UNIIT-2
(05) 3 Fundamentals of Economics Consumer and suppliers behaviour,
Total utility and marginal utility, Law of diminishing marginal utility, Elasticity of demand and supply
curve, Market equilibrium, Consumer and supplier surplus, Global welfare, Deadweight loss
Fundamentals of Economics INTRODUCTION
The commodity market started with the barter system and eventually developed to the era of electronic
trading systems. In simple words, a market is defined as a meeting place for buyers and sellers to
strike a deal. The technological advances have progressed to such an extent that now-a-days, a deal
for a commodity can be struck with a click of a mouse. This is the concept of a virtual market place
that has the potential of eliminating a physical market place. Microeconomics is the branch of
economics that deals with how households or firms make decisions and how they interact in the
markets. The restructured power systems treat electric energy as a commodity rather than a service
as in vertically integrated systems. As in the case of any other commodity, the behavior of
consumer and suppliers in electricity markets are analyzed using the concepts of microeconomics.
This chapter is aimed at providing some fundamental concepts associated with microeconomics that
are relevant to electricity market. We start by modelling consumer behaviour, followed by supplier
behaviour modeling. Later on we will see how these behaviours set equilibrium at the marketplace
Consumer Behaviour
Total Utility and Marginal Utility
It is a common practice to explain concepts of microeconomics using common consumer goods as an
example. However, we will explain it by considering number of units of electrical energy as a
commodity. This would help the reader to relate things later on while studying concepts associated
with electric power markets.
Total utility and marginal utility
We begin with the notion that the consumer achieves some satisfaction from consuming a product,
electric energy in this case. If this satisfaction is absent, the consumer would not demand it at all.
This term is called total utility. Similarly, marginal utility is the utility obtained from the last unit
consumed. Let us explain these terms with the help of an example.
Let there be a square shaped room as shown in Figure 2.1. Small circles in the figure represent
incandescent lamps located at the same height from the ground, as a source of light for the whole
room. Suppose there are nine lamps in all, fitted in the room as per the plan shown in the figure. Let
us assume that all lamps are of the same rating and luminance (a scientific word for brightness).
When all lamps are off, there is complete darkness in the room. Let us assume that there is an
interlock arrangement in the switchgear such that for putting lamps ON at L level, the lamps at M
level should be ON. Similarly, for putting lamps at M level ON, the central lamp - C should be ON.
Now suppose a person enters the room and puts lamp C ON. Since this lamp is at the center, it
spreads even light all across the room. This light is good enough for a person to move to each and
every corner of the room. Let us assume that the ‘satisfaction' this person gets by putting lamp C
ON is 10 units.
Now suppose the person switches the lamp - M1 ON. This bulb still adds to the brightness of the room,
but the satisfaction that it adds to the person is lesser than that provided by lamp C. For this lamp,
the person in the room may not get a satisfaction of 10 units, but it will definitely be lesser than 10
units as room is already lit from the state of total darkness by lamp C. Let us say the person gets
satisfaction equal to 9 units. Similarly, for all lamps sequentially put ON thereafter would render
diminishing satisfaction to the person in the room. This satisfaction for each of the lamps lighted is
nothing but the marginal utility. For first lamps C, it was 10 units, for subsequent lamps it went on
reducing. Let us define total utility as the sum of marginal utilities.
Figure 2.1:Room with lamp positions
The results of marginal and total utility gained by putting lamps on sequentially are tabulated in Table
1
No. of Marginal Total
Lamp
Lamps utility utility
- 0 - 0
C 1 10 10
M1 2 9 19
M2 3 8 27
M3 4 7 34
M4 5 6 40
L1 6 5 45
L2 7 4 49
L3 8 3 52
L4 9 2 54
Table 2.1: Marginal and total utility after putting the lamps on
Law of Diminishing Marginal Utility
The above pattern of marginal utility provided by sequence of putting bulbs on is called as law of
diminishing marginal utility. It states that after consuming a certain amount of a good or service, the
marginal utility from it diminishes as more and more is consumed. This law is quite natural and
should hold for most of the products one consumes.
Consumer Surplus
The person entering the room in the previous example would have been indifferent to the number
lamps to be put ON had electricity been for free. Then the person would not have bothered about
the marginal utility and the total utility. But as soon as the person is made to pay for the usage of
electric energy, he would start thinking and would rather make a judicious choice about how many
lamps to put on. The person then would have calculated how much utility he could have obtained if
he had spent same amount of energy on other usage, for example say, air conditioner. In other
words, how many lamps the person would have put ON depends not only on the marginal and total
utilities but also on the price of electricity.
Let the price of electricity be INR 4 for each lamp equivalent rating. We now define marginal utility of
one INR as the extra utility when additional one INR is spent on other available usage in general.
For the sake of simplicity, let it be 1 unit. In other words, after spending one INR, the marginal
utility associated with it is one unit. Having the information on price and marginal utility of INR,
the person can determine how many lamps to be put ON. Consider only one lamp, C is ON. The
person obtains marginal utility of 10 (from table 2.1). Since, marginal utility of 1 INR is equal to 1
unit of utility, the utility obtained in this case would be (10/1 =10 INR). On the expenditure side,
the person spends 4 INR to get the lamp ON. Then, the person will go ahead and put the lamp ON
(as a matter of fact, he is left with no choice in this case!). When the person puts the second lamp
ON, i.e., M1, he obtains a marginal utility of 9 units which is equivalent of (9/1) = 9 INR. Since, the
marginal utility that the person would obtain is greater than the price he pays (INR 4), he would go
ahead to put the second lamp ON. The person keeps on making such comparisons before putting the
next lamp ON.
What happens when he puts ON lamp L2, i.e. seventh lamp? It renders utility equal to 4 INR which is
equal to price per unit of electricity. The answer is that the person will be indifferent. However, one
thing is for sure: the person will not put ON lamps after 7th lamp as the price he pays is more than
the worth he accrues. This decision making process can be easily understood with the help of Figure
2.2. The horizontal line at INR 4 depicts the price of electricity. Before lamp no. 7 is lit, the
marginal utility (converted into INR) is more than the price of electricity. At 7th lamp it becomes
equal while for lamps 8, 9 and 10, the marginal utility is lesser than the price.
Table 2.2 summarizes these results at each stage. It provides details about total utility and total
expenditure at each stage. Last column of Table 2.2 depicts nothing but the person's surplus in
terms of money. In other words, it is the difference between what he gains and expenditure towards
the same. The shaded area in Figure 2.2 is called as net consumer surplus. The net consumer surplus
represents the extra value that the person in the room is able to get from being able to buy all the
electric energy at INR 4, even though the value he attaches to electric energy is higher than the
price of electricity.
Figure 2.2:Decision making based on marginal utility and net consumer surplus
Total Total
No. of Surplus
utility Expenditure
Lamps (INR)
(INR) (INR)
0 0 0 0
1 10 4 6
2 19 8 11
3 27 12 15
4 34 16 18
5 40 20 20
6 45 24 21
7 49 28 21
8 52 32 20
9 54 36 18
Table 2.2: Details about total expenditure and total utility at each stage
Consumer Equilibrium
The word equilibrium used in generic terms means the position of balance. In the above example, the
person in the room will stop or rest or attain equilibrium after lighting 6th or 7th lamp on. Last
column of Table 2.2 reveals the fact that the person's surplus is maximized at 6th and 7th lamp. In
other words, the shaded area in Figure 2.2 representing net consumer surplus is maximized at
equilibrium. In general, we can then say that consumer's equilibrium with respect to the purchase of
one good is attained when the difference between total utility in terms of money and the total
expenditure on it is maximized.
Market Demand Curve
The relation shown in Figure 2.2 is termed as individual demand curve. It is easy to infer that the
peculiar nature of this curve is due to law of diminishing marginal utility. Thus, the demand curve
can be termed as marginal utility curve. If, instead of the discrete demand curve as shown in Figure
2.2, a continuous function is established, the nature of the curve will be the one with negative slope
or downward sloping.
It is unlikely that all the persons entering the dark room will feel the same marginal utility with each of
the lamps. If we aggregate the individual demand curves of sufficiently large number of consumers,
the discontinuities of Figure 2.2 will be smoothened and will give a market demand curve or the
demand function. This is shown in Figure 2.3.
Figure 2.3: Demand function
Demand Elasticity
The downward sloping demand curve can be seen from a different perspective. It emphasizes that a
small increase in the price of a commodity will decrease its demand. The rate of change of the
demand curve with respect to price would surely quantify the change. However, to make the
changes comparable, the percentage changes rather than absolute changes are computed. Thus, the
price elasticity of demand becomes the ratio of relative change in demand to the relative change in
price. It is given as:
....................................................................(2.1)
Where ε depicts elasticity, π price and q, the quantity.
The price elasticity of demand can be defined as a measure of how much the quantity demanded of a
good responds to a change in the price of that good, computed as the percentage change in quantity
demanded divided by the percentage change in price.
Downward sloping demand function of Figure 2.3 and equation 2.1 together depict that the price
elasticity of demand will be a negative number. Many a times, elasticity is presented as an absolute
value by dropping a minus sign. Measuring demand responsiveness then becomes a simple task. If
the elasticity number is higher, higher is the demand responsiveness. We follow the convention with
negative sign in-tact. Various cases of price elasticity of demand are established in Table 2.3.
Elasticity
Sr. No. Type of Elasticity
Range
1 ε=0 Perfectly inelastic
2 -1 < ε < 0 Inelastic
3 ε = -1 Unit elastic
4 - ∞ < ε < -1 Elastic
5 ε=-∞ Perfectly elastic
Table 2.3: Various cases of demand elasticity
Figure 2.4 shows plots of demand elasticity for various cases. In case of unit elasticity, the demand
curve takes shape of a rectangular hyperbola. When demand is perfectly inelastic, the demand curve
takes the form of a vertical line parallel to y axis. It means demand is not responsive to changes in
price.
Supplier Behaviour
Law of Diminishing Marginal Product:
Just as we have law of diminishing marginal utility in case of consumer, we have law of diminishing
marginal product for supplier. This law establishes the input-output relationship for the producer in
short-run. This law is depicted in Figure 2.5
Figure 2.4: Various cases of demand elasticity
Supply Function
Suppose, the total commodity output is called as y. Let us assume that there is only one factor of
production, ‘x'. Thus, the production function is given as
y = f(x).........................................................................................................................(2.2)
For almost all goods and technologies, the production y increases with x at the beginning. But as
cheaper resources start depleting, costlier resources are employed for production and for the same
quantity of production, the cost starts increasing. In other words, the rate of increase of y decreases
as x gets larger. The inverse of production function will be:
x = g(y).......................................................................................................................(2.3)
This function indicates how much of the variable production factor is required to produce a specified
amount of commodity. If unit cost of factor of production x is w, then, the cost function is given as:
cos t (y)= w. g(y)...............................................................................................................(2.4)
Figure 2.6 shows cost function and the marginal cost function which is the derivative of the cost
function. The convexity of the function is due to law of diminishing marginal product.
Figure 2.6: Cost function and marginal cost function
Supply functions
Suppose there are many suppliers and they make use of different technologies and fuels to produce
electric energy. Thereby, these producers will have different marginal costs and will have different
power producing quantities at different price levels. If the amount supplied by a large number of
producers is aggregated, a smooth and upward sloping curve is obtained as shown in Figure 2.7.
This is typically known as supply curve.
Figure 2.6: Cost function and marginal cost function
Suppliers' surplus
Suppliers' surplus can be explained on similar lines to the consumer surplus. The entire supply of
commodity is traded at the market price . The suppliers' revenue is the product of traded quantity q
and the market price . Let us consider Figure 2.8. The horizontal line depicts the market price . The
shaded portion shows producers' net surplus. This arises from the concept of all goods being traded
at a price higher than their opportunity costs. Eventually, net surplus is the area between supply
curve and horizontal line depicting market price.
Figure 2.8: Suppliers' net surplus
The supplier whose opportunity cost is equal to the market price is called as marginal producer. The
marginal producer neither accrues any profit nor loss. The infra-marginal producers accrue profit
while the extra-marginal producers would find it worthwhile to sell the commodity only in case
market price increases.
Supplier's Equilibrium
If supplier's marginal cost function is as shown in Figure 2.6, at what level should the supplier stop
producing that commodity? To answer this question, let us explain what is meant by opportunity
cost. The supplier has a threshold price in mind below which it will not sell its commodity. There
are two reasons for deciding this threshold price. First of course is that the total revenue will be less
than total cost of producing that commodity. Second and important reason could be that the supplier
could make use of same resources required to produce the commodity under consideration to
produce some other commodity that would fetch more money. In that case, the revenue from the
sale of the commodity under consideration will be less than the opportunity cost associated with the
production of the same. In other words, the supplier will sell the commodity at a price at which the
opportunity cost of production is equal or lesser.
Supply Elasticity
An increase in the price of a commodity encourages suppliers to make larger quantities of this
commodity available. The price elasticity of supply quantifies this relation. The supply elasticity
can be defined in a similar fashion to the demand elasticity. Only difference is to replace supply
curve by demand curve.
......................................................................................................(2.5)
It is worthwhile to note that due to upward sloping nature of supply curve, the price elasticity of supply
will be a positive number. Various cases of price elasticity of supply are shown in Table 2.4.
Elasticity
Sr. No. Type of Elasticity
Range
1 ε=0 Perfectly inelastic
2 -1 < ε < J Inelastic
3 ε = -1 Unit elastic
4 - ∞ < ε < -1 Elastic
5 ε=-∞ Perfectly elastic
Table 2.4: Various cases of supply elasticity
Figure 2.9 shows plots of supply elasticity for various cases.
Market Equilibrium
We have seen how consumers and suppliers would behave individually. Let us now consider how the
consumers and suppliers would interact with each other at the marketplace. We take the case of a
perfectly competitive market, although the electricity market is seldom a perfectly competitive
market. A perfectly competitive market has many attributes, the most important being that a single
player is not able to change the market price. Similarly, under perfect competition case, all market
buyers buy at the same market clearing price. The market equilibrium is achieved at a price called
market clearing price such that the quantity that the suppliers are willing to sell is equal to quantity
that the consumers wish to obtain. In other words, market equilibrium is a state of zero excess
demand and zero excess supply.
Figure 2.10: Market equilibrium
Consider Figure 2.10 for more explanation. It depicts supply and demand curves for a particular
product denoted by S and D, respectively. What should be the market equilibrium price? Suppose
that price is π1. At this price, the consumers demand the quantity d1 and the producers supply the
quantity s1. Obviously, there is a mismatch. Consumers want more than what the producers are
willing to supply. The excess demand will create competition among the buyers and push the price
up. It will increase, say, to π2. Excess demand is present at this price also. Thus price will increase
further. Indeed, the price will keep increasing as long as there is an excess demand. Finally it will
converge to π*, at which there is no excess demand. Corresponding quantity is q*.
Just the opposite happens if the initial price is π3 . The quantity demanded d3 is less than the quantity
supplied s3. There is a mismatch in the form of excess supply. The price will keep falling as long as
there is excess supply. Where will the price finally settle? The answer is again π* , at which there is
no excess supply.
Thus,π* and q* mark the price and quantity at equilibrium, respectively. The equilibrium situation in a
competitive market is said to be Pareto efficient. An economic situation is Pareto efficient if the
benefit derived by any of the parties can be increased only be decreasing benefit enjoyed by one of
the other parties. In Figure 2.10, suppose the quantity exchanged is s1 instead of q*. At that
quantity, there is someone willing to sell extra units of the good considered at price π1, which is
less than the price π4 that someone else is willing to pay for that extra unit. If trade can be arranged
between these two parties at any price between π1 and π4 , both parties will be better off and as per
definition, this is not the Pareto efficient situation. Thus, if total amount traded is less than the
equilibrium q*, the situation is not Pareto efficient. Similarly, any amount in excess of the
equilibrium value is not Pareto efficient because the price that someone would be willing to pay for
an extra unit is lower than the price that it would take to get it supplied.
It is not difficult to conclude that the Pareto efficiency is achieved only when goods are allocated on
the basis of a single marginal rate of substitution, as happens in a competitive market.
Areas DS1, DS2, SS1, SS2, etc. in context to the explanation given under "global elfare" and
"deadweight loss" not depcted on figure 2.11
Global Welfare
Global welfare is the sum of net consumer surplus and net producer surplus. It is the quantification of
the overall benefit that arises from trading. Global welfare is maximized when market is settled at
the intersection of supply and demand curves. The global welfare is also termed as social welfare
and social surplus. Global welfare is explained with the help of Figure 2.11. In this figure, sum of
the areas DS1, DS2 and DW2 represents the consumer surplus while sum of areas SS1, SS2 and
DW1 represents the producer surplus. The total area consisting of areas DS1, DS2, SS1, SS2, DW1
and DW2 represents the global welfare. It is clear from the figure that if the price is set to any infra-
marginal value rather than the equilibrium price, there is a reduction in the global welfare.
Figure 2.11: Global welfare and deadweight loss
Deadweight loss
What happens when the price is forcefully set at some value other than the equilibrium price? It leads
to reduction in global welfare and creation of deadweight loss. Suppose the price is set at π2 due to
some intervention by say, the government, as shown in Figure 2.11. In this case, the consumers
reduce their consumption from q* to q. The consumer surplus then becomes equal to area DS1,
while producers' surplus is the sum of areas DS2, SS1 and SS2. Similarly, if price is set at π1 , the
suppliers reduce their production to q from q*. The net consumer surplus is the sum of areas DS1,
DS2 and SS2, while producers' surplus is area SS1. Thus, these interventions while setting price
have undesirable effect of reducing the global welfare by an amount equal to the sum of areas DW1
and DW2. The amount equivalent to this area is called as the deadweight loss. In general, regulated
tariff is the major source of deadweight loss. From electric market point of view, the network
constraints can be a major source of creation of deadweight loss. This will be discussed in further
chapters.
SHORT-RUN AND LONG-RUN
In section 2.2, we have seen the consumer behavior and associated cost functions. Recall production
function of Figure 2.5. Equation 2.2 suggests that the output is a function of only a single factor of
production – ‘x'. In reality, the output is a function of many factors of production. Thus,
y=f(x1,x1..............xn)............................................................................................(2.6)
However, all the production factors do not affect the output in the same way. Some factors make
immediate changes while others take long time to be effective. In other words, some factors affect
the production in the short-run while the others do so in the long-run. There is no clear-cut
distinction about the time horizon which divides the production factors between short-run and long-
run. In short-run, some of the production factors are fixed. Long-run window provides the time span
sufficient enough for various factors to be adjusted. To provide an analogy, a reactive power
support by means of a capacitor bank can be termed as a short-run factor as compared to the
construction of an entirely new parallel circuit for increasing capacity of a heavily loaded
transmission corridor.
In the short-run, the output often depends on a single production factor while the rest of the factors are
considered to be fixed. Thus, cost functions and marginal cost functions depicted in Figure 2.8 are
essentially short-run cost function and short-run marginal costs function.
The short-run behavior of a commodity producing firm in a perfectly competitive market can be
explained as follows. In this type of market, the only option left to the firm is to maximize its profit
is by adjusting its output, as it cannot influence the market price. This can be posed as follows:
...............................................................................................(2.7)
Optimum will be achieved when
.....................................................................................................(2.8)
Thus, to maximize its profit, the firm will raise its production up to that level at which the marginal
cost is equal to the market price. This point will be elaborated further in section 2.8 where we will
see the profit maximization of a firm in a perfectly competitive market.
In the long-run, the firm will have more degrees of freedom to work with. Thus, defining a long-run
cost function is a complex task. The long-run cost function as against the short-run cost function
will be given as in equation 2.6. It should be noted that the long-run cost function (Cost LR) is the
solution of an optimization problem.
such that
y = f(x1,x2,........xn)
wi is the unit cost of production of factor xi. It is worthwhile to note that in general, the decisions
about power system operation are short-run, while those associated with planning are the long-run
solutions. For example, optimal scheduling of generation requires generation costs to be known.
These costs are short-run costs that assume the plant size and the network capacity to be fixed.
VARIOUS COSTS OF PRODUCTION
Let us now see what the components of production cost are for a firm. In the short run, some of the
factors of production are fixed. The cost associated with these factors does not depend on the
amount produced and is thus a fixed cost. Let us take an example of a generating company. For a
certain fixed maximum capacity of a plant, the cost of land and associated machinery does not
depend on the output of the plant. On the other hand, the quantity of fuel consumed by this plant
depends on the output. Thus, the cost of fuel is a variable cost.
The cost function for a generating plant can be defined as function of level of MW output. It can be
given as follows:
.......................................................................................................(2.9)
Where, is the variable cost and the fixed cost. The average cost is defined as the cost per MW output of
a plant. It is the sum of average fixed cost and average variable cost. Thus, the average cost is given
as:
....................................................................(2.10)
RELATIONSHIP BETWEEN LONG RUN AND SHORT RUN AVERAGE COSTS
As discussed earlier, there are many factors of production that are fixed in the short-run but variable in
the long-run. That is why a firm's short-run cost curve differs from that of a long-run cost curve. For
a firm, to increase its output in short-run requires increase in those factors of production which
show their effect in short-run. For example, for a vehicle manufacturer, increasing number of
workers is one such solution in order to increase number of vehicles produced. In the long-run, it
can increase its vehicle production by building more number of factories. In short-run calculation,
the costs of these factories will not figure and are supposed to be fixed, while in the long-run, they
are variable. Figure 2.14 shows three average short run cost curves for three sizes of vehicle
manufacturing factories – small, medium and large. The figure also shows the long-run average cost
curve. As the firm moves along the long-run cost curve, it adjusts the factory size to the quantity of
production.
As seen from the figure, long run average cost curve has a much flatter U shaped curve than short run
average cost curve. All short-run curves lie on or above the long run cost curve. The long-run cost
curve provides a lower envelope for all short run average cost curves. This peculiar relationship
exists because of flexibility associated while obtaining long-run cost curve. In short, the firm gets to
choose which short run curve it wishes to employ.
Figure 2.14: Long run AC and Short run AC
As the firm moves from a small size factory to medium size factory, the cost per vehicle starts
reducing till a certain point. As long as the average production cost decreases, the product is said to
display economies of scale. In the electricity business, the transmission systems are said to exhibit
economies of scale.
PERFECTLY COMPETITIVE MARKET
A perfectly competitive market, in brief terms, can be explained as a market form in which no
consumer or producer can influence the market price. Perfect competition has a market equilibrium
which is Pareto efficient. The defining characteristics of a perfectly competitive market can be
given as follows:
1. Atomicity : An atomic market is the one in which there are a large number of small producers and
consumers They are so small that individual actions have no significant impact on others. Firms
are price takers.
2. Complete information : All consumers and sellers know the prices set by all firms.
3. Homogeneity : All firms sell an identical product.
4. Free entry : No firm has barrier for entry into or exit out of market.
5. Uniform price: Each firm charges the same price in the market.
In addition to this, there are obvious behavioral assumptions such that the consumers try to maximize
utility while suppliers try to maximize profit.
Markets for agricultural products with sufficiently large number of suppliers and consumers can be
assumed to be a perfectly competitive market. On the other hand, the electricity markets seldom
exhibit prefect competition due to less number of dominant players.
A firm in a competitive market, like most other firms, tries to maximize profit, which equals total
revenue minus total cost. We have seen the concepts of total, average and marginal costs of a firm.
Similar concepts pertaining to revenue of a firm exist. Total revenue (TR) is price times the quantity
( π*,q), and average revenue (AR) is total revenue (π*,q ) divided by the quantity (q). Therefore, for
all firms, average revenue equals the price of the good. On the other hand, marginal revenue (MR)
is the change in total revenue from the sale of each additional output. Total revenue is (π*,q ) and π
is fixed for a competitive firm (firm being a price taker in perfectly competitive market). Therefore,
when q rises by 1 unit, total revenue rises by π rupees. Therefore, for firms in perfectly competitive
markets, marginal revenue equals the price of the good.
The Firm's Supply Decision under Perfect Competition
Equation 2.8 showed that in order to maximize the profit, the firm will raise its production up to that
level at which the marginal cost is equal to market price. Let us explain this point graphically with
the help of the concept of marginal revenue. To understand firm's supply decision under perfect
competition, refer to Figure 2.15.
Figure 2.15: Profit maximization for a firm under perfect competition
The marginal-cost curve (MC) is upward sloping. The average cost curve (AC) is typically U shaped.
And the marginal cost curve crosses the average cost curve at the minimum of average cost. The
figure also shows a horizontal line at the market price ( π*). The price line is horizontal because the
firm is a price taker. The price of the firm's output is the same, regardless of the quantity that the
firm decides to produce. We have mentioned that for a competitive firm, the firm's price equals both
its average revenue (AR) and its marginal revenue (MR).
We can use Figure 2.15 to find the quantity of output that maximizes profit. Imagine that the firm is
producing at q1. At this level of output, marginal revenue is greater than marginal cost. That is, if
the firm raised its level of production and sales by 1 unit, the additional revenue (MR1) would
exceed the additional costs (MC1). The profit, which equals total revenue minus total cost, would
increase. Hence, if marginal revenue is greater than marginal cost, as it is at q1, the firm can
increase profit by increasing production.
Now suppose the firm produces quantity q2. In this case, marginal cost is greater than marginal
revenue. If the firm reduced production by 1 unit, the costs saved (MC2) would exceed the revenue
lost (MR2). Therefore, if marginal revenue is less than marginal cost, as it is at q2, the firm can
increase profit by reducing production.
Where do these marginal adjustments to the level of production end? Regardless of whether the firm
begins with production at a low level (such as q1) or at a high level (such as q2), the firm will
eventually adjust production until the quantity produced reaches q*. Thus, a generic rule for profit
maximization can be laid down as follows: At the profit-maximizing level of output, marginal
revenue and marginal cost are exactly equal.
We can now see how a competitive firm decides the quantity of its good to supply the market. Because
a competitive firm is a price taker, its marginal revenue equals the market price. For any given
price, the output that maximizes the profit of the competitive firm is found by looking at the
intersection of the price with the marginal cost curve. However, this analysis does not hold good if
the market is not perfectly competitive. There are various forms of imperfect competition and then
the firms are not mere price takers. The firms can strategically decide upon their actions that reflect
in the market price.