INTRODUCTION TO ECONOMICS By stewart Mbegu and Kulwa Guyashi

CONSUMER THEORY

Consumer theory is a theory of microeconomics that relates preferences to consumer demand curves. The link between personal preferences, consumption, and the demand curve is one of the most complex relations in economics. Implicitly, economists assume that anything purchased will be consumed, unless the purchase is for a productive activity.

Preferences are the desires by each individual for the consumption of goods and services, and ultimately translate into employment choices based on abilities and the use of the income from employment for purchases of goods and services to be combined with the consumer's time to define consumption activities.

Consumption is separated from production, logically, because two different consumers are involved. In the first case consumption is by the primary individual; in the second case, a producer might make something that he would not consume himself. Therefore, different motivations and abilities are involved.

The models that make up consumer theory are used to represent prospectively observable demand patterns for an individual buyer on the hypothesis of constrained optimization.

Prominent variables used to explain the rate at which the good is purchased (demanded) are the price per unit of that good, prices of related goods, and wealth of the consumer.

The fundamental theorem of demand states that the rate of consumption falls as the price of the good rises. This is called the substitution effect. As prices rise, consumers will substitute away from higher priced goods and services, choosing less costly alternatives. Subsequently, as the wealth of the individual rises, demand increases, shifting the demand curve higher at all rates of consumption. This is called the income effect. As wealth rises, consumers will substitute away from less costly inferior goods and services, choosing higher priced alternatives.

Income effect and price effect deal with how the change in price of a commodity changes the consumption of the good. The theory of consumer choice examines the trade-offs and decisions people make in their role as consumers as prices and their income changes.

Utility Theory

In economics, utility can be defined as satisfaction or pleasure derived from consuming some goods or services.

Or

Utility is a measure of the relative satisfaction from, or desirability of, consumption of various goods and services. Given this measure, one may speak meaningfully of increasing or decreasing utility, and thereby explain economic behavior in terms of attempts to increase one's utility. For illustrative purposes, changes in utility are sometimes expressed in units called utils.

Utility can be applied by economists in such constructs as the indifference curve, which plots the combination of commodities that an individual or a society would accept to maintain a given level of satisfaction.

                                                            School of Thought

In school of thought, there is cardinal utility theory and ordinal utility theory.

Cardinal utility theory

According to cardinal utility theory utility is measured cardinally.  Thought that later on people will invent a machine to measure their utility. The machine will be known as Utilitomator which measure in terms of Utils.

Quantity of Soda(Bottle)	Utility (Utilis)	Marginal utility
0	0	-
1	50	50
2	88	38
3	121	33
4	150	29
5	178	28
6	160	-18
7	158	-2

Total Utility graph

Total utility is the maximum or total amount of satisfaction that a person gets after consuming a certain good. The graphs of total utility starts at zero then go up and later on starts decreasing but can not go beyond horizontal line. Vertical line is for utility and horizontal line is for quantity.

Graph of total utility

Utils
			Tu
				Quantity

                                                                                                                                         Marginal Utility

In economics, the marginal utility of a good or of a service is the utility of the specific use to which an agent would put a given increase in that good or service, or of the specific use that would be abandoned in response to a given decrease. In other words, marginal utility is the utility of the marginal use — which, on the assumption of economic rationality, would be the least urgent use of the good or service, from the best feasible combination of actions in which its use is included. Under the mainstream assumptions, the marginal utility of a good or service is the posited quantified change in utility obtained by increasing or by decreasing use of that good or service.

Graph of marginal Utility

Utils
				Quantity
		Mu

Principles of decreasing Marginal Utility                                                                                         According to this principle, as you add more units of utility then marginal utility will be diminishing until reaches negative.

Ordinal Utility Theory

Ordinal utility theory says that because of subjective thing, it can not be measured in exact amount instead it can be measured in ordinal terms.  Example a first glass of water gives more satisfaction than the 2^nd.

Economists distinguish between cardinal utility and ordinal utility. When cardinal utility is used, the magnitude of utility differences is treated as an ethically or behaviorally significant quantity. On the other hand, ordinal utility captures only ranking and not strength of preferences. An important example of a cardinal utility is the probability of achieving some target.

Utility functions of both sorts assign real numbers ("utils") to members of a choice set. For example, suppose a cup of orange juice has utility of 120 utils, a cup of tea has a utility of 80 utils, and a cup of water has a utility of 40 utils. When speaking of cardinal utility, it could be concluded that the cup of orange juice is better than the cup of tea by exactly the same amount by which the cup of tea is better than the cup of water. One is not entitled to conclude, however, that the cup of tea is two thirds as good as the cup of juice, because this conclusion would depend not only on magnitudes of utility differences, but also on the "zero" of utility.

It is tempting when dealing with cardinal utility to aggregate utilities across persons. The argument against this is that interpersonal comparisons of utility are suspect because there is no good way to interpret how different people value consumption bundles.

When ordinal utilities are used, differences in utils are treated as ethically or behaviorally meaningless: the utility values assigned encode a full behavioral ordering between members of a choice set, but nothing about strength of preferences. In the above example, it would only be possible to say that juice is preferred to tea to water, but no more.

Neoclassical economics has largely retreated from using cardinal utility functions as the basic objects of economic analysis, in favor of considering agent preferences over choice sets. As will be seen in subsequent sections, however, preference relations can often be rationalized as utility functions satisfying a variety of useful properties.

Ordinal utility functions are equivalent up to monotone transformations, while cardinal utilities are equivalent up to positive linear transformations.

Utility Functions

While preferences are the conventional foundation of microeconomics, it is often convenient to represent preferences with a utility function and reason indirectly about preferences with utility functions. Let X be the consumption set, the set of all mutually-exclusive packages the consumer could conceivably consume (such as an indifference curve map without the indifference curves). The consumer's utility function ranks each package in the consumption set. If u(x) ≥ u(y), then the consumer strictly prefers x to y or is indifferent between them.

Indifference Curve Theory                                                                                                                             

The aim of indifference curve analysis is to analyze how a rational consumer chooses between two goods. In other words, how the change in the wage rate will affect the choice between leisure time and work time.  Indifference analysis combines two concepts; indifference curves and budget lines (constraints).

indifference curve

An indifference curve is a line that shows all the possible combinations of two goods between which a person is indifferent. In other words, it is a line that shows the consumption of different combinations of two goods that will give the same utility (satisfaction) to the person. For instance, in Figure 1 the indifference curve is I1. A person would receive the same utility (satisfaction) from consuming 4 hours of work and 6 hours of leisure, as they would if they consumed 7 hours of work and 3 hours of leisure.

Figure 1: An indifference curve for work and leisure

Characteristics of Indifference Curve                                                                                          

1.  Convex to origin                                                                                                               2.  They don’t cross each other                                                                                                               3.  Consumption in one indifference curve is of the same.  Give the same satisfaction.                        4.  Indifference curve slopes downward to right                                                                                     5.  Higher indifference curve represents a higher level of satisfaction than a lower      
     indifference curve.                                                         

An important point to remember is that the use of an indifference curve does not try to put a physical measure onto how much utility a person receives.
The shape of the indifference curve

Figure 1 highlights that the shape of the indifference curve is not a straight line. It is conventional to draw the curve as bowed. This is due to the concept of the diminishing marginal rate of substitution between the two goods.

Indifference Schedule

Combination	Good x	Good y	Marginal rate of Substitution
A	1	12	-
B	2	8	4
C	3	5	3
D	4	3	2
E	5	2	1

The marginal rate of substitution is the amount of one good (i.e. work) that has to be given up if the consumer is to obtain one extra unit of the other good (leisure).
The equation is below

The marginal rate of substitution (MRS) = change in good X / change in good Y

Using Figure 1, the marginal rate of substitution between point A and Point B is;
MRS = -3 / 3 = -1 = 1

Note, the convention is to ignore the sign. The reason why the marginal rate of substitution diminishes is due to the principle of diminishing marginal utility. Where this principle states that the more units of a good are consumed, then additional units will provide less additional satisfaction than the previous units. Therefore, as a person consumes more of one good (i.e. work) then they will receive diminishing utility for that extra unit (satisfaction), hence, they will be willing to give up less of their leisure to obtain one more unit of work.

The relationship between marginal utility and the marginal rate of substitution is often summarized with the following equation;

MRSyx = Mu_x / Mu_{y                or}      
MRSyx = Change in X / Change in Y

MRSyx is the amount of x whose loss can be compensated by one unit gain in y.  In other words, MRSyx represents the amount of x which the consumer has to give up for the gain of one addition unit of y so that as the level of satisfaction remain the same. It is possible to draw more than one indifference curve on the same diagram. If this occurs then it is termed an indifference curve map (Figure 2).

Figure 2: An indifference map

The general rule is that indifference curves further too the right (I4 and I5) show combinations of the two goods that yield a higher utility, while curves to the left (I2 and 11) show combinations that yield lower levels of utility.
A Budget Line (budget constraints)

The budget line is an important component when analyzing consumer behavior. The budget line illustrates all the possible combinations of two goods that can be purchased at given prices and for a given consumer budget (Income). Remember, that the amount of a good that a person can buy will depend upon their income and the price of the good.

Constraints to the consumers are money income and Prices of goods and services.  In order to maximize the consumer satisfaction, the consumer must consider the budget line.

This discussion outlines the construction of a budget line and how the change in the determinants (income and prices) will affect the budget line.

Figure 3 constructs a budget line for a given budget of £60, £2 per unit of x and £1 per unit of y.

With a limited budget the consumer can only consume a limited combination of x and y (the maximum combinations are on the actual budget line).
A change in consumer income and the budget line
If consumer income increases then the consumer will be able to purchase higher combinations of goods. Hence an increase in consumer income will result in a shift in the budget line. This is illustrated in Figure 4. Note that the prices of the two goods have remained the same, therefore, the increase in income will result in a parallel shift in the budget line. Assume consumer income increased to £90.
Figure 4: An increase in consumer income

If consumer income fell then there would be a corresponding parallel shift to the left to represent a fall in the potential combinations of the two goods that can be purchased.
A change in the price of a good and the budget line

If income is held constant, and the price of one of the goods changes then the slope of the curve will change. In other words, the curve will pivot. This is illustrated in Figure 5. Figure 5: A change in price

The reduction of the price of good x from £2 to £1 means that on a fixed budget of £60, the consumer could purchase a maximum of 60 units, as opposed to 30. Note that the price of good y has remained fixed, hence the maximum point for good y will remain fixed.
Equation of the line
Y = ax + b  Where by x and y are variable and x is constant.
Px X  + Py Y = M         This is the budget line equation and  M is the consumer income.
The consumers can not spend more than their income (M), Px is the price of good x , Py is the price of good y, X is good x, and Y is good y.
A consumer will be at equilibrium if and only if the budget line is tangent to indifference curve. When  Px/Py = Mux/Muy
Indifference analysis combines two concepts; indifference curves and budget lines (constraints).
The first stage is to impose the indifference curve and the budget line to identify the consumption point between two goods that a rational consumer with a given budget would purchase.
The optimum consumption point is illustrated on Figure 6.
Figure 6: The optimum consumption point

A rational, maximizing consumer would prefer to be on the highest possible indifference curve given their budget constraint. This point occurs where the indifference curve touches (is tangential to) the budget line. In the case of Figure 6, the optimum consumption point occurs at point A on indifference curve I3.

Indifference analysis can be used to analyze how a consumer would change the combination of two goods for a given change in their income or the price of the good.

The next section looks at the income and substitution effects of a change in price.

If we assume that the good is normal, then the increase in price will result in a fall in the quantity demanded. This is for two reasons; the income effect (have a limited budget, therefore can purchase lower quantities of the good) and the substitution effect (swap with alternative goods that are cheaper).

These two processes can be visualized using indifference analysis (see Figure 7).

Figure 7: An increase in the price of good x (a normal good)

Due to the price of good x increasing, the budget line has pivoted from B1 to B2 and the consumption point has moved. The decrease in the quantity demanded can be divided into two effects;

The substitution effect

The substitution effect is when the consumer switches consumption patterns due to the price change alone but remains on the same indifference curve. To identify the substitution effect a new budget line needs to be constructed. The budget line B1* is added, this budget line needs to be parallel with the budget line B2 and tangential to 11. Therefore, the movement from Q1 to Q2 is purely due to the substitution effect.

The income effect

The income effect highlights how consumption will change due to the consumer having a change in purchasing power as a result of the price change. The higher price means the budget line is B2, hence the optimum consumption point is Q2. This point is on a lower indifference curve (I2). Therefore, in the case of a normal good, the income and substitution effects work to reinforce each other.

Real and Money Income                                                                                                                    Money income measure a consumer’s income in terms of monetary units and Real income measure the purchasing power of consumer’s money income.

Deriving Consumers’ Demand curve

If these curves are plotted for many different prices of good , a demand curve for good  can be constructed. The diagram below shows the demand curve for good Y as its price varies. Alternatively, if the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed.

Now from the price consumption curve, the demand curve is derived as shown by the graph above.
Illustration 1

Rose Bole has only $100 to spend on her two passions in life: buying books and attending movies. If all books cost $5.00 and all movies cost $2.50 (these are simply assumptions to make the problem easier--as is the assumption that only two items are involved in the problem), the graph below shows the options open to Rose. The budget line is a frontier showing what Rose can attain. The budget line limits choices; it is due to scarcity. The cost of a book is $5.00 or two movies. Spending money on a product means that money cannot be used to purchase another product. In the case of books versus movies, the tradeoff is a straight line because one more book always costs two movies, regardless of how many books Rose has already.

You should be able to see that the slope of the budget line depends only on the price of books relative to the price of movies. If either books get cheaper or movies get more expensive, the budget line in the graph above will get steeper. If this is not immediately obvious, compute the possibilities open to a person with $100 to spend if books and movies both cost $5.00 (a case of more expensive movies), and the possibilities open to a person with $100 to spend if books and movies both cost $2.50 (a case of cheaper books). Graphing the possibilities open to a person with only $50 to spend but with books costing $5.00 and movies costing $2.50 gives you a line that is to the left of the line in the graph above, but parallel to it, which means that it has the same slope. The amount of money available to spend does not determine the slope of the budget line; only the ratio of prices does that.

Illustration 2

The marginal propensity to consume is less than the average propensity to consume because of errors in measuring permanent income. True or False? Explain your answer.

True because current income is not a good measure of permanent income. Increases in observed current income levels in the economy are typically part permanent and part transitory. Permanent increases in income affect consumption but transitory increases do not. Thus, even though consumption will typically be a more or less constant fraction of permanent income and thus vary in roughly the same proportion as permanent income, it will vary less than proportionally with changes in current income because only a portion of changes in current income are typically permanent. If consumption is a constant fraction of permanent income, the marginal propensity to consume out of permanent income will equal the ratio of consumption to permanent income. This ratio of consumption to permanent income is also the average propensity to consume out of permanent income. The marginal propensity to consume out of current income, on the other hand, will typically be less than the ratio of consumption to current income (or average propensity to consume out of current income) as indicated by the Keynesian consumption function

(1) C = a + b Y,

where C is consumption, Y is income, and b, the marginal propensity to consume, is less than the ratio C/Y, which is in turn less than unity. Note that in the current-income consumption function above, the average propensity to consume out of current income (C/Y) will fall as current income increases.

The relationship between the current and permanent income consumption functions can be seen from FIGURE 1.

The average level of both current and permanent income is given by Yo. When current income is above Yo, permanent income (denoted with a P superscript) is also above Yo, but by a smaller amount. Consumption depends on permanent income according to the consumption function

(2) C = kYp.

Consumption varies less than current income because permanent income varies less than current income. As a result, the current-income consumption function, given by equation (1), is flatter than the permanent-income consumption function, given by equation (2). The marginal propensity to consume out of current income, which is equal to the slope b, is less than the marginal (and average) propensity to consume out of permanent income, which is equal to the slope k. The average propensity to consume out of current income is given by the slope of a line (not shown in FIGURE 1) drawn from the point on the current income consumption line associated with the amount of consumption to the origin. The slope of such a line will be smaller, and the average propensity to consume will therefore be smaller, the greater the level of consumption.

Illustration 3

Zero time preference implies that consumption is the same in all years regardless of income. True or False? Explain your answer.

False! Zero time preference would only lead to equal consumption in all years if the interest rate were zero. In a two-period model, consumption will be the same in both years if the rate of time preference equals the real rate of interest. Assume that the individual's two-period utility function is of the time-separable form

U = U(C0) + [1/(1 + p)] U(C1)

where C0 and C1 are the levels of consumption in year 0 and year 1 respectively and p is the rate of time preference. It can be shown that -(1 + p) is the slope of the individual's indifference curves where they cross the 45 degree ray from the origin (along which C0 equals C1). If the individual is endowed with incomes Y0 and Y1 in the two years and and can borrow and lend at the constant real interest rate r, his two-period budget line will have a slope equal to -(1 + r). The indifference curve and the budget line will therefore be tangent at the 45 degree ray from the origin, and consumption will be the same in both years, when (1 + p) = (1 + r) ---that is, when p = r. If p is zero but r is not zero, the positive r will result in the individual consuming less in year 0 than in year 1. This is shown in FIGURE 1 below.

Given zero time preference (p = 0), the slopes of all indifference curves where they cross the 45 degree ray from the origin are equal to -1. If the interest rate is positive, the slope of the consumer's budget line will be steeper than -1. The individual will consume the combination C0 and C1 in the respective years. Since this combination is to the left of the 45 degree ray, more is consumed in year 1 than in year 0.

For consumption to be the same in both years the interest rate would have to equal the rate of time preference. Since the rate of time preference is the slope of the indifference curves where they cross the 45 degree ray, equality of the rate of time preference with the rate of interest would imply that the indifference curves and the budget line have the same slope along the 45 degree ray from the origin. Tangency of the two curves would then occur where consumption in the two years is the same.

QUESTIONS FOR CONCENTRATION

1. With the help of diagram, what is the income consumption curve?
2. Derive demand curve from price consumption curve.
3. With the help of diagram what is total utility?
4. With the help of diagram what is marginal utility?
5. A consumer spends all her income on food and clothing.  At the current prices Pf is shs1000 and Pc is shs 500, she maximizes her utility by purchasing 20 units of food and 50 units of clothing. What is consumer income? And what is consumer’s marginal rate of substitution of food for clothing at equilibrium position?

6. You are given the following marginal utilities of goods x and y obtained by a consumer.

             

Units	MUx (Utils)	MUy (Utils)
1	30	20
2	25	18
3	20	16
4	15	14
5	10	12
6	5	10
7	1	8

Given that the prices of goods x and y are shs 5 and shs 2 respectively.  Further    that the consumer income to spend on the two goods is shs 22. Find out the optimal combination of goods.

7. Distinguish between total utility and marginal utility.
8. Given two commodities for consumption say a and b, what is the condition for utility maximization?

Practice Multiple-Choice Questions with Answers

1. As long as the principle of diminishing marginal utility is operating, any increased consumption of a    good

a. lowers total utility.

b. produces negative total utility.

c. lowers marginal utility and, therefore, total utility.

d. lowers marginal utility, but may raise total utility.

2. Among all the combinations of goods attainable by a consumer, the one that maximizes total utility is the one

that:

a. maximizes the marginal utilities per dollar of each good.

b. maximizes the marginal utilities per pound (or other physical unit) of each good.

c. equates the marginal utilities per dollar of each good.

d. equates the marginal utilities per pound (or other physical unit) of each good.

3. A utility contour (or indifference curve) shows all the alternative combinations of two consumption goods

that

a. can be produced with a given set of resources and technology.

b. yield the same total of utility.

c. can be purchased with a given budget at given prices.

d. equate the marginal utilities of these goods and, therefore, make the consumer indifferent between them.

7. At any given point on an indifference curve, the absolute value of the slope equals

a. unity--otherwise there would be no indifference.

b. the marginal rate of substitution.

c. the consumer’s marginal utility.

d. none of the above.

8. If a consumer’s marginal rate of substitution equals 2 eggs for 1 hamburger,

a. the consumer’s indifference curve must be positively sloped.

b. the consumer’s indifference curve must be convex with respect to the origin of the graph.

c. the ratio of the consumer’s marginal utility of 1 egg to that of 1 hamburger must equal ½.

d. all of the above are true.

9. In the presence of declining marginal rates of substitution, consumers who again and again sacrifice a unit of

one good cannot remain on their original consumption-indifference curves (that is, they cannot maintain their

original levels of welfare) unless they receive as compensation

a. again and again equal units of another good.

b. ever smaller units of another good.

c. ever larger units of another good.

d. either (a), (b), or (c), depending on the tastes of the consumer involved.

10. Which of the following is a correct representation of the budget constraint in a world with only food and f s shelter, where M = income, P = price of food, P = shelter price, S = the quantity of shelter, and F = the

quantity of food.

f s a. M = P (S) + P (F)

s f s b. F = M/P - P /P (S)

s s f c. S = M/P - P /P (F)

s f s d. F = M(P ) + P /P (S)

e. None of the above is correct.

11. All points on or below a budget constraint

a. are attainable with the given income.

b. are equally desirable.

c. represent market basket combinations that exhaust the income available.

d. are described, in part, by a, b, and c above.

13. In a preference ordering exercise in which two baskets of goods are being considered, it is assumed by

Indifference theory that the consumer is able to

a. measure the amount of pleasure expected from the preferred basket.

b. say how much more one basket is valued over the other.

c. calculate only the absolute value of the less desirable basket.

d. make no absolute measure of the value of any of the market baskets.

14. Indifference curves that intersect would be illogical constructs because

a. more is better than less.

b. of diminishing marginal utility.

c. of the transivity property of indifference theory.

d. of both a and c above.

e. of none of the above.

15. The marginal rate of substitution between food and shelter for a given point on an indifference curve

a. is equal to the absolute value of the slope of the indifference curve at that point.

b. is equal to the rate at which the consumer is willing to exchange the two goods in the marketplace.

c. reflects the relative values the consumer attaches to the two good.

d. is described, in part, by each of the above statements.

16. If a man prefers Budweiser to Schlitz and Schlitz to Pabst, and if he is indifferent between Budweiser and

Miller, he must

a. prefer Miller to Pabst.

b. prefer Schlitz to Miller.

c. be indifferent between Schlitz and Miller.

d. be indifferent between Budweiser and Pabst.

e. be indifferent between Pabst and Miller.

17. If a market basket is changed by adding more to at least one of the goods, then every consumer will

a. rank the market basket more highly after the change.

b. rank the market basket more highly before the change.

c. rank the market basket just as desirable after the change.

d. be unable to decide whether he prefers the first market basket to the second or the second to the first.

e. recognize this as one of the unsolved problems in economics.

18 An indifference curve is.

a. a collection of market baskets that are equally desirable to the consumer.

b. a collection of market baskets that the consumer can buy.

c. a curve whose elasticity is constant for every price.

d. a curve which passes through the origin and includes all of the market baskets that the consumer regards

as being equivalent.

19. If A, B, C, and D are any four market baskets, and if the consumer has ranked them so that D is preferred to

C, A is not preferred to B, and B is not preferred to C, then

a. A is preferred to C.

b. A is preferred to D.

c. B is preferred to D.

d. D is preferred to A.

e. D is not preferred to B.

20. Suppose that a market basket of two goods is changed by adding more to one of the goods and subtracting

one unit from the other.

a. The consumer will rank the market basket more highly after the change.

b. The consumer will rank the market basket less highly after the change.

c. The consumer will be indifferent between the market baskets.

d. Any of the above statements may be true.

21. Which of the following is not an assumption of ordinal utility analysis?

a. Consumers are consistent in their preference.

b. Consumers can measure the total utility received from any given basket of good.

c. Consumers are non-satiated with respect to the goods they confront.

d. All are necessary.

e. None of the above.

22. As long as all prices remain constant, an increase in money income results in

a. an increase in the slope of the budget line.

b. a decrease in the slope of the budget line.

c. an increase in the intercept of the budget line.

d. a decrease in the intercept of the budget line.

e. both (a) and (c).

23. If the prices of both goods increase by the same percent, the budget line will

a. shift parallel to the left.

b. shift parallel to the right.

c. pivot about the x axis.

d. pivot about the y axis.

e. none of the above.

24. Cardinal utility theory assumes that consumers can

a. rank baskets of goods as to their preference.

b. determine the number of utils that can be derived from consuming all goods.

c. determine the marginal rate of substitution between goods.

d. avoid the law of diminishing marginal utility.

e. all of the above.

25. The budget allocation rule states that

a. the marginal utility of x equals the marginal utility of y at maximum utility.

b. the marginal utility of x divided by its price be equal to marginal utility of all other goods divided by

their prices.

c. the marginal utility of x equals the marginal rate of substitution of x for y.

d. the ratio of prices of x to y be greater than the ratio of marginal utility of x to the marginal utility of y.

e. none of the above.

26. In spending all his or her income, the consumer chooses the market basket that maximizes his or her utility.

Which of the following statements will be correct?

1. The marginal utility is the same for each commodity.

2. The marginal utility per dollar spent is the same for each commodity.

3. The marginal utility of each commodity is proportional to its price.

a. 1 only.

b. 2 only.

c. 1 and 2 only.

d. 2 and 3 only.

e. 1, 2, and 3.

27. A consumer buys only jellybeans and wrinkle remover and the more of any one he buys, the lower the

marginal utility of that good. In spending all his income, his marginal utility of a pound of jellybeans is 12

and his marginal utility of a jar of wrinkle remover is 15. The price of jellybeans is $8 per pound and the

price of wrinkle remover is $11 per jar. For maximum satisfaction, this consumer should

a. buy more wrinkle remover and fewer jellybeans.

b. by less wrinkle remover and more jellybeans.

c. buy more wrinkle remover and the same quantity of jellybeans.

d. buy the same quantity of wrinkle remover and more jellybeans.

e. remain where he is, since his present position is the best attainable one.

Utility and Choice – Answers

1. d 2. c 3. b 4. c 5. d 6. d 7. b 8. c 9. c 10. e 11. a 12. d 13. d 14. d 15. d 16. a 17. a 18. a 19. d 20. d 21. b 22. c 23. a 24. b 25. b 26. d 27. b

Additional Notes

 

Additional Notes

 

THEORY OF PRODUCTION AND COST

Production is the transformation of inputs into output.  Inputs (Factors of production) include:

·                   Land

·                   Labour

·                   Capital

·                   Entrepreneurship

What is a firm?

Firms are suppliers of goods and services; the question is why firms produce goods and services. The objective of the firm is to produce goods and services to earn profit.

The firms combine and processes resources of production in order to produce output that will directly or indirectly satisfy consumers’ wants and needs.

What is production?

Firms employ resources (Inputs) to produce output that will be sold in the market.  The general production problem facing the firms is to determine how much output to produce and ho much labour and capital to employ to produce that output most efficiently.  This means that input output relationship which maximizes profit.

An engineering information in the form of a production function and economic information on prices of inputs and outputs must be combined in order to answer those questions.

THEORY OF PRODUCTION

The theory of production explain physical both technical and technological relationship between inputs and output (It is what we call production function)

For simplicity, let us assume that all inputs or factors of production can be grouped into two broad categories:

·                     Labour (L)

·                     Capital (K)

The general equation for the production function will be

            Q = f (L, K)

The function defines the maximum rate of output (Q) per unit of time obtained from a give rate of capital (K) and labour (L) inputs.  Output may be in physical units like vehicles or it may be intangible e.g. Medical services.

Production function

Production function is the mathematical relationship between inputs used to produce output and the output produced. It shows how output will be affected by changes in the quantity of one or more of units of the inputs.

It is the physical relationship between a firm’s physical inputs and outputs depending on a given state of technical know how. It can be in:

·                     Algebraic form

·                     A tabular form

·                     A graphical form

In Algebraic Form

TPP = F (F1, F2, F3, _ _ _ Fn)

This implies that total output or total physical product depends on the quantity of factors F1, F2 etc that are used.

A production function may take a form of schedule or table, a graph, line or curve, in algebraic equation or of mathematical model.

FACTORS OF PRODUCTION

In economics, factors of production (or productive inputs) are the resources employed to produce goods and services. They facilitate production but do not become part of the product (as with raw materials) or significantly transformed by the production process (as with fuel used to power machinery). To 19th century economists, the factors of production were land (natural resources, gifts from nature), labor (the ability to work), and capital goods (human-made tools and equipment). Recent textbooks have added entrepreneurship and "human capital" (labor's education and skills). "Land" can include ecosystems while sometimes the overall state of technology is seen as a factor of production.^[2] In any event, it is the scarcity of the factors of production which poses humanity's economic problem, often forcing us to choose between competing goals. The number and definition of factors varies, depending on theoretical purpose, empirical emphasis, or school of economics.

Also factors of production can be:

Fixed Factor

Inputs that can not be increased in supply within a given period of time.

Variable Factor

An inputs that can be increased in supply in a given period of time.

Periods

Short run

The period of time over which at least one factor is fixed.

Long run

The period of time long enough for all factor to be varied.

Factors affecting production function

·                     Quantities of resources used

·                     State of technological knowledge

·                     Size of the firm

• Relative prices of the factors of production and the manner in which the factors of  production are combined.

Nature of production function

Every management has to make choice of production depending on:

·                     Industrial knowledge

·                     Prices of various factors of production and its own capacity to manage.

·                     The output I is the result of a joint use of the factors of production.

The choice of technique

This choice exists because there are usually several ways to produce a particular product or to carry particular economic tasks.  Each technique is characterized by the proportions of the different factors of production which it uses.

The techniques may include:

·                     Capital Intensive Technique – This is when ones uses a lot of capital relative to          
            labour for the given quantity of output.

·                     Labour Intensive Technique – This is when one uses a lot of labour relative to
            capital for a given quantity of output.

The business firm may decide to use more of one of the technique than the other so as to minimize costs. i.e. to produce a given amount of output at the least possible cost.

The least –cost combination of factors

The aim of the producer is to maximize the profit and minimize the cost of production.  The optimum factor proportions are those which minimize costs for the given output level.

The condition for the least cost combination is therefore the slope of the Isoquant should be equal to the slope of Isocost.

MRSLk = Change in L / Change in K

Isocost – Equal cost for a given output.

Isoquant – Tells all the alternative processes and combinations of processes that are available and for any combination of inputs.

Total product (TPL)

Total product is the maximum output that produced by factors of production.  Because labour is only variable factor then total output can change with the change in labour hence total output of labour.

The average product of labour (APl)

Average output is the produced per worker i.e. total product divide by the number of units of variable factor of production (Labour)

APL = TPL /L

Marginal product of labour (MPL)

Marginal product is the change in total output per change in labour.  It is the change in total output when one more unit of labour is employed with the amount of other inputs remains the same.

MPL = ∆ TPL / ∆ L

Stages of production

There are three stages of production, these stages include:

Stage I

Characterized by increase in APL, the increase mean that the technical efficiency of labour – the product per labour rise.

Stage II

APl decrease and MPl fall but positive since total product continue to increase but fall in a rate.

Stage III

MPL falls and negative and the total product is falling.  Here it involves the applications of larger quantities of labour to a unit of capital.

Graphical presentation

Output
			Stag II		TPL	Stage III
	Stag I
					APL
						Labour
0

                                                                                     MPL

Relationship between MPL and TPL

• MPL is upward sloping when TPL is convex.
• MPL is downward sloping when TPL is concave.
• MPL lies in the first quadrant (MPL is +v) when TPL is upward sloping.
• MPL is crossing the labour axis (MPL = 0) when TPL reaches a maximum.
• MPL lies in quadrant (MPL is –ve) when TPL is downward sloping.

Relationship between MPL and ATL

• When MPL lies above the APL, the APL is upward sloping because the MPL causing APL rise.
• MPL lies below the APL causing the APL curve to be downward sloping.
• MPL intersects the APL at point where the APL is maximized.
• The MPL reaches a maximum at a lower level of employment than does the APL.

The Relationship between TPL, ATL, and MPL Using Calculus

if total physical product of a variable factor eg Fertilizer can be expressed as an equation as

TP = 100 + 32q + 10q² - q²

 Where TP is the output given tonnes per hectare.

and q is the quantity of fertilizer applied in kgs per hectare.

From this we can derive the APP function simply as

 AP = 100/q + 32 +10q - q²

The MP is the rate of increase in TP when additional fertilizer applied

MP = 32 + 20q -3q²

LAW OF RETURNS

For production to take place, factors of production need to be combined.  An increase in the quantity of any factor of production will increase in production may so proportionate to the increase in factors of production or it may be more proportionately or less proportionately as compared to the increase in factors of production.

In production, a return to scale refers to changes in output subsequent to a proportional change in all inputs (where all inputs increase by a constant factor). If output increases by that same proportional change then there are constant returns to scale (CRTS). If output increases by less than that proportional change, there are decreasing returns to scale (DRS). If output increases by more than that proportion, there are increasing returns to scale (IRS)

Short example: where all inputs increase by a factor of 2, new values for output should be:
Twice the previous output given = a constant return to scale (CRTS)
Less than twice the previous output given = a decreased return to scale (DRS)
More than twice the previous output given = an increased return to scale (IRS)

Law of Increasing Returns

Other things remain constant, when units of labour and capital are increased, marginal products goes to increase.  it occurs when production increase more proportionately as compared to the increase in factor of production.

Causes of Increase in Returns

• Increase in efficiency
• Carrying of division of labour and differentiation process to the best possible units
• Existence of external economies

Law of Decreasing Returns

Other things remain constant, if one factor of production is fixed in supply and successive units of variable factor are added to it, then the extra output derived from the employment of each successive unit of the variable factor must after a time decline.  This comes about because each successive unit of the variable factor has less of the fixed factor to work with.

Causes of Diminishing Returns

• Fixed productive capacity
• Rising prices of factors of production
• Limited capacity for organizations and supervision.

Law of Constant Returns

Occurs when the increase in production is appropriate with the increase in factors of production.

More Illustration see a Table below

Q	1	2	3	4	5	6	7	8	9
TP	141	196	259	324	385	436	471	484	469
AP	141	98	86	81	77	72	67	60	52
MP	49	60	65	64	57	44	25	0	-31

Cost of Production

Basic definitions

Cost comes from factor price and how many units are used.

Accounting Cost. Actual expenses plus depreciation.

Economic Cost. Cost to a firm of using resources in production.

Any costs incurred by a firm may be classed into two groups: fixed cost and variable cost. Fixed costs are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages, and general upkeep. Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category. Fixed cost and variable cost, combined, equal total cost.

Revenue is the total amount of money that flows into the firm. This can be from any source, including product sales, government subsidies, venture capital and personal funds.

Marginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to quantity output. It may also be defined as the addition to total cost as output increase by a single unit. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is approximately 80 dollars, although this is more accurately stated as the marginal cost of the 5.5th unit due to linear interpolation. Calculus is capable of providing more accurate answers if regression equations can be provided.

Therefore, Total Cost =Variable Cost + Fixed Cost.

            SHORT RUN AND LONG RUN

The production process is generally divided into long run planning decision in which a firm chooses the least expensive method of production from among or possible methods, and short run adjustment decision in which a firm adjust its long run decision to reflect new information.

The term long run and short run do not necessarily refer to a specific period of time independent of the nature of the production process.  They refer to the degree of the flexibility the firm has in changing the level of output.  Therefore, in long run by definition, the firm can value the inputs as much as it wants.  In short run some of the flexibility that existed in the long run no longer existing.  In short run some inputs are so costly to adjust that they are treated as fixed.  So in long run all inputs are variable and in the short run some inputs are fixed.

A Table of costs

Units	FC	VC	AFC	AVC	ATC	MC
0	100,000	0	0	0	0	-
1	100,000	40,000	100,000	40,000	140,000	140,000
2	100,000	60,000	50,000	30,000	80,000	20,000
3	100,000	70,000	33,333	23,333	56,666	10,000
4	100,000	85,000	25,000	21,250	46,250	15,000
5	100,000	130,000	20,000	26,000	46000	55,000
6	100,000	170,000	16,667	28,330	45,000	40,000

From the above table, you can draw the graphs by using the date given.

ATC = AVC + AFC

As you increase more output AFC becomes more small that’s why ATC and AVC become closer.  The AFC is represented by the distance between AVC and ATC at any point in the graph.

The cost of production is simply the sum of the costs of all of the various factors.

COST CURVES

In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are a few different types of cost curves, each relevant to a different area of economics.

The Short Run average total cost curve (SATC or SAC)

Typical short run average cost curve

The average total cost curve is constructed to capture the relation between cost per unit and the level of output, ceteris paribus. A productively efficient firm organizes its factors of production in such a way that the average cost of production is at lowest point and intersects Marginal Cost. In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity where it has enjoyed all the possible benefits of specialization and no further opportunities for decreasing costs exist. This is usually not U shaped, it is a checkmark shaped curve. This is at the minimum point in the diagram on the right.Example: Q=2K^.5L^.5 STC=Pk(K)+Pw(Q²/4K) SATC or SAC= (Pk(K)/Q)+Pw(Q/4K)

The long-run average cost curve (LRAC)

Typical long run average cost curve

Essentially, the long-run average cost curve depicts what the minimum per-unit cost of producing a certain number of units would be if all productive inputs could be varied. Given that LRAC is an average quantity, one must not confuse it with the long-run marginal cost curve, which is the cost of one more unit. The LRAC curve is created as an envelope of an infinite number of short-run average total cost curves. The typical LRAC curve is U-shaped, reflecting economies of scale when negatively-sloped and diseconomies of scale when positively sloped. Contrary to Viner, the envelope is not created by the minimum point of each short-run average cost curve. This mistake is recognized as Viner's Error.

In a long-run perfectly competitive environment, the equilibrium level of output corresponds to the minimum efficient scale, marked as Q2 in the diagram. This is due to the zero-profit requirement of a perfectly competitive equilibrium. This result, which implies production is at a level corresponding to the lowest possible average cost, does not imply that other production levels are not efficient. All points along the LRAC are productively efficient, by definition, but are not equilibrium points in a long-run perfectly competitive environment.

In some industries, the LRAC is always declining (economies of scale exist indefinitely). This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply.

The average cost is the total cost divided by the number of units produced.

The marginal cost curve (MC)

Typical marginal cost curve

A marginal cost that graphically represents the relation between marginal cost incurred by a firm in the short-run product of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables, like technology and resource prices, constant. The marginal cost curve is U-shaped. Marginal cost is relatively high at small quantities of output, then as production increases, declines, reaches a minimum value, then rises. The marginal cost is shown in relation to marginal revenue, the incremental amount of sales that an additional product or service will bring to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns - Diminishing returns).

Combining cost curves

Cost curves in perfect competition compared to marginal revenue

Cost curves can be combined to provide information about firms. In this diagram for example, firms are assumed to be in a perfectly competitive market. The marginal cost curve will cut the average cost curve at its lowest point. In a perfectly competitive market a firm's profit maximising price would be at or above the price at which the average cost curve cuts the marginal cost curve. If the marginal revenue is above the average total cost price the firm is deriving an economic profit.

Profit Maximization

In economic terms, profit is the difference between a firm's total revenue and its total opportunity cost. Total revenue is the amount of income earned by selling products. In our simplified examples, total revenue equals P x Q, the (single) price of the product multiplied times the number of units sold. Total opportunity cost includes both the costs of all inputs into the production process plus the value of the highest-valued alternatives to which owned resources could be put.

For example, a firm that has $100,000 in cash could invest in new, more efficient, machines to reduce its unit production costs. But the firm could just as well use the $100,000 to purchase bonds paying a 7% rate of interest. If the firm uses the money to buy new machinery, it must recognize that it is giving up $7000 per year in forgone interest earnings. The $7000 represents the opportunity cost of using the funds to buy the machinery.

We will assume that the overriding goal of the managers of firms is to maximize profit:  = TR - TC. The managers do this by increasing total revenue (TR) or reducing total opportunity cost (TC) so that the difference rises to a maximum.

An Example

Suppose you are running a business that produces and sells office furniture. It's a small operation, and in a typical day you produce three custom desks. You are able sell these desks for $500 a piece. You employ five workers, each of whom earns $15 per hour ($120 per day), and you work alongside them and pay yourself at the same rate. Material inputs cost $150 per desk. Of course, you have additional "overhead" expenses, including rent, a secretary/bookkeeper, electricity, etc. This overhead, which we will assume does not vary with the number of desks produced (i.e., it's a fixed cost) comes to $130 per day. Thus, your company earns a profit of  = ($500 x 3) - ($720 + 450 + 130) = $1500 - $1300 = $200 per day. (Wages for six workers come to $720. Materials for three desks cost $450. Overhead is $130.) Working five days a week for 50 weeks a year that comes to an annual profit of $50,000. Pretty nice - but could you do better?

Suppose you decide to increase production to four desks per day. This requires you to hire two more workers (at another $240) and purchase another $150 worth of materials. Overhead expense doesn't change. Your total cost rises to $1690. You find that you are able to sell the fourth desk for $500. Was this a good decision? [Engage brain here.]

You're right. [I'm giving you the benefit of the doubt here.] Total revenue rises to $2000 per day, while total costs rise to $1690. Profit increases to $310 per day. Good show, old man/woman/[insert desired politically correct term here]!

This nice result may lead you to increase production to five desks a day. If you are able to sell all five desks for $500 each, and if your variable costs of producing the desks - what you pay in labor and materials - doesn't increase, producing a fifth desk makes sense. TR rises to $2500, TC rises to $2080, and profit increases to $420. So you sell five desks.

Suppose, however, that you find that the labor market is so tight that you cannot hire another two workers at $15 per hour. In fact, to hire your ninth and tenth workers, you must pay $20 per hour. That increases the labor cost of the fifth desk by $80 ($40 per worker times two workers). TC rises to $2160, which still allows profit to increase to $340. But we have a problem brewing. Can you really get away with paying your veteran workers $15 an hour, while at the same time hiring new workers at $20 per hour? Not likely. So when you hire the ninth and tenth workers, you are forced to raise the wages of your first eight workers (Pay yourself more; hey, you deserve it.). Let's recalculate profit for Q = 5. TR = $500 x 5 = $2500. TC = ($160 x 10) + ($150 x 5) + $130 = $2480. That leaves a profit of $20. Doesn't look like such a good idea now, does it Einstein? Thus, if you realize that your costs will rise sharply if you produce a fifth desk each day, you will decline to produce the desk.

Application

Our little example illustrates the situation every business owner or manager faces. Businesspeople know what their current position is (revenue and costs) and they can estimate TR and TC for a higher (or lower) level of production. By actually changing output levels, they learn by experience what their demand and cost curves look like. In the process, they discover what happens to profit as they change output levels. Through this discovery process, businesspeople seek to find the output level that maximizes profit.

As omniscient onlookers, we can describe this process a bit more analytically. A firm should increase its output so long as the marginal revenue earned from additional units of production is greater than the marginal cost of those units. Marginal revenue is the additional revenue earned by selling one more unit of a product. (In our example, MR = $500.)

Marginal cost is the additional cost incurred in producing one more unit of output. So long as MR > MC, profit grows. However, when MR < MC, profit shrinks. So firms expand output only to the point at which MR = MC. This point maximizes profit.

The profit-maximization rule applies both to firms that are able to sell their product at a constant price (as in our example) and to firms that find they must reduce the price of their product to increase sales. In the real world, firms have to engage in trial-and-error discovery processes, searching for the profit-maximization point. But the process can be succinctly described by the marginal revenue-marginal cost rule.

.

QUESTIONS FOR CONCENTRATION

1.            Define total, average, and marginal product.

2.            Define total, average, and marginal cost.

3.            Define total, average, and marginal revenue.

4.            Explain the short run and long run cost curves of a firm.

5.            Write short notes on:

a)    Variable costs

b)    Fixed costs

           6.  If you increase production to an infinitely large level, the average variable cost      
                and the average total cost will merge. Why?

           7.  Draw a long run cost curve.

          a)  Why does it slope downward initially?

          b)  Why does it eventually slope upward? 

      8. A professor has written a book for which he receives royalty payments of 15%  
          of total revenue from sales of the book.  Because their loyalty income is tied to

          revenue not profit, he wants the publisher to set the price so that total revenue  
          is maximized.  However the publisher’s objective is maximum profit.  If the  

          revenue function is TR = 100,000Q – 10Q²

          Determine:

a)     The output rate that will maximize total royalty revenue and also the amount of

       Royalty income that Professor would receive.

b)     The output rate that would maximize profit to publisher (Hind: apply the

       Knowledge of calculus)

         9. What are three stages of short run production function? Use a well labelled 
             graph to explain this concept.

        10. Explain the following:

a)             Constant return of scale

b)             Increasing return of scale

c)              Decreasing return of scale.

       11. Explain why a fixed cost is said to be fixed.

       12. Explain why a variable cost is said to be variable.

      13. What is the relevant range and why is it important to a full understanding of the  
            behavior of costs?

     

      14. Plot the following data on two separate graphs: graph one for the variable costs  
            and graph two for the fixed costs; and comment on the saying, the more we  
            make, the cheaper our production costs are

VC/unit	Output	FC/unit
2.00	-	∞
2.00	100	100.00
2.00	200	50.00
2.00	300	33.33
2.00	400	25.00
2.00	500	20.00
2.00	600	16.67
2.00	700	14.29
2.00	800	12.50
2.00	900	11.11
2.00	1,000	10.00

Theory of Production Questions with Answers

1. If 1 orchard, 7 workers, and 3 tons of fertilizer yield 1,000 bushels of peaches, while 1 orchard, 7 workers, and 4 tons of fertilizer yield 1,300 bushels,

a. the average product of labor equals 1,150 bushels.

b. the marginal product of labor cannot be calculated.

c. the average product of fertilizer equals 1,150 bushels.

d. the marginal product of fertilizer cannot be calculated.

When answering the next five questions (2-6), refer to the following graph.

2. The marginal product of labor is rising with increased use of labor until

a. 10 workers are employed.

b. 20 workers are employed.

c. 30 workers are employed.

d. 40 workers are employed.

3. The average product of labor is falling with increased use of labor once

a. 10 workers are employed..

b. 20 workers are employed.

c. 30 workers are employed

d. 40 workers are employed.

4. As long as fewer than 30 workers are employed,

a. the average product of labor exceeds the marginal product of labor.

b. the marginal product of labor exceeds the average product of labor.

c. the marginal product of labor is rising.

d. both (a) and (c) are true.

7. An isoquant curve shows

a. all the alternative combinations of two inputs that yield the same maximum total product.

b. all the alternative combinations of two products that can be produced by using a given set of inputs fully

and in the best possible way.

c. all the alternative combinations of two products among which a producer is indifferent because they yield

the same profit.

d. both (b) and (c).

8. A negatively sloped isoquant implies

a. products with negative marginal utilities.

b. products with positive marginal utilities.

c. inputs with negative marginal products.

d. inputs with positive marginal products.

9. The marginal rate of technical substitution is

a. the rate at which a producer is able to exchange, without affecting the quantity of output produced, a

little bit of one input for a little bit of another input.

b. the rate at which a producer is able to exchange, without affecting the total cost of inputs, a little bit of

one input for a little bit of another input.

c. the rate at which a producer is able to exchange, without affecting the total inputs used, a little bit of one

output for a little bit of another output.

d. a measure of the ease or difficulty with which a producer can substitute one technique of production for

another.

10. In the presence of a diminishing marginal rate of technical substitution between labor and capital, output can

be kept unchanged only if

a. equal successive sacrifices of capital go hand in hand with ever smaller increases of labor.

b. equal successive sacrifices of capital go hand in hand with ever smaller sacrifices of labor.

c. equal successive increases in labor go hand in hand with ever smaller increases in capital.

d. qual successive increases in labor go hand in hand with ever smaller sacrifices of capital.

11. If the capital-labor ratio changes from 100 to 150, while the marginal rate of technical substitution between capital and labor changes from 50 to 100, the elasticity of input substitution

a. cannot be calculated.

b. remains unchanged.

c. equals 2.

d. equals 0.5.

12. If a simultaneous and equal percentage decrease in the use of all physical inputs leads to a larger percentage decrease in physical output, a firm’s production function is said to exhibit

a. decreasing returns to scale.

b. constant returns to scale.

c. increasing returns to scale.

d. diseconomies of scale.

13. If a firm triples all inputs, and output triples as well, the firm is subject to

a. constant returns to scale.

b. increasing returns to scale.

c. economies of scale.

d. both (b) and (c).

14. For a given short-run production function,

a. technology is assumed to change as capital stock changes.

b. technology is assumed to change as the labor input changes.

c. technology is considered to be constant for a given production function relationship.

d. technology is assumed to change positively until diminishing returns set in and then it changes in the

other direction.

15. Which is a true statement?

a. Decreasing returns to scale and diminishing returns to production are two ways of stating the same thing.

b. Increasing returns to scale is a short-run concept, and diminishing returns to production is a long-run

concept.

c. Constant returns to scale is a short-run concept, and decreasing returns to scale is a long-run concept.

d. All the above are true.

e. None of the above is true.

16. An isocost line identifies

a. the least costly combination of inputs needed to produce a given level of output.

b. the relative prices of inputs.

c. the technological relationships among inputs.

d. the rate at which one input can be substituted for another in the production process.

17. The expansion path identifies

a. the least costly combination of inputs required to produce various levels of output.

b. the firm’s demand curves for the inputs.

c. the various combinations of inputs that can be used to produce a given level of output.

d. the least-cost combination of outputs.

18. A tangency point between an isoquant and an isocost line identifies

a. the least costly combination of inputs required to produce various levels of outputs.

b. the various levels of output that can be produced using a given level of inputs.

c. the various combinations of inputs that can be used to produce a given level of output.

d. the least costly combination of inputs required to produce a given level of output.

19. A firm is employing 100 units of labor and 50 units of capital to produce 200 widgets. Labor costs $10 per unit

L K and capital $5 per unit. For the quantities of inputs employed, MP = 2 and MP = 5. In this situation, the firm

a. is producing the maximum output possible given the prices and relative productivities of the inputs.

b. could lower its production costs by using more labor and less capital.

c. could increase its output at no extra cost by using more capital and less labor.

d. should use more of both inputs in equal proportions.

20. Suppose a firm is using two inputs, labor and capital. What will happen if the price of labor falls?

a. The firm’s average cost curve will shift downward.

b. The firm’s marginal cost curve will shift downward.

c. To produce an unchanged output, the firm would use more labor.

d. All of the above.

Theory of Production – Answers

1. b 2. b 3. c 4. b 5. d 6. c 7. a 8. d 9. a 10. d

11. d 12. c 13. a 14. c 15. e 16. b 17. a 18. d 19. c 20. d

Theory of Cost Question with Answers

1. In the short run, a firm’s fixed cost

a. is zero.

b. cannot be escaped.

c. can be escaped only by cutting production to zero.

d. is not correctly described by any of the above.

2. When average total cost rises from $10 to $30 as total production rises from 100 to 300 units, average

variable cost

a. cannot be calculated.

b. equals $10.

c. equals $20.

d. equals $30.

10. At the point where a straight line from the origin is tangent to the variable-cost curve

a. marginal cost equals average total cost.

b. marginal cost equals average fixed cost.

c. marginal cost equals average variable cost.

d. average total cost is minimized.

11. If a profit-maximizing firm’s marginal product of labor equals 1 ton of output, while the marginal product of capital equals 7 tons of output and the use of capital is priced at $14 per unit, then

a. the price of labor must be $2.

b. the price of labor must be $7.

c. the price of labor must be $14 as well.

d. none of the above is true.

12. A firm’s long-run average-total-cost line is

a. identical to its long-run marginal-cost line.

b. also its long-run supply curve.

c. in fact the average-total-cost curve of the optimal plant.

d. tangent to all the curves of short-run average total cost.

13. Average fixed cost

a. is U-shaped.

b. declines over the entire output range.

c. is a long-run concept only.

d. is influenced by diminishing returns to production.

e. is described by none of the above.

14. If average total cost is 100 for a given output and marginal cost is 70, we then know that average fixed cost is

a. 30.

b. 170.

c. 70.

d. not possible to determine with the information given.

15. If average fixed cost is 40 and average variable cost is 80 for a given output, we then know that average total

cost is

a. 40.

b. 120.

c. 80.

d. not possible to determine with the information given.

16. The output where diminishing returns to production begin is also the output where

a. marginal cost is at a minimum.

b. average total cost is at a minimum.

c. average variable cots is at a minimum.

d. marginal and average cost intersect.

17. Which of the following statements about marginal cost is incorrect?

a. A U-shaped marginal cost curve implies the existence of diminishing returns over all ranges of output.

b. When marginal cost equals average cost, average cost is at its minimum.

c. In the short run, the shape of the marginal cost curve is due to the law of diminishing marginal returns.

d. When marginal cost is falling, total cost is rising.

18. Which of the following statements about the relationship between marginal cost and average cost is correct?

a. When MC is falling, AC is falling.

b. AC equals MC and MC’s lowest point.

c. When MC exceeds AC, AC must be rising.

d. When AC exceeds MC, MC must be rising.

19. The slope of the total variable cost curve equals

a. average variable cost.

b. marginal cost.

c. average cost.

d. marginal physical product.

20. In the short run, diminishing marginal returns are implied by

a. rising marginal cost.

b. rising average cost.

c. rising average variable cost.

d. all of the above.

Theory of Cost – Answers

1. b 2. a 3. c 4. d 5. a 6. b 7. b 8. d 9. c 10. c 11. a 12. d 13. b 14. d 15. b 16. a 17. a 18. c 19. b 20.

Additional Notes

 

Additional Notes

 

THEORY OF MARKET STRUCTURE

DEFINITION OF THE TERMS

Market

A market is an area or place however large of small where by buyers and sellers are in sufficiently close contact with one another so that transaction of goods and service take place.

Market exists for all commodities and for all services.  There are different types of markets; the following are types of market:

Financial Market

The market in short term and long term loans, market for foreign currencies (Capital market and money market)

Labour Market

Where labour services are sold by workers and brought by employers associations, trade unions, employment offices, and the situations vacant columns in news papers and magazines.

Land Market

Land is usually sold through estate agents and advertisements in news papers

Commodity Market

Held in particular place or building.  The markets are conducted by brokers who act as agents for buyers and sellers.

Consumer Goods Market

Formed by wholesale and retail trades.  In the retail market, the finished products are made available to the consumers.

In general we have:

Ø  Goods market

Ø  Financial market

Ø  Factor market

MARKET STRUCTURE

Market structure describes the important features of a market.  Market structures include perfect competition, monopoly, oligopoly, and monopolistic competition market structures.

The main dimension of market structure (Determinants of market structure)

Ø  Number of sellers

Ø  Numbers of buyers

Ø  Nature of product

Ø  Condition of entry

Ø  Control over prices

Ø  Control over supply and output

Market structure is important to a large extent because it shapes the market conduct e.g.

Ø  A company which has a monopoly power will behave differently from the one faced with several rivals producers.

Ø  A company selling a branded, advertised product will behave differently from the one selling completely standardized products.

Generally, a type of market structure influences how a firm behave in pricing, supplying goods, barriers to entry into the market, efficiency, and competition.

Market conduct in turn affect the economic performance of the industry i.e. how the prices are determined and whether profits are low or high.

Therefore, Market Structure → Market behaviour → Economic performance

The following are the market structures:

•      Perfect Competition

•      Monopoly

•      Oligopoly – Competition amongst the few

•      Monopolistic Competition

These monopoly, oligopoly, and monopolistic competition fall under the category of Imperfect competition.

Perfect competition

Perfect competition describes the perfect being markets in which there are many small firms, all producing homogeneous goods. This market attempts to explain how a perfect economy or pure free enterprise system tends to operate.  In the short term, such markets are productively inefficient as output will not occur where marginal cost is equal to average cost, but allocatively efficient, as output under perfect competition will always occur where marginal cost is equal to marginal revenue, and therefore where marginal cost equals average revenue. However, in the long term, such markets are both allocatively and productively efficient. In general a perfectly competitive market is characterized by the fact that no single firm has influence on the price of the product it sells. Because the conditions for perfect competition are very strict, there are few perfectly competitive markets.

A perfectly competitive market may have several distinguishing characteristics, including:

•      Many buyers/Many Sellers – Many consumers with the willingness and ability to buy the product at a certain price, Many producers with the willingness and ability to supply the product at a certain price.

•      Free Entry/Exit Barriers – It is relatively easy to enter or exit as a business in a perfectly competitive market.

•      Perfect Information - For both consumers and producers are having perfect knowledge of market and prices.

•      Firms Aim to Maximize Profits - Firms aim to sell where marginal costs meet marginal revenue, where they generate the most profit.

•      Homogeneous Products – The characteristics of any given market good or service do not vary across suppliers.

•      Sellers are price takers – have to accept the market price.

•      Perfect mobility of resources – There must be no restrictions on the movement of goods and factors of production like labour and capital.  In this case the goods can be moved to those places where there is great demand for them.  Similarly labour and capital can be moved to those places where they are more productive.

•      Producers aim to maximize profit

Examples of perfect competition:

–     Financial markets – stock exchange, currency markets, and bond markets?

–     Agriculture

Advantages of Perfect Competition:

•      High degree of competition helps allocate resources to most efficient use

•      Price = marginal costs

•      Normal profit made in the long run

•      Firms operate at maximum efficiency

•      Consumers benefit

What happens in a competitive environment?

•      New idea? – firm makes short term abnormal profit

•      Other firms enter the industry to take advantage of abnormal profit

•      Supply increases – price falls

•      Long run – normal profit made

•      Choice for consumer

•      Price sufficient for normal profit to be made but no more Monopolistic competition

Short-run equilibrium of the firm under monopolistic competition

Long-run equilibrium of the firm under monopolistic competition

Profit

In perfect competition to earn economic profit in the long run, which is to say that a firm cannot make any more money than is necessary to cover its economic costs. In order not to misinterpret this zero-long-run-profits thesis, it must be remembered that the term 'profit' is also used in other ways. Neoclassical theory defines profit as what is left of revenue after all costs have been subtracted, including normal interest on capital plus the normal excess over it required to cover risk, and normal salary for managerial activity. Classical economists on the contrary defined profit as what is left after subtracting costs except interest and risk coverage; thus, if one leaves aside risk coverage for simplicity, the neoclassical zero-long-run-profit thesis would be re-expressed in classical parlance as profits coinciding with interest in the long period, i.e. the rate of profit tending to coincide with the rate of interest. Profits in the classical meaning do not tend to disappear in the long period but tend to normal profit. With this terminology, if a firm is earning abnormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit only.

The shutdown point

When a firm is making a loss, it will have to decide whether to continue production or not. This decision will, in fact, depend on the different total costs levels and whether the firm is operating in the short run or in the long run.

If the firm is in the short run, and is making a loss whereby:

• Total costs (TC) is greater than total revenue (TR)
• and whereby total revenue is greater than total variable cost (TVC)

it is advisable for the firm to continue production. If it fails to achieve these conditions, it is advised to close down so that the only costs the firm will have to pay will be the fixed costs.

Even if the firm stops producing, it will have to continue to meet the level of fixed costs. Since whether the firm produces or not, it will have to pay fixed costs, it is better for it to continue production in an attempt to decrease total costs and increase total revenue, thus making profits. This can be done by:

• Increasing productivity. The most obvious methods involve automation and computerization which minimize the tasks that must be performed by employees. All else constant, it benefits a business to improve productivity, which over time lowers cost and (hopefully) improves ability to compete and make profit.
• Adopting new methods of production like Just In Time or lean manufacturing in an attempt to reduce costs and wastages.

In the long run, the condition to continue producing requires the price P to be higher than the ATC, i.e. the line representing market price should be above the minimum point of the ATC curve.

•      If P is equal to ATC, the firm is indifferent between shutting down and continuing to produce. This case is different from the short run shut down case because in long run there's no longer a fixed cost (everything is variable).

IMPERFECT OR MONOPOSTIC COMPETITION

where the conditions necessary for perfect competition are not satisfied. It is a market structure that does not meet the conditions of perfect competition.
Forms of imperfect competition include:

• Monopoly, in which there is only one seller of a good.
• Oligopoly, in which there is a small number of sellers.
• Monopolistic competition, in which there are many sellers producing highly differentiated goods.

There may also be imperfect competition in markets due to buyers or sellers lacking information about prices and the goods being traded.

There may also be imperfect competition due to a time lag in a market. An example is the “jobless recovery”. There are many growth opportunities available after a recession, but it takes time for employers to react, leading to high unemployment. High unemployment decreases wages, which makes hiring more attractive, but it takes time for new jobs to be created.

MONOPOLY

Monopoly is a market structure in which there is a single seller, selling commodities that have no close substitute and there are barriers of entry.

Examples of monopoly are: gas and water companies, post office, Tanesco etc.

Characteristics of Monopoly market structure:

·         The market consists of one producer or supplier

·         There are many buyers

·         Product produced has no close substitute

·         Producer is protected from entry of competitions into the market by barriers of entry

·         Producer is the price searcher/ maker.

·         Consumer choice limited

·         Abnormal profits in long run

·         Possibility of price discrimination

·         Prices in excess of MC (Abnormal profit)

Causes of Monopoly

·         Legal restrictions

·         Control of essential resources

·         Technological / technical superiority

·         Economies of scale

Advantages of monopoly

•      May be appropriate if natural monopoly

•      Encourages innovation and new product

•      Development of some products not likely without some guarantee of monopoly in production

•      Economies of scale can be gained – consumer may benefit

Disadvantages of Monopoly

–     Exploitation of consumer – higher prices

–     Potential for supply to be limited - less choice

–     Potential for inefficiency

–     Unequal distribution of income

What should be done to reduce the monopoly power

• Tax away all the profits of monopolists above the normal profits and distribute these revenue to the public by improving government services.
• Treat all monopolists as public utilities by regulating their output and prices requiring them to produce more and charge less than they would if they were completely free and unregulated.
• Each firm produces a product which is slightly differentiated from that of rival producer.
• To have free entry into the market or to have few barriers.

OLIGOPOLY
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). The word is derived from the Greek oligo 'few' plus -opoly as in monopoly and duopoly. Because there are few participants in this type of market, each oligopolist is aware of the actions of the others. The decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by oligopolists always involves taking into account the likely responses of the other market participants.

In this market structure firms might be producing identical products in which case we refer to perfect oligopoly.  Also firms might be producing differentiated products hence called Imperfect oligopoly.  Here we can have two or three firms dominating the market, their behaviour is markedly unique and no simple model can adequately described or predict their actions.

Oligopoly market structure is characterized by:

•      Industry dominated by small number of large firms

•      Many firms may make up the industry

•      High barriers to entry

•      Products could be highly differentiated – branding or homogenous

•      Non–price competition

•      Price stability within the market - kinked demand curve?

•      Potential for collusion?

•      Abnormal profits

•      High degree of interdependence between firms

Examples of oligopolistic structures:

•      Supermarkets

•      Banking industry

•      Chemicals

•      Oil

•      Medicinal drugs

•      Broadcasting

Measuring Oligopoly:

Concentration ratio – the proportion of market share accounted for by top X number of firms:

•      E.g. 5 firm concentration ratio of 80% - means top 5 five firms account for 80% of market share

•      3 firm CR of 72% - top 3 firms account for 72% of market share 

Price and Output Decisions for an Oligopolist
No single model can describe oligopoly. There are four commonly used models: Nonprice Competition, The Kinked Demand Curve, Price Leadership, and Cartel.

1. Nonprice Competition

• Oligopolies often compete through nonprice methods such as advertising and product differentiation.
• The reason is that changes in price would be easy for competitors to match, while it is more difficult to compete with clever or important product improvement.

2. The Kinked Demand Curve: A demand curve facing an oligopolist that assumes rivals will match a price decrease, but ignore a price increase.

• Oligopolists are price makers.
• Above the "kink" in the demand curve, demand is relatively elastic (flat). An increase in price would not be copied by competitors, and consumers would shift to the cheaper product, causing a large decrease in QD from a given increase in price.
• The segment of the demand curve below the "kink" is relatively inelastic (steep). A decrease in price would be copied by competitors and each firm keeps its original market share, implying a small decrease in QD from a given decrease in price.
• The price established at the "kink" changes very infrequently.  

3. Price Leadership: A pricing strategy in which a dominant firms sets the price for an industry and the other firms follow -- both for price increases and decreases.

• An informal process that assumes firms do not collude.

4. Cartel: A group of firms formally agreeing to control the price and output of a      product.

• Replaces competition with cooperation in order to reap monopoly profits.
• Cartels are illegal in the in many countries, even in TZ, but not in other countries (Ex. OPEC).
• If one firm "cheats" it increases output above the agreed level and increases profits.  

DUOPOLY

A true duopoly is a specific type of oligopoly where only two producers exist in one market. In reality, this definition is generally used where only two firms have dominant control over a market. In the field of industrial organization, it is the most commonly studied form of oligopoly due to its simplicity.

Duopoly models in economics

There are two principal duopoly models, Cournot duopoly and Bertrand duopoly:

• The Cournot model, which shows that two firms assume each others output and treat this as a fixed amount, and produce in their own firm according to this.

·         The Bertrand model, in which, in a game of two firms, each one of them will assume that the other will not change prices in response to its price cuts. When both firms use this logic, they will reach a Nash Equilibrium.

Characteristics of Duopoly

• Industry dominated by two large firms
• Possibility of price leader emerging – rival will follow price leaders pricing decisions
• High barriers to entry
• Abnormal profits likely

MONOPOLISTIC COMPETITION

Monopolistic competition,is a market structure in which there are many sellers producing highly differentiated goods.

There may also be imperfect competition in markets due to buyers or sellers lacking information about prices and the goods being traded, there may also be imperfect competition due to a time lag in a market. An example is the “jobless recovery”. There are many growth opportunities available after a recession, but it takes time for employers to react, leading to high unemployment. High unemployment decreases wages, which makes hiring more attractive, but it takes time for new jobs to be created.

Characteristics of monopolistic type of market structure:

•      Many buyers and sellers

•      Products differentiated

•      Relatively free entry and exit

•      Each firm may have a tiny ‘monopoly’ because of the differentiation of their product

•      Firm has some control over price

Examples – restaurants, professions – solicitors, etc., building firms – plasterers, plumbers, etc.

                  Review of the Four Market Structures

Market Structure	Number of Sellers	Type of Product	Entry Condition	Examples
Perfect Competition	Large	Homogenous	Very Easy	Agriculture
Monopoly	One	Unique	Impossible	Public utilities
Monopolistic Competition	Many	Differentiated	Easy	Retail trade
Oligopoly	Few	Homogenous or differentiated	Difficult	Autos, steel, oil

QUESTIONS FOR CONCENTRATION

1. Show with the help of the diagrams, the conditions of super-normal profits and losses of a firm working under perfect competition in the short run.

2. A firm under perfect competition finds that at the equilibrium level of output its AR is Tshs 28, while its marginal cost is Tshs 28 and SATC is Tshs 68, and SAVC is Ths 24.  Will the firm produce or shut down? Why?

3. What are two things you must know to determine the profit maximizing output under perfect competitive market structure.

4. When a firm is making a zero profit is not adviced to close down. Why? Under what condition the firm should close down? ( consider perfect competitive market structure)

5. Write short notes of perfect competitive market structure.

6. A profit maximizing firm has an average of total cost of Tshs 40 but it gets a price of Tshs 30 for each goods it sells. What would you advice the firm to do and what would you advice the firm to do if you know AVC is Tshs 35.

7. What is monopoly type of market structure and what causes or makes a firm to have monopoly power?

8. What is oligopoly market structure?

9. Why do monopolistic competitive firms advertise and perfect competitive firms do not advertise?

10. Your average total cost is Tshs 30, the price you receive for the goods is Tshs 12.  Should you keep on producing the good? Why?

Perfect Competition

1. A firm operating in a perfect market maximizes its profit by adjusting

a. its output price until it exceeds average total cost as much as possible.

b. its output price until it exceeds marginal cost as much as possible.

c. its output until its marginal cost equals output price.

d. its output until its average total cost is minimized.

5. In the short run, no firm operates with a loss, unless

a. variable cost equals fixed cost.

b. variable cost falls short of fixed cost.

c. total revenue covers variable costs.

d. total revenue covers fixed cost.

6. For a firm operating in a perfect market, its short-run supply is identical with the rising arm of

a. its marginal-cost curve.

b. its average-fixed-cost curve.

c. its average-total-cost curve.

d. none of the above.

7. A good’s short-run supply curve is shifted to the right by

a. a fall in the good’s price.

b. a rise in the prices of inputs used to make the good.

c. an improvement in the technology of making the good.

d. none of the above.

8. Being a price taker in a market means that the seller

a. charges each consumer the maximum that she will be3 able to pay for the product.

b. has no choice but to charge the equilibrium price that results from the market supply and demand curves.

c. takes her price from her average total cost curve.

d. sells her products at different prices to different customers.

9. The statement that marginal cost = marginal revenue leads to profit maximization of loss minimization is true

a. all the time.

b. only in the long run.

c. only if marginal cost is rising at the point of equality.

d. only if average total cost is falling at the point of equality.

10. In perfect competition, when economic profits exist in the short run, they are very tenuous because

a. costs will inevitably increase and eliminate profit.

b. price will fall because market supply will increase.

c. firms are driven to increase output in the short run to the point where average total cost will equal price.

d. firms are driven in the short run to reduce output until average total cost equals price.

11. When a profit-maximizing firm is at its short-run optimum point,

a. the average cost of the product is at its lowest possible point whether a profit is being made or not.

b. the firm will be shut down if its price is less than the average fixed cost.

c. the profit per unit of output will be at its maximum possible level.

d. all the above will be true.

e. none of the above will be true.

12. If a firm is producing where its SMC = price and the LMC is less that LAC, then it would do better in the

long run by

a. increasing output with its existing plant until LMC equals price.

b. increasing plant size until LMC and SMC are identical and equal to price.

c. decreasing plant size until LAC, SAC, and price are equal.

d. doing nothing because it is already at the long-run profit maximizing point.

13. The competitive firm maximizes its profit by operating where

a. average costs are at a minimum.

b. total revenue is at a maximum.

c. profit per unit is at a maximum.

d. marginal cost equals price.

23. For a competitive firm the demand curve

a. is horizontal

b. coincides with the marginal revenue curve.

c. coincides with the average revenue curve.

d. all of the above.

24. In the short run, if price falls, the firm will respond by

a. shutting down.

b. equating average variable cost to marginal revenue.

c. reducing output along its marginal cost curve as long as marginal revenue exceeds average variable cost.

d. none of the above.

25. In the short run, a competitive firm’s supply curve is

a. its average variable cost curve to the right of the marginal cost curve.

b. its marginal cost curve above the average variable cost curve.

c. its marginal cost curves above its average cost curve.

d. the horizontal summation of the marginal cost curves.

26. In a constant cost competitive industry if price rises above its long-run equilibrium level, which of the

following will not occur as the industry adjusts to a new LR equilibrium?

a. New firms will enter the industry.

b. Economic profit will be eliminated.

c. Input prices will rise.

d. Existing firms will increase production.

27. The term increasing cost industry is used to describe

a. a firm with a rising average cost curve.

b. an industry subject to decreasing returns to scale.

c. an industry with a rising marginal cost curve.

d. an industry in which the prices of one or more inputs are bid up as output expands.

28. Along the long-run supply curve, all of the following can vary except

a. the level of profits.

b. the number of firms in the industry.

c. input prices.

d. the level of input usage.

29. The short-run supply curve for a competitive industry is derived by

a. horizontally summing the marginal cost curves for each firm in the industry.

b. horizontally summing the average variable cost curves for each firm in the industry.

c. vertically summing the marginal cost curves for each firm in the industry.

d. none of the above.

30. Generally, supply is

a. more elastic in the long run than in the short run.

b. more elastic in the short run than in the long run.

c. more elastic the more firms in the industry.

d. more elastic the lower the input prices.

Perfect Competition – Answers

1. c 2. b 3. c 4. d 5. c 6. d 7. c 8. b 9. c 10. b

11. e 12. b 13. d 14. d 15. a 16. d 17. b 18. c 19. a 20. a

21. c 22. a 23. d 24. c 25. b 26. c 27. d 28. a 29. a 30. a

Monopoly

1. In the long run, a profit-maximizing monopoly produces an output volume that

a. equates long-run marginal cost with marginal revenue.

b. equates long-run average total cost with average revenue.

c. assures permanent positive profit.

d. is correctly described by both (a) and (c).

When answering questions 2-6, refer to the following graph about a monopoly firm:

2. Which of the following is true?

a. Curve A indicates average total cost.

b. Curve B indicates average total cost.

c. Curve C indicates average fixes cost.

d. Curve D indicates marginal cost.

7. With respect to price elasticity, it is true that

a. monopoly market demand need not be less elastic than market demand in a competitive industry.

b. monopoly firms face less elastic demand than do competitive firms.

c. a monopolist should not produce where demand is inelastic.

d. all the above are correct statements.

8. A monopolist will maximize profit

a. where total revenue is maximized.

b. where the slope of the total revenue function equals the slope of the total cost function.

c. where average cost is at a minimum.

d. where all the above are true.

e. somewhere other than the solutions listed because none of them is true.

10. If the LMC curve is below the MR curve at the point of output for a monopolist that is making profit, then the

firm has

a. too large a plant size.

b. too small a plant size.

c. insufficient knowledge about plant size until he knows his short-run marginal cost.

d. insufficient knowledge about plant size until he knows his demand curve.

11. If a monopolist’s demand curve is downward sloping and linear, then its total revenue curve must be

a. identical to the demand curve.

b. a ray from the origin with a slope equal to price.

c. negatively sloped with twice the slope of the demand curve.

d. a rising function of output that increases at an increasing rate.

e. a rising function of output that increases at a decreasing rate, reaches a maximum, then falls.

12. All of the following are true about a monopolist except

a. average and marginal revenue are not the same.

b. marginal revenue is greater than price.

c. marginal revenue is zero if price elasticity of demand equals 1.

d. marginal revenue decreases with increases in output.

e. marginal revenue can be negative.

13. Suppose that an excise tax is imposed on the monopolist’s product. If the monopolist’s marginal cost is

horizontal in the relevant range, which of the following statements must be true?

a. The price will increase by an amount less than the tax.

b. The price will increase by an amount equal to the tax.

c. The price will increase by an amount greater than the tax.

d. The price may either increase or decrease.

e. An excise tax will have no effect on the price-output decision of a monopolist.

14. Which of the following is not true?

a. A monopolist typically seeks to maximize profits.

b. A monopolist sets price as high as possible.

c. A monopolist may engage in advertising.

d. Monopolists price on the elastic portion of their demand curves.

e. Profits are not guaranteed even if the firm is a monopolist.

15. Since entry is barred in a monopoly, in the long run the monopolist will

a. do nothing since entry will not force an adjustment.

b. adjust output but leave the price at the short run profit maximizing level.

c. adjust price but leave the output at the short run profit maximizing level.

d. adjust both price and output levels to reflect long run scale of plant adjustments.

e. set price equal to long run average costs.

16. The cost curves associated with monopolists are

a. always different from those faced by perfectly competitive firms.

b. always lower than those faced by competitive firms.

c. always higher than those faced by competitive firms.

d. always L-shaped rather than U-shaped.

e. typically have no relationship to the selling side of the market.

17. If a monopolist had no costs, the best possible price would be where demand is

a. infinitely elastic.

b. relatively (but not perfectly) elastic.

c. unit elastic.

d. relatively (but not completely) inelastic.

e. completely inelastic.

18. If a monopolist has only fixed costs and chooses that output at which marginal cost equals price, it will

a. earn positive economic profits.

b. earn zero economic profits.

c. incur a loss equal to its variable costs.

d. incur a loss equal to its fixed costs.

e. cannot tell from the information given.

19. If the monopolist maximizes profits when marginal revenue equals marginal cost equals average cost,

economic profits must be

a. negative.

b. positive.

c. zero.

d. either (a) or (c).

e. cannot tell from the information given.

20. A monopolist will discontinue production if

a. marginal revenue is less than marginal cost.

b. marginal revenue is less than average total cost.

c. marginal revenue is less than average fixed cost.

d. price is less than average total cost.

e. price is less than average variable cost.

21. The supply curve for a monopolist

a. is equal to the marginal cost curve above the average variable cost curve.

b. is equal to the marginal cost curve above the average cost curve.

c. cannot be uniquely determined.

d. is equal to the average variable cost curve above the marginal cost curve.

e. is typically perfectly inelastic.

22. If a monopoly is unable to cover its short-run variable costs, it should

a. shut down.

b. raise price.

c. lower price.

d. increase output.

e. reduce output.

23. If the product demand curve and the industry’s cost curves were the same whether the industry operated

under conditions of perfect competition or monopoly, what could be said about the price and output under

monopoly vis-a-vis the competitive price and output?

a. price would be the same; output would be lower under monopoly.

b. Output would be the same; price would be higher under monopoly.

c. Price would be the same; output would be lower under perfect competition.

d. Price would be higher and output would be lower under monopoly.

e. Both price and output would be lower under perfect competition.

24. The conditions necessary for a firm to be able to price discriminate include

a. segmentable markets.

b. differences in price elasticity of demand among the segments.

c. the inability of customers to transfer products.

d. all of the above.

e. none of the above.

25. Price discrimination is

a. illegal.

b. a technique that can improve the firm’s revenue and profit performance.

c. immoral in most cases.

d. impossible if consumers have perfect information.

e. difficult to administer.

Monopoly – Answers

1. a 2. b 3. c 4. a 5. a 6. b 7. d 8. b 9. d 10. b

11. e 12. b 13. a 14. b 15. d 16. e 17. c 18. d 19. b 20. e

21. c 22. a 23. d 24. d 25. b 26. c

Imperfect Competition

1. A monopolistically competitive market is characterized by all of the following except

a. easy entry.

b. differentiated products.

c. excess capacity.

d. economic profit in the long run.

2. An oligopolistic industry can be characterized by all of the following except

a. many sellers.

b. mutual interdependence.

c. economies of scale.

d. a homogenous product.

3. The kinked demand curve faced by an oligopolist is based on the assumption that

a. rivals will follow a price increase but not a price cut.

b. rivals will follow a price decrease but not a price increase.

c. rivals will follow both a price decrease and a price increase.

d. rivals will ignore both a price increase and a price decrease.

4. A common criticism of the kinked demand curve model is that

a. it does not explain the interdependence of the demand curve.

b. it does not explain why costs remain rigid in the face of changing demand.

c. it does not explain how price was determined.

d. none of the above.

5. Which of the following does not characterize monopolistic competition?

a. Product differentiation.

b. Many producers.

c. Absence of advertising.

d. Some control over price.

e. All of the above characterize monopolistic competition.

6. Product differentiation gives each seller a small amount of monopoly power because

a. little or nothing can be said concerning the social desirability or undesirability of product differentiation.

b. there can be little substitution between product groups.

c. the products of other firms are not perfect substitutes.

d. the presence of excess capacity greatly reduces monopoly power.

e. the monopolistic competitor faces a downward sloping demand curve.

7. A monopolistically competitive firm differs from a perfectly competitive firm in that, unlike the perfectly

competitive firm, it

a. faces a downward sloping demand curve.

b. can change the characteristics of its product.

c. can vary the price of its product.

d. tends to operate with excess capacity.

e. all of the above.

8. One of the differences between a perfectly competitive firm’s long-run equilibrium and the long-run

equilibrium of a monopolistically competitive firm is that

a. LMS = MR under perfect competition, but not under monopolistic competition.

b. SAC = LAC under perfect competition, but not under monopolistic competition.

c. SMC = LMC under perfect competition, but not under monopolistic competition.

d. LAC = LMC under perfect competition, but not under monopolistic competition.

e. economic profits are zero under perfect competition, but not under monopolistic competition.

9. In the neighborhood of the long-run equilibrium of a monopolistically competitive firm, average cost will be

a. decreasing.

b. constant.

c. increasing.

d. at a minimum.

e. either (a) or (c).

10. A conclusion that monopolistic competition will be characterized by excess capacity

a. means that the firm produces less than the profit-maximizing level of output.

b. means that the firm produces more than the profit-maximizing level of output.

c. means that the firm does not operate its plant at the minimum point of the long-run average cost curve.

d. means that the firm does not operate its plant at the minimum point of the long-run marginal cost curve.

e. means that there are too many firms in the industry.

11. The long-run equilibrium price charged by the monopolistic competitor is

a. likely to be lower than the perfect competitor’s price.

b. likely to equal long-run marginal cost.

c. likely to exceed long-run average cost so that all firms are earning positive economic profits.

d. likely to exceed the monopolist’s price.

e. likely to lie somewhere between the perfect competitor’s price and the monopolist’s price.

12. The firm under monopolistic competition is likely to produce less and set a higher price than under perfect

competition because

a. the firm faces decreasing returns to scale.

b. the firm faces increasing costs.

c. the firm must incur selling expenses, including advertising.

d. the firm operates where marginal revenue equals marginal cost.

e. the firm faces a downward sloping demand curve.

13. In order to constitute an oligopolistic market structure

a. there must be a few firms in a given relevant market.

b. there must be a few firms selling in a national market.

c. there must be more than 20 firms selling in the international market.

d. there must be fewer than 15 firms in any given market.

14. The key feature of oligopoly is

a. excess capacity.

b. high profitability.

c. product differentiation.

d. interdependence of firms.

e. the impersonal nature of the market.

15. The basic behavioral assumption of the kinked demand model is

a. each duopolist assumes that his or her rival’s price is invariant with respect to his or her own price.

b. each duopolist assumes that his or her rival’s output is invariant with respect to his or her own output.

c. duopolists recognize their mutual interdependence and agree to act in unison.

d. each duopolist assumes that if he or she lowers the price, his or her rivals will do the same but that if he

or she raises the price, his or her rivals may not follow suit.

e. none of the above.

16. The kinked demand curve is used to

a. illustrate the difference between pure and differentiated oligopoly.

b. explain the stability of oligopolistic prices.

c. illustrate the nature of zero-sum games.

d. explain the prevalence of oligopoly in American industry.

e. illustrate the linear programming problem faced by the firm.

17. The basic behavioral assumption of the Cournot model is

a. each duopolist assumes that his or her rival’s price is invariant with respect to his or her own price.

b. each duopolist assumes that his or her rivals’ output is invariant with respect to his or her own output.

c. duopolists recognize their mutual interdependence and agree to act in unison.

d. each duopolist assumes that if he or she lowers the price, his or her rivals will do the same but that if he

or she raises the price, his or her rivals may not follow suit.

e. none of the above.

18. A typical Cournot solution is defined as

a. one in which the solution is identical to the purely competitive market.

b. one in which the solution is identical to the monopoly solution.

c. one in which the output is above the monopoly and below the purely competitive result.

d. none of the above

19. If the firms in a monopolistically competitive “industry” made economic profit,

a. they might earn this profit permanently.

b. new firms would enter their “industry” until the profit was eliminated.

c. the price elasticity of demand would have to be less than one in absolute value.

d. both (b) and (c) would be true.

23. In long-run equilibrium, a monopolistically competitive firm will find

a. marginal cost below average total cost.

b. marginal cost equal to minimum average total cost.

c. both (a) and (b).

d. neither (a) nor (b).

Imperfect Competition – Answers

1. d 2. a 3. b 4. c 5. c 6. c 7. e 8. d 9. a 10. c

11. e 12. e 13. a 14. d 15. d 16. b 17. b 18. c 19. b 20. c

21. c 22. c 23. a

Additional Notes

 

Additional Notes