Chapter 7: The price system and the microeconomics

Utility and Marginal Utility

Utility is the total amount of satisfaction received from consumption.

Total utility: It is the total amount of satisfaction derived from the consumption of a given quantity of goods.

Average Utility: It is the utility derived per unit of commodity consumed.

Marginal Utility: It is the utility derived from the consumption of an additional unit of goods.

Equimarginal principle is when consumers maximize their utility where their marginal valuation for each product consumed is same. It is represented as:

(MU/P)A =(MU/P)B =……….. = (MU/P)N

Where, MU= marginal utility

P= price

A, B and N = different product

Budget lines

It is the graphical representation of various combinations of two goods that a consumer can buy with given income and prices.

As the price of X has fallen comparatively of Y, the consumers will substitute X with Y. This is the Substitution Effect of price change.

With the fall of price if X, the consumers will have a higher real income and will now purchase more of product X. this is called income effect of price change.

Indifference Curve

Indifference curve refers to the curve that shows the different combinations of two goods that give a consumer equal satisfaction.

Effect of change in income on Consumer choice

If the income increases then this will allow the consumer to choose better combination of goods. So if the budget constrain rises, then the consumers will increase the consumption of both goods.

When there is fall in consumer’s income, the budget line shifts to left in parallel way.

Income and substitution effect of price change using indifference curve

In case of food, both income and substitution effects are positive, resulting in substantial increase in consumption. For clothing, the substitutional effect is negative but fall in consumption is some extent offset by positive income effect.

Short-run and Long-run production

The underlying principle of production is that the firms should produce their products at the lowest possible costs.

Isoquant is a graphical representation of factor inputs (labour and capital) that can produce the same quantity of output.

Production Function

It is the functional relationship between factors input and the output produced.

Short-run production function

In short run production, at least one factor input remains constant so, the short run production function explains how the output increases when one factor input is increased continuously keeping other factor input fixed.

Short run cost

These consist of:

  • Fixed cost: Those costs that are independent of output in short run.
  • Variable cost: Those costs that varies directly with output in long run.

Total cost (TC) = Total fixed cost (TFC) + Total variable cost (TVC)

Long-run production function


In long run all the factors input (Capital and labour) are variable. So, the long run production function explains how the output increases when all the factors input used in the production process are increased continuously.

Since all the factors of production are variable, in long run the firms have a greater scope of reducing the costs of production by substituting the expensive factor input by cheaper one.

Firms and Industries

“Firm” is a generic term to denote a business organization that buys factor of production to produce goods and services. They include:

  • Partnerships
  • Cooperatives
  • Private or public limited companies
  • State owned firms

Small and Medium enterprises (SEMs) are firms with fewer than 250 employees.

“Industry” is the sum of all firms making the same product.

The firm’s revenue

Total revenue = Price × Quantity

Average Revenue = total revenue ÷ output

Marginal revenue is the addition to the total revenue resulting from sale of one additional revenue.


Profit is the difference between total revenue and total cost.

Abnormal profit is that which is earned above normal profit.

Market Structures

Market structure describes the way in which goods and services are supplied by firms in a particular market or industry.

  1. Perfect competition
  2. Monopolistic Competition
  3. Oligopoly
  4. Monopoly
  5. Contestable market
  1. Perfect Competition

It is an ideal market structure that has many buyers and sellers, identical products and no barriers of entry. Its characteristics are:

  • Many buyers and sellers
  • Free entry to and exit from market
  • Perfect knowledge
  • Homogeneous goods
  • Factors of production are perfectly mobile.

In short run, firms can make supernormal profits. Above is a diagram of short run equilibrium for a perfectly competitive market, here red area shows super normal profits hence, it is assumed that firms are short run profit maximizers.


In long run where profits are compared away only normal profits are made.

  1. Monopolistic Competition

Characteristics of monopolistic market are:

  • A monopolistic competitive market has imperfect competition. Firms are short run profit maximizers.
  • Firms sell non- homogenous products due to branding.
  • There are no barriers to entry and to exit the market.
  • Examples of monopolistic competitions include hairdressers.

In this competition consumers get wide variety of choice.

In short run, firms profit maximize at the point MC=MR. The supernormal profits produced in the short run might increase dynamic efficiency through investment.

In long run, new firms enter the market since they are attracted by profit that existing firms make and this makes the demand for the existing firm’s product more price elastic.


Oligopoly is defined as a market situation where the total output is concentrated in the hands of few firms.

Oligopoly has following characteristics:

  • The market is dominant by few firms
  • There is high barriers to entry to and exit from
  • Firms are independent, this means that the actions of one firm affects another firm’s behavior
  • Firms differentiate their products from other firms using branding

Firms in an oligopoly have a strong incentive to collude. By making agreements, they can maximize their own benefits and restrict their output, to cause the market price to increase. Collusion is more likely to happen where there are only few firms.


A monopoly is where a single firm controls the entire output of the industry. The characteristic of monopoly are:

  • Sole seller in the market
  • High barriers to entry
  • Price makers
  • Price discrimination
  • A monopolist earns supernormal profits in both the short run and long run

Monopoly power can be gained when there are multiple suppliers. If two large firms in an oligopoly have greater that 25% market share, they are said to have monopoly power.

Monopoly is affected by factors like

  • Barriers to entry
  • Number of competitors
  • Advertising

Natural monopoly is a market situation where the monopolist has overwhelming cost advantage.

Contestable Market

Contestable market has following characteristics:

  • The market face actual and potential competition
  • There is low consumers
  • The number of firms in market varies
  • There is no significant entry or exit barriers

There is no different degree of contestability across market. All the market has the potential to be contestable. Sunk cost are the barrier to contestability.

Example of contestable market are:

Telecommunications, personal and corporate banking, etc.


Integration is a way in which the individual part of business have come together through merger or acquisition or purchase.

 Horizontal integration is where a firm merges acquires another in same line of business.

Vertical integration is where a firm grows by producing backward or forwards in supply chain.


A cartel is a formal agreement between members firms in an industry to limit competition. The agreement may involve fixing the quantity of production and price of the product. Organization of Petroleum Exporting Countries (OPEC) is the example of it.

Objectives of Firm

  • Profit Maximization
  • Sales revenue Maximization
  • Sales Maximization
  • Loss Minimization

Pricing Policy

  1. Price Discrimination

Three steps of price discrimination are:

First degree price discrimination is when each consumer is charged a different price.

Second degree is when prices are different according to the volume purchased.

Third degree is when different group of consumers are charged a different price for same goods or services.

  1. Limit Pricing

Limit pricing involves firms setting lower short run price to deter new firms from entering contestable market.


  1. Price Leadership

 Price leadership is where all the firms in the market accept the price that is set by the leading firm.