daily experiences, and we cannot deny their relation to economics. It
is possible that there is an increase in fuel prices as a consequence of an oil price increase in
the world market. Heavy traffic is a result of an unregulated increase in the volume of
vehicles and the government’s insufficient resources to finance the construction of new
roads. The discounted prices of goods can be levelled-off by new stocks of products at
regular prices. So think about it: is it a waste of time to learn economics?

INTENDED LEARNING OUTCOMES

After studying this module, the students will be able to:

1. Define economics and explain the role in business and to the economy as a whole.
2. Differentiate microeconomics from macroeconomics by citing an examples.
3. Describe the different economic models and find how it is applied to the various types of
businesses.
4. Differentiate and identify economic theories from economic models.

DEFINITION OF TERMS

• Economics defined as the study of the proper allocation and efficient utilization of
scarce productive resources to produce commodities for the maximum satisfaction of
unlimited wants and needs.

• Microeconomics deals with the behaviour of individual components such as

household, firm, and individual owner of production. It focuses on the behaviour of a
particular unit of the economy such as consumers, producers, and specific markets. In
microeconomics, you will often encounter terms like consumer’s behaviour, production
theory, cost and profit, and the market structures.

• Macroeconomics deals with the behaviour of economy as a whole with the view of
understanding the interaction between economic aggregates such as unemployment,
inflation and national income. In macroeconomics, the initial discussions begin with how
growth and output are measured and how multipliers work. Labor, employment, and
inflation are included for long-term effects, as well as monetary, fiscal and trade policies.

• Economic theory is a preposition about certain related variables that scientifically

explain a certain phenomenon. It tries to explain economic phenomena, to interpret why
and how the economy behaves and what is the best to solution-how to influence or to solve
these economic phenomena.

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• Economic model is essentially a simplified framework for describing the working of
the economy. It is used to illustrate, demonstrate, and represent a theory or parts of it. It
simplifies an explanation or description of a certain phenomenon, often employing graphs,
diagrams, or mathematical formulae.

• Circular Flow Diagram pictures the economy as consisting of two groups-

households and firms-that interact in two market; goods and services market in which firms
sell and households buy and the labor market in households sell labor to business firms or
other employees.

• Production Possibility Frontier (PPF), Production Possibility Curve (PPC), or a

Production Possibility Boundary (PPB) is a curve which shows various combinations of the
amounts of two goods which can be produces within the giver resources and technology/ a
graphical representation showing all the possible options of output for two products that
can be produced using all factors of production, where the given resources are fully and
efficiently utilized per unit time.

Methodologies of Economics

Every profession and field of studies utilizes tools in order for them to come up with
the best decisions. In case of economics, the main tool use is the model. Economic model is
a representation of the actual scenario.
Economic models can be presented in three forms; the tabular, graphical and
mathematical or econometric.
1. Tabular model. This is economic model presented in table. Table has column and
rows forming a cell. In economics, tabular form of model is also known as schedule.

Table 1.1
Total Cost Schedule
Quantity Total Utility
0 25
5 50
10 75
15 100

2. Graphical Model. This is economic model presented using graph. There are several
types of graphs as discussed in your statistics class however in the field of economics the
most common form of graphical model is the line graph and it is called as curve.

Figure 1.1
Total Cost Curve

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3. Mathematical or econometric model. This model is in the form of an equation.
When we say equation, it is a combination of numbers (coefficient or constant),
letters (variables) and an equal sign (=). In case of mathematical and econometric
model, there is still a difference between the two; econometric model have error
term (Ԑ) while mathematical model doesn’t have.

TC =25 + 5Q (equation 1. Mathematical Model)

TC = 25+ 5Q + Ԑ (equation 2. Econometric Model)

This form of model is commonly called as function.

Since economic model is a tool used for decision making, it is important that we
understand the three general assumptions of the model. Assumptions are set of conditions
that need to satisfy to make the model valid. These three assumptions are:

1. Ceteris paribus assumption. It is a Latin word which means holding other variable
constant. In some books, it is also defined as remaining other things the same. This
assumption is a nature of all economic models. All of the economic models have variables in
which the model merely focuses. On our example above (total cost model), the main
variables are total cost and quantity. Under the ceteris paribus assumption, merely quantity
is the concept that varies and affect the total cost and other factors that might affect total
cost, we assume all of that as constant. This is for us to isolate the effect of the specific
independent variable to dependent variable.
2. Optimization assumption. Every economic model goal is to optimize something.
When we say optimization, we either maximize or minimize something. We maximize all of
the things that are favourable to decision maker while we minimize all things that are
unfavourable for decision maker. Examples of things that we maximize are revenue and
resources while we usually minimize the cost and risk.
3. Positive versus Normative Economic Statement. The difference between
microeconomics and macroeconomics is based on the degree of details considered. Another
valuable feature is the reason in examining a problem. Positive economics relates to what is.
It is an economic analysis that explains what happens in the economy and why, without
making any recommendations to economic policy, or in simple idea, it deals with how should
be verified by facts. Normative economics concerns itself with what should be. It is an
economic statement that makes recommendation to economic policy. This economic
statement is employed to make value judgments about the economy and suggests solutions
to economic problems. Instead of restricting its involvement on facts, it extends to the
specific actions that we should do to address the issues that depend on our values.

Analytics using Economic Model

Economic models can be used in three levels; descriptive, predictive and prescriptive.
These are the steps of making decision using economic models.
1. Descriptive Analytics. This step covers the description of economic model. We
commonly put emphasize on the highest and lowest point of the curves or schedule, the
relationship exist between the two or more variables, the slope and coefficient of the model.
2. Predictive Analytics. This step covers the forecasting of possible outcomes after
describing the economic model. Based on the relationship establish, we can identify the
possible effect of independent variable to dependent variable once change.
3. Prescriptive Analytics. This step is the process of making recommendations and
suggestions to attain the main goals of economic model which is to optimize.

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Circular Flow Diagram

For us to better understand how economy work, it is important to understand the

circular flow diagram. It is a depiction of how money and products are exchanged within an
economy. A circular flow diagram might be used by a business to show how a specific series
of exchanges of goods, services and payments make up the building blocks of a given
economic system of interest.

Figure 2
Circular Flow Diagram

The economy can be thought of as two cycles moving in opposite directions. In one
direction, we see goods and services flowing from individuals to businesses and back
again. This represents the idea that, as laborers, we go to work to make things or provide
services that people want.

In the opposite direction, we see money flowing from businesses to households

and back again. This represents the income we generate from the work we do, which we
use to pay for the things we want.

Both of these cycles are necessary to make the economy work. When we buy
things, we pay money for them. When we go to work, we make things in exchange for
money.

The circular flow model of the economy distills the idea outlined above and shows
the flow of money and goods and services in a capitalist economy.

What Are Circular Flow Diagrams?

We all need to buy goods. Sometimes those goods are groceries, while other times
those goods are clothing for an important event. Whatever the goods might be, purchasing
them forms a crucial piece in a functioning economy.

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Simply put, each time we buy a good we are contributing to the economy. In this
lesson, we'll look at how those purchases are just part of a bigger piece of the economic
puzzle. You see, the economy works in a circular motion known as the circular flow diagram
in economics.
The circular flow diagram is a basic model used in economics to show how an
economy functions. Primarily, it looks at the way money, goods, and services move
throughout the economy. In the diagram, there are two main characters, known as firms and
households, where households represent consumers and firms represent producers.

The Role of Households

Let's take a look at the role of the consumer, or the households. In a circular flow
diagram, households consume the goods offered by the firms. However, households also
offer firms factors so that the firms can produce products for the household to later
consume.
For example, households may supply land to produce goods or they may offer
themselves in the form of labor. Households also offer capital, which is a monetary form of
investing that helps firms create products for consumption. All three forms (land, labor, and
capital) are offered to firms so that they can make products that households need and
consume.

The Role of Firms

Now let's look at the role of firms. The main function of the firms is to offer goods. In
order to do this, firms take the factors (land, labor, and capital) from households and
convert products into goods and services that consumers need and want. The role of firms
makes up the second part of the circular flow diagram.
Production Possibilities Frontier
Since economics deals with scarcity and used models in making decision, one of the
known economic tools used in allocating resources is the Production Possibilities Frontier
(PPF). Production possibilities frontier (PPF), also known as production possibility curve,
indicates the maximum output combinations of two goods or services an economy can
achieve by fully using all available resources efficiently.
The production possibility frontier indicates the maximum production possibilities of
two goods or services, assuming a fixed level of technology and only one choice between the
two.
Producing one good always creates a trade-off over producing another good. In other words,
if more of good A is produced, less of good B can be produced given the resources and
production technology remain constant.

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Figure 2
Production Possibilities Frontier

Hence, the production of one good or service increases when the production of the
other good or service decreases. The PPF measures the efficiency in which the two goods or
services are produced together. In that way, it helps managers to determine the most
beneficial mix of commodities for the business.

Let’s look at an example.

Typically, opportunity cost occurs when a manager chooses between two alternative
ways of allocating business resources. In other words, if one action is chosen, the other
action is foregone or given up. There is a trade-off. Hence, the production possibility frontier
provides an accurate tool to illustrate the effects of making an economic choice.

At any given point of a PPF, the company produces at maximum efficiency by fully
using its resources. At an economic level, this is known as the Pareto efficiency, which
suggests that, when allocating resources, the choice of one will worse off the other. Also,
any point inside the PPF is inefficient because at that point the output is greater than the
output that the existing resources can produce.
For example, a country produces pizza and sugar. If the country decides to ramp up its
sugar production, using the existing fixed resources, it has to lower its pizza production.
Hence, at points A, B, and C, the economy achieves the maximum production possibilities
between pizza and sugar. Points D and E are inside the PPF line and is inefficient because all
the resources are not being used properly. Point F is simply beyond the amount of
production attainable with the current level of resources.

End of Chapter Exam

Part I. Read each statement carefully. Answer the questions by selecting the letter that
corresponds to your answer.

1. Which of the following is true about microeconomics?

a. It deals with the aggregate behavior of firms and household to which the performance of each will be
evaluated.

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b. It is a broader approach to tackle the economy which includes all sectors and their performance in
the perspective of the household.
c. It is the individual study of household and firm, its individual behavior and used for decision making
purposes.
d. All of the Above
2. Which of the following does the economist usually used in making their studies?
a. Models b. Actual Scenarios c. Assumptions d. Perspective View of Society
3. The following are the main assumption about Product Possibilities Frontier. Which is not included?
a. There are only two goods produced within the economy.
b. The PPF curve bowed about the origin.
c. Not all resources are being utilized for two goods.
d. All of the above are the assumptions of PPF.
4. Which of the following statement is the importance of the ceteris paribus assumption?
a. It assures the accurateness of the model
b. It represents the realistic concept of the model
c. It eliminates the values of other variables that may affect the model so that it is easy to give emphasis
on the independent variables that can affect most
d. It holds the values of other variables easily to determine what is the relationship and impact of the
independent to dependent.
5. What is the goal of every economic models and assumptions?
a. To maximize the unwanted things in the part of decision maker
b. To optimize every resources
c. To minimize things that hold constant
d. To gain profit
6. Which of the following should you remember about positive economic statement?
a. It states opinion of individuals about certain economic situation
b. It states fact and base on the actual scenario
c. It cannot be prove or disapprove
d. All of the above
7. What is the implication of the difference between mathematical model and econometric model?
a. Mathematical model is the actual scenario while econometric model is a sample
b. Mathematical model is idealistic while econometric model is realistic
c. Mathematical model is scientific way of nurturing economic scenario while econometric is more on
artistic way
d. All of the above
8. We need to decide or make choices because of:
a. rationality b. scarcity c. objectivity d. fallacy
9. When we make recommendation based on model derived, what type of analytics you apply?
a. Descriptive b. Predictive c. prescriptive d. declarative
10. Who among the following satisfies their need?
a. When the accident occur, Janice immediately proceed to Nazareth Hospital to save the life of his
spouse
b. Alex asked her wife to look for Dra. Mercado, his friend to be her official OB-gyne.
c. Olive decided to purchase Generic drugs since he believe that it has the same efficacy as the branded
one.
d. All of the above

Part II. Answer the questions as instructed. Use the space provided to answer the questions.

1. Refer to the model:

QL = 10 + .2W + .4S - .3T + e

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Where: QL = quantity of labor

W = wage rate
S = level of satisfaction to workplace safety
T = # of overtime given after 6:00 PM

1.1 describe the model

___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
________

1.2 Considering the ceteris paribus assumption, forecast the Q L if:

QL W S T
500 4.00 4
500 4.75 4
510 4.00 6.5

1.3 Make prescription based on the model:

___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
________

2. . The following is a Production Possibilities table for good X and good Y.

Good Production
Alternatives
A B C D E
X 0 3 6 9 12
Y 33 30 25 15 0

a. Plot the Production Possibilities Frontier of the data with good X on the horizontal axis
and
Good Y on the vertical axis.(10 pts).
b. What do the points on the curve indicate? (5 pts).
2. What does it mean for an economy to be on its production possibilities frontier? Why is it
not recommended to be outside (or to the northeast) of the frontier? (10 pts).

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Chapter 2
DEMAND SUPPLY AND MARKET EQUILIBRIUM

INTRODUCTION

As an individual, we often ask why the price of gasoline, fishes, rice grains and
other commodity increases or sometime decreases. We also wonder how the price is
being affected by the different forces. Most of us also want to explain why during rainy
season some commodities such as umbrella, rain coat, and soup commonly have price
increase while halo-halo, beach accommodation, and sun block prices increases during
summer. All of these questions can be explained in this chapter.

INTENDED LEARNING OUTCOMES

1. define and explain the definition of demand, supply and equilibrium.

2. differentiate changes in the demand and supply curve; movement along the curve and
shifting of the curve.
3. explain how price and non-price factors affect the demand, supply and market
equilibrium using graphical and mathematical analysis.

Demand is relationship between price and quantity demanded. It is also defining as

the amount of goods and services that the consumer/ buyer are willing and able to buy or
consume in different prices at a particular time.
From the definition, we can come-up to the much known concept in economics, the
law of demand. Law of Demand states that as the price of the commodity increases,
quantity demanded decreases. There is a negative relationship between price and quantity
demanded ceteris paribus. Ceteris paribus is a Latin word which means holding other
variable constant.
Demand can be represented in three forms.
1. Demand Schedule is the tabular presentation showing the price and quantity
demanded for a particular good.

Price Qd
3 25
5 20
7 17

Table 2.1
Demand Schedule for the commodity

2. Demand Curve is the curve that shows relationship between price and quantity
supplies. It is downward sloping which implies that there is negative relationship
between price and quantity demanded.

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Figure 2.1
Demand Curve of Automobiles

3. Demand Function is a mathematical model showing the relationship between price

and quantity demanded. An example of the demand function is shown in equation
2.1 Equation 2.1
Qd = 3 – 4P

CHANGES OCCUR BROUGHT BY PRICE FACTOR

Movement along the Demand Curve

 This will happen if the price factor has been changed.

Case No. 2.1

The price of good X rises from $3 to $5. The changes occur base on the situation is
that the demand curve remains its position but the point will move along the curve as
shown in Figure 2.2 panel A. The point moves from point A to point B. When price of
commodity X increases, quantity demanded will decrease.

On the other hand, as the price of the commodity X decreases from $5 to $3, the
Quantity demanded for the product X increases from 10 to 15. This is shown in figure 2.2
panel B.

PANEL A PANEL B

Figure 2.2
Movement along the Demand Curve
CHANGES OCCUR BROUGHT BY NON-PRICE FACTOR

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Shifting of the Demand Curve
 Shifting of the demand curve occurs when the non-price factor changed. The
following are the non-price factor that affects the demand curve.
1. Price of related commodity
2. Outlook
3. Income
4. Number of consumer
5. Taste and Preferences

For you to easy memorize the non-price factors just remember the acronym POINT

PRICE OF RELATED COMMODITY- one of non-price factor that affect the demand curve is
the price of related commodity which includes substitute goods and complementary goods.

Substitute Goods are those commodities in which they perform the same function
and can satisfy the same needs and wants. Examples of these are ballpen and pencil, sugar
and honey, coffee and tea, and omnibus services of jeep services. Meanwhile,
complementary goods are goods in which you consume it hand on hand, or consume it on
tandem. Examples of these are coffee and sugar, socks and shoes, belt and pants, hospital
services and doctor’s services, and DVD and DVD player.

Case No. 2.2

The fare for omnibus services increases by Php3. 00 each. What will happen to the
demand of jeep services?
If we’re going to analyze, omnibus services and jeep services perform the same
function therefore omnibus services is a substitute of jeep services. If the price of omnibus
services increases, according to the law of demand, quantity demanded for omnibus
services will decrease and consumers of omnibus services will shift to jeep services. Figure
2.3 shows the change that occurs.
As stated in the previous section, if the price of omnibus services, the quantity
demanded for omnibus services will decrease according to the law of demand. The question
is what the consumer will use if they will not render the service of omnibus.

PANEL A- Omnibus PANEL B- Jeep

Figure 2.3
Changes in Demand Curve of Omnibus and Jeep Services

Figure 2.3 panel A shows the change in demand curve of omnibus services as its
price increases. Because the change that occurs is brought by the price of omnibus, from10
point A, the quantity demanded for omnibus services declines and move to point B as its
price increases from $2 to $5.

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Figure 2.3 panel B shows the changes in demand curve in jeep services brought by
the changes in demand curve in omnibus services. Because the price of jeep services did not
change but the demand for jeep services increases, therefore the demand curve shifts to the
right.

OUTLOOK OR CONSUMER’S EXPECTATION – If people expect the price of good to increase,

they will want to buy it before the price increases. Conversely, if the people expect the price
decline, they will purchase less and wait for the decline.

Case No. 2.3

What will happen to the demand of flowers when Valentine’s day is coming? How
about after the Valentine’s Day?
Figure 2.4 shows the changes in the demand of curve of flower before and after the
Valentine’s Day.

Figure 2.4 panel A shows the change in demand curve of flower before the
Valentine’s Day. As we all know, more people will purchase flower to celebrate the occasion.

PANEL A- Before PANEL A- After

Figure 2.4
Changes in Demand Curve of Flower before and after Valentine’s Day.

INCOME- it is the amount of money that the individual or household receives from providing
the factors of production. It is divided into two; the disposable income and the non-
disposable income.

Disposable income is part of income use by individual to purchase the goods and
services the individual or household needed. It is the one considered most by the
economist whether there will be changes in demand curve or not.
Non-disposable income is part of income that is not use by household or individual
for their consumption. This is the part of income that is being saved for future
purposes. Sometimes, it became an investment of household or individual in the
future.

Remember: The changes in disposable income affect most the current demand, but if
the overall income increases, it is more likely that the disposable income will also
increases.

In considering the income, goods can be classified as normal or inferior goods. The
commodity is considered normal good if the demand for that good increase as the
income (disposable income) also increases. On the other hand the commodity is

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considered inferior good if the demand for that good decrease as the income of
individual increases.

Remember: Income has positive or direct relationship with the demand for normal
good while income has negative or inverse relationship with the demand for inferior
good.

Case No. 2.4

Joseph, a carpenter earns Php3, 000 a month. From his income, he usually consumes
25 kg of rice a month and 20 cans of sardines every month. But when he promoted as a pore
man and his income increases to Php5, 000, he is now consuming 30 kg of rice a month but
with regard to sardines, he only consuming 10 cans of it a month.
In this case, rice is a normal good for Joseph while sardines are inferior goods to him.
The changes in demand curve here are shifting of the demand curve as illustrated in figure
2.3.
Figure 2.5 panel A shows the change in the demand curve for rice as income
(disposable income) of Joseph increases. The demand curve shifts to the right. As we can
observe in the graph, the demand for rice increases from 25 to 30 even the price of rice
remains at 28. This is the reason why rice is considered normal good.
On the other hand, figure 2.5 panel B shows the change in demand curve of
sardines. Considering that the income of Joseph increases, the demand for sardine
decreases from 20 cans to 10 cans. The demand for sardine changes even the price of
sardine is still 13. This I the main reason why a sardine in this case is consider as inferior
good. 12

PANEL A- RICE PANEL B- SARDINES

Figure 2.5
Changes in the Demand Curve of Rice and Sardines

Case No. 2.6

When the price of DVD player increases, what will happen to the demand of DVD?
Analyzing the case, you cannot use DVD unless you have a DVD player. If the price of
DVD player increases, base from the law of demand, quantity demanded for DVD player will
decline. If there is fewer consumers want to purchase the player, obviously they are more
likely not willing to purchase DVD. The changes occur in this situation is presented on figure
2.5
Figure 2.5 panel A shows the change occur in the demand curve of DVD player as its
price increases. Because price of DVD player is the one that change, movement along the

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curve from point A to B will occur. The quantity demanded for DVD player will decline while
the price of player increases.
Figure 2.5 panel B shows the changes occur in the demand curve of DVD. Because
we consume DVD and DVD player in tandem, a decrease in the quantity demanded in player
will lead a decrease in DVD as well. Even the price of DVD did not change, while the demand
for DVD declines, the change that occurs is shifting of the demand curve to the left.

PANEL A- DVD player PANEL B- DVD

Figure 2.7
Changes in Demand Curve of DVD and DVD Player

NUMBER OF CONSUMER OR CONSUMER’S POPULATION – Demand is the relationship

between price and quantity demanded by all consumers in the market. If the number of
consumers increases, then demand will also increase. The demand curve will shift to the
right.
Case No. 2.7
When the late 1990 comes, most of the government agencies and some of the
private company’s take a biggest consideration the advanced studies as one of the
requirement to promote an employee. What happen to the demand of graduate studies
services?

Figure 2.8
Changes in Demand for Graduate School Services

Figure 2.8 shows the changes on the demand curve for the graduate school services.
As shown in the figure, the demand curve shifts to the right because there are additional
potential customers that will enroll in the advanced studies. The more people will consume
the product, the more demand for the product.

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TASTE AND PREFERENCE OF CONSUMER- it is the behavior of consumer which is affected by

weather, perception, information, occasion, what is in and others.
Case No. 2.8
What will happen to the demand of halo-halo during summer? How about during
rainy seasons?
Analyzing the case, as we all know, we prefer halo-halo during summer while during
rainy seasons, we are avoiding it. Because of this, our taste and preferences is being affected
by the weather condition. Figure 2.9 shows the change that occurs in the demand curve of
halo-halo.

Figure 2.9 panel A shows the changes in demand curve of halo-halo when the season
change to summer. As mentioned earlier, demand for halo-halo will increase because we
prefer it during summer. An individual may consume 5 units of halo-halo a week during
summer while when summer is not coming, individual may consume only 1 unit a week or
did not consume at all.

PANEL A- Summer PANEL A- Rainy

Figure 2.9
Changes in Demand Curve of Halo-halo during Summer and Rainy Season

Figure 2.9 panel B shows the changes in demand curve of halo-halo when the
seasons change to rainy season. Unlike the first panel, the demand curve shifts to the left
because only few or nobody wants halo-halo during rainy days. Note, even the price didn’t
change, the demand for halo-halo declines
***Things to Remember*** if the changes occur is brought by price factor (price of
commodity that is in subject), quantity demanded is the one that change but if the changes
that occur is brought by non-price factors, demand is the one that will change.

Supply is the relationship between price and quantity supplied. It is the total amount15
of goods and services that the sellers are willing and able to sell or produce. This is the
inverse of the demand. Supply has positive relationship with price. This is state on the law of
supply.
Law of Supply states that as the price of the commodity increases, quantity supplied
also increases. There is a positive relationship between price and quantity supplied. The
same with demand, it can be expressed in three forms.

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1. Supply Schedule is tabular presentation of supply showing the price and
quantity supplied of a particular good ceteris paribus.
Table 2.1
Demand Schedule for the commodity
Price Qd
3 25
5 20
7 17

2. Supply Curve is a graph of supply showing the upward- sloping relationship

between price and quantity supplied. It is upward sloping which implies a
positive relationship between quantity supplied and price.

Figure 2.10
Supply Curve

3. Supply function is a mathematical model in showing the relationship between

price and quantity supplies. From the equation 2.2, the sign of the coefficient of
price is positive which denotes its relationship to quantity.
Qs = 5 + 3P Equation 2.2

CHANGES OCCUR BROUGHT IN SUPPLY CURVEBY PRICE FACTOR

Movement along the Supply Curve

This is only occur when the price of the subjected commodity changes.
Case No. 2.10
The price of corn in the market increases. What will happen to the supply of corn?
The answer is shown in figure

Figure 2.11
Change in Supply Curve of Corn as Its Price Increases.

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Figure 2.11 presents the movement along the supply curve as the price of the corn
increases. This connotes that as the price of corn increases, the more willing that the sellers
want to sell corn.

CHANGES OCCUR IN SUPPLY CURVE BROUGHT BY NON-PRICE FACTOR

Shifting of the Supply Curve

 Shifting of the supply curve occurs when the non-price factor changed. The following
are the non-price factor that affects the demand curve.
1. Productivity (Improvements in machines and production processes of a good or
service)
2. Inputs ( Change in the price of inputs required to produce the good or service.)
3. Government Actions (Subsidies, Taxes and Regulations)

4. Technology (Improvements in machines and production processes of a good or

service)
5. Outputs ( Price changes in other products produced by the firm)
6. Expectations (outlook of future prices and profits)
7. Size of Industry (Number of firms in the industry)
For you to easily memorize the determinants of supply curve, just remember the
acronym PIG TOES.

PRODUCTIVITY- It is the capacity of an input to produce output.

Case No. 2.11

Alvin can only produce 100 units of bread a day but because he acquire machine, he
can produce 200 units of bread a day. What is the change occur in the supply curve? How
about if earthquake comes and machines and bakery?

PANEL A- With Machine PANEL B- Without Machine

Figure 2.12
Change in Supply Curve of Bread base on Productivity

Figure 2.12 shows the change in supply curve as productivity changes. On panel A,
the supply curve shifts to the right as Alvin acquire machine. The price didn’t change but the
supply of bread increases. In contrast, as machine and factory (bakery) depreciated,
destroyed, productivity declines and the supply will decline too. So when earthquake comes
and destroy the assets of the firm, supply will tend to decline as presented in panel B.

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 Basic Microeconomics
INPUTS – this refers to the raw materials or factors of production needed to produce a
certain product. It also includes the price of those raw materials. If the availability of inputs
in high, most probably, the supply of goods we are talking about is also high, otherwise
supply is low. If the price of raw materials
Case No. 2.12
The price of flour increases. What will happen to the supply of bread?

Figure 2.13
Change in Supply Curve of Bread base on Inputs
We can glean in figure 2.13 shows the changes occur in the supply of bread due to
the change in price of flour. Remember that we are under the assumption of ceteris paribus,
holding other variable constant, such as budget for production. Therefore, the only changes
that will occur is that the supply curve of bread will shift to the left, meaning the supply of
bread will decline.

GOVERNMENT ACTION- this refers to the power of the government to intervene in the18
market that will affect the supply. Some of the government actions are the subsidies, taxes
and regulation

 Subsidies are the incentive given by the government to motivate the producer to
provide more products in the market. If government imposes subsidies, then the
supply for commodity will increase and supply curve shift to the right. (the same as
shown in figure 2.12 panel A)
 Taxes are the power of the government to impose a certain percentage of amounts
to persons and property. It is said that it is universal because everything within the
cover of the state can impose tax. It should be paid compulsory. If the government
imposes tax to certain product or business, the seller and producer are less likely to
sell or produce the product and the supply curve will shift to the left. (the same as
shown in figure 2.12 panel B)
 Regulations are the power of the government to impose some rule to control some
of political, administrative and economic activity done within the vicinity of the
state. Examples of these are permits and ordinance before putting up a business.
Most of the time, this is one of the legal barriers that a new entrants may encounter.
Increasing the control of regulation, or the implementation of it, the less likely the
firms want to enter or to produce commodity.

TECHNOLOGY is the same as productivity. Remember, acquisition of technology will lead to

productivity.

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 Basic Microeconomics

OUTPUT comprises the price of other commodity produced by the firm. Firms nowadays do
not produce only one product line. Other product lines may affect the supply of the
commodity we are talking about. If the firm sought that the price of other product will tend
to decrease, they are less likely to produce it, instead they will produce more of another
commodity in which they sought that they will become profitable. 19

Case No. 2.13

Figure 2.14
Change in Supply Curve of Non-food
UNILIVER produces food and non-food product. If the price of food product will
decline, what will happen to the production of non-food goods?
Assessing the case, if the price of food declines Uniliver will less likely to produce
food products according to the law of supply. Therefore the changes occur in will be
movement along the curve. In order to become more profitable, they will produce another
commodity which is the non-food. In this case, the supply curve will shifts to the right as
shown in figure 2.14.

EXPECTATION is the preview of the firms about the price of commodity they are selling in
the future. If firms expect the price of goods they produce to rise in the future, then they will
hold off selling at least part of the production until the price rises. Expectation of future
price increases tends to reduce the supply. Conversely, expectation of future price decreases
tends to increase supply.

SIZE OF INDUSTRY refers to the number of sellers in the industry. Industry refers to a group
of firms selling the same product. Remember that the supply curve refers to all firms
producing the product. If the number of firms increases, then more goods will be produced
at each price, supply will increase, supply curve shifts to the right. A decline in the number of
firms would shift the supply curve to the left.

DEMAND AND SUPPLY EQULIBRIUM

The term equilibrium means that all forces in the market are in the balance. Market
equilibrium is the point in the graph where the demand and supply meet or quantity
demanded is equal to quantity supplied (Qd = Qs). Market equilibrium has two points the
equilibrium price and equilibrium quantity. Equilibrium Price (P*) is the price at which

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 Basic Microeconomics
quantity demand is equal to quantity supplied. Equilibrium Quantity (Q*) is the quantity
traded in the equilibrium price.

Figure 2.15
Demand and Supply Equilibrium

Determining Equilibrium Point Using Mathematical Model

Consider the demand function of Q = 26 – 2P and supply function of Q = 10 + 2P.
Find the market equilibrium:
Since Qd = Qs
Therefore we may equate 26 – 2P = 10 + 2P
-2P – 2P = 10 – 26

-4P = -16
-4 -4

P* = 4
The equilibrium price is 4. On computing the Q*, we just need to substitute the derived P*
to either of the two equations.

Q* = 26 – 2 (4)
Q* = 26 – 8
Q* = 18
Q* = 10 + 2(4)
Q* = 10 + 8
Q* = 18

The equilibrium quantity is 18.

Note: The importance of knowing the equilibrium price is that it is the one that prevails in
the market.

Determining Equilibrium Price and Quantity in Tabular Form

Table 2.3
Demand Supply Schedule
Qs P Qd Qs-Qd
-15 0 150 -165
30 3 120 -90

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 Basic Microeconomics
70 7 97 -27
85 9 85 0
97 12 67 30

From the table 2.3, we can denote that the equilibrium price and equilibrium
quantity is the point where quantity supplied less quanity demanded is equal to zero (Qs-Qd
= 0). Therefore P* is Php9.00 while Q* is 85.
However, if the market set the price below Php9.00, the market will experience
shortage. Shortage is a situation in which quantity demanded is greater than quantity
supplied. In demand-supply curve, it is any point below the equilibrium point
On the other hand, if market set their price above the P*, they will experience
surplus. Surplus is a condition in which quantity demanded is less than quantity supplied. In
graphical model it is any point above the equilibrium point.

Government Intervention
Between price and quantity, government has more control to the price than the
quantity. The government may set the price floor or price ceiling.
Price Floor is the minimum price set by the government in which the commodity
can be purchase. Price Ceiling is the maximum price set by the government in which the
commodity can be purchase.

EFFECTS OF CHANGE IN DEMAND AND SUPPLY

Change of Demand
As the demand increases (this is due to the changes in POINT), the equilibrium
point (P* and Q*) also increases as shown in the figure 2.17 panel A.
As the demand decreases (this is due to the changes in POINT), the equilibrium
point (P* and Q*) also decreases as shown in the figure 2.17 panel B.

PANEL A PANEL B
Figure 2.17
Changes in Equilibrium Point as Demand Curve Changes

Change of Supply
As the supply increases (this is due to the changes in PIG TOES), the equilibrium
quantity increases while the equilibrium price decreases. This can be gleaned in Figure 2.18
panel A.

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 Basic Microeconomics
As the supply decreases this is due to the changes in PIG TOES), the equilibrium
quantity decreases while the equilibrium price increases. This can be gleaned in Figure 2.18
panel B.

Figure 2.18
Changes in Equilibrium Point as Supply Curve Changes

Simultaneous Shifts

As we have seen, when either the demand or the supply curve shifts, the results are
unambiguous; that is, we know what will happen to both equilibrium price and equilibrium
quantity, so long as we know whether demand or supply increased or decreased. However,
in practice, several events may occur at around the same time that cause both the demand
and supply curves to shift. To figure out what happens to equilibrium price and equilibrium
quantity, we must know not only in which direction the demand and supply curves have
shifted but also the relative amount by which each curve shifts. Of course, the demand and
supply curves could shift in the same direction or in opposite directions, depending on the
specific events causing them to shift.

Figure 2.19
Simultaneous Decreases in Demand and Supply

For example, all three panels of Figure 2.19 “Simultaneous Decreases in Demand and
Supply” show a decrease in demand for coffee (caused perhaps by a decrease in the price of
a substitute good, such as tea) and a simultaneous decrease in the supply of coffee (caused
perhaps by bad weather). Since reductions in demand and supply, considered separately,
each cause the equilibrium quantity to fall, the impact of both curves shifting simultaneously
to the left means that the new equilibrium quantity of coffee is less than the old equilibrium

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 Basic Microeconomics
quantity. The effect on the equilibrium price, though, is ambiguous. Whether the equilibrium
price is higher, lower, or unchanged depends on the extent to which each curve shifts.

Both the demand and the supply of coffee decrease. Since decreases in demand and
supply, considered separately, each cause equilibrium quantity to fall, the impact of both
decreasing simultaneously means that a new equilibrium quantity of coffee must be less
than the old equilibrium quantity. In Panel (a), the demand curve shifts farther to the left
than does the supply curve, so equilibrium price falls. In Panel (b), the supply curve shifts
farther to the left than does the demand curve, so the equilibrium price rises. In Panel (c),
both curves shift to the left by the same amount, so equilibrium price stays the same.

If the demand curve shifts farther to the left than does the supply curve, as shown in
Panel (a) of Figure 2.19 “Simultaneous Decreases in Demand and Supply”, then the
equilibrium price will be lower than it was before the curves shifted. In this case the new
equilibrium price falls from $6 per pound to $5 per pound. If the shift to the left of the
supply curve is greater than that of the demand curve, the equilibrium price will be higher
than it was before, as shown in Panel (b). In this case, the new equilibrium price rises to $7
per pound. In Panel (c), since both curves shift to the left by the same amount, equilibrium
price does not change; it remains $6 per pound.

Regardless of the scenario, changes in equilibrium price and equilibrium quantity

resulting from two different events need to be considered separately. If both events cause
equilibrium price or quantity to move in the same direction, then clearly price or quantity
can be expected to move in that direction. If one event causes price or quantity to rise while
the other causes it to fall, the extent by which each curve shifts is critical to figuring out what
happens. Figure 2.20 summarizes what may happen to equilibrium price and quantity when
demand and supply both shift.

Figure 2.20
Simultaneous Shifts in Demand and Supply

If simultaneous shifts in demand and supply cause equilibrium price or quantity to

move in the same direction, then equilibrium price or quantity clearly moves in that
direction. If the shift in one of the curves causes equilibrium price or quantity to rise while

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 Basic Microeconomics
the shift in the other curve causes equilibrium price or quantity to fall, then the relative
amount by which each curve shifts is critical to figuring out what happens to that variable.

As demand and supply curves shift, prices adjust to maintain a balance between the
quantity of a good demanded and the quantity supplied. If prices did not adjust, this balance
could not be maintained.

Notice that the demand and supply curves that we have examined in this chapter
have all been drawn as linear. This simplification of the real world makes the graphs a bit
easier to read without sacrificing the essential point: whether the curves are linear or
nonlinear, demand curves are downward sloping and supply curves are generally upward
sloping. As circumstances that shift the demand curve or the supply curve change, we can
analyze what will happen to price and what will happen to quantity.

End of Chapter Test

Part I. Read each statement carefully. Answer the questions by selecting the letter that
corresponds to your answer.
1. According to the law of demand…
A. there is a positive relationship between quantity demanded and price
B. as the price rises, demand will shift to the left
C. there is a negative relationship between quantity demanded and price
D. as the price rises, demand will shift to the right

2. Each point along the market demand curve shows

A. the quantity of the good that firms would be willing and able to supply at a specific
price
B. the relationship between the price of the good and total quantity demanded at a
series of prices
C. the opportunity cost of supplying a given quantity of goods to the market
D. the quantity of the good that consumers would be willing and able to purchase at a
specific price

3. A decrease in the price of a particular good, with all other variables constant, causes:
A. a shift to a different demand schedule with higher quantities demanded
B. a shift to a different demand schedule with lower quantities demanded
C. a movement along a given demand curve to a lower quantity demanded
D. a movement along a given demand curve to a higher quantity demanded

Figure 1

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 Basic Microeconomics
4. Which of the following could explain a movement from point F to point G in Figure-
1?
A. an increase in buyers' incomes
B. a decrease in the expected future price of the good
C. an increase in the price of the good
D. an increase in the price of a complement

5. If automobiles are a normal good and the price of automobiles rises, then holding all
else constant, the
A. demand for automobiles will rise
B. b. quantity demanded of automobiles will fall
C. c. demand for automobiles will fall
D. d. quantity demanded of automobiles will rise

Figure 2

6. Suppose that initially the market for cassette tapes is at point A on demand curve D1
in Figure -2. If the price of cassette tapes decreased
A. the demand curve will shift to D3
B. the market will move to point B on demand curve D1
C. the market will move to point C on demand curve D1
D. there will be no change from point A

7. All of the following except one would increase the amount of a particular model of a
Ford automobile that buyers would like to buy. Which is the exception? ( e )
A. an increase in buyers' incomes
B. an expected future increase in the price
C. an increase in the U.S. population
D. a decrease in the price of steel

8. Which of the following is assumed constant along the demand curve for gasoline?
A. the price of gasoline and the prices of related goods
B. the price of gasoline, buyers' incomes, and tastes
C. all variables affecting demand other than the price of gasoline
D. all variables affecting demand other than the supply of gasoline

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 Basic Microeconomics

Figure 3

9. In Figure -3, a movement from point G to point H would represent ( a )

A. change in demand
B. the impact of a decrease in the price of a substitute good
C. higher prices for the inputs used to produce this product
D. a change in demand plus a change in quantity demanded

10. Betsy graduates from college, where she earned $3,000 a year working part-time,
and takes a job as a third grade teacher, where she now earns $30,000 per year.
After receiving her first pay check, she gave away her bicycle and purchased a new
car. Therefore:
A. bicycles are a normal good for Betsy
B. automobiles are an inferior good for Betsy
C. automobiles are a normal good for Betsy
D. bicycles and automobiles are complementary goods for Betsy

11. If buyers expect the price of a good to rise in the future, the result is:
A. a decrease in supply today
B. an increase in supply today
C. a decrease in quantity demanded today
D. an increase in demand today

12. At a price of $5.00 per doll, most stores cannot keep Beanie Baby dolls in stock
because consumers buy them all as soon as shipments arrive. This implies that there
A. is an excess supply of Beanie Babies, and the price must fall for equilibrium to
be reached
B. will be an upward shift in the supply curve for Beanie Babies
C. is an excess demand for Beanie Babies, and the price must rise for equilibrium
to be reached
D. is an excess demand for Beanie Babies, and the price must fall for equilibrium
to be reached

13. Procter & Gamble Co. is a major soap producer. All of the following, except one,
would shift its supply curve of liquid soap inward. Which is the exception?
A. an increase in the price of a key ingredient of liquid soap

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 Basic Microeconomics
B. environmental regulations force Procter & Gamble to use a more costly
technology to produce liquid soap
C. a decrease in the price of liquid soap
D. an increase in the wage rate for factory workers who produce liquid soap

Figure 4

14. Which of the following statements about the market represented by Figure-4 is
correct?
A. at a price of $50.00, there is an excess supply of 11 million units
B. at a price of $50.00, there is an excess demand of 11 million units
C. at a price of $50.00, there is an excess supply of 15 million units
D. at a price of $50.00, there is an excess demand of 15 million units

15. Consider the market represented by Figure -4. If the price of the good is currently
$50.00, the price will:
A. fall, causing the quantity demanded to fall
B. fall, causing the quantity supplied to fall
C. rise, causing the demand curve to shift to the right
D. rise, causing the supply curve to shift to the left

16. An excess supply of rice in a competitive market would indicate that:

A. the problem of scarcity has been solved in that market
B. buyers want to purchase more rice at the current price than the sellers want to
sell
C. the market will not be able to approach equilibrium
D. the entire supply curve must shift to the left in order to attain equilibrium
E. the current price exceeds the equilibrium price

17. If both the demand and supply curves for computers shift to the right, the price of
computers may rise, fall, or remain unchanged.
A. True
B. False

18. If the demand for baseball cards rises and the supply curve does not shift, then the
price
A. will rise and quantity will fall

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B. and quantity will rise
C. will fall and quantity will rise
D. and quantity will fall

Figure 5

19. Consider the market for ground beef represented by Figure -5, which is initially in
equilibrium at point J. Assume that ground beef is an inferior good. Which of the
following could explain a movement to a new equilibrium at point M?
A. a change in tastes away from hamburgers combined with an increased price for
cattle feed
B. an increase in buyers' incomes combined with a cost-saving technological
improvement
C. a decrease in the price of hot dogs combined with an increased price for labor
D. a decrease in buyers' incomes combined with a decrease in the number of acres
owned by cattle ranches

20. Consider the market for ground beef represented by Figure -5, which is initially in
equilibrium at point J. Which of the following is correct if equilibrium shifts to point
K?
A. there is an excess supply of 50,000 pounds at the price of $1.00
B. the demand decreased due to a lower price substitute
C. there is an excess demand of 25,000 pounds at the price of $1.00
D. the shift in supply will cause a temporary shortage, which will disappear when
the price rises to $1.50

21. A government-imposed price ceiling below the market's equilibrium price will create
an excess demand for the product. As a result of the excess demand, either the
demand curve will tend to shift to the left or the supply curve will shift to the right-
or both.
A. True
B. False

22. Price ceilings are primarily targeted to help _______, while price floors generally
benefit _________.

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 Basic Microeconomics
A. producers; no one
B. increase tax revenue for governments; producers
C. producers; consumers
D. consumers; producers

Part II. From the following data, plot the supply and the demand curves and determine the
equilibrium price and quantity. Likewise, identify for each price whether surplus or shortage
is derived. Please use graphing paper for a single graph and label properly. (15 pts).

Price Quantity Demanded Quantity Supplied

(Per Siomai)
30 5 60
25 15 50
20 20 20
15 45 15
10 75 10
5 100 5

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CHAPTER 3
ELASTICITY OF DEMAND AND SUPPLY

INTRODUCTION
We know from the law of demand how the quantity demanded will respond to a price
change: it will change in the opposite direction. But how much will it change? It seems
reasonable to expect, for example, that a 10% change in the price charged for a visit to the
doctor would yield a different percentage change in quantity demanded than a 10% change
in the price of a Ford Mustang. But how much is this difference?

INTENDED LEARNING OUTCOMES

1. Explain the concept of price elasticity of demand and supply and its calculation.
2. Explain what it means for demand and supply to be price inelastic, unit price
elastic, price elastic, perfectly price inelastic, and perfectly price elastic.
3. Explain how and why the value of the price elasticity of demand changes along a
linear demand curve.
4. Understand the relationship between total revenue and price elasticity of
demand.
5. Discuss the determinants of price elasticity of demand.

ELASTICITY is the responsiveness of one variable to changes in another variable. This

concept answers the following questions:
• When price rises what happens to demand? Demand falls. BUT! How much does
demand fall?
• If price rises by 10% - what happens to demand? We know demand will fall. By more
than 10%? By less than 10%?
• Elasticity measures the extent to which demand will change

We may calculate elasticity of all factors affecting another variable. Overall, it refers to
the sensitiveness of dependent variable in response to changes in independent variable.

Economic Application of the Concept of Elasticity. Since elasticity has wide use, in
economics it is commonly utilized in the demand and supply. For the elasticity of demand,
we have price elasticity of demand and supply, income elasticity and cross price elasticity.

Price Elasticity of Demand - The responsiveness of demand to changes in price

• Elastic demand - Where % change in demand is greater than % change in price
• Inelastic demand - Where % change in demand is less than % change in price -
inelastic

The formula of calculating price elasticity of demand is the mid-point formula.

𝑄𝑑2− 𝑄𝑑1
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑑 (%Ϫ 𝑄𝑑 ) = 𝑄𝑑2+ 𝑄𝑑1 Equation 3.1
2
𝑃2− 𝑃1
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃(%Ϫ𝑃) = 𝑃2+ 𝑃1 Equation 3.2
2
%Ϫ 𝑄𝑑
𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 (Ԑ𝑝) = Equation 3.3
%Ϫ𝑃

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 Basic Microeconomics
Note: The price elasticity of demand is actually the negative of the percent change in
quantity demanded divided by the percent change in price. Thus, the price elasticity of
demand is always positive.

After the calculation, it is important to interpret the result of the calculated values.
Below is the summery of values and interpretation of result.

Table 3.1
Interpretation of the Calculated Result
Value of demand elasticity Description Definition Impact on Revenues
Greater than one (ε >1) Elastic %ΔQ > %ΔP P R
Equal to one (ε=1) Unit-elastic %ΔQ = %ΔP P - R
Less than one (ε< 1) Inelastic %ΔQ < %ΔP P R

To illustrate, let’s take an example presented in Figure 3.1.

Figure 3.1
Demand Curve

If we’re going to calculate the price elasticity of demand from point A to point B, the
following steps shall be followed.

Step 1. Determine the Qd2 and Qd1; P2 and P1. In this case, since the problem ask from
point A to B, the Qd2 and P2 will be the coordinates of point B (Qd2 = 2; P2 = 25) while Qd1 and
P1 will be the coordinates of point A Qd1 = 1; P1 = 30)

Step 2. Calculate the percent change in Qd. Substitute the values identified (Qd) to
equation 3.1.
2−1 1
%Ϫ 𝑄𝑑 = = = 0.67
2+1 1.5
2
Step 3. Calculate the percent change in P. Substitute the values identified (P) to
equation 3.2.
25 − 30 5
%Ϫ𝑃 = = = − 0.18
25 + 30 27.5
2
Step 4. Calculate the price elasticity of demand. Substitute the values calculated from
step 1 (%Ϫ 𝑄𝑑 = 0.67) and step 2( %Ϫ𝑃 = −0.18) to equation 3.3.
0.67
Ԑ𝑝 = = −3.67
−0.18
Step 5. Interpret the result. Get the absolute value of the computed price elasticity of
demand then refer to Table 3.1. As it can be noted, the value of price elasticity of demand is

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 Basic Microeconomics
-3.67 and its absolute value is 3.67. With this we can say that the commodity is price elastic
since it is greater than 1.

Price Elasticities Along a Linear Demand Curve

Figure 3.2
Price Elasticities of Demand for a Linear Demand Curve

What happens to the price elasticity of demand when we travel along the demand
curve? The answer depends on the nature of the demand curve itself. On a linear demand
curve, such as the one in Figure 3.2 “Price Elasticities of Demand for a Linear Demand
Curve”, elasticity becomes smaller (in absolute value) as we travel downward and to the
right.
The price elasticity of demand varies between different pairs of points along a linear
demand curve. The lower the price and the greater the quantity demanded, the lower the
absolute value of the price elasticity of demand.
We have already calculated the price elasticity of demand between points A and B; it
equals −3.00. Notice, however, that when we use the same method to compute the price
elasticity of demand between other sets of points, our answer varies. For each of the pairs
of points shown, the changes in price and quantity demanded are the same (a $0.10
decrease in price and 20,000 additional rides per day, respectively). But at the high prices
and low quantities on the upper part of the demand curve, the percentage change in
quantity is relatively large, whereas the percentage change in price is relatively small. The
absolute value of the price elasticity of demand is thus relatively large. As we move down
the demand curve, equal changes in quantity represent smaller and smaller percentage
changes, whereas equal changes in price represent larger and larger percentage changes,
and the absolute value of the elasticity measure declines. Between points C and D, for
example, the price elasticity of demand is −1.00, and between points E and F the price
elasticity of demand is −0.33.
On a linear demand curve, the price elasticity of demand varies depending on the
interval over which we are measuring it. For any linear demand curve, the absolute value of
the price elasticity of demand will fall as we move down and to the right along the curve.

The Price Elasticity of Demand and Changes in Total Revenue

Suppose the public transit authority is considering raising fares. Will its total revenues
go up or down? Total revenue is the price per unit times the number of units sold1. In this
case, it is the fare times the number of riders. The transit authority will certainly want to
know whether a price increase will cause its total revenue to rise or fall. In fact, determining

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 Basic Microeconomics
the impact of a price change on total revenue is crucial to the analysis of many problems in
economics.
We will do two quick calculations before generalizing the principle involved. Given the
demand curve shown in Figure 3.2 “Price Elasticities of Demand for a Linear Demand Curve”,
we see that at a price of $0.80, the transit authority will sell 40,000 rides per day. Total
revenue would be $32,000 per day ($0.80 times 40,000). If the price were lowered by $0.10
to $0.70, quantity demanded would increase to 60,000 rides and total revenue would
increase to $42,000 ($0.70 times 60,000). The reduction in fare increases total revenue.
However, if the initial price had been $0.30 and the transit authority reduced it by $0.10 to
$0.20, total revenue would decrease from $42,000 ($0.30 times 140,000) to $32,000 ($0.20
times 160,000). So it appears that the impact of a price change on total revenue depends on
the initial price and, by implication, the original elasticity. We generalize this point in the
remainder of this section.
The problem in assessing the impact of a price change on total revenue of a good or
service is that a change in price always changes the quantity demanded in the opposite
direction. An increase in price reduces the quantity demanded, and a reduction in price
increases the quantity demanded. The question is how much. Because total revenue is
found by multiplying the price per unit times the quantity demanded, it is not clear whether
a change in price will cause total revenue to rise or fall.

We have already made this point in the context of the transit authority. Consider the
following three examples of price increases for gasoline, pizza, and diet cola.
Suppose that 1,000 gallons of gasoline per day are demanded at a price of $4.00 per
gallon. Total revenue for gasoline thus equals $4,000 per day (=1,000 gallons per day times
$4.00 per gallon). If an increase in the price of gasoline to $4.25 reduces the quantity
demanded to 950 gallons per day, total revenue rises to $4,037.50 per day (=950 gallons per
day times $4.25 per gallon). Even though people consume less gasoline at $4.25 than at
$4.00, total revenue rises because the higher price more than makes up for the drop in
consumption.
Next consider pizza. Suppose 1,000 pizzas per week are demanded at a price of $9 per
pizza. Total revenue for pizza equals $9,000 per week (=1,000 pizzas per week times $9 per
pizza). If an increase in the price of pizza to $10 per pizza reduces quantity demanded to 900
pizzas per week, total revenue will still be $9,000 per week (=900 pizzas per week times $10
per pizza). Again, when price goes up, consumers buy less, but this time there is no change
in total revenue.
Now consider diet cola. Suppose 1,000 cans of diet cola per day are demanded at a
price of $0.50 per can. Total revenue for diet cola equals $500 per day (=1,000 cans per day
times $0.50 per can). If an increase in the price of diet cola to $0.55 per can reduces
quantity demanded to 880 cans per month, total revenue for diet cola falls to $484 per day
(=880 cans per day times $0.55 per can). As in the case of gasoline, people will buy less diet
cola when the price rises from $0.50 to $0.55, but in this example total revenue drops.
In our first example, an increase in price increased total revenue. In the second, a
price increase left total revenue unchanged. In the third example, the price rise reduced
total revenue. Is there a way to predict how a price change will affect total revenue? There
is; the effect depends on the price elasticity of demand.

Price Elasticity of Demand versus Slope

Be careful not to confuse elasticity with slope. The slope of a line is the change in the
value of the variable on the vertical axis divided by the change in the value of the variable on
the horizontal axis between two points. Elasticity is the ratio of the percentage changes. The

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 Basic Microeconomics
slope of a demand curve, for example, is the ratio of the change in price to the change in
quantity between two points on the curve. The price elasticity of demand is the ratio of the
percentage change in quantity to the percentage change in price. As we will see, when
computing elasticity at different points on a linear demand curve, the slope is constant—
that is, it does not change— but the value for elasticity will change.

Income Elasticity of Demand. The second application of elasticity is the income elasticity of
demand. It is defined as the responsiveness of demand to changes in incomes. Based on the
calculated value, we can determine whether the commodity is normal, inferior and luxury.
• Normal Good – demand rises as income rises and vice versa; positive value
• Inferior Good – demand falls as income rises and vice versa; negative value
• Luxury good is a commodity whose income elasticity of demand is greater than 1 (εI
> 1)

We can calculate the income elasticity of demand using the midpoint formula.

The formula of calculating price elasticity of demand is the mid-point formula.

𝑄𝑑2− 𝑄𝑑1
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑑 (%Ϫ 𝑄𝑑 ) = 𝑄𝑑2+ 𝑄𝑑1 Equation 3.4
2
𝑌2− 𝑌1
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌(%Ϫ𝑌) = 𝑌2+ 𝑌1 Equation 3.5
2
%Ϫ 𝑄𝑑
𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 (Ԑ𝑦) = Equation 3.6
%Ϫ𝑦

For example, take a look on the case. Mr. X is military personnel. Year 2019, President
Duterte increases their salary given them incentives to change their purchasing power.
Before his salary is PhP22,000 but now it becomes PhP33,000. Unknowingly, his availment of
movie house services also changes from once (1) a month to four (4) times a month whiles
his consumption of DVD movies decreases from 6 DVDs to 2 DVDs a month. Calculate the
income elasticity of demand for movie house services and DVD.
The following are the procedure of solving the problem:
For Movie House Services
Step 1. Determine the Qd2 and Qd1; Y2 and Y1.
Qd2 = 4 Qd1= 1 ; Y2 = PhP33, 000 Y1 = PhP22, 000
Step 2. Calculate the percent change in Qd. Substitute the values identified (Qd) to
equation 3.4.
4−1 3
%Ϫ 𝑄𝑑 = = = 1.2
4+1 2.5
2
Step 3. Calculate the percent change in Y. Substitute the values identified (Y) to
equation 3.5.
33, 000 − 22,000 11,000
%Ϫ𝑌 = = = 0.4
33, 000 + 22,000 27,500
2
Step 4. Calculate the income elasticity of demand. Substitute the values calculated
from step 1 (%Ϫ 𝑄𝑑 = 1.2)) and step 2( %Ϫ𝑌 = −0.4) to equation 3.6.
1.2
Ԑ𝑦 = =3
0.4

Step 5. Interpret the result. To determine if normal or inferior, look on the sign of the
income elasticity. If it is positive, the commodity is normal good otherwise it is inferior. If we
want to determine if it is elastic, inelastic or unit elastic; get the absolute value of the

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 Basic Microeconomics
computed income elasticity of demand then refer to Table 3.1. As it can be noted, the value
of income elasticity of demand is +3, its sign is positive therefore we can say that it is normal
good. Getting its absolute value, it is equal to 3, thus we can say that movie house services is
income elastic. Since it is greater than 1, we can also say that commodity is luxury.

For DVD, the following is the solution.

Given : Qd2 = 2 Qd1= 6; Y2 = PhP33, 000 Y1 = PhP22, 000

Required : Ԑ𝑦 =?
2−6 4
Solution : %Ϫ 𝑄𝑑 = 2+4 = = −1
−4
2
33,000−22,000 11,000
%Ϫ𝑌 = 33,000+22,000 = = 0.4
27,500
2
−1
Ԑ𝑦 = = −2.5
0.4
Interpretation : The DVD is an inferior- luxury-income inelastic good for Mr. X.

Cross-price Elasticity of Demand. The third application of elasticity is the cross-price

elasticity of demand. This refer to responsiveness or sensitiveness of demand of good x to
the changes in price of another good (good y). Good X is one commodity to which the
responsiveness of demand will be calculated while Good Y is another commodity to which
the changes in price will be calculated. Results of the computed cross-price elasticity of
demand can be interpreted based on Table 3.1 and as follows:

Goods which are complements: Cross Elasticity will have negative sign (inverse
relationship between the two)
Goods which are substitutes: Cross Elasticity will have a positive sign (positive
relationship between the two)
Goods which are unrelated: Cross Elasticity will be zero (no relationship between
the two).
To calculate the cross-price elasticity of demand, midpoint formula will be used.

𝑄𝑑𝑥2− 𝑄𝑑𝑥1
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑑𝑥 (%Ϫ 𝑄𝑑𝑥 ) = 𝑄𝑑𝑥2+ 𝑄𝑑𝑥1 Equation 3.7
2
𝑃𝑦2− 𝑃𝑦1
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑦 (%Ϫ𝑃𝑦 ) = 𝑃𝑦2+ 𝑃𝑦1 Equation 3.8
2
%Ϫ 𝑄𝑑𝑥
𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 (Ԑ𝑥𝑦) = Equation 3.9
%Ϫ𝑃𝑦

Example: JJJ is a teenager who loves to consume Milk Tea, Pastries and Coffee. It
was noticed that when the price of coffee increases from PhP120 to Php140 per cup in a
known Coffee Shop, JJJs consumption of Pastries decreases from 5 units a week to 2 units a
week. On the other hand, JJJ increase the consumption of Milk Tea from 2 times a week to 4
times a week. Calculate the cross-price elasticity of demand for Milk Tea and Pastries over
the price of coffee.

The following are the procedure of solving the problem:

For Milk Tea. In this case, Good X is the Milk Tea while Good Y is Coffee.

Step 1. Determine the Qdx2 and Qdx1; Py2 and Py1.

Qd2 = 4 Qd1= 2 ; Py2 = PhP140 and Py1 = PhP120.

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 Basic Microeconomics
Step 2. Calculate the percent change in Q dx. Substitute the values identified (Qdx) to
equation 3.7.
4−2 2
%Ϫ 𝑄𝑑𝑥 = = = .67
4+2 3
2
Step 3. Calculate the percent change in PY. Substitute the values identified (Py) to
equation 3.8.
140 − 120 20
%Ϫ𝑃𝑦 = = = 0.15
140 + 120 130
2
Step 4. Calculate the cross-price elasticity of demand. Substitute the values
calculated from step 1 (%Ϫ 𝑄𝑑𝑥 = .67)) and step 2( %Ϫ𝑃𝑦 = 0.15) to equation 3.9.
0.67
Ԑ𝑥𝑦 = = 4.47
0.15

Step 5. Interpret the result. To determine if it is substitute or complement, look on

the sign of the cross-price elasticity. If it is positive, commodity X and Y are substitute
otherwise it is complement. If we want to determine if it is elastic, inelastic or unit elastic;
get the absolute value of the computed income elasticity of demand then refer to Table 3.1.
Result revealed that the value of cross-price elasticity of demand is +4.47, its sign is
positive therefore we can say that coffee and milk tea are substitute. Getting its absolute
value, it is equal to 4.47, thus we can say that milk tea is cross-price elastic with coffee since
it is greater than 1.

For pastries, Good X is pastries while Good Y is Coffee

Given : Qdx2 = 2 Qd1= 5; Py2 = PhP140 Py1 = PhP120

Required : Ԑ𝑥𝑦 =?
2−5 −3
Solution : %Ϫ 𝑄𝑑𝑥 = 2+5 = = −0.86
3.5
2
140−120 20
%Ϫ𝑃𝑦 = 140+120 = = 0.15
130
2
−0.86
Ԑ𝑦 = = −5.57
0.15
Interpretation : The pasties are elastic-complement of Coffee for JJJ.

End of Chapter Exam

Part I. Read each statement carefully. Answer the questions by selecting the letter that
corresponds to your answer.

1. If a 20% tuition increase leads to a 10% decline in enrolment, the price elasticity of
demand is
a) 2
b) 0.2
c) 0.5
d) 0.3

2. If the consumer decreases their purchases of a good by 20% when its price rises by 10%,
we can conclude that the price elasticity of demand for the good is:
a) –20
b) –10
c) –2

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 Basic Microeconomics
d) 2

3. If the % increase of a commodity demanded is greater than the % decrease in its price,
the coefficient of price elasticity of demand is
a) greater than one
b) less than one
c) equal to one and
d) zero

4. A negative income elasticity of demand means that when income increases, the amount
of the commodity purchased
a) decreases
b) increases
c) remains constant
d) is zero

5. If the income elasticity of demand is greater than one, the good is

a) essential
b) a luxury
c) an inferior good
d) has elastic demand

6. If the amounts purchased of 2 commodities both increase or decrease when the price of
one changes, the cross elasticity of demand between them is
a) positive
b) negative
c) zero
d) equals to one

7. Which of the following elasticity’s measures a movement on the demand curve :

a) price
b) income
c) cross
d) all of the above

8. A business firm selling in a very competitive market faces a

a) highly elastic demand curve
b) highly inelastic demand curve
c) demand curve of unit elasticity
d) small demand curve

9. A public university knows that demand from potential students is elastic. If the university
wants to increase tuition revenue, it should
a) raise its tuition fee
b) hold its tuition rate constant and increase faculty salaries
c) lower its tuition rate
d) increase its enrolment

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 Basic Microeconomics
10. A local store noticed that when it increased the price of milk from $2.50 per gallon to
$3.50 per gallon, it sold the same amount of milk per week (165 gallons). Since everything
else remained the same, we would say that
a) demand for milk is perfectly elastic
b) demand for milk is elastic
c) demand for milk is perfectly inelastic
d) demand for milk is unitary elastic

11. Price elasticity of demand is defined as the

a) quantity demanded divided by the price
b) change in the quantity demanded divided by the change in price
c) Percentage change in the price divided by the percentage change in the quantity
demanded.
d) Percentage change in the quantity demanded divided by the percentage change in the
price.

12. If the quantity demanded of a particular good changes very little when the price of the
good changes substantially, the demand for the good is
a) perfectly elastic
b) perfectly inelastic
c) elastic
d) inelastic

13. If a very small change in the price of a good cause a huge change in the quantity
demanded, the demand for the good is
a) perfectly elastic
b) perfectly inelastic
c) elastic
d) inelastic

14. If Filipinos spend about the same amount of money on beef when its price is relatively
high as when it is relatively low, the demand for beef is
a) perfectly elastic
b) perfectly inelastic
c) elastic
d) inelastic

15. A footwear manufacturer increased its production of men’s golf shoe by 20% when
prices on this type of shoe is increased by 15%. We may conclude that
a) the price elasticity of supply on this type of shoe is 20%/15% or 1.33
b) the price elasticity of supply on this type of shoe is 15%/20% or .75
c) the price elasticity of supply on this type of shoe is 20%
d) the price elasticity of supply on this type of shoe is 15%.

16. A perfectly elastic demand is represented graphically by a:

a. relatively steep demand curve.
b. relatively flat demand curve.
c. vertical demand curve.
d. horizontal demand curve.

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 Basic Microeconomics
17. Suppose that a good has an income elasticity of demand of -2.0. This means that the
good is:
a. normal.
b. inferior.
c. a substitute.
d. a complement.

18. If two goods have a cross-price elasticity of demand of -0.8. This means that these goods
are:
a. normal.
b. inferior.
c. substitutes.
d. complements.
One of the new entrants in the airline industry is the Cross Fare Airlines. They
categorize their market into two, the business travelers and the holiday makers. Suppose
that business travelers and holiday makers have the following demand for airline tickets
from Manila to Palawan.

Qd (Business Travelers) Qd (Holiday Makers)

PRICE
Y1= Php50, 000 Y2= Php55, 000 Y1= Php50, 000 Y2= Php55, 000
150 2100 1500 1000 1250
200 2000 1300 800 1000
250 1900 1100 600 750
300 1800 900 400 500
350 1700 700 200 250
*** Y – disposable income

In addition, the research unit of the company noticed that hotel accommodation in
Palawan has significant impact to their sales. When the Hotel accommodation in Palawan
gave 20 percent discounts, sales from business travelers and holiday maker increases by 20
percent too. Meanwhile, discounts and promo made by Cebu Pacific greatly affect their
sales. 10 percent discounts in the price of CebuPac, leads to 3 percent decrease in their sales
from business travelers and 20 percent from Holiday Makers.

15. At Y1 which is amounting to Php50, 000, as the price rise from 200 to 250, what is
the price elasticity of demand (εp) for Business Travelers?
A. εp= 2.40769230771 C. εp = 2.504567321967
B. εp = -2.30769230771 D. εp d = -2.78234517364

16. How about when Y of business travelers increases from Y 1 to Y2, at the price of
airfare is 350, what is the value of the income elasticity of demand (ε y)?
A. εy = 8.75 C. εy = 7.86
B. εy = -8.75 D. εy = -7.86

17. At Y1, as the price falls from 350 to 200, what is the price elasticity of demand for
Holiday Makers?
A. εp = 2.40 C. εp = 2.50

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 Basic Microeconomics
B. εp = -2.20 D. εp = -2.70

18. How about when Y of Holiday makers increases from Y 1 to Y2, at the price of airfare
is 250, what is the value of the income elasticity of demand (ε y)?
A. εy = 2.33 C. εy = 2.45
B. εy = -2.33 D. εy = -2.45

19. How sensitive does the cross fare airlines to the changes in the price of hotel
accommodation?
A. 1 C. – 1
B. 2 D. answer not given

20. How sensitive does the demand for cross fare airlines for the business travelers to
the changes in the price of Cebu Pacific?
A. 0.3 C. -0.3
B. .03 D. -0.03

21. How about the holiday makers?

A. 0.02 C. -0.02
B. 2 D. -2

22. If you are the manager of Cross Fare Airlines, will decreasing their price will increase
their total revenue? Why?
A. Yes, since the airfare is normal good
B. No, since the airfare is inferior good
C. Yes, since the airfare is elastic
D. No, since the airfare in inelastic

23. When it is based on the income, what can you say about Cross Fare Airlines?
A. It is normal for the business travelers and inferior for the holiday makers.
B. It is inferior for the business travelers and normal for the holiday makers.
C. It is both normal for both business travelers and holiday makers.
D. It is both inferior for both business travelers and holiday makers.

24. If you are the manager of Cross fare Airlines, will you be threatened on the
marketing strategy of Cebu Pacific?
A. Yes because the sales of Cross Fare Airlines is sensitive to the discount of Cebu
Pacific.
B. No because the sales of Cross Fare Airlines is not sensitive to the discount of
Cebu Pacific.
C. Yes for Business Travelers because it is sensitive to the Cebu Pacific Strategy
while no for Holiday Makers because it is not sensitive.
D. No for Business Travelers because it is not sensitive to the Cebu Pacific Strategy
while yes for Holiday Makers because it is sensitive.

Part II. Answer the questions as instructed.

1. Steaks sell at a price of P250 per kilo. An increase in income of 20% from the original
P25,000 causes your demand to increase from 2 to 5 kilos per month. Compute for
the income elasticity of demand for steak.

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 Basic Microeconomics
2. A decrease in the price of Good Y from P20.00 to P15.00 causes the quantity
demanded for GoodX to increase by 15% from the level 150 units.
3. Calculate cross price elasticity for products A and B to find out how responsive is X to
the changes in the price of Y.
X: original price for 180units changed to P30.00 for 150 units.
Y: original price of P75.00 for 200 units increased to P150.00 for 100 units.

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Chapter 4
CONSUMER CHOICE AND DEMAND

INTRODUCTION

In day to day living, we always make choice especially when we consume product.
The goods and services that we consume is basically the one that can satisfy us. Satisfaction
is much subjected concept and no one can say that the satisfaction that I gain is the same as
yours.
Basically, demand first comes up with satisfaction. Satisfaction before has no
measurement but in order to study the level of satisfaction, economist coined a
measurement on this, it is called utility.

INTENDED LEARNING OUTCOMES

1. To explain how economist measures the level of satisfaction of individual.

2. To calculate and interpret the marginal utility and marginal rate of substitution.
3. To explain the law of diminishing utility.
4. To utilized isoquant and isocost in making choice.
5. To calculate the optimal choice.

Theory of Preference
For us to better understand satisfaction, the most common way to analyse satisfaction
is determining the preference of us from one commodity over the others. Preference is the
degree on how individual likes one commodity over the other. There are three assumptions
of preference which applies to all utility models.
1. Preference is complete. This means that individual will choose one commodity
from another for as long as he/she knows completely the information about the
commodities.
2. Preference is consistent. If you prefer apple than orange, then orange than
grapes, you cannot say that you prefer grapes than apple. This is to maintain the
uniformity of your proposition regarding your preference.
3. The More is better. For a rational individual, you will prefer to have PhP2, 000
worth of groceries than only PhP1, 000 worth of groceries. This applies only in
normal conditions however on the latter part of this module; there are some
exceptions that will violate this assumption.

Utility as Satisfaction

Level of satisfaction is measured as utility and the unit of satisfaction is called utils.
Remember that the higher the utils, the higher the level of satisfaction.
Utility can be measured in two methods, the ordinal and cardinal method. Ordinal
method is done when an individual ranks the utility for commodity. For example, Andrew
ranks apple, orange and mango according to level of satisfaction he derive in consuming 1
unit of fruit. Then using ordinal method Andrew will answer in this way:
I prefer apple than orange but I prefer orange than mango. From this, Andrew ranks
the fruit as apples ranks 1, orange ranks 2 and mango as rank 3.
Cardinal method is the process in which individual give the intensity of utils he
derive in 1 unit of goods. In above example, Andrew may rate apple as 7 utils while orange
has 4 utils and mango has 1 util.
Most of the time, the individual use ordinal method but for the purpose of studying
consumer behavior, economist often ask the cardinal value of utility of individual. For

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 Basic Microeconomics
example, you ask the level of satisfaction in consuming water since water is free.
Considering that you just finish jogging for 3 hours. Table 4.1 shows the total utility and
marginal utility for every glass of water you drink.
Table 4.1
Total Utility and Marginal Utility for Glass of Water
Glass of H2O Total Utility Marginal Utility
(TU) (MU)
0 0 -
1 5 5
2 9 4
3 12 3
4 14 2
5 14 0
6 13 -1
7 10 -3
As you can noticed, total utility for glass of water increases. When you drink 1 glass
of water, your level of satisfaction is 5, but when you drink additional glass, your satisfaction
increases to 9 and so on.
However, if we're going to look for the value of marginal utility, it declines as you
consume additional glass of water. Marginal utility is additional or extra utils the individual
gains when he or she consumes additional 1 unit of commodity. From table 4.1, when you
drink 1 glass of water marginal utility is 5, when you drink another glass of water, the
marginal utility is 4. But when you drink the 5 th glass of water, your marginal utility is equal
to 0 and when you drink the 6th glass, MU is equal to -3. When you graph your TU and MU:

Figure 4.1
Total Utility and Marginal Utility in Consuming Glass of Water

From figure 4.1, we can gleaned that when TU curve is on its peak, MU intersects the
X-axis which means MU is equal to zero. The graph of MU is downward sloping. At 5 th glass
of water, you already the saturation point. Saturation point is the point where your total
utility curve is on its peak and the marginal utility is equal to 0.
In this instance, we can observe the law of diminishing marginal utility. Law of
Diminishing Marginal Utility states that as we consume more and more units of goods, the
marginal utility decreases.
Indifference Curve

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 Basic Microeconomics
Indifference curve is a tool which shows the different combination of goods and
services that an individual consumes that yields the same level of satisfaction or utility.
Indifference curve has four assumptions:
1. There are only two goods available in the market.
2. Indifference curve bows against (Convex) the origin.
3. Any point along the curve utilizes the same level of satisfaction.
4. Indifference curve never intersects.
Figure 4.2 is an example of indifference curve. We have two commodities, the food
and cloth. An individual feels indifferent what combination of food and clothes should he
consume.
At point A, the individual may consume 10 units of food and 4 units of clothes. He
may also consume at point B in which he may eat 4 units of food and 12 units of clothes.
Both A and B utilizes the same level of utility or satisfaction.

Figure 4.2
Indifference Curve

Budget Constraints
As we all know, there is no free in this world. All commodities have its price.
Therefore an individual cannot easily choose among the combination of goods that lies along
the indifference curve. Therefore, we may say that we are constraints with our budget.
In order to determine the combination of goods that will satisfy our utility and
budget, economist use the budget line. Budget line is the line that represents combination
of goods that can be purchased by your income.

Figure 4.3
Budget Line

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 Basic Microeconomics
Figure 4.3 shows the budget line of an individual. If individual has Php1,000
therefore at point A, individual can buy 10 units of food and 4 units of clothes. On the other
hand, using Php1,000 as well, individual can purchase t point B where he can buy 4 units of
food and 12 units of clothes.

Consumer Equilibrium

Consumer equilibrium is the point where budget line tangent to the indifference
curve. In real sense, it is a combination of goods in which the individual optimize his utility
and budget.

Figure 4.4
Consumer Equilibrium

Referring to table 4.4, the consumer equilibrium can be found at point C. Therefore
individual can consume 7 units of food and 8 units of clothes which also satisfy his income.
Mathematically, consumer equilibrium can be express in terms of:

𝑀𝑈𝑥 𝑃𝑥
=
𝑀𝑈𝑦 𝑃𝑦

Or

𝑀𝑈𝑥 𝑀𝑈𝑦
=
𝑃𝑥 𝑃𝑦

Where MUx is the marginal utility for first commodity, MUy is marginal utility for
second commodity, Px is price of first commodity and Py is the price of second commodity.
Let us say that Xyntia wants to buy Pizza and render Video Rentals. Suppose that she
has a monthly budget for two commodities of Php3.00, each pizza cost Php6.00 and Video
rentals of Php36.00.

Availing the Video rentals

Q TU MU MU/P
0 0
1 200 200 33.33
2 290 90 15
3 370 80 13.33
4 440 70 11.67

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 Basic Microeconomics
5 500 60 10
6 550 50 8.33
7 590 40 6.67

Consumption of Pizza
Q TU MU MU/P
0 0
1 250 250 83.33
2 295 45 15
3 335 40 13.33
4 370 35 11.67
5 400 30 10
6 425 25 8.33
7 445 20 6.67

In this case, quantity 2- 6 for both commodities satisfy the condition of consumer
equilibrium. But to determine which combination she can afford, then you need to multiply
the combination of goods to its price. In this case the point where Xyntia will consume 4
units of pizza and 4 movie theater. In computation:
I = PxX + PyY
36 = (Php6 x 4) +(Php3X )
Php36.00 = Php36.00

Income Effect versus Substitution Effect

Normally, the optimal choice changes due to some factors particularly the income of
individual and the price of commodity. This changes lead to either income effect or
substitution effect.
Figure 4.5 panel A shows using graphical method how the income effect occurs.
Commonly income effect is due to changes in income of individual whether it increases or
decreases or changes the purchasing power (price of both commodity changes
proportionately).
Clothes Clothes

C
B C
B A
A

Food Food
Panel A Panel B
Figure 4.5
Income Effect versus Substitution Effect

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 Basic Microeconomics
Let us say individual’s income decreases, the budget line (thin line) will shift to the left
(thick line) leading to shifting of the indifference curve to the left. In effect, the optimal
choice changes from point A to point B. This means that the combination of food and clothes
decreases (less food and clothes consumption for individual). On the other hand, when
income increases, the budget line (thin line) will shift to the right (broken line) leading to
shifting of the indifference curve to the right. In effect, the optimal choice changes from
point A to point C which manifests that the combination of food and clothes increases.

Figure 4.5 panel B shows how substitution effect occurs using graphical model.
Substitution effect happened when the price of one commodity in the indifference curve
and budget line changes (increases/ decreases). When the price of one commodity
decreases, the budget line will pivot outward away from the origin. If the price of
commodity increases, the budget line will pivot inward towards the origin.
Let us say that the price of food increases, we can notice from Figure 4.5-panel B that
the budget line pivoted (tilted) towards the origin (thin line to thick line) since individual
have less consumption of food (according to law of demand). In effect, the indifference
curve will shift to the left having a new optimal choice; from point A to point B. This leads to
additional unit of clothes for individual to be consumed and less of food on the other hand.
If the price of food decreases, the tendency of individual is to consume more of food (law of
demand) thus the budget line will pivot outwards (thin line to broken line). This leads to
changes in optimal choice from point A to point C. This connotes that individual will
consume more food and less clothes.

End of Chapter Exam

Part I: Read each statement carefully then answer the question that follows by choosing the
letter that corresponds to your answer.

1. Which of the following can best describe the basket?

B. Goods and services to which individual might consume.
C. It is usually compose of 1 commodity or service.
D. It cannot be rank because its preference it the same.
E. All of the above.

2. The statements below are the assumption about consumer preference, which is not
included?
A. Preference is known and complete.
B. Preference is inconsistent.
C. More commodities are better.
D. Preference is transitive

3. How do we use ordinal method of determining the consumer’s utility?

A. We just rank which basket of goods we prefer over the other.
B. We just give grade on the baskets of our choices depending on the cost we will incur
in consumption.
C. We will give the level of satisfaction that we derive in each basket of goods.
D. Answer not given

4. When do we use the cardinal method?

A. In day to day living
B. In conducting researches and studies

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 Basic Microeconomics
C. In determining cost
D. Both A and C

5. How will you describe marginal utility?

A. It always diminishes.
B. It is an additional utility gain in additional unit of consumption for goods.
C. It is the total utility divided by the number of goods being consumed.
D. Both b and c

6. Is more is always better?

A. Yes because it is the economist assumption about consumer preference.
B. No because we have the law of diminishing marginal utility.
C. Yes because additional consumption means additional satisfaction we can get.
D. No because satisfaction varies from time to time.

7. What is the value of your marginal utility when your total utility reaches its peak?
A. Positive C. Zero
B. Negative D. Cannot be determined

8. Which of the following statement is true about indifference curve?

A. The higher the indifference curve, the same satisfaction an individual gets.
B. The indifference curve concaves the origin.
C. There are only two goods available for consumption.
D. Point along the curve, represents different level of satisfaction.

9. Which statement below can best describe the budget line?

A. It is straight horizontal line.
B. It is straight vertical line.
C. It is downward sloping linear curve.
D. It is upward sloping linear curve.

10. Shifting of the budget line occurs when:

A. Price of one commodity increases.
B. Price of one commodity decreases.
C. Income of individual changes.
D. Answer not given

11. How can you determine the utility maximization point in indifference curve?
A. Where budget line and indifference curve intersect.
B. Where the budget line and indifference curve is equal.
C. Where the budget line tangent the indifference curve.
D. Both A and B.

12. What does the utility maximization point implies?

A. It is the combination of goods and services in which the individual maximizes its utility.
B. It is the combination of goods and services in which the individual maximizes its
budget.
C. It is the combination of goods and services in which the individual maximizes its
resources.
D. Both A and B

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 Basic Microeconomics

13. What do you call for the slope of indifference curve?

A. Marginal cost
B. Marginal utility
C. Marginal satisfaction
D. Marginal rate of substitution

14. Income effect may occur due to what reason?

A. Increase in price on one commodity
B. Decrease in price of one commodity
C. Increase in price of one commodity and decrease in price of another commodity
D. Increase in price of both commodities in the budget line.

15. How can we determine the optimal choice?

A. It is the point of intersection between indifference curve and budget line.
B. It is the point of tangency between indifference curve and budget line.
C. It is the point where indifference curve meets the budget line.
D. It is the point where budget line is above indifference curve.

1. On the conduct of research, it is noticed that the market feels indifferent for the
concert and movies. Below is the indifference curve and budget line (on average) faces
by the market.

*** U1 – Original Indifference Curve Y1 – Original Budget Line

Figure 4.6
Consumption of Movie house and Concert
1.1 If the price of movie increases, what bundles of good does individual might consume to
achieve the optimal choice?
1.2 If the income of individual increases, how many bundles of movie and concert does
individual might consume.
1.3 If the price of both commodities increases by 5%, how many bundles of good does the
individual might consume?
1.4 Referring on the original bundle of goods (optimal choice), if the price of movie is
Php150, how much is the concert?

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 Basic Microeconomics
1.5 If the price of movie decreases, the new optimal choice is 10 hours of movies and 7
hours of concert. The price of concert is the based on your answer to question 29, how
much is the new price of movie?
1.6 From the original bundle of goods, the optimal choice changes to 6 hours of movie and 7
hours of concert. This can be attributed to:

2. The well- known ice cream in town conducted a survey on how they are satisfied with the
product they are offering. As a result, they get the average of their satisfaction and graph
it as shown below.

2.1 Based from the graph, the market can maximized the level of satisfaction at what point?
2.2 What is the marginal utility of the market for ice cream from point A to point B?
2.3 If the price of ice cream is Php25.00, how much should be the market have to maximize
their satisfaction?
2.4 The Region I can be found at:
2.5 At point C, what is the value of marginal utility?

3. The following tables illustrate Sofia’s utilities from watching first-run movies in a
theater and from renting movies from a video store. Suppose that she has a monthly
entertainment budget of $36, each movie in a theater costs $6, and each video rental
costs $3.

Movies in a Theater
Q TU MU MU/P
0 0
1 200
2 290
3 370
4 440
5 500
6 550
7 590

Movies from a Video Store

Q TU MU MU/P
0 0
1 250

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 Basic Microeconomics
2 295
3 335
4 370
5 400
6 425
0 0
3.1 Complete the tables.
3.2 Do these tables show that Sofia’s preferences obey the law of diminishing marginal
utility? Explain your answer.
3.3 How much of each good will Sofia consume in equilibrium?
3.4 Suppose the prices of both types of movies drop to $1 while Sofia’s entertainment
budget shrinks to $10. How much of each good will she consume in equilibrium?

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 Basic Microeconomics
Chapter 5
Theory of Production

INTRODUCTION
Basically, goods and services cannot be produced without utilizing the factors of
production such as land, labor, capital, and entrepreneurship. It is the fundamental
decision of the firm to determine the amount of goods and services to produce and how
much factors of production to apply together with other inputs to generate an output
with the highest level of efficiency.
This module focuses with the general discussion of production theory, with
the specific case where there is one variable input depicting the law of diminishing
marginal returns, three stages of production, and the return to scale. An in-depth
discussion on the two variable inputs such as isocost and isoquant concepts also
follows, extending to the condition for attaining the producer’s equilibrium.

INTENDED LEARNING OUTCOMES

After studying this module, students will be able to:

1. Describe the three stages of production.
2. Explain the relationship between Marginal Product (MP) and Average Product (AP).
3. Explain the difference between short-run and long-run analysis of production.
4. Explain the Law of Diminishing Marginal Returns and give numerical example.

Theory of Production

It explains the principles in which the business/firm has to take decisions on how
much of each commodity it sells and how much it produces and also how much of raw
material i.e., fixed capital and labor it employs and how much it will use. It defines the
relationships between the prices of the commodities and productive factors on one hand
and the quantities of these commodities and productive factors that are produced on the
other hand.

Production. It is the transformation of inputs into outputs. Further, it is defined as the

process of transforming inputs into outputs can be any of the following kinds:
 Change in the Form (Raw material transformed to finished goods )
 Change in Place ( Supply chain, Factory to Retailer)
Production takes inputs and uses them to create an output which is fit for
consumption of a good or product which has value to an end-user or customer. Also, it
defined as a process of combining various inputs to produce an output for consumption. It is
the act of creating output in the form of a commodity or a service which contributes to the
utility of individuals. In other words, it is a process in which the inputs are converted into
outputs.

Elements Production. There are three element of production. These three are
interdependent in order to satisfy the definition of production.
1. Inputs are the factors of production or resources. In economics, it is also known as
factors of production. Factors of production are the inputs needed for the creation
of a good or service. The factors of production include land, labor, entrepreneurship,
and capital. Land has a broad definition as a factor of production and can take on
various forms, from agricultural land to commercial real estate to the resources
available from a particular piece of land. Natural resources, such as oil and gold, can

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 Basic Microeconomics
be extracted and refined for human consumption from the land. Capital typically
refers to money. But money is not a factor of production because it is not directly
involved in producing a good or service. Instead, it facilitates the processes used in
production by enabling entrepreneurs and company owners to purchase capital
goods or land or pay wages. As a factor of production, capital refers to the purchase
of goods made with money in production. For example, a tractor purchased for
farming is capital. Along the same lines, desks and chairs used in an office are also
capital. Labor actually means any type of physical or mental exertion. In economic
terms, labor is the efforts exerted to produce any goods or services. It includes all
types of human efforts – physical exertion, mental exercise, use of intellect, etc.
done in exchange for an economic reward. Entrepreneurship is the secret sauce that
combines all the other factors of production into a product or service for the
consumer market.
2. Process is a set of steps and procedures to convert inputs into output.
3. Output is the result that has been created by the inputs (in this case, when labor and
capital are combined). There are two types of output. These are either goods or
services. Goods are materials that satisfy human wants and provide utility, for
example, to a consumer making a purchase of a satisfying product? A common
distinction is made between goods that are tangible property, and services, which
are non-physical. While services are transaction in which no physical goods are
transferred from the seller to the buyer. The benefits of such a service are held to be
demonstrated by the buyer's willingness to make the exchange.

Most of the economist analyse and explain economic phenomena using quantitative
approach. Among of the three elements, input and output can be quantify thus these two
elements were used to explain the theory of production. Combining the concepts of the
elements of production, we will come up with what do we call production set. Production
set is the combinations of inputs and output in a given production. Production set can be:
1. Technically feasible. It is a production set with given output that is viable to
produce from a given set of input. Production set is technically feasible if the input
is greater than or equal to the output (Input > Output). Under this technically
feasible production set, we can further categorize this set into two.
1.1 technically efficient. This refer to the set in which the firm produces more
output using less of inputs needed in production. The firm utilizes all of the
inputs to its full extent in order to have maximum output.
1.2 technically inefficient. This refer to the set in which the firm produces less
output using more of inputs needed in production. The firm were not able to
utilize the inputs to its full extent in order to have maximum output. Resources
were wasted most probably due to lack of knowledge in the process, delay of
inputs and using of wrong equipment and tools.
2 Technically not feasible. It is a production set that is considered not viable/
possible to produce. Doing the input-output analysis, it is the set in which the input
is less than the expected output (input<output).

Note: Technically feasible and not feasible production set can be determined using
input-output analysis. In a proposal (Feasibility Studies or Business Plan), you can verify the
correctness of technical study using this input-output analysis.
The concept of Production set can be presented using the following diagram (figure
5.1):

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 Basic Microeconomics

Production
Set

Technicaly Technicaly
Feasible Not Feasible

Technically Technically
Efficient Inefficient

Figure 5.1
Concept Map of the Production Set

The theory involves some of the most fundamental principles of economics. These
include the relationship between the prices of commodities and the prices of the productive
factors used to produce them and also the relationships between the prices of commodities
and productive factors, on the one hand, and the quantities of these commodities and
productive factors that are produced or used, on the other.
In understanding the theory of production, the production set is commonly
represented by production function, production schedule, and Total Product Curve.

Form of Production Set

Production set can be presented into three forms. The production function shows the
relationship between quantities of various inputs used and the maximum (technically
feasible) output can be produced with those inputs used per unit of time expressed in
equation. Production schedule on the other hand shows combination of input and output
(technically feasible) through table while production curve (Total Product Curve) is through
line graphs.
These three are the tool of analysis used in explaining the input-output relationship. It
describes the technical relationship between inputs and output in physical terms. In its
general form, it holds that production of a given commodity depends on certain specific
inputs. In its specific form, it presents the quantitative relationships between inputs and
outputs. A production function may take the form of a schedule, a graph line or a curve, an
algebraic equation or a mathematical model. The production function represents the
technology of a firm.

Short-run Analysis of Production

• In the short run, capital is fixed – Only changes in the variable labor input can change the
level of output
• Short run production function Q = f ( L,K ) = f ( L )

Long-run production

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 Basic Microeconomics
• An empirical production function is generally so complex to include a wide range
of inputs: land, labour, capital, raw materials, time, and technology. These variables form
the independent variables in a firm’s actual production function.
• A firm’s long-run production function is of the form: Q = f(Ld, L, K, M, T, t) where Ld
= land and building; L = labour; K = capital; M = materials; T = technology; and, t = time.
• For sake of convenience, economists have reduced the number of variables used in
a production function to only two: capital (K) and labor (L). Therefore, in the analysis of
input-output relations, the production function is expressed as: Q = f(K, L)
• Increasing production, Q, will require K and L, and whether the firm can increase
both K and L or only L will depend on the time period it takes into account for increasing
production, that is, whether the firm is thinking in terms of the short run or in terms of the
long run.
• Economists believe that the supply of capital (K) is inelastic in the short run and
elastic in the long run.
• Thus, in the short run firms can increase production only by increasing labor, since
the supply of capital is fixed in the short run. In the long run, the firm can employ more of
both capital and labor, as the supply of capital becomes elastic over time.

Short-run Analysis of Production

All production in real time occurs in the short run. In the short run, a profit-maximizing
firm will:
• Increase production if marginal cost is less than marginal revenue (added
revenue per additional unit of output)
• Decrease production if marginal cost is greater than marginal value
• Continue producing if marginal variable cost is less than price per unit, even if
average total cost is greater than price
• Shut down if average variable cost is greater that price at each level of
output

Table 5.1
Hypothetical Data of Production with One Variable
(4) (5)
(3) Total
Points (1) Land (2) Labor Marginal Average
Product
Product Product
A 1 0 0 0 -
B 1 1 4 4 4
C 1 2 10 6 5
D 1 3 18 8 6
E 1 4 24 6 6
F 1 5 28 4 5.6
G 1 6 30 2 5
H 1 7 30 0 4.29
I 1 8 28 -2 3.5
J 1 9 24 -4 2.67

Production with One Variable Input

In order for us to analyse the production set with only one variable, we need to define
the important terms.

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 Basic Microeconomics
Average Product (AP) is the quantity of total output produced per unit of a variable
input, holding all other inputs fixed. Average product, usually abbreviated AP, is found by
dividing total product by the quantity of the variable input. Average product is generally
considered less important than total product and marginal product in the analysis of short-
run production.

Average Product = Total Product/ Units of Variable Factor Input

Marginal Product (MP) is the additional output produced as a result of employing an

additional unit of the variable factor input. Thus, we can say that marginal product is the
addition to Total Product when an extra factor input is used.
Marginal Product = Change in Output/ Change in Input

Thus, it can also be said that Total Product is the summation of Marginal products at
different input levels.
Total Product = Ʃ Marginal Product

700

600

500 TP
400

300

Panel A 200

100

0
1 2 3 4 5 6 7 8 9 10 11 12

100
80
60
40 AP
Panel B
20
0
-20 1 2 3 4 5 6 7 8 9 10 11 12

-40 MP
-60

Figure 5.2
Total Product, Marginal Product and Average Product Curves
As we can depict in Figure 5.2 panel A, it can be noticed that the total product curve is
upward sloping at a decreasing rate forming an inverted parabola. The TP curve is divided
into three stages/ phases.
Stage I: Stage of Increasing Returns. This stage starts at the origin until the highest
portion of AP (Panel A). MP and AP both are rising, and the MP is more than AP (Panel B). As
more of the variable input is added to the fixed input, the marginal product of the variable
input increases. Most importantly, marginal product is greater than average product, which

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 Basic Microeconomics
causes average product to increase. The producer is not making the best possible use of the
fixed factor. A particular portion of fixed factor remains unutilized. The total product curve
has a positive slope. Average product is positive and the average product curve has a
positive slope.
Stage II: Stage of Decreasing Returns. It goes from the highest portion of the AP until
MP is zero. MP and AP both are falling and MP through positive is less than AP. In Stage II,
short-run production is characterized by decreasing, but positive marginal returns. As more
of the variable input is added to the fixed input, the marginal product of the variable input
decreases. Most important of all, Stage II is driven by the law of diminishing marginal
returns. The stage where there is less than proportionate change in output due to change in
labor force. Hence at this stage the producer will employ the variable factor in such a
manner that the utilization of fixed factor is most efficient.
The three product curves reveal the following patterns in Stage II. The total product
curve has a decreasing positive slope. In other words, the slope becomes flatter with each
additional unit of variable input. Marginal product is positive and the marginal product curve
has a negative slope. The marginal product curve intersects the horizontal quantity
axis at the end of Stage II. Average product is positive and the average product curve
has a negative slope. The average product curve is at its a peak at the onset of
Stage II. At this peak, average product is equal to marginal product.
Stage III: Stage of Negative Returns. It begins where MP is zero until its negative
range. TP is diminishing and the MP is negative. In this stage of short-run production, the law
of diminishing marginal returns causes marginal product to decrease so much that it
becomes negative.
The total product curve has a negative slope. It has passed its peak and is heading
down. Marginal product is negative and the marginal product curve has a negative slope.
The marginal product curve has intersected the horizontal axis and is moving down. Average
product remains positive but the average product curve has a negative slope.
These three distinct stages of short-run production are not equally important. Stage I,
and with largely increasing marginal returns, is a great place to visit, but most firms move
through it quickly. Because each variable input is increasingly more productive, firms employ
as many as they can, as quickly as they can. Stage III, with negative marginal returns, is not
particularly attractive to firms. Production is less than it would be in Stage II, but the cost of
production is greater due to the employment of the variable input. Not a lot of benefits are
to be had with Stage III.
In Stage II even though production cost rises with additional employment, there are
benefits to be gained from extra production. It tends to be the choice of firms for short-run
production; it is often referred to as the "economic region." Firms quickly move from Stage I
to Stage II, and do all they can to avoid moving into Stage III. Firms can comfortably, and
profitably, produce forever and ever in Stage II.

Therefore, State II of production is the most favourable stage because the MP of labor and
AP of labor are both positive though declining.

Marginal product focuses on the changes between production totals and the quantity
of resources. Average product shows output at a specific level of input. The peak of the
average product curve is the point at which the marginal product curve and average product
curve intersect. Figure 5.2 Panel B shows the important relationship between MP and AP.
MP > AP, AP rises as the variable input increases
MP = AP, AP is constant; In some books it is stated that it is when AP reaches its maximum.
MP < AP, AP falls as the variable input increases

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 Basic Microeconomics
Take note: It is important to describe the three stages of production because these will help
us define the quantity of labor (or any other input) that a profit maximizing firm will employ.

Law of Diminishing Marginal Product/ Return

It states that as one input variable is increased, there is a point at which the marginal
increase in output begins to decrease, holding all other inputs constant. *The law of
diminishing marginal returns/ product describes a pattern in most production portion in
the short run. By holding one of the inputs constant except for one (it may be capital or
labor) and continually increasing the other input, a certain point will be arrived at wherein
the rate in the increase of output will fall. It says that output will decrease even if there is an
increase in one of the inputs.
It is also called as the Law of Variable Proportion. It states that as units of one input
are added with all other inputs held constant, a point will be reached where the resulting
additions to output will begin to decrease or the marginal product will decline. Simply put, it
says that output will decrease even if there is an increase in one of the inputs.
The law of diminishing marginal returns is a theory in economics that predicts that
after some optimal level of capacity is reached; adding an additional factor of production
will actually result in smaller increases in output. This law affirms that the addition of a
larger amount of one factor of production, ceteris paribus, inevitably yields decreased per-
unit incremental returns. This law only applies in the short run because, in the long run, all
factors are variable. This concept explains the following scenario:
• Use of chemical fertilizers. A good example of diminishing returns includes the use of
chemical fertilizers- a small quantity leads to a big increase in output. However,
increasing its use further may lead to declining Marginal Product (MP) as the efficacy
of the chemical declines.
• Revising into early hours of the morning. If you revise economics for six hours a day,
you will improve your knowledge quite a bit. However, if you continue to revise into
the early hours of the morning, the amount that you learn increases by only a small
amount because you are tired.
• Employing extra workers. A cafe may wish to serve more customers during the busy
summer months. However, employing extra workers may be difficult because of a lack
of space in the cafe.

Production with Two Variable Inputs

When more than one input level is free to be altered, a firm faces the question of
what is the best input combination to use. This section examines the various alternative the
firm faces when deciding how to produce each particular level of output. The first topic in
this section is the Isocost.

Isocost

This shows the different combinations of capital (K) and labor (L) that produces can
purchase or hire given their total outlay and the factor prices. The following example and
figure shows what an Isocost line is.
Suppose the price of capital is 2 pesos, the price of labor is 1 peso, the total outlay of
the producer is 20 pesos per time period and all is spent in both inputs. The isocost line is
given by the line CD in Figure 1. If the producer spends all his outlay on purchasing or hiring
capital, he could purchase 10 units of it (₽20/₽2 = ₽10). This is shown in point C. On the
other hand, if total outlay is spent on purchasing or hiring labor, he could purchase 20 units
of it (₽20/₽1 = 20). This is shown in point D. By joining both points, we can now define the
isocost line CD.

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 Basic Microeconomics

Capital
12
(k)
C
10

2
Labor
0 D
(L)
0 5 10 15 20 25
Figure 5.3
Isocost Line

Figure 5.4
Isocost Curve Map

If you plot the initial isocost line, as long as long as production continues, it may shift
in two directions. An isocost that shifts to the right indicates an increase in total outlay,
while a leftward shift denotes a decrease in total outlay. As shown in Figure 5.3.
Isocost line pertains to cost-minimization in production, as opposed to utility-
maximization. For the two production inputs labour and capital, with fixed unit costs of the
inputs, the equation of the isocost line is where w represents the wage rate of labour, r
represents the rental rate of capital, K is the amount of capital used, L is the amount of
labour used, and C is the total cost of acquiring those quantities of the two inputs. The
absolute value of the slope of the isocost line, with capital plotted vertically and labour
plotted horizontally, equals the ratio of unit costs of labour and capital.
The slope is: The isocost line is combined with the isoquant map to determine the
optimal production point at any given level of output. Specifically, the point of tangency
between any isoquant and an isocost line gives the lowest-cost combination of inputs that
can produce the level of output associated with that isoquant. Equivalently, it gives the
maximum level of output that can be produced for a given total cost of inputs. A line joining
tangency points of isoquants and is costs is called the expansion path.

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 Basic Microeconomics
Isoquant

Figure 5.4
Isoquant Map

An isoquant is a curve which shows the different combinations of capital (K) and labor
(L), which yield the same level of output. An isoquant is a firm’s counterpart of the
consumer’s indifference curve. ‘Iso’ means equal and ‘quant’ means quantity. Therefore, an
isoquant represents a constant quantity of output.
The isoquants show the combinations of labor and capital that produce various levels
of output. Isoquants farther from the origin correspond to higher levels of output. Points a,
b, c and d are various combinations of labor and capital the firm can use to produce 24 units
of output. A shift of an isoquant to the right means that there is an increase in production,
while a shift to the left denotes a decline in production. We will now proceed to the
characteristics of isoquant.

Characteristics of Isoquant
1. Negatively Sloped. The negatively sloped isoquant can be explained through the
diminishing marginal rate of technical substitution (MRTS). Marginal Rate of Technical
Substitution is the amount of capital that a producer is willing to give up in exchange
of labor and still lies on the same isoquant. We can say that MRTS is the slope of
isoquant. This is shown in this equation:
∆𝐾
MRTS = -
∆𝐿
MRTS is also equal to the ratio of the marginal product of labor to marginal
product of capital, or
∆𝐾 𝑀𝑃𝑘
MRTS = - ∆𝐿 = 𝑀𝑃𝐿
2. Convex to the Origin. An isoquant is convex to the origin because of the
diminishing MRTS, meaning, a producer is willing to give up less and less of capital
to gain additional amount of labor. The less remaining capital makes it more
valuable than additional labor.
3. Do not intersect. This figure illustrates why isoquants do not intersect. In Isoquant
I, points H and I create the same level of production. In isoquant II, point H and J
also produce the same level of production. It follows that points I and J have equal
level of production even though the producer is using different level of capital and
labor. If they intersect each other, there would be a contradiction and we will get
inconsistent results

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 Basic Microeconomics

Figure 5.5
Isoquants do not intersect

To further elaborate, we have this Example:

Table 5.2
Levels of Isoquant Schedule

The table shows points on three different isoquants. Plotting three points on the
same set of axes and joining them by smooth curves, we get a map of isoquants shown in
the next figure.

Figure 5.6
Maps of Isoquant

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 Basic Microeconomics
Finding the Producer’s Equilibrium

Economic production is the result of the output we produce by employing factors like
land, labour, capital, and entrepreneurship. It is possible to determine the optimum amount
of production possible considering different combinations of these inputs. Such a
determination is called the producer’s equilibrium. A producer is in equilibrium graphically
when given his total outlay and the factor prices, the producer maximizes the production.
This is shown by the point of tangency between the isocost and isoquant.

Suppose that total outlay increases from 12 pesos to 20 pesos and 28 pesos, where
the price of capital is 1 peso and the price of labor is 2 [Link] can now derive the
producer’s equilibrium in Figure 5.7.

Figure 5.7
Producer’s Equilibrium

At the points of tangency, the absolute slopes of the isoquant and isocost are equal.
𝑃
𝑀𝑃𝐾𝑆 = 𝐿
𝑃𝑘

Since MRTS= MPL/ MPK , at equilibrium:

𝑀𝑃𝐿 𝑃𝐿
=
𝑀𝑃𝑘 𝑃𝑘
After finding the producer’s equilibrium, it is much safe to check it through the use of
this formula:
TO = KoPk + LoPL
TO = total outlay
Ko = equilibrium capital
Pk = price of capital
Lo = equilibrium level of labor
PL = Price of labor

Refer to Figure 5.7 at Isoquant I, the optimal combination is in point a where capital =
6 and labor = 3. To check we multiply 6 to the price of capital which is 1 peso and we add the
factor of 3 multiplied by the price of labor which is 2. We will get 6 in both. Then we will add
it together so we can get 12. The optimum combination of capital and labor to get the total
outlay of 12 pesos is in point a. The following table shows the same with Isoquants II and III.

Table 5.3

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 Basic Microeconomics
Optimal Combination

The least cost combination of factors or producer's equilibrium is now explained with
the help of isoquant and isocosts. The optimum combination or the least cost combination
refers to the combination of factors with which a firm can produce a specific quantity of
output at the lowest possible cost.

End of Chapter Test

1. The main function of the firm is to engage in production in which the primary activity is
to:
A. Gather resources for production
B. Sell all of the output produces
C. Convert raw materials to finish product
D. Design the most efficient process in the production

2. The following are the elements of production EXCEPT for:

A. Input
B. Output
C. Techniques
D. Process

3. The production set is composes of:

A. Set of inputs and outputs that is technically feasible
B. Set of inputs and outputs that is technically efficient
C. Set of inputs and outputs that is technically inefficient
D. Set of inputs and outputs that is technically not feasible

4. Why it is important to determine the value of average product?

A. To determine the level of productivity of the set of workers that they have
B. To determine the contribution of one worker to the total production
C. To determine the basis of setting the price
D. To determine the technically efficient set of workers at a given output.

5. If you’re going to decide how many inputs/ workers should you hire, which of the
following will be your basis of decision?
A. It is the peak of Total Product
B. It is the peak of MP
C. It is the point of intersection between MP and AP
D. It is the portion when MP is positive

6. Which of the following is true about production function?

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 Basic Microeconomics
A. Labor is constant in the short-run since it is easy to add workers than machine
B. Capital is a variable resources in the short-run since machines, buildings and
vehicles cannot be operated without workers
C. Capital is constant in the short-run since it takes time to change the set of
machine and building the firm have.
D. All of the above

7. When marginal product is equal to zero, we may conclude that:

A. Total product is positive
B. Total product is negative
C. Total product is on its peak
D. Total product is increasing

8. When MP is above AP:

A. MP is increasing
B. AP is increasing
C. MP is decreasing
D. AP is decreasing

9. On a total product hill, it composes the three axes, the Z axis determines the:
A. Level of output
B. Level of capital used
C. Level of labor used
D. Level of efficiency

10. Efficiency is one of the concepts that an economist and manager must understand.
Why do you think you need understand it?
A. Because it is useful in the field of production.
B. Because it is useful in the field of selling
C. Because it is useful to minimize the cost.
D. Because it is one way to maximize the profit.

11. How can we use the tool of isocost and isoquant in the production?
A. It will help us to determine the combination of goods and services we need to
produce.
B. It will help us to determine the combination of inputs we need to use in the
production.
C. It will help us to determine how many machine we need to use in order to
maximize the profit.
D. All of the above

12. Using resource saving technology is one method to achieve the efficiency. Which of
the following technology is common in all sectors?
A. Computer
B. Tractors
C. Robotics
D. All of the above

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 Basic Microeconomics

For the number 14- 16, refer to the graph.

K

10

3
1000
100 200 L
2 3 10

13. In order to produce 1,000 units of output, how many units of labor should you used?
A. 2
B. 5
C. 10
D. 3

14. In order to produce 1,000 units of output, how many units of capital should you used?
A. 2
B. 5
C. 200
D. 100

15. When your budget in production increases to 200, which of the following should you
do in order to maximize your resources?
A. Increase my production
B. Decrease my production
C. Increase my budget
D. Decrease my budget

16. Diminishing returns refers to the decrease in…

A. long-run average cost that results from increases in output.
B. average total cost that results from decreases in input prices.
C. profit that results from increases in output.
D. average product that results from increases in the variable input.

17. If a firm is producing a given level of output in a technically-efficient manner, then it

must be the case that…
A. it is choosing the lowest-cost method of producing that output.
B. this output level is the most that can be produced with the given levels of
inputs.
C. each input is producing its maximum marginal product.
D. both a and b

18. If a firm is producing a given level of output in an technically-feasible manner, then it

must be the case that…

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 Basic Microeconomics
A. it is choosing the lowest-cost method of producing that output.
B. The output level is greater than the input used.
C. The input level is greater than output level.
D. Both A and B

Please answer the following questions as instructed.

1. The following is the production schedule of Glennsky Enterprises. Fill the

missing value for

Average Product (AP) and Marginal Product (MP). (18 pts).

Land Labor Total Product Average Marginal

Product Product
1 0 0
1 1 6
1 2 16
1 3 24
1 4 30
1 5 34
1 6 34
1 7 32
1 8 26

2. Using the following data on the table below, at what points do diminishing returns
begin? Please show your computation. (22 pts).
Points Units of Labor (L) Total Product
(Quantity/day
A 0 0
B 1 27
C 2 62
D 3 95
E 4 122
F 5 126
G 6 125

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 Basic Microeconomics
Chapter 6
Theory of Cost and Profit

INTRODUCTION

The production and sale of goods and services are always profit-motivated.
However, production depends on certain factors like the law of diminishing marginal returns
and marginal productivity. Cost is the most important consideration in production. A
producer will not just jump into a particular investment by simply looking at the potential
revenue of the business.
Revenue may be substantial but the producer will think twice because of the
implication on the pricing of the commodity. Consumers will not be so enthusiastic in
patronizing the offered product if the price is quite high. Inefficiency in the production
process has a direct impact on cost, because it takes away the incentives being rewarded by
the market for producers that are not wasteful. The market forces the producer to manage
cost of production by finding the least cost in expanding output.
In this module, we will study how cost and profit affect market behavior.
Likewise, we will look into the nature and types of cost, and the basis for a firm in
leaving the market. Different cost concepts are used to answer questions important
to the firm.
INTENDED LEARNING OUTCOMES
After studying this module, students will be able to:
1. Define Cost and Profit.
2. Differentiate Economic Cost from Accounting Cost.
3. Explain the Different Types of Cost.
4. Construct a Graph of the Different Types of Cost.
5. Differentiate Total Revenue from Marginal Revenue.
6. Distinguish between Economic and Accounting Profit.
7. Identify Profit Maximization and Loss Maximization.
8. Identify the classification of Profit.
9. Identify the types of Economic Cost.
10. Discuss and explain decision to operate or shut down.

Profit, Total Revenue and Total Cost

The firms main goal or objective is to maximize profit. As we all know, profit is
computed as the difference of Total Revenue and Total Cost
Π = TR – TC

Economic versus Accounting Profit

After differentiating the implicit and explicit cost, the next thing needed to understand
is the economic profit and accounting profit. Economic profit is the total revenue minus
total cost, including both explicit and implicit costs. Meanwhile, accounting profit refers to
the firm’s total revenue minus only the firm’s explicit costs.
The one that we usually compute using financial statement is the accounting profit.
Economic profit is more reliable in determining a certain economic activity is worth of
investing for. Economic cost and gains usually used in doing the benefit-cost analysis.

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 Basic Microeconomics

Figure 6.1
Economic versus Accounting Profit

Components of Calculating Profit

As defined in previous section, profit is the difference between total revenue and total
cost. Total revenue is the amount of goods being sold or services being rendered. This can
be computed as quantity sold multiply by its price.
TR = P X Q
Total Cost is the market value of the inputs a firm uses in production. A firm’s cost of
production includes all the opportunity costs of making its output of goods and services. A
firm’s cost of production includes explicit costs and implicit costs.
• Explicit costs are input costs that require a direct outlay of money by the firm.
• Implicit costs are input costs that do not require an outlay of money by the
firm.

Opportunity cost
 The value of the next best alternative that is forgone when another alternative is
chosen.
 The opportunity cost of a particular alternative is the payoff associated with the best
of the alternatives that are not chosen.

Example: What is the cost to an airline of using one of its planes in scheduled
passenger service?
 An airline’s expenditures on fuel and salaries are explicit costs
 Whereas the income it forgoes by not leasing its jets is an implicit cost.
 The sum total of the explicit costs and the implicit costs represents what the
airline sacrifices when it makes the decision to fly one of its planes on a
particular route which is the opportunity cost.

Case No. 6.1

Suppose that you own and manage your own business and that you are
contemplating whether you should continue to operate over the next year
or go out of business. If you remain in business, you will need to spend
PhP100,000 to hire the services of workers and PhP80,000 to purchase
supplies; if you go out of business, you will not need to incur these
expenses. In addition, the business will require 80 hours of your time every

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 Basic Microeconomics
week. Your best alternative to managing your own business is to work the
same number of hours in a corporation for an income of PhP75,000 per year

In case number 6.1, the opportunity cost of continuing in business over the next
year is PhP255,000. This amount includes an explicit cost of PhP180,000—the required cash
outlays for labor and materials; it also includes an implicit cost of PhP75,000—the income
that you forgo by continuing to manage your own firm as opposed to choosing your best
available alternative.

TOTAL AND MARGINAL REVENUE

• Total Revenue. In economics refers to the total receipts from sales of a given
quantity of goods or services. It is the total income of a business and is calculated by
multiplying the quantity of goods sold by the price of the goods. For example, if company A
produces 100 notebooks and sells them for Php50 each, the total revenue would be 100 *
Php50 = Php5, 000. In economics, total revenue is often represented in a table or as a curve
on a graph.
• Marginal Revenue is the additional revenue generated from the sale of an
additional unit of output. In other words, it's the change in total revenue from the sale of
one more unit of a good. For example, if Company A sold one more notebook and their
revenue increased from Php5, 000 to Php5, 050, the marginal revenue would be equal to
Php50.

Table 6.2
Points Q TC TR PROFIT (π)
A 0 1600 0 -1600
B 100 400 1600 1200
C 200 4600 3200 -1400
D 300 4800 4800 0
E 400 5048 6400 1352
F 500 5550 8000 2450
G 600 6400 9600 3200
H 700 8000 11200 3200
I 800 12800 12800 0

Likewise, using the same hypothetical data presented in Table 2, the firm icurs losses
during the span of its operation from points A to C, a situation in which a negative profit
occurs after deducting TC in column 3 to TR in column 4. The firm is in equilibrium level at
points D and I where, after subtracting TC from TR, we calculate a zero total profit. From
point E to H, the firm incurs profit. This produces a positive result after deducting TC from
TR. In symbols:
TR › TC = Profit
TR ‹ TC = Loss
TR =TC = Breakeven

Short-Run Cost Analysis

Short run for a firm is a time horizon when one input is held constant. To analyse the
short-run costs, it is essential to fix the level of capital and study the changes in the quantity
of labor hired. The following are the types of short-run costs:

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 Basic Microeconomics
The two basic types of costs incurred by businesses are fixed and variable. Fixed costs
do not vary with output, while variable costs do. Fixed costs are sometimes called overhead
costs.
1. Fixed cost are expenses that do not change in proportion to the activity of a
business, within the relevant period or scale of production. For example, a retailer must pay
rent and utility bills irrespective of sales. They are incurred whether a firm manufactures 100
widgets or 1,000 widgets. In preparing a budget, fixed costs may include rent, depreciation,
and supervisors' salaries. Manufacturing overhead may include such items as property taxes
and insurance. These fixed costs remain constant in spite of changes in output. It stays the
same no matter how much output changes.
A cost that does not change with an increase or decrease in the amount of goods or
services produced or sold. It is an expense that must be paid by a company, independent of
any specific business activities. Fixed cost does not change with the volume of production.
Examples are rent, salaries of top management, interest payments on borrowed
capital, insurance premiums, interest payments and most of the depreciation allowances of
plant and equipment.
2. Variable costs fluctuate in direct proportion to changes in output. In a
production facility, labor and material costs are usually variable costs that increase as the
volume of production increases. It takes more labor and material to produce more output,
so the cost of labor and material varies in direct proportion to the volume of output. It
varies with output and when output rises, variable cost rises; when output falls, variable
cost falls.
***Examples are payment for raw materials, utilities, fuel, shipping/freight costs,
wages, tax payments and the like.

Other types of cost

1. Total Cost is the sum of variable cost and fixed cost. It increases in total cost is
due to the increase in variable cost.
2. Marginal Cost is the cost of producing one additional unit of output. It can be
found by calculating the change in total cost when output is increased by one unit.
3. Average Fixed Cost (AFC). It is the fixed cost per unit of output. As the total
number of units of the good produced increases, the average fixed cost decreases because
the same amount of fixed costs is being spread over a larger number of units of output.
Average Fixed Cost (AFC) = TFC/Q where TFC is Total Fixed Cost, Q is total number of
units produced. Unit fixed costs decline along with volume, following a rectangular
hyperbola. As a result, the total unit cost of a product will decline as volume increases.
4. Average Variable Cost (AVC). It is a firm's variable costs (labor, electricity, etc.)
divided by the quantity of output produced.
Average Variable Cost (AVC) is the TVC of a firm divided by the total units of output
(Q).
AVC = TVC/Q where TVC is Total Variable Cost, and total number of units produced.
5. Average Cost/Average Total Cost (AC/ATC). Average Cost (AC) is the TC of a firm
divided by the total units of output (Q). AC = TC/Q = AFC + AVC
6. Marginal Cost is the change in total cost that arises when the quantity produced
changes by one unit. In general terms, marginal cost at each level of production includes any
additional costs required to produce the next unit. The additional cost incurred to produce
one additional unit of output is called the Marginal Cost (MC). MC = dC/dQ. It is the change
in the total cost when the quantity produced changes by one unit. It is the cost of producing
one more unit of a good. Marginal cost is not related to fixed costs.

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 Basic Microeconomics
Example:

In Table 6.1, the first four columns are hypothetical costs schedules (TFC,
TVC, and TC) and are plotted in Figure 6.2. We see that TFC is 30 pesos
regardless of the level of output represented by the straight line. TVC has
zero value when output is also zero, but it increases with the level of output.
The curve of the TVC is caused by the diminishing returns. The area between
the TC curve and the TVC curve is the TFC curve. Figure 6.3 shows the graph
of the next four costs schedule which is AFC, AVC, ATC, and MC. In Figure
6.1, the AFC curve is continuously declining as output expands but does not
touch the axis, while the area between ATC and AVC is the AFC. Notice that
the MC curve is graphed between two points because it is derived between
successive points. Observe that AFC, AVC, and ATC are U=shaped and the MC
cuts at the lowest point of AVC and AC.

Table 6.1
Hypothetical Cost Schedule
Q TFC TVC TC AFC AVC ATC MC
0 30 0 30 - - - -
1 30 15 45 30 15 45 15
2 30 20 50 15 10 25 5
3 30 22.5 52.5 10 7.5 17.5 2.5
4 30 27.5 57.5 7.5 6.875 14.375 5
5 30 37.5 67.5 6 7.5 13.5 10
6 30 60 90 5 10 15 22.5

100

80

60 TFC
TVC
40
TC
20

0
1 2 3 4 5 6 7

Figure 6.2
Total Cost, Total Fixed Cost, Total Variable Cost Curves

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 Basic Microeconomics

50

40
AFC -
30
AVC -
20 ATC -

10 MC -

0
1 2 3 4 5 6

Figure 6.3
Average Total Cost, Average Fixed Cost, Average Variable Cost and Marginal Curves

Why does the MC Curve pass through the AVC and ATC curves at their minimum points?

The Marginal Cost (MC) curve intersects the average total cost (ATC) curve at its
lowest point because once the marginal cost exceeds the average cost, the average cost
starts to increase. When marginal cost is less than average cost, the average cost falls as
production increases. The minimum average cost is reached when the average cost falls to
the same level as the marginal cost. As marginal cost increases above the minimum average
cost, the average cost begins to rise.

Average Total Cost and Marginal Cost are connected because they are derived from
the same basic numerical cost data. The general rules governing the relationship are:
1. Marginal Cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling,
and when marginal cost is above average total cost, average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also
where Average Total Cost (ATC) = Marginal Cost (MC).

Why are the AVC and ATC curved-U Shaped?

Average Total Cost starts off relatively high, because at low levels of output total
costs are dominated by the fixed cost; mathematically, the denominator is so small that
average total cost is large. Average total cost then declines, as the fixed costs are spread
over an increasing quantity of output. In the average cost calculation, the rise in the
numerator of total costs is relatively small compared to the rise in the denominator of
quantity produced. But as output expands still further, the average cost begins to rise. At the
right side of the average cost curve, total costs begin rising more rapidly as diminishing
returns kick in.
The nature ‘U’ shaped short-run Average Cost curve can be attributed to the law of
variable proportions. This law tells that when the quantity of one variable factor is changed
while keeping the quantities of other factors fixed, the total output increases with an
increasing rate and then declines with more than proportionate.
Thus, the Average Costs of the firms continue to fall as output increases because it
operates under the increasing returns due to various internal economies. Due to the
operation of the law of increasing returns the firm is able to work with the machines to their
optimum capacity and as a consequence the Average Cost is minimum.

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 Basic Microeconomics
The average variable cost curve is U-shaped. Average variable cost is relatively high
at small quantities of output, then as production increases, it declines, reaches a minimum
value, then rises. This shape of the average variable cost curve is indirectly attributable to
increasing, then decreasing marginal returns (and the law of diminishing marginal returns).

Why does the AVC curve begin to rise?

The average variable cost (AVC) curve will at first slope down from left to right, then
reach a minimum point, and rise again. AVC is ‘U’ shaped because of the principle of variable
proportions, which explains the three phases of the curve:

1. Increasing returns to the variable factors, which cause average costs to fall,
followed by:
2. Constant returns, followed by:
3. Diminishing returns, which cause costs to rise

Long run Cost Analysis

As mentioned in the previous chapter, there are no any fixed resources or input of
production in the long-run. Thus in long cost analysis; there is no fixed cost as well. Similar
with short run analysis, total cost, total fixed cost and total variable cost have similar
behaviour. However, in long run there are some concepts associated with long run average
cost curves.

Figure 6.5
Long run Average Cost Curve
In figure 6.5, the long-run average cost curve can be divided into three parts;
economies of scale, constant return to scale and diseconomies of scale.
Economies of scale is a condition in which firm incurs decreasing long-run average
cost as the output increases. This is favourable condition in firm since it may lead to
decreasing price. As output increases, the average cost of producing that output is likely to
decline, at least to a point. Some of the reasons why this is occur are:
1. If the firm operates on a larger scale, workers can specialize in the activities at
which they are most productive
2. Scale can provide flexibility. By varying the combination of inputs utilized to
produce the firm’s output, managers can organize the production process more
effectively
3. The firm may be able to acquire some production inputs at a lower cost because it
is buying them in large quantities and can, therefore, negotiate better prices. The
mix of inputs might change with the scale of the firm’s operation if managers take
advantage of lower-cost inputs.
A diseconomy of scale is a condition that the long-run average cost increases as
output increases. Some of the reasons why there are diseconomies of scale are:

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 Basic Microeconomics
1. At least in the short-run, factory space and machinery may make it more difficult
for workers to do their jobs effectively.
2. . Managing a larger organization may become more complex and inefficient as the
number of tasks increases
3. The advantages of buying in bulk may have disappeared once certain quantities
are reached. At some point, available supplies of key inputs may be limited,
pushing up costs.
Constant Return to Scale is a condition in which long run average cost remains the
same as output increases.

End of Chapter Test

1. A firm that uses it is own building for the production purposes is an example of?
a. explicit cost
b. implicit cost
c. sunk cost
d. non sunk cost

2. It is the cost of variable of factors of production

a. fixed cost
b. total cost
c. variable cost
d. marginal cost

3. The relationship between cost per unit of output and the level of output ceteris paribus.
a. short run average cost
b. short run marginal cost
c. long run average cost
d. long run marginal cost

4. It shows for each unit of output, the added total cost incurred in the long run. It shaped like
economies and diseconomies of scale.
a. short run average cost
b. short run marginal cost
c. long run average cost
d. long run marginal cost

5. When our input increases by 2, our output increases exactly by 2.

a. economies of scale
b. diseconomies of scale
c. constant return to scale
d. answer not given

6. Total cost divided by the quantity of output.

a. average variable cost
b. average fixed cost
c. average total cost

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 Basic Microeconomics
d. marginal cost

7. The property whereby long run average total cost rises as the quantity of output increases.
a. economies of scale
b. diseconomies of scale
c. constant return to scale
d. answer not given

8. The market value of all inputs that a firm uses in production.

a. fixed cost
b. variable cost
c. total cost
d. marginal cost

9. The increase in total cost that arises from an extra unit of production.

a. fixed cost
b. variable cost
c. total cost
d. marginal cost

10 .Cost that are incurred only if a particular decision is made.

a. avoidable cost
b. unavoidable cost
c. implicit cost
d. explicit cost

11. Average product of labor increases when it is _________ the MPL.

a. equal
b. above
c. below
d. none of the above

12. When AP is neither increases nor decreases in labor, meaning we are at point in which APL is at
maximum, then?
a. MP = AP
b. MP < AP
c. MP > AP
d. none of the above

13. The following are the reasons why there an economies of scale EXCEPT:
a. technical and managerial divisibilities
b. higher degree of specialization
c. dimensional relations
d. none of the above

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 Basic Microeconomics
14. A diseconomy of scale was cause by___________.
a. diminishing return to management
b. exhaustibility of natural resources
c. increase in output forces, increase in spending.
d. all of the above

15. The following are the cost curves features usually seen on a typical firms, EXCEPT:
a. marginal cost rises with the quantity of output
b. the average total cost curve is V-shaped
c. the marginal cost curve crosses the average total cost curve at the minimum of average total cost.
d. none of the above

Part II. Answer the following questions as instructed.

1. A single firm operating in the short-run has a fixed amount of capital and 2 units of a
variable amount of labor. Suppose the cost of single unit of capital is 100 and the cost of
hiring workers is 10. Find the following: VC, FC, TC, MC, AVC, AFC, and ATC.
L K TP/Q VC FC TC MC AVC AFC ATC
0 1 0
2 1 5
4 1 15
6 1 20
8 1 24
10 1 27
12 1 30

2. Plot the graph and explain what happen to SMC, AVC, AFC and ATC in
the short run total cost curve.
3. Based on the following cost information below:

Quantity (Q) Fixed Cost (FC) Variable Cost VC)

1 5 8
2 5 15
3 5 23
4 5 32
5 5 42
3.1 What is the Total Cost of producing 3 units?
3.2 What is the Average Total Cost of producing 3 units?
3.3 What is the Marginal Cost of producing the 4th unit of output?

4. Using the following data below, compute the following: TC, MC, AFC, AVC, and ATC.(40
pts)
Output Total Total Total Marginal Average Average Total
Fixed Variable Cost Cost Fixed Variable Average
Cost Cost Cost Cost Cost
1 100 50
2 100 80
3 100 100
4 100 110
5 100 150

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 Basic Microeconomics
6 100 220
7 100 350
8 100 640

Plot the graph and explain the relationship between Long-Run Average and
Marginal Cost Curves

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 Basic Microeconomics
Chapter 7
Perfectly Competitive Market

INTRODUCTION
All businesses face two realities: no one is required to buy their products, and even
customers who might want those products may buy from other businesses instead. Firms
that operate in perfectly competitive markets face this reality. In this chapter we will learn
how such firms make decisions about how much to produce, how much profit they make,
whether to stay in business or not, and many others. Industries differ from one another in
terms of how many sellers there are in a specific market, how easy or difficult it is for a new
firm to enter, and the type of products that are sold. This is referred to as the market
structure of the industry.

INTENDED LEARNING OUTCOMES:

After studying this module, students will be able to:
1. Define and explain what “perfect competition’ is.
2. Identify and explain the assumptions/conditions/characteristics of perfect competition.
3. Discuss the determination of short-run and long-run periods.
4. Identify the profit maximization, shutdown and loss.

Perfect competition/market is a market structure which consists of a very large

number of buyers and sellers offering a homogeneous product. Under such condition, no
firm can affect the market price. Price is determined through the market demand and supply
of the particular product, since no single buyer or seller has a real control over price.
Firms are said to be in perfect competition when the following conditions occur: (1)
many firms produce identical products; (2) many buyers are available to buy the product,
and many sellers are available to sell the product; (3) sellers and buyers have all relevant
information to make rational decisions about the product being bought and sold; and (4)
firms can enter and leave the market without any restrictions—in other words, there is free
entry and exit into and out of the market.

Market Structure
Individual commonly changes its behaviour depending on their environment.
Similarly, firms also vary its behaviour depending on the environment. The environment of
the firm is the market structure. How the market will behave, depending on the number of
buyers or sellers, its dimensions, the existence of entry and exit barriers, etc. will determine
how equilibrium is reached.
A market is a composed of buyers and sellers, who through their interaction, both real
and potential, determine the price of a commodity.. The concept of a market structure is
therefore understood as those characteristics of a market that influence the behaviour and
results of the firms working in that market.
The main aspects that determine market structures are: the number of buyer and
sellers in the market, their relative bargaining power, in terms of ability to set prices; the
degree of concentration among them; the degree of differentiation and uniqueness of
products; and the ease, or not, of entering and exiting the market. The interaction and
differences between these aspects allow for the existence of several market structures.
Market structure can be presented using figure 7.1

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Market Structure

Perfect Imperfect Competitive

Competitive Market

Monopoly Monopolistic Oligopoly

Competition

Figure 7.1
Market Structure

As shown in Figure 7.1, market structure can be divided into two; perfectly
competitive market and imperfect competitive market. Under perfectly competitive market
are monopoly, monopolistic competitive market and oligopoly. Discussion of perfectly
competitive market will be discussed in this chapter while imperfect competitive market will
be on the succeeding chapter.

Perfect competition: Conditions

• A large number of sellers, each acting independently and not colliding with
any other.
• Selling a homogeneous product
• No artificial restrictions placed upon price or quantity
• Easy entry and exit
• All buyers and sellers have perfect knowledge of market conditions and any changes
that occur in the market
• Firms are “price takers”

A perfectly competitive firm is known as a price taker, because the pressure of

competing firms forces them to accept the prevailing equilibrium price in the market. If a
firm in a perfectly competitive market raises the price of its product by so much as a penny,
it will lose all of its sales to competitors. When a wheat grower wants to know what the
going price of wheat is, he or she has to go to the computer or listen to the radio to check.
The market price is determined solely by supply and demand in the entire market and not
the individual farmer. Also, a perfectly competitive firm must be a very small player in the
overall market, so that it can increase or decrease output without noticeably affecting the
overall quantity supplied and price in the market.

The Revenue of a Competitive Firm

A firm in a competitive market tries to maximize profit, which equals total revenue
minus total cost. The average revenue is total revenue divided by the quantity sold (amount
of output). Average revenue tells us how much revenue a firm for the typical unit sold. (total
revenue is P x Q , price times quantity).

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The marginal revenue is the change in total revenue from the sale of each additional
unit of output. Total revenue is P x Q and P is fixed for a competitive firm. Therefore, when Q
rises by 1 unit, total revenue rises by P euros. For competitive firms, marginal revenue
equals the price f the good (attention: ONLY FOR COMPETITIVE MARKETS).

Formula:
• Total Revenue (TR = P X Q)
• Average Revenue (AR = TR / Q)
• Marginal Revenue (MR = ΔTR /ΔQ)

Profit Maximization and the Competitive Firm’s Supply Curve

A simple example of profit maximization

If marginal revenue is greater than marginal cost the firm should increase the
production. If marginal revenue is less than marginal cost, the firm should decrease
production. If the firms think at the margin and make incremental adjustments to the level
of production, they are naturally led to produce the profit maximizing quantity.

The Marginal Cost Curve and the Firm’s Supply Decision

Figure 7. 2
Cost and Supply Curve of Firm under Perfectly Competitive Market

In general, we use the rule that at the profit-maximizing level of output, marginal
revenue and marginal cost are exactly equal. Because a competitive firm is a price taker, its
marginal revenue equals the market price. For any given price, the competitive firm’s profit-
maximizing quantity of output is found by looking at the intersection of the price with the
marginal cost curve. When the price rises, the firm finds that marginal revenue is now higher
than marginal cost that the previous level of output, so that the firm increases production.

Overall, the following conditions determine the profit maximization points are:
 MR=MC
 P = MC
 AR = AC

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The firm supply curve is the portion of MC upwards from the intersection point of
AVC. In Figure 7.1, the supply curve is the solid portion of MC from the intersection of AVC.
Thus, firm will start producing the goods at P with the quantity at M.

The Firm’s Short-Run Decision To Shut Down

In some circumstances the firm will decide to shut down and not produce anything
at all. Here we should distinguish between a temporary shutdown of a firm and the
permanent exit from the market. A shutdown refers to a short-run decision. Exit refers to a
long-run decision. These decisions differ because most firms cannot avoid their fixed costs in
the short run but can do so in the long run.
If the firm shuts down, it loses all revenue from the sale of its product. At the same
time, it saves the variable cost of making its product. Thus the firm shuts down if the
revenue that it would get from producing is less than its variable cost of production.
Mathematics:
 Shut down if TR < VC
𝑇𝑅 𝑉𝐶
 Shut down if <
𝑄 𝑄
 Shut down if P < AVC
If the price doesn’t cover the average variable cost, the firm is better off stopping
producing altogether. The firm might reopen it the conditions change. If the firm produces
anything, it produces the quantity at which marginal cost equals the price of the good. Yet it
the price is less than average variable cost at the quantity, the firm is better off shutting
down.

Spilt Milk And Other Sunk Costs

Economists say that a cost is a sunk cost when it has already been committed and
cannot be recovered. Sunk costs cannot be avoided regardless of the choices you make. (If
you cannot erase the cost; if something has already been invested like in infrastructure or if I
want to go to the cinema, buy a ticket and lose it). Because nothing can be done about sunk
cost, you can ignore them when making decisions.

The Firm’s Long Run Decision To Exit Or Enter A Market

If the firm exits a market, it will lose all revenue from the sale of its product, but now
it saves both fixed and variable costs of production. Thus, the firm exits the market if the
revenue it would get from producing is less than its total costs. Mathematics:
The firm will enter the market if such an action would be profitable, which occurs if
the price of the good exceeds the average total cost of production. The entry criterion is:
Enter P > ATC

Measuring Profit in Our Graph for the Competitive Firm

The profit equals total revenue (TR) minus total cost (TC). As can be noted in figure
7.3, If the price in market is 12, the firm will produce 10 units. Therefore the total revenue is
120 (12x10). Looking on the AC curve, when firm produces 10, it average cost associated
with production is equal to 9. Therefore, the total cost of producing 10 units is 90 (9x10).
Getting the difference between TR and Total Cost (TR-TC) we will come up with a Profit of
30 (120-90), which is the shaded part.

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12

8
Tota Tota

Revenue Cost

10

Figure 7.3
Graphical Presentation of Firms with Profit

10

8 MR= P= AR

6 12
Figure 7.4
Graphical Presentation of Firms with Loss

Figure 7.4 shows the graph of the firm’s condition when there is loss. Since the profit
maximization/ loss minimization condition is MR=MC, the firm must produce at 12.
Calculating the total revenue, TR = 96 (8 x 12). To calculate the total cost, we will look the
ATC cost curve. At Q=12, the ATC= 10 therefore Total Cost is equal to 120 (TC=10x12). With
this, we can say that firm incurred loss amounting to 24 (Profit/Loss = 96-120= -24)

The Long Run: Market Supply with Entry and Exit

Now consider what happens if the firms are able to enter or exit the market. Let’s
suppose that everyone has access to the same technology for producing the good and access
to the same markets to buy the inputs into production. Therefore, all firms and all potential
firms have the same cost curves.

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If firms already in the market are profitable, then new firms will have an incentive to
enter the market. This entry will expand the number of firms, increase the quantity of the
good supplied, and drive down prices and profits. Conversely, if firms in the market are
making losses, then some existing firms will exit the market. Their exit will reduce the
number of firms; decrease the quantity of the good supplied and drives up prices and
profits. At the end of this process firms that remain in the market must be making zero
economic profit (Profit=(P-ATC) x Q) An operating firm has zero profit if and only if the price
of the good equals the average total cost of producing that good.
The long-run equilibrium of a competitive market with free entry and exit must have
firms operating at their efficient scale. (price = marginal cost in competitive markets M free
entry and exit forces price to equal average total cost; price equal marginal and average
total cost; marginal and average total cost equals each other = efficient scale).

WHY DO COMPETITIVE FIRMS STAY IN BUSINESS IF THEY MAKE ZERO PROFIT?

To answer this question, we must keep in mind that profit equals total revenue
minus total cost, and that total cost includes all the opportunity costs of the firm. In
particular, total cost includes the opportunity cost of the time and money that firm owners
devote to the business.

End of Chapter Test

Choose the one alternative that best completes the statement or answers the question.

1) Perfect competition is an industry with

A) a few firms producing identical goods.
B) many firms producing goods that differ somewhat.
C) a few firms producing goods that differ somewhat in quality.
D) many firms producing identical goods.
2) In a perfectly competitive industry, there are
A) many buyers and many sellers.
B) many sellers, but there might be only one or two buyers.
C) many buyers, but there might be only one or two sellers.
D) one firm that sets the price for the others to follow.

3) In perfect competition, the product of a single firm

A) is sold to different customers at different prices.
B) has many perfect complements produced by other firms.
C) has many perfect substitutes produced by other firms.
D) is sold under many differing brand names.
4) In perfect competition, restrictions on entry into an industry
A) do not exist.
B) apply to labor but not to capital.
C) apply to both capital and labor.
D) apply to capital but not to labor.
5) In perfect competition,
A) there are significant restrictions on entry.
B) each firm can influence the price of the good.
C) there are few buyers.
D) all firms in the market sell their product at the same price.

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6) In perfect competition, a firm that maximizes its economic profit will sell its good
A) below the market price.
B) above the market price.
C) below the market price if its supply curve is inelastic and above the market price if
its supply curve is elastic.
D) at the market price
7) Economists assume that a perfectly competitive firm's objective is to maximize its
A) revenue.
B) economic profit.
C) output price.
D) quantity sold

8) The break-even point is the output level at which

A) average cost equals average revenue.
B) average fixed cost equals average variable cost.
C) marginal cost equals marginal revenue.
D) total cost equals total revenue

9) Economic profit is maximized when

A) marginal revenue equals marginal cost.
B) marginal revenue is greater than marginal cost.
C) marginal revenue is less than marginal cost.
D) total revenue equals total cost.

10) A firm shuts down if price falls below the minimum of

A) average total cost.
B) average fixed cost.
C) average variable cost.
D) marginal cost.

Part II. Answer the questions as instructed.

1. A firm’s marginal cost curve above the average variable cost curve is equal to the
firm’s individual supply curve. This means that every time a firm receives a price
from the market it will be willing to supply the amount of output where the price
equals marginal cost. What happens to the firm’s individual supply curve if marginal
costs increase?
2. How does a perfectly competitive firm decide what price to charge?
3. What prevents a perfectly competitive firm from seeking higher profits by increasing
the price that it charges?
4. How does a perfectly competitive firm calculate total revenue?
5. Since a perfectly competitive firm can sell as much as it wishes at the market price,
why can the firm not simply increase its profits by selling an extremely high
quantity?
6. The AAA Aquarium Co. sells aquariums for PhP20each. Fixed costs of production
are PhP20. The total variable costs are Php20 for one aquarium, PhP25 for two
units, PhP35 for the three units, Php50 for four units, and Php80 for five units. In the
form of a table, calculate total revenue, marginal revenue, total cost, and marginal
cost for each output level (one to five units). What is the profit-maximizing quantity
of output? On one diagram, sketch the total revenue and total cost curves. On
another diagram, sketch the marginal revenue and marginal cost curves.

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7. A computer company produces affordable, easy-to-use home computer systems and
has fixed costs of PhP250. The marginal cost of producing computers is PhP700 for
the first computer, PhP250 for the second, PhP300 for the third, PhP350 for the
fourth, PhP400 for the fifth, PhP450 for the sixth, and PhP500 for the seventh.
7.1 Create a table that shows the company’s output, total cost, marginal cost,
average cost, variable cost, and average variable cost.
7.2 At what price is the zero-profit point? At what price is the shutdown point?
7.3 If the company sells the computers for PhP500, is it making a profit or a loss?
How big is the profit or loss? Sketch a graph with AC, MC, and AVC curves to
illustrate your answer and show the profit or loss.
7.4 If the firm sells the computers for PhP300, is it making a profit or a loss? How
big is the profit or loss? Sketch a graph with AC, MC, and AVC curves to
illustrate your answer and show the profit or loss.

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Chapter 8
Imperfect Competitive Market

INTRODUCTION

As presented in Figure 7.1 from previous chapter, market structure can be divided into
two; perfectly competitive market and imperfect competitive market. The perfect
competitive market as discussed will be the basis of comparison for other type of market
structure.
In reality, no specific firm or product that may fall under perfectly competitive market.
In a national level, most of commodities and products fall under the imperfect competitive
market. Behaviour of the firm varies when it comes to monopoly, oligopoly and
monopolistic competitive market. In some books, there are several types of imperfect
competitive market, but for this module, we will focus only into three, monopoly, oligopoly
and monopolistic competitive market.

INTENDED LEARNING OUTCOMES

1. To explain how monopolist behaves based on characteristics, setting of price and
quantity, profit maximization condition and the deadweight loss.
2. To analyse and explain the firm behaviour under monopolistic competitive market as
compare to monopoly and perfectly competitive market.
3. To describe the behaviour of firms under oligopoly in terms of characteristics, setting
price and quantity and strategic behaviour.

Monopoly
Monopoly is considered the extreme of imperfectly competitive market. This is
characterized by many buyers and one sole seller of a product without close substitute. The
best examples of this in Philippines national level are the power supply distributor (Meralco;
Batelec and other cooperatives), railways services, and water services. To better understand
what monopoly is, the following are the characteristics:
1. Many buyers; one sole seller in one geographic area of a product without close
substitute.
2. Buyers are price taker; seller is price maker
3. Incur dead weight loss in making operation
4. There are high barriers to entry and exit.

There are many buyers, one sole seller of product without close substitute within a
specific geographic area. This characteristic refers to having only one seller of a product that
is no close substitute. Take an example of the power supply distributor. In specific
geographic area, merely Meralco distribute the electricity. Further, there is no close
substitute product that will replace their services.
Buyers are price taker; seller is price maker. This is characteristics of the market that
buyers just take the price set by the seller. Monopolist (referring to seller) sets price about
the market equilibrium as presented in Figure 8.1.
As it can be noted, the general condition of profit maximization (loss minimization) is
where MR=MC. In this case, the profit maximization condition is where firm must product of
Q= 5. At Q=5, when it based on competitive market firm will set price at P= 5 as well.
However, since they are the only seller in the market, rational monopolist will set it price as
high as 10. This is the portion of demand curve that is above the intersection point of
MR=MC.

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Price

10
8

5 B

Quantity
5 6

Figure 8.1
Monopolist Revenue, Cost and Demand Curve

Calculating the total revenue (TR), it is equal to 50 (5 x 10) while total cost (TC) is
equal to 40 (5 x 8). Therefore profit is equal to 10 (50-40). Take note, monopolist may set it
price at a maximum of 10 but they can offer other prices lower than 10. This process is called
as discrimination pricing. This type of pricing is done by monopolist that gives different set
of price depending on the type of buyers. In the example of Meralco, the firm provides
different rates to different types of clients. Those who consumes minimum have its own rate
compare to those in residential (who consume above the minimum consumption) at the
same time have different rate if it is commercial or industrial.

Incur deadweight loss in the operation. Because of this characteristic, monopolist

created a social cost which is called as dead weight loss. Deadweight loss is the social cost of
setting price above the equilibrium price. In Figure 8.1, dead weight loss is the triangle
portion created due to the intersection of MR and MC, D=AR and AC and the horizontal line
on the price of 10. To be specific, that is the triangle MCB. Calculating the deadweight loss,
we will use the formula for calculating area of a triangle since deadweight loss form a
triangle. The formula is:

1
Area of Triangle = 𝐵𝐻
2

1
In this case, deadweight loss is equal to (6-5)(10-5) which is equal to 2.5. This means
2
that societal loss due to having price above equilibrium price is amounting to 2.5.

There are high barriers to entry and exit. Barriers to entry and exit commonly refer to
factors that hinder for the firm to put up or open a business. There are two types of barriers;
legal and technological barrier. Legal barriers are those permits, laws and rules and
regulations that permit the firm to enter in the market. Technological barriers are the
necessary equipment, processes, steps and plant needed for the operation of the firm.
In case monopoly, there are high barriers needed since government usually owned
firms under this type of market structure. At the same time, there are some laws such as
copyright, patents and intellectual property rights that allow firm to produce the product by
themselves only. Firms under monopoly as well commonly hinder by technology by having

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high amount of plants and processes as well as equipment that makes it hard for a business
to put up.

Monopolistic Competition

Monopolistic competition is a market structure which combines elements of

monopoly and competitive markets. Essentially a monopolistic competitive market is one
with freedom of entry and exit, but firms can differentiate their products. Therefore, they
have an inelastic demand curve and so they can set prices. However, because there is
freedom of entry, supernormal profits will encourage more firms to enter the market
leading to normal profits in the long term. A monopolistic competitive industry has the
following features:
 Many firms producing differentiated products
 Freedom of entry and exit.
 Firms have price inelastic demand; they are price makers because the good is highly
differentiated
 Firms make normal profits in the long run but could make supernormal profits in the
short term
 Firms are allocatively and productively inefficient.

Many firms producing differentiated product. This is feature or characteristics of

market structure that somehow a resemblance with perfectly competitive market however
the product produce in this structure is unique and differentiated. An example of firm under
this type is the restaurants, movie producers, concerts and music production. This entire
firm have similar type however varies depending in the type of cuisines offered artist and
genre of movie and song.
Freedom of entry and exit. Since the product usually offered is almost the same but
offered variety of the product, it is easy for the firm to enter and exit in the market. There
are low legal and technological barriers that permit them to enter or exit in market.
Firms have price inelastic demand; they are price makers because the good is
highly differentiated. Since the market have many buyers and sellers, any changes in price
do not affect the quantity demanded. If the price increases, it is easy to shift from one
variety of products to another product that satisfies the sae needs and wants.
Firms make normal profits in the long run but could make supernormal profits in
the short term. In the short run, the diagram for monopolistic competition is the same as for
a monopoly. The firm maximises profit where MR=MC. This is at output Q1 and price P1,
leading to supernormal profit. This can be found in Figure 8.2.
As it can be noted, the firm under monopolistic competitive market behaves the same
with monopoly in terms of setting price and quantity. Supernormal profit incur due to the
behaviour of setting the quantity equals to the point where MR=MC then setting price above
the equilibrium price corresponding to the demand curve.

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Figure 8.2
Diagram monopolistic competition short run

Firms are allocatively and productively inefficient. Efficiency of firms in monopolistic

competition occurs to allocative inefficient. Figure 8.3 show a price set above marginal cost

Figure 8.3
Diagram monopolistic competition Long- run

Further, there is productive inefficiency as shown in Figure 8.3 that firm not producing
on the lowest point of AC curve. There is also a dynamic efficiency that makes possible as
firms have profit to invest in research and development. It is also known that X-efficiency
that makes possible as the firm does face competitive pressures to cut cost and provide
better products.

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Oligopoly
An oligopoly is a market structure in which a few firms dominate. When a market is
shared between a few firms, it is said to be highly concentrated. Although only a few firms
dominate, it is possible that many small firms may also operate in the market.
In some oligopolies, such as steel or oil, the product is identical, or undifferentiated,
across producers. Thus, an undifferentiated oligopoly sells a commodity, such as an ingot of
steel or a barrel of oil. But in other oligopolies, such as automobiles or breakfast cereals, the
product is differentiated across producers. A differentiated oligopoly sells products that
differ across producers, such as a Toy.
Because oligopolists are interdependent, analysing their behaviour is complicated. No
single model or single approach explains oligopoly behaviour completely. At one extreme,
oligopolists may try to coordinate their behaviour so they act collectively as a single
monopolist, forming a cartel, such as the Organization of Petroleum Exporting Countries
(OPEC).At the other extreme, oligopolists may compete so fiercely that price wars erupt,
such as those that break out among airlines, tobacco companies, computer chip makers, and
wireless service providers. Many theories have been developed to explain oligopoly
behavior. We will study three of the better-known approaches: collusion, price leadership,
and game theory. As you will see, each approach has some relevance in explaining observed
behavior, although none is entirely satisfactory as a general theory of oligopoly. Thus, there
is no general theory of oligopoly but rather a set of theories, each based on the diversity of
observed behavior in an interdependent market.

Characteristics of Oligopoly
Interdependence – If one oligopoly firm changes its price or its marketing strategy, it
will significantly impact the rival firm(s). For instance, if Pepsi lowers its price by 20 cents per
bottle, Coke will be affected. If Coke does not respond, it will lose significant market share.
Therefore, Coke will most likely lower its price too. Interdependence on decision- making.
Barriers to entry – It is difficult to enter an oligopoly industry and compete as a small
start-up company. Oligopoly firms are large and benefit from economies of scale. It takes
considerable know-how and capital to compete in this industry.
Oligopoly, a firm can earn super-normal profits in the long run as there are barriers to
entry like patents, licenses, control over crucial raw materials, etc. These barriers prevent
the entry of new firms into the industry.
Few Sellers - there are just several sellers who control all or most of the sales in the
industry. Under Oligopoly, there are a few large firms although the exact number of firms is
undefined. Also, there is severe competition since each firm produces a significant portion of
the total output.
Prevalent advertising – advertising is a powerful instrument in the hands of an
oligopolistic. A firm under oligopoly can start an aggressive advertising campaign with the
intention of capturing a large part of the market. Other firms in the industry will obviously
resist its defensive advertising.

Oligopoly firms frequently advertise on a national scale. Many world series, World cup finals
, NBA, NCAA finals advertisements are done by oligopoly forms.

Collusion or Cartel

Collusion and Cartels In an oligopolistic market, there are just a few firms so, to
decrease competition and increase profits, they may try to collude, or conspire to rig the
market. Collusion is an agreement among firms in the industry to divide the market and fix
the price. A cartel is a group of firms that agree to collude so they can act as a monopoly to

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increase economic profit. Cartels are more likely among sellers of a commodity, like oil or
steel.
Colluding firms, compared with competing firms, usually produce less, charge more,
block new firms, and earn more profit. Consumers pay higher prices, and potential entrants
are denied the opportunity to compete. Collusion and cartels are illegal in the United States
and other countries such as Philippines.

Game Theory

How will firms act when they recognize their interdependence but either cannot or do
not collude? Because oligopoly involves interdependence among a few firms, we can think
of interacting firms as players in a game. Game theory examines oligopolistic behavior as a
series of strategic moves and countermoves among rival firms. It analyzes the behavior of
decision makers, or players, whose choices affect one another. Game theory is not really a
separate model of oligopoly but a general approach, an approach that can focus on each
player’s incentives to cooperate—say, through cartels or price leaders—or to compete, in
ways to be discussed now. To get some feel for game theory, let’s work through the
prisoner’s dilemma, the most widely examined game.
The game originally considered a situation in which two thieves, let’s call them Ben
and Jerry, are caught near the crime scene and brought to police headquarters, where they
are interrogated in separate rooms. The police know the two guys did it but can’t prove it, so
they need a confession.
Each faces a choice of confessing, thereby “squealing” on the other, or “clamming up,”
thereby denying any knowledge of the crime. If one confesses, turning state’s evidence, he is
granted immunity from prosecution and goes free, while the other guy is put away for 10
years. If both clam up, each gets only a 1-year sentence on a technicality. If both confess,
each gets 5 years. What will Ben and Jerry do?
The answer depends on the assumptions about their behavior—that is, what strategy
each pursues. A strategy reflects a player’s game plan. In this game, suppose each player
tries to save his own skin—each tries to minimize his time in jail, regardless of what happens
to the other (after all, there is no honor among thieves).

Figure 8.4
Prisoners Dilemma (Pay-off Matrix) of years in jail

Figure 8.4 shows the payoff matrix for the prisoner’s dilemma. A payoff matrix is a
table listing the rewards (or, in this case, the penalties) that Ben and Jerry can expect based
on the strategy each pursues. Ben’s choices are shown down the left margin and Jerry’s
across the top. Each prisoner can either confess or clam up. The numbers in the matrix

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indicate the prison time in years each can expect based on the corresponding strategies.
Ben’s numbers are in red and Jerry’s in blue.
Take a moment now to see how the matrix works. Notice that the sentence each
player receives depends on the strategy he chooses and on the strategy the other player
chooses. What strategies are rational assuming that each player tries to minimize jail time?
For example, put yourself in Ben’s shoes.
You know that Jerry, who is being questioned in another room, will either confess or
clam up. If Jerry confesses, the left column of Exhibit 6 shows the penalties. If you confess
too, you both get 5 years in jail, but if you clam up, you get 10 years and Jerry “walks.” So, if
you think Jerry will confess, you should too. What if you believe Jerry will clam up? The right-
hand column shows the two possible outcomes. If you confess, you do no time, but if you
clam up too, you each get 1 year in jail. Thus, if you think Jerry will clam up, you’re better off
confessing. In short, whatever Jerry does, Ben is better off confessing.
The same holds for Jerry. He is better off confessing, regardless of what Ben does. So
each has an incentive to confess and both get 5 years in jail. This is called the dominant-
strategy equilibrium of the game because each player’s action does not depend on what he
thinks the other player will do. But notice that if each crook could just hang tough and clam
up, both would be better off. After all, if both confess, each gets 5 years, but if both clam up,
the police can’t prove otherwise, so each gets only 1 year in jail. If each could trust the other
to clam up, they both would be better off. But there is no way for the two to communicate
or to coordinate their actions. That’s why police investigators keep suspects apart, that’s
why organized crime.

Comparison of Different Market Structure

To sum it up, table 8.1 show the difference of each market structure.

Table 8.1
Comparison Matrix of Different Market Structure
PERFECT MONOPOLISTIC
OLIGOPOLY
CHARACTERISTICS COMPETITION COMPETITION MONOPOLY
Many buyers, no one Many buyers, no one Many buyers, no one
Many buyers, no one of
Size And Number Of of which is large of which is large of which is large
which is large relative to
Buyers relative to the overall relative to the overall relative to the overall
the overall market.
market. market. market.
Many sellers, no one
Many sellers, no one of Few sellers, each of
Size And Number Of of which is large
which is large relative to which is large relative One seller.
Sellers relative to the overall
the overall market. to the overall market.
market.
The outputs of
Degree Of Substitutability The outputs of The outputs of different
different sellers may There are no close
Among Different Sellers’ different sellers are sellers are
or may not be substitutes.
Products homogeneous. heterogeneous.
differentiated.
Buyers may or may
Extent To Which Buyers Buyers are well- Buyers may or may not Buyers are well-
not be well-informed
Are Informed About informed about the be well-informed about informed about the
about the offerings
Prices And Available offerings of the offerings of offerings of the sole
of competing
Alternatives competing suppliers. competing suppliers. supplier.
suppliers.
Technological and Either technological or
Neither technological
Neither technological legal barriers to entry legal barriers
nor legal barriers to
nor legal barriers to may or may not exist. completely block
entry exist.
Conditions Of Entry entry exist. entry.
Entry into the market Entry into the market
Entry into the market is
is free. may be blocked or Entry into the market
free.
free. is completely blocked.
Sellers are price Sellers are price
Seller Influence On Price Sellers are price makers. Seller is a price maker.
takers. makers.
Buyer Influence On Price Buyers are price Buyers are price takers. Buyers are price Buyers are price

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takers. takers. takers.

Extent of Strategic Sellers do not behave Sellers do not behave Sellers behave Seller does not behave
Behavior strategically. strategically. strategically. strategically.

End of Chapter Exam

I. MULTIPLE CHOICE: Read each statement carefully then answer the question that follows
by selecting the letter that corresponds to the best answer. Write your answer on the
answer sheet provided.

1. Which of the following best describes imperfect competition?

a. It offers differentiated product.
b. It has only one seller and few buyers.
c. It lies between monopoly and perfect competition.
d. It has several characteristics which may be attributed from monopoly.

2. Firms under oligopoly has a dilemma on:

a. Self interest and social welfare
b. Self interest and cooperation
c. Cooperation and social welfare
d. Social welfare and resources available

3. Firms under oligopoly will be benefited if:

a. Cooperation prevails c. Socially efficient prevails
b. Self interest prevails d. MR and MC are equal

4. The price of an oligopolistic firms is:

a. Greater than the price set by monopolist
b. Less than the price set by competitive firm
c. Greater than the price set by competitive firm
d. Both A and B

5. The quantity set by the firm under oligopoly is:

a. Greater than the quantity produce by monopolist
b. Less than quantity produce by competitive firm
c. Greater than the quantity produce by competitive firm
d. Answer not given
EXXON
Refer to the figure.
Drill two Drill one
wells well
$4 million $3 million
Drill two
$4 million profit $6 million profit
wells profit profit
TEXACO

$6 million $5 million
Drill one
profit $5 million profit
well$3 million
profit profit

6. If cooperation prevails in the competition, what is the outcome for both parties?
a. Texaco gains more profit than Exxon
b. Exxon gains more profit than Texaco

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 Basic Microeconomics
c. Both of them will gain $4 million
d. Both of them will gain $5 million

7. If self interest prevails on part of Texaco and cooperation on Exxon, how much will
be the profit of Exxon?
a. $3 million c. $5 million
b. $4 million d. $6 million

8. How firms under monopolistic competitive market set its price?

a. The same behavior as perfect competition
b. The same behavior as monopoly
c. The same behavior as oligopoly
d. Answer not given

9. How firms under monopolistic competitive market set the quantity to produce?
a. The same behavior as perfect competition
b. The same behavior as monopoly
c. The same behavior as oligopoly
d. Answer not given

10. What characteristic of monopolistic competitors can be attributed to perfect

competitive market?
a. Free entry and exit
b. The behavior of price setting
c. The behavior of quantity setting
d. Types of product being offered

11. Which of the following statement is true about the difference between perfect
competitive market and monopolistic competition?
a. In monopolistic competition there are few sellers while the perfect has many.
b. Monopolistic competition has excess gap while perfect competition has mark-
up.
c. Monopolistic competition has both excess gap and mark-up while perfect
competition has not.
d. Answer not given.

12. Which of the following is an example of positive externalities?

a. Pollution c. Innovation
b. Noise of car d. Barking of dogs

13. Which of the following product is subjected to sin tax?

a. Cigarette c. Bread
b. Baby Oil d. All of the above

14. Which of the following is the response of government to promote positive

externalities of a firm?
a. Tax
b. Subsidies
c. Patent Law
d. Both A and B
15. According to Coase Theorem, it is better to:

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 BASIC MICROECONOMICS

a. Promote public policies

b. Promote private policies
c. Have public policies to minimize transaction cost
d. Have private agreement if both parties are willing to shoulder the transaction
cost.

II. IDENTIFICATION: Read each statement carefully then determine the word or group
of words being described. Write your answer on the answer sheet provided.
1. The costs that parties incur in the process of agreeing to and following through on a
bargain.
2. A proposition that if private parties can bargain without cost over the allocation of
resources, they can solve the problem of externalities on their own.
3. taxes enacted to correct the effects of a negative externality
4. Involves altering incentives so that people take account of the external effects of
their actions.
5. Refers to the uncompensated impact of one person’s actions on the well-being of a
bystander.
6. Many firms selling products that are similar but not identical.
7. The graph of demand curve under monopolistic competiton.
8. a positive externality on consumers from the new entrants in monopolistic
completion
9. a negative externality on incumbent firm from the new entrants in monopolistic
completion
10. Refers to those market structures that fall between perfect competition and pure
monopoly.
11. Only a few sellers each offer a similar or identical product to the others.
12. an oligopoly with only two members
13. An agreement among firms in a market about quantities to produce or prices to
charge
14. A group of firms acting in unison.
15. a situation in which economic actors interacting with one another each choose their
best strategy given the strategies that all the others have chose

III. TRUE OR FALSE: Read each statement carefully then determine whether it is correct or
not. If the statement is correct write TRUE, otherwise FALSE.

1. The oligopoly price is greater than the monopoly price but less than the
competitive price (which equals marginal cost)
2. As the number of sellers in an oligopoly grows larger, an oligopolistic market
looks more and more like a competitive market
3. Prisoner’s dilemma is the study of how people behave in strategic situation.
4. Each firm knows that its profit depends only on how much it produces.
5. The dominated strategy is the best strategy for a player to follow regardless of
the strategies chosen by the other players.
6. In monopolistic competition, each firm faces a horizontal demand curve.
7. There is large excess capacity in perfect competition in the long run.
8. Economist has argued that brand names have no useful impact on the product
under monopolistic competition.
9. Critics argue that firms use advertising and brand names to take advantage of
consumer irrationality and to reduce competition

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 BASIC MICROECONOMICS

10. Defenders argue that firms use advertising and brand names to inform
consumers and to compete more vigorously on price and product quality.
11. Externalities cause markets to be inefficient, and thus fail to maximize total
surplus
12. When the impact on the bystander is adverse, the externality is called a positive
externality.
13. When the impact on the bystander is beneficial, the externality is called a
negative externality.
14. Negative externalities lead markets to produce a smaller quantity than is socially
desirable.
15. Positive externalities lead markets to produce a larger quantity than is socially
desirable.

IV. CLASSIFICATION: Classify each product what markets they are belong. Write Monopoly,
Perfect Competition, Monopolistic Competition. Oligopoly.
1. Rice
2. Sugar
3. Coffee
4. VCD (movie)
5. Fuel
6. Telecommunication
7. Electricity
8. Train Services
9. Soy Sauce
10. Vinegar
11. Wheat
12. Novels
13. Milk
14. Jeep Services
15. Cooking Oil

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References

Gabay, Kristoffer . et al. (Second Edition, 2012). Concepts and Principles of Economics, Rex
Book Store, Inc.
McEachern, William A. Economics: A Contemporary Introduction. Thomson Sourthern
West. 2006
Pindyck, Robert S. and Rubinfeld, Daniel L. (Fifth Edition). Microeconomics Printice-Hall Inc
Upper Saddle River, New Jersey.
Remedios P. Magnaye, DBA, Inesio H. Sadiangcolor, MBA, Gemar G. Perez, MBA, Andres R.
Delos Santos, EdD, Joven F. Andrada, BSE, Nemesio Y. Tiongson, PhD, Rudolfo C.
Acosta, PhD. Basic economics : with taxation and land reform. Jimczyville
Publications, ©2014.
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