ECO101- Hand out for Mid2

Explain utility maximization of a consumer in terms Law of Equi-Marginal

Utility or Equating Marginal Utilities per dollar spent.

The equi-marginal principle, also known as the law law of equi-marginal utility or
Gossen’s second law, is a rule of economics that states a consumer will distribute
his/her income on various commodities in a manner that the marginal utility
derived from the last unit of money spent on each good is equal.

Suppose there are only two goods in the world: apples and oranges. At present, a
consumer is spending his entire income consuming 10 apples and 10 oranges a week. For
a particular week, the marginal utility (MU) and price (P) of each are as follows:

So, the consumer’s marginal (last) dollar spent on apples returns 20 utils per dollar, and
his marginal (last) dollar spent on oranges returns 30 utils per dollar. The ratio MU O / PO
(O = oranges) is greater than the ratio MUA/PA (A = apples).

Here,
MU O 30
= =30
Po 1
MU A 20
= =20
PA 1
MU O MU A
Therefore , >
PO PA

Since oranges give more utility the consumer will buy more oranges and will buy less

number of apple as apples give less utility. As a result number of oranges increase that
O and as number of apples decreases that increases MU A. If the process
reduces MU
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continues MUO and MUA will be equal at a point in time. It confirms consumer’s
equilibrium. The equilibrium that occurs when the consumer has spent all of his or her
income and the marginal utilities per dollar spent on each good purchased are equal:
MU O MU A
= =. . .. .. . ..
Po PA

A person in consumer equilibrium has maximized total utility. By spending his or her
money on goods that give the greatest marginal utility and, in the process, bringing about
the consumer equilibrium condition, the consumer is adding as much to total utility as is
possible.

Explain the properties of an indifference curve.

(a) Indifference curves are downward sloping (from left to right).

The assumption that consumers always prefer more of a good to less requires that
indifference curves slope downward from left to right. More simply, indifference
curves are downward sloping because a person has to get more of one good in
order to maintain the same level of satisfaction (utility) when giving up some of
another good.

(b) Indifference curves are convex to the origin. As we move down and to the right
along the indifference curve, it becomes flatter. The absolute value of the slope of
the indifference curve is the marginal rate of substitution (MRS). The MRS is the
amount of one good an individual is willing to give up to obtain an additional unit
of another good and maintain equal total utility. Since MRS is negative or MRS
declines that’s why an IC is convex to the origin.

(c) Higher IC gives higher utility

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 Higher IC contains more goods. More goods mean more utility. Indifference
curves farther away from the origin represent greater total utility than those closer
to the origin.

(d) Two ICs never intersect

Suppose two ICs, I1 and I2 (where I1 is lower IC and I2 is higher IC) intersect at A.
It implies that the higher IC, I2 and lower IC, I1 give same utility at A. It cannot be
as it violates transitivity assumption or violates property 3 (Higher IC gives higher
utility).

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 Explain the budget equation. When does budget line rotate and shift?

Budget line represents all the combinations, or bundles, of two goods a person
can purchase, given a certain money income and prices for the two goods. Budget
Constraint can also be expressed by the following equation known as budget
equation.

M =P1X1 + P2X2 M = money income

Lets solve it for X2 X1 = commodity 1
M =P1X1 + P2X2 P1 = Price of commodity 1
⇒ P2X2 = M - P1X1 X2 = commodity 2
M P1
− x1
⇒ X = P2 P2
2 P1X1 = expenditure on X1
P2X2 - expenditure on X2

M
=
P 2 Purchasing power or real income
p1
=
p 2 relative price or slope of the budget line

Suppose income of a consumer is Tk. 1200. Suppose price of X 1 commodity is

Tk. 100 and price X2 is Tk. 80. If the consumer spends all his money on either X 1

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 or X2, consumer can purchase either 15 units of X 2 or 12 units of X1. By
combining these two extreme points we can derive budget line.

Budget line rotates if prices change or relative price (P 1/P2) changes or the slope of
the budget line changes but real income remains unchanged.

Budget line shifts if real income changes but relative price (P 1/P2) or the slope of
the budget remains unchanged.

Explain equilibrium or utility maximization of a consumer in terms

indifference curve analysis.

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 Consumer equilibrium exists at the point where the slope of the budget constraint
is equal to the slope of an indifference curve or where the budget constraint is
Px MU x
1
= 1

P x2 MU c 2
tangent to an indifference curve. In the exhibit, this point is E. Here,
MU x MUx 2
1
=
P Px 2
or, rearranging, we have, x1
.
The absolute value of the slope of the indifference curve at any point is the
marginal rate of substitution, which is equal to the marginal utility of one good
MU x
1

MU x 2
divided by the marginal utility of another good, or .
The necessary condition for consumer equilibrium is obviously that the individual
will try to reach a point on the highest indifference curve possible. This point is
where the slope of the budget constraint is equal to the slope of an indifference
curve (or where the budget constraint is tangent to an indifference curve). At that
point, consumer equilibrium is established and the following condition holds:

In the figure, the preceding condition is met at point E.

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 Derive demand curve from indifference curve analysis.

We can now derive a demand curve within a budget constraint–indifference curve

framework.
Exhibit 8(a) shows two budget constraints, one reflecting a $10 price for good X
and the other reflecting a $5 price for good X. As the price of X falls, the
consumer moves from point A to point
B. At B, 35 units of X are consumed; at A, 30 units of X are consumed. So, a
lower price for X results in greater consumption of X. By plotting the relevant
price and quantity data, we derive a
demand curve for good X in Exhibit 8(b).

Exhibit 8

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 From Indifference Curves to a Demand Curve (a) At a price of $10 for good X,
consumer equilibrium is at point A, with the individual consuming 30 units of X.
As the price falls to $5, the budget constraint moves outward (away from the
origin) and the consumer moves to point B and consumes 35 units of X. Plotting
the price–quantity data for X gives a demand curve for X

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Relationship between MP and AP; MC and AC and MP/AP and MC/AC

As long as MP is rising AP is also rising and MP > AP. At the highest point of AP, MP
intersects AP. At the intersection point MP = AP. Beyond that as MP falls AP also falls
and MP < AP.

As long MC is falling AC is also falling and MC < AC. At the lowest point of AC, MC
intersects AC. At this point MC = AC. Beyond that as MC rises and AC also rises and MC >
AC.

When MP and AP are rising, MC and AC are falling. When MP = AP, MC = AC. Beyond
that if MP and AP fall, MC and AC rise. When AP is maximum, AC is at minimum.

Explain the properties of a perfect competitive market

1. There are many sellers and many buyers, none of which is large in relation to
total sales or purchases.
Given many buyers and sellers, each buyer and each seller may act independently of
other buyers and sellers, respectively, and each is such a small part of the market as to
have no influence on price.

2. Each firm produces and sells a homogeneous product.

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Each firm sells a product that is indistinguishable from all other firms’ products in a
given industry. As a consequence buyers are indifferent to the sellers.

3. Buyers and sellers have all relevant information about prices, product quality,
sources of supply, and so forth.

Buyers and sellers know who is selling what, at what prices, at what quality, and on
what terms. In short, they know everything that relates to buying, producing, and selling
the product.

4. Firms have easy entry and exit.

In the long-run new firms can enter the market easily, and existing firms can exit the
market easily. There are no barriers to entry or exit.

What level of output does the profit-maximizing firm produces in the short-run?

A competitive is a price taker as it takes the price determined by market demand and
supply. Therefore the firm decides how much to produce to maximize profit. Profit
Maximization Rule tells us that profit is maximized by producing the quantity of output
at which MR = MC.

In Exhibit 3, the perfectly competitive firm’s demand curve is the same as its marginal
revenue curve and they are drawn at the equilibrium price of $5. The firm’s marginal
cost curve (MC) is also shown. On the basis of these curves, the firm will continue to
increase its quantity of output as long as marginal revenue is greater than marginal cost.
It will not produce units of output for which marginal revenue is less than marginal cost.
Therefore, the firm will stop increasing its quantity of output when marginal revenue
and marginal cost are equal. The profit maximization rule for a firm says, produce the
quantity of output at which MR = MC. In Exhibit 3, MR = MC 5 at 125 units of output.
For the perfectly competitive firm, the profit maximization rule can be written as P = MC
because, for that firm, P =M R and MR = MC. Therefore, in perfect competition, profit is
maximized when, P= MR = MC.

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On the basis of above diagram, the firm maximizes profit at a price $5 and quantity 125
units for which P = MR = MC.

What are the short-run possible outcomes of a competitive firm? Explain.

(1) In the short-run a competitive firm has three possible outcomes: (1) Firm can
make economic profit (2) Firm can make normal profit (3) Firm may incur
economic loss

(2) Economic profit

Perfect competitive firm in the short-run may make economic profit in terms per
unit profit or total profit. At point R, MR = MC. Competitive firm produces Q*
amount of output and sells at market determined price P*. Average revenue, AR
= Q*R and average cost, AC = Q*T. Therefore, AR > AC. The firm makes economic
profit per unit is RT. Total economic profit for Q* amount of output is MP*RT.

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 (3) Normal profit

Short-run competitive firm makes normal or zero economic profit if TR = TC or AR

= AC. In figure (b) competitive firm produces Q* amount of output and sells at
market determined price P*. At equilibrium E, MR = MC and also AR = AC. So that
in this situation short-run competitive firm can make only normal or zero
economic profit.

(4) Economic loss

Short-run competitive firm may incur economic loss. Economic loss occurs if TR –
TC < 0 or TR < TC or TC > TR or AR < AC OR AC > AR. In the following figure, AC >
AR by the amount RT which is per unit economic loss. Total economic loss =
P*MRT.

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The Perfectly Competitive Firm’s Short-Run Supply Curve

The perfectly competitive firm produces (supplies output) in the short run if price is
above average variable cost. It shuts down (does not supply output) if price is below
average variable cost. Therefore, the short-run (firm) supply curve is the portion of the
firm’s marginal cost curve that lies above the average variable cost curve. Only a price
above average variable cost will induce the firm to supply output. The short-run supply
curve of the perfectly competitive firm is illustrated in Exhibit.

If the perfectly competitive firm’s short-run supply curve is the part of its marginal cost
curve above its average variable cost curve, then deriving the short-run market
(industry) supply curve is a simple matter: We horizontally add the short-run supply
curves for all firms in the perfectly competitive market or industry.

PERFECT COMPETITION IN THE LONG RUN

The number of firms in a perfectly competitive market may not be the same in the short
run as in the long run. For example, if the typical firm is making economic profits in the
short run, new firms will be attracted to the industry and the number of firms will
increase. If the typical firm is sustaining losses, some existing firms will exit the industry
and the number of firms will decrease.

The following conditions characterize long-run competitive equilibrium:

1. Economic profit is zero; that is, price (P) is equal to short-run average total cost
(SRATC): P = SRATC The logic of this condition is clear when we analyze what will
happen if price is above or below short-run average total cost. If it is above,
positive economic profits will attract firms to the industry in order to obtain the
profits. If price is below, losses will result and some firms will want to exit the
industry. Long-run competitive equilibrium cannot exist if firms have an incentive
to enter or exit the industry in response to positive economic profits or losses.
For long-run equilibrium to exist, there can be no incentive for firms to enter or
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 exit. This condition is brought about by zero economic profit (normal profit),
which is a consequence of the equilibrium price being equal to short-run average
total cost.
2. Firms are producing the quantity of output at which price (P) is equal to marginal
cost (MC):
P=MC
Perfectly competitive firms naturally move toward the output level at which
marginal revenue (or price, because, for a perfectly competitive firm, MR = P)
equals marginal cost.
3. No firm has an incentive to change its plant size to produce its current output;
that is, at the quantity of output at which P= MC, the following condition
holds: SRATC = L RATC

The three conditions necessary for long-run competitive equilibrium can be stated as
shown in Exhibit: long-run competitive equilibrium exists when P = MC = SRATC =
LRATC . In conclusion, long-run competitive equilibrium exists when firms have no
incentive to make any changes—that is, when there is no incentive for firms to do any of
the following:
1. enter or exit the industry.
2. produce more or less output.
3. change their plant size.

A firm that produces its output at the lowest possible per-unit cost (lowest ATC) is said
to exhibit productive efficiency. The perfectly competitive firm is productively efficient
in long-run equilibrium, as shown in Exhibit . Productive efficiency is desirable from
society’s standpoint because perfectly competitive firms are economizing on society’s

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scarce resources and therefore not wasting them.

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