A.A.

2022-2023

BUSINESS & INDUSTRIAL ECONOMICS:

A.2. MOOC wrap up - Fundamentals of
Economics
Cristina Rossi-Lamastra*
Daniela Silvestri*
*Politecnico di Milano School of Management
 Table of contents 2

A.1. Basics of theory of demand, production, and costs

▪ A.1.1. Demand and price elasticity
▪ A.1.2. Technology
▪ A.1.3. Profit maximization and cost minimization
▪ A.1.4. Cost functions

A.2. Basics of market structures

▪ A.2.1. Perfect competition
▪ A.2.2. Monopoly
 3

A.1.1. Demand and price elasticity

 Demand curve 4

The demand curve tells the quantity buyers wish to purchase at various prices
Law of Demand: the demand curve has a negative slop (when price falls, the quantity
demanded increases)
Direct demand curve: given the price, how many units are demanded at that price?
▪ Qi(pi,z) quantity demanded of good i, is a function of price and other possible variables
affecting the demand of good i (e.g., price of all other goods, income)
Inverse demand curve: given the quantity, what is the price at which that quantity is sold?
▪ Pi(qi,z) the price of good i, is a function of quantity and other possible variables
Implications: which is the % decrease in demand when a % increase in price occurs?
If the decrease in demand is (very) limited, an increase in price leads to an increase in
firm’s revenues

Wrapping up
- Law of demand
- Direct vs. inverse demand
- Implications for firms
- Exceptions
- Movement vs. shift in the demand

What is the inverse demand function of Q(P) = 240 – 2P?

 Consumer preferences and budget constraint 5

Indifference curve map

Indifference curve show all combinations of two goods that
give the consumer equal utility
▪ Diminishing marginal utility: indifference curves are
convex as the utility decreases with extra units of the
same good
▪ Marginal rate of substitution (MRS): slope of the
indifference curve expressing the amount of one good the
consumer is willing to trade for another 𝜕𝑈
∆𝐹 𝜕𝑞1
𝑀𝑅𝑆 = − =−
∆𝑆 𝜕𝑈
Budget line 𝜕𝑞2

𝒑𝟏𝒒𝟏 + 𝒑𝟐𝒒𝟐 ≤ 𝒀
Combination of goods that can be afforded with the current
income
▪ Optimal bundle: the consumer maximize utility where
the highest indifference curve is tangential to the
budget line
▪ Marginal rate of transformation (MRT): slope of the
budget line, how many units of one good the consumer
must give up to purchase more of the other given the
current prices 𝑀𝑈1 𝑝1
𝑀𝑅𝑆 = − =− = 𝑀𝑅𝑇
𝑀𝑈2 𝑝2
 Price elasticity of demand (1/2) 6

Price elasticity: percentage change in the quantity of a good demanded

that results from a 1 percent change in its price
q
q q p q p
=    
p p q p q
p

1. Elastic demand: |𝜀| > 1

▪ High demand elasticity: an increase in price causes a sizable
reduction of demand
▪ Flat demand curve

2. Inelastic demand: |𝜀| < 1

▪ Low demand elasticity: an increase in price causes a limited
reduction of demand
▪ Steep demand curve
Price elasticity of demand (2/2) 7

Elastic |𝜀| > 1 Inelastic |𝜀| < 1

p

q
Perfectly elastic : |𝜀| → ∞ Perfectly inelastic : |𝜀| = 0
p p

q q
Implications of the demand elasticity (1/3) 8

The demand curve and its elasticity

may influence the success of a firm’s
pricing decisions
▪ Pricing strategies
▪ Sales forecasting

Take away message:

Firms aim to reduce the demand
elasticity of their products because, in
case of an inelastic demand, increases
in prices lead to increases in revenues

DA: inelastic demand curve

DB: elastic demand curve
 Implications of the demand elasticity (2/3) 9

Elastic demand curve Inelastic demand curve

A decrease in the price will lead to an A rise in the price will lead to an
increase in the revenues generated increase in the revenues generated
from selling the product from selling the product
 Implications of the demand elasticity (3/3) 10
Relationship between price elasticity and total expenditures

Factors influencing price elasticity of demand

▪ Characteristics of the product
▪ Existence of close substitutes
▪ Proportion of the expenditure for the good
▪ Customers’ loyalty to the product
▪ Length of time period considered
▪ Peak and off-peak demand

Interpretation of the graph:

Total expenditure starts at zero when Q is zero and
increases to its maxmum value at the quantity
corresponding to the midpoint of the demand curve (M)
 Reducing demand elasticity: 11
Product differentiation

How firms reduce the demand elasticity?

It is possible to reduce the demand elasticity of a product by
differentiating it from other products (of competitors and/or of the firm)

Product differentiation is
▪ Conducive to market power: it allows setting high prices without
losing customers
▪ A widespread competitive strategy
▪ Real differentiation: by changing the real characteristics of the
product, for instance through innovation
▪ Perceived differentiation: by changing consumers’ perception of
the characteristics of the product, for instance through advertising
 Cross price elasticity of demand 12

Cross price elasticity: percentage change in the quantity demanded of

one good that results from a 1 percent change in the price of the other

▪ The cross price elasticity can be either positive or negative

▪ Good x and z are complements if ∈𝑥𝑧 < 0
▪ Good x and z are substitute if ∈𝑥𝑧 > 0
 13

A.1.2. Technology and production

 Technology and production 14

When choosing quantities to produce and prices to charge, firms face

constraints
• Customers (demand), competitors (market structure), nature of the
production process (technology)
▪ Technology: the set of processes that a firm can use to turn a vector X of
N inputs into a vector Y of M outputs

x1 y1
x2 y2
Technology
… …

… …

xn ym
Q=F(K,L)

Production set: the set of all combinations of

inputs and outputs that are technologically feasible
Production function: the maximum possible
outputs from a given vector of inputs. It is the
boundary of the production set
 Marginal Product (MP) 15
Production in the short run
The marginal product (MP) of an input is the output variation due to the
variation of 1 unit of this input, holding all other inputs constant:

𝜕𝑦 Rate of change of output as the level

𝑀𝑃𝑖 =
𝜕𝑥𝑖 of input i changes

Law of diminishing marginal

product (common feature of many
production processes): the marginal
product of an input decreases as
the level of that input increases,
holding other inputs constant. In
general

MPi  2 f ( xi , x j )
= 0
xi xi
2
 Production function and Isoquants 16
Production in the long run

1. If there is 1 input x and 1 output y, the production function is y=f(x)

2. With 2 inputs, x1 and x2, and 1 output y, the production function is
y=f(x1, x2)

Isoquant: set of all input bundles that produce the same output level y
• Isoquants can be graphed both in a 2D plan or in 3D plan

x2 y
y=8
y=8

x2 y=4

x1
x1
 Technical Rate of Substitution (TRS) 17

TRS measures the trade-off between

the two inputs
• It is the rate at which input 2 can be
substituted with input 1 to keep the
output level constant
▪ Graphically, it is the slope of the
isoquant
• TRS: the amount by which the
quantity of one input has to be
reduced (-Δx2) when one extra unit
of another input is used (Δx1=1), so
that output remains constant
Assumption of diminishing TRS:
y y the slope of the isoquant
dy = dx1 + dx2 dx2 MP1 decreases (in absolute value)
x1 x2 = = TRS ( x1 , x2 ) =
dx1 MP2 when moving to the right along
= MP1dx1 + MP2 dx2 = 0
the isoquant
Some Properties of well-behaved technologies 18

Monotonicity Convexity
If two bundles of inputs, (x1’, x2’)
Production increases if one input and (x1’’, x2’’) both produce y
increases, while the other input units of output, then their
stays constant weighted average produces at
least y units of output

(tx1' + (1 − t ) x1'' , tx2' + (1 − t ) x2'' )

t  (0,1)
 Returns to Scale (1/2) 19

• Marginal products describe the change in output as one input changes

• Returns to scale describe how output changes as all inputs change in the
same proportion (e.g., all inputs double, or halve)
→ Returns to scale may vary along the production function
→ It is a long run concept

Constant returns to Increasing returns to Decreasing returns to

scale scale scale
 Returns to scale (2/2) 20

A single technology can locally exhibit different returns-to-

scale
 21

A.1.2. Cost functions

 Cost Functions: Taxonomy 22

In the short run, we have

• Total cost function: C(y)
• Fixed cost function: FC
• Variable cost function: VC(y)
• Average total cost function: ATC(y)
• Average variable cost function: AVC(y)
• Average fixed cost function: AFC(y)
• Marginal cost function: MC(y)

In the long run, we have

• Average cost function: AC(y)
• Long-run marginal cost function: LMC(y)

How do these cost functions relate to each other?

• Specifically, how do long-run and short-run cost functions relate?
Note: y is quantity produced also called level of output, thus you will also see costs function expressed as C(q)
 Short run: Total, variable, and fixed costs 23

• Total cost function, C(y): is the minimum cost of all inputs (fixed
and variable) when producing y units of output

• Fixed cost function, FC: is the cost of inputs, which are fixed in
the short run. FC does not vary with the firm’s output

• Variable cost function, VC(y):

is the cost of variable inputs
when producing y units of
output. It varies with the firm’s
output and depends on the level
of the fixed input

C ( y ) = F + VC ( y )

Can you provide some examples of fixed costs? And of variable costs?
 Short run: Average costs 24

• Average total cost function, AC(y): is the total cost of each unit of output
C ( y) F VC ( y )
AC ( y ) = = + = AFC ( y ) + AVC ( y )
y y y

• Average variable cost function, AVC(y): is the

variable cost of each unit of output
• AVC(y) increases with output. If the MP is
• Increasing, VC(y) increases at a decreasing
rate as y increases: AVC(y) is decreasing
• Decreasing, VC(y) increases at an increasing
rate as y increases: AVC(y) is increasing
• Usually, along the production function, the MP is first
increasing and then decreasing → Thus, AVC(y) is
U-shaped, AC(y) likewise
• Average fixed cost function, AFC(y): is the fixed
cost of each unit of output. It decreases as output
increases
 Short run: Marginal Costs 25

• Marginal cost function, MC(y): is the change in the (total/variable)

cost associated to a unitary change in output
• Considering infinitesimal changes, and noting that fixed cost FC
does not vary with the output level y, we have

 C ( y )  VC ( y )
MC ( y ) = =
y y

• In other words, MC(y) is the derivative of total cost with respect to

quantity, which is equivalent to the derivative of the variable cost
• It gives the slope of the C(y) and VC(y) curves as output changes
Average and Marginal Costs Functions: 26
Graphical representation

▪ AC decreases when MC<AC

▪ AC increases when MC>AC
▪ AC is the same when MC=AC
 Long-Run: Total cost curves 27

Suppose that there are 3 possible levels of input 2

• x2 = x2’, x2 = x2’’, x2 = x2’’’ with x2’ < x2’’ < x2’’’
In the short run, the firm can choose just one of them and has a
different short-run total cost curve for each possible level of input 2
(and thus of fixed costs)
• A larger amount of the fixed input increases the fixed cost (F’<F’’<F’’’)
In the long-run, the firm can choose among the 3 levels of input 2,
depending on the quantity y to be produced. The result is the long-run
total cost curve (light blue line)

The firm’s long-run

total cost curve is the
lower envelope of the
short-run total cost
curves
 Long-Run: Average and marginal cost curves 28

For any output level y, the long-run total cost curve always gives the
lowest possible total production cost
• Similarly, the long-run average total cost curve gives the lowest
possible average total cost → The long-run average total cost
curve is the lower envelope of all the short-run average total cost
curves
• Similarly, the long-run marginal cost curve gives the lowest
possible marginal cost → The long-run marginal cost curve is the
higher envelope of all of the short-run marginal cost curves
 29

A.1.3. Profit maximization and cost

minimization
 Profit Maximization 30

▪ A firm profits (𝜋) are given by the difference of revenues minus costs of
production
=σ𝑛𝑖=1 𝑝𝑖 𝑦𝑖 − σ𝑚
𝑖=1 𝑖 𝑥𝑖
▪ In order to maximize profits, the firm needs to choose the amount of
output to produce and the production plan to employ
• A firm uses inputs x = 1, 2, · · · , m to make products i = 1, 2, · · · , n
• Output levels are y1, · · · yn
• Input levels are x1, · · · xm
• Product prices are p1 , · · · pn
• Input prices are 1, · · · m
▪ We will study the profit-maximization problem of a firm that faces
competitive markets for both factors of production and output
▪ The competitive firm takes all output prices p1 , · · · pn and all input
prices 1, · · · m as given constants
 Profit Maximization in the Short Run 31

• Profit function in the short run is

• In the short run, input 2 is fixed
• Consider a firm which produces output y using the production function y=f(x1, x2),
where input 2 is fixed at a certain level 𝑥2 y=f(x , x )
1 2

With p the product price and 1 and 2 the max pf ( x1 , x2 ) − 1 x1 − 2 x2

x1
input prices, the profit maximization problem
of the firm is

Applying the first-order condition we have:

The firm maximizes profit by choosing the

level of input 1 (and producing the level of
output) at which the marginal revenue
product of input 1 equals its price (e.g., pMP1 ( x1* , x2 ) = 1
wage of input 1)
 Profit Maximization in the Short Run 32

• We can solve the problem graphically

• Solving for y from the (short-run) profit function, we obtain the
equation describing the isoprofit lines representing all the
combinations of output (y) and input (x1) that give a constant level of
profit

 = py − 1 x1 − 2 x2
 2 1
y= + x2 + x1
p p p
1
MP1 =
p

The slope of the isoprofit

line equals the slope of
the production function
 Profit Maximization in the Long Run 33

• In the long run, the firm can choose the level of all inputs, thus the profit
maximization problem is

max pf ( x1 , x2 ) − 1 x1 − 2 x2
x1 , x2

• Analogously to the short run case, the firm maximizes profits by choosing the
level of inputs (and producing the level of output) at which

In the long-run the value of the

pMP1 ( x1* , x2* ) = 1
marginal product of each factors
pMP2 ( x1* , x2* ) = 2 should equal its price
 Cost Minimization in the long run 34

Key question: how to minimize the costs of producing a certain output y?

The cost minimization problem can be written as min 1 x1 + 2 x2
x1 , x2

such that f ( x1 , x2 ) = y
• The solution gives the cost function: minimum cost of producing y, given
input prices
c(1 ,  2 , y )

We obtain the solution graphically, by considering isoquants and isocosts, i.e.,

set of all the input bundles having the same cost C
• The solution is such that C 1
1 x1 + 2 x2 = C  x2 = − x1
2 2

1
TRS ( x1* , x2* ) =
2
 35

A.2. Basic of Market Structures

 Introduction 36

It is possible to define different market structures depending on

• The number of firms operating on a market
• The ways in which these firms interact when they make their
pricing and output decisions
• Q produced depends on how firms behave in these different market
structures

• Perfect competition benchmark

• Monopoly
• Monopolistic competition Imperfect competition
• Oligopoly
 37

A.2.1. Perfect competition

 Perfect Competition 38
Main Hypotheses

In perfect competition
1. There are many (infinite) firms on the market, N→∞, where N is
the number of firms they are small relative to the market and
unable to affect the market price
2. Firms produce a homogeneous good, having access to the same
technology and thus having the same cost curves (i.e., firms sell a
standardize product or substitute products) thus they compete
on price, the only relevant variable
3. In consequence of 1 and 2, firms have no influence over the market
price → They are price-takers
4. Firms can entry and exit the market at no cost, there are no barriers
to the establishment of a new firm. If new firm enter, they incur in the
same costs as the incumbent

5. Perfect information all firms knows about prices and product

characteristics
 Perfect Competition 39
Demand Curve

• If p’ > pe , the firm has no demand

• At the equilibrium price pe , market demand is equal to market supply
• If p” < pe, the firm faces the entire market demand
• But it cannot serve it due to its very limited productive capacity
• Atomistic hypothesis: the firm’s technology allows it to supply just a small
part of the market demand
• If the price of one of the input goes up they still cannot charge a higher price
for its product
 Short Run: Profit Maximization Problem 40

• Given p (price-taking assumption), each firm offers the quantity that

maximizes its profit
max  ( y ) = R( y ) − C ( y ) = py − C ( y )
y 0

• First and second order conditions for profit maximisation

 ( y )
(i )
y
= p − MC ( y ) = 0 p = MC ( y * )
 2 ( y) d
(ii ) = ( p − MC ( y ) ) = −
dMC ( y )
 0 at y = ys* dMC ( y * )
0
y 2
dy dy dy

The second order condition states that MC is increasing

The firm offers the quantity at

which the MR of producing
that quantity equals the MC
In perfect competition,
marginal revenue is equal
to price, thus p=MC
 Short Run: the shut down 41

We have to compare the y*>0 solution with the no production case (y=0)
• The firm’s profit function is  s ( y ) = py − C ( y ) = py − F − VC ( y )
• If the firm chooses y = 0 then its profit is
 ( y ) = 0 − F − VC (0) = − F

• The firm chooses an output y>0 only if

VC ( y )
 ( y ) = py − F − VC ( y )  − F py − VC ( y )  0 p
y
= AVC ( y )

• If p > AVC(y) → y* > 0

the firm has a positive production level

• If p < AVC(y) → y* = 0
the firm shut-down, producing no output

In the short run firms maximize profit by

setting p=MC provided that p is higher then
the minimum value of AV
Short Run: Economic profits and losses 42

In the short run, firms in perfect competition can make economic profits or
report losses
 Short Run: Industry Supply 43

The total quantity supplied in the industry at the market price is the sum of
quantities supplied at that price by each firm
• The short-run industry supply is N
S ( p) =  Si ( p)
i =1
Where N is the number of firms, i = 1, … , N, which is temporarily fixed in the
short-run, and Si(p) is the firm i’s supply function
 Long Run: Profit Maximization Problem 44

• In the long-run, all inputs are variable, thus, the cost C(y) of producing
y units of output consists only of variable costs. The firm’s long-run
profit function is
 ( y ) = py − C ( y )

max ( y ) = py − C ( y )
• The profit maximization problem is y 0

p = MC ( y ) and
• The first and second order conditions are
dMC ( y )
0
dy
• Additionally, the firm must not report losses otherwise it would exit
the industry. So
 ( y )= py − C ( y )  0
C ( y)
p  = AC ( y )
y
 Long Run: Industry Supply 45

The industry long run supply function is the sum of firms’ supply function.
In the long run, firms in the industry are free to exit and firms outside the
industry are free to enter, this dynamic causes N to vary. Specifically:
• Firms enter when incumbents gain economic profits and this happens when
p> min AC(y) → N increases
• Entry increases industry supply, p falls causing some firms to make losses
and exit the industry → N decreases

The process ends when the long-run

market equilibrium price emerges
pe=min AC(y), thus firms make zero
profit, this defines the number of firms
in the industry in the long run
 46

A.2.2. Monopoly
 Monopoly 47

• There is one firm in the industry, which faces the market demand as
its unique constraint
• What causes monopolies
▪ A legal permission (e.g., the salt monopoly)
▪ A patent (e.g., on a new drug)
▪ Sole ownership of a resource (e.g., a toll highway)
▪ The formation of a cartel (e.g., OPEC)
▪ Control over key inputs
The monopolist wants to maximize its economic profit

max  ( y ) = r ( y ) − C ( y ) = p( y ) y − C ( y )
y

• It produces the output y*, at which marginal revenue equals marginal

cost
( )
MR y * = MC y * ( )
 Monopoly 48
Graphical overview

• Marginal revenue MR(y) is the change in revenues for one unitary

change in output
• At the profit-maximizing output y*, MR(y*) = MC(y*)

Profit max: MR=MC

Total revenue: P*Q
Total costs: ATC*Q
Profit: TR-TC
 Monopoly Price and demand Elasticity 49

It is possible to express the profit maximizing condition in monopoly

in terms of demand elasticity
𝑝 − 𝑀𝐶 1
=−
𝑝 𝜀
The monopolist
• Can charge a higher price the lower the demand elasticity
• Has market power (as p>MC) and this market power is higher the
lower the demand elasticity
 Monopoly vs. Perfect competition 50

Compared to perfect competition (where the price is equal to marginal cost),

the monopoly offers a lower quantity at a higher price (p>MC)
• This leads to the MONOPOLY DEAD-WEIGHT LOSS