Course Code ECN 301

Course Title MICROECONOMIC THEORY I

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Table of Content Page
Module 1 Subject Matter of microeconomic Theory

1.0. Rationale
1.1. Goal
1.2. Learning Objectives
1.3. Definition of Microeconomics
1.4. The role of Economic Theory
1.5. Development Stages of Microeconomics
1.6. Economic Modeling in Microeconomics
1.7. Questions

Module 2 Choice and Demand

2.0. Rationale
2.1. Goal
2.2. Learning Objectives
2.3. Preferences and Utility
2.4. Utility Maximization and Choice
2.5. Income and Substitution Effects
2.6. Demand and Elasticity
2.7. Questions

Module 3 Production and Supply

3.0 Rationale
3.1 Goal
3.2Learning Objectives
3.3 Introduction
3.4 Production function
3.5 Cost function
3.6 Profit function
3.7Assignment

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Module 4 Partial Equilibrium Competitive Model
4.0 Rationale
4.1 Goal
4.2 Learning Objectives
4.3 Introduction
4.4 Definition of market
4.5 Perfect Competition
4.6 Market demand curve
4.7 Timing of the supply response
4.8 Equilibrium price determination
4.9 Pricing and output decision
4.10 Cases of profit maximization in the short run
4.11 Long run equilibrium
4.12 Assignment.

Module 5 Models of Imperfect Competition

5.0. Rationale
5.1. Goal
5.2. Learning Objectives
5.3. Monopoly and Price Discrimination
5.4. Traditional model of imperfect competition: Oligopoly
5.5. Questions

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MODULE ONE: SUBJECT MATTER OF MICROECONOMIC THEORY

1.0. RATIONALE
There are essentially two main branches of Economics, namely Microeconomics and
Macroeconomics. The study of microeconomics is however important in understanding how
individuals and firms take decisions to maximize satisfaction and profit respectively.

1.1. GOAL
The goal of this module is to ensure that learners can understand fully the subject matter of
Microeconomic Theory.

1.2. LEARNING OBJECTIVES

At the end of this module, learners are expected to be able to:
i) Define Microeconomics
ii) Understand the role of economic theory
iii) Identify and explain the development stages of Microeconomics
iv) Understand economic modeling in Microeconomics

1.3. DEFINITION OF MICROECONOMICS

Microeconomics focuses on the behavior of individual decision makers such as consumers and
firms. Consumers make decisions on what kind of goods to buy, what kind of services to provide
to firms and the price to pay for goods and services. Producers make decisions on what goods and
services to produce, the techniques of production to be used, the market for their products, the kind
of services they would need from consumers and the prices which goods should be sold. In other
words, microeconomics is the study of individual choice, and how that choice is influenced by
economic forces. It has been defined simply as how people choose under conditions of scarcity.
1.4. THE ROLE OF ECONOMIC THEORY
Economists have often been accused of making unrealistic assumptions about how people behave
thus making void, most economic theories. However, it has been argued that Economic theory
plays some key roles.

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 (1) Useful predictions can be made and useful insights into our behavior could be gained
if we assume that people act as if they were governed by the rules of rational decision
making.
(2) Even if economic theories fail on descriptive grounds, they often provide very useful
guidance for making better decisions. In other words, if they don’t always predict our
behavior, it can provide useful insights into how we can achieve our goals more
efficiently.

1.5. DEVELOPMENT STAGES OF MICROECONOMICS

The development of Microeconomics could be divided into three main stages.
(i) The pre-industrial stage.
(ii) The Industrial stage.
(iii) The Modern era.

The Pre-Industrial Stage

In the pre-industrial stage, religion played a more obvious role. Idea about labour, wages, property
rights, just prices, usury, taxation, debt, monopoly power as well as weights and measures must be
inferred from the rules that were expressed in the Scriptures. Economic thinking was also
influenced by secular teachings of the Greeks such as Socrates (468-399BC), Plato (427-347BC)
and Aristotle (384-322BC).

With the rise nation states and expanded trade, economic thought was restructured to deal with
these forces. Mercantilism (or Kameralism in Germany and Colbertism in France) provided a
justification for and explanation of the activities of the rising merchant class. Excesses in
regulation and inflation ultimately led to a re-evaluation of economic thought. This brought about
the Physiocrats in France and was led by Francois Quesnay (1694-1774). They constructed the
foundation for market oriented economics.

The Industrial Stage

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The industrial revolution gave birth to Classical Economics. Adam Smith (1723-1790) is generally
recognized as the founder of the Classical School. Adam Smith was largely influenced by the work
of the Physiocrats. Industrial Revolution brought about technological change, which made many
traditional solutions to economic problems less effective. According to Adam Smith, Man was by
nature self-interested and as such would pursue his own self-interest. The existing moral system,
directed largely by sympathy, would prevent behavior that is inappropriate or unjust. However,
moral sentiments could be corrupted. Therefore, the market will be necessary to provide a second
level of checks on unjust behavior. The system of jurisprudence, provided by the Government
would provide a third check on the behavior of self-interested individuals.

Mainstream Microeconomics came up in Mid 1800s and there were three separate roots- the
British root entrenched in the Utilitarianism of Jeremy Bentham (1748-1832), the Major European
root which emerged from the French rationalism of Descartes and the Austrian root emanating
from the work of Carl Menger. Each of these roots has different ideological foundations and
different implications. Two of these roots, Utilitarianism and rationalism have been grafted on to
one another and the differences have reduced over time.

Jeremy Bentham laid the foundation for British Utilitarian Microeconomics. The main tenets of
Bentham’s ideology were:
(i) The rationality of individuals.
(ii) Individuals are guided by pain and pleasure.
(iii) Right and wrong are tied to pain and pleasure.
(iv) The sum of individual utilities is the total utility of the community.
(v) If each individual maximize their utility, it will maximize the utility of the community.

John Stuart Mill (1806-1873) connected Classical Economics and Utilitarianism to the
development of market oriented microeconomics. The next link in British Microeconomics was
William Stanley Jevons. He simplified Bentham’s Utilitarian Philosophy and it has become the
foundation for mainstream microeconomics. Jevons modifications to the Utilitarianism of Mill and
Bentham were partially influenced by changes that had occurred in the industrial revolution. Large

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scale manufacturing was more fully developed and the emphasis began to shift from a focus on
society to “industry”.

Carl Menger (1840-1921), an Austrian developed the concept of marginal utility concurrently and
independent of Jevons. However, because his concept was explicitly normative in that it required
a value judgment about which classes of goods were of a higher need, it was not integrated into
mainstream microeconomics, but was used as a foundation for the Austrian School of Economics.

The Modern Era

There was a major development in Mainstream microeconomics through the publication of Alfred
Marshall’s (1842-1924) “Principles of Economics” in 1890 in England. He introduced
Mathematics in the working of Economics. Marshall is well known for his scissors analogy of
supply and demand with the resultant equilibrium. He developed the concepts of marginal Utility,
Consumer surplus, pure competition, elasticity and many of the standard concepts of modern
mainstream microeconomics.

While the British were constructing their microeconomics on Utilitarianism, there were a number
of French writers who were applying marginal analysis to economic problems. They were Louis
Marie Henri Navier (1785 – 1836), Joseph Minard (1781-1870), Arsine-Jules-Emile-Juvenal
Dupuit (1804-1866) and Antoine-Augustin Cournot (1801-1877). The French rationalist root of
Microeconomic theory can be traced from Cournot and the French Engineers to Walras (1834-
1910) and Pareto (1848-1923). Their main focus was on how to improve the welfare of the society.
However, Cournot is best known of the early contributors to French rationalist microeconomics.
He is well known for his analysis of the law of demand, monopoly, duopoly and competitive
market models.

Modern mainstream microeconomic theory can be said to have evolved from two separate
philosophical foundations: British utilitarianism and French Rationalism. The Utilitarian approach
focused on individual behavior and the optimization of the welfare of the individual. The
Rationalist approach focused on social welfare. The two approaches were grafted into one through
the works of Francis Ysidro Edgeworth (1845 – 1926) and Vildredo Pareto (1848-1923). The

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elements of indifference curve analysis were brought together by Pareto and have been associated
with the basic criteria used as a measure of efficiency, “Pareto Optimality”. Indifference functions
(or curves) and the concept of Pareto efficiency have become two of the major concepts used by
modern neo-classical micro economists and have played a major role in shaping the perspective of
modern, mainstream neoclassical Microeconomics.

1.6. ECONOMIC MODELING IN MICROECONOMICS

All economies are complex in nature because diverse decisions take place at the same time.
Thousands of firms are involved in producing millions of different goods and millions of
individuals are involved in deciding on the kind of goods to buy. In spite of these numerous
activities taking place at the same time, there is need for coordination.
However, it is obvious that it would be practically impossible to describe the features of an
economy in complete detail. It therefore becomes imperative to abstract from these complexities
and develop models that could capture the essentials. Just as a road map is helpful, even though it
does not give information of every house, an economic model, for example, of the market for rice
will be very useful even though it does not account for every detail of the rice economy.
Essentially, any economic model should serve two main purposes: analysis and prediction. It
should be able to explain the behavior of individual economic units. It should also be able to predict
what will happen when there is a change in some magnitudes in the economy. Even though
economic models serve these purposes, not all of them are good. This requires constant verification
from time to time which can be done by:

(i) Determining the validity of the assumptions on which the model is based. (Direct
approach)
(ii) Confirming validity by proving that the model can correctly predict real world events.
(Indirect approach)
The validity of a model could be determined by its predictive power, reality of assumptions, the
extent of information it provides, its generality and simplicity.

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There are a lot of economic models presently being used. However, they differ in terms of their
assumptions and the degree of detail provided. In spite of these differences, all economic models
must contain three attributes. They are:
(i) Ceteris Paribus assumption.
(ii) Optimization assumption.
(iii) The Positive - Normative distinction.

Ceteris Paribus Assumption

Economic models are often used to show simple relationships. For example, a model of the market
of rice may seek to explain the price of rice with a small number of variables that can be measured.
Any researcher recognizes that there are other forces that will affect the price of rice apart from
those constituted in the model. What Economists do is to assume that these forces are constant
during the period of study without ignoring them. This ensures that only a few forces are studied
in a simplified setting. This is the Ceteris paribus assumption which is used in economic modeling.

Optimization Assumption
Most economic models are built on the premise that each economic agent acts rationally i.e. they
are aiming for a goal at each point in time. Consumers are expected to maximize satisfaction, firms
are expected to maximize profit and the Government is expected to maximize public welfare. Even
though these assumptions may not always be true, they have been widely accepted as a good
starting point in developing economic models because they are useful for generating models that
are precise and solvable and they are clearly valid empirically.

Positive-Normative Distinction
Most economic models have attempted to distinguish between positive and normative questions.
Some Economists have been concerned primarily with positive economic theories in which,
attempts have been made to explain economic phenomena that are observed. However, others have
viewed economic theories from a normative stance in which a definite position is taken on what
should be done. Thus, there are ambiguities in the normative or positive stance of economic
theories.

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1.7. QUESTIONS
1) Which of the following is not true about Microeconomics?
(a) It studies the behaviour of individuals and firms in making decisions.
(b) It analyzes market failure.
(c) It explains what should happen in a market.
(d) It deals with the effects of national economic policies on aspects of the economy
2) Which of the following is not true about an economic theory?
(a) It serves as a corrective measure for introspection.
(b) It can substitute for data when they are not available.
(c) It can yield insights even when it is wrong.
(d) None of the above.

3) Which of the following could explain the emergence of the physiocratic school of
thought?
(a) Inflation (b) Deregulation (c) expanded trade (d) Rising merchant class

4) Which of the following is not associated with French Rationalism?

(a) Cournot (b) Minard (c) Walras (d) None of the above

5) Which of the following economic theories is not viewed at all from a positive stance?
(a) Theory of demand (b) Theory of markets
(c) Theory of Indifference curves (d) None of the above
6) Which of the following is not always true about economic models?
(a) They consist of a set of mathematical equations.
(b) They are road maps of reality.
(c) They are subjective in design.
(d) All of the above.

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MODULE TWO: CHOICE AND DEMAND

2.0. RATIONALE
The primary goal of every consumer is to maximize satisfaction. This goal:
i) Drives the consumer in making choices that will best suit this purpose.
ii) Helps in knowing how to respond to changes in prices from time to time.
iii) Helps to understand how the elasticity of demand influences the consumer’s choice.

2.1. GOAL
The goal of this module is to help learners understand how choices are made in order to maximize
utility and also understand the factors that influence these choices.

2.2. LEARNING OBJECTIVES

At the end of this module, learners should be able to understand:
i) How preferences connect to utility.
ii) How choices affect the maximization of utility.
iii) The income and substitution effects of a change in price.
iv) The connection between demand and elasticity.

2.3. PREFERENCES AND UTILITY

PREFERENCES
In the process of making choices, individuals respond in different ways. Given a range of goods,
their preferences will differ. However, three basic properties often characterize individuals’
preferences if we assume they all act rationally.
(i) Completeness.
(ii) Transitivity.
(iii) Continuity.
Completeness: This property states that individuals are always decisive in their actions. In other
words, they can always make up their mind when confronted with any pair of options. If we
consider X and Y, the individual can always specify any of these three possibilities.

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 (a) X is preferred to Y.
(b) Y is preferred to X.
(c) X and Y are equally attractive or he is indifferent between X and Y.

Transitivity: This property states that individuals are always consistent in their choices. If we
consider a set of alternatives X, Y and Z and an individual prefers X to Y and Y to Z, he must also
prefer X to Z.

Continuity: This Property states that the choices of individuals are not limited to the pair of
options they are confronted with at a given period. Given a pair of option X and Y, if an individual
prefers X to Y, then, options reasonably close to X must also be preferred to Y.

UTILITY
Utility is often connected to preferences. More desirable situations offer more utility than less
desirable ones. In other words, if an individual prefers X to Y, then, the utility assigned to X will
be more than the utility assigned to Y.

Characteristics of Utility rankings

(1) Non-Uniqueness.
(2) Ceteris paribus assumption.

Non-Uniqueness
The issue here is not to debate whether numbers can be attached to utility rankings but that the
numbers attached can not be unique. For example, there is no difference whether we say that U(X)
= 10 and U(Y) = 7 or U(X) = 7000 and U(Y) = 45. In both cases, it implies that X is preferred to
Y. However, we can not know how much more is X preferred to Y since there can not be a unique
answer. The scale we adopt in our rankings will always differ. It also means that we can not
compare utilities between people. If an individual reports that a meal of rice provides a utility of
10 and another reports that the same meal provides a utility of 100, we can not conclude on which
individual derives more satisfaction from the meal since they could be operating on different
scales.

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Ceteris paribus assumption
Utility is always affected by a variety of factors. It is not only affected by the consumption of
physical commodities but by psychological attitudes, peer group pressures, personal experiences
and the environment. As a result, the usual practice is to limit choices to options that are
quantifiable while holding constant the other things that affect behavior. This ensures the analysis
of choices is manageable within a simplified setting.
e.g. We can present a Utility function in the form.

U = U (X1, X2, …………..Xn)

What this means is that utility is influenced by the Xs while the others are assumed constant.
Trades and Substitution
Preferences involve choices and choices involve substituting one good for another. The
Indifference curve can be used to explain the concept of substitution.
An indifference curve shows the combination of consumption bundles among which the individual
is indifferent i.e. the bundles all provide the same level of Utility.

Quantity of Y

𝒀𝟏

𝒀𝟐

𝑿𝟏 𝑿𝟐 Quantity of X

The slope of the curve shows the rate at which the individual is willing to trade X for Y. This slope
is referred to as the marginal rate of substitution. It is negative, meaning that if an individual gives
up some of Y, he or she must be compensated by an additional amount of X to remain indifferent
between the bundles. The curve is drawn in such a way that the slope diminishes as X increases.
This is based on the assumption that individuals become progressively less willing to trade away
Y to get more X.

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Characteristics of Indifference Curve
(1) The movement of an Indifference Curve in a northeast direction represents movements
to higher levels of satisfaction. This is because more of a good is preferred to less.
(2) Two indifference curves cannot intersect because they are not consistent with rational
preferences.
(3) Indifference curves are convex to the origin. In other words, two points within the
indifference curve can be joined by a straight line. This implies diminishing marginal
rate of substitution.
Types of Utility functions
An examination of the types of Utility functions may provide insights into observed behavior and
could also help in solving problems.
(1) Cobb-Douglas Utility
U(X,Y) = 𝑿𝜶 𝒀𝜷 …….. (1) where α and β are positive constants. The relative sizes
of ɑ and β would show the relative importance of the two goods to the individual.

Quantity of Y

Quantity of X

(2) Perfect substitutes Utility

U(X,Y) = ɑX + βY ……. (2) where ɑ and β are positive constants.

Quantity of Y

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Quantity of X
 For example, a litre of fuel is the same in total as in Mobil. In other words, I am willing
to give up 10 litres of fuel in Mobil in exchange for 10 litres of fuel in total

(3) Perfect Complements Utility

U(X,Y) = min (ɑX, βY) ……….. (3) where ɑ and β are positive parameters.

Quantity of Y

Quantity of X

This means the pair of goods will be used in fixed proportional relationship represented
by the vertices of the curves. For such goods, only by choosing the goods together can
utility be increased.
The min in the equation implies that utility is given by the smaller of the two terms in
the parenthesis. For example, assume that 3 left shoes and 1 right shoe provide 3 units
of utility. This is given by:

U(X, Y) = min (3X, Y)

where X refers to left shoe and Y refers to right shoe.

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 6 left shoes and 1 right shoe will only provide 3 units of Utility because the extra left
shoe without the right shoe is of no value as shown by the horizontal section of the
indifference curves. In a more general form, neither of the two goods in equation 3 will
𝑦 𝛼
be in excess only if ɑX = βY. Hence, = which shows the fixed proportional
𝑥 𝛽

relationship between the two goods.

(4) Constant Elasticity of Substitution Utility

The three cases mentioned so far are special cases of a more general constant elasticity
of substitution function (CES) which takes the form
𝑿𝜹 𝒀𝜹
U(X,Y) = + such that the utility function will be a function of the value of
𝜹 𝜹
the parameter δ.

Homothetic and Non-homothetic (Heterothetic) preferences

A utility function is homothetic if the marginal rate of substitution for the function depends only
on the ratio of the amounts of the two goods, not on the total quantities of the goods.
(Most utility functions are homothetic).

However, a utility function is non-homothetic (heterothetic) if the marginal rate of substitution for
the function does not depend on the ratio of the amount of the two goods but on the quantities of
the goods.

U(X,Y) = X + In Y is non-homothetic because the MRS increases or decreases based on the

quantity chosen of Y. (Demonstrate).

2.4. UTILITY MAXIMIZATION AND CHOICE

Given a fixed amount of money to spend, utility will be maximized when an individual buys the
quantities of goods that will exhaust the total income and for which the rate of psychic trade-off

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between any two goods is equal to the rate at which the goods can be traded for the other in the
𝑷𝒙
market place i.e. MRS(x,y) =
𝑷𝒚

We shall attempt to demonstrate utility maximization using

(i) The Graphical approach.
(ii) The Mathematical approach.

The Graphical Approach

Quantity of Y

B
D
𝑌∗ C
A

𝑋∗ Quantity of X

The first order condition for utility to be maximized requires that the indifference curve is tangent
to the budget line. At this point, two things must happen.
(i) All available funds will be spent, assuming non-satiation (An individual should spend
all of his or her income to maximize utility from it.)
(ii) The individual’s psychic rate of trade off (MRS) will be equal to the rate at which the
𝑃
goods can be traded ( 𝑃𝑥 )
𝑦

It would be irrational to choose point A because the individual can get to a higher utility level by
spending more of income. So also will be point B because a higher utility level can be obtained
just by reallocating expenditures. At point D, the income will be too small to attain that level. At
point C, where combination X*Y* is chosen will be the position of maximum utility since no
higher utility level can be attained.

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The second order condition requires that the Marginal rate of substitution (MRS) be diminishing.
Given the figure below

Quantity of Y

C
B

Quantity of X

Point C is inferior to many other points, which can also be purchased with the available funds.
Thus, the rule of tangency is not sufficient in achieving maximum utility.

Mathematical Approach
The graphical approach is usually limited in application because the n-goods case cannot be
presented in a two-dimensional graph. Thus, the mathematical approach is often more adopted as
it provides additional insights into utility maximization.

Assume we have Utility = U(X1, X2, …………….Xn)……………. (1)

Subject to the Budget constraint

M = 𝑷𝟏 𝑿𝟏 + 𝑷𝟐 𝑿𝟐 + …………….. + 𝑷𝒏 𝑿𝒏 ………………. (2)

Note that the equality sign is necessary given the assumption of non-satiation. We can now set up
a Lagrangian expression.

L = U(𝑿𝟏 , 𝑿𝟐 ,…….. 𝑿𝒏 ) + λ (M - 𝑷𝟏 𝑿𝟏 - 𝑷𝟐 𝑿𝟐 …………. – 𝑷𝒏 𝑿𝒏 ) ……….. (3)

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Setting the partial derivatives of L(with respect to X1, X2, …..Xn and λ ) equal to zero gives us the
First order (necessary conditions) for a maximum.
𝝏𝑳 𝝏𝑼
= – λ 𝑷𝟏 = 0 …………………………. (4)
𝝏𝒙𝟏 𝝏𝒙𝟏

𝝏𝑳 𝝏𝑼
= – λ 𝑷𝟐 = 0 …………………………. (5)
𝝏𝒙𝟐 𝝏𝒙𝟐

.
.
.
.
𝝏𝑳 𝝏𝑼
= – λ 𝑷𝒏 = 0 …………………………. (6)
𝝏𝒙𝒏 𝝏𝒙𝒏
𝝏𝑳
= M - 𝑷𝟏 𝑿𝟏 - 𝑷𝟐 𝑿𝟐 …………. – 𝑷𝒏 𝑿𝒏 = 0 ………………. (7)
𝝏𝛌
If we rewrite equations (4) and (5),
𝜹𝑼⁄𝜹𝑿𝟏 𝑷𝟏 𝑴𝑼𝑿𝟏 𝑷𝟏 𝑷𝟏
= ……………. (8) or = or MRS(X1, X2) = ………… (9)
𝜹𝑼⁄𝜹𝑿𝟐 𝑷𝟐 𝑴𝑼𝑿𝟐 𝑷𝟐 𝑷𝟐

This means that the individual should equate the psychic rate of trade off to the market trade off
rage as stated earlier. We can still manipulate equations (4) – (6) so that:
𝜹𝑼⁄𝜹𝑿𝟏 𝜹𝑼⁄𝜹𝑿𝟐 𝜹𝑼⁄𝜹𝑿𝒏
λ= = = …………….. = or
𝑷𝟏 𝑷𝟐 𝑷𝒏

𝑴𝑼𝑿𝟏 𝑴𝑼𝑿𝟐 𝑴𝑼𝑿𝒏

λ= = = ……………….. = ………… (10)
𝑷𝟏 𝑷𝟐 𝑷𝒏

λ = Marginal Utility of an extra naira of consumption expenditure (Marginal Utility of Income)

This means that for utility to be maximized, the marginal utility per naira spent on each good must
be equal.
The second order condition for utility maximization requires that the determinant of the bordered
hessian matrix is greater than zero i.e.

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 𝑓11 𝑓12 𝑓13
|𝐻𝑏 | = |𝑓21 𝑓22 𝑓23 | > 0 (Where 1= x, 2 = y and 3 = λ)
𝑓31 𝑓32 𝑓33

The General rule is that if the number of goods in question is even, the determinant will be positive.
If the number of goods is odd, the determinant will be negative.

Example
Find the utility maximization values for a Cobb-Douglas Utility function.
(Assume that ɑ + β = 1)

U(X, Y) = 𝑿𝜶 𝒀𝜷 ………. (1)

s.t. M = P1X + P2Y ……….. (2)

Set a Lagrangian function
L= 𝑿𝜶 𝒀𝜷 + λ(M - P1X - P2Y) ………. (3)

Obtain the First Order Condition

𝝏𝑳
= α𝑿𝜶−𝟏 𝒀𝜷 - λ P1 = 0 ……….. (4)
𝝏𝐗

𝝏𝑳
= β𝑿𝜶 𝒀𝜷−𝟏 - λ P2 = 0 ………. (5)
𝝏𝐘

𝝏𝑳
= M - P1X - P2Y = 0 ……….. (6)
𝝏𝛌

If we divide equation (4) by (5),

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𝛂𝑿𝜶−𝟏 𝒀𝜷 𝑷𝟏 𝛂𝒀 𝑷𝟏
= → = ……….. (7)
𝛃𝑿𝜶 𝒀𝜷−𝟏 𝑷𝟐 𝛃𝐗 𝑷𝟐

From eqn (7), 𝛂𝑷𝟐 𝒀 = 𝛃𝑷𝟏 𝐗

𝛃 𝛃 𝟏
Since M=P1X + P2Y, M = P1X + P1X → M = P1X (1 + ) = P1X ( )
𝛂 𝛂 𝛂

𝛂𝐌
Thus, X* becomes ……..(8)
𝑷𝟏
𝛃𝐌
Using similar manipulations, Y* = ………… (9)
𝑷𝟐

Indirect Utility Function

Since individuals will always desire to maximize utility, given a budget constraint, the optimal
level of utility obtainable will depend indirectly on the prices of the goods bought and their level
of income. This dependence is reflected by the indirect utility function V. If either prices or income
were to change, the level of utility that can be attained would also be affected. Therefore, the
indirect utility function refers to the function that gives maximum utility achievable at given prices
and income.

Given our example of Cobb-Douglas Utility function which gives the optimal values as:
𝛂𝐌 𝛃𝐌
X* = and Y* =
𝑷𝟏 𝑷𝟐

If we substitute the values of X* and Y* into the original function U(X,Y), it becomes:

𝛂𝐌 𝛂 𝛃𝐌 𝛃
U(X,Y) = ( ) ( ) ……………. (10)
𝑷 𝑷 𝟏 𝟐

Equation (10) gives out indirect utility function which means that utility (indirect) will increase as
income increases and will fall as price increases.

20
Expenditure Function
This refers to the minimal amount of income (expenditure) necessary to achieve a given utility
level at a given price. It can be represented by the function E.

The problem is to minimize

E = P1X + P2Y …………. (1)

̅ = 𝑿𝜶 𝒀𝜷 …………. (2)
s.t. 𝑼
̅ is the utility target.
where 𝑼

We obtain a Lagrangian expression such that:

̅ - 𝑿𝜶 𝒀𝜷 ) ……….. (3)
L = P1X + P2Y + (𝑼
The FOC are given by equating the partial derivatives to Zero.
𝝏𝑳
= P1 - λα𝑿𝜶−𝟏 𝒀𝜷 = 0 ……….. (4)
𝝏𝐗

𝝏𝑳
= P2 - λβ𝑿𝜶 𝒀𝜷−𝟏 = 0 ………. (5)
𝝏𝐘

𝝏𝑳
̅ - 𝑿𝜶 𝒀𝜷 = 0 ……….. (6)
= 𝑼
𝝏𝛌

Dividing equation (4) by equation (5),

𝑷𝟏 𝛂𝑿𝜶−𝟏 𝒀𝜷 𝑷𝟏 𝛂𝒀
= → = ……….. (7)
𝑷𝟐 𝛃𝑿𝜶 𝒀𝜷−𝟏 𝑷𝟐 𝛃𝐗

This is equivalent to equation (7) of the Cobb-doulas utility example.

However, we wish to solve for expenditures as a function of P1 P2 and ̅̅̅
𝑼.

21
 𝛃 𝛂
Restating eqn. (7), 𝑷𝟐 𝒀 = P1X and P1X = 𝑷𝟐 𝒀
𝛂 𝛃

𝛃 𝛃 𝟏
Since E = P1X + P2Y = P1X + P1X → E = P1X 1 + ) = P1X ( )
𝛂 𝛂 𝛂

𝛂𝐄 𝛃𝐄
Thus, X* = ……(8) and Y* = ……… (9)
𝑷𝟏 𝑷𝟐

Note that the expenditure minimizing values will be the same as the utility maximizing values
(based on the principle of nonsatiation)

Inserting these expenditure minimizing values into equation (2),

𝛂 𝛃
̅ = (𝛂𝐄) (𝛃𝐄)
𝑼
𝑷 𝑷𝟏 𝟐

𝛂 𝛂 𝛃𝐄𝛃
̅ = (𝛂 𝐄𝛂 ) (𝛃
𝑼 ) ………….. (10)
𝑷 𝟏 𝑷𝟐 𝛃

𝛂𝛂 𝛃 𝛃
̅=
𝑼 (Since 𝛂 + 𝛃 = 1) …………….. (11)
𝑷𝟏 𝛂 𝑷𝟐 𝛃

̅ 𝑷𝟏 𝛂 𝑷𝟐 𝛃
𝑼
E= ………….. (12)
𝛂𝛂 𝛃 𝛃

Equation (12) gives the minimum expenditure necessary to reach the target utility level U

Equation (12) also implies that a higher utility target would require greater expenditures. In the
same way, an increase in P1 and P2 would also require greater expenditures to attain a given utility
target. Otherwise, there would be a need to reduce utility.

22
 2.5. INCOME AND SUBSTITUTION EFFECTS

When the price of a good changes, it produces two different effects. The first is a substitution
effect. Here, there is a re-allocation of consumption pattern between the good and its substitute.
Secondly, there is an income effect. Here, there is a change in demand due to an adjustment in
purchasing power. This adjustment in purchasing power is shown by a parallel shift of the new
budget line. This is called the compensating variation. The essence of the compensating variation
is to ensure that the consumer remains on the same level of satisfaction or choice as before the
price change. The compensated budget line could either pivot around the original choice (Slutsky)
or pivot around the original indifference curve (Hicks). We shall attempt to demonstrate the two.

The Hicks Analysis

Quantity of M

X Y
𝑨/ 𝑰𝑪𝟐

Z
𝑰𝑪𝟏

B 𝑪/ C Quantity of N

23
 Suppose there is a fall in price of N, the budget line will rotate outwards from AB to AC indicating
that the maximum amount of N that can be bought has increased. We draw a compensated budget
line A/C/ parallel to the new budget line (AC) and at the same time pivoting around the original
indifference curve so that the consumer can keep utility constant.

The movement from equilibrium level Z to Y is the income effect showing the changes in
purchasing power from one budget line to the other.
The movement from equilibrium level X to Z is the substitution effect showing the changes in the
purchase of N. At Z, more of N is bought by substituting M for N.

The Slutsky Analysis

Quantity of M

𝑨/
X Y
Z 𝑰𝑪𝟑

𝑰𝑪𝟐
𝑰𝑪𝟏
B 𝑪/ C Quantity of N

The same analysis stands except that in this case, the compensated budget line pivots around the
original choice, rather than the original indifference curve.

24
In summary, the pivot of the budget line shows the substitution effect while the shift shows the
income effect.

Our analysis above is valid for normal goods in which the substitution and income effects reinforce
each other. For example, a fall in price of a good will increase the purchasing power and also make
the good cheaper. This will result into more of the good being demanded.

However, for an inferior good, the income and substitution effects work in opposite directions,
making the effect of a price change indeterminate. For example, a fall in price will always cause
an individual to tend to consume more of a good because of the substitution effect. But, if the good
is inferior, the increase in purchasing power caused by the fall in price may cause less of the good
to be bought. Thus, the total effect on the demand for the good can not be determined. The total
effect will always be determined by which of the two effects outweigh the other.
2.4. DEMAND AND ELASTICITY

Price Elasticity of Demand

If we represent price elasticity of demand by 𝒆𝒑 , then,

𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝

𝒆𝒑 =
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐩𝐫𝐢𝐜𝐞

𝝏𝑸 𝑷 𝝏𝑸
= . (Always bear in mind that 𝒆𝒑 will be negative since < 0)
𝝏𝑷 𝑸 𝝏𝑷

Price Elasticity and Total Expenditure

The total expenditure on any good is the product of the price (P) and the quantity (Q) i.e. E = PQ.
We can examine how total expenditure changes when price changes.
Note that Q = f(P). Using Product function rule,

𝝏𝑬 𝝏𝑷 𝝏𝑸 𝝏𝑸
= 𝑸 +P = 𝑸+P
𝝏𝑷 𝝏𝑷 𝝏𝑷 𝝏𝑷

25
If we divide both sides by Q, we have:
𝝏𝑬 𝝏𝑸 𝑷
/𝑸 =1+ . = 1 + 𝒆𝒑
𝝏𝑷 𝝏𝑷 𝑸

𝝏𝑬
Since Q is positive, the sign of will depend on the value of 𝒆𝒑
𝝏𝑷

𝝏𝑬
When 𝒆𝒑 = - 1 (Unit elastic), = 0 (This means expenditure will remain unchanged for any
𝝏𝑷
good with unit elastic demand when price changes)

𝝏𝑬
When 𝒆𝒑 > - 1 (inelastic), > 0 (This means expenditure will move in the same direction with
𝝏𝑷
changes in price for any good with inelastic demand)
𝝏𝑬
When 𝒆𝒑 < - 1 (elastic), < 0 (This means expenditure will move in the opposite direction
𝝏𝑷
with changes in price for any good with elastic demand)

Income Elasticity of Demand

If we represent which elasticity of demand by 𝒆𝒚 , then,

𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝

𝒆𝒚 =
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐢𝐧𝐜𝐨𝐦𝐞

𝝏𝑸 𝒀
= .
𝝏𝒀 𝑸

𝒆𝒚 > 0 for normal goods and 𝒆𝒚 < 0 for inferior goods. 0< 𝒆𝒚 < 1 for necessities
and 𝒆𝒚 > 1 for Luxuries.

Cross Elasticity of Demand

If we represent cross elasticity of demand by 𝒆𝑪 , then,

26
 𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝 𝐨𝐟 𝐚 𝐠𝐨𝐨𝐝 (𝐗)
𝒆𝑪 =
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐚𝐧𝐨𝐭𝐡𝐞𝐫 𝐠𝐨𝐨𝐝 (𝐘)

𝝏𝑸𝒙 𝑷𝒚
= .
𝝏𝑷𝒚 𝑸𝒙

𝒆𝑪 > 0 for Substitutes and 𝒆𝑪 < 0 for Complements.

Linear demand and Elasticity

We can show that a linear demand curve has different elasticity values at each point on the curve.
Let us assume a linear demand function:
Q = a + bP, where a and b are constants.

𝝏𝑸
=b
𝝏𝑷
𝝏𝑸 𝑷 𝑷
Recall that 𝒆𝒑 = . Thus, 𝒆𝒑 = b.
𝝏𝑷 𝑸 𝑸

As P rises, Q will fall and 𝒆𝒑 will become a larger negative number (or become more elastic).

Remember that b will always be less than zero. Thus, demand becomes more inelastic as we move
down a linear demand curve (or as price reduces)

Example
Assume Q = 12 – 2p.

𝝏𝑸 𝑷 𝑷
Recall that 𝒆𝒑 = . = -2 ( )
𝝏𝑷 𝑸 𝟏𝟐−𝟐𝑷

If P = 6, Q = 0. This means P would range between 0 and 6. The mid-point is 3. So, demand is unit
elastic when P = 3.

Demand will be price elastic for P>3. If P = 4 for example,

27
 𝟒
𝒆𝒑 = -2 ( ) = -2 (elastic)
𝟒
Demand will be price inelastic for P<3. If P = 2 for example,

𝟐
𝒆𝒑 = -2 ( ) = - 0.5 (inelastic)
𝟖
2.7. QUESTIONS

1) Given that the utility Akpos derives from the consumption of 6 units of X and 5 units of Y is
11. If X and Y are perfect complements, what extra utility will he derive from 9 units of X
and 5 units of Y?
(a) 14 (b) 11 (c) 0 (d) Uncertain.

2) Chika claims she derives 10 units of utility from the consumption of a plate of rice and Chuka
claims she derives 40 units of utility from consuming the same plate. Which of the following
cannot be correct?
(a) Chika’s Utility is higher than that of Chuka. (b) Chika prefers another type of food than
Chuka. (c) Chuka’s Utility is higher than that of Chika. (d) None of the above.

3) Given goods X and Y, an indirect utility function implies that utility can fall when:
(a) The price of good X rises by 8% and the price of Y fall by 7%.
(b) There is an expectation of a fall in price in the future.
(c) Taste falls.
(d) All of the above.

4) The lowest amount of income required to achieve a given utility level at a given price is
known as the:
(a) Expenditure function (b) income function (c) utility function (d) price function
5) The substitution effect of a price change works the same way for a normal and an inferior
good. (a) True (b) False (c) Uncertain (d) I don’t know
6) For an inferior good, a fall in the price of the good will leave quantity demanded unchanged
when: (a) Income effect > Substitution effect (b) Income effect < Substitution effect
(c) Income effect = Substitution effect (d) we cannot be certain.

7) The price for a good increases and total expenditures for the good increases, this implies that
demand is: (a) Unit elastic (b) Elastic (c) Inelastic (d) Luxurious
8) A movement along a linear demand curve implies that demand has become more elastic.
(a) Uncertain (b) False (c) True (d) I don’t know

28
MODULE 3: PRODUCTION AND SUPPLY

3.0 Rationale

One of the three economic agents in an economy is Firm. The principal activity of any firm is to turn
inputs to output. In addition, the major objective of every firm is to maximize profits. Economists are
interested in the choices the firm makes in accomplishing this goal. Hence, there is need to develop some
methods of analyzing those choices. This is the major focus of this module.

3.1 Goal

The goal of this topic is to familiarize learners with the methods and processes by which firms make
production choices in their combination of inputs to maximize profit both in the short run and long run
periods.

3.2 Learning Objectives

At the end of this topic learners should be able to

i. Define production function

ii. Identify and explain common production concepts
iii. Understand different types of production function
iv. Explain the concept of technical progress in production process
v. Define cost function and different cost concepts
vi. Differentiate between economist cost and accountant cost
vii. Distinguish between short-run and long-run periods
viii. Understand the relationship between short-run and long –run cost curves
ix. Define profit function
x. Discuss the concept of profit maximization and marginalism
xi. Explain the relationship between marginal revenue and elasticity

3.3 INTRODUCTION

This section examines the production and supply of goods produced by rational economic agent.
The institutions that coordinate the transformation of inputs to outputs are called firms. In other
words, firms are economic agents whose role is to transform factor of production into goods and

29
services. Firms refer to the “transformation unit” concerned with converting factor inputs into
higher valued intermediate and final goods and services. Hence, they perform the role of producers.

Firms make certain basic choices in the production process. The objective of this module is to
develop methods of analyzing these choices. Therefore, the module is organized as follows:

In section 3.4, we examine various ways of modeling the physical relationship between inputs and
outputs through the introduction of production function. Two measurable aspects of production
functions, which are, returns to scale and elasticity of substitution are discussed. We concluded
the section by how technical improvements are reflected in production functions.

The production function developed is then used to explain the cost function in section 3.5. In
economic theory, it assumed that firms seek to produce their output at lowest possible cost. The
section also examines the concept of short run and long run in the production process.

In section 3.6, analysis of firm’s supply decision is presented. This decision is usually based on
the assumption that firm makes input and output choices to maximize profit. Also, the implication
of profit maximization assumption will be studied in details.

3.4 PRODUCTION FUNCTIONS

As stated in section 3.0, the principal activity of any firm is to convert inputs into outputs. To
achieve this singular objective, economists construct a model to analyse this inputs-outputs
behaviour of a firm. Therefore, a production function is a model which formalizes the relationship
between inputs and outputs. The production function is a purely technical relation which connects
factor inputs into outputs. It represents the technology of a firm of an industry, or of the economy
as a whole.

Formally, a production function can be represented as:

q = f (k , l , m,.....) (3.1)

Where q represents the firm’s output of a particular good in a period, k is the capital input such as
machines used in the production process, l represents the labour input, m is the raw materials used
in production while the dotted lines are the possibility of other variables that may affect the
production process. To keep our model compact for meaningful analysis and for convenience, we

30
shall concentrate on only two factors of production which are labour and capital. Hence,
throughout this course, our production function is defined as a mathematical description of a
technical combination of factor inputs such as labour and capital to produce a given level of output.

The firm’s production function for a particular product q shows the maximum amount of goods
that can be produced using alternative combination of inputs capital and labour. This can be
presented as:

q = f (k , l ) (3.2)

Where q, k, l are as earlier defined while f is the function that define the technical relations between
inputs k and l to output q in the production process.

3.4.1 PRODUCTION CONCEPTS

1) Marginal Physical Productivity: The marginal physical product of an input is the additional
output that can be produced by employing one more unit of that input while holding all other inputs
constant.

Mathematically, given a production function q = f (k , l )

q
Marginal physical product of capital= MPk = = fk (3.3)
k

q
Marginal physical product of labour= MPl = = fl (3.4)
l

Marginal physical product, as illustrated above, referred to as the change in output to change in
input. In the above equations (3.3 and 3.4), the concept of partial derivative is employed to reflect
the fact that all other input usage is held constant while the input of interest is being varied.
Therefore, the knowledge of differentiation in calculus is assumed in this course. Please refer
to your SSC 106 lecture material for discussion on calculus.

Example 1

Given that the production function for a firm in a particular period is presented below:
q = f (l , k ) = 60l 2 k 2 − l 3 k 3 (3.5)

31
Derive the marginal physical product of labour and capital function
Solution
q
Marginal product of labour= MPl = = 120lk 2 + 3l 2 k 3 (3.6)
l
q
Marginal product of capital= MPk = = 120l 2 k 2 + 3l 3 k 2 (3.7)
k
Scenario one: Suppose from equation 3.5, capital input k is 2. Our total output q then becomes
q = 60l 2 (2) 2 − l 3 (2) 3 (3.8)

q = 240l 2 − 8l 3 (3.9)
Obtain marginal product from equation 3.9
q
Marginal product of labour = MPl = = 480l + 24l 2 (3.10)
l
Student task 1: obtain the marginal product of capital, assuming the value of labour is 3.
2) Diminishing Marginal Productivity: It may be concluded that the marginal physical product
of an input depends on how much that input is used. However, an input like labour cannot be added
indefinitely to a given fixed input (equipment) without essential deterioration in the productivity
of the variable input (labour). This is the notion of diminishing marginal physical productivity of
the variable input.
Mathematically, the assumption of diminishing physical marginal productivity is an assumption
about the second-order partial derivatives of the production function:
From equation 3.3 and 3.3 we can derive our second-order partial derivatives of capital and labour
respectively as

MPk  2 k
= 2 = f kk  0 (3.11)
k k

MPl  2 l
= 2 = f ll  0 (3.12)
l l

The concept of diminishing marginal productivity was first proposed by the 19th century
economist Thomas Malthus who was concerned about the rapid increase in population vis-a vis
low labour productivity.

32
3.) Average Physical Product: Average productivity of labour (APl) is defined as output per unit
of labour input. It is often used as a measure of efficiency. Mathematically, it could be expressed
as:

output q f (l , k )
APl = = = (3.13)
labourinput l l

Example 2

Given that the production function for a firm in a particular period is presented below:

q = f (l , k ) = 60l 2 k 2 − l 3 k 3

Derive the average product of labour given that k is 2.

From equation 3.9, we have q = 240l 2 − 8l 3 after substituting 2 for k

q 240l 2 − 8l 3
APl = = = 240l − 8l 2 (3.14)
l l

Student task 2: Obtain the average product of capital, assuming the value of labour is 3.

4) Isoquant and Isoquant Map: Given the production function q = f (k , l ) where both capital
and labour are allowed to change. An isoquant (from iso, which means equal) records the
combination of capital (k) and labour (l) that are able to produce a given quantity of output (q). In
other words, an isoquant shows those combinations of capital and labour that yield the same level
of output. Mathematically, isoquant records the set of k and l that satisfies:

f (k , l ) = q0 (3.15)

An isoquant is analogous to the indifference curve under the theory of consumer behavior. It is
possible to have different isoquants in the capital-labour graph where each isoquant represents a
different level of output. Therefore, the further away an isoquant is from the origin, the higher the
level of output. When more than one isoquant is presented on the same graph, we have an isoquant
map.

33
 K per
period

KA A

q = 20
KB B

q = 10

LA LB L per period

Figure 1: Isoquant Map

As presented in the graph above, an isoquant, like indifferent curve, is convex to the origin and
slopes downward from left to right. This implies that an isoquant has a negative slope. The slope
of these curve show the rate at which labour can be substituted for capital while keeping output
constant. The negative of this slope is called the (marginal) rate of technical substitution (RTS).

5) The Marginal Rate of Technical Substitution (RTS): The slope of an isoquant shows how
one input can be exchanged for another while holding output constant. Analysing the slope
provides an insight about the technical possibility of substitution between labour and capital.

The marginal rate of technical substitution shows the rate at which labour can be substituted for
capital while holding output constant along an isoquant. Mathematical, RTS is given as follows:

− dk
RTS l ,k = (3.16)
dl

Where dk and dl are marginal product of capital and labour respectively. It can further be deduced
from equation 3.16 that RTS of substituting labour for capital is the ratio of marginal product of
capital to marginal product of labour which can be proved mathematically.

34
Exercise: Proof that RTS is the ratio of marginal product of capital to marginal product of
labour

Given that q = f (k , l )

Differentiating totally, we have,

f f
dq = .dk + .dl = 0 (3.17)
k l

f f
Since = MPk and = MPl
k l

Then, equation 3.17 becomes:

MPl .dl = −MPk .dk (3.18)

Divide both sides by MPk dl

MPl dk
=− =RTS (l for k) (3.19)
MPk dl

Hence, the RTS is given by the ratio of the inputs’ marginal productivities and it is negatively
sloped.

6) Return to Scale: The concept of return to scale attempts to address the question on how output
responds to simultaneous and equal increase in all inputs. For instance, suppose all inputs are
doubled: would output double or not?

If the production function q = f (k , l ) and all inputs are multiplied by the same positive constant,
λ (where λ>1), the return to scale of the production function can be classified as:

Scenario Effect on output Return to Scale

I f (k , l ) = f (k , l ) = q Constant
II f (k , l )  f (k , l ) = q Decreasing
III f (k , l )  f (k , l ) = q Increasing

35
 Note: < represents “less than”, > represents “greater than”

Intuition from the table

• If a proportionate increase in inputs increases output by the same proportion, the production
function exhibits constant return to scale.
• If output increases less than proportionately, the function exhibits diminishing returns to
scale.
• If output increase more proportionately, there is increasing returns to scale

7) Elasticity of Substitution: This concept measures the “ease” at which a factor can be
substituted for another factor. This has to do with the shape of a single isoquant as oppose to
the whole isoquant map. As mentioned earlier, the rate of technical substitution along an
isoquant decrease as the capital –labour ratio decreases. Elasticity of substitution is denoted by
Ϭ.

For the production function q = f (k , l ) , the elasticity of substitution ( ) measures the

k
proportionate change in relative to the proportionate change in the RTS along an isoquant. That
l
is,

%( k ) d ( k ) RTS  ln(k )  ln(k )

= l = l . = l = l (3.20)
%RTS dRTS k  ln RTS  ln( f l )
l fk

Where fl and fk are marginal product of labour and marginal product of capital respectively and
%  is percentage change.

36
Graphic Description of the Elasticity of Substitution

K per
period

RTSA
A RTSB

(k/l)A q = q0

(k/l)B

L per
period
Figure 2: Elasticity of Substitution

To move from point A to point B on isoquant q=q0, both the capital and labour ratio (k/l) and the
RTS will change. Recall that the elasticity of substitution ( ) is defined to be the ratio of these
proportional changes. It is a measure of how curved the isoquant is. Because (k/l) and the RTS
move in the same direction, the value of  is always positive. Our interest is on the magnitude of
these changes.

*If  is high, the RTS will not change much relative to k/l, and the isoquant will be relatively flat.

*Low value of  implies a rather sharp curved isoquant as the RST will change by substantial
amount as k/l changes.

*In general, it is possible that  will vary as we move along an isoquant and as the scale of
production changes. However, for convenience, we will assume that  is constant along an
isoquant.

37
3.4.2 Common Forms of Production Function
Based on our analysis on the elasticity of substitution, it is possible to identify four types of
production functions characterized with two inputs case.
Case 1: Linear production function (  =  ): This type assumes perfect substitutability of factors
of production. That is, a given commodity can be produced using only capital, or only labour or
by an infinite combination of capital and labour.

Suppose that the production function is given by

q = f (k , l ) = ak + bl (3.21)
We can easily show that this production function exhibits constant return to scale. For any   1,
f (k , l ) = ak + bl =  (ak + bl ) = f (k , l ) (3.22)
All isoquants for this production function are parallel straight lines as depicted below. Because
along any straight line isoquant, the RTS is constant, the denominator of elasticity of substitution
becomes zero (0), hence,  is infinity. This type of production function is not common in the real
world because the two inputs can be considered as perfect substitute. An industry characterized by
this type could use only capital or only labour depending on the inputs’ prices. It is hard to see
such production process in reality.

K per
period
Slope=

q3
q2
q1

L per period
Figure 3: Linear production function

38
The Isoquant AB indicates that a given quantity of a product may be produced by using only capital
or only labour. This is possible only when the two factors, K and L, are perfect substitutes for one
another.

Case 2: Fixed production function (  = 0 ): This production function assumes perfect

complementarity of factor inputs. That is, zero substitutability between factor inputs. Capital and
labour must be used in fixed ratio. The isoquant take a shape of a right angle or are L-shapeas
demonstrated in figure 4. This production function is also referred to as input-output isoquant or
Leontief isoquant.

Because k/l is a constant, we can see from the definition of elasticity of substitution that  is zero.
This type of production function has a wide range of applications. For instance, many machines
require a certain number of labour to run them while labourers on the other hands may require
some level of capital to produce.

K per
period

q3

q2

q1

L per period
Figure 4: L-shape production function

Such an Isoquant assumes zero substitutability between K and L. Instead, it assumes perfect
complementarity between the factors. That is, K and L are treated as perfect complements to one
another. The perfect complementarity assumption implies that a given quantity of a commodity
can be produced by one and only one combination of K and L and that the proportion of the inputs
is fixed. In other words, K and L are required in a fixed proportion to produce a given quantity of

39
a commodity. It also implies that if quantity of an input is increased and the quantity of other input
is held constant, there will be no change in the output.

Case 3: Cobb Douglas production function (  =1): This provides a middle ground between the
two extreme cases of perfect substitutability and perfect complementarity discussed above. It is
widely used in the analysis of production. Cobb Douglas function (CDF) assumes continuous
substitutability of capital and labour over a certain range, beyond which factors cannot substitute
for each other. Isoquants for this type of production function exhibit the normal convex shape as
presented in Figure 5. It can also be inferred from equation 3.20 that the elasticity of substitution
is 1 for Cobb Douglas function.

The mathematical form of the Cobb Douglas production function is given by

q = f (k , l ) = Ak  l  (3.23)

Where A, α and β are all positive constant.

Depending on the value of α and β, the Cobb Douglas function exhibits any degree of returns to
scale. Let us assume all input are increased by a scalar of  , equation 3.23 becomes

f (k , l ) = A(k ) (l )  =  +  Ak  l  =  +  f (k , l ) (3.24)

Hence, if α + β=1, CDF exhibits constant returns to scale because output also increase by a scalar
 . If α + β>1, we have increasing returns to scale while the function exhibits decreasing returns
to scale if α + β<1.

Many researchers have used the constant returns to scale version of the production function to
describe aggregate production relationships in many countries. The CDF has proved to be quite
useful because it is linear in logarithms as demonstrated below:

40
 K per
period

q3

q2

q1

L per period

Figure 5: Cobb Douglas Production function

Introduce logarithm to equation 3.23, we have

ln q = ln A +  ln k +  ln l (3.25

Where α can be interpreted as the output elasticity with respect to capital input, and β as output
elasticity to labour input.

Case 4: Constant Elasticity of Substitution production function (CES): The CES is a

functional form that incorporates all of the three previous cases and allows  to take on other
values. The function was first introduced by Arrow et al. 1961. The function is given by


q = f (k , l ) = k  + l  
/
(3.26)

For ρ≤1, p≠0, and η>0. The function incorporate an exponent of η/ρ to permit explicit of returns
to scale factors. Hence, for η>1, the function exhibits increasing return to scale while for η<1, we
have diminishing returns.

If we apply the definition of elasticity of substitution to CES function, the measure of  is provided
below

41
 1
 = (3.27)
1− 

For ρ=1, ρ=-  and ρ=0, we have the linear, fixed proportions and Cobb Douglas function
respectively as discussed above.

8) Technical progress: This represents an improvement in the method of production. This may
arise from the use of improved, more- productive inputs or from better methods of economic
organization. Technical progress often shifts the isoquant towards the origin. For example, in
figure 3, the new isoquant is established at q1.That is the original isoquant q0 shifts towards the
origin and this implies that a given level of output can now be produced with less input. For
instance, due to the improvement in technology, with k1 units of capital it now takes l1 units of
labour to produce q0 whereas it took l2 units of labour to produce q0 before the technical
advancement. We can see here that the major effect of technical progress is increase in output per
q0 q0
worker as output per worker increase from to . The concept of technical progress generates
l2 l1
efficiency in production in which the same output is produced with lesser inputs.

Suppose we have q = A(t ) f (k , l ) (3.28)

as a production for some goods. The term A(t) in equation 3.28 represents all the influences that
go into determining q besides capital and labour. Here changes in A over time represent technical
progress. This is why A is shown as a function of time. It is implicitly assumed that dA/dt>0. That
is, particular level of labour and capital inputs become more productive over time.

42
 K per
period

K2

K1 q0

q0

L1 L2 L per period

Figure 6: Technical Progress

3.5 COST FUNCTIONS

In this section, we examine the costs that a firm incurs when it produces output. It is necessary to
distinguish between accounting cost and economic cost. Accountant cost emphasizes out-of pocket
expenses, historical cost, depreciation other direct cost. Economist cost, on the other hands, is
based on the concept of opportunity cost. Economic cost of any input is given by the size of the
payment that is necessary to keep the resources in its present employment. Accountants are only
concern with explicit cost while economists consider both explicit and implicit costs of production.
For instance, in calculating capital costs, accountants consider the historical price of the particular
machine under investigation and apply some more-or-less arbitrary depreciation rule to determine
how much of that machine original price to charge current cost. However, economists consider the
historical machine as a “sunk cost” which is not relevant to output decision. They instead regard
the implicit cost of the machine to be what someone else would be willing to pay for its use. Hence,
the cost of one machine hour, to economists, is the rental rate for that machine in its best alternative
use. This distinction between accountant and economist cost also led the differences between
accountant and economic profit. Throughout this course we shall use economists’ definition of
cost.

43
3.5.1 ECONOMIC COST, ECONOMIC PROFIT AND COST MINIMIZATION

As stated earlier, the economic cost of any input is the payment required to keep that input in its
present employment. That is, economic cost is the remuneration the input would receive in its best
alternative. For further analysis, two assumptions are important. First, we will assume that there
are only two inputs: labour (l, measured in labour-hour) and homogenous capital (k, measured in
machine hours). Second, we assume that inputs are hired in perfectly competitive markets where
firms can buy or sell all the labour or capital services they want at the prevailing rental rate (w and
v for labour and capital respectively). This implies that, graphically, the supply curve for firm’s
input is horizontal at the prevailing factor prices. Both w and v are hence treated as “parameter”
in the firm’s decisions because they have no control on their prices.

Given the two assumptions above, the firm’s total cost is given by

total cos t = C = wl + vk 3.29

Where l and k represent inputs usage during the period. Equation 3.29 represent the isocost

Assuming that the firm produces a single output (q=f(k,l)) which it sells at price (p). Total revenue
is derived by multiply firm’s output (q) by selling price (p). Therefore, the firm’s total revenue is
given by

total revenue= pq = pf (k , l ) 3.30

Recall that economic profits (π) is the difference between total revenue and total cost which can
be represented by

 = totalrevenue − total cos t = pq − wl − vk = pf (k , l ) − wl − vk 3.31

Equation 3.31 shows that economic profit is a function of the amount of capital and labour
employed. Our interest here is to examine how the firm can produce a given output at minimum
cost. Hence, the firm will produce a particular level of output level (say, q0) which means that the
firm’s revenues are fixed at pq0.

44
3.5. 2 COST-MINIMIZING INPUT CHOICES

Mathematically, our aim here is to minimize total cost at a given level of output. That is we want

to minimize C = wl + vk subject to q = f (k , l ) = q0 . This is a constrained minimization problem.

Mathematical derivation

Minimize C = wl + vk (objective function)

Subject to f (k , l ) = q0 (constraint function)

Step 1: Set up a Lagrangian function

L = wl + vk + q0 − f (k , l ) 3.32

Where λ is the Lagrangian multiplier which show how much in extra costs would be incurred by
increasing the output constraint slightly.

Step 2: Obtain the first order condition for each variable

L f 3.33
= w− =0
l l

L f
= v− =0 3.34
k k

L
= q0 − f (k .l ) = 0 3.35


Divide equation 3.33 by 3.34, we have

f
w
= l =
k RTS( l for k) 3.36
v
k

45
 f f
Note that = MPk and = MPl
k l

Equation 3.36 states that the cost minimizing firm should equate the RTS for the two inputs to the
ratio of their prices.

Alternatively, we can derive the cost minimization condition by cross-multiply equation 3.36 to
give

MPk MPl
= 3.37
v w

This that for cost to be minimized, the marginal productivity per naira spent should be the same
for all inputs.

Graphical illustration
Cost minimization can be shown graphically. This is depicted in figure 7. Given the output
isoquant q0, our aim is to find the least costly point on the isoquant. Different cost curves (Isocost)
are represented by C1, C2 and C3. It is clear from the figure that the minimum cost for producing
output q0 is given by C1, where the total cost curve is tangential to the isoquant. The cost-
minimizing input combination is l* and k*. Hence, the mathematical and graphical illustration
produce the same result.

K per
period
C1

C2

C3

K*

q0

L* L per period
46
Figure 7: Cost Minimisation
3. 5. 3 THE FIRM’S EXPANSION PATH

A firm can follow the cost- minimization process for each level of output. That is, if it finds the
combination of inputs that minimize the cost of producing output q. If the input cost (w and v)
remain constant for all amounts the firm may demand, we can trace this locus of cost minimization
choices as presented below. The line OE records the cost-minimizing tangencies for successively
higher levels of output. For the level of output q1, the minimum cost is given by C1 with k1 and l1
as input combination. Other tangencies in the figure can be interpreted in a similar way for higher
level of output. The locus of these tangencies is called the firm’s expansion path. Hence, with
given factor prices (w and v) and production function (q0), the optimal expansion path is
determined by the points of tangency of successive isocost line and successive isoquants.
Expansion path records how input expands as output expands while holding the prices of the inputs
constant.

The shape of expansion path depends on the nature of production function. If the production
function is homogenous and exhibits constant returns to scale, the expansion path will be a straight
line through the origin as the RTS depend only on the ratio of k to l as illustrated in figure 8. If the
shape of production is non-homogenous, the optimal expansion path may not be a straight line,
even if the ratio of factor prices remains constant.

K per
period

q3

q2

q1
C1 C2 C3

0 L per period

Figure 8: Expansion Path

47
Example

Obtain the cost minimization condition from the following Cobb-Douglas production function.

q = f (k , l ) = k  l  given the cost equation as C = wl + vk

Step 1: Derive the Lagrangian function

L = wl + vk +  (q0 − k  l  )

Step 2: Obtain the first order condition for each variable

L
= w − k  l  −1 = 0 3.38
l

L
= v − k  −1l  = 0 3.39
k

L
= q0 − k  l  = 0 3.40


Divide equation 4.10 by 4.11

w k  l  −1  k
= = . 3.41
v k  −1l   l

Which also confirm that costs are minimized when the ratio of the inputs’ prices is equal to the
RTS. Since the production function is Cobb-Douglas and homothetic, the RTS depends only on
the ratio of the two inputs. If the ratio of costs does not change, the firm will use the same input
ratio no matter how much it produces. Hence, the expansion path will be a straight line through
the origin.

Numerical example

Suppose α=β=0.5, w=12, v=3 and the firm wishes to produce q0=40. Obtain the input combination
to achieve this given level of output and minimum cost.

48
Solution

Substitute all the parameters provided into our production function and cost equation above, we
have

Cost equation C = 12l + 3k 3.42

Production function 40 = k l
0.5 0.5
3.43

Our objective is to minimize cost subject to the production function

Step 1: Derive the Lagrangian function

L = 12l + 3k +  (40 − k 0.5l 0.5 ) 3.44

Step 2: Obtain the first order conditions and equate them to zero

L
= 12 − 0.5k 0.5 l 0.5−1 = 12 − 0.5k 0.5 l −0.5 = 0 3.45
l

L
= 3 − 0.5k 0.5−1l 0.5 = 3 − 0.5k −0.5 l 0.5 = 0 3.46
k

L
= 40 − k 0.5 l 0.5 = 0 3.47


Divide equation 3.45 by 3.46

12 0.5k 0.5 l −0.5 

=
3 0.5k −0.5 l 0.5 

4 k
= , k = 4l 3.48
1 l

Substitute equation 3.48 into 3.47, we have

40 = (4l ) 0.5 l 0.5

40 = 2l , l = 20.

49
To get the value of K, substitute 20 for l in equation 3.48

k=4(20), k =80.

Therefore, the cost minimizing input combination would be to combine 20 units of labour and 80
units of capital.

To get the minimum cost, substitute 20 for labour and 80 for capital in equation 3.42.

C = 12l + 3k , C=12(20) + 3(80), C= 240 + 240, C=480.

This is the minimum cost to produce 40 units of output.

3.5.4 COST FUNCTIONS

Our focus here is to examine the firm’s overall cost structure. Using the expansion path discussed
above, we can derived the total cost function.

1) Total cost function: The total cost (TC) function shows the total cost incurred by firm for any
set of input cost and output level. TC is specified below:

C = TC = C (v, w, q) 3.49

It is evident from figure 8 that total cost increase as output (q) increases. The starting point is to
analyze the relationship between total cost and output while holding input prices constant. In this
sense, cost function is defined as the relationship between cost output. That is, C = c(q) .

2) Average cost and marginal cost functions: Average cost function is the cost per unit of output.
It is obtained by dividing TC by output.

C (v, w, q) TC
AC = AC (v, w, q) = = 3.50
q q
Marginal cost function (MC) is found by computing the change in total costs for a change in output
produced. It is the addition to total cost that results from production of extra unit of output.
C (v, w, q) TC
MC = MC (v, w, q) = = 3.51
q q

50
It can be inferred from the definition of both AC and MC that the two functions depend on the
level of output being produced and on the prices of inputs. However, for convenience, we shall
assume that prices of inputs remain constant and that technology does not change. If we relax these
conditions, cost curves will shift to new position

Graphical analysis of total cost

From figure 9a, initially, the total cost curve is concave with total cost rising rapidly for increases
in output. The rate of increase slows as output expands towards the middle range. (point of
inflection) Beyond this middle range, the total cost curve becomes convex and costs begin to rise
progressively and more rapidly. Curve of this nature represents a cubic total curve.

Figure 9a: Total cost curve, Figure 9b: Average cost curve and marginal cost curve

Graphical analysis of average and marginal costs

51
In figure 9b above, the computation of AC and MC curves requires some geometric intuition
because of the assumed shaped of the curve. For this cubic total cost curve, average cost and
marginal cost curves will be “U” shaped. Recall that marginal cost is simply the slope of the total
cost curve. Therefore, because of the assumed shape of total curve, MC curve is U-shaped, with
falling over the concave portion of TC curve and rising beyond the point of inflection. Also,
because the slope of TC is always positive, MC is always greater than zero. On the other hands,
AC equal MC for the first unit of output. As output increases, AC exceeds MC. As long as AC >
MC, average costs must be falling because the lower costs of the newly produced units are below
average cost, they continue to pull AC downward. Marginal cost, however, rises and equal to AC
at q*. After this point, MC > AC and the AC must be rising because they are being pulled upward
by increasing marginal costs.

It has been proved that AC curve also has a U-shape and that it reaches the lowest point at q* where
AC and MC intersect.

3.5.5 Cost functions and shifts in cost curves

Up till now, we have drawn cost curves on the assumption that only quantity produced affect cost
while other factors are held constant. Specifically, construction of the curves assumes that input
prices and level of technology do not change. If these factors are allowed to change, the cost curve
will shift. Increase in an input price will raise total, average and marginal costs. However, increase
in cost will be influenced by the relative significance of the input in the production process. If an
input account for a large fraction of total cost, and increase in its price will raise costs significantly.
For instance, an increase in wage rate in building industry would significantly raise home-builder
cost because labour is a major input in construction. On the other hands, a price for a relatively
minor input will have a small cost in impact. For instance, a rise in nail prices will not have much
impact on home cost.

Technical improvement allows the firm to produce a given output with fewer inputs. Therefore,
such improvement obviously shift total curve downward (if input price stay constant).

52
3.5.6 Distinction between short run and long run

Understanding the difference between short run and long run period in economic analysis is crucial
especially in the discussion on the theory of firms and costs. Short run period is a period in which
economic actors have only limited flexibility in their action. In this period, at least one factor of
production is fixed. However, long run period provides greater freedom as all factors of production
are variable. To illustrate the distinction between the two concepts, we assume that capital input is
held constant at a level of k0. The implication of this is that the firm is free to vary only its labour
in the short run. Hence, short run production function is presented below

q = f (k 0 , l ) 3.52

Here, firm change its level of output by vary its labour input.

Short run total costs

Recall that Total cost for the firm is C = vk + wl

Due to the assumption about capital input, the short run total cost (SC) would be

SC = vk 0 + wl 3.53

Short run fixed and variable costs

Equation 3.53 can be divided into fixed and variable component, vk0 represents the short run fixed
cost while the second term wl is the short run variable cost. Therefore short run fixed costs are
cost associated with inputs that cannot be varied in the short run while short run variable costs are
those input that can be varied in order to change the firm’s output level. This implies that fixed
cost will be incurred at zero level of output.

Short run marginal and average costs

In economics, it more useful to analyse short run cost on a per unit of output basis rather than on
a total basis. The two most important per-unit concepts that can be derived from the firm’s short
run total cost function are short run average total cost function (SAC) and short run marginal cost
function (SMC). Derivations of the two concepts are presented below:

53
 SC
SAC =
q
3.53
SC
SMC =
q

The two functions above are identical to those developed in equations 3.50 and 3.51 for the long
run cost function and their derivation follows the same process. Because the short run total cost
curve has the same general type of cubic shape, these short run average and marginal cost curves
will also be U-shaped.

Relationship between short-run and long run cost curves

In the long run, all inputs, including capital, are variable. In this way, we can establish the
relationship between the short-run costs and long run costs as presented in figure 10 . Short run
total cost curves for three levels of capital input are presented. Inference from the figure shows
that long run total cost (TC) less than the short run cost, except at that level of output which
assumed that fixed capital is appropriate to long run cost minimization. For instance, with capital
input k1, the firm can obtain full cost minimization when k1 level of output is produced. Hence,
short run and long run total cost are equal at this point. At other output level, short run cost is
greater that long run cost.

Technically, the long run total cost curves are called an “envelope” of their short run curves. Short
run curve can be represented as

Short run total cost= SC (v, w, q, k ) 3.54

Here, the set of short run total cost curve is generated by allowing k to vary while holding v and
w constant. Long run total cost curve (TC) must also follow the relation in equation 3.55 and that
k must be chosen to be cost minimizing for any level of output.

A first order cost for cost minimization is that

SC (v, w, q, k )
=0 3.55
k m

54
 Figure 10: Long run TC and AC

Relationship between short run and long run marginal and average curves

The envelope total cost curve relationships explained under section 4.7 above can be used to show
the association between short run and long run marginal and average curves. This is presented in
figure 11 below. Short run and long run average costs are equal at that output for which capital
input is appropriate. At q1, Short run average cost SAC (k1) =long run average cost (AC) because
minimal cost is incurred at q1 when k1 is used. At any other output level, SAC exceeds ACs. It is
important to note marginal cost curve also pass through the lowest point of the of long run average
cost curve. Hence, we can establish that at q1, long run average cost and marginal cost are equal.
It can be seen from the curve that when AC reaches it minimum, SAC also reaches its minimum
at this level of output q1. Lastly, because the SAC curve reaches its minimum at output level q 1,
the short run marginal cost (SMC) also passes through this point.

55
The minimum point of the long run AC brings together the four most important per unit costs. At
this point

AC=MC=SAC=SMC 3.56

As we shall see later, equation 3.56 represents the equilibrium point for a competitive firm in the
long run.

Figure 11: Long run Marginal cost curve

56
3.6 PROFIT MAXIMISATION

In section 3.5, we examined how firms minimize costs for any level of output they choose. In this
module, we will focus on how the level of output is chosen by profit-maximising firms. As
discussed earlier, a firm is an economic agent who is responsible for transforming inputs to output.
The primary objective of firms is to maximize profit. Profit is the difference between total revenue
and total cost.

3.6.1 THE CONCEPTS OF PROFIT MAXIMIZATION AND MARGINALISM

Most models of supply assumed that the firm and its manager pursue the goal of achieving the
largest possible economic profits possible. A profit maximizing firm chooses both its inputs and
its outputs with the sole goal of achieving maximum economic profits. Firms can pursue other
goals such and wealth maximization but our focus in this course is on profit maximization.
However, in maximizing profit, firms often make their decisions in a “marginal” way. That is,
firms consider the incremental or marginal profit of producing one more unit of output, or at the
additional profit available from hiring one more labourer. As long as this incremental profit is
positive, extra output will be produced or extra labourer will be hired. When the incremental profit
of an activity becomes zero, it would not be profitable to produce since hiring additional labourer
will not increase total output.

The first step here is to examine the level of output a firm will choose to produce in order to obtain
maximum profit. Let us assume that a firm sells some level of output, q, at a market price of p per
unit.

Total revenues (R) are given by

R(q) = p(q).q 3.57

Here, we have allowed for the possibility that the selling price the firm receives might be affected
by how much (quantity) it sell.

In producing output q, certain economic costs are incurred and this is denoted by C (q) as we
discussed in section 3.5.

57
The difference between revenues and costs is called economic profits (  ). Since both revenues
and costs depend on the quantity produced, economic profits will also depend on quantity
produced. Hence, economic profit function is mathematically presented below

 (q) = R(q) − C (q) = p(q).q − C (q) 3.58

To maximize profits, there are two conditions which must be fulfilled. These are the “necessary
condition” and the “sufficient condition”.

Necessary or First-Order Condition (FOC)

The necessary condition for choosing the value of output (q) that maximizes profits is to find the
derivative of total profit in equation 3.58 and set it equal to zero. Taking the derivative of equation
3.58, we have

d dR dC
=   (q) = − =0 3.59
dq dq dq

There the first order condition (necessary condition) for profit maximization is that

dR dC
= 3.60
dq dq

dR dC
Note that is Marginal revenue (MR) while is marginal cost (MC).
dq dq

Hence, to maximize economic profits, the firm should choose that output for which marginal
revenue is equal to marginal cost. That is

dR dC
MR = = = MC 3.61
dq dq

Sufficient of Second-Order Condition (SOC)

Equation 3.59 or 3.60 is only a necessary condition for a maximum profit. For sufficient condition,
it is also requires that we obtain the second derivative which must be less than zero (negative) of
equation 3.59 and we have

58
d 2 d  (q )
= 0 3.62
dq 2 dq

Equation 5.6 can be interpreted to mean that marginal profit must be decreasing at the optimal
(maximum) level of q. For any output q less than optimal level of output (says q*), profit must be
increasing (i.e   (q )  0) ; and for output greater than q*, profit must be decreasing (  ( q )  0) .
Only if this condition holds has a true maximum been achieved.

Sufficient condition can also be obtained from equation 3.61 by taking the derivative of both the
MR and MC which must satisfy the following relation

dMR dMC
 3.63
dq dq

Graphical analysis

The relationship among total revenue, total cost and profit expressed above can be represented in
Figure 12 below. The graph depicts typical cost and revenue function. For low level of output,
costs exceed revenues and therefore economic profit is negative. In the middle range of output,
revenues exceed cost and so economic profit is positive. Lastly, at high output level costs rise
sharply and exceed revenues. The vertical distance, in the middle range, between revenues and
costs (profit) is shown in the graph by line PT. Here profits reach maximum at q*. The first order
condition is satisfied at this level of output as the slope of revenue curve (MR) is equal to the slope
of the cost curve (MC). Also, the sufficient condition is satisfied at the output level because profits
are decreasing to the right of q* and increasing to the left of q*.

59
 Figure 12: Profit maximizing level of output

3.6.2 MARGINAL REVENUE

As stated earlier, it is the revenue obtained from selling one or more unit of output (MR) that is
relevant to the profit-maximising firm’s output decision. If the firm can sell all the output it intends
to sell without any effect on market price, the market price will be the extra revenue (MR) obtained
from selling one additional unit. In this case, MR=market price. However, if a firm must reduce
its market price in order to sell additional unit, revenue obtained from selling one more unit will

60
be less than the price of that unit (MR<P). In this case, the firm faces a downward sloping demand
curve.

As discussed in equation 3.58,

R(q) = p(q).q

dR d  p(q).q  dp
MR(q) = = = p + q. 3.68
dq dq dq

Notice here also that MR is a function of output and MR will be different for different level of
output.

Now, if price does not change as quantity increases (dp = 0) , the firm is a price taker and its
dq

demand is a straight line. However, if price falls as quantity increases (dp  0) , marginal
dq
revenue will be less than price. Hence, a profit maximizing firm must know how increase in output
will affect its price before making an optimal output decision.

For example, if the demand curve for Bread is

q = 100 − 10 p 3.69

Obtain the market price and determine the firm’s MR. Also, find the level of output at which
total revenue is at maximum

To get the price, make p the subject of the formular, we have

p = 10 − q 3.70
10

To get the MR, we must first determine the total revenue

2
R = pq = (10 − q )q = 10q − q 3.71
10 10

dR
MR = = 10 − q 3.72
dq 5

61
Conclusion: since MR<p for all value of q. For instance, if the firm produces 30 loaves of bread
per day, equation 3.70 shows that he will receive a price of N7 per loaf. But at this level of output,
equation 3.72 reveals that MR will be N4 while the total revenue will be N210 (N7x30).

Note that the total revenue is at maximum when MR equal zero. To get the maximum revenue, set
the MR function to zero. We have,

dR
MR = = 10 − q =0,
dq 5

10 = q ; q = 10 * 5 = 50
5

Hence, the level of output that will maximize the total revenue is 50 units and the maximum
revenue will be N350 (N7x50).

3.6.3 MARGINAL REVENUE AND ELASTICITY

The concept of marginal revenue (discussed above) is directly related to the elasticity of demand
curve facing the firm. Recall that elasticity of demand (eq,p) is defined as the percentage change in
quantity that results from 1 percent change in price:

dq p
eq , p = . 3.73
dp q

This definition can be obtained from the expression of MR in equation 5.8 by factoring p out of the
expression as presented below

dp  q dp 
MR = p + q. = p 1 + .  3.74
dq  p dq 

 q dp 
Observed that the term  .  in equation 5.14 is the inverse of price elasticity of demand from
 p dq 
equation 3.73, hence, we can re-write MR as:

 1 
MR = p 1 +  3.75
 eq , p 

62
As stated earlier, if the demand is negatively sloped, eq , p  0 and MR will be less than

price. If demand is elastic ( eq , p  −1) , MR will be positive, here the sale of one more unit will not

affect price will not really affect price. If the demand facing the firm is infinitely elastic
(eq , p = −) , MR will be equal to price, in this case, the firm is a price taker. On the other hand, if

demand is inelastic (eq , p  −1) , MR will be negative. For this type of demand, increase in output

can be obtained by large decline in price which will consequently lead to decrease in total revenue.
If the demand is unitary, MR will be zero.

Relationship between marginal revenue and elasticity of demand can be summarized in the
following table

Elasticity coefficient Nature of demand Marginal Marginal

revenue revenue
eq , p  −1 elastic MR>0 positive

eq , p = −1 Unitary MR=0 No
change
eq , p  −1 inelastic MR<0 negative

Marginal Revenue and Average Revenue curves

Every demand curve has a marginal revenue curve associated with it. If the firm must sell all its
output at one price, it convenient to consider the demand curve facing the firm as an average
revenue curve. Average revenue is defined as total revenue per unit of output sold. Hence, the
demand curve shows the revenue per unit. That is, P=AR. Marginal revenue on the other hand,
shows the extra revenue provided by the last unit sold. As noted earlier, in a downward sloping
demand curve, MR will lie below the demand curve

3.6.4 SHORT-RUN SUPPLY BY A PRICE-TAKING FIRM

In this module, we will focus only on supply decisions in the short run in the market where a firm
is considered as a price-taking firm. That is, where a firm has not control over the market price.
Hence, in the market, firms take price as given (fixed). Therefore, the demand curve of a price-

63
taking firm is perfectly elastic and horizontal through the fixed price. The market price is given by
P* in figure 13 below. Also, recall that for a perfectly elastic demand, price equal MR (P*=MR) as
additional unit can be sold without affecting price. Hence, from figure 13, output level q* provides
maximum profit because at q*, price is equal to short run marginal cost. The position of average
curve determines whether the firm is making profit or loss. As we have in figure 13, the firm earns
profit on each unit sold because at output q*, price exceeds average cost. However, if price were
below average cost (says p***), the firm would have a loss on each unit sold. Also, if price and
average cost were equal, profit would be zero. Another thing to note is that at q*, marginal cost has
a positive slope. This is also requires for a true maximum profit. If P=MC on a negatively sloped
section of the MC, this would not be a point of maximum profit because increasing output would
yield more in revenue than production cost would yield. Hence, profit maximization requires both
that P=MC and that MC be increasing at this point.

In relation to the firm’s short-run supply curve, the positively sloped portion of the short-run
marginal cost curve above the point of minimum average variable cost (AVC) is the short –run
supply curve of a price-taking firm. For prices below this level, the firm’s profit maximizing
decision is to shut down and produce no output. Therefore, the firm’s short-run supply curve shows
how much it will produce at various possible output prices. Any factor that shifts the firm’s short
run MC (such as changes in input prices or change in the level of fixed input employed) will
automatically shift the short run supply curve.

64
 Figure 13: Short-Run Supply Curve for a Price-Taking Firm

Therefore, the firm’s short run supply curve is the part of marginal curve above the minimum point
on short run average variable cost. This is represented by the thick part of SMC in figure 13. In
other words, supply curve for a price taking firm consists of the positively sloped segment of the
firm’s short run marginal cost above the point of minimum average variable cost.

3.7 Practicing Questions

1. Briefly explain the following production concept
i) Production function
ii) Marginal product and average product
iii) Diminishing marginal productivity
iv) Isoquant and Isoquant map
v) Marginal rate of technical substitution
vi) Returns to scale
vii) Elasticity of substitution
viii) Technical progress

65
2. Explain four forms of production function. Substantiate your explanation with appropriate
graphs where necessary.

Suppose the production function for a Wrist Watch is given by q = kl − 0.8k − 0.2l
2 2
3.

Where q represents the annual quantity of Wrist Watch produced, k represents annual
capital input, and l represents annual labour input.

a) Suppose k=10; graph the total and average productivity of labour curves, At what level of
labour input does this average productivity reach a maximum. How many wrist watches
are produced at that point?
b) Again assuming that k=10, graph the marginal product curve of labour. At what level of
labour input does MPl=0?
c) Suppose capital inputs were increase to k=20. How would your answer to parts (a) and (b)
change?
d) Does the wrist watch production function exhibit constant, increasing, or decreasing returns
to scale?.

4. Given the production function for a commodity as q = 0.1k l

0.2 0.8

i) Identify the production function above.

ii) Obtain the MPk and MPl

iii) Determine the RTS

iv) Find the elasticity of substitution of the production function

5. Clearly differentiate between Accountant costs and Economist cost

6. Briefly explain the following cost concepts
i. Average cost and marginal cost
ii. Fixed and variable costs
7. Distinguish between short-run and long-run total cost curve

8. A firm producing Rechargeable Lamps has a production functions given by q = 2 k .l

66
In the short run, the firm’s amount of capital equipment is fixed at k = 64. The rental rate for
capital is v = N2, and the wage rate for labour is w = N4

i. Calculate the firm’s short run total cost and short run average cost.
ii. Derive the firm’s short run marginal cot function
iii. What are the short run total cost, short run average cost and short run marginal cost for
the firm if it produces 25 Rechargeable Lamps, 50 Rechargeable Lamps, 100
Rechargeable Lamps and 200 Rechargeable Lamps.
9. State the two conditions for profit maximization under the total approach and marginal
approach
10. Clearly show the relationship between marginal revenue and elasticity
11. In a perfectly competitive market, firm is considered as a price taker. Using the marginal
cost curve, derive the firm’s short run supply curve.
12. Loto Venture is a small business that acts as a price taker (MR=P) in Moro, Osun State.
The prevailing market price of Plastic Chair is N20 per chair. Loto’s costs are given by

Total cost = 0.1q + 10q + 50

2

Where q = number of plastic chairs Loto plans to sell in a day.

a) How many plastic chair should Loto sell in a day to maximize his profit?
b) Calculate Loto’s maximum daily profit
c) Determine the firm’s short run supply function

67
MODULE 4: PARTIAL EQUILIBRIUM COMPETITIVE MODEL

4.0 Rationale

Producers and consumers interact to exchange goods and services using money as a medium of exchange.
This could be done via telephone, internet fax and so on. The platform through which the exchange takes
place is referred to as “Market”. There are different types of market ranging from one seller and one
buyer to many buyers and many sellers. It is often said that production is not complete until the goods
produce reach the final consumer. Hence, there is need to study the role of market in economic analysis.

4.1 Goal

The goal of this topic is to introduce learners to the concept of partial equilibrium model of a perfectly
competitive market.

4.2 Learning Objectives

At the end of this topic learners should be able to

xii. Define Market structure

xiii. Identify basic characteristics of perfect competition
xiv. Differentiate between individual demand and market demand
xv. Differentiate between individual supply and market supply
xvi. Understand the timing of market supply in response to changes in demand condition
xvii. Understand the concepts of elasticity of demand
xviii. State the conditions for profit maximization
xix. Explain price and output determination in a perfectively competitive market in the short
run
xx. Describe the long run equilibrium condition in a perfect competitive market.

4.3 INTRODUCTION: In this module, we will focus on the model of price determination under
perfect competition originally developed by Alfred Marshal. We will provide analysis of the
supply-demand interaction as it relates to a single market. Model developed here referred to partial
equilibrium model of price discrimination because it focuses on only a single market.

68
4.4 DEFINITION OF MARKET

A market is any arrangement in which buyers and sellers get in touch with each other to exchange
goods and services using money as a medium of exchange. Buyer and sellers may be anywhere in
the world and may deal with one another by means of telephone, fax system and so on. In this
module, we shall focus on pure or perfect competitive market.

4.5 Perfect Competition

A perfectly competitive industry is one that obeys the following assumptions:

1) A relatively large number of firms: The output of each firm makes up only a very small
proportion of the total output. Therefore, changes in a single firm’s output level has little
or no measurable effect on total market supply and therefore no influence on the market
price
2) Homogenous product: Firms in this market produce and sell the same homogenous product.
That is, each unit of market output is a perfect substitute of another unit. Consequently,
buyers are indifferent between suppliers. In this market trade mark, patents or special brand
name do not exist.
3) Firms are price takers: Inference from the two assumptions above suggests that the demand
curve for a perfectly competitive firm is infinitely elastic indicating that the firm can sell
all its products at the prevailing market price. This implies that individual firm is a price
taker.
4) Free entry and free exit: In a perfectly competitive market, there is no barrier to entry and
exit. Also, resources in the market are assumed to be completely mobile. That is, resources
can be shifted in and out of the market without any transaction cost
5) Perfect information: Firms in the market have adequate information concerning the
prevailing prices. They also know the prices of all resource inputs and various alternative
technologies that are available for production. Buyers have information about the price,
quality and nature of the product.
6) Profit maximistion: As mentioned in the previous modules, each firm in a perfectly
competitive market attempts to maximize profit.

69
The atomism of buyers and sellers with the assumption of product homogeneity imply that
MR=AR=P in perfectly competitive market as demonstrated below

dTR
TR = pq , MR = =p
dq

TR pq
TR = pq , AR = = =p
q q

Therefore, MR = AR = p

4.6 MARKET DEMAND CURVE

Recall from module 2 that we constructed individual demand functions that shows how changes
in the quantity of a good that a utility maximizing individual chooses as the market price and other
factors change. For two commodity case, an individual demand function can be presented as:

q x = x( p x , p y , I ) 4.1

Where px and py are prices of commodity x and y respective and I denotes individual income. Note
that, market demand function can be derived from individual demand function by adding up all
individuals demand function in market place. Consequently, we can construct total demand
function (market demand) in a market place as

n
Q x =  xi ( p x , p y , I i ) , 4.2
i =1

Here we use capital letter Q to represent market demand, we also use subscript i to represent
individual demand function for good x. Market demand function is constructed based on the
assumption that everyone in the market place faces the same prices for both goods. Hence p x and
py enter equation 4.2 with person’s specific subscript. On the other hand, individual income enters
the function with his own specific demand function. This means that market demand depends on
total income of all individuals in the market as well as the distribution of income among
individuals.

70
 From equation 4.2, we can draw a market demand curve. Since, quantity demanded depends not
only on its own price, but also on prices of other goods and on the income, we allow the price of
x to vary while holding the price of y and income constant. Figure 1 presents market demand curve
where there are only two individuals in the market. Market demand is determined by adding up
the quantities demanded by each person. Hence, a market demand curve is the horizontal
summation of each individual’s demand curve.

PX
px

PX*

X1 X3
X2
X1 X2 X3

a) Individual 1 b) Individual 2 c) Market demand

Figure 1: Market demand from individual demand curves

As discussed in module 2, changes in the price of x, would result in movement along the demand
curve. But any change in other determinants (such as price of y and consumer income) will cause
a shift in the demand curve. To refresh our memory, economists refer to movement along the
demand curve as “change in quantity demand” while any shift in the position of the demand curve
is called “change in demand”.

Example: Obtain the market demand function for orange from the following individual demand
function

Individual 1, q1 = 10 − 2 p x + 0.5 p y + 0.2 I 1 4.3

Individual 2, q 2 = 12 − 3 p x + 0.3 p y + 0.4 I 2 4.4

71
Where px and py represent price of orange and price of grapefruit respectively (given in Naira per
dozen) and I1 and I2 represent income for individual 1 and individual 2 respectively.

Since market demand is defined as the horizontal sum of individual demands, market demand
function will be

Q( p x , p y , I 1 , I 2 ) = q1 + q 2 = 10 − 2 p x + 0.5 p y + 0.2 I 1 + 12 − 3 p x + 0.3 p y + 0.4 I 2 4.5

Q = 22 − 5 p x + 0.8 p y + 0.2 I 1 + 0.4 I 2 4.6

To graph the market demand for equation 4.6, we hold py , II and I2 constant by assuming constant
value for them. This is important because demand curve reflects only the two-dimensional
relationship between quantity of x and price of x.

Since our focus, in this module, is on partial equilibrium (single market), we shall assume that all
other determinants of quantity demand are constant except the price of the good. As stated earlier,
we shall use capital Q to represent market demand and capital P to mean market price.

4.6.1 Elasticity of market demand

Given that market demand is presented as follow:

Q = f ( P, P o , I ) 4.7

Where Q is market demand, P is market price for the good, Po as prices of other goods and I as
the incomes of all potential demanders.

Price elasticity of market demand follow a similar patter as described for individual demand in
module 2.

Q( P, P 0 , I ) P
Price Elasticity of Market Demand= eQ , P = . 4.8
P Q

Please note that other factors such as income and price of other goods are held constant while
computing the own price elasticity of market demand. That is why we use the symbol  to denote
partial derivative. Discussion on types of price elasticity of market demand follows similar
discussion presented in module 2.
72
We will also examine other elasticity concept such as cross elasticity and income elasticity of
market demand.

Q( P, P 0 , I ) P 0
Cross Elasticity of Market Demand= . 4.9
P 0 Q

Q( P, P 0 , I ) I
Income Elasticity of Demand= . 4.10
I Q

4.7 TIMING OF THE SUPPLY RESPONSE

In the analysis of competitive price, it is important to decide the length of time to be allowed for a
supply response to changing demand conditions as this has significant impact on the establishment
of equilibrium position. For this analysis, we will examine three different time periods.

1) Very short run

2) Short run
3) Long run

In the short run, quantity supply is fixed and does not respond to changes in demand; hence, there
is no response from supply. In the short run, existing firms may change the quantity they are
supplying, but no new firm can enter the industry. However, in the long run, new firms may enter
an industry, thereby producing a flexible supply response

4.7.1 Pricing in the very short run

Figure 2 below presents the graphical analysis of a typical firm in the very short run period. As
noted above, there is no supply response in this market. The goods are already in the market place
and must be sold for whatever price the market will bear. In this period, price acts only as a device
to ration demand. That is, since quantity supply is fixed, price will adjust to clear the market of
quantity that must be sold during the period. In figure 2, market demand is represented by the curve
D, supply is fixed at Q*and the price that clears the market is P1. At this price, consumers are
willing to take all that is offered in the market. Sellers want to dispose of Q* without regards to
price. Hence P1 and Q* is an equilibrium price-quantity combination. But if demand shifts to D’,

73
the equilibrium price will rise to P2 but Q* remains fixed because there is no response from supply.
Therefore, in the very short run, supply curve is a vertical straight line at output Q*

Figure 2: Pricing in the Short Run

4.7.2 Short run market supply

Recall that, in the short run, the number of firms in an industry is fixed. However, these firms
adjust the quantity they are producing in response to changing conditions. They do this by varying
altering the levels of employment for those inputs that can be varied in the short run. As noted in
the previous module, short run supply curve for individual firm is represented by short run
marginal cost curve above the minimum point of the average variable cost curve. To construct the
short run market supply curve, we simply add quantity supply by all the firms in the market. The
relationship between price and quantity supplied is called a short run market supply curve. Market
supply curve here is the horizontal sum of the two firms. Because each firm’s supply curve has a
positive slope, the market supply curve will also have a positive slope. The positive slope reflects
the fact that short run marginal costs increase as firms attempt to increase their outputs.

74
 Given the short run supply function for each of the n firms in the industry as qi ( p, v, w) , where p

is the price of commodity, v and w represent price of capital and labour respectively. The short
run supply function shows total quantity supplied by each firm to a market. This is given as

n
Qs ( p, v.w) =  qi ( p, v.w) 4.11
i =1

It is assumed here that the firms in the industry face the same market price and the same prices for
inputs. Hence market supply presented in figure 3 shows the relationship between Q and P, holding
v and w constant. This means that changes in v, w and technology will result to shift in the market
supply curve.

P
SA p S

P1

qA qB
Total
output per
a) Firm A b) Firm B c) The Market period

Figure 4: short-Run Supply Curve

4.7.3 Short-run supply elasticity: This simply refers to the responsiveness of the output of firms
in an industry to changes in prices. The measure shows how proportional changes in market price
are met by changes in output. It is defined as:

Qs P
e S ,P = . 4.12
P QS

QS
Since, supply is an increasing function of price, (  0) meaning that supply elasticity is
P
positive.

75
4.8 Equilibrium Price Determination: Knowledge of market demand and market supply
discussed above jointly produce the equilibrium price and quantity. The two curves jointly
establish equilibrium price and quantity through the intersection of both demand curve and supply
curves.

S
P

P1

D
Q
Q1

Figure 4: Equilibrium Price and Quantity

The two curves intersect at price P1 and quantity Q1. The equilibrium price serves two important
functions. First, it acts as a signal to producer by providing them with information on how much
should be produced. The second function is to ration demand for individuals to decide how much
of their incomes to devote to a particular goods. Hence, equilibrium price is one at which quantity
demanded is equal to quantity supply.

Mathematically, an equilibrium price P* is derived by solving the equation

QD ( P * , P' , I ) = QS ( P * , v, w) 4.13

Holding other factors constant, equation 6.13 can be represented as

Q D ( P * ) = QS ( P * ) 4.14

76
Alternatively, equilibrium price and quantity can be achieved using the total approach and
marginal approach discussed in previous section.

4.9 Pricing and Output Determination under Perfect Competition: short run equilibrium

Recall that a firm is in equilibrium at the output level where profit is maximized. The short run
equilibrium here can equally be regarded as short run profit maximization. Our objective is to
determine the price-quantity relationship that maximizes profit in the short run.

Also, as presented in module 5, there are two approaches to short run equilibrium which are the
total approach and marginal approach.

Under the total approach, total profit (profit=TR-TC) is maximized when the difference between
TR and TC is greatest. Hence, the equilibrium of a firm in the one at which total profits are
maximized. Therefore, given that profit =  = TR − TC , the following conditions are necessary
for profit maximization under the total approach

d
i) =0 (necessary or first order condition)
dq

d 2
ii)  0 (Sufficient or second order condition)
dq 2

However, marginal approach is more useful to analyse short run equilibrium of a firm. Recall that
MR is the change in TR for a unit change in quantity, MC is the derivate of TC and that in a
perfectly competitive market, MR and market price are equal. Hence, marginal approach tells that
the perfectly competitive firm maximizes short run total profit when following two conditions are
satisfied:

i) MR=MC-necessary of first order condition

ii) MC must be rising at the point of intersection- second order condition

77
 P MC

P* MR=D=AR

Q* Q

Figure 5: Marginal approach for Output determination

Mathematical derivation of market equilibrium in a perfect competition

 = R −C
FOC :
d dR dC
= − =0
dq dq dq
dR dC
=  MR = MC
dq dq

As noted in the previous section, MR=AR=P. Thus, under perfect competition, short run first order
condition requires that P=AR=MR=MC.

For Sufficient condition (SOC):

d 2 d 2 R d 2 C
= − 0
dq 2 d 2 C dq 2
d 2 R d 2C

d 2 C dq 2

This implies that the slope of MR curve is lower than the slope of MC curve. That is, the MC curve
is steeper than MC curve which also suggests that MC curve must cut MR curve from below at

78
profit maximizing level of output. The implication of the SOC is that the MC curve must be rising
at the point of intersection.

4. 10 Cases of profit under short run in perfectly competitive firm

Case 1: Economic or abnormal profit: Due to the assumption of free entry and free exit, it is
possible for perfectly competitive firm to make abnormal profit. This kind of profit is presented
below:

PRICE/ MC

COST AC

E
P* MR = AR
PROFIT

0 Q*
B QUANTITY

Figure 5: Abnormal Profit

From the diagram above, the profit is maximized at point E where both FOC and SOC are satisfied.
Rectangle OP*EQ* is the total revenue (TR) while the area OCBQ* represents the total cost (TC).
The difference between the TR and TC, captured by the shaded area, represent the firm’s abnormal
or economic profit in the short run. This is given by rectangle CP*EB.

The presence of such economic profit provides an incentive to potential new entrants. As more
firms enter into the market to compete for the available output, the amount of abnormal profit for
the existing firm tends to decline up to the point where TR=TC. In this case, the firm will be
earning zero economic profit. At this point, the firm is operating at the breakeven point. This is
presented in the figure below

79
 AC
PRICE/ MC

COST
AVC

P* MR = AR

0 Q*
QUANTITY
Figure 6: Breakeven point

Case 2: Loss minimizing condition: In case 1 above, the firm was maximizing total profit because
price is greater than AC. If price is less than AC (P<AC) but greater than average variable cost
(AVC), the firm will be minimizing total loss but it can still continue to operate as long as the firm
can cover its average variable cost and part of its fixed cost. The case of a loss minimizing
condition is illustrated in the following diagram:

MC AC

PRICE/

COST
D
C
LOSS
P* MR = AR
E

0 Q*
QUANTITY 80
Figure 7: Loss minimizing condition

In the graph above, TR is given by area OP*EQ* while the TC is represented by rectangle OCDQ*.
Here, the firm is making a loss corresponds to the area P*CDE.

Case 3: Shut down condition

If the firm cannot cover its short run variable cost, the only recommended option is to close down
since by discontinuing operation, the firm is better off. In the graph below, the closing down point
is at point F. if price falls below P, the firm does not cover its variable costs and is better off if it
closes down.

AC
MC
PRICE/ AV
C
COST

P MR = AR = D
E

0 Q*
QUANTITY

Figure 8: Short down point

4.11 Long Run Equilibrium of the Firm

In the long run, all factors of production and all production costs are variable. Therefore output is
expanded until economies of scale runs and excess capacity vanishes. The optimal level of output
for the firm in the long is the point at which long MC intersect the price or MR curve. The presence
of positive economic profit in the short run encourages new firm to enter the industry. It is a wise
economic decision for entrepreneur to shift their economic resources away from those lines of

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production where variable cost cannot be covered to the one where more economic profit can be
earned. Since there are no barriers to entry, the industry will continue to receive new entrants. This
will increase the market supply of the product and price will fall continuously until all economic
profits are eliminated. Hence, in the long run, perfectly competitive firm will earn normal profit.
This is presented below:

LMC
PRICE/ LAC
COST
SAC

SAC

SAC
MR = AR = D
P*

Q* QUANTITY

Figure 9: Long run equilibrium of a firm

4.12 Assignment

1. Define the term “market structure”

2. Identify common feature of perfectly competitive market

3. Differentiate between individual demand and market demand

4. Identify and explain different timing of supply response to changes in demand condition

5. Graphically explain the concept of equilibrium in perfectly competitive market

6. Discuss the condition for pricing and output determination under perfectly competitive market

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7. With the aid of appropriate diagram, explain different cases of short-run profit maximization
under the perfectly competitive market.

8. Graphically present the condition for long run equilibrium in a perfectly competitive market.

9. Suppose the demand for Computer is given by Q = 100 – 2P and the supply by

Q = 20 + 6p. Determine the equilibrium price and quantities for Computer

10. Assume that an Entrepreneur’s short run total cost is given by

C = q 3 − 10q 2 + 17q + 66

If the price of his product (P) is N5, determine the output level at which he maximizes profit

11. Given that the demand curve for a perfectly competitive firm is

P = 100 − 2Q and total cost as C = 50 + 40Q

i. Find the profit maximizing level of output

ii. Obtain the total profit
iii. Test for the second order condition.

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MODULE FIVE: THE MODELS OF IMPERFECT COMPETITION

5.0. RATIONALE
In our analysis so far under the theory of the firm, one of the most important assumptions was that
both suppliers and demanders were price takers. All economic actors were assumed to exert no
influence on prices. Consequently, prices treated as fixed parameters in their decisions.
Henceforth, however, we wish to explore the consequences of dropping the price taking
assumption especially for suppliers of goods and services.

5.1. GOAL
The goal of this module is to understand how markets will act and perform in the absence of the
price taking assumption.

5.2. LEARNING OBJECTIVES

At the end of this module, learners should have been able to understand:
i) What monopoly is and how it can occur.
ii) The inverse elasticity rule under monopoly.
iii) The cost and benefit of monopoly.
iv) What price discrimination is.
v) The conditions through which price discrimination can occur.
vi) The types of price discrimination.
vii) What oligopoly is, the forms they can occur and the characteristics.
viii) Pricing under homogenous oligopoly

5.3. MONOPOLY AND PRICE DISCRIMINATION

Definition of monopoly
Monopoly is a market structure in which there is a single supplier in the market. Monopoly power
derives from the existence of barriers to entry. These barriers make it impossible or unprofitable
for other firms to enter the market. If other firm could enter the market, the firm ceases to be a

84
monopoly. Barriers to entry could be classified into two general types. These are: Technical
barriers and Legal barriers
Technical barriers may result from the following:

i) Absolute cost advantage: One technical basis of a monopoly is the special knowledge
of a low cost production technique which confers on an existing monopoly an absolute
cost advantage. This gives the incumbent firm the opportunity to earn excess profit
without fear of entry, provided the firm can overcome the problem of allowing the
special knowledge of low cost production to be known to others.

ii) Economies of large scale production that requires large capital expenditure can also
constitute a serious barrier to entry. The argument is usually presented in two forms.
(a) If the technique of production is such that relatively large scale firms are low
cost producers, then an incumbent firm can enjoy monopoly powers earning
excess profit since the large capital requirement drives out potential entrants.
(b) The strategic behaviour in which incumbent firms finds it profitable to drive
others out of the industry by price cutting also constitute barriers to entry.

iii) Product differentiation: Firm produce similar but unidentical products to create a
long time barrier to entry. For instance, consumers goodwill towards a more established
brand name that practices product differentiation can make it difficult for new brands
to enter.

Legal Barriers
Many pure monopolies are created as a matter of law rather than a matter of economic conditions.
One important example of a government granted monopoly condition is in the legal protection of
a production technique by Patent. The defense made of such a government granted monopoly is
that the patent system makes innovation more profitable and therefore acts as an incentive to
technical progress. Whether the benefits of such innovation exceed the cost of having the
monopoly is an open question. Another example of a legally created monopoly is the awarding of
exclusive Franchise to serve a market, as in the case of public utilities.

85
THE INVERSE ELASTICITY RULE UNDER MONOPOLY
We recall that TR = P(q). q ………… (1)
Where P(q) is the market price (inverse dd function)
q is the level of sales
𝒅𝑷
Then, MR = P + q (Using product function rule) ………… (2)
𝒅𝒒
𝒒 𝒅𝑷
= P (1 + . ) ………… (3)
𝑷 𝒅𝒒

If we denote 𝒆𝒑 as the price elasticity of the demand can facing the monopoly, then we can write
𝟏
MR = P (1 + ) ………….. (4)
𝒆𝒑

As in the case of monopoly, the demand curve facing the firm is negatively sloped, hence 𝑒𝑝 < O

and MR < P, if we assume the firm wishes to maximize profit, we can establish a connection
between P and MC. Setting MR = MC (condition for profit maximization)
𝟏
MC = P (1 + ) …………… (5)
𝒆𝒑

𝑷−𝑴𝑪 𝟏
Thus, =− …………….. (6)
𝑷 𝒆𝒑

i.e. the gap between P and MC will decrease as the demand curve facing the firm becomes more
elastic. In other words, the inverse elasticity rule states that the assumptions of profit
maximization implies that the gap between the price of a firm’s output and its MC is
inversely related to the price elasticity of the demand curve facing the firm. This observation
leads to two general conclusions about monopoly pricing.

i) The monopolist will only choose to operate in region in which the market demand curve
is elastic i.e. 𝒆𝒑 < -1, if demand were inelastic MR will be negative and could not

therefore be equated to MC (which is presumably always positive). Eqn (6) shows that
𝒆𝒑 > -1 implies an implausible MC.

86
 ii) A second implication of the equation is that, the firm’s mark-up over MC (measured as
a fraction of price) depends inversely on the elasticity of market demand.
If 𝒆𝒑 = -2, P = 2MC, whereas if 𝒆𝒑 = 10, P = 1.11 MC.

SUPPLY CURVE UNDER MONOPOLY

In the theory of Perfect Competitive market presented earlier, it was possible to speak of an
industry Supply curve. We constructed this curve by allowing the demand curve to shift and
observing the supply curve that was traced out by the series of equilibrium price – quantity
combination. This type of construction is not possible for the monopolistic market. With a fixed
market demand curve, the Supply curve for a monopolist will be only one point, namely the price
quantity combination for which MR = MC. If the demand curve should shift, the MR curve would
also shift and a new profit maximization output would be chosen. However, connecting the
resulting series of equilibrium points on the market demand curves would have little meaning.
This locus might have a very strange shape, depending on how the market demand curve elasticity
and its associated MR curve changes as the curve is shifted. In this sense, the monopoly firm has
no well-defined supply curve.

Illustration: Monopoly with Linear Demand

Suppose a monopoly market has a linear demand curve of the form
Q = 2000 – 20P or P = 100 – 0.05Q naira
and the cost of the monopoly firm is given by TC = 0.05𝑸 𝟐 + 10000 naira.
To maximize profit, this producer chooses that output level for which MR = MC

TR = PQ = 1000 - 0.05 Q2
𝜹𝑻𝑹
MR = = 100 – 0.1Q
𝜹𝑸

MC = 0.1Q
MR = MC → 100 – 0.1Q = 0.1Q
100 = 0.1Q + 0.1Q
= 0.2Q

87
 𝟏𝟎𝟎
Q = = 500
𝟎.𝟐

P = 100 - 0.05 (500) = 100 - 25 = 75 naira

π = TR - TC
= 500 (75) - [0.05 (500)2 + 10000]

= 37,500 - [12500 + 10000]

= 37,500 - 22,500

= 15,000
Using the inverse elasticity rule, show the relation between P and MC at the profit maximizing
level of output.
MC = 0.1 (000) = 50
𝝏𝑸 𝑷 𝟕𝟓
Recall that 𝒆𝒑 = . = -20.
𝝏𝑷 𝑸 𝟓𝟎𝟎

𝑷−𝑴𝑪 𝟏
The inverse rule states that =− (Check)
𝑷 𝒆𝒑

𝑷−𝑴𝑪 𝟏
= → 3P – 3MC = P → 2P = 3MC → 𝑷 = 𝟏. 𝟓 𝑴𝑪
𝑷 𝟑

COST AND BENEFIT OF THE MONOPOLY

Under Perfect Competition, economic efficiency is possible. First, in the Perfectly Competitive
firm, it is the case that in the Long Run, market price equals the min of the SR and LR ATC or P
= MR = MC = Min ATC = Min SRAC. Thus producing at the minimum of AC in both the SR
and LR ensures productive efficiency. Second, in addition to productive efficiency, Perfectly
Competitive firms produce the level of output at which P = MC. This condition is referred to as
allocative efficiency.

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MONOPOLY AND RESOURCE ALLOCATION

𝑷𝒎 B

DWL
𝑷𝒄
A E MC (=AC)

AR = D

MR
O 𝑸𝒎 𝑸𝒄 Quantity

In order to evaluate the allocative and distributive effect of a monopoly, we need a precisely
defined basis of comparison. A particularly simple one is provided by the perfectly competitive,
constant cost industry. We recall that the long-run Supply curve of a Perfectly competitive
constant cost industry is infinitely elastic with P = MC = AC. It is convenient to think of a
monopoly as arisen from the “capture” of such a competitive industry and to treat the individual
firms that constitute the competitive industry as now being single plant in the monopolist empire.
We can then compare the performance of this monopoly to the performance of the previously
competitive industry to arrive at a statement about the welfare consequences of monopoly. The
figure above shows a single linear demand curve for a product produced by a constant cost
industry. If the market were competitive, output would be 𝑸𝒄 i.e. production would occur

where P = LRMC = LRAC. Notice that total consumer surplus will be triangle DE𝑷𝒄 .. Under

a single price monopoly, output will be 𝑸𝒎 where MC = MR compared with the competitive
output level. Monopoly output is less than a competitive output. The restriction in output from

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𝑸𝒄 to 𝑸𝒎 represents the misallocation brought about through monopolization and gives rise to
the following consequences.

(i) Loss of consumer surplus and income distribution

The restriction is output from 𝑸𝒄 to 𝑸𝒎 through monopolization reduces consumer
surplus to ∆BPm indicating that total consumer surplus lost is PmBEPc. Part of this
loss is captured by the monopoly as profit. These are measured by the rectangle
PmBAPc and they reflect a transfer of income from consumers to the firm. This is to
say that income is redistributed from consumers to producers through monopolization.
Whether such a transfer is regarded as desirable depends on prevailing societal norms
about whether consumers or producers (i.e. the monopolist) are more deserving of such
gains. As for any transfer, difficult issues of equity arise in attempting to access social
desirability.

(ii) Misallocation due to dead weight loss

From the above analysis, we see that out of the total consumer surplus of PmBEPc lost
as a result of monopolization, one part of it represented by rectangle PmBAPc is
transferred to the monopolist. The other part rep by the ∆BEA is the loss in consumer
surplus transferred or allocated to nobody. This is the Dead Weight Loss (DWL). The
society therefore suffered a pure DWL as a result of the monopolization of the
previously competitive market.
.
(iii) Misallocation of input resources: The total value of input resources released from
use by the output restriction is shown by the area AEQcQm. This is the value of
transferred inputs. Essentially, it is like the monopolist closes down some of the plants
that operated in the competitive case. These inputs are therefore, transferred elsewhere
to produce other goods. Transferring these inputs elsewhere will cause these other
goods to be over produced relative to their Pareto efficient level.

(iv) Misallocation due to rent seeking behaviour: Some economists contend that the
efficiency loss to society is much larger than the DWL. Posner (1975) argued that part

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 of the monopoly profit may also represent a loss to society to the extent that it creates
incentives for a firm to use real resources to become a monopoly. For instance, suppose
a firm can become a monopoly by persuading the government to pass a law that restricts
entry into the market, the use of a firm’s resources to hire lobbyists, lawyers, and
economists to argue the firm’s case before legislators is a cost to the society because
these resources could have been productively employed elsewhere. Expenditure used
in seeking the political system to obtain economic returns that are not available things
normal market transactions are said to be spent on rent-seeking activities.

Rent Seeking
This is spending time and money not on the production of real goods and services, but rather on
trying to get the Government to change the rules so as to make one’s business more profitable.

BENEFITS OF MONOPOLY
The welfare harm from monopoly may be off-set by several benefits. These benefits are usually
ignored when calculating the DWL. Nonetheless, the most clearly recognized benefit of monopoly
is in Research and Development (R & D). Theoretically, the monopolist has large amount of profit
that can be spent on R & D to bring about innovations in product quality and technology of
production. The prospect of receiving monopoly profit may motivate firms to develop new
products, improve existing products, develop new methods of production, improve on existing
techniques of production, and to lower cost of producing goods for the society. If a firm succeeds
in developing a new product, it can obtain a patent that prohibits other firms from using the
patented technology for a fixed number of years. Without the patent, other firms will copy the
technology. The patent therefore gives the monopoly a period to recover part of cost invested in
R & D that generates this technology. Without monopoly, R & D leading to societal progress may
not occur.

PRICE DISCRIMINATION
Firms in competitive markets lack discretion in their pricing policy because they are price takers.
To maximize profit, the monopolist may use non-uniform pricing usually called Price

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discrimination. This refers to any non-uniform pricing policy used by a firm with market power in
order to maximize profit.

A firm’s incentive for PRICE DISCRIMINATION

A firm practices price discrimination to increase its profit. It is profitable because consumers who
value the good most pay more than if prices were uniform. To show that it is profitable, consider
the figure below which shows the demand curve facing a monopoly.

Price

𝑷𝟎

A
𝑷𝟏

B C D

O 𝑸𝟎 𝑸𝟎+𝟏 Quantity

A price discriminating monopoly will sell Q at Po and the extra unit at P1

TR is given by: TR = 𝑷𝟎 𝑸𝟎 + 𝑷𝟏 𝑸𝟎+𝟏 = Area (A + B + C). The monopolist that does

not practice price discrimination will sell all the 𝑸𝟎+𝟏 units at 𝑷𝟏 per unit for which 𝑷𝟏 𝑸𝟎+𝟏

= Area (B + C). Clearly, area A is the loss in revenue when the non-uniform pricing situation
(Price discriminating situation) is compared with the uniform pricing situation. All methods of
price discrimination can be viewed as attempts to minimize the decrease in TR on all existing
output whenever a decrease in price is needed to induce the sale of one more unit.

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CONDITIONS FOR PRICE DISCRIMINATION
All firms willing to practice price discrimination may be unable to do so except the following
conditions are fulfilled:
(1) Possession of Market Power: A firm must have some market power (the ability to set
price above MC profitably
(2) Identification of consumer Willingness to Pay: A firm must know or be able to infer
consumers’ willingness to pay for each unit. Furthermore, this willingness to pay must
vary across consumers. This will enable the firm to identify consumers to change the
higher price
(3) Ability to prevent or limit resale: To price-discriminate successfully, a firm must be
able to prevent or limit resale by consumers who pay the lower price to those who pay
the higher price. Any attempt to charge one group a higher price than another is
doomed to fail if resale is possible.

TYPES OF PRICE DISCRIMINATION

There are many methods of charging non-uniform pricing and all methods aim at capturing all or
part of consumer surplus. We have first, second and third degree price discrimination.
In first degree price discrimination, the entire consumer surplus is captured by the firm
practicing price discrimination. In first degree, otherwise known as perfect price discrimination,
consumers are left with no consumer surplus, implying that the non-competitive firms is able to
charge a maximum price each consumer is willing to pay for each unit of the product.
In second degree price discrimination, the price per unit depends on the number of unit
purchased. The firm that can prevent or at least control resale between two individuals charges
these different customers different prices for the same product. However, the firm does not know
the demand curve of each individual. Rather the firm makes use of its knowledge about the
underline distribution demand in the population.
Third degree price discrimination is a form of price discrimination in which each group of
consumer faces its own pricing per unit. It is assumed that the seller can divide consumers into
two or more independent groups, each of which has its own demand function with different
elasticity at common prices.

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5.4. TRADITIONAL MODEL OF IMPERFECT COMPETITION: OLIGOPOLY
We now examine price determination in between the two polar extremes of perfect competition
and monopoly. In this case, we modify the monopoly model to consider the situation in which a
market is dominated by a few firms. This type of market structure is called oligopoly. In the real
world situation, firms that account for most of the output in an economy are oligopoly. There is
no single model that can explain all the forms that the oligopoly market structure can take. The
market may produce homogenous or differentiated products. We can as well have cooperative
and non-cooperative oligopoly. Despite the variants of oligopoly, the following is a summary of
their major characteristics.

(1) Small number of dominant firms: Oligopolistic firms are often large firms, each
producing a significant proportion of total market output. In some cases, a market may
actually consist of many firms, however, to the extent that the market is dominated by
one or a few firms, the market structure is considered to be Oligopoly.

(2) Mutual interdependence: Because the market is dominated by a few times, the price
and output decision of one firm may affect the profitability of the remaining firms in
the market. Mutual interdependence is an incentive to developing alternatives to price
competition in the pursuit of economic profit.

(3) Barriers to Entry: Like monopoly markets, oligopoly markets are usually
characterized by considerable resource immobility especially economies of scale.
Barriers to entry limit the threat of competition and facilitate the ability of firms to earn
long run economic profits.

(4) Homogenous or differentiated product: The output of an Oligopolist market may

either be homogenous or differentiated. .

FOCUS OF ANALYSIS
As stated earlier, no single model can be used to explain all the possible forms of the oligopolistic
market structure. Nonetheless, we will examine a few of the basic elements that are common to

94
many of the models that are in current use. To that end, our focus of analysis will be on three
specific issues.

(1) Pricing of homogenous goods in markets that contain relatively few firms.
(2) Product differentiation and advertisement in such market.
(3) The effects that entry and exit possibilities have on long run outcome in imperfectly
competitive markets.

Given the above focus of analysis, our current concerns are on relaxing the stringent assumption
of the perfectly competitive model and see what the results of changing those assumptions have.
As we did under monopoly, the Perfectly Competitive model will continue to serve as a useful
benchmark since departure from the competitive norm may involve efficiency losses.
The specific criteria that will be used in this comparison are:
i) Whether prices under this imperfectly competitive market of oligopoly equal MC.
ii) Whether in the long run, production occurs at min AC.

At the end of the analysis we will see that often imperfectly completive markets will last one or
both of these desirable features of perfect competition.

PRICING UNDER HOMOGENOUS OLIGOPOLY

To examine the general theory of price determination in markets in which relative few firms
produce a single homogenous product, we make the following assumptions.

i) There are no information or transaction costs. This means that the good in question
obeys the law of one price. The law holds when a homogenous good trades at the same
price no matter who buys it or which firm sells it. In this case, we can speak
unambiguously of the price of the goods.
ii) The market is perfectly competitive on the demand side. This means that there are many
demanders, each of whom is a price taker.

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 iii) There are a fixed number of n identical firms (where n is taken to be a relatively small
number). However, the method of analysis does not depend on the value of n.

Now we denote the output of each firm in our model by

𝒒𝒊 ( i = 1, 2…….n) .
The inverse demand form for the good is denoted by
f(Q) i.e. P =f(Q) = f(𝒒𝟏 , 𝒒𝟐 , 𝒒𝟑 , … … 𝒒𝒏 )
Where Q = 𝒒𝟏 + 𝒒𝟐 + 𝒒𝟑 +……. + 𝒒𝒏 .
Each firm’s decision problem is to maximize its own profit. Thus, given the market price of the
good and the firm’s TC which are denoted by TCi (qi).
Hence, the firm’s goal is to maximize profit.
𝝅𝒊 = TR - TC
= f(Q) 𝒒𝒊 - TCi (qi)

π = f(𝒒𝟏 + 𝒒𝟐 + 𝒒𝟑 + ⋯ … + 𝒒𝒏 )𝒒𝒊 - TCi (qi)

Most of the issues to be discussed ultimately centers around how firms are assumed to choose the
output that will maximize the profit in the equation above.

There are four different models regarding this profit maximizing decision. These models are
called oligopoly price models. They are:
i) Quasi – competitive model: This assumes price taking behaviour by all firms. ie. price
is treated as fixed. Alternatively, this model is called QUASI COMPETITIVE
SOLUTION because the equilibrium solution is obtained by setting price equal to
marginal cost as is done under perfect competition.
ii) Cartel Model : Here it assumed that firms can collude perfectly in choosing industry
output.
iii) Cournot Model: This assumes that firm i treats firm j’s output as fixed in its decision.
𝜹𝒒𝒋
Mathematically, = 0
𝜹𝒒𝒊

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 iv) Conjectural variation model: Here it is assumed that firm j’s output will respond to
𝜹𝒒𝒋
variation in firm i’s output. Mathematically, ≠ 0
𝜹𝒒𝒊

QUASI – COMPETITIVE MODEL OR SOLUTION

Recall that the Perfectly competitive model is characterized by the equality of price and MC i.e P
= MC. Here each firm assumes (probably incorrectly) that its decision will not affect market price.
Under this condition, the FOC for profit maximization is:
𝜹𝛑𝒊 𝛅𝐓𝐂𝐢 (𝐪𝐢)
=P - =0
𝜹𝒒𝒊 𝜹𝒒𝒊

i.e. P - MCi (qi) = 0 → P = MCi (qi) ( i = 1, 2…….n)

The equation above results in n supply equations and together with the market clearing demand
equation, P =f(Q) = f(𝒒𝟏 , 𝒒𝟐 , 𝒒𝟑 , … … 𝒒𝒏 ) ensures that the market arrives at the short run
competitive solution.

To simplify, consider a market in which there are two firms i.e P = f(Q) = f(𝒒𝟏 + 𝒒𝟐 )

The total revenue of each firm depends on its own output and that of the rival.
R1 = R1(q1, q2) = Pq1 = q1 f(q1 + q2)
Similarly, R2 = R2 (q1, q2) = Pq2 = q2 f(q1 + q2)

The profit of each firm equals its own TR less cost i.e.
π1 = R1 (q1, q2) - C1(q1)
π2 = R2 (q1, q2) - C2(q2)

The solution is determined by solving the eqn. P = C1’(q1), and P = C2’(q2)

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Numerical Illustration
Let the demand and cost firms in a duopoly market be given by:
P = 100 – 0.5(q1 + q2) , C1 = 5q1, C2 = 0.5q22.
Find the competitive solution for P, q1, and q2. Find also the TC level for each firm
𝜹𝑪𝟏 𝜹𝑪𝟐
MC1 = = 5 MC2 = = q2
𝜹𝒒𝟏 𝜹𝒒𝟐

P = MC1 P = MC2
100 – 0.5(q1 + q2) = 5 100 – 0.5(q1 + q2) = q2
100 – 5 = 0.5q1 + 0.5q2 100 – 0.5q1 - 0.5q2 = q2
100 – 5 = 0.5q1 + 0.5q2 100 = 0.5q1 + 0.5q2 + q2
95 = 0.5q1 + 0.5q2 100 = 0.5q1 + 1.5q2
190 = q1 + q2 ….. (1) 200 = q1 + 3q2 ……. (2)

Subtract eqn (2) from eqn (1)

10 = 2q2
q2 = 5
190 = q1 + q2
190 = q1 + 5 → q1 = 185

Sub. for q2 and q1 in P = P = 100 – 0.5 (190)

= 100 – 95 = 5

π1 = Pq1 - C1 (q1)
= 5 (185) - 5(185) = 0
π2 = Pq2 - C2 (q2)
= 5(5) - 0.5 (5)2

= 25 – 12.5 = 12.5

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CAR TEL SOLUTION / MODEL
This assumption of price taking behaviour may be inappropriate in oligopoly industry in which
each firm recognizes that its decisions have obvious effect on price. An alternative assumption
will be that firms as a group recognize that they can affect price and manage to coordinate their
output positions so as to achieve a monopolist profit. Coorperating oligopoly can occur when a
small number of firms coordinate their actions to maximize joint profit.
When the actions are coordinated openly subject to explicit cartel agreement, we have overt
collusion.
When firms in an oligopoly market coordinate their actions despite the lasting explicit cartel
agreement, the resulting coordination is sometimes referred to as tacit collusion

The most widely recognized example of a cartel is the OPEC. Another example is the International
Tin Cartel which operated successfully for many years. Notice that a cartel does not necessarily
involve all the producers of a particular product. If a few large firms make most of the sales in the
market and if they coordinate their activities, they can form a cartel without involving the smaller
firms in the market. In overt or tacit collusion, a cartel acts like a multi-plant monopolist and

chooses members’ output 𝒒𝟏 , 𝒒𝟐 , 𝒒𝟑 , … … 𝒒𝒏 so as to maximize total industry profit given by π

= TR – TC

π = PQ - [TC1(q1) + TC2(q2) + TC3 (q3) + ….. + TCn (qn)]

= f(q1 + q2 + + qn) x (q1 + q2 + …. + qn) - ∑𝒏𝒊=𝟏 𝐓𝐂𝐢 (𝐪𝐢)
𝜹𝛑𝒊 𝜹𝑷
The FOC for a max are that = P + (q1 + q2 + … + qn) - MCi(qi) = 0
𝜹𝒒𝒊 𝜹𝒒𝒊

𝛿π𝑖
i.e. = MR(Q) - MCi(qi) = 0
𝛿𝑞𝑖

Notice that MR can be written as a function of the combined output Q of all firms since its value
is the same no matter which firm’s output level is changed. At the profit maximizing point, this
common MR will be equated to each firms’ MC. This statement can be expressed mathematically
that the cartel solution requires that MR(Q) = MCi(qi)

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where Q = q1 + q2 + …+ qn.
To simplify let n = 2, then the resulting duopoly has the following demand and cost
P = 100 – 0.5(q1 + q2) C1 = 5q1 C2 = 0.5q22
R = (100 – 0.5Q)Q MC1 = 5 MC2 = q2
R = 100Q - 0.5Q2
MR = 100 – Q
= 100 – (q1 + q2)
MR = MC1 MR = MC2
100 - q1 – q2 = 5 100 – q1 – q2 = q2
95 = q1 + q2 ….. (1)
100 = q1 + 2q2 ……..(2)
Subtracting (1) from (2), 5 = q2 q1 = 90
P = 100 – 0.5(Q) = 100 – 0.5 (95) = 100 – 47.5 = 52.5
π1 = Pq1 - C1 π2 = Pq2 - C2
= 52.5(90) - 5(90) = 52.5(5) - 0.5(5)2
= 4,275 = 250

VIABILITY OF THE CARTEL MODEL

There are 3 problems with the cartel or collusion solution.
(1) Legality problem: Effectively, overt or tacit collusion translates into monopolistic
decision. There are many countries that regard monopolistic decision an illegal.
Therefore intending cartel members may have the problem of confronting the authority.

(2) Inadequate information: Cartel solution requires a considerable amount of

information for appropriate decision making by the directors of the cartel. Specifically,
the cartel directors must know the market demand function and each member firm’s
cost function. The information may be costly to obtain and some cartel members may
be reluctant to provide needed information.

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 (3) Uncooperative behaviour of members: Since each cartel member will produce an
output for which P>MCi, each firm or producer will have an incentive to expand output.
This practice results in production above each member’s production quota. The
difficulties of the OPEC cartel in dictating output level to its members in the mid 1980s
attests to this problem.

Conditions that can enhance the enforcement of cartel agreement

Cartel agreements are easier to enforce if it is easy to detect violation of agreement. Four factors
can aid the detection of cheating by members
(a) There are few members in the market
(b) Prices do not fluctuate independently
(c) Prices are widely known
(d) All cartel members sell identical product at the same point in the distribution chain.

5.5. QUESTIONS
1) Describe three ways through which monopoly can occur as a result of market conditions.
2) Define and state the inverse elasticity rule under monopoly.
3) Mention three factors that can prevent the practice of price discrimination.
4) Describe the three forms of price discrimination.
5) Describe the four major characteristics of an oligopolistic market.
6) What are the assumptions that determine prices under homogenous oligopoly?
7) Identify the four models of oligopoly pricing, stating the assumptions of each.
8) What are the factors that can break the enforcement of a cartel agreement?

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