Wednesday, November 28, 2007


A firm is a monopoly if

  • It is the sole seller of its product
  • its product does not have close substitute
  • the market has barriers of entry

Three sources of bariers of entry

  • A single firm owns a key resource
  • The govt gives a single firm the exclusive right to produce the good
  • Costs of production make a single producer more efficient than a large number of producers

A natural monopoly is when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms

Natural monopoly arises when there are economies of scale over the relevant range of output

The ATC in a natural monopoly is downward sloping due to huge FC and small MC

Sunday, November 25, 2007

Theory of Cost and Theory of Firm

Fixed costs are those which do not vary with the quantity of output produced
Variable costs are those which vary with the quantity of output produced


For any firm Average revenue is the demand curve. How? See below

AR = TR/Q = PXQ/Q = P(which is nothing but the demand curve)

Practice the various cost curves(ATC,AVC,AFC,MC)

Remember , the marginal cost surve crosses the average cost curve at the minimum point which is also called efficient scale.

Also remember
Marginal cost < average total cost, average total cost is falling
Marginal cost > average total cost, average total cost is rising

For a competitive firm AR is independent of output and is parallel to the horizontal axis. How? See the explanantion below

Competitive firm is a price taker firm, you as a firm cannot increase/decrease the price. So, you will charge the same price if one buys 1 item or more than 1 item. So, AR remains the same for any quantity demanded.

For a competitive firm demand curve(AR) is infinitely elastic and for these firms AR=MR=P

Profit maximizing point is at MR=MC

Tuesday, November 20, 2007

Theory of production

Production Function

Opportunity cost is of two types

  1. Explicit -incurred due to factors of production, requires outlay of money
  2. Implicit - Does not require outlay of money

An important implicit cost is the cost of capital

Accounting profit = Revenue - explicit cost

Economic profit = Revenue - (Explicit + Implicit cost)

Accounting profit > Economic profit

Sunk costs are costs that have already been incurred and which cannot be recovered to any significant degree

Production function is the correspondence between input and output

The common Cobb-Douglas function used in macroeconomic modeling is

Y = KαL1 − α

where K is capital and L is labor. When the model coefficients sum to one, as in this example, the production function is first-order homogeneous, which implies constant returns to scale, that is, if all inputs are doubled that output will double.

There is a substitutability between the factors of production. The firm can either use capital-intensive or labor-intensive process.

The relationship between output change and proportionate chnages in both inputs is referred to as returns to scale. This is a long-term phenomenon.

Remember in long run all imputs are variable

In contrast to the concept of returns to scale, when output changes because one input changes while the other remains constant, the changes in the output rates are referred to as returns to a factor.

Remember in short run at least 1 input is fixed.

The production function defines the maximum rate of output per unit time obtained from a given rate of labor and capital input

Total product of labor - is the maximum rate of output forthcoming from combining varying rates of labor input with a fixed capital input

Marginal product of labor - increase in output arising from an additional unit of the variable input, holding all other inputs constant. It is the slope of the total product curve.

Average product of labor - is the total product per unit of the variable input = TPL/L

Inflection point - At this point total product function changes from increasing at an increasing rate to increasing at a decreasing rate.

Remember this

MPL=APL When APL is maximum

MPL>APL when APL is rising

MPL < size="1">L, when APL is falling

Marginal revenue product is defined as marginal revenue times marginal product and represents the value of the extra unit of labor


Labor will be hired until MRP = W,

We know for a price-taker market MR = P(given)( You can derive this using calculus)

So, P*MP = W (This P*MP is also called value of MP of labor and is denoted by VMPL)

So, MP = W/P

Which stage should a profit-maximizing firm going to operate?

For a production process to be economically feasible profit >=0

i.e; TR>=TC,

PXQ >= wL(w = wage, L =labor)

Q/L >= w/P

APL >= MPL(This is the necessary condition)

The sufficient condition is MPL>=0

Sunday, November 4, 2007

Assignment 7

1. It is known that quantity demanded decreases by two units for each $1 increase in price. At a price of $5, quantity demanded is ten units.

a. What will be the quantity demanded if price is zero?
b. Write an equation for quantity demanded as a function of price.
c. Write an equation that expresses price as a function of quantity.
d. Write an equation for total revenue.

Ans : Let us assume that the demand function is given by Q = a + bP

It is given that quantity demanded decreases (Q) by 2 units when Price increases (P) by 1 unit

We know that Slope = Q/P = -2 (negative sign is because if Q decreases , P increases)

Substituting the value of slope in the above equation , we get

Q=a + (-2)P
Q= a – 2P

At P = $5, Q=10

So, 10 = a-2*5
a = 20
Q = 20 – 2P

a. At price=0, Q=20
b. Q=20-2P
c. P=10-0.5Q
d. TR = PQ=10Q-0.5Q2

2. A market consists of three people, A, B, and C, whose individual demand equations are as follows:

A.: P=35-0.5QA
B: P=50- 0.25QB
C: P=40-2.00 QC

The industry supply equation is given by QS = 40 +3.5 P.

a. Determine the equilibrium price and quantity.
b. Determine the amount that will be purchased by each individual.

Ans: Market demand is the horizontal summation of individual demand.
So, first find our indidual demand

QD= QA+ QB+ QC=290-6.5P

a. QS =QD (Since at equilibrium quantity demanded = quantity supplied)
Equating the above equation , we get P=25,Q=127.5
b. QA=70-2P = 70-2*25 = 20
QB=200-4P = 200-4*25 = 100
QC=20-0.5P = 20-0.5P = 7.5

3. The demand equation faced by Du Mont Electronics for its personal computers is given by P = 10,000- 4Q

a. Write the marginal revenue equation.
b. At what price and quantity will marginal revenue be zero?
c. At what price and quantity will total revenue be maximized?
d. If price is increased from $6,000 to $7,000, what will the effect be on total revenue? What does this imply about price elasticity?
P=10000 – 4Q
a. MR = dPQ/dQ = 10000-8Q
b. MR= 0 = 10000-8Q
So, Q = 1250, P=10000-5000 = 5000
c. TR is maximum when MR =0 , So, TR will be maximized when P=5000 and
d. At price $6000, Q=1000, TR=PQ=6000000
At price $7000, Q=750, TR=PQ=5250000
Since TR decreases, demand is elastic.

4. Write a demand equation for which the price elasticity of demand is zero for all prices.

Ans: QD = a
5. The price elasticity for rice is estimated to be -0.4 and the income elasticity is 0.8. At a price of $0.40 per pound and a per capita income of $ 20,000, the demand for rice is 50 million tons per year.

a. Is rice an inferior good, a necessity, or a luxury? Explain.
b. If rice per-capita income increases to $20,500, what will be the quantity demanded of rice?
c. If the price of rice increases to $0.41 per pound and income per capita remains at $20,000, what will be the quantity demanded?
a. Inferior goods are those where quantity demanded decreases when Income increases. For luxury goods price elasticity is > 1, For necessity price elasticity is less than than 0
In this case income elasticity is 0.8 which is greater than 0 and hence it is not inferior
Price elasticity is -04. which is less than 0 and hence it is a necessity.
b. %change in Q/%change in I = 0.8
--------- = 0.8

Q2-50/50/20500-20000/20000 = 0.8
Q2 = 51
c. Q2-50/50/0.41-0.40/0.40 = -0.4
Q2 = 49.5 million

6. The McNight Company is a major producer of steel. Management estimates that the demand for the company’s steel is given by the equation.

Qs =5,000 – 1,000 Ps +0.1I + 100 Pa

where QS is steel demand in thousands of tons per year, PS is the price of steel in dollars per pound, I is income per capita, and Pa is the price of aluminum in dollars per pound. Initially, the price of steel is $1 per pound, income per capita is $20,000, and the price of aluminum is $0.80 per pound.

a. How much steel will be demanded at the initial prices and income?
b. What is the point income elasticity at the initial values?
c. What is the point cross elasticity between steel and aluminum? Are steel and aluminum substitutes or complements?
d. If the objective is to maintain the quantity of steel demanded as computed in part (a), what reduction in steel prices will be necessary to compensate for a $20 reduction in the price of aluminum?

a. Qs = 5000-1000*1+0.1*20000+100*.80 = 6080
b. Point income elasticity = dQd/dI*I/Qd = 0.1*20000/6080 = 0.33
c. Point cross elasticity = dQs/dPa*Pa/Qs = 100*0.80/6080 = 0.01
d. 6080 = 5000-1000*Ps+0.1*20000+100*0.6
1000Ps = 60+2000+5000-6080
1000Ps = 980
Ps = 0.98
Reduction required = 1-0.98/1*100 = 2%

7. Consider the following five data points:

X -1.0 0.0 1.0 2.0 3.0
Y -1.0 1.0 1.0 2.5 3.5

a. Use regression analysis to calculate by hand the estimated coefficients of the equation Y = B + aX.
b. Compute the coefficient of determination.
c. What is the predicted value of Y for X = 1.0? For X = 3.5?

8. Annual prices and beef consumption per capita in six cities are as follows:

City Price per Pound Consumption per Capita
1 $2.00 55
2 1.90 60
3 2.10 50
4 1.80 70
5 2.30 45
6 2.20 48

If demand equation is to be estimated using these data, would the linear form (i.e., Q = B + aP) or the multiplicative form (i.e., Q = BPa) be more appropriate? Explain.

R2(linear model) = 0.92
R2(multiplicative model) = 0.96 Hence multiplicative model is more appropiate

Click below to get the calculations
Click Here

9. The MacWend Drive- In has determined that demand for hamburgers is given by the following equation:

Q = 205.2 + 23.0A – 200.PM + 100.PC + 0.51I

where Q is the number of hamburgers sold per month (in 1,000s), A is the advertising expenditures during the previous month (in $1,000s), PM is the price of MacWend burgers (dollars), PC is the price of hamburgers of the company’s major competitor (dollars), and I is income per capita in the surrounding community (in $1,000s).
a. Are the signs of the individual coefficients consistent with predictions from economic theory? Explain.
b. If A = $5,000, PM = $1, PC = $1.20, and I = $20,000, how many hamburgers will be demanded?
c. What is the advertising elasticity at A = $5,000?

10. Motorland Recreational Vehicles estimates the monthly demand (Q) for its product is given by the equation

log Q = 1.00 – 1.50log P + 3.00 log I R2 = 0.21

where P is price and I is income per capita in thousands. The t-statistics are shown in parentheses and logarithms to the base 10 were used to transform the equation. Assume that estimates are generated by sample of 400 observations.

a. Rewrite the expression as a multiplicative demand equation.
b. Based on the equation, is the product an inferior good, a necessity, or a luxury good?
c. Is the equation likely to be useful in predicting demand for Motorland’s product? Why or why not?

Monday, October 15, 2007

Session 7

Things to remember



∑(Xi-X)(Yi- Y )
= -----------------

Elasticity =


R2 = Coefficient of determination = ESS/TSS= ∑(Y(HAT)-Y(BAR))2 /∑(Yi-Y(BAR))2

Always explain R2 in EXAM


1. X and Y are substitutes
2. X and Y are complements
3. X is a luxury good
4. X is a inferior good

Here cross price elasticity = -0.8, Since it is negative it means if Price of Y decreases, quantity demanded of X increases. Hence they are complements.

In the multiplicative model, elasticity is constant