MGEC08 Supplementary Notes
1
MGEC08 – ECONOMICS OF MARKETS
AND FINANCIAL DECISION MAKING
Supplementary notes – Demand & supply analysis
Types of markets
Demand & supply curves
Consumer surplus, producer surplus, total surplus
Price floor & price ceiling
Elasticities
Utility maximization, including income and substitution effects
Production costs
MGEC08 Supplementary Notes
2
Chapter 1 – Demand and Supply Analysis: Introduction & Review
Review – What is Economics?
• Economics is a study of the production, distribution, and consumption of
goods and services.
• Two major branches in economics – microeconomics & macroeconomics.
 Microeconomics focuses on the decisions made at the individual level and
the allocation of resources.
 Macroeconomics focuses on overall functioning of the economy (i.e., what
happens to the aggregate quantities).
Types of Markets
• Economic agents interact with each other in different markets. These markets
include:
 Factor markets: markets for the factors of production such as labour,
physical capital, land and materials used in production.
 Goods markets: markets for the outputs of production.
o The outputs of production are goods and services, which may be
intermediate goods and services or final goods and services.
 Capital markets: markets that serve to bring the suppliers of funds (i.e.,
savers) and the demanders for funds (i.e., borrowers) together.
o They allow providers or suppliers of long-term sources of funding, to
exchange their capital for long-term claims on a firm’s cash flow and
assets (that is, debt and equity securities).
MGEC08 Supplementary Notes
3
Basic Economics Principles and Concepts
Demand
• Demand shows the relationship between the quantity of goods or services that
consumers/buyers are willing to buy and the price of that goods or services.
• The law of demand: Holding all else constant, there is an inverse relationship
between price and quantity demanded (i.e., the demand curve is downward
sloping).
 Each point on the demand curve shows the MAXIMUM price consumers
are willing to pay (per unit) for any particular quantity.
• Change
P
in
quantity
demanded – movement
along the demand curve.
• Change in demand – shift
in the demand curve.
D
Q
• A typical demand function for good X :
𝑄𝑥𝑑 = 𝑓(𝑃𝑥 , 𝑖𝑛𝑐𝑜𝑚𝑒, 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑒𝑠, 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑝𝑙𝑒𝑚𝑒𝑛𝑡𝑠, 𝑒𝑡𝑐. )
• Factors that causes the demand curve to shift:
 Consumer’s income
 Price of substitutes.
 Price of complements.
MGEC08 Supplementary Notes
4
Supply
• Supply shows the relationship between the quantity of goods or services that
producers are willing to offer/sell and the price of that goods or services.
• The law of supply: Holding all else constant, there is a positive relationship
between price and quantity supplied (i.e., the supply curve is downward
sloping).
 Each point on the supply curve shows the per-unit MINIMUM price
producers must receive so that they are willing to sell at each level of
output.
P
S
• Change
in
quantity
supplied
–
movement
along the supply curve.
• Change in supply – shift
in the supply curve.
Q
• A typical supply function of good X :
𝑄𝑥𝑠 = 𝑓(𝑃𝑥 , 𝑖𝑛𝑐𝑜𝑚𝑒 (𝐼), 𝑤𝑎𝑔𝑒𝑠, 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙, 𝑡𝑒𝑐ℎ𝑛𝑜𝑙𝑜𝑔𝑦, 𝑒𝑡𝑐. )
• Factors that causes a shift in the supply curve:
 Prices of production factors and inputs
 Change in production technology.
MGEC08 Supplementary Notes
5
Market Equilibrium
• Market equilibrium refers to the situation in which the quantity demanded
at a given price is equal to the quantity supplied at that price.
P
• If there is excess supply,
S
there will be pressure for
price to drop.
P0
• If there is excess
demand, there will be
pressure for price to rise.
D
Q
Q0
Example: Suppose the (market) demand and supply curves of good X are:
𝑄𝑥𝑑 = 15 − 10𝑃𝑥
𝑄𝑥𝑠 = 10𝑃𝑥 − 5
Find the equilibrium price and quantity.
Answer:
Equilibrium is given by 𝑄𝑥𝑑 = 𝑄𝑥𝑆
15 – 10PX = 10PX – 5
20PX = 20
Px* = $1
Q*x = 15 – 10 ×1 = 5
Or
Q*x = 10 ×1 – 5 = 5
The equilibrium price is $1, and the equilibrium quantity is 5.
MGEC08 Supplementary Notes
6
Consumer Surplus, Producer Surplus & Total Surplus
• Consumer surplus (CS) measures the difference between the maximum price
the consumer is willing to pay (or total benefits) of consuming a given quantity
and the actual price.
CS = Maximum willingness to pay – Actual payment
P
If consumers buy Q0 units,
• Max. willingness to pay = 1 + 2
• Actual payment = 2
1
P
0
• CS = 1
2
D
Q
0
Q
• Producer surplus (PS) is the difference between total revenue the producers
received from selling a given quantity of goods and the total variable cost of
producing that amount.
PS = TR – TVC of producing that quantity.
P
S
If producers sell Q0 units,
• TR = 3 + 4 (= 2 above)
• TVC = 4
P0
• PS = 3
3
4
Q
0
Q
MGEC08 Supplementary Notes
7
• Total surplus (TS) is the difference between the total benefits enjoyed by
consumers by consuming a given quantity and the total variable costs of
producing that quantity.
TS = Total benefits – TVC
TS = CS + PS
P
S
If Q0 units are traded
• Total benefits = 1 + 3 + 4
1
• TVC = 4
P0
• TS = 1 + 3
3
4
CS
D
PS
Q
0
Q
Example: Suppose the demand and supply curves of good:
𝑄𝑥𝑑 = 15 − 10𝑃𝑥
𝑄𝑥𝑠 = 10𝑃𝑥 − 5
Find the consumer surplus, producer surplus and total surplus when
the market is in equilibrium.
Answer: The equilibrium price is $1, and the equilibrium quantity is 5.
• Consumer surplus = 0.5 × ($1.5 – $1) × 5 = $1.25.
• Producer surplus = 0.5 × ($1 – $0.5) × 5 = $1.25.
• Total surplus = $1.25 + $1.25 = $2.5.
MGEC08 Supplementary Notes
8
Price Floor & Total Surplus
• Price floor refers to minimum price buyers are required to pay for a good or
service.
• Examples include minimum wage.
P
S
If price cannot fall below P1:
1
P
• Quantity traded = Q1
1
2
4
• new TS = 1 + 2 + 3
3
5
•  in TS = – (4 + 5) =
P0
deadweight loss (DWL)
D
Q
Q1
Q0
Price Ceiling & Total Surplus
• Price ceiling refers to maximum price sellers are allowed to charge for a good
or service.
• Examples include rent control.
P
S
If price cannot rise above P1:
• Quantity traded = Q1
1
4
• new TS = 1 + 2 + 3
2
5
•  in TS = – (4 + 5) = DWL
P0
P1
3
D
Q
Q1
Q0
MGEC08 Supplementary Notes
9
The Tax Burden
• Suppose a (per-unit) tax is imposed on consumers/buyers:
P
After the tax of T is imposed:
S
• Quantity traded = Q1
• Price paid by buyers = PC
PC
1
• Price received by sellers = PS
2
• Tax revenues = (PC – PS)Q1
P0
PS
• DWL = 1 + 2
D–T
D
Q
1
Q
0
Q
• Suppose a (per-unit) tax is imposed on producers/sellers:
P
After the tax of T is imposed:
S+T
S
• Quantity traded = Q1
• Price paid by buyers = PC
PC
1
• Price received by sellers = PS
2
• Tax revenues = (PC – PS)Q1
P0
PS
• DWL = 1 + 2
D
Q
1
Q
0
Q
MGEC08 Supplementary Notes
10
Elasticities
• Elasticity measures how sensitive/responsive of a variable to a change in
another variable.
(Own Price) Elasticity of Demand
• Own price elasticity of demand (𝐸𝑃𝑑 ) measures how responsive quantity
demanded will be when there is a change in the price of the good.
𝐸𝑃𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
=
𝑑𝑄𝑥𝑑 ⁄𝑄𝑥𝑑 𝑑𝑄𝑥𝑑
𝑃
=
×
𝑑𝑃⁄𝑃
𝑑𝑃
𝑄𝑥𝑑
 Since demand curve is downward sloping, we look at the absolute value.
• Demand is elastic if 𝐸𝑃𝑑 > 1.
 If price increases by 1%, then qty demanded will fall by more than 1%.
 The demand curve is relatively flat.
• Demand is inelastic if 𝐸𝑃𝑑 < 1.
 If price increases by 1%, then qty demanded will fall by less than 1%.
 The demand curve is relatively steep.
• Demand is unit elastic if 𝐸𝑃𝑑 = 1.
 If price increases by 1%, then qty demanded will fall by exactly 1%.
• Demand is perfectly elastic if 𝐸𝑃𝑑 = ∞.
 If price increases by 1%, then qty demanded will fall to zero.
 The demand curve is horizontal.
• Demand is perfectly inelastic if 𝐸𝑃𝑑 = 0.
 If price increases by 1%, then qty demanded does not change.
 The demand curve is vertical.
MGEC08 Supplementary Notes
11
Cross Price Elasticity of Demand
• Cross price elasticity of demand (𝐸𝑃𝑑𝑦 ) measures how responsive quantity
demanded will be when there is a change in the price of other good.
𝐸𝑃𝑑𝑦
=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑋 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌
𝑃𝑦
𝑑𝑄𝑥𝑑 ⁄𝑄𝑥𝑑 𝑑𝑄𝑥𝑑
=
=
×
𝑑𝑃𝑦 ⁄𝑃𝑦 𝑑𝑃𝑦
𝑄𝑥𝑑
• If 𝐸𝑃𝑑𝑦 > 0, then X & Y are substitutes.
• If 𝐸𝑃𝑑𝑦 < 0, then X & Y are complements.
Income Elasticity of Demand
• Income elasticity of demand (𝐸𝐼𝑑 ) measures how responsive quantity
demanded will be when there is a change in consumers’ income.
𝐸𝐼𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
=
𝑑𝑄𝑥𝑑 ⁄𝑄𝑥𝑑 𝑑𝑄𝑥𝑑
𝐼
=
×
𝑑𝐼 ⁄𝐼
𝑑𝐼
𝑄𝑥𝑑
• If 𝐸𝐼𝑑 > 0, then X is a normal good.
• If EXP < 0, then X is an inferior good.
(Own Price) Elasticity of Supply
• Own price elasticity of supply (ES) measures how responsive quantity
supplied will be when there is a change in the price of the good.
 We are looking at what happens when we move along the supply curve.
𝐸𝑃𝑠 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
=
𝑑𝑄𝑥𝑠 ⁄𝑄𝑥𝑠
𝑑𝑄𝑥𝑠
𝑃
=
×
𝑑𝑃⁄𝑃
𝑑𝑃
𝑄𝑥𝑠
MGEC08 Supplementary Notes
12
Chapter 2 – Demand and Supply Analysis: Consumer Demand
Utility
• A utility function is a representation of the satisfaction that a consumer
receives from a basket of goods or services.
• The utility of a basket is measured in utils, which represent the ranking of the
utility of the goods and services:
𝑈 = 𝑈(𝑄𝑋1 , 𝑄𝑋2 , … , 𝑄𝑋𝑛 )
where 𝑄𝑋𝑖 is quantity of good or service i in the bundle
Indifference Curves
• Indifference curve (IC) shows the combinations of consumption set such that
the level of satisfaction/utility is the same.
Prosperities of Indifference Curve
• The shape of indifference curve depends on the utility function, which
captures the consumption preference.
• The utility function is assumed to be well behaved (i.e., continuity,
completeness, transitivity, and non-satiation)  the indifference curve is
smooth and display diminishing marginal rate of substitution (MRS).
 MRSX,Y shows the amount of Y that a consumer is willing to give up in
order to obtain an additional unit of X, holding the level of satisfaction
constant, i.e., MRSX,Y = –
∆Y
∆X
on the same IC =
MUX
MUY
 The slope of the indifference curve is the MRSX,Y.
MGEC08 Supplementary Notes
13
• Indifference curves shift in a parallel fashion (i.e., indifference curves
NEVER cross).
Y
IC1
IC0
X
Budget Constraint
• Budget constraint (BC) shows the combinations of goods may be purchased
given current prices and level of income.
Total income (I) = Total expenditure
I = PXQX + PYQY
𝑄𝑌 =
𝐼
𝑃𝑌
𝑃
− ( 𝑋 ) 𝑄𝑋
𝑃𝑌
QY
Change in I, PX, and/or PY will
shift the BC.
𝐼
𝑃𝑌
BC
QX
𝐼 ⁄𝑃𝑋
MGEC08 Supplementary Notes
14
Utility Maximization
• Objective: Choose the consumption bundle that will maximize utility for a
given level of income.
Max U = U(QX, QY)
subject to I = PXQX + PYQY
QY
𝐼
• The optimal bundle is the one
𝑃𝑌
such that
Q0Y
𝑀𝑈𝑋
𝑀𝑈𝑌
=
𝑃𝑋
𝑃𝑌
(point A)
A
IC
BC
QX
Q0X
𝐼 ⁄𝑃𝑋
Income Effect and Substitution Effect
• Substitution effect (SE): the change in the quantity of a good consumed due
to a change in the relative price of goods.
• Income effect (IE): the change in the quantity of a good consumed due to a
change in consumer’s purchasing power. The change in purchasing power can
comes from a change in income or a change in relative price of goods.
 Holding all else constant, when income rises, and the demand for the goods
increases, then the goods are normal goods.
 Holding all else constant, when income rises, and the demand for the goods
decreases, then the goods are inferior goods.
MGEC08 Supplementary Notes
15
Case 1: X is normal goods & Px 
QY
𝐼
𝑃𝑌
𝑃0
• Slope of BC0 = 𝑋
Q0Y
𝑃𝑌
A
C
• Slope of BC =
1
B
IC1
1
𝑃𝑋
𝑃𝑌
IC0
BC0
BC1
QX
Q0X
𝐼
𝐼
0
𝑃𝑋
1
𝑃𝑋
When Px :
• The budget constraint rotates to BC1.
• SE: holding utility constant (i.e., IC at IC0), the consumption bundle changes
from point A to point B
 The consumption of X  while the consumption of Y , as X becomes
relatively less expensive.
P
P1
PY
PY
• IE: holding ( X) constant at X, the consumption bundle changes from point B
to point C.
 The consumption of X  because when Px , purchasing power of the same
income Px  and X is a normal good, so consumers buy more X.
• Total effect: Point A to Point C.
MGEC08 Supplementary Notes
16
Case 2: X is inferior goods & Px 
QY
𝐼
• Slope of BC =
0
𝑃𝑌
C
Q0Y
IC1
A
0
𝑃𝑋
𝑃𝑌
𝑃1
• Slope of BC1 = 𝑋
𝑃𝑌
B
BC0
IC0
BC1
QX
Q0X
𝐼
𝐼
0
𝑃𝑋
1
𝑃𝑋
When Px :
• The budget constraint rotates to BC1.
• SE: holding utility constant (i.e., IC at IC0), the consumption bundle changes
from point A to point B
 The consumption of X  while the consumption of Y , as X becomes
relatively less expensive.
PX
P1X
Y
Y
• IE: holding ( ) constant at , the consumption bundle changes from point B
P
P
to point C.
 The consumption of X  because when Px , purchasing power of the same
income Px  and X is an inferior good, so consumers buy fewer X.
• Total effect: Point A to Point C.
MGEC08 Supplementary Notes
17
Chapter 3 – Demand and Supply Analysis: Production Cost
Objectives of the Firm
• The primary objective of any firm is to maximize profit.
• Firm’s profit:
Profit () = Total Revenue (TR) – Total Cost (TC)
• Note: there is a difference between accounting profit and economic profit.
 Accounting profit = Total revenues – Total explicit costs.
 Economic profit = Total revenues – Total explicit and implicit costs.
• Normal profit is the accounting profit such that both explicit and implicit costs
are covered.
Accounting profit = Economic profit + Normal profit
 When accounting profit > normal profit (i.e., positive economic profit), it
will have a positive impact on firm’s equity.
Example: Consider a company that has revenues of $100 million, explicit costs
of $60 million, and implicit costs of $30 million.
• Accounting profit = $100 – $60 = $40 million
• Economic profit = $100 – $60 – $30 = $10 million
• Normal profit = $40 – $10 = $30 million
MGEC08 Supplementary Notes
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Economic Rent
• Economic rent is any payment to an owner of a particular resource or good
(usually fixed in supply) in excess of the costs needed to bring that factor into
production.
P
S
• What happens to the price of a
good when demand increases?
Price  & economic rent 
• What happens if the limited
P0
supply increases?
Price  & economic rent .
D
0
Q
Q0
Analysis of Revenue, Costs, and Profits
Total, Average, and Marginal Revenue
• Total revenue (TR) is the total receipts from the sale of a good or service.
TR = P  Q
• Average revenue (AR) is the average revenue per unit sold.
AR =
𝑇𝑅
𝑄
• Marginal revenue (MR) is the change in TR generated by an additional unit
of output.
MR =
∆𝑇𝑅
∆𝑄
=
𝑑𝑇𝑅
𝑑𝑄
• For perfectly competitive firm, P = AR = MR.
MGEC08 Supplementary Notes
19
• Firms that have some market power, P = AR > MR.
• TR maximizes when MR = 0.
P
• MR
lies
below
demand
because to sell an additional
unit, firm needs to lower price
(not just for the last unit sold
but for all units sold).
MR
D = AR
Q
Q0
The Production Function & Productivity
• Production function shows the relationship between the quantity of inputs a
firm uses and the quantity of output it produces.
q = F(K, L)
• Total product (TP/Q) is the total amount of output from all inputs.
• Average product (AP) of an input is the amount of output produced per unit
of that input.
AP of an input =
TP
Total quantity of input employed
• Marginal product (MP) of an input is the additional quantity of output that
is produced by using one more unit of that input.
MP of an input =
∆TP
∆ quantity of input employed
MGEC08 Supplementary Notes
20
Law of Diminishing Returns or Law of Diminishing Marginal Products
• Usually, the production function shows that as more and more of a input is
employed in the production process, holding other inputs and production
technology constant, leads to a decline in the marginal product of that input –
we called this diminishing returns to an input (or diminishing marginal
product).
Relationship between Average Product and Marginal Product
• Look at the relationships between AP and MP (using labour as example).
APL, MPL
APL
MPL
L
Observations:
 MPL increases initially, reaches its maximum and then begins to falls.
 APL increases initially, reaches its maximum and then begins to falls.
 If MPL > APL, then APL .
 If MPL < APL, then APL .
 If MPL = APL, then APL is maximized.
MGEC08 Supplementary Notes
21
The Cost Functions in the Short Run
Total Fixed Cost and Total Variable Cost
• Total cost (TC) is the sum of all costs of producing goods or services.
• Total fixed cost (TFC) is a cost that does not depend on the quantity of output
produced.
• Total variable cost (TVC) is a cost that depends on the quantity of output
produced.
TC = TFC + TVC
TC, FC, VC
TC = TFC + TVC
TVC
TFC
q
• The total cost curve and the variable cost curve become steeper as more output
is produced due to diminishing returns (diminishing marginal products).
MGEC08 Supplementary Notes
22
Average Cost and Marginal Cost
• Average fixed cost (AFC) is the fixed cost per unit of output.
𝑇𝐹𝐶
AFC =
𝑄
• Average variable cost (AVC) is the variable cost per unit of output.
AVC =
𝑇𝑉𝐶
𝑄
• Average total cost, or average cost (AC), is total cost divided by quantity of
output produced.
AC =
𝑇𝐶
𝑄
=
𝑇𝐹𝐶
𝑄
+
𝑇𝑉𝐶
𝑄
= AFC + AVC
• Marginal cost (MC) is the change in TC when there is a unit change in output.
MC =
∆𝑇𝐶
∆𝑞
=
𝑑𝑇𝐶
𝑑𝑞
AC, AFC, AVC, MC
MC
AC
AVC
AFC
Q
MGEC08 Supplementary Notes
23
Observations:
 When MC < AVC, AVC falls.
 When MC > AVC, AVC rises.
 When MC = AVC, AVC is at its minimum.
 When MC < AC, AVC falls.
 When MC > AC, AVC rises.
 When MC = AC, AC is at its minimum.
Relationship between MP & MC, AP & AVC
• Suppose, TC = PK  K + PL  L
 In the short run, K is held fixed, so
̅ + PL  L
TC = P̅K × K
Marginal Product & Marginal Cost
• Marginal cost: MC =
MC =
𝑑𝑇𝐶
𝑑𝑄
=
𝑑(𝑃𝐾 × 𝐾+ 𝑃𝐿 × 𝐿)
𝑑𝑄
𝑑(𝐹𝐶+𝑉𝐶)
𝑑𝑄
=
𝑑(𝑃𝐾 × 𝐾)
𝑑𝑄
+
𝑑(𝑃𝐿 × 𝐿)
𝑑𝑄
Since PK, PL and K are held fixed, then
MC =𝑃𝐿 ×
𝑑𝐿
𝑑𝑄
MC = 𝑃𝐿 ×
1
𝑃𝐿
=
𝑑𝑄 ⁄𝑑𝐿
𝑀𝑃𝐿
Note: For given technology, capital stock and PL, when MPL is maximized, MC
is minimized.
MGEC08 Supplementary Notes
24
Average Product & Average Variable Cost
• Average variable cost: AVC =
AVC = 𝑃𝐿 ×
AVC =
TVC
Q
P ×L
= L
Q
𝐿
𝑄
𝑃𝐿
𝐴𝑃𝐿
Note: For given technology, capital stock and PL, when APL is maximized, AVC
is minimized.
Example: Suppose the cost of capital is $500 per day (PK = $500 and K = 1) and
the wage paid to each worker (L) is $100 per day (PL = $100). Also,
the firm is a competitive firm which takes the prices of input as given.
L Q
APL MPL FC
VC
AFC AVC AC
MC
FC/Q VC/Q TC/Q TC/Q
0 0
28
$500 0
$500 −
−
−
−
−
1 31 31 33
$500 $100 $600 $16.13 $3.23 $19.35 $3.23
2 64 32 32
$500 $200 $700 $7.81 $3.13 $10.94 $3.03
3 93 31 25
$500 $300 $800 $5.38 $3.23 $8.60 $3.45
4 112 28 12
$500 $400 $900 $4.46 $3.57 $8.04 $5.26
5 115 23 – 7 $500 $500 $1000 $4.35 $4.35 $8.70 $33.33
6 96 26 – 32 $500 $600 $1100 −
$6.25 $11.45 −
7 49 7
– 63 $500 $700 $1200 −
$14.29 $24.49 −
Note:
MPL = 28 + 8L – 3L2
APL = 28 + 4L – L2
TC = $500 + $100L
TC
MGEC08 Supplementary Notes
25
The above can be generalized into the following diagrams.
APL, MPL
MPL
APL
L
AVC, MC
MC
AVC
Q
MGEC08 Supplementary Notes
26
Profit Maximization of a Competitive Firm
• Firm’s objective is to maximize profit:
Max π = TR(Q) – TC(Q)
Q
𝑑𝜋
𝑑𝑄
=
𝑑𝑇𝑅(𝑄)
𝑑𝑄
𝑑𝑇𝑅(𝑄)
𝑑𝑄
−
=
𝑑𝑇𝐶(𝑄)
𝑑𝑄
=0
𝑑𝑇𝐶(𝑄)
𝑑𝑄
MR = MC
 Profit maximization rule: To maximize profit, firms equate MR to MC
(i.e., choose the level of output, q, such that MR = MC).
• Since a competitive firm has no market power, i.e., it cannot influence the
output price  it is a price taker. For a competitive firm.
 AR is constant and equals to P: AR =
𝑇𝑅
 MR is constant and equals to P: MR =
𝑑𝑇𝑅
 Profit maximization rule:
𝑄
=
𝑑𝑄
𝑃×𝑄
𝑄
=
𝑑(𝑃 ×𝑄)
MR = P = MC
Firm’s Decision to Supply in Short Run
• A firm’s profit:
π = TR(Q) – TC(Q)
π = P  Q – TVC – TFC
π = P  Q – AVC  Q – FC
π = (P – AVC)  Q – FC
 If P (= MC) ≥ minimum AVC, then Q > 0.
 If P < minimum AVC, then Q = 0 &  = – FC
=P
𝑑𝑄
=P
MGEC08 Supplementary Notes
27
Firm’s Short-Run Supply Curve
AC, AVC, MC
MC
AC
AVC
P0 = AVCMIN
Q
Note:
• The breakeven point is the quantity produced at which all costs are covered.
 Under perfect competition, the breakeven point is the quantity at which TR
= TC (i.e., P = AC).
• The shutdown point is the quantity produced at which the average revenue is
less than the average variable cost (i.e., quantity at which AR < AVC).
 Under perfect competition, the shutdown point is the quantity at which P <
AVC.
 At the shutdown point, the firm must pay fixed costs but stops production
because it cannot cover variable costs.
MGEC08 Supplementary Notes
28
The Cost Function in the Long Run
• In microeconomics, long run is different from short run because:
1) All inputs become variable  firms can choose the amount of capital and
labour employed.
2) In a perfectively competitive market, there will be free entry and exit.
Long Run Average (Total) Cost Curve
• The long-run average total cost curve (LRATC) shows the relationship
between output and average total cost when fixed cost has been chosen to
minimize average total cost for each level of output.
• The LRAC is U-shape with a flat bottom, and it is the “envelope” of the shortrun average cost curves. In the long run, frim chooses the level of capital and
it will choose the level of capital that minimizes the average cost of producing
a specific level of output.
LRATC, SRATC
LRATC
Q
MGEC08 Supplementary Notes
29
Minimum Efficient Scale
• Minimum efficient scale (or efficient scale of production), QMES, is the
level of output such that LRATC reaches its minimum.
 It is the level of output such that LRAC = LRAC.
SRATC,
LRATC
SRMC
LRATC
LRMC
SRATC(K*)
Q
QMES
Returns to Scale
• The shape of the LRATC is closely related to the returns to scale.
• Returns to scale (RTS) refer to the change in output produced when ALL
inputs change by the same proportion.
• There are increasing returns to scale (IRTS) when all inputs increase by a
factor of x, output increases by more than a factor of x.
 IRTS is also knows as economies of scale.
 When there is IRTS, the LRATC declines as output increases.
• There are decreasing returns to scale (DRTS) when all inputs increase by a
factor of x, output increases by less than a factor of x.
MGEC08 Supplementary Notes
30
 DRTS is also knows as diseconomies of scale.
 When there is DRTS, the LRATC rises as output increases.
• There are constant returns to scale (CRTS) when all inputs increase by a
factor of x, output increases by a factor of x.
 When there is CRTS, the LRATC remains unchanged as output increases.
Long Run Industry Supply
• The long-run supply curve for an industry is the relationship between
quantities supplied and prices when firms are able to enter or exit the industry
in responses to the short-run level of economic provide and when changes in
industry output influence resource process over long run.
• An increasing-cost industry is one in which the prices and costs increase for
increased output.
 Long-run supply curve is upward sloping.
 Examples: resource-constrained industries, such as oil, natural gas.
• A decreasing-cost industry is one in which the prices and costs decrease for
increased output.
 Long-run supply curve is downward sloping.
 Examples: transportation industry, electric power industry.
• A constant-cost industry is one in which the prices and costs remain the same
for increased levels of output.
 Long-run supply curve is flat.
 Example: retail industry, any industry in which each firm uses such a small
portion of the resources.
MGEC08 Supplementary Notes
31
Relationship between Marginal Product and Profit Maximization
• To maximize profit, firm equates MR to MC.
• Recall, MC and MP are inversely related.
Case 1: A Single Input (say Labour)
• Given MC and MP are inversely related, MC =
• Profit maximization:
MR =
𝑃𝐿
𝑀𝑃𝐿
𝑃𝐿
𝑀𝑃𝐿
MPL  MR = PL
Marginal revenue product
Price of labour
• If there is a single input, the profit-maximizing level of output is the point at
which
Marginal revenue product (MRP) = Price of the input
Case 2: Multiple Inputs
• If there is more than one input, the profit-maximizing level of inputs is the
point at which marginal products per dollar is equalized for all inputs.
𝑀𝑃1
𝑃1
=
𝑀𝑃2
𝑃2
=⋯=
𝑀𝑃𝑛
𝑃𝑛