FAM PGPX 2023

Weekly Summary

Week 1

● We define marginal utility as the additional satisfaction a consumer gets when you have
consumed one more unit of the product. For most products, in general, marginal utility keeps
declining with every additional product you consume. The best way to think about marginal
utility is the money that comes into your pocket, whereas price is the money that goes out of
your pocket (expense you incur). So, as long as MU happens to be greater than price, you have
everything to gain.
● Therefore, how can we construct a demand curve? When price decreases, existing consumers
have greater incentive to consume more, whereas new consumers tend to join the market.
Therefore, the demand curve is downward sloping, everything else being equal. Of course,
there are issues: it is within a range, time dependent, etc.
● With the demand curve in place, let us consider price elasticity of demand. It is nothing but the
percentage change in the quantity consumed for a percent change in the price of the product.
While various textbooks talk about several methods of calculating elasticity of demand, I
follow the simple metric of the inverse of slope multiplied by price quantity ratio.
● If elasticity is less than one, we call the product price inelastic. In other words, consumers DO
NOT react to price change as much. So, if you increase the price, while your overall quantity
decreases, your total revenue increases. Here is a small nuance I want to get: FOR PROFIT
MAXIMIZATION, NEVER OPERATE IN THE INELASTIC REGION OF THE DEMAND
CURVE. Why?
○ Profits are loosely defined as revenue minus cost, right?
○ When you increase the price, your revenue goes up, right?
○ And when quantity decreases, your overall cost goes down, right? (I know some of you
are itching to say, it can remain the same. Granted! Even if it remains the same!!!)
○ So, when price increases revenue increases, but cost remains the same or reduces,
right? So, profit has to go up, right?
○ Remember, every product becomes elastic after a price... So, simple logic: If your
product is inelastic, you simply are not charging enough
● If elasticity is greater than one, we call the products elastic. Market is highly sensitive to price.
So, if price increases, quantity decreases more than the increase in price. So, total revenue goes
down. Similarly, if price decreases, quantity increases more than price reduction. So, total
revenue goes up.
● Now, let us understand the supply side of the story. What happens when the price increases?
Existing suppliers want to supply more, and the new (perhaps, not so efficient) suppliers also
want to enter the market. So, everything else being constant (jargon is, ceteris paribus), supply
curve is upward sloping.
● A market is not made of either suppliers or producers alone. It requires BOTH of them to
participate. If there is a place where producers and buyers can interact, Adam Smith says that,
 as if controlled by an invisible hand, optimal price and quantity get determined in the market.
What happens if the price is less than the equilibrium prices? Shortages. What happens if the
price is more than the equilibrium price? Excess supply. I wanted you to visualize the
following:
○ Demand remains constant; supply curve shifts to the left/right
○ Supply remains constant; demand curve shifts to the left/right
○ What happens when both curves shift? You should have four different combinations
○ You should be clear by now on what variables (price/quantity) unambiguously
increase/decrease, and which of them could go either direction.

Week 2:

● While demand represents the marginal utility of the consumer, supply represents the marginal
cost of the consumer. To see this, we first look at productivity
○ AP is the number of units produced DIVIDED by the total workforce, and MP is the
additional production for an extra worker.
○ I explained how AP would be inverted U shaped curve, and how MP would intersect
AP at the top AP curve. As long as MP is above AP, AP increases. (Think run rate
here!)
○ In the short run, as some factors are fixed, increasing others beyond a point will start
generating negative productivity. That is why MP can go negative as well.
● We distinguished between two types of costs: Fixed and variable. Total cost is F + w. L. F is
the fixed cost and w.L is the variable cost
○ Average variable cost is nothing but wL/Q = w/(Q/L) = w/AP. Since AP is inverted U
shaped, AVC is U shaped.
○ AFC is continuously decreasing. (Why?)
○ Similarly, MC = w/MP
○ AC = AFC+AVC
○ Using the same run rate logic, convince yourself that MC would intersect at the bottom
point of AC and AVC
○ We discussed: MC curve above AVC is the supply curve of the firm. Why?
● Any part of the fixed costs that are non-recoverable are SUNK COSTS
● THOU SHALT LEARN TO IGNORE SUNK COST IN THY DECISION MAKING (first
commandment of microeconomics)
● Only time they matter is before you incur them; i.e., before you enter
● That is, once you enter, your only hope is (P-AVC) multiplied by quantity is sufficient to cover
your sunk cost
● At the same time, you have to consider opportunity cost in decision making
● THOU SHALT LEARN TO CONSIDER OPPORTUNITY COST IN THY DECISION
MAKING (second commandment of microeconomics)
○ One of the things I asked you to look up re opportunity cost is comparative cost
advantage. In short, it is an explanation for why you should not be doing everything
even if you are amazing at everything
 ● Do you produce if the price is below average variable cost? Ideally, no. However, in some
cases, you do.
○ When there are start up costs
○ When there are direct and indirect network externalities
○ When alternative sources of revenue are available
○ Setting up of new businesses, especially when there are direct network effects
○ There are other examples, and I will leave it to you to discuss this
● In the long run, if I increase my output and my average cost reduces, we call this the idea of
economies of scale. What are the strategic implications of economies of scale?
○ Consolidation, M&A, giant firms and reduction in variety. There could be other
consequences
○ Why economies of scale? Better bargaining with the vendors, standard operating
procedures, etc.
○ Production linked incentives are all about you being able to achieve economies of scale
(You might want to study that a bit more)
● Firms that enjoy perpetual economies of scale are called Natural Monopolies
● We also talked about economies of scope, where variety is everything. What are some of the
source of scope economies?
○ Tightly linked production processes
○ Brand name etc.
● We also discussed the idea of consumers' surplus and producers' surplus
○ Simply put, consumers' surplus is the difference between what the consumer intends to
pay and what the consumer ends up paying. Graphically, it is the area under the
demand curve, above the price, left of quantity
○ Producers' surplus is the difference between what the producer receives and what the
producer wants (price and the MC). Graphically, it is the area above the supply curve,
below the price left of quantity.

Week 3:

● What is a perfectly competitive market?

○ There are too many buyers and sellers that no single player has any major say in the
market
○ Entry and exit are free
○ Price is fixed by some entit
○ There is probably minimal product differentiation
○ I think I mentioned US generic drug market (where brand name is not allowed) as one
of the examples of quasi-perfect competition
■ There are so many generic medicine manufacturers in India, Israel, US,
Canada, etc. that are willing to pounce on any medicine at a moment's notice.
With the doctors not being allowed to write brand names of medicines on their
prescription pads, there is almost zero product differentiation
● You need to convince yourself that price equalling marginal cost is the only way of an
equilibrium
● To convince yourself, let us consider the following example:
○ Say, the price prevailing in the market is Rs 15. You are currently producing 10 units,
and your current total variable cost is Rs 100
○ Now, suppose you are considering producing 11 uits, and your total variable cost
increases to Rs 112. That is, marginal cost for 11th unit is Rs 12
○ If you, indeed produce the 11th unit, the cost you incur is Rs 12, but the revenue you
obtain is Rs 15. So, your profit increases by Rs 3
■ To convince yourself, let us do the following calculation: Currently, your total
variable cost is Rs 100, and your revenue is 10*15 = Rs 150. So, gross profit is
Rs 50
■ Now, if you produce 11 units your revenue increases to Rs 165. And your cost
is Rs 112. So, your gross profit moves to Rs 53, which is greater than Rs 50
■ Your average variable cost was 10 earlier, and now it is 10.18
○ Let us look at the other side. Imagine you produce 10 units at Rs 15 each. Your total
revenue continues to be Rs 150. And your total variable cost continues to be Rs 100.
Your profit is Rs 50.
■ At the same time, let us assume producing the 11th unit costs you Rs 17 extra
(marginal cost).
■ If you produce 10 units, your profit is 50. If you produce 11 units, your
revenue is Rs 165 and your cost is Rs 117. This implies your profit is Rs 48
■ This implies your profit reduces.
■ Notice, average variable cost at 11 units is 170/11= 10.63.
■ So, now if you assume the product to be infinitesimally divisible, you have a
nice rule: P = MC is where you stop production. If the product is not
infinitesimally divisible, you stop at the last point where P>MC
○ I hope this example convinces you that it is marginal cost, and not average variable
cost, which ought to define production decisions.
○ In common lingo out there, they describe margin to be the difference between price
and some kind of average cost. I think it is a misinterpretation
● Given the number of questions I saw on the concepts of consumer and producer surplus, I
thought I would elaborate what they mean using very simplified examples:
○ Imagine there are several consumers, each wanting one unit of a commodity. To keep
it even simplistic, let us assume that they need one unit and one unit only. Each
consumer has a different marginal utility associated with the product. Suppose,
consumer 1 has a marginal utility of 100, consumer 2 has a marginal utility of 99 and
so on. In other words, Consumer 1 is willing to pay Rs 100, consumer 2 is willing to
pay Rs 99 and so on. Now, imagine the price of the product to be Rs 20. How much
has the consumer 1 gained by consuming the unit? 100 - 20=80, right? Consumer 2
would have gained 99-20 = 79, correct? And so on till you reach a customer who
places a value of 20 for the product. Any consumer below this value would not
consume. Now, what is the total gain from all these consumptions? 80 + 79 + 78 +
...Does that make sense? So, graphically, it is the area under the demand curve to the
left of quantity above the price...
 ○ Similarly, assume an industry's supply curve is something like this. MC of the first unit
is Rs 1, MC of second unit is Rs 2, and so on... So, how much did I gain by the first
unit? Rs 20 - Rs 1 = 19. Second unit is 18, and so on. So what is the total producers'
surplus? 19 + 18 + 17 + ... It is simply the area above the supply curve, below the
price, left of quantity.
○ Total surplus is consumers' surplus + producers' surplus. In simple words, it is MU -
MC. Imagine, someone wants to pay Rs 20 L for a car, and the cost for Maruti is Rs 2
L. Say, price is Rs 5 L. Consumers' surplus is Rs 15 L and PS is Rs 3 L. Total surplus
is 18 L, which is same as MU-MC.
● This is really under the assumption that everything is measurable in terms of money, right? Fair
enough, if you don't agree...
● Any tampering with the free market implies that there is a problem. We specifically discussed
the following cases:
○ Higher price than the market price
○ Lower price than the market price
○ What happens when there is an international trade?
○ In all these cases, some consumers who would have consumed in a free market would
have been left out, and a few producers who could have produced would have been left
out, resulting in deadweight loss
○ Make sure you understand all these cases clearly and why deadweight loss emerges.

Week 4:

● On externalities -- When your consumption decisions/ production decisions impact other

people, we can no longer claim that free market economics work. We end up with market
failure
○ When there is a positive externality - remember LoJack - you always have a problem
of under consumption than what is socially optimal
○ When there is a negative externality - remember pollution - you always have a problem
of over consumption than what is socially optimal
○ This arises because when individuals make decisions (consumption/production) they
base their decision on their own utilities and costs, and ignore the problem they create
for others
○ How do we solve the problem of externalities: a) Impose taxes in case of negative and
subsidy in case of positive externality; b) Impose limits (negative externality) or take
the choice away (positive externality)
○ You can also consider the Coase theorem which says that if there are well defined
property rights, and there are no transaction costs, your social optimality is
automatically taken care of
○ For the lack of time, we are not able to discuss public goods, but the main problem that
happens in this case is a tragedy of commons (a version of playing alpha without a care
for the future). Remember the contribution game where five of you contributed money
for a common kitty? Contribution is always suboptimal! And that is the main issue
 with why cooperatives fail, and the main reason why common property resources are
sub-optimally utilized. Again, in an MBA class, I am fine sacrificing that bit of nuance
that comes with discussion of public good
● On adverse selection: We looked at how individuals sometimes incur stupid costs which are
completely not necessary and do not help improve productivity. On the prima facie while they
look stupid, they are well calculated decisions
○ The answer to this is adverse selection as proposed by Akerloff. He says, when there is
uncertainty in the market, the good types are hurt.
○ Why? There is a confusion between the good types and the bad types, and people value
expectation (assuming risk neutrality). So, while good types do not get as much as they
deserve, bad types get more than what they deserve.
○ This increases the presence of bad types, which in turn, drives the expected value
further down. This again, hurts the good type further
○ So, what does the good type do? They acquire some seemingly useless costs. The cost
is such that the good type will be happy incurring that cost, but the bad type will not
have incentive to incur that cost. It is sufficiently costly, but not too costly as well. In
that context, we ended up discussing several examples.
■ Remember the video clip? The hero broke a concrete slab and the goon
stopped advancing. The hero could be of two types: Strong type or weak type.
If he is asked, he will say, he is a strong type (he is a Tamil hero, after all!).
So, his word has no information. So, what does the hero do? He breaks a slab.
If the slab is made of cardboard, even the weak type can mimic the signal. So,
that action would have revealed no information. If the slab is made of iron, the
hero himself would not have attempted to break it. Why? His status as Tamil
hero notwithstanding, he would have hurt himself. So, his action of not
breaking the iron slab conveys no information.
■ So, the fact that it is a concrete slab serves us perfectly. A strong hero will be
able to break a concrete slab, whereas a weak hero would not have attempted
breaking this slab; instead he would have run away... So, this is sufficiently
costly, without being too costly. A perfect signal that conveys the message that
the hero is super strong (not that we ever doubted it)
○ So, next time when someone asks you why you are doing an MBA, you can proudly
yell, 'BECAUSE PEACOCKS HAVE BRIGHT FEATHERS.'