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curve shows what producers wish to sell
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The
intersection identifies the equilibrium price and quantity in the market
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As illustrated in Figure 3
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FIGURE 3
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4 Elasticity of Demand
Elasticity measures the sensitivity of one variable to another
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It is denoted by, ep:
ep = (%∆Q)/ (%∆P)
The percentage change in a variable is the absolute change in the variable divided by the original
level of the variable
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When the price of a good increases
ep =of(∆Q/Q)/
the quantity demanded usually falls
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When the price elasticity is greater than one, demand is price elastic, because the
percentage decline in quantity demanded is greater than the percentage increase in price
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In general, the
price elasticity of demand for a good depends on the availability of other goods that can be
substituted for it
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Demand will then be highly price elastic
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4
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We
study how consumers make consumption decisions, and how their preferences and budget
constraints determine their demand for various goods
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The theory of consumer behaviour undertakes three basic assumptions about people’s
preferences for one market basket versus another
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Thus, for any two market baskets A and B, a consumer will
prefer A to B, will prefer B to A, or will be indifferent between the two
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Transitivity means that if a consumer prefers
basket A to basket B and basket B to basket C, then the consumer also prefers A to C
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Consumers always prefer
more of any good to less
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These three assumptions form the basis of consumer theory
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Consumer preferences can be graphically illustrated through indifference curves
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1)
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A utility function (measure that
assigns a level of utility to individual market baskets) can be represented by a set of indifference
curves
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1 shows three indifference curves (with different utility levels – U3 > U2> U1)
associated with a particular utility function
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1: INDIFFERENCE CURVES

Budget Constraint
So far, we have focused on the first element of consumer theory – consumer preferences
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The budget line indicates all combinations of goods for which the total amount of
money spent is equal to income
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Given the consumer’s income as M and prices of the two
goods as Px and Py respectively, the budget line represents the following budget constraint:
Px x + Py y = M
The budget line (Figure 4
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The magnitude of the slope tells us the rate at which the two
goods can be substituted for each other without changing the total amount of money spent
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2: BUDGET LINE

Consumer Choice
Given preferences and budget constraints, consumer’s choice of different goods can be
determined
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The maximizing market basket must satisfy two conditions:
 It must be located on the budget line
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As illustrated in Figure 4
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This point
is the consumer’s equilibrium point
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At E, equilibrium point, the
marginal rate of substitution (MRS) between the two goods equals the price ratio
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Thus at the consumer’s equilibrium,
MRS = Px / Py

FIGURE 4
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Objective of the Firm
The theory of the firm focuses on the supply side of the market
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The Production Function
The production function summarizes the characteristics of existing technology
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It is denoted as:
Q = f (K,L)
Where Q is the output, K is the units of capital, and L is the units of labour used in production of
Q
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1
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As labour increases, ceteris paribus, output increases
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The marginal product of labour is defined as the

change in output resulting from a change in labour, keeping all other factors constant
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Thus
MPL = ∂Q/∂L; APL = Q/L
As depicted in Figure 5
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Also, when marginal product is
greater than average product, average product is increasing; and when marginal product is less
than average product, average product is decreasing
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The relationship between the total product curve and marginal product is also
important
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When marginal product is zero, total product reaches its maximum
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1: PRODUCTION FUNCTION
The shapes of these curves reflect the law of variable proportions
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Costs of Production
A firm’s costs are determined by its production function
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Figure 5
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FIGURE 5
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2B: LONG RUN COST

The average and marginal costs are U-shaped curves
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When average cost is at a minimum, marginal cost is equal
to average cost
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2B)
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It is also a U-shaped curve,
depicting economies and diseconomies of scale
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Many firms produce more than one product, which may be closely linked to one another
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Two situations can arise—
economies of scope and diseconomies of scope
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In contrast, if a firm’s joint output is less than that which could
be achieved by separate firms, then its production process involves diseconomies of scope
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Pricing and Output Decisions under Different Market Structures
Perfect Competition
In perfect competition, there are a very large number of firms in the industry and the product is
homogeneous
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Thus although competition is perfect, there is
no rivalry among the individual firms
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The products of the firms are perfect substitutes for one another so that the priceelasticity of the demand curve of the individual firm is infinite
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Monopoly
In a monopoly situation there is only one firm in the industry and there are no close substitutes
for the product of the monopolist
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Entry is blockaded
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Hence the demand of the individual firm has a negative slope, but its
price elasticity is high due to the existence of the close substitutes produced by the other firms in
the industry
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Thus each seller thinks that he would keep some
of his customers if he raised his price, and he could increase his sales, but not much, if he lowered
his price: his demand curve has a high price elasticity, but is not perfectly elastic because of the
attachment of customers to the slightly differentiated product he offers
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Oligopoly
Oligopoly is an industry structure characterized by a few large firms producing most, or all, of
the output of some product
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The characteristic of oligopoly that distinguishes it from other forms of market structures is
the mutual interdependence of firms in the industry
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Therefore, any price or output decision a firm makes must
be made with the thought of its rivals in mind and with some sort of guess about how rivals will
respond
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The nature of an oligopolistic industry makes it impossible for economists to develop a
single model that is applicable to all industries exhibiting oligopolistic characteristics
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The implications of these

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