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• Marginal utility is the added satisfaction that a consumer gets from having one more unit of a good or service. The concept of marginal utility is used by economists to determine how much of an item consumers are willing to purchase.
• A consumer is in equilibrium when given his tastes, and price of the two goods, he spends a given money income on the purchase of two goods in such a way as to get the maximum satisfaction, According to Koulsayiannis, “The consumer is in equilibrium when he maximises his utility, given his income and the market prices.”
• As shown in Figure, the horizontal line Px shows the constant utility of money, and MUx curve represents the diminishing marginal utility of a good. The intersection of MUx and Px curve takes place at E that is when the quantity consumed is OQx, then MUx=Px(MUm).
• Thus, consumer achieves equilibrium at E. Above point E, MUx > Px(MUm) implying that a consumer increase the consumption of good as utility achieved is more. At point R, consumer gains MU as RC where the cost incurred is TC. Thus, the marginal gain is RT and this situation exists till a consumer reaches point E.
• If we look at the point below point E, where MUx < Px (MUm), a consumer would consume more than OQx and loses utility. Thus, satisfaction is increased by reducing the consumption. Therefore, point E is the equilibrium point.

• An indifference curve, with respect to two commodities, is a graph showing those combinations of the two commodities that leave the consumer equally well off or equally satisfied—hence indifferent—in having any combination on the curve.
• An indifference curve maps the consumption bundles that the consumer views as equal. The consumer is equally as happy to consume at any point along the indifference curve. One can also refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer.
• The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity bundles. Graphically, the indifference curve is drawn as a downward-sloping convex to the origin.
• The above diagram shows the U indifference curve showing bundles of goods A and B. To the consumer, bundles A and B are the same as both of them give him equal satisfaction. In other words, point A gives as mu as point B to the individual. The consumer will be satisfied at any point along the curve assuming that other things are constant.
• The slope of the indifference curve is the marginal rate of substitution (MRS).
• The MRS is the amount of a good that a consumer is willing to give up for a unit of another good, without any change in utility. If the consumer values apples, for example, the consumer will be slower to give them up for oranges, and the slope will reflect this rate of substitution.

Hence, the slope of the Indifference curve represents the marginal rate of substitution between two goods.

An indifference curve is a graph showing a combination of two goods that give the consumer equal satisfaction and utility.

Each point on an indifference curve indicates that a consumer is indifferent between the two and all points give him the same utility.

• People seek the highest level of utility, which means that they wish to be on the highest possible indifference curve. However, people are limited by their budget constraints, which show what tradeoffs are actually possible. The solution to this problem, i.e. the combination of goods and services that will maximize an individual’s total utility given their budget, is called the consumer equilibrium. The consumer is in equilibrium when he maximizes his utility, given his income and the market prices.
• A budget line is a graphical representation of various combinations of two goods that a consumer can afford at specified prices of the products at a particular income level. A budget line can be drawn on the basis of the expenditure plan.
• Consumer equilibrium exists at the point on the indifference curve where the budget line is tangent to the curve. Thus, at the equilibrium point, the slope of the budget line is equal to the slope of the indifference curve.

Increase in price of factors of production- If the price of inputs increases the supply curve will shift left as sellers are less willing or able to sell goods at any given price. Inputs include land, labor, energy, and raw materials.

Number of suppliers: As more firms enter the industry the market supply curve will shift out driving down prices. The market supply curve is the horizontal summation of the individual supply curves. Similarly, a decrease in the number of firms in the market will bring down the supply making prices more competitive. Fewer sellers less product in the market.

An increase in the price of a competing good will reduce the supply and make the prices more competitive. Sellers would prefer to sell fewer goods and higher prices and make more profit.

Improvement in technology may in fact aid in the production and might just be a cause of greater supply. When a firm discovers a new technology that allows it to produce at a lower cost, the supply curve will shift to the right as well. A technological improvement that reduces costs of production will shift supply to the right, causing a greater quantity to be produced at any given price. The most significant factories in the state of technology. If there is a technological advancement related to the production of the goods, the supply increases.

Other related factors are

• Good’s own price: An increase in price will induce an increase in the quantity supplied.
• Prices of related goods: For purposes of supply analysis, related goods refer to goods from which inputs are derived to be used in the production of the primary good.
• Expectations: Sellers’ expectations concerning future market conditions can directly affect supply.
• Government policies and regulations: Government intervention can take many forms including environmental and health regulations, hour and wage laws, taxes, electrical and natural gas rates and zoning and land use regulations. These regulations can affect a good supply.

Key Points 

Under perfect competition, a demand curve of the firm is perfectly elastic because the firm can sell any amount of goods at the prevailing price. So even a small increase in price will lead to zero demand. This indicates that the firm has no control over price.

Perfect competition in an industry structure is when, there are many firms, none large enough to influence the industry, producing homogeneous products. Firms are price takers. There are no barriers to entry. Agriculture comes close to being perfectly competitive.

Perfect competition leads to the Pareto-efficient allocation of economic resources. Because of this, it serves as a natural benchmark against which to contrast other market structures. However, in practice, very few industries can be described as perfectly competitive.

A perfectly competitive market has several important characteristics:

• All producers contribute insignificantly to the market. Their own production levels do not change the supply curve.
• All producers are price takers. They cannot influence the market. If a firm tries to raise its price consumers would buy from a competitor with a lower price instead.
• Products are homogeneous. The characteristics of a good or service do not vary between suppliers.
• Producers enter and exit the market freely.
• Both buyers and sellers have perfect information about the price, utility, quality, and production methods of products.
• There are no transaction costs. Buyers and sellers do not incur costs in making an exchange of goods in a perfectly competitive market.
• Producers earn zero economic profits in the long run

Short run refers to that time period in which the supply of certain factors is fixed i.e. it cannot be increased or decreased. For e.g. plant, machinery, building etc. Therefore, a firm can increase the production of a commodity in the short run, by increasing the use of variable factors such as labor and raw materials.

For example, a firm wants to increase the production of books from 1000 to 2000 daily. To do so, it will need more factors of production. But, there are some factors whose supply cannot be increased immediately e.g. printing press, building, etc. Therefore, the firm will have to use those factors whose quantity can be increased immediately such as labour, raw material etc. In the given example, printing press and building are fixed factors of production, labour and raw material are variable factors of production.

Key Points

• The production function is differently defined in the short run and in the long run. This distinction is extremely relevant in microeconomics. The distinction is based on the nature of factor inputs.
• Those inputs that vary directly with the output are called variable factors. These are factors that can be changed. Variable factors exist in both, the short run and the long run. Examples of variable factors include daily-wage labour, raw materials, etc.
• On the other hand, those factors that cannot be varied or changed as the output changes are called fixed factors. These factors are normally characteristic of the short run or short period of time only. Fixed factors do not exist in the long run.
• Consequently, we can define two production functions: short-run and long-run. The short-run production function defines the relationship between one variable factor (keeping all other factors fixed) and the output. The law of returns to a factor explains such a production function.

Elastic demand will mean that when price increases, demand will fall by a greater percentage than the price increased. This means a fall in revenue.

• The degree of elasticity of demand helps in defining the shape and slope of a demand curve. Therefore, the elasticity of demand can be determined by the slope of the demand curve. The flatter the slope of the demand curve, the higher the elasticity of demand.
• When demand is perfectly elastic (or elasticity of demand is infinity), equilibrium price remains unchanged with an increase or decrease in supply. When demand is perfectly elastic, buyers will only buy at one price and no other.
• Perfectly elastic demand is a theoretical concept and cannot be applied in a real situation. However, it can be applied in cases, such as a perfectly competitive market and homogeneity products. In such cases, the demand for a product of an organization is assumed to be perfectly elastic.
• From an organization’s point of view, in a perfectly elastic demand situation, the organization can sell as much as it wants as consumers are ready to purchase a large quantity of products. However, a slight increase in price would stop the demand.
• Hence, if elasticity of demand is infinity, equilibrium price remains the same no matter supply increases or decreases.

The law of variable proportions is as follows:

“If a producer increases the units of a variable factor while keeping other factors fixed, then initially the total product increases at an increasing rate, then it increases at a diminishing rate, and finally starts declining."

The reason behind the law of variable proportion is the following.

As we hold one-factor input fixed and keep increasing the other, the factor proportions change. Initially, as we increase the amount of the variable input, the factor proportions become more and more suitable for the production and marginal product increases. But after a certain level of employment, the production process becomes too crowded with the variable input and the factor proportions become less and less suitable for the production. It is from this point that the marginal product of the variable input starts falling.

The Average Cost is the per-unit cost of production obtained by dividing the total cost (TC) by the total output (Q). 

The average cost is expressed as:

AC = TC/Q

Marginal Cost

In economics, marginal cost is the change in the total cost when the quantity produced changes by one unit. It is the cost of producing one more unit of a good. Marginal cost includes all of the costs that vary with the level of production. For example, if a company needs to build a new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being produced. Economic factors that impact the marginal cost include information asymmetries, positive and negative externalities, transaction costs, and price discrimination. Marginal cost is not related to fixed costs. An example of calculating marginal cost is: the production of one pair of shoes is $30. The total cost for making two pairs of shoes is $40. The marginal cost of producing the second pair of shoes is $10.

Average Cost

The average cost is the total cost divided by the number of goods produced. It is also equal to the sum of average variable costs and average fixed costs. Average cost can be influenced by the time period for production (increasing production may be expensive or impossible in the short run). Average costs are the driving factor of supply and demand within a market. Economists analyze both short run and long run average cost. Short run average costs vary in relation to the quantity of goods being produced. Long run average cost includes the variation of quantities used for all inputs necessary for production.

Relationship Between Average and Marginal Cost

Average cost and marginal cost impact one another as production fluctuate:

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• When the average cost declines, the marginal cost is less than the average cost.
• When the average cost increases, the marginal cost is greater than the average cost.
• When the average cost stays the same (is at a minimum or maximum), the marginal cost equals the average cost.

Some of the major differences between Average Cost vs Marginal Cost:

• Average cost is nothing but the Total cost divided by the number of units manufactured which shows the result as per unit cost of the product, whereas Marginal cost is extra cost generated while producing one or some extra unit of products and it is calculated by dividing the change in total cost with Chang in total manufactured unit.
• Marginal cost considered all cost which fluctuates during the level of production and fixed cost remain constant up to a certain level of production, whereas Average cost considered Fixed cost and Variable cost. In Average cost, both Fixed and Variable cost is product cost whereas in margin cost Fixed cost is considered as period costs and Variable cost is product cost.
• Average cost calculates the effect on total unit due to change in output level whereas marginal cost is calculated to find out if producing one extra unit of product is profitable or not.
• Average cost method also called a weighted average method and Marginal cost method is also called as variable costing.
• Both average cost vs marginal cost is measured under the same units and obtain the result from Total cost.
• If an objective is to increase profit during production level than the marginal cost technique is useful and when an objective is to reduce cost during production level, in that case, the Average cost technique is used$.

Perfect Competition: Perfect competition or pure competition (sometimes abbreviated to PC) is a type of market structure. It is important to note that this form of market structure does not actually exist in the real world and is thus considered to be theoretical.

In a perfectly competitive market:

• There are very many small firms
• All of these firms sell the same homogeneous product, often classified as a commodity
• There are no barriers to entering or exiting the market
• Both producers and consumers have perfect knowledge (for the present, as well as the past and future) regarding the nature and price of the product for sale from each firm
• All firms in the market are price takers, meaning they do not have the power to affect the price of the goods they sell
• Transportation for goods is affordable and efficient
• There are no government controls on the market.

Perfect Competition Short Run Equilibrium Loss Making:

• In the diagram above, the firm is making a Loss.
• We can intuitively tell it makes a loss because its average costs are higher than the average revenue.
• In the Perfect Competition short-run, the firm will continue to produce if he can recover the average variable cost, as fixed costs are paid regardless of production.

​Therefore, under perfect competition and short run , a firm would continue to produce provided it is able to recover its variable costs.