MICROECONOMICS — DETAILED COURSE NOTE

Production Theory • Cost Theory • Market Structures • Factor Pricing • Elementary Price Theory & Applications

COURSE OUTLINE
• Production Theory: production function; short run and long run; fixed and variable inputs; production in the short run;
short-run and long-run cost curves; fixed, variable, average and marginal costs; Cobb-Douglas production function;
technical progress.

• Perfectly Competitive Markets.

• Monopoly Markets.

• Monopoly and Price Discrimination.

• Monopolistic Competition.

• Oligopoly and Different Types of Oligopoly.

• Pricing of Factors of Production.

• Elementary Price Theory and Applications.

PART ONE: PRODUCTION THEORY

1. Meaning of Production
Production is the process of transforming inputs (resources) into goods and services that satisfy human wants. A bakery,
for example, combines flour, sugar, labour, an oven, electricity and capital to produce bread.

Factor Meaning Reward

Land Natural resources Rent

Labour Human effort Wages

Capital Man-made resources used for production Interest

Entrepreneur Organizes other factors and bears risk Profit

2. Production Function
A production function shows the relationship between quantities of inputs and the maximum quantity of output that can be
produced with those inputs, given technology.

Q = f(L, K)

Q = output; L = labour; K = capital; f = functional relationship. A production function deals with physical quantities,
not money.

3. Short Run and Long Run

Short run: a period in which at least one factor is fixed. Example: a bakery may have one fixed oven while labour and raw
materials vary. Short run does not mean a particular number of months or years; it is defined by input flexibility.

Long run: a period sufficiently long for all factors to vary. The firm can change factory size, machinery, labour, capital and
its scale of operation.

Short Run Long Run

At least one input is fixed All inputs are variable

Plant size usually fixed Plant size can change

Fixed costs exist No fixed costs in the economic sense

Adjusts within existing capacity Can change scale of operation

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4. Production in the Short Run
The main concepts are Total Product (TP), Average Product (AP) and Marginal Product (MP).

Total Product: total output produced.

Average Product: output per unit of variable input.

AP = TP / L

Marginal Product: additional output from one additional unit of the variable factor, other factors remaining constant.

MP = ∆TP / ∆L

Example: if 4 workers produce 80 units and 5 workers produce 100 units, MP = (100−80)/(5−4) = 20.

5. Law of Variable Proportions

As more units of a variable factor are added to fixed factors, total output initially increases at an increasing rate, then at a
decreasing rate, and may eventually decline. It is also called the Law of Diminishing Returns.

Stage I — Increasing Returns: TP rises at an increasing rate and MP rises.

Stage II — Diminishing Returns: TP rises at a decreasing rate and MP falls but remains positive. This is generally the
rational stage.

Stage III — Negative Returns: TP falls and MP becomes negative.

TP–MP relationship: MP > 0 → TP rises; MP = 0 → TP is maximum; MP < 0 → TP falls.

AP–MP relationship: MP > AP → AP rises; MP < AP → AP falls; MP = AP → AP is at its maximum.

6. Cost Theory
Cost of production is the value of resources sacrificed or expenses incurred in producing goods and services.

Fixed Cost (FC): does not change with output in the short run. Examples: rent, insurance and some administrative
salaries.

Variable Cost (VC): changes with output. Examples: raw materials, packaging and production fuel.

TC = FC + VC

Average Fixed Cost: AFC = FC/Q. AFC continuously falls as output rises.

Average Variable Cost: AVC = VC/Q. Generally U-shaped in the short run.

Average Total Cost: ATC = TC/Q = AFC + AVC.

Marginal Cost: additional cost of one more unit.

MC = ∆TC/∆Q = ∆VC/∆Q

Important cost-curve relationships: MC < ATC → ATC falls; MC > ATC → ATC rises; MC = ATC → ATC is at its
minimum. The same logic applies to AVC.

7. Long-Run Cost Curves

The Long-Run Average Cost (LRAC) curve shows the lowest possible average cost for each output level when all inputs
are variable. It is often called the planning curve.

Economies of scale: output increases while average cost falls. Sources include specialization, bulk purchasing, better
technology and managerial/financial advantages.

Diseconomies of scale: output increases while average cost rises, possibly because of communication problems,
bureaucracy, poor coordination and difficult supervision.

Constant returns to scale: output increases proportionately with inputs and average cost remains roughly constant.

8. Cobb-Douglas Production Function

A common form is:

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 Q = A L^α K^β

Q = output; A = technology/productivity parameter; L = labour; K = capital; α and β = output elasticities.

Returns to scale: α+β > 1 → increasing returns; α+β = 1 → constant returns; α+β < 1 → decreasing returns.

Example: Q = 2L^0.6K^0.4. Since 0.6+0.4=1, there are constant returns to scale.

9. Technical Progress
Technical progress means improvements in technology, knowledge, machinery or production methods that allow more
output from the same inputs or the same output from fewer inputs.

Types: neutral (does not favour labour or capital), labour-saving (reduces labour required), and capital-saving (reduces
capital required relative to labour).

PART TWO: PERFECTLY COMPETITIVE MARKETS

Perfect competition is a market structure with many buyers and sellers, homogeneous products, free entry and exit and
perfect information. No individual firm can determine price; it is a price taker.

Features:
• Many buyers and sellers.

• Homogeneous/identical products.

• Free entry and exit.

• Perfect information.

• Firms are price takers.

• High mobility of factors.

Firm vs industry: the industry contains all firms producing the product; the individual firm accepts the market price
determined by market demand and supply.

For a perfectly competitive firm: P = AR = MR.

Profit maximization: MR = MC, provided MC is rising. Since P = MR, equilibrium output occurs where P = MC.

Profit: π = TR − TC. Short-run outcomes: AR > ATC → supernormal profit; AR = ATC → normal profit; AR < ATC → loss. A
firm may continue operating in the short run if it covers variable costs.

PART THREE: MONOPOLY MARKETS

A monopoly is a market structure in which one firm is the sole or dominant supplier of a product with no close substitutes
and significant barriers to entry.

Features:
• One major seller.

• Many buyers.

• No close substitute.

• Strong barriers to entry.

• Significant price-setting power.

• Firm and industry are essentially the same.

• Supernormal profit may be possible in the long run.

Sources of monopoly power: legal barriers, control over essential raw materials, economies of scale, patents and high
start-up costs.

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Monopoly equilibrium: MR = MC. Unlike perfect competition, the monopolist generally has P > MR and uses the
demand curve to determine the price at the profit-maximizing quantity.

PART FOUR: MONOPOLY AND PRICE DISCRIMINATION

Price discrimination occurs when a seller charges different prices to different consumers/groups for the same product or
service, where the difference is not fully explained by cost differences.

Example: adults ■5,000 and students ■3,000 for the same cinema screening.

Conditions:
• Some monopoly/market power.

• Ability to separate consumers into groups.

• Resale must be prevented or limited.

• Groups should differ in price elasticity of demand.

First-degree: attempts to charge each consumer the maximum they are willing to pay; also called perfect price
discrimination.

Second-degree: price varies with quantity purchased or product version, e.g. bulk discounts and package sizes.

Third-degree: different identifiable groups pay different prices, e.g. student or senior discounts and different market
prices.

PART FIVE: MONOPOLISTIC COMPETITION

Monopolistic competition has many firms, differentiated products, relatively free entry and exit, and some control over
price.

Examples: restaurants, hair salons, clothing brands, bakeries and beauty products.

Features: many firms; product differentiation by quality, packaging, brand, location, design or service; relatively easy
entry and exit; advertising; and some price control.

PART SIX: OLIGOPOLY AND DIFFERENT TYPES

An oligopoly is a market structure dominated by a small number of large firms. Its key feature is interdependence: the
decision of one firm affects the others.

Features:
• Few large firms.

• Strong interdependence.

• High barriers to entry.

• Homogeneous or differentiated products.

• Strategic behaviour.

• Advertising may be important.

• Firms may compete or collude.

Pure/perfect oligopoly: firms sell homogeneous products; examples often used include petroleum, steel and cement.

Differentiated oligopoly: firms sell similar but differentiated products; examples include cars, smartphones and soft
drinks.

Collusive oligopoly: firms cooperate on matters such as price, output or market sharing. A cartel is a formal arrangement
to coordinate such behaviour.

Non-collusive oligopoly: firms compete independently while considering likely reactions of competitors.

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Kinked demand curve: a theory of price rigidity. If one firm raises price, rivals may not follow and it loses customers; if it
cuts price, rivals may follow and it gains little market share. Therefore firms may hesitate to change prices.

Diagram explanation: the kink represents the current price-output position. The two segments reflect different
expected competitor responses above and below the current price.

PART SEVEN: PRICING OF FACTORS OF PRODUCTION

Factor pricing refers to the determination of prices/rewards paid to factors of production.

Factor Reward

Land Rent

Labour Wage

Capital Interest

Entrepreneur Profit

Demand for factors: factor demand is called derived demand because firms demand factors for the goods and services
they help produce. For example, demand for bread creates demand for bakers, ovens, flour and machines.

Marginal Revenue Product (MRP): the additional revenue earned from employing one additional unit of a factor.

MRP = MP × MR

Under perfect competition in the product market, MR = P, so MRP = MP × P.

Further factor-pricing principle: a profit-maximizing firm hires a factor up to the point where the factor's MRP
equals its factor price. For labour, this is commonly written as MRP_L = W.

PART EIGHT: ELEMENTARY PRICE THEORY AND APPLICATIONS

Price theory explains how demand and supply interact to determine prices and quantities in markets.

Demand: quantity consumers are willing and able to buy at various prices during a given period, other things remaining
constant. The law of demand says that price and quantity demanded generally move in opposite directions.

P ↑ → Qd ↓ and P ↓ → Qd ↑

Supply: quantity producers are willing and able to offer for sale at various prices, other things remaining constant. The law
of supply says price and quantity supplied generally move in the same direction.

P ↑ → Qs ↑ and P ↓ → Qs ↓

Market equilibrium: occurs where Qd = Qs. The equilibrium price and quantity are determined at the intersection of
demand and supply.

Shortage/excess demand: Qd > Qs, usually at a price below equilibrium. This creates upward pressure on price.

Surplus/excess supply: Qs > Qd, usually at a price above equilibrium. This creates downward pressure on price.

Movement vs shift: a movement along demand or supply is caused by a change in the good's own price. A shift is
caused by other determinants such as income, tastes, related-good prices, input prices, technology, taxes, subsidies,
population and expectations.

Price Elasticity of Demand:

PED = %∆Qd / %∆P

PED > 1 → elastic; PED < 1 → inelastic; PED = 1 → unitary elastic.

Income Elasticity: YED = %∆Qd / %∆Y.

Cross Elasticity: XED = %∆Q_A / %∆P_B. Substitutes generally have positive XED; complements generally have
negative XED.

Consumer surplus: willingness to pay minus actual price paid.

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Producer surplus: actual price received minus the minimum price the producer is willing to accept.

Price ceiling: legal maximum price. If set below equilibrium, it can create a shortage.

Price floor: legal minimum price. If set above equilibrium, it can create a surplus.

IMPORTANT FORMULAS TO MEMORIZE

Concept Formula

Average Product AP = TP / L

Marginal Product MP = ∆TP / ∆L

Total Cost TC = FC + VC

Average Fixed Cost AFC = FC / Q

Average Variable Cost AVC = VC / Q

Average Total Cost ATC = TC / Q = AFC + AVC

Marginal Cost MC = ∆TC / ∆Q

Total Revenue TR = P × Q

Average Revenue AR = TR / Q

Marginal Revenue MR = ∆TR / ∆Q

Profit π = TR − TC

Profit maximization MR = MC

Perfect competition P = AR = MR

Cobb-Douglas Q = AL^αK^β

Factor MRP MRP = MP × MR

Price elasticity PED = %∆Qd / %∆P

EXAM MEMORY MAP

Inputs → Production → Costs → Revenue → Profit → Market Structure → Factor Pricing → Price Theory

The central profit-maximization condition that repeatedly appears across microeconomics is MR = MC, subject to the
relevant market and short-run/long-run conditions.

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