ZCAS UNIVERSITY

BACHELOR OF ECONOMICSAND FINANCE/BACHELOR OF ECONOMICS

BEF/BEC/BDF/BBF/BFI 131: INTRODUCTION TO MICRECONOMICS

FIRST YEAR

FIRST SEMESTER

Author: Chilinda Munthali Muya

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system, or transmitted in any form or by any means, electronic or mechanical,
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TABLE OF CONTENTS

1.0 INTRODUCTION.........................................................................................................................6
1.2 MODULE AIM.............................................................................................................................6
1.3 OBJECTIVES.....................................................................................................................................6
1.4 ASSESSMENT DETAILS............................................................................................................7
1.5 READINGS...................................................................................................................................7
1.5.1. Prescribed Reading...............................................................................................................7
1.6 TIME FRAME..............................................................................................................................7
1.7 STUDY SKILLS............................................................................................................................8
1.8 NEED HELP?................................................................................................................................8
2.0 UNIT ONE: THE STUDY AND METHODOLOGY OF MICROECONOMIS.......................9
2.1 INTRODUCTION.......................................................................................................................9
2.2 AIM.............................................................................................................................................9
2.3 OBJECTIVES.............................................................................................................................9
2.4 TIME REQUIRED......................................................................................................................9
2.5 REFLECTION............................................................................................................................9
2.6 READINGS..........................................................................................................................10
2.7 Defining Economics...............................................................................................................10
2.11 ACTIVITIES...........................................................................................................................24
3 UNIT TWO: DEMAND AND SUPPLY..............................................................................................26
3.1 INTRODUCTION.........................................................................................................................26
3.2 AIM......................................................................................................................................26
3.3 OBJECTIVES...............................................................................................................................26
3.4 TIME REQUIRED.........................................................................................................................26
3.5 REFLECTION.........................................................................................................................26
3.6 READING....................................................................................................................................27
3.7 Demand.....................................................................................................................................27
3.8 Supply........................................................................................................................................29
3.9 CONSUMER AND PRODUCER SURPLUS.....................................................................................33
3.10 government intervention..........................................................................................................34
3.11 ACTIVITIES...............................................................................................................................39
3.12 SUMMARY...............................................................................................................................40
4 UNIT THREE: ELASTICITIES OF DEMAND AND SUPPLY................................................41
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 4.1 INTRODUCTION.....................................................................................................................41
4.2 AIM.......................................................................................................................................41
4.3 OBJECTIVES.......................................................................................................................41
4.4 TIME REQUIRED................................................................................................................41
4.5 REFLECTION......................................................................................................................41
4.6 READINGS..................................................................................................................................41
4.7 Elasticity of demand..................................................................................................................42
4.8 Cross price elasticity of demand............................................................................................44
4.9 Income elasticity of demand..................................................................................................45
4.10 Price elasticity of supply.....................................................................................................46
4.11 ACTIVITIES.......................................................................................................................46
4.12 SUMMARY........................................................................................................................46
5 UNIT FOUR: CONSUMER CHOICE THEORY.......................................................................................48
5.1 INTRODUCTION.........................................................................................................................48
5.2 AIM............................................................................................................................................48
5.3 OBJECTIVES...............................................................................................................................48
5.4 TIME REQUIRED.........................................................................................................................48
5.5 REFLECTION...............................................................................................................................48
5.6 READINGS..................................................................................................................................48
5.7 Concept of utility.......................................................................................................................49
5.8 The budget and indifference curves..........................................................................................53
5.8.1 Utility maximization and choice.............................................................................................54
5.8.2 Adjustments to income changes...........................................................................................55
5.9 Adjustments to price changes...................................................................................................56
5.10 ACTIVITIES...............................................................................................................................59
5.11 SUMMARY...............................................................................................................................60
5 UNIT FIVE: THEORY OF THE FIRM................................................................................................61
6.1 INTRODUCTION.................................................................................................................61
6.2 AIM.......................................................................................................................................61
6.3 OBJECTIVES.......................................................................................................................61
6.4 TIME REQUIRED................................................................................................................61
6.5 REFLECTION......................................................................................................................61
6.6 READINGS..........................................................................................................................61
6.7 production............................................................................................................................62

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 6.8 Short run costs.......................................................................................................................64
6.9 Revenue.................................................................................................................................69
6.10 ACTIVITIES.......................................................................................................................73
6.11 SUMMARY........................................................................................................................74
6 UNIT SIX: PERFECT COMPETITION...............................................................................................75
7.1 INTRODUCTION.....................................................................................................................75
7.2 AIM...........................................................................................................................................75
7.3 OBJECTIVES...........................................................................................................................75
7.4 TIME REQUIRED....................................................................................................................75
7.5 REFLECTION..........................................................................................................................75
7.6 READINGS..............................................................................................................................75
7.7 The determinants of market structure........................................................................................76
7.10 ACTIVITIES...............................................................................................................................85
7.11 SUMMARY...............................................................................................................................85
7 UNIT SEVEN: IMPERFECT COMPETITION.....................................................................................86
8.1 INTRODUCTION.........................................................................................................................86
8.2 AIM............................................................................................................................................86
8.3 OBJECTIVES...............................................................................................................................86
8.4 TIME REQUIRED.........................................................................................................................86
8.5 REFLECTION...............................................................................................................................86
8.6 READING....................................................................................................................................87
8.7 Monopoly..................................................................................................................................87
8.8 Monopolistic competition.........................................................................................................93
8.9 Oligopoly...................................................................................................................................95
8.10 Game theory...........................................................................................................................97
8.11 ACTIVITIES...............................................................................................................................99
8.12 SUMMARY...............................................................................................................................99
8 UNIT EIGHT: LABOUR MARKET..................................................................................................100
9.1 INTRODUCTION.......................................................................................................................100
9.2 AIM..........................................................................................................................................100
9.3 OBJECTIVES.............................................................................................................................100
9.4 TIME REQUIRED.......................................................................................................................100
9.5 REFLECTION.............................................................................................................................100
9.6 essential reading...............................................................................................................101

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 9.7 Demand for labour............................................................................................................101
9.8 Supply for labour.....................................................................................................................103
9.9 ACTIVITIES...............................................................................................................................105
9.10 SUMMARY.............................................................................................................................105
10 UNIT NINE: WELFARE ECONOMICS.......................................................................................106
10.1 INTRODUCTION.....................................................................................................................106
10.2 AIM........................................................................................................................................106
10.3 OBJECTIVES...........................................................................................................................106
10.4 TIME REQUIRED.....................................................................................................................106
10.5 REFLECTION...........................................................................................................................106
10.6 READINGS..............................................................................................................................107
10.7 EQUITY AND EFFICIENCY.......................................................................................................107
10.8 Distortions.............................................................................................................................108
10.9 Market failure.......................................................................................................................109
10.10 Externalities and public goods............................................................................................110
10.11 Public goods........................................................................................................................113
10.12 Monopoly............................................................................................................................114
10.13 Imperfect information.........................................................................................................117
10.14 ACTIVITIES.......................................................................................................................118
10.15 SUMMARY........................................................................................................................119

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1.0 INTRODUCTION

Welcome! You are about to embark on the study of microeconomics.

Economics is a discipline which deals with the broad issue of resources allocation. Within it, an ongoing
debate is raging over the question of how best to organise economic activities such that the allocation of resources
will achieve that which society desires. This study exposes all members of society to the consequences of economic
analysis. Economics affects our livelihood as we all make decisions on how our resources can be allocated.

To some of you, economics is not the main area of study and this introductory course is just one of those things
which you have to endure in order to receive the academic qualification. May I remind you that the purpose of an
academic programme is not to tell you what various things are; instead, its aim is to help you develop academic
skills, the most important of which is a creative and critical way of thinking about almost anything. Learning what
things are, will provide you with some knowledge but will not provide you with the skill of analytical thinking.
Therefore, the academic programme has been carefully design to provide students with the necessary exposure to
the more fundamental methods of analysis that will, hopefully, equip you for life with an ability to understand the
broad dimensions of society contribute to it and benefit from it. The implication of this is that the course which you
are now beginning to study is indeed a complex subject. Still, it is our view (and experience) that with patience and
hard work everyone can gain the necessary command over it.

I would therefore strongly advise against picking a single textbook and concentrating one’s effort on it. Instead,
you should conduct your study along the lines and recommendations of this subject guide. In it you will find a well-
focused organisation of the subject which will highlight those things which are deemed to be important. You will
find, on each topic, references to readings from a set of textbooks which will help you understand each topic
through the use of different methods of exposition.

This module has been written in such a way as to make learning more effective and more interesting. It is like
having a personal tutor because you proceed at your own rate of learning and any difficulties you may have are
cleared before you have the chance to practice incorrect ideas or techniques. Read each UNIT carefully and carry
out any instructions or exercise that you are asked to do. In almost every topic, you are required to make a response
of some kind, testing your understanding of the information in the UNIT.

1.2 MODULE AIM

The course introduces students to major principles of economics and business. It also exposes students
to quantitative economics used in solving problems. It further aims to give the students an
understanding of how the economy functions.

1.3 OBJECTIVES

By the end of the course, students should be able to:

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 • Demonstrate knowledge in the key concepts in economics for resource allocation

• Discuss the principles of microeconomics

• Explain how quantitative techniques can be used to resolve economic problems.

• Explain how economics works in society.

1.4 ASSESSMENT DETAILS

One assignment weight 10%

One Test weight 30%
Final exam 60%
Total 100%

1.5 READINGS
1.5.1. Prescribed Reading

1. Begg, D., Fischer, S., Vernasca, G. and Dornbusch, R. (2011) Economics, 10th edition.
London: McGraw-Hill.
2. Hardwick, P. B. Khan, B. and Langmead, J. (2006) Introduction to Modern Economics. London: Longman.
3. Lipsey, R. and Chrystal, A. (2011) Economics, 12th edition. New York: Oxford University press.

RECOMMENDED READING
1. Anderton, A. (2008) Economics, 5th edition. Harlow: Pearson education.
2. Frank, R. H. (2010) Microeconomics and Behaviour, 8th edition. London: McGraw-Hill.
3. Grant, S. J. (2000) Introductory Economics, 7th edition. Harlow: Pearson education.
4. McConnell, C. R., Brue, S. L., Grant R. and Flynn, S. M. (2010) Essentials of Economics, 2nd
edition. London: McGraw-Hill/Irwin.
5. Sloman, J. and Garratt, D. (2010) Essentials of Economics, 5th edition. Harlow: Pearson Education
limited.

1.6 TIME FRAME

You are required to spend a minimum of 150 hours to finish studying the module and attempt all
the activities.

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.

1.7 STUDY SKILLS

For you to be able successfully complete this module, you will need to do the following:

To successfully complete this course you need a minimum of 150 hours. You are expected to spend
at least 30 hours of lecture and 10 hours of seminar on this module. This is equivalent to 3 hours of
lecture and 1 hour of tutorial per week on a full semester at ZCAS. In addition, there shall be arranged contacts
with lecturers from ZCAS from time to time during the course. You are also requested to spend some time reading
additional prescribed and recommended books and/or internet resources.

1.8 NEED HELP?

If you need help on the module, please use the following contacts:

Course Tutor

Email: information@zcas.edu.zm

Zambia Centre for Accountancy Studies (ZCAS University Dedan Kimathi Road, P O Box 35243, Lusaka, Zambia

Tel: +260 1 232093/5, Fax: +260 1 222542

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2.0 UNIT ONE: THE STUDY AND METHODOLOGY OF MICROECONOMIS

2.1 INTRODUCTION
Welcome to Unit 1 of the Introduction to Microeconomics Module! This first unit will introduce you to
the study of economics and how resource allocation is done by society.

2.2 AIM

The aim of this unit is to highlight the importance of microeconomics in our lives as consumers.

2.3 OBJECTIVES
At the end of this unit you should be able to do the following

• Define the fundamental economic problem, and describe an economic good.

• Be able to define and draw the production possibility frontier and the concept of efficiency.
• Be able to define and compute opportunity cost.
• Be able to determine and compute absolute and comparative advantage
• Explain the difference between positive and normative economics;
2.4 TIME REQUIRED

You are required to spend a minimum of 2 hours on this unit as follows with all its activities.

2.5 REFLECTION

Think about the number of things you would want to have to make your living better, think
about the amount of money you earn, can you afford to have all your wants? How then can you
decide to allocate your finances to your unlimited wants? Write your answer in the spaces
provided

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

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2.6 READINGS
Begg et al chap 1 , Lipsey chap 2, Sloman and Garrat, chap 1 , Brue et al chap 1

2.7 Defining Economics

Economics is a study of human behaviour, how they allocate limited resources to their unlimited wants. (Begg et
al, 2011. P3). It is mainly concerned on how society makes choices under the conditions of scarcity of resources.
Economics is about deciding what, how and for whom to produce.

According to Brue et al (2010, p43) a market system will have to decide on the specific types and quantities of
goods to be produced. Therefore only goods and services that are produced at continuing profit will be produced.
The “How” question is a decision based on what combinations of resources and technologies will be used to
produced goods and services, how will the production be organised?

What do you think are human wants?

Biologically human beings need air, water, food, clothing and shelter. But in modern society people desire goods
and services that make their livelihood better what we deem as comfortable e.g. bottled water, plasma TV, iPhones,
burgers and pizzas.

What are the resources available?

Society possesses productive resources such as labour and managerial skills, tools and machinery, land and mineral
deposits that are used in the production of goods and services that satisfy our wants.

Unfortunately, the reality is that our wants exceed the productive capacity of our resources. We have limitless
wants and limited resources. For example the income we have is not enough to buy what we need. Therefore,
scarcity restricts options and demand choices.
Because we can’t have it all we must decide what we will have and what we will forgo.

2.7.1 Microeconomics and Macroeconomics

There are two main approaches to the study of economics, these are microeconomics and macroeconomics.

1. Microeconomics studies individual decisions of economic actors such as consumers and firms about
consumption or production of particular commodities.

2. Macroeconomics emphasizes interactions of the economic actors in the economy as a whole. Therefore,
macroeconomics deals with aggregates economic variables such as national income, gross domestic product
(GDP) etc.

2.7.2 Positive and Normative economics

The advice that economists give can be classified into two broad categories:
1. Normative
2. Positive

Normative advice depends upon a value judgement and it tells others what they ought to do.
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Positive advice is where the adviser is saying, ‘If this is what you want to do, then here are ways of doing it.’
In contrast, positive statements do not involve value judgments. They are statements about what is, was, or will
be; that is, statements that are about matters of fact.
Table 1.1: Examples of Positive and Normative statements
Positive statements Normative statements
Higher interest rates cause people to save People should save more
more
High income tax rates discourage effort Governments should tax the rich to help the
poor
High taxes on cigarettes discourage Smoking should be discouraged
smoking
Road – user charges would increase traffic The tax system should be used to reduce
traffic
People are more worried about inflation Technical change is a bad thing because it
than unemployment puts some people out of work
The burning of fossil fuels is causing Governments should do more to reduce
global warming carbon emissions in order to save the planet
from global warming
Source ; own construct.

It is difficult to have a rational discussion of issues if positive and normative issues are confused.
Much of the success of modern science depends on the ability of scientists to separate their views on what does, or
might, happen in the world, from their views on what they would like to happen.
Distinguishing what is true from what we would like to be, or what we feel ought to be, depends to a great extent
on being able to distinguish between positive and normative statements.
Normative statements depend on value judgments. They involve issues of personal opinion, which cannot be
settled by recourse to facts.
2.7.3 Basic concepts
In economics we have basic concepts that are used to in the communication among economists and also with the
general public. Below are some of these basic concepts
Resources and Scarcity
Scarcity is a fundamental problem faced by all economies because not enough resources - land, labour, capital, and
entrepreneurship - are available to produce all the goods and services that people would like to consume.
Scarcity makes it necessary to choose among alternative possibilities: what products will be produced and in what
quantities.
Opportunity cost
The concept of opportunity cost emphasises scarcity and choice by measuring the cost of obtaining a unit of one
product in terms of the number of units of other products that could have been obtained instead. In economics there
is no ‘‘free lunch’’. According to Sloman and Garratt (2010, p7) making a choice involves sacrifice. You buy
yourself some food, the money spent could have been used to buy something else which you have forgone just to
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buy the food. On the other hand the resources (land, equipment, labour) which have been used to prepare that very
lunch could have been used to produce something else instead. Such sacrifices are what we call opportunity costs.
Opportunity cost is the value of the good, service, or time forgone to obtain something else. To obtain more of one
thing, society forgoes the opportunity of getting the next best thing
The formula for calculating opportunity cost is:
Opportunity cost = What we had to give up
What we got in return
Rational behaviour

The viewpoint that guides individuals to make rational decisions is comparing the marginal benefits and
marginal costs of their actions. Human behaviour reflects rational behaviour. This implies that Individuals
look for and purse opportunities that increase their utility, pleasure, satisfaction. Begg et al (2011, p92)
defines Utility as the satisfaction obtained from consuming a good or service. We allocate our time, energy
and money to maximise our satisfaction. Therefore we weigh our costs and benefits to make rational
(sensible) choices. Consumers are rational on what to buy; firms are rational on what to produce and how to
produce it. Rational behaviour doesn’t mean you cannot make a mistake with your choices but it means
people make decision with some desired outcome in mind. Self -interest does not mean selfishness it means
that each economic unit tries to achieve its own particular goal, which usually requires delivering something
of value to others.( Brue et al , p 38). For example, you want to get a raise on your salary then you would
need to work hard and satisfy the employer’s wants.

The budget line (individuals economic problem)

Having learnt that our wants are limitless and that our resources are limited, consumers have to make a decision on
what to buy and forgo. This is because our wants go beyond our basic needs of food shelter, clothing. The
economic problem can be depicted by a budget line/ budget constraint. Our individual budgets are constrained by
our income. You can only buy what your income can allow you to buy. The budget is also constrained by the prices
of the good and services.

For example you have K 50 and you have two things you would want to buy; apples and note books. Apples are
selling at K2.5 each and books K5 each. The choices you can make are;

• You can decide to spend all your money on apples and you will buy 20 apples and no books bought.

• You can decide to just buy books and you buy 10 books and no apples bought.

• If you only bought apples, you can decide to give up 2 apples so that you can buy a book. You will buy 18
apples remaining with K5 to buy one book at K5 each.

• On the other hand if you bought books only, you may decide to give up one book to buy apples. You will
buy 9 books remain with K5 and buy two apples.
From table 1.2 below we see how we can combine apples and book with the available income of K50. The budget
line shows all the combinations of any two products that can be purchased, given the prices of the products and the
consumers’ income.
Table 1.2 budget line
Units of Units of Total
apples books expenditure
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 price=k (price=k5/uni
2.5/unit t)
)
20 0 20×2.5 +
0×5=50
18 1 18×2.5
+1×5=50
10 5 10×2.5 +
5×5=50
8 6 8×2.5 + 6×5=50
6 7 6×2.5 +7×5=50
4 8 4×2.5 +8×5=50
2 9 2×2.5 + 9×5=50
0 10 0×2.5 +
10×5=50

y=books, x=apples

From the graph every point shows the combination of apples and books, including fractions, which can be bought
with the income of K50. The slope of the graph measures the ratio of the price of apples (pa) to the price of books
(pb), slope = pa/ pb=-(K2.5/K5) = -1/2. Therefore you need to give up one book to get two apples.

All combinations of books and apples on and inside the budget line are attainable from the income available. This
means that whatever combination or point on the budget line and anywhere under the curve is affordable to this
consumer. The combinations on the line exhaust all the available income while the combinations under the curve
leave the consumer with some change. Let’s assume tomorrow you will not be able to find the two goods available
for sell, to maximise your utility you will spend all your income today. Contrary, the combinations above the curve
are not attainable. This means that the consumer cannot afford the combinations above. He/she will need extra
income to afford them but unfortunately K50 is the only available income at the moment.

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Now let us apply the concept of opportunity cost to our example. Remember the definition of opportunity
cost. Therefore in our example, for us to buy the first book we give up 2 apples. We trade off 2apples for a
book. So the opportunity cost of a first book is 2 apples. To obtain the opportunity cost of a second book we
still give up another two apples. Therefore the opportunity cost remains the same for an extra book we buy.
This is what is called constant opportunity cost. This is why we have a constant slope for the budget line. A
straight budget line has a constant slope. Choices are different among consumers, each consumer picks a
combination that is best for them and one that maximises marginal benefit. To get opportunity cost for
buying one apple = what you give up in terms of books/what you gain in terms of apples=1 book/2apples= ½

This means the opportunity coat of buying one apple is ½ the book forgone.

What shifts the budget line? An increase in income moves the budget line upwards or outwards. This is
because your income is now enough to buy you more of both goods. On the other hand a reduction in
income shifts the budget line inwards or downwards. This is because the income is now little.

From our example suppose your income increased to K100. The prices of apples and books remain the same.
How will the new budget line shift?

x -axis =apples

y-axis=books

The budget line shifts upwards. This is because an increase in income makes you afford to buy more of both
goods. With an income of K100 you now are able to buy 20books only or 40 apples only. The combination
of the two goods are now more than before.

This comes to a conclusion that higher budget lines imply higher incomes and lower budget lines implies
lower income.

Homework; Using the example above, answer the following question for each given scenario. Explain the
changes in the movement in the graph.

1. Recalculate the table and draw the graph, assuming that the price of apples increase to Kr4 each while
price of books and income (K5 and K50) remains the same.
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 2. Recalculate the table and draw the graph, assuming that the price of the book reduces to kr3 each and
the price of apples and income (K2.5 and K50) remains the same as before.
3. Recalculate the table and draw the graph assuming that both the price of apples and books increase to
K3/apple and K6/book.

Production Possibility Frontier

Production Possibility Frontier (PPF) or Production Possibility Boundary shows the maximum combinations of
output that the economy can produce using all the available resources (see Figure 1.1)
Let us now look at how society makes decision under scarcity. Society has to decide what goods to produce
and what services to provide. They have to decide what to produce given the limited resources available.
The economic resources available to society are; land, labour, capital and entrepreneurial skills. Economic
resources are all the natural, human and manufactured resources that can be used to produce goods and
services. This may include equipment, tools, machinery, building, farms, factory, agricultural products,
transportation, and all types of labour and mineral resources. All these are called factors of production
(F.O.P).
 Land is all natural resources used in the production such as arable land, forests, mineral and oil deposits and
water resources.
 Labour this involves physical and mental talents of individuals used in the production of goods and services
 Capital is all manufactured aids used in producing consumer goods and services. This includes all factory,
storage, transportation, tools and machinery. The purchase of these goods is what is called investment.
 Entrepreneurial ability. This is a special form of human resource. he innovates, makes decisions, risk bear
Production possibility model;

Under this model we will assume

 Full employment meaning society is using all the resources available in the production process
 Fixed resources-the quantity and quality of F.O.P are fixed.
 Fixed technology the state of technology is constant
 Two goods. Society is only producing two goods i.e. clothing and food.

A production possibility table lists the different combinations of two products that can be produced with a
specific set of resources, assuming full employment.
Table 1.3 production possibility frontier
Type of A B C D E
products
food(hundre 0 1 2 3 4
d thousand)
clothing 10 9 7 4 0
products(tho
usands)

At alternative A all resources are employed to produce clothing and at E all resources are employed to
produce food products. These are very unrealistic extremes, an economy will produce both food products
and clothing as at B, C, and D. As we move from A to E we increase the production of food and giving up
the production of clothing.
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Plotting the data above we have a production possibility curve.

Figure 1.2

y=clothing
x=food products
Each point on the production possibility curve represents some maximum combination of two products that
can be produced if resources are fully and efficiently employed. As you move down the curve society is
shifting resources from the production of clothes to the production of food thus, producing more of food
products and less of clothing and vice versa. The curve is a constraint because it shows the limit of
attainable outputs. Points on the curve are attainable because society uses all the available resources in
production of the two goods. Points under the curve are attainable but are not efficient this is to say that
they are using less of the resources or rather some resources are not fully utilised, thus these points are not
desirable as those on the curve. Points beyond the curve are not attainable with the current available
resources and technology.
Let us apply the principle of opportunity cost on this scenario.

Scenario TWO

At point A society is producing zero units of food and 10 units of clothing. To produce one unit of food
society shifts resources from clothing to food production thus giving up one unit of cloth. Therefore the
opportunity cost of producing the first unit of food is one, which is the unit of cloth forgone. To produce the
second unit of food society gives up 2 units of cloth. The opportunity cost of producing an additional unit of
food is increasing. This is what is called increasing opportunity cost. To have more of food society has to
give up more units of clothes. From the shape of the curve is shows that society must give up greater
amounts of cloth to acquire equal increments of food products.
Why is this so? This is because economic resources are not completely adaptable to alternative uses. Many
resources are better at producing one type of good than at producing others.
Let’s relax the assumption that quantity and quality of resources and technology are fixed. When the amount
of resources changes the PPF shifts positions and the potential maximum output of the economy changes.

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Although resources are fixed at a particular time, over time they increase. For example an increase in labour
and entrepreneur skills due to an increase in population, there’s also a new discovery of mineral resources,
new and many more. The net result is the ability to produce more of both goods. The economy will grow by
expanding its output. This will result in the PPF shifting outwards as in the graph above.
An advancing technology also brings both new and better and improved ways of producing the good.
Therefore economic growth is as a result of increases in supplies of resources, improvement in resource
quality and technological advancement.
OPPORTUNITY COST, ABSOLUTE AND COMPARATIVE ADVANTAGE

When two individuals (or firms and nations) have different opportunity costs of performing various tasks,
they can always increase the total value of available goods and services by trading with one another. The
idea of opportunity cost can provide a reason why individuals trade and why trade can be mutually
beneficial.
Let us consider an example.
We have two individuals’ martin and Natasha. They both can produce two different goods, wheat and cotton
on one acre piece of land.

YIELD PER ACRE OF WHEAT

AND COTTON
MARTIN NATASHA
WHEAT 6 2
COTTO 2 6
N
Martin can produce three times the wheat that Natasha can on one acre of land, and Natasha can produce
three times the cotton. We say that Natasha has absolute advantage in the production of cotton and Martin
has absolute advantage in the production of wheat.
Absolute advantage is when a country/individual uses fewer resources to produce that product than the other
country does. (Begg et al, 2011. P12)

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We suppose that they both use the one acre of land to produce both wheat and cotton. They divide the land
in half to produce the two products; martin will produce 3bushels of wheat and 1 bale of cotton, Natasha
will produce one bushel of wheat and 3bales of cotton.

Cotton

Wheat

They consume exactly what they produce; martin 3wheat and 1cotton and Natasha 1 wheat and 3cotton. This
can be seen from the graph above.
Because both individuals have absolute advantage in the production of one product specialisation and trade
would be of benefit. Martin can specialise in the production of wheat only and Natasha can produce cotton
only and they can exchange in trade.
For martin if he gets the half acre that is used in the production of cotton and uses it to produce wheat. He
will produce 6bushels of wheat. The same applies to Natasha if she uses the half acre of land for wheat to
produce cotton, she will produce 6bushels

YIELD PER ACRE OF WHEAT AND

COTTON
MARTIN NATASHA
WHEAT 6 0
COTTON 0 6

They can trade 2bushels of wheat for 2bales of cotton. This is more than their initial consumption of 3 to 1.

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 Cotton

Wheat

We see from the graph that they are consuming way beyond their budget line. This is what we call gains
from trade. Martin has gain one more bale of cotton and one bushel of wheat. This is as a result of
specialising in the production of a good he has absolute advantage in and trading it for a good he has no
absolute advantage in.. The same applies to Natasha.

A person or a nation has a comparative advantage in the production of a product when it can produce the
product at a lower domestic opportunity cost than can a trading partner. The real cost of producing cotton is
the wheat that is sacrificed to produce it.
To illustrate comparative advantage let us look at this example.

YIELD PER ACRE OF WHEAT AND

COTTON

MARTIN NATASHA
WHEAT 6 1
COTTON 6 3
Martin has absolute advantage in producing both cotton and wheat. This is because he is producing more of
both goods on an acre piece of land than Natasha. Who has comparative advantage?
The opportunity cost of producing wheat by martin is 1bale of cotton.This is because martin is sacrificing
the 6bales of cotton to produce 6bushels of wheat. His opportunity cost of producing cotton is also 1. He is
sacrificing 6bashels of wheat to gain 6bales of cotton.
Natasha’s opportunity cost for producing wheat is 3 bales of cotton. She is sacrificing 3bales of cotton to
produce 1bushel of wheat. Then, her opportunity cost of producing cotton is 1/3 bushel of wheat. She is
sacrificing 1 bushel of wheat to gain 3bales of cotton.
OPPORTUNITY
COST
MARTIN NATASHA
WHEAT 1 3

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 COTTON 1 1/3
The opportunity costs shows that martin has a lower cost in producing wheat and Natasha has a lower cost
in producing cotton. Therefore they can specialize in the product of their advantage.
If they used half the acre to produce both goods, they would consume exactly what the produce.
YIELD PER ACRE OF WHEAT
AND COTTON
MARTIN NATASHA
WHEAT 3 1/2
COTTO 3 1.5
N
They need to specialize in the product of comparative advantage. However Martin will not fully specialize. He will
produce both goods.

YIELD PER ACRE OF WHEAT

AND COTTON
MARTIN NATASHA
WHEAT 4.5 0
COTTON 1.5 3
Martin is willing to sacrifice 1bushel of wheat for 1bale of cotton. He would even be happy if he got more
of cotton for 1 bushel of wheat. As for Natasha she is willing to sacrifice 3bales of cotton to have 1 bushel
of wheat. She would be happy if she could give less cotton for 1 bushel of wheat. Therefore martin will
trade 1 bushel of wheat for 2bales of cotton. Natasha would be happy to give 2bales of cotton for 1 bushel
of wheat.
YIELD PER ACRE OF WHEAT AND
COTTON
MARTIN NATASHA
WHEAT 3.5 1
COTTON 3.5 1
They both gain from trade because they move beyond their production possibility frontier.
The price at which they will trade is 1bushel of wheat for 2bales of cotton. The price of the product is
determined by the opportunity cost of the seller and the buyer.
Sellers < Price < Buyers
opportunity = = opportunity
cost cost
1cotton per Price 3cotton per 1
1wheat wheat
Therefore the number between 3 and 1 is 2 therefore Natasha is happy to give less cotton for one wheat. Martin two
is happy to gain 2 cotton for 1wheat.

Marginal concept
The marginal concept is widely used in economics in a variety of contexts. It generally means one additional unit.
Below are a few examples illustrating how the marginal concept might be used.
a) For example, if an individual has a choice of going for a good meal or going for a good film at a local
cinema. The marginal rate of substitution of meals for films is the quantity of films the consumer must
sacrifice to increase the quantity of meals by one unit without changing total utility

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 b) Marginal productivity of a labour is the increase in total output obtained by employing one more unit of
labour.

2.7.4 Actors in a market economy: households, firms, government, external sector

A market economy is self-organizing in the sense that when individuals (households and firms) act independently
to pursue their own self-interest, responding to prices set on open markets, they produce co-ordinated and relatively
efficient economic activity.

Modern economies are based on the specialization and division of labour, which necessitate the exchange of goods
and services. Exchange takes place in markets both local and international, and is facilitated by the use of money.

Much of economics is devoted to a study of how markets work to co-ordinate millions of individual, decentralized
decisions. Three pure types of economy can be distinguished: command, free market and mixed .

Command economy: Is one in which a government planning office decides what will be produced and for whom
it will be produced. The command economy allows little scope for individual economic freedom.

Free market economy: The free market economy allows individuals to pursue their self – interest without
government restrictions.
Mixed market economy: the government and private sector jointly solve economic problems. The government
influences decision through taxation, subsidies and provision of free services such as defence and police.

In practice, all economies are mixed economies in that their economic behaviour responds to mixes of tradition,
government command, and price incentives. Governments play an important part in modern mixed economies.
Governments create and enforce important background institutions such as private property. Governments
intervene to increase economic efficiency by correcting situations where markets do not effectively perform their
coordinating functions. Governments also redistribute income and wealth in the interests of equity.
2.7.5 Models (static, dynamic and comparative), graphs and maths

In order to address the problems that we face economists have developed an approach that involves developing
theories and building models. These help the economist to understand problems and find realistic and practical
solutions where possible!
Theories are constructed to explain things! These theories are built around definitions, assumptions, and
predictions. They simplify the problem in hand and allow the economist to observe the problem first hand. The
basic elements of any theory are its variables.
A variable is a magnitude that can take on different possible values.
Endogenous and exogenous variables
An endogenous variable is a variable that is explained within a theory. An exogenous variable influences
endogenous variables but is itself determined by forces outside the theory.
Assumptions
A theory’s assumptions concern motives, physical relationships, lines of causation, and the conditions under which
the theory is meant to apply, as well as the direction of causation!
The variable that does the causing is called the independent variable and the variable that is caused is called the
dependent variable.
Predictions
A theory’s predictions are the propositions that can be deduced from it. These propositions are then taken as
predictions about real-world events.
Models
Economists often proceed by constructing what they call economic models. More often, a model means a specific
quantitative formulation of a theory. The term ‘model’ is often used to refer to an application of a general theory in
a specific context.
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Evidence
Economists make much use of evidence, or, as they usually call it, empirical observation. Such observations can be
used to test a specific prediction of some theory and to provide observations to be explained by theories.
Testing the evidence
A theory is tested by confronting its predictions with evidence. Are events of the type contained in the theory
followed by the consequences predicted by the theory?
Generally, theories tend to be abandoned when they are no longer useful. A theory ceases to be useful when it
cannot predict better than an alternative theory. When a theory consistently fails to predict better than an available
alternative, it is either modified or replaced.
Theories about human behaviour
So far we have talked about theories in general. But what about theories that purport to explain and predict human
behaviour?
A scientific study of human behaviour is only possible if humans respond in predictable ways to things that affect
them. Is it reasonable to expect such stability? We humans have free will and can behave in capricious ways if the
spirit moves us. This thus implies human behaviour really is unpredictable! How is it that human behaviour can
show stable responses even though we can never be quite sure what one individual will do?

Successful predictions about the behaviour of large groups are made possible by the statistical ‘law’ of large
numbers. Very roughly, this ‘law’ asserts that (under a carefully specified set of conditions) random movements of
a large number of items tend to offset one another.
Individuals may do peculiar things that, as far as we can see, are inexplicable. But the group’s behaviour will
nonetheless be predictable, precisely because the odd things that one individual does will tend to cancel out the odd
things that some other individual does.

Why do economists often disagree?

When all their theories have been constructed and all their evidence has been collected, economists still disagree
with each other on many issues. There are five possible sources that results in economists disagreeing: Different
benchmarking, Different time frames being used, Lack of knowledge, Different values held by economists, Both
sides of the problem are justified.

Economic data
Economists seek to explain observations made of the real world. Real-world observations are also needed to test the
predictions of economic theories.
Collecting data
Political scientists, sociologists, anthropologists, and psychologists all tend to collect much of the data they use to
formulate and test their theories. Economists are unusual among social scientists in mainly using data collected by
others, often government statisticians.
In economics there is a division of labour between collecting data and using it to generate and test theories. The
advantage is that economists do not need to spend much of their scarce research time collecting the data they use.
The disadvantage is that they are often not as well informed about the limitations of the data collected by others, as
they would be if they collected the data themselves.

Index Numbers
Once data are collected they can be displayed in various ways. Where we are interested in relative movements
rather than absolute ones, the data can be expressed in index numbers. Comparisons of relative changes can be
made by expressing each price series as a set of index numbers. To do this we take the price at some point of
time as the base to which prices in other periods will be compared. We call this the base period.
The formula of any index number is:

Value of index in period t = (value in period t/value in base period) × 100

Index numbers – An example
Price of cocoa and coffee

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 P Period Cocoa Coffee

2001 (Q1) 100.4 146.7

2001 (Q2) 104.5 146.4
2001 (Q3 100.8 129.7
2001 (Q4) 121.8 126.4
2002 (Q4) 149.0 136.6

(average price in each quarter; US cents per kg)

Index numbers as averages

Index numbers are particularly useful if we wish to combine several different series into some average. This can be
done by:

– An un-weighted index

– An output-weighted index

An index that averages changes in several series is the weighted average of the indexes for the separate series,
the weights reflecting the relative importance of each series.

Price indexes

Economists make frequent use of indexes of the price level that cover a broad group of prices across the whole
economy. One of the most important of these is the retail price index, RPI, which covers goods and services that
individuals buy. All price indexes are calculated using the same procedure. First, the relevant prices are collected.
Then a base year is chosen. Then each price series is converted into index numbers. Finally, the index numbers are
combined to create a weighted average index series where the weights indicate the relative importance of each price
series.

Graphing economic data

A single economic variable such as unemployment or GDP can come in two basic forms:

• Cross-section

• Time-series

Scatter diagrams

Another way in which data can be presented is in a scatter diagram. This type of chart is more analytical than
those shown previously. It is designed to show the relationship between two different variables. To plot a scatter
diagram, values of one variable are measured on the horizontal axis and values of the second variable are measured
on the vertical axis.

Any point on the diagram relates a specific value of one variable to a corresponding specific value of the other.

Graphing economic relationships

23 | P a g e
Theories are built on assumptions about relationships between variables.

How can such relationships be expressed?

When one variable is related to another in such a way that to every value of one variable there is only one possible
value of the second variable, we say that the second variable is a function of the first.

When we write this relationship down, we are expressing a functional relationship between the two variables.

A functional relationship can be expressed in words, in a numerical schedule, in an equation, or in a graph.

Functions

Let us look in a little more detail at the algebraic expression of this relationship between income and consumption
spending.

To state the expression in general form, detached from the specific numerical example shown previously, we use a
symbol to express the dependence of one variable on another.

Using ‘f’ for this purpose, we write C = f(Y).

This is read ‘C is a function of Y’. Spelling this out more fully, it reads ‘The amount of consumption spending
depends upon the household’s income.’

The variable on the left-hand side is the dependent variable, since its value depends on the value of the variable on
the right-hand side.

The variable on the right-hand side is the independent variable, since it can take on any value.

Graphing relationships

Different functional forms have different graphs - When income goes up consumption goes up.

In such a relationship the two variables are positively related to each other.

The slope of a straight line

Slopes are important in economics.

They show you how fast one variable is changing as the other changes.

The slope is defined as the amount of change in the variable measured on the vertical or y-axis per unit change in
the variable measured on the horizontal or x-axis.

Maxima and minima

So far, all the graphs we have shown have had either a positive or negative slope over their entire range.

But many relationships change direction as the independent variable increases.

2.11 ACTIVITIES

1. The table shows consumer spending by households and income from 1999 to 2009, both in
millions.
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 UK 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
income 1067 1109 1136 1160 1192 1227 1254 1290 1323 1330 1265
consumption 644 673 695 720 743 767 784 796 815 822 796

A. Plot the scatter diagram with consumption on the vertical axis and income on the horizontal axis.
B. Fit a line through these points.
C. Are consumption and income related?
D. What is the equation of the line?

2.12 SUMMARY

In summary you have learnt these key concepts

 Economics analyses what, how and for whom society produces. It is the study of how
limited resources are allocated amongst unlimited wants.
 Microeconomics is the study of small units such as individuals, firm, market and an
industry. Macroeconomics is the study of aggregated units on the economy.
• The production possibility curve or frontier shows the maximum amount of one good that can be
produced given the output of the other good.
• The opportunity cost of a good is the quantity of the other goods sacrificed to make an additional unit of
the good. It is the slope of the PPF
• A country enjoys an absolute advantage over another country in the production of a product if it uses
fewer resources to produce that product than the other country does.
• A country enjoys a comparative advantage in the production of a good if that good can be produced at a
lower cost in terms of other goods.
In the next chapter you will look at how you make a choice of the amount of a good given its own price, price
of amount good, your income levels and many other factors.

25 | P a g e
 3 UNIT TWO: DEMAND AND SUPPLY

3.1 INTRODUCTION

In this unit we will learn how individuals demand and the supply for a particular good will
determine the price at which the good will be sold in the market.

3.2 AIM

The aim for this unit is to introduce you to; The law of demand and supply , the factors that
affect how much of a good you will purchase and consume and the concept of equilibrium
price and quantity.

3.3 OBJECTIVES

At the end of this unit you should be able to do the following

• Define and apply the law of demand and supply

• Draw the demand and supply curves

• Shift the demand and supply curves depending on the factors influencing equilibrium

• To explain the difference between quantity demanded and demand

3.4 TIME REQUIRED

This unit should take you at least 2hours to complete.

3.5 REFLECTION

Think of how much of a good you would buy if its price fell or rose? Write your answer in the
spaces provided

………………………………………………………………………………………………
………………………………………………………………………………………………
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 ………………………………………………………………………………………………

3.6 READING
Begg et al chap 3 , Sloman and Garrat, chap 2 , Brue et al chap 3

3.7 Demand
Demand is a schedule or a curve that shows the various amounts of product that consumers will purchase at
each of the several possible prices during a specified period of time. Quantity demanded is the amount
consumers are willing and able to buy at a given price over a period of time. From our example on the
budget line we can draw up demand for that consumer at different prices. As we change the prices of either
apples or books the quantity bought also changes. Thus, the law of demand states that as prices falls,
holding all other things equal or constant, the quantity demanded rises and as prices rise the quantity
demanded falls. This is an inverse relationship. Why are we holding other things equal or constant? There
are many factors that affect the demand of goods purchased. but for now we look at just prices. What other
things do you think will affect the quantity purchased? There are two reasons for this law;

1. People will feel poorer. They will not be able to buy much of the goods with their income. Their purchasing
power will go down and this is what is called the income effect of price rise. Purchasing power is the
amount of goods you can buy in the income available.
2. In comparison to other goods related to it, it will be more expensive and people will switch to alternative
products. This is the substitution effect.

QUESTION. How do you think people will react in the case of a fall in price?

We look at an example.

The table below shows the how many kilos of potatoes per month will bought at various prices. We have
demand schedules for Tracey, Darren and a market demand. The market demand is the total demand for
Tracey and Darren and everyone else in the market.
Price per Tracey’s deman Darren’s Total market
kilo (kilos) d demand(kilos)
demand(tonnes)

A 20 28 16 44

B 40 15 11 26

C 60 5 9 14

D 80 1 7 8

E 100 0 6 6

We plot the market demand and we have the following;

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 PRICE PER KILO

QUANTITY
DEMANDED
The graph is downward sloping showing the inverse relationship that quantity demanded has with price.
From the graph we start at point E where at k100 the total demand is 100 going down the graph prices are
falling and quantity demanded is increasing.

Determinants of demand.

What are the other factors that affect demand?

1. Tastes/preference. Taste is affected by advertising, fashion, observing, health consideration and experiences
of consuming the good. The more desirable people find the product the more they will demand for it.
Therefore a change (let’s say, a favourable change) in a consumers taste, the demand for that commodity
will increase at each price. Thus, the demand curve will shift outwards. The reverse is true.
2. The number of buyers. An increase in the number of buyers increase the amount demanded at each price.
The individual demand curve is not affect by the number of consumers but the market demand curve will
shift outwards.
3. The number and price of related goods. There are four types of good; substitute goods, complementary
goods, normal goods and inferior goods. Substitute goods are goods which are considered by consumers
as alternatives to each other e.g coffee and tea. As the price of one goes up, the demand for the other rises.
Complementary goods are goods which are consumed together e.g bread and butter. As the price of one
goes up the demand for both goods reduces.
Therefore demand is affected by the number and the price of substitute and complementary goods. If the
price of a good rises, consumers will buy more of a substitute good and less of that good, thus, the demand
curve will shift downwards. In reverse a rise in price of a substitute good will increase the demand of the
good in question and the demand curve will shift outwards. For a complementary good a rise in price will
shift the demand for both goods downwards.

4. Income. As peoples income rise, their demand for the good will either rise or fall depending whether the
good is normal or inferior. Normal goods are goods whose demand rises as income increases. And
inferior goods are goods whose demand fall as income increases. For a normal good the demand curve
will shift outwards and inferior good it will shift inwards.
5. The distribution of income also affects demand. The poor demand for inferior goods because they cannot
afford luxury goods but if income was redistributed from the rich to the poor, the demand for luxury goods
will increase.
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6. Expectations of future price changes. If people thought that the price of a good will rise in the near future,
they will buy more of that good now before it goes up.
7. Advertising; a successful advertising campaign increases the demand for a product or service

3.8 Supply
We start with an illustration.
Let’s suppose you are a farmer and you have a piece of land which you wish to use to produce crops for sell.
Your decision of what crop to grow will depend on the price of the commodity in the market. If you notice
that the price of apples is high you will plant cotton. And if the price gets higher you will increase the
production of apples. This illustrates the relationship between supply and price. When the price of a
commodity rises, the quantity supplied increases. This is because as output increase beyond a certain level,
costs raise more and more rapidly, thus the price has to rise so that it is worth to produce more and incur the
higher costs. It has to be profitable for the producer. And when it is profitable more people will also be
encouraged to produce the good and thus the market supply will increase.

Let us consider the table below. The table shows the quantity of apples that will be supplied at different
prices for an individual supplier and market supply.

Price/kilo Farmer x’s Market

supply supply
A 20 50 100
B 40 70 200
C 60 100 350
D 80 120 530
E 100 130 700

y=price/ki lo x=quantity supplied

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 The market supply curve is the total individual supplies in the market. From the graph the supply curve is
upward sloping showing that as prices rise quantity supplied also increases.

There are other factors that affect the supply of a commodity. These are;
1. Cost of production. The higher the cost of producing a good the less profitable it is at any price. Thus
producers will cut back on production and shift to producing goods with lower costs. Costs change because
of input prices such as wages, raw material prices, rent, interest rate etc.; changes in technology,
organisational changes and government policies such as subsidies and tax.
2. Profitability of alternative products. If some alternative products become more profitable to supply than
before, producers will shift resources to produce that good. The goods become profitable if their prices rise.
This is what are called substitute good. Substitute goods are two goods where an increase in production of
one good means diverting resources away from producing it. Thus supply of the first good fall and shifts the
curve inwards. There are good that are produced together e.g. sugar and molasses. An increase in
profitability of sugar will increase the production of both sugar and molasses thus shifting the supply curve
outwards.
3. Expected prices changes. When prices are expected to rise, producers may reduce the amount they sell so
that they increase the stock and sell when the prices go up.
4. Number of seller. A greater number of sellers in the market will increase the supply of the good.
5. Nature, random shocks and unpredictable events. These may include weather, disease affecting farm
outputs, war, earthquakes, breakdown of machinery.
Market equilibrium

Now we see how the decisions of a consumer and a buyer will interact to determine the price and quantity
they will both be happy with. We are assuming that no buyer or seller can set the price. We get the two
examples for apples. The table shows the total market demand and supply.
Price Total market total Market
per demand(tonnes) supply(tonnes)
kilo
20 700 100
40 500 200
60 350 350
80 200 530
100 100 700

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 price

Quantity
demanded
y=price/kilo

x=quantity demanded

From the graph if we start with price k20, consumers demand 700 while suppliers supply 100. There is too
much demand that suppliers cannot supply at that price. This is called excess demand With this situation
consumers will be willing to pay a higher price and producers are willing to accept a higher price.
Therefore, the shortage in the market will drive the price up. The price will continue to rise, demand will fall
and supply will increase until there is no more shortage at price 60. .If we start at price k100 consumers will
only demand 100tonnes and suppliers will supply 700 but this is too much for the market. This is called
excess supply. There will be excess goods on the market. The farmers will start to compete with themselves
and drive the price down to capture consumers. As the price fall the demand will increase and supply will
reduce until at price 60 where both demand and supply are equal. Thus the market will clear, there will not
be any excess supply neither will demand be too much. This is what is called the equilibrium price.

The area above the equilibrium is excess supply while the area below equilibrium is excess demand.

Change in equilibrium

Now let’s put into play changes in demand and supply due to other factors.

A change in demand.

We assume there is an increase in the consumers’ income. The demand curve will shift outwards to the right.

At price k60 consumers are now demanding 550 which is more than what suppliers are supplying (350) in
the market. This creates a shortage and consumers will be willing to pay a higher price. Therefore, the new
equilibrium is realised at price 70 and the quantity is 500.

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 price

quantity

A change in supply

We assume there is an improvement in technology advance and it has lowered the cost of production. With
a lower cost of production the producer will now produce more goods. This will shift the supply curve
outwards.

price

quantity

At price 60 there is now excess supply of goods. Consumers are demanding 350 whilest producers are
supplying 550. With this excess supply price will be forced to go down to 45 and quantity to somewhere
between 400 and 500, so lets says 450.

Now let the changes happen at the same time.

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 price

quantity

We have a new equilibrium but the price remains the same although both quantity demanded and supplied
have now increased to 550. This is because the excess supply created by the rise in supply is cleared by the
excess demand created by the rise in income.

We can describe the equilibrium in a given market in a simple mathematical way. Remember demand
function is a relationship between the quantity demanded and the price of a given good or service, keeping
other things equal. The relationship between price and quantity demanded is negative therefore the equation
will take the form;
D
Q =a−bP
where y represents quantity demanded, -m represents the slope of the curve. Its negative because the
demand curve slopes downward. X represents price of the commodity, b is the intercept of the equation.
This is a direct function. And inverse function is when price is on the Y axis.

for the supply curve the quantity supplied has a positive relation with the price of the commodity. Therefore
S
the slope of the supply equation is positive. Q =c+dP

Equilibrium is met determined when demand is equal to supply.

QD =Q S
a−bP=c+dP
(a−c )
P=
b+d
bc +da
Q=
(b+d )

3.9 CONSUMER AND PRODUCER SURPLUS

From market equilibrium we find a measure of gain that consumers and sellers obtain from trading at the
equilibrium price. For consumers the measure of trade gain is called consumer surplus whilst for producers
is called producer surplus.

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Consumer surplus is Equivalent to the difference between the maximum price (reservation price)a
consumer is willing to pay for a good and the actual price paid.it is the net gain from a purchase of a good.
For example, you want to buy a pair of jeans trousers. You are willing to pay K200 for it. If the actual price
of a trouser is K150. When you but it you gain a surplus of K50.

Total consumer surplus = the sum of all consumer surpluses gained by all buyers of a good in the market.

Consumer surplus is measured by the area below the market demand curve and above the equilibrium price.
This willingness to pay is nothing else but the slope of the indifference curve; that is, it is the marginal
utility of X measured in terms of the quantity of Y that would be needed to compensate for a loss of a unit of
X. In that sense, the downward sloping demand schedule represents diminishing marginal utility.

Producer surplus is the difference between the (market) price a seller actually receives and his/her
(seller’s) cost. It is the measure of gain that the sellers obtain from selling a given quantity of a good at
equilibrium price. A seller would not sell below his/her cost, If the market price is below a seller’s cost the
seller will leave the market

3.10 government intervention

Government should intervene in the markets to correct such market failure. it can use price ceiling and
floor, taxes, subsidies, laws and regulations, property rights, direct provisions of goods and services.

Price floor and ceiling

The government or an industry regulator can set a maximum price in an attempt to prevent the market
price from rising above a certain level. One aim of this might be to prevent the monopolistic
exploitation of consumers. This is called price ceiling.

To be effective a maximum price has to be set below the free market price. A price below or at the
ceiling price is legal. Anything above is not legal. the rationale for price ceiling on products is that they
enable consumers to obtain some essential good and services that they could not afford at equilibrium
price.

One example might be when shortage of foodstuffs threatens large rises in the free market price.

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A maximum price seeks to control the price – but also involves a normative judgement on behalf of the
government about what that price should be. An example of a maximum price is shown in the next
diagram.

The normal equilibrium price is shown at Pe – but the government imposes a maximum price of P max.
This price ceiling creates excess demand equal to quantity Q2-Q2 because the price has been held
below the equilibrium.

It is worth noting that a price ceiling set above the free market equilibrium price would have no effect
whatsoever on the market – because for a price floor to be effective, it must be set below the normal
market-clearing price. Price ceiling prevents the usual market adjustments in which competition among
buyers bids up the price, inducing more production and rationing some buyers out of the market.

How do sellers apportion Q2 among consumers?should it be first come first serve basis?should it be on
favoritism?this might not lead to unequitable distribution of resources. Government must establish some
formal system for rationing it to consumers. One way is to give ration coupons, which authorizes
bearers to buy a fixed amout of the good.

Maximum prices and consumer and producer welfare

How does the introduction of a price ceiling affect consumer and producer surplus? This is shown in the
next diagram. At the original equilibrium price consumer surplus = triangle ABPe and producer surplus
equals the triangle PeBC.

Because of the maximum price ceiling, the quantity supplied contracts to output Q2. Consumers gain
from the price being set artificially lower than the equilibrium, but there is a loss of consumer welfare
because of the reduction in the quantity traded. At P max the new level of consumer surplus = the
trapezium ADEPmax. Producer surplus is reduced to a lower level Pmax EC. There has been a net
reduction in economic welfare shown by the triangle DBE.

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Black Markets

A black market (or shadow market) is an illegal market in which the market price is higher than a
legally imposed price ceiling. Black markets develop where there is excess demand for a commodity.
Some consumers are prepared to pay higher prices in black markets in order to get the goods or services
they want.

With a shortage, higher prices are a rationing device.

• Good examples of black markets include tickets for major sporting events, rock concerts and
black markets for children’s toys and designer products that are in scarce supply.
• There is also evidence of black markets in the illegal distribution and sale of computer software
products where pirated copies can often dwarf sales of legally produced software.

Another problem arising from the maintenance of a maximum price is that in the long run, suppliers
might respond to a maximum price by reducing their supply – the supply curve becomes more elastic in
the long term. This is illustrated in the next diagram which looks at the effect of a maximum price for
rented properties.

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If landlords decide that they cannot make a satisfactory rate of return by selling rented properties in the
market because of the maximum price, they might decide to withdraw some properties from the market.
At the maximum rent, the long run supply curve shows a smaller quantity of rented properties available
for tenants – which with a given level of market demand cause the excess demand (shortage) in the
market to increase.

The quality of rented properties might deteriorate over time because landlords decide to cut spending on
maintenance and improvements. The end result would be a loss of allocative efficiency because there are
fewer properties on the market and the quality is getting worse – fewer people’s needs and wants are being
met at the prevailing market price.

Price floor

A minimum price is a price floor below which the market price cannot fall. To be effective the
minimum price has to be set above the equilibrium price.The best example of a minimum price is a
minimum wage in the labour market How does a minimum wage work?

• Employers cannot legally undercut the current minimum wage rate per hour. This applies both to
full-time and part-time workers
• A diagram showing the possible effects of a minimum wage is shown below. The market
equilibrium wage for this particular labour market is at W1 (where demand = supply)
• If the minimum wage is set at Wmin, there will be an excess supply of labour equal to E3 – E2
because the supply of labour will expand (more workers will be willing and able to offer
themselves for work at the higher wage than before) but there is a risk that the demand for
workers from employers (businesses) will contract if the minimum wage is introduced.

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The main aims of the minimum wage

The equity justification: That every job should offer a fair rate of pay commensurate with the skills and
experience of an employee.

Labour market incentives: The NMW is designed to improve incentives for people to start looking for work
– thereby boosting the economy’s labour supply.

Labour market discrimination: The NMW is a tool designed to offset some of the effects of persistent
discrimination of many low-paid female workers and younger employees.

Possible disadvantages of a minimum wage

Although all political parties are now committed to keeping the minimum wage, there are still plenty of
economists who believe that setting a pay floor represents a distortion to the way the labour market
works because it reduces the flexibility of the labour market

• Competitiveness and Jobs: A minimum wage may cost jobs because a rise in labour costs
makes it more expensive to employ people. It will be interesting to observe whether the
minimum wage is said to have caused extra unemployment during the current economic
downturn.

• Effect on relative poverty: Is the minimum wage the most effective policy to reduce relative
poverty? There is evidence that it tends to boost the incomes of middleincome households where
more than one household member is already in work whereas the greatest risk of relative poverty
is among the unemployed, elderly and single parent families where the parent is not employed.

Can a minimum wage actually increase employment?

• The Keynesian argument that higher wage rates will increase the disposable incomes of lower-
paid workers many of whom have a high propensity to consume. Thus they will increase their
spending and this will feed through the circular flow of income and spending
• The efficiency wage argument that raising pay levels for low-paid employees may have a
positive effect on their productivity. In addition to the psychological benefits of being paid more,
38 | P a g e
 businesses may take steps to improve production processes, workplace training etc if they know
that they must pay at least the statutory pay floor.

The importance of elasticity of demand and supply of labour

• The impact of a minimum wage on employment levels depends in part on the elasticity of demand
and elasticity of supply of labour in different industries
• If labour demand is inelastic then the contraction in employment is likely to be less severe than if
employers’ demand for labour is elastic with respect to changes in the wage level.
• In the next diagram we see the possible effects of a minimum wage when both labour demand and
labour supply are elastic in response to a change in the market wage rate.
The excess supply created is much higher than in the previous diagram.

3.11 ACTIVITIES
1. This question is concerned with the supply of oil for
central heating .in each case consider whether there is a
movement along the supply curve(and which direction) or a
shift in it(whether left or right). Use Graphs.

1) New oil fields start up in production.

2) The demand for central heating rises.
3) The price of gas falls.
4) Oil Company anticipates an upsurge in demand for central heating oil.
5) The demand for petrol rises.
6) New technology decreases the cost of oil refining.
7) All oil products become more expensive.

2. Explain the law of demand.

3. Why does a demand curve slope downwards?

4. How is the market demand curve derived from individual demand curves?

5. You are given total demand and supply of wheat.

Quantity Quantity supplied price Surplus or
demanded shortage
85 72 3.4

80 73 3.7

75 75 4

70 77 4.3

65 79 4.6

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 60 81 4.9

a) What is equilibrium price and quantity?

b) Calculate and fill in the shortage or the surplus.
c) What is excess demand and excess supply?

3.12 SUMMARY

In summary you have learnt these key concepts;

• Demand curve represents the willingness and ability of a buyer to purchase a

particular commodity at various prices

• Market demand is the horizontal summation of individuals demand curves

• Changes in any of the determinants of demand will shift the demand curve

• Supply curve shows the amount of a product the producers are willing to supply the market at
various prices.

• Equilibrium price and quantity are determined at the intersection of the supply and demand
curves.
In the next chapter you will look at how consumers make decisions on their consumption.

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 4 UNIT THREE: ELASTICITIES OF DEMAND AND SUPPLY

4.1 INTRODUCTION

This unit will introduce you to the concept of elasticity. You will understand why buyers of some products
respond to price increases by substantially reducing their purchase. And why price increases on some goods
make producers to increase their output while hikes on other products barely cause any output increase.

4.2 AIM
The aim of this unit is to introduce you to the concept of

1. Own price elasticity

2. Cross price elasticity

3. Income elasticity

4. Supply elasticity

4.3 OBJECTIVES

At the end of this unit you should be able to do the following

 describe how elasticities measure the responsiveness of demand and supply

• define and calculate price elasticity of demand
• indicate the determinants of price elasticity
• describe the relationship between demand elasticity and revenue
• recognise the fallacy of composition
• describe how cross-price elasticity relates to complements and substitutes
• define and calculate income elasticity of demand
4.4 TIME REQUIRED

You should be able to spend a minimum of 2hours on this unit.

4.5 REFLECTION
If you heard that the price of fuel, for example, increased by 10%, by how much do you
think the demand for fuel would reduce?

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4.6 READINGS
Begg et al chapter 4, Brue et al, chapter 4 p81-99 , Sloman and Garratt, chapter 3, p 56-80

4.7 Elasticity of demand

In the previous unit you learnt that the quantity of a product demanded will vary inversely to the price of that product.
That is, the direction of change in quantity demanded following a price change is clearly stated. However, what is not
known is the extent by which quantity demanded will respond to a price change.

To measure the responsiveness of the quantity demanded to change in price, we use a measure called price elasticity
of demand. Elasticity is a dimensionless measure of the sensitivity of one variable to changes in another, holding other
variables constant. For some products consumers are highly responsive to price changes. When a small change in
price causes a very large change in quantity demanded, we say demand for the particular good is elastic. When a
substantial change in price causes a small change in the quantity demanded, we say demand is inelastic. This is
because consumers pay less attention to prices changes for the commodity.

The price elasticity of demand is a measure of the responsiveness of quantity demanded to a price change. Own Price
Elasticity of Demand is the percentage change in the quantity demanded relative to a percentage change in its own
price. The formula for elasticity is given as;

%ΔQ
ε=
%ΔP
Q 2 −Q 1
×100
Q1
=
P2 −P1
×100
P1
ΔQ P
¿ ×
ΔP Q
Since price and quantity demanded generally move in opposite direction, the sign of the elasticity coefficient is
generally negative. When you have price Elasticity of -2.72, the Interpretation is; a one percent increase in price
results in a 2.72% decrease in quantity demanded.

Let us work out this example together.

Quantity Q2-Q1 price P2-P1 Ed

1 - 125

2 1 100 -25 (1/-25)*(125/1)= -5

4 2 50 -50 (2/-50)*(100/2)= -2

5 1 10 -40 (1/-40)*(50/4)= -0.3

Elasticity is interpreted in the following way. All values of elasticity will be taken in absolute terms meaning we ignore
the negative sign.

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 When (|ED| < 1): a change in price brings about a relatively smaller change in quantity demanded (ex. gasoline).
This is called Inelastic demand. This makes total Revenue = P×Q to rise as a result of a price increase

 When (|ED| = 1): a change in price brings about an equivalent change in quantity demanded. This is called unitary
elastic demand. Total revenue TR= P×Q remains the same as a result of a price increase
 When (|ED| > 1): a change in price brings about a relatively larger change in quantity demanded (ex. expensive
wine). This is called Elastic demand. Total revenue TR = P×Q falls as a result of a price increase

 Perfectly Inelastic Demand– Quantity demanded does not respond to a change in price. Ed=0. the demand curve is
vertical

 Perfectly Elastic Demand – Quantity demanded will go from 0 to infinity at a particular product price. That is, if
the price isn’t right, 0 is demanded, as soon as the price is right, infinite amounts will be demanded. Ed = ∞

price

Perfect elastic perfect inelastic

The relationship between revenue and price elasticity of a p

Price inelastic demand | ED | < 1 Price elastic demand | ED| > 1

P P
Q Q
TR TR

When demand for a good is inelastic, a fall in the price will result in a small increase in quantity demanded therefore
the revenue realized will be less. But when demand is elastic a small fall in prices results in a huge increase in
quantity demanded therefore, revenue is greater.

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 From the graph above, at point P= a/b, Ed = − ∞; at P = 0, Ed = 0; at P= a/2b, Ed = −1
In the region of the demand curve to the left of the mid-point M, demand is elastic, that is − ∞ ≤ Ed < – 1 . In the region
to the right of the mid-point M, demand is inelastic, – 1 < Ed ≤ 0

4.7.1 Determinant of price elasticity

There are four determinants of a good’s own-price elasticity of demand

Necessities v. discretionary goods (or luxuries): necessities tend to have inelastic demands; luxuries have elastic
demand. Depends on the buyer’s preferences.

. Availability of close substitutes: the greater the number of available substitutes, the more elastic the demand

I. Definition of the market: broad definitions (e .g. food) have less elastic demands than do narrowly defined markets
(e.g. Nestlé’s chocolate) which have more substitutes.

V. Time horizon: the greater the time horizon, the easier for consumers to find substitutes, or make do without, so the
more elastic the demand.

V. Proportion of Income – The higher the price of a good relative to consumer incomes, the greater the price elasticity of
demand. Ex/ a 100% increase in the price of a two penny box of matches is a very low fraction of my annual salary,
compared to a 100% increase in the price of a porshe boxter (60K to 12K) So the price elasticity of demand on the
match box will be much more inelastic than on the porshe boxter. Price elasticity is importnant in calculating the
price rise required to eliminate a shortage(excess demand) or the price fall to eliminate a surplus

4.8 Cross price elasticity of demand

Cross price elasticity is the responsiveness of quantity demanded of a good to changes in the price of another good. It
Shows the percentage change in the quantity demanded of good Y in response to a change in the price of good X.

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 %ΔQ y
ε xy=
%ΔP x
Q2 −Q1
×100
Q1
¿
P2−P 1
×100
P1
ΔQ y Px
¿ ×
ΔP x Q y

If Eyx = - 0.36: A one percent increase in price of good x results in a 0.36% decrease in quantity demanded of good Y

Classification:

 If (Edyx > 0): implies that as the price of good X increases, the quantity demanded of Good Y also increases.
Thus, Y and X are substitutes in consumption (ex. chicken and pork).

 If (Edyx < 0): implies that as the price of good X increases, the quantity demanded of Good Y decreases. Thus Y
& X are Complements in consumption (ex. bear and chips).

 If (Edyx = 0): implies that the price of good X has no effect on quantity demanded of Good Y. Thus, Y & X are
Independent in consumption (ex. bread and coke)

4.9 Income elasticity of demand

Income elasticity of demand shows the percentage change in the quantity demanded of good Y in response to a
percentage change in Income. It Measures how far the demand curve shifts horizontally when income changes

%ΔQ
ε I=
%ΔI
Q2 −Q1
×100
Q1
¿
I 2 −I 1
×100
I1
ΔQ I
¿ ×
ΔI Q
If EI = 2.27: A one percent increase in income results in a 2.27% increase in quantity demanded of good Y

 Classification:

 If EI > 0, then the good is considered a normal good (ex. soap).

 If EI < 0, then the good is considered an inferior good . All inferior goods are necessities

High income elasticity of demand for luxury goods, income elasticity is above unity. Low income elasticity of demand
for necessary goods, income elasticity are below unity.

45 | P a g e
4.10 Price elasticity of supply

The price elasticity of supply is the percentage change in quantity supplied per percentage change in price

Elasticity of supply can be inelastic (Es<1), perfect inelastic(Es=0 vertical), perfectly elastic (Es=∞ horizontal), elastic
(Es>1) . the size of the elasticity of supply depends mainly on the time horizon: the longer, the more elastic, in
general, because firms have more time to adjust their production processes in order to increase their profits.

4.11 ACTIVITIES

1. Draw a diagram with two supply curves, one steeply sloping and one gently sloping. Ensure that the two
curves cross. Draw a demand curve through the point where they cross and mark the equilibrium price and
quantity. Now assume that the demand curve shifts to the right. Show how the shape of the supply curve will
determine just what happens to the price and quantity.
2. Assume that a football club has the following demand curve for season tickets

Qd = 50,000-50P

a) What quantity of season tickets is demanded when season tickets are free (p=0)?

b) At what price do season tickets cease to be bought (Q=0)?

c) Using the information from a and b sketch the demand curve for the club.

d) What amount of season tickets is demanded at p=600 and p=700. What revenue is generated from season ticket
sales at each price?

e) Calculate the midpoint price elasticity between 600 and 700.

f) What can you say about the price elasticity of demand between the points on the demand curve corresponding
to season tickets prices of 600 and 700

g) In what price range does raising season ticket prices increase revenues from season ticket sales.

4.12 SUMMARY
You have learnt the following concepts;

• Elasticity of demand (own price) measures the sensitivity or responsiveness of quantity

demanded to changes in the own price of a
good.

• Elastic quantity is more responsive to price changes

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• Inelastic quantity is less responsive to price changes

• Cross price elasticity of demand measure the sensitivity of quantity demanded of one god to changes in the price
of related good.

• Income elasticity of demand measures the sensitivity of quantity demanded to changes in income holding
constant the prices of all goods constant.

In the next chapter you will look at how business make their decisions on what quantity to
produce and what costs to incur to maximise

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5 UNIT FOUR: CONSUMER CHOICE THEORY

5.1 INTRODUCTION
In this unit we use consumer choice to explain the demand curves and consumers tastes and
preferences.

5.2 AIM
The aim of this unit is to make you understand how consumers taste and preferences help them make
decisions on what to purchase and consume.

5.3 OBJECTIVES
At the end of this unit you should be able to do the following

• Explain and draw indifference curves

• Explain their properties

• Draw and explain the substitution and income effect of a price change

• Derive the demand curve using preferences.

5.4 TIME REQUIRED

You should take a minimum of 2hours to finish this unit.

5.5 REFLECTION
Think of how the satisfaction you get from consuming a good will make you decide on how many
of that product to buy.

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 5.6 READINGS
Begg et al chapter 5

5.7 Concept of utility

Having learnt about the individual and society’s economic problem, the demand and supply curves ,
consumer theory adds on to explain how a consumer chooses how much to consume by understanding the
basic mechanism behind the decision process for a consumer.

The main focus will be on;

1. Consumer tastes and utility. Tastes or preferences are the driving force behind what a consumer chooses to
consume. Utility is the satisfaction a consumer gets from consuming a good.
2. The behaviour assumption that consumers are rational, rational behavior is when a consumer tries to get the
best from the consumption decision by picking a bundle that maximizes satisfaction.
3. Consumer income. The resources available for consumption
4. Prices at which goods can be bought.

TASTES AND UTILITY

A consumption bundle is what you would like to consume. It contains different quantities of various goods.
If we have two goods in a bundle i.e. mango and jeans. One bundle can contain 3mangoes and one pair of
jeans and another bundle can contain 5 mangoes and 6 pairs of jeans. The problem comes in on how to
choose between the bundles.

Utility is obtained after consuming a good. it represents what a consumer achieves by consuming a
particular consumption bundle. If you prefer mangoes to bananas you will gain more utility when you eat a
banana than a mango. Therefore a consumer prefers one bundle of goods to another if the utility gotten from
the consumption of that bundle is greater than consuming the other.

This economic concept of rationality involves two assumptions:

Assumption 1: People know their desires and know the consequences of each choice of means.

Assumption 2: People will behave in a consistent manner. By this we mean that if people have two feasible options
available and choose one over the other, they should not, at a later date, choose the other option if both are still
feasible.
If for example you have 100 kwacha to buy mangos and bananas at price K2 for mangoes and K3 for
banana, you could buy (4M,3B) or (6M,5B) or (8M,4B). if you decide to buy bundle (6M,5B) over the other
two bundles, if peradventure your income reduce to K50 and you decide to buy bundle (4M,3B) then you
are not consistent because even at K50 you can still afford the first bundle. You will have to buy and
consume (6M, 5B), unless you consume much more than the first bundle and you could not afford it at first.

Assumption about tastes/preference. For a preference to be rational, it has to be;

49 | P a g e
A. The completeness; the consumer can always rank alternative bundles of goods according to the
satisfaction or utility they provide. It is unnecessary to quantify this utility. One bundle is better than
another, worse than or exactly as good as the other.
A consumer can make a decision on the bundle he/she prefers.

To express preference we use binary relation on X to compare or order the bundles x ≥ y: ‘x is at

least as good as y’ → weak preference x ≻ y iff x ≥ y and y ≥/ x: ‘x is strictly preferred to y’ →
strict preference x ∼ y iff x ≥y and y ≥ x: ‘x is indifferent to y’ → indifference relation
Completeness: ∀x, y ∈ X, either x ≥y or y ≥ x

Completeness is an important assumption which enables us to use a continuous, real number function to
represent preferences. We are always able to rank two or more things in order of preference, but in most
cases, we are not choosing between one thing or the other, but between complex bundles of goods

B. Transitivity; we assume that the ranking of possible bundles is internally consistent which means if a
bundle A is preferred to bundle B and B is preferred to bundle C, then A must be preferred to bundle C.
Transitive: ∀x, y, z ∈ X, if x ≥ y and y ≥ z, then x ≥ z

C. Consumers prefer more to less; if bundles B offers more mangoes but as many bananas as bundle C, we
will assume bundle B is preferred. E.g B(6M,5B) C(5M,5B).

Let us illustrate the three assumptions of rationality on a graph.

Bananas
Preferred
region
d c

b
e
Dominated
region
Mangoes

From the graph point A presents a bundle containing, let’s say, 3Mangoes and 3 bananas. If we are
consuming at point A, and more is preferred to less, then any point beyond point A , such as C, will be
preferred to A and any combination below point A such as B is not preferred. A is better than B. therefore
by transitivity C is preferred to A, A is preferred to B, thus C is preferred to B. how do we compare point D
and E? D and E both have more of one good and less of the other. the consumer who likes mangoes would
prefer E and the one who likes bananas who pick D. if point D is as good as point A and A is as good as E,
then point D is as good as point E.

We can clearly see that the implication of rationality and consistency is that individuals will find points of equal
taste arranged along a line by joining the three points. The three points A,D,E are giving the same utility. Therefore

50 | P a g e
if we keep utility constant, adding an extra mango means a consumer has to give up some bananas. The opportunity
cost of consuming an extra mango is giving up some bananas. This is called the Marginal rate of substitution.
It tells how many mangoes a consumer could exchange for an additional banana without changing total
utility.

For example, if a consumer had 6CDs and no banana. If they played the discs and does not enjoy the 6 th disc much,
the utility of this bundle is low. They are hungry and cant enjoy the music anymore. For the same low amount of
utility they could give up a lot of disc for some bananas. If they now eat a lot of bananas and play a few CDs. They
will be reluctant to sacrifice the discs to gain more bananas . this is called diminishing marginal rate of substitution.
When a person has more of one good, they are willing to give up more of a it to get the good that is relatively little.
The amount sacrificed diminishes as successive units of the other good increases.
From the figure above the line that pass through point A, D,E is called the indifference curve. It’s a curve that
represents all combination of consumption bundles that provide the same level of utility for a consumer.
An indifference curve is the locus of points each of which (point) represents the given level of satisfaction.
Each point represents a bundle of two goods under consideration; as one moves from one to another point
of the curve, the proportion of the two goods changes as the quantity of one good increases while that of
other decreases. But the increase in one good is just sufficient to compensate the loss of utility due to the
decrease in the quantity of the other good, leaving the consumer neither better nor worse off than before.
The consumer is indifferent between consuming any bundle on the curve. Point C is has more of both goods
therefore it offers a higher utility than A. it will lie on a higher indifference curve. Point B has less of both
goods offering lower utility than A. it will lie on a lower indifference curve. Point D and E offer the same
utility as A, thus they lie of the same curve. Indifference curves are downward sloping

First and foremost proposition of the alternative approach of ordinal utility is that the satisfaction or utility
derived from the satisfaction of the wants is a mental phenomenon. Utility is thus subjective and its cardinal
measure on an absolute scale is neither feasible nor is it necessary. It is not feasible to exactly and precisely
measure a purely psychological phenomenon which is experienced and recorded only mentally. This aspect
makes utility a purely subjective experience.

Example;
A point like A depicts a bundle which consists of X0 units of X and Y0 units of Y. We write A as A = (X0, Y0).
Similarly, B is a point where we have X1 units of X and Y1 units of Y (B = (X1, Y1)). The subscripts and so on
are ways of identifying different ‘packages’ of X and Y. They do not indicate the magnitude of X and Y.

• A ≻i B (meaning: A is preferred by individual i to B).

• ‘A ≿ C’ means ‘I prefer or am indifferent between A and C’.
• A ≿ B ≿ C.
• We introduce utility, then the above will read as bundle A gives a greater utility than B, B gives a greater
utility than C. Denote the number by U (for utility). Then,we clearly have U(A) ≥ U(B) ≥ U(C). We are
thus mapping from preferences onto real numbers.
• We call this mapping the ordinal utility function. Ordinal means that the function only tells us about
CHARATERISTICS OF INDIFFERENCE CURVES

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1. The indifference map of a consumer is expressed through a set of indifference curves. Each indifference
curves in the map is associated with a given level of satisfaction but the satisfaction level differs from
curve to curve.

Bananas

U3

U2
U1
Mangoes

The above diagram highlights two (2) important characteristics of indifference curves:

1. nearly the curve to origin, lower is the satisfaction level and further the curve away from the
origin higher the satisfaction level;
2. the movement from one point to another on the same indifference curve represents
substitution of one for another good so that the loss of utility from the units of the good given up is
just compensated by the additional unit derived from the extra unit of the other good

2. The slope of a an indifference curve gets flatter as we move to the right. This reflects DMRS. This is
why an indifference curve slopes downwards from left to right. This property is obvious from the above
diagram. The reason of downward sloping indifference curve is that the consumer has to give up less and
less number of units that he gives up in exchange for an additional unit of the other good. It is because
with an increase in the stock of the good its marginal significance decreases while the marginal
significance of the other good whose stock decreases. Thus the marginal significance of one good in terms
of the other decreases with every increase in its quantity (proportionate share).

52 | P a g e
 The consumer gives up an amount of one good to gain an extra amount of the other good that gives him the
exact utility forgone. If the slope of the IC is say 2, the individual is willing to give up 2 units of y to get a
unit of X, keeping utility constant.

3. Indifference curves are parallel to each other. If the curves are not parallel to each other they intersect
each other at some point. At the point of intersection the satisfaction of both curves shall be equal and
quantities both good shall be the same on such a point which contradicts one of the above properties.

Bananas
X
Z
Y

Mangoes

From graph X and Y are on the same indifference curve meaning they are giving the same level of utility. Y
and Z are also lying on the same indifference curve. This means that X is indifferent to Z but this does not
follow transitivity as Z has more of both goods than X and more is preferred to less.

4. The indifference curves are convex to the origin. The downward sloping shape makes it invertible convex
to the origin. A concave curve will loose the property of marginal significance of one good in terms of
another diminishing with an increase in the quantity of the good. Besides a concave curve will be
invertible rising from left to right.

5.8 The budget and indifference curves

Remember the slope of the budget line gives us the price ratios for the two goods.

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 Slope of the budget line= where is the price of the good on the horizontal axis and is the price

of the good on the vertical axis. Given income M to buy two goods X and Y at price for X and for Y.

the budget constraint would be X and the budget line will be

Y=

Characteristics of Utility functions

1. The ordinal utility function, then, simply represents individuals’ preferences over the space of economic
goods. A function u is said to represent these preferences if A B implies that U(A) ≥ U(B).
2. u must be increasing in both X and Y : the more we have of either good the more preferred the bundle is.
MARGINAL UTILITY we mean the net change in total utility by having consumed an additional unit of a
commodity. The extra satisfaction a consumer derives from one additional unit of that product.

For a given level of, say, Y, we can define the marginal utility of good X (MUX).Mathematically, this is
defined as:

This construct is called the derivative of U with respect to X, keeping Y constant at Y0. It tells us how utility
would change if we changed X, while keeping Y constant. The form which we give to the utility function
reflects our beliefs about how people relate to the world of economic goods (i.e. their preferences).

Law of Diminishing Marginal Utility; Explains that the more of a good a person gets, the less utility he
gets from each additional unit.

Consumer wants in general are insatiable, but wants for particular items can be satisfied for a time. The
more of a specific product that consumers obtain, the less they will desire more units of that product

 It is important to note that your marginal utility begins to fall after the very first unit you consume.
 In other words, your very first mango holds great utility. While you may enjoy your second mango, it
doesn’t bring as much utility as the first. At some point, your MU becomes negative. (takes away from
your total satisfaction).
From the definition we deduce the following:
 Along with increase in use of any commodity, TU increases at a decreasing rate, hence MU decreases.
 When the total utility reaches maximum, MU becomes zero. This situation is called point of saturation.
 When total utility itself falls, MU becomes negative.

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5.8.1 Utility maximization and choice.
The objective of the allocation of the budget among different consumption uses is to obtain the maximum
satisfaction from the combination of goods that are allowed to enter the consumption budget.

But the objective has to be realized within the limit set by the income at the given prices of the goods. The
objective can be realized by locating the purchase decision at the highest indifference curve that is attainable
with the allocated budget for the purchase. The budgetary limit constrains the consumer to remain within
the feasible area delimited by the budget line. Income will not permit him/her to go to any point that lies
above the budget line. But all the points lying within the area between the two axes and the budget line.

A rational consumer will choose an affordable bundle that maximizes her utility.

Bananas
A1

Q2 U3

A2
U2

U1
Q1
Mangoes

The consumer is maximizing utility at a point where the budget line is tangent to the indifference curve. All
point on a higher indifference curve are unattainable because its way beyond the budget.

If we are at point Q2, then all indifference curves below are offering lower utility. Point A on the budget line
lies on a lower indifference curve than point Q2. therefore they will not be preferred to Q2.

The budget line never crosses a higher indifference curve. At point Q the slope of the budget line coincides
with the slope of the indifference curve.
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 Slope of the budget line=

Slope of the indifference curve

Maximizing point
is

5.8.2 Adjustments to income changes

Given tastes and prices, a higher income will shift the budget line outwards. This means with a higher
income the consumer can buy more of both goods. The new budget line will be tangent to a higher
indifference curve because more is preferred to less.

The fall in income will result in an inward shift in the budget line and at a lower indifference curve.

Bananas

b
U2

a
U1
Mangoes

Income expansion path; shows how the chosen bundle of goods varies with consumer income levels,
keeping constant everything else.

5.9 Adjustments to price changes

When prices changes the budget line pivots from the axis where prices are constant.

Bananas

c
3
F F’ mangos
2 4
From the graph above, the initial budget line is AF’ with an income of k50 and prices for bananas and
mango are K10 and K5 respectively. The price of mango increases to K10 and the price of bananas remain

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the same. The budget line moves inwards to AF. With higher mango prices, the consumers can now afford
fewer mangoes for any given number of bananas. The bundles between the two budget lines are now
unaffordable.
The changes in prices have two effect; the substation and income effect. Substitution effect of a price
change is the adjustment of demand to the relative price changes. When the price of mangoes increase it
becomes expensive so consumers will buy less of the expensive good and buy more of a cheaper good. They
will substitute mangoes for bananas .

Income effect of a price change is the adjustment of demand to changes in real income alone. When prices
change, the purchasing power of a consumer changes aswel. For instance, when prices increase the same
level of income will not be enough to buy the same bundle.
Substitution effect.

We have two goods X1 and X2. The initial budget line EF , the consumer is maximizing at point A, where
the indifference curve is tangent to the budget line. When the price of good x1 reduces, keeping the price of
x2 constant, the budget line pivots to EF’. This shows a movement from bundle at point A to point B. this is
the overall change as a result of a fall in prices. This is now broken down into substitution and income
effect. First, Draw a hypothetical budget line HH that is tangent to the initial indifference curve at point C.
the line HH restores the consumer to the original utility and standard of living. The line HH is drawn to
show the amount of income that a consumer should have in order to have the same level of utility as before.
This hypothetical income the consumer has in order to have the same utility as before is called
compensating variation.
The movement from point A to point C is the substitution effect. The fall in the price of X 1 has made X1
cheaper than before. Consumers will now buy more of X 1 and less of X2. They substitute X1 for X2.
Substitution effect is always negative.

H
A
B

H F’

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The movement from point C to B is the income effect. The fall in prices increases the real income of the
consumer. Thus the budget line will shift from HH to EF’. When both goods are normal goods, an increase
in real income will increase the quantity demanded of both goods. Point B is north east of point C. in the
case of an inferior good point B will lie in between point A and C, which is north west of point C.
Inferior and Giffen goods.

Bananas

c
U2
H
a

U1

Mangoes
Xa Xc F H F’

I.E
S.E

Substitution effect is always negative but income effect is positive for a normal good and negative for an
inferior and giffen good. You saw for the case of normal good the effects are all in one direction. However,
the case of an inferior good results in the two effects be in different directions. Look at the graph below. The
price of mango falls and the budget line pivots and moves from AF to AF” the optimal choice moves from
point a to c. The consumer is initially at point a where there is maximization of utility consuming mangoes
and bananas.
A hypothetical budget line(HH) is drawn and is tangent to the original indifference curve at point b. the
consumer is consuming at point b and is maximizing the same utility as before the change in prices. A
movement from point a to b is substitution effect. You consume more of a cheaper good and less of an
expensive good. The move from point b to c is income effect. As income increases, the quantity demanded
of mangoes decreases. For an inferior good it is always true that income and substitution effects go in
opposite direction. The income effect is smaller than substitution effect. If it was a giffen good the income
effect would be larger than the substitution effect and the final result would be a fall in the quantity
demanded.
Demand curve

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 Bananas

U2
b c

a
U1

Ma Mb Mc
Mangoes

Pa

Pb

Pc D

Ma Mb Mc

We derive a demand curve for a normal good. The top part of the graph above shows how the optimal
choice of the consumer changes as prices of mangoes changes. We start from point a and the price of
mangoes is Pa, quantity demanded is Ma. now price reduces to Pb and quantity demanded is Mb .

The bottom part, using information from the top part, we graph prices against quantity demanded. There is a
negative relationship between prices and quantity demanded. This is a demand curve of an individual.

5.10 ACTIVITIES

1. consider a consumer who consumes only two goods :peas and beans. She has an income of K10, the
price of beans is 20ngwee while the price of peas is 40ngwee.
a) Draw the budget line

b) Suppose that the consumer consumes 30kg of beans. Assuming that she spends all her income, how
many kgs of peas is she going to consume?

c) Assume that the price of peas falls from 40ngwee to 20ngwee. Assuming that the consumer still
consumes30kg of beans, find the new quantity of peas.

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 d) After the decrease in price of peas to 20ngwee, assume that the consumer is just as well off as she
was in (b) if she has an income of K7.60. However, with that income and the new price of peas, she
would have consumed 20kg of beans. Find the quantity of peas she would have consumed in this
case. Show it on the graph.

e) Find the substitution effect due to the decrease in the price of peas that is the difference between the
solution in (d) and in (b).

f) Find the income effect, which is the difference between solution in (c) and (d).

5.11 SUMMARY

In summary you have learnt;

 Consumer tastes can be represented by a map of indifference curves

 Indifference curves do not intersect and show utility. Higher indifference curves reflect higher utility.
• Indifference curves exhibit a diminishing marginal rate of substitution.
• Utility maximising consumers choose a consumption bundle at which the highest reachable
indifference curve is tangent to the budget line.
In the next unit you will learn about the responsiveness of quantity demanded and supplied to changes in
prices and income

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5 UNIT FIVE: THEORY OF THE FIRM

6.1 INTRODUCTION
This unit will introduce you to how firms make their decisions on how much to produce, cost of
production and profit maximisation

6.2 AIM
The aim of this unit is to introduce you to;

• The concept of cost minimization

• Profit maximisation

6.3 OBJECTIVES
At the end of this unit you should be able to do the following

• Calculate marginal revenue, marginal cost, marginal product of labour and profit

• Draw curves associated with costs, revenue, and production

• Determine the output at which firm will maximize their profit

• Determine the level at which a firm will be forced to shut down its operations.

6.4 TIME REQUIRED

This unit should take you at least 2 hours to finish.

6.5 REFLECTION
How do you think firms decide on how much output to produce to maximize their profits?

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6.6 READINGS
Begg et al, chapter 6 & 7 , Sloman and Garrat, chapter 4 , Brue et al , chapter 6

6.7 production

How do firm decide how much to produce and offer to sale? Output depends on the amount of resources and
how they are used. Different combination of inputs will lead to different amounts of output. The cost of
producing any level of output will depend on the amount of inputs used and the price the firm pays for the
inputs.

There are three types of business organisations; sole trader, partnerships and companies. All these
organisation will have to make decision on how much to produce, what revenue and profit will they get
from the output produced.

Economic cost Vs accounting costs.

Accountants track the actual payment and receipt of a company. On the other hand economist are interested in how
revenue and cost affect the firms decision, allocation of resources to a particular activity. Economist identify the
cost of using resources (opportunity cost). Economic costs include explicit and implicit cost. Explicit cost is the
monetary payment a firm must make to an outside to obtain a resource. Implicit cost is the monetary income that a
firm sacrifices when it uses a resource it owns rather than supplying it in the market.

Example Gomez runs a small pottery firm. He hires one helper at K12, 000 per year, pays annual rent of
K5000 for his shop, and spends K20, 000 per year on materials. He has K40, 000 of his own funds invested
in equipment (pottery wheels, kilns etc) that could earn him K4000 per year if alternatively invested. He has
been offered K15, 000 per year to work as a porter for a competitor. He estimates his entrepreneurial talents
are worth K3000 per year. Total annual revenue from pottery sales is K72, 000. Calculate the accounting
profit and the economic profit for Gomez’s pottery firm. The accounts book will show the following;

Total sales revenue……………………………………………………K72, 000

Total expenses

cost of material………………………………………………………………………………………………..K 20,000

helpers salary…………………………………………………………………………………………………..K12, 000

rent on shop……………………………………………………………………………………………………..K 5,000

Total explicit cost………………………………………………………….(K 37,000) Accounting

profit………………………………………………………....K 35,000
The accounting profit of K 35,000 is a good indication of the firm’s performance. However it ignores implicit
costs and overstates the economic success of the firm. The economic profit is calculated below;
Accounting profit…………………………………………………….K35, 000
Total implicit cost
Forgne interest……………………………………………………….K4, 000
Forgone entrepreneur skills…………………………………………...K3, 000
Forgone salary…………………………………………………………K15, 000
Total implicit costs……………………………………………………K22, 000
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Economc profit…………………………………………………………K13, 000

After considering implicit costs the economic profit is K 13,000, showing the economic success of the firm.

When a firm wants to produce a product it will make use of the factors of production that include buildings,
machines, land, labour and mineral resources. Some of these factors of production are called fixed factors
because they are not easily replaced nor acquired in a given period of time. If a firm wants to increase
production, building a new factory and acquiring machinery will take time. But factors of production such
as labour and mineral resources are easily increased, sourced and replaced. Such are called variable factors.
Therefore, the short run is the time period during which atleast one factor of production is fixed. In the
short run output can be increased using variable factors. The long run is the time period in which all inputs
can be varied. The time frames talked about here are not fixed; they differ from firm to firm.

Short run production

The firm uses so many fop but for now We will focus on the labour output relationship of production,
holding all other factors equal. In this short run a firm can only change the units of labour to increase
production. Total product (TP) is the total quantity produced for a particular good. marginal product(MP)
is the extra output producing by adding a unit of a variable input(labour) . average product(AP) is output
per unit of an input labour. This is also called labour productivity.

MP=change in TP/change in labour or ∆TP/∆L

AP=total product/units of labour

Production is subject to diminishing returns in the short run. The law of diminishing returns states that,
assuming technology is fixed, successive units of a variable resource are added to a fixed resource (capital
or land) beyond some point the extra unit of output attributed to the additional unit of a variable input will
decline . Production function is a function that specifies the output of a firm, an industry, or an entire
economy for all combinations of inputs. This function is an assumed technological relationship, based on
the current state of engineering knowledge; it does not represent the result of economic choices, but rather is
an externally given entity that influences economic decision-making. See graph below.

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The graph shows diminishing returns at play. As additional labour is increase output increases up to a
certain level, then any additional labour increases output at a declining rate. The product curve has three
phases 1) increasing return 2) diminishing returns and 3) negative returns. The law of diminishing returns
assumes that all units of labour are of equal quality. Each additional worker is of the same innate ability,
motor combination, education, training and experience.

Marginal product is the slope of the total product curve. The graph shows several points where the relative
position of the average and marginal product curves tell us something about how the average product of
labour is changing. This illustrates the average-marginal rule where when a marginal value is less than an
average value, the average is falling and when the marginal value is greater than average value, the average

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is rising. When the two are equal, the average is constant - which implies that the average should be at a
maximum or minimum point.

6.8 Short run costs

A firms cost of production depends on its output. The more it produces, the greater the quantity of fop it
must use. The more the fop the greater the cost. The greater the productivity of factors, the smaller will be
the quantity needed to produce a given level of output and hence the lower the cost of output. The higher the
rice of the input the higher the cost of production.

fixed cost: Business expenses that are not dependent on the level of goods or services produced by the
business. They tend to be time-related, such as salaries or rents being paid per month, and are often referred
to as overhead costs.
variable cost: A cost that changes with the change in volume of output of a firm. These include payment of
materials,power, transportation etc. variable cost can be altered or controlled by changing output levels.
Total cost ; Is the sum of fixed and variable cost.
TC=TFC+TVC

average total cost:

Average cost or unit cost is equal to total cost divided by the number of goods produced (the output
quantity,( Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus
average fixed costs (total fixed costs divided by Q).

ATC=TC/Q=AFC+AVC where AFC=TFC/Q AVC=TVC/Q

marginal cost:

The increase in cost that accompanies a unit increase in output; Additional cost associated with producing
one more unit of output. a change in output due to a unit change in output.
MC=change in TC/change in Q= ∆TC/∆Q

Output TFC TVC TC AFC AVC ATC MC

0 12 0 12

1 12 10 22 10

2 12 16 28 6

3 12 21 33 5

4 12 28 40 7

5 12 40 52 12

6 12 60 72 20

7 12 91 103 31

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 Please calculate AFC AVC and ATC

Cost Curve

MC are costs the firm can control directly and immediately.MC is the cost incurred to produce one last unit
of output. It can also be the cost saved by not producing the last unit.

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From the graph MC declines sharply, reaches a minimum then rises abruptly. This is because total cost rise
at a decreasing rate then increases at an increasing rate. Total fixed costs are horizontal because they do not
depend on the level of output.MC cuts the AVC and ATC at their minimum points. When MC is less than
the current average total cost, the ATC is falling. The reverse is true. At the point of intersection of MC and
ATC, average cost has stopped falling but not yet rising.

Long run production cost

In the LR the firm makes all resource adjustments. There is no distinction between variable and fixed cost
because all factors are variable. There are key assumption made when constructing a long run cost curve; 1)
factor prices are given, 2)the state of technology and factor quality are given and 3)firms choose the least
cost combination of factors for each output. A firm can choose a production technique that is either labor or
capital intensive. A technique that uses more capital than labour is called capital intensive. A technique that
uses more labour than capital is labour intensive.

A firm that is expanding has to expand to successively larger plant sizes with larger output.
From the graph SAC1 is the smallest short run average total cost and SAC5 is the largest. The vertical lines
show the outputs at which the firm should change plant size to realise the lowest attainable average total
cost.as we move from SAC1 costs are increasing. With plant size one the lowest ATC is attain at output
200.. to expand output to 400, the firm constructs a larger plant size2. Plant size 3 yields the lowest ATC.
Tracing these lowest points of SAC gives us the long run cost curve.

Scale of production.

In the long run all factors vary. If we double the input Does that mean output also doubles.

o Constant returns to scale; a given percentage increase in inputs results in the same percentage increase in
output

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o Increasing returns to scale; a given percentage increase in input results in a larger percentage increase in
output.
o Decreasing returns to scale; a given % increase in inputs results in a smaller % increase in output.

Economies and Diseconomies of Scale

The change in long-run average cost as output increases is the basis for two important concepts: economies of
scale and diseconomies of scale. A firm enjoys economies of scale in a situation where average cost goes
down when output goes up. By contrast, a firm suffers from diseconomies of scale in the opposite situation,
where average cost goes up when output goes up. The extent of economies of scale can affect the structure of
an industry. Economies of scale can also explain why some firms are more profitable than others in the same
industry.

Source: www.google.com/economiesofscalegraph.
Figure above illustrates economies and diseconomies of scale by showing a longrun average cost curve that
many economists believe demonstrates many real-world production processes. For this average cost curve,
there is an initial range of economies of scale (0 to Q_), followed by a range over which average cost is flat
(Q_ to Q__), and then a range of diseconomies of scale (Q > Q__).

Economies of scale have various causes. They may result from the physical properties of processing units
that give rise to increasing returns to scale in inputs. Economies of scale can also arise due to specialization
of labor. As the number of workers increases with the output of the firm, workers can specialize on tasks,
which often increases their productivity. Specialization can also eliminate time-consuming changeovers of
workers and equipment. This, too, would increase worker productivity and lower unit costs.

Economies of scale may also result from the need to employ indivisible inputs. An indivisible input is an
input that is available only in a certain minimum size; its quantity cannot be scaled down as the firm’s
output goes to zero. An example of an indivisible input is a high-speed packaging line for breakfast cereal.

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Even the smallest such lines have huge capacity, 14 million pounds of cereal per year. A firm that might
only want to produce 5 million pounds of cereal a year would still have to purchase the services of this
indivisible piece of equipment.

Indivisible inputs lead to decreasing average costs (at least over a certain range of output) because when a
firm purchases the services of an indivisible input, it can “spread” the cost of the indivisible input over more
units of output as output goes up.

The region of diseconomies of scale (e.g., the region where output is greater than Q__ in Figure above is
usually thought to occur because of managerial diseconomies. Managerial diseconomies arise when a given
percentage increase in output forces the firm to increase its spending on the services of managers by more
than this percentage. To see why managerial diseconomies of scale can arise, imagine an enterprise whose
success depends on the talents or insight of one key individual (e.g., the entrepreneur who started the
business). As the enterprise grows, that key individual’s contribution to the business cannot be replicated by
any other single manager. The firm may have to employ so many additional managers that total costs
increase at a faster rate than output, which then pushes average costs up.

Minimum efficient scale

Economies and diseconomies of scale are important determinants of an industry’s structure. Minimum
efficient scale is the lowest level of output at which a firm can minimize long run average costs. From the
figure above the MES level occurs at point Q1, because of the extended range of constant returns to scale,
firms producing substantially greater outputs could also realize the minimum attainable long run average
cost.

In the event where economies of scale continue over a wide range of output and diseconomies of scale
appear at high levels of output. This pattern of declining long run average cost occurs only to a few large
scale producers. Small firms cannot realize the MES. In cases where economies of scale are few and
diseconomies come into play quickly, the MES occurs at low levels of output.this industry a large number
of relatively small producers.eg agriculture

The long run average cost curve is determined by technology and economies and diseconomies of scale

6.9 Revenue
A firms profit is defined as revenue minus cost.

1. Total Revenue – It is the total sale proceeds of a firm by selling a commodity at a given price. If a firm
sells 3 units of an article at $ 24, its total revenue is 3 x 24.

TR = P x Q, where TR is the total revenue, P the unit price and Q the quantity.

2. Average Revenue – It is the average receipts/earnings from the sale of units of the commodity. It is
obtained by dividing the total revenue by the number of units sold. The average revenue of a firm is in fact
the price of the commodity at each level of output since TR = P x Q, therefore, AR = TR / Q = P x Q / Q =
P.

3. Marginal Revenue MR – is the extra total revenue gained by selling one more unit of the commodity.

MR=change in TR/change in Q=∆TR/∆Q

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 The relationship between AR,TR, MR and output depends on the condition the firm operates. If the firm is
too small to affect market prices it will face different revenue curves from the large firms that affect prices.

1. Revenue curves when prices is not affected by the firms output – The average revenue curve is a horizontal
straight line parallel to X axis and the marginal revenue curve coincides with it. This is since the number
of firms selling an identical product is very huge, the price is determined the market forces of supply and
demand so that only one price tends to prevail for the whole industry.

Since the demand

curve is the firm’s average revenue curve, the shape of AR curve is horizontal to the X axis at
price OP and the MR curve coincides with it. Any change in the demand and supply
circumstances will change the market price of the product and consequently the horizontal AR
curve of the firm.

2. Revenue curves when price varies with output, if a firm has a large market share it will face a downward
sloping demand curve. this implies to sell more it has to lower the price. Recall that Average revenue equal
price, then AR has to fall when more is sold. So the average revenue curve is the downward inclining
industry demand curve and its related marginal revenue curve lies below it. The marginal revenue is lower
than the average revenue. by lowering the price, marginal revenue also falls but the rate of fall in marginal
revenue is greater than that in average revenue.

In the diagram the MR curve falls below the AR curve and lie half a way on the perpendicular drawn from
AR to Y axis. This relation will always exist amidst straight line downward sloping AR and MR curves.

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PROFIT MAXIMISATION

How much output should the firm produce if it want to maximize profits?

The profit maximising condition is that marginal revenue should be equal to marginal cost. The firm should
produce output at a point where MR=MC. This is because at output levels below that point MR>MC,
producing more of the output there will be a greater addition to revenue than to cost. Beyond the profit
maximising point MR<MC any additional output adds more to cost than revenue.

AR and AC are used to measure the amount of profit at the maximum.

We first look at the case when a firm is too small to affect market price.

From the graph MC=MR at output Qpm. at this point the firm is making economic profits because the AR>ATC. The
difference between the two curves gives us the amount of profit realised. When the AR<ATC the firm is making
losses and there is no need to continue producing output. . When AR=ATC the firm is making normal profits. The
firm is just making enough revenue to cover all its costs.
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 ATC
Price

AVC
P*
loss P=MR=AR

MC

Quantity
Q*

ATC
MC

price AVC

P*
Loss=TFC
P=MR=AR

Shutdown point

Q*

Since the firm cannot affect the prices of the commodity, if it makes economic prices, more firms will enter the
market and share the profits. In the end they will all earn zero profits. they will break even. Firms will continue to
operate at zero profits because they are able to cover their average total costs, for as long as P>ATC. If the firm
makes losses in the short run, in the long run the firm will close down. However, most firms will leave the market
and the remaining firms will earn zero profits. The firm needs to know whether the losses are big when producing
at Q1. Remember, fixed costs are supposed to be paid for even if the output is zero.
If revenue exceeds variable costs, the firm is earning something towards its overhead costs. they will
produce at Q1 even though they are making losses. if revenue is less than variable costs the firm will not
produce anything at all.firm will decide to shut down at the point where MR=AVC.

Secondly, revenue when prices vary with output.

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The firm can either make economic profits or losses in the short run. But in the long run it either makes zero
profits or shuts down. For as long as P>ATC. If the firm makes losses in the short run, in the long run the
firm will close down. However, most firms will leave the market and the remaining firms will earn zero
profits. The firm needs to know whether the losses are big when producing at Q1. Remember, fixed costs
are supposed to be paid for even if the output is zero.

If revenue exceeds variable costs, the firm is earning something towards its overhead costs. they will
produce at Q1 even though they are making losses. if revenue is less than variable costs the firm will not
produce anything at all.firm will decide to shut down at the point where MR=AVC.

6.10 ACTIVITIES

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1. Explain the law of diminishing returns.
2. Explain the difference between explicit and implicit cost.
3. What is economies, constant and diseconomies of scale?
4. Explain, with the aid of a graph, the relationship between a total product curve, average and marginal product
curves.
5. Why does the average revenue and marginal revenue curve slopes downwards for a firm that has control over
price? Show graph.

6.11 SUMMARY

In summary you have learnt;

• Production function shows the maximum output that can be produced using given
quantities of inputs

• Total cost curve is derived from the production, for given wages and rental rates of factors of
production.

• Marginal cost curve reflects the marginal product of the variable factor holding other factors fixed.
In the next unit you will learn of different market structure and how the firms market their decisions.

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6 UNIT SIX: PERFECT COMPETITION

7.1 INTRODUCTION
This unit is about the types of market that are there in an economy. Market structure, which refers
to the economic environment in which buyers and sellers in an industry operate. We will see how a
particular firm has influence over the market forces.

7.2 AIM

The aim of this unit is to introduce you to the concept of;

• Perfect competition

7.3 OBJECTIVES

At the end of this unit you should be able to do the following

• define perfect competition

• describe why a perfectly competitive firm equates marginal cost and price
• demonstrate how profits and losses lead to entry and exit
• draw the industry supply curve
• carry out comparative static analysis of a competitive industry.

7.4 TIME REQUIRED

you should take at least four hours to finish this unit

7.5 REFLECTION

Think of a situation where there are a number of firm producing the same good, how will the decision of one
firm affect the market demand?

7.6 READINGS
Begg et al, chapter 8, Sloman and Garrat, chapter 5 , Brue et al , chapter 7,8, & 9

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7.7 The determinants of market structure
Market structure is the interconnected characteristics of a market such as; number and relative strength of buyers and sellers,
degree of freedom in determining price, level and forms of competition, extent of product differentiation, and ease of entry
into and exit the market.

1. The number of agents in the market

2. Their information set and mobility

3. The nature of the product

4. Entry and exit from the market.

The types of market structure include; perfect completion, monopoly, oligopoly, monopolistic completion, and duopoly.

7.7. 1 Perfect competition

Characteristics of the market.

1. a large number of firms, each firm has a small market share

2. free entry and exit, and

3. a relatively homogeneous product, the products are identical

4. price takers

5. buyers and sellers know the prices and the nature of the product.

The key condition for a competitive market, is price taking. Every firm and every consumer must take the market price of the
good as given. No one can unilaterally affect the price by their choice of how much to buy or sell.

This means the individual firm will face a horizontal demand curve. It will be horizontal at the market price, established by
supply and demand on the market as a whole. Recall, from the previous lecture, that the perfectly competitive firm will
maximize its profits by setting MC = p*.

(Why? Because profit maximization for any firm means setting MC = MR, and for a perfectly competitive firm, MR = p*.)

The firm faces a horizontal market demand curve because it’s a price taker. If it charges a price higher than p It will not sell
any output. Buyers will go to other firms whose product is just as good. It will not charge less than p because all the other
firms will know about it.

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Firms supply curve

We can use what we know about profit maximization under perfect competition to derive the firm’s individual supply curve.
Remember that a supply curve shows how much quantity is produced at each price. A market supply curve shows how much
quantity all firms together will produce at each price. An individual firm’s supply curve shows much quantity that firm will
produce at each price. To derive this curve, we need to consider the firm’s response to different market prices. The profit
maximizing point is;

SMC=MR=P

Consider five different prices, p1 < p2 < p3<p4 < p5. For each of these prices, we can figure out the quantity that a PC firm
will produce. From these choices we can see the firm’s supply curve taking shape: it looks just like the MC cost curve.

There is one exception to the rule that the firm’s supply curve is identical to the MC: when p* < AVC, the firm’s shut-down
condition is satisfied. If we follow the MC down to the

AVC, we can see that for any price above the minimum point of the AVC will induce the firm to stay open and produce. But
for prices below the minimum AVC, the firm will shut down and produce q = 0. So it turns out the supply curve has two parts.
The upper part corresponds to when the firm stays open, while the lower (vertical) part corresponds to when the firm shuts
down.

Figure 2. short run supply curve. MC ATC

Cost, revenue
f
P6
AVC e
P5
P4 d
breakeven
P3 c
b
P2
P1 Shut down point
a
Quantity supplied

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 • At P1, P1<min AVC. Firms will not produce anything at all

• At P2 they will produce Q2 but will be indifferent between shutting down and producing.
Their loss is equal to fixed costs.

• At P3 the firm will supply Q3 and minimise its losses.

• At P5 it will supply Q5 earning normal or zero profits. This is the break even point.

• At P6 it will supply Q5 and realise economic profits.

The market supply curve is the summation of all individual firms supply curves.

Profit maximisation in the short run.

The profit maximisation point of every firm is when MR=MC.

In this SR equilibrium, we have the firm making a profit.If demand increases or decreases, this will affect the choices and
profits of all the firms in the market. Note that the increase in price tends to increase profits or reduce losses while a decrease
in demand increases losses or decrease profits.

The long run supply curve

In the SR, this has no effect on the supply curve; but in the LR, firms enter for profits and leave to escape losses, leading to
supply curve shifts. We want to use this information to derive a LR supply curve. A LR supply curve, just like a SR supply
curve, shows the total quantity that will be supplied in a market at different prices; but unlike the SR supply curve, it shows
the quantity supplied after all long-term changes, including entry and exit of firms, have been taken into account.

We can come up with a long run supply curve by changing demand, and then finding the equilibrium points after allowing LR
adjustments, including entry and exit. Start with an initial (short-run) supply and demand. If we are in long-run equilibrium,
profits are zero. Now, let demand shift to the right. In the shortATC-run, price rises a lot. But the higher price creates profits,
and profits attract entry in the long run. So eventually supply shifts to the right as well, pushing price back down (though
possibly not as low as it was before). Once profits are back to zero again, you’re in a new long-run equilibrium. Do this all
again to find a third long run equilibrium, and then connect the dots to get the long-run supply curve.

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FIGURE 3. LONG RUN SUPPLY CURVE

S2 S3
S1
LR
prices

P3

P2
P1 D3

D2

D1

Q1 Q2 Q3 Quantity supplied

The interpretation of the LR supply curve is pretty much the same as the SR supply curve: it shows the willingness of
producers to sell at each price. But the LR supply curve measures this willingness in the broadest sense, including all firms
that might potentially supply this product.

Notice that the LR supply curve is flatter than the SR supply curve. This must be so, since the LR supply curve takes into
account the quantity responses of all firms, not just the ones currently in the market, but potential firms as well.

The long run MC curve is flatter than the short run MC curve. In the long run a firm will exit the market if it fails to cover its
long run ACs. Therefore at any price below P=LRATC, the firm exits the market. The firm will produce any output if price is
above LRATC. Therefore the long run supply curve is the LRMC above the LRATC=P.

Profit maximization in the long run

In the long run, entry and exit become possible. Why? Because potential firms can buy fixed inputs and become actual firms.
And existing firms can sell off or stop renting their fixed inputs and go out of business.

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Firms will choose to enter the industry if the existing firms in the industry are making economic profits. The profits are an
incentive to enter. Now, remember that the market supply curve is just the summation of all the individual firms’ supply
curves. If we add more firms, therefore, the market supply must shift to the right. But what effect does a right shift of supply
have? It drives down the price on the market, thereby reducing the profits of each

firm.
LRMC
FIGURE 4.

P
S1 LRAC
P S2

P2

P1

Q
Q Q

When few new firms enter the markets, they firms will make profits, but smaller profits than before. But if there are still
economic profits being made, more firms will enter. This must continue until there are no economic profits. So entry finally
stops when the last firm to enter the market are making normal profits and are producing at their lowest average total cost.
What if typical firm is making losses? Then the reverse process will take place. Firms will exit the market, causing a left shift
of market supply, causing a rise in market price, causing a reduction of losses. This continues until losses are zero. Thus, LR
competitive equilibrium consists of two conditions:

• p* = MC

• p* = minimum ATC

The first condition is caused purely by profit maximization, and it’s true in both the SR and the LR. The second condition,
however, is caused by entry and exit in the LR. It won’t necessarily be true in the SR.

It turns out that the perfectly competitive firm produces not just at the minimum of its

SRATC, but also it’s LRATC. Why? Because any PC firm not at its minimum LRATC will, in the LR, change its input
combination to take advantage of lower average costs. If firms are able to make positive profits by moving outward on the
LRATC curve, those profits will attract entrants into the industry in the usual fashion. So by the same arguments as before,
profits will eventually dissipate to zero. The price must be at the bottom of the LRATC, not just the SRATC.

An industry supply curve is the horizontal aggregation of individual firms output at different prices. And it is flatter. Higher
prices do not merely induce firms to expand their production but new firms also enter. In extreme case the industry long run
supply curve is horizontal if all existing firms and potential entrants have identical cost curves and the industry’s expansion or
contraction will not affect the resource prices and the production cost. This means the entry or exit of firms will not shift the

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long run ATC of individual firms. This is a case where industry’s demand for resources is small in relation to the total demand
for the resources. This is called a constant cost industry.

If the industry in question has a large impact on the markets for its inputs, then the LR supply curve may slope upwards. If the
effect of entry into the industry is to bid up the price of inputs, so that a firm’s cost curves rise as a result of the entry of new
firms, then the market price after adjustment will be higher than it was before. In this case, the LR supply curve must be
upward-sloping. An increase in market demand results in economic profits and attract new firms. These new entrant s increase
market supply and lowers the profits but because costs rise, the ATC will shift upwards. The overall results is a higher than
original equilibrium price. the industry will produce larger output at a higher product price because the expansion has
increased resource price and the minimum average cost; this is called an increasing-cost industry, which results from
external diseconomies.

On the other hand, if entry into the industry creates a greater demand for inputs that allows those inputs to be produced
through mass production techniques (i.e., at lower average cost), then the industry can benefit from lower costs of production.
In this case, the LR supply curve is downward-sloping. This is called a decreasing-cost industry, which results from external
economies.

An increase in costs.

Consider a higher increase in the input price that hits all the firms in the industry. We assume all firms have the same cost
curves and the long run industry supply curve is horizontal. Initially the industry is in equilibrium at P1 and Q1 where the
long run supply curve meets the industry demand curve. Individual firms are producing q 1* output at the lowest point on the
LAC1.

The increase I the price of inputs will shift the long run ATC from LAC1 to LAC2. In the short run some factors are fixed,
there we have STC2 ,SVC2 and the MC2. New equilibrium is reached at P2 where SRSS2 intersects the demand curve. At that
price a firm equates MC=P2 and supplies q2. This covers variable cost but not fixed costs.

With the passage of time, fixed factors are now varied and some firms leave the industry. Long run equilibrium moves to P 2*
since the new LRSS2 intersects demand at P2* and Q*. the firm produces q2*. As a result of the increase in cost of production
equilibrium price rises and output falls.

FIGURE 7. A cost increase in a competitive industry

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 SATC 1
LAC 2
SAVC 2

SRSS 2
LAC 1 SRSS 1

LRSS 2
P2 P2

P1 P1 LRSS 1

A shift in market demand curve.

The demand curve shifts from dd to d1. On the SRSS we move from point A to A’.when demand rises its takes a big price rise
to induce individual firms tto move up their steep short run supply curves with given fixed factors. In the long run, firms
adjust all factors and their long run supply curves are flatter. The supernormal profits attract new firms into the industry.

The supply curve is rising either cause it takes higher prices to attract higher costs firms into the industry or the collective
expansion bids up some inputs prices or both. The new long run equilibrium is at point A’’, with a higher output but a lower
price than the short run. Figure 8. a shift in the demand curve.

SRSS LRSS
prices

P3

P2

P1

D2

D1

Q1 Q2 Q3 Quantity supplied

Perfect competition and efficiency

Two things are required if economic efficiency can be said to exist;

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Productive efficiency- Products must be made with the least possible use of scare resources. This means that goods and
services must be produced with the least-cost methods available. It suggests that we cannot have more of one good without
giving up another. Productive efficiency is achieved when the output is produced at minimum average total cost and it exists
when producers minimise the wastage of resources in their production processes.

Productive efficiency can be shown through the firm’s cost curve. First production must take place on the lowest possible
average cost curve. Secondly production needs to occur at the lowest point on that lowest cost curve. The lowest point on a
firm’s average cost curve is therefore a point of technical efficiency.

The production possibility curve may also help to clarify productive efficiency. Recall that the PPF shows the maximum
production points for the combinations of any two products. Given this it must be true that productive efficiency can only
exist when an economy is producing right on the boundary of it production possibility frontier.

Allocative efficiency ; Allocative efficiency is concerned with whether we are producing the goods and services that match
our changing needs and preferences and which we place the greatest value on. Allocative efficiency has to do with
allocating the right amount of scarce resources to the production of the right products. This means producing the combination
of the products that will yield the greatest possible level of satisfaction of consumer wants. It tells us how much of each good
we should produce.

Allocative efficiency is reached when no one can be made better off without making someone else worse off. This is also
known as Pareto efficiency.

Consumer and producer surplus.

From market equilibrium we find a measure of gain that consumers and sellers obtain from trading at the equilibrium price.
For consumers the measure of trade gain is called consumer surplus whilst for producers is called producer surplus.

Consumer surplus is Equivalent to the difference between the maximum price (reservation price)a consumer is willing to
pay for a good and the actual price paid.it is the net gain from a purchase of a good. For example, you want to buy a pair of
jeans trousers. You are willing to pay K200 for it. If the actual price of a trouser is K150. When you but it you gain a surplus
of K50.

 Total consumer surplus = the sum of all consumer surpluses gained by all buyers of a good in the market.

Consumer surplus is measured by the area below the market demand curve and above the equilibrium price. This willingness
to pay is nothing else but the slope of the indifference curve; that is, it is the marginal utility of X measured in terms of the
quantity of Y that would be needed to compensate for a loss of a unit of X. In that sense, the downward sloping demand
schedule represents diminishing marginal utility.

Producer surplus is the difference between the (market) price a seller actually receives and his/her (seller’s) cost. It is the
measure of gain that the sellers obtain from selling a given quantity of a good at equilibrium price. A seller would not sell
below his/her cost, If the market price is below a seller’s cost the seller will leave the market

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Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing
and able to pay) equals the cost of the resources used up in production.

The condition required for allocative efficiency is that price = marginal cost of supply.

In the diagram above, the market is in equiibrium at price P1 and output Q1. At this point, the total area of consumer and
producer surplus is maximised. If for example, suppliers were able to restrict output to Q2 and hike the market price up to P2,
sellers would gain extra producer surplus by widening their profit margins, but there also would be an even greater loss of
consumer surplus. Thus P2 is not an allocative efficient allocation of resources for this market whereas P1, the market
equilibrium price is deemed to be allocative efficient.

Pareto efficiency and perfect competition

in what type of economy is the total gain from trading made as large as is possible? This is the economic efficiency question.

Since in a perfect competition consumers and producers are price takers, the market is in equilibrium because quantity
demanded is equal to quantity produced. The firm’s equate marginal revenue to marginal cost thus equating price to marginal
cost. In the long run price is equal to the minimum average cost. Marginal cost and average cost are equal. This triple equality
tells us that although a competitive firm may realise economic profits or loss in the short run, it will earn a normal profit in the
long run. This suggests a great social significance concerning efficiency of a purely competitive economy. A competitive
market uses the limited resources available to society in a way that maximises the satisfaction of consumers. There is both
productive and allocative efficiency.

Productive efficiency requires that goods are produced in the least costly way whilst allocative requires that resources be
apportioned among the firms and industry to yield the mix of products that is most wanted by society.

Productive efficiency; p=minimum ATC. This means that unless firms use the best available(least cost) production
methods and combinations of inputs, they will not survive.

Allocative efficiency; p=MC

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The money price is of any product is society’s measure of the relative worth of an additional unit of that product. The price of
a product is the marginal benefit derived from it. The marginal cost of an additional unit of a product measures the values or
relative worth, of other goods sacrificed to obtain it.

Therefore, P=MC. Each item is being produced to the point at which the value of the last unit is equal to the value of the
alternative goods sacrificed by its production. The nature of the market makes adjustment of firm’s expansion and entry to
restore and return to allocative efficiency point. The invisible hand in a competitive market is at work. Business and resources
suppliers seek to further their self interest which organises the private interests of producers in a way that is fully in sync with
society’s interest in using scarce resources efficiently.

We can show under some specific (but not too restrictive) conditions that a competitive outcome where consumers maximize
utility subject to their budget constraints, producers maximize profit subject to their technology, and quantity demanded
equals quantity supplied in all markets is Pareto efficient. This is known as the First Welfare Theorem of Economics. Note,
Pareto efficiency has nothing to do with equity. An allocation where I have all the goods in the world is indeed Pareto
efficient, because in order for someone else to be better off, say you, I would be made worse off. Some might say this
allocation isn’t equitable, but how do we define equitable? Economists have less to say on this subject

7.10 ACTIVITIES

1. Define the concept of market structure and list the fundamental assumptions of the perfect
competition model.
2. Provide a graphical representation of equilibrium in the perfect competition model in the long run,
distinguishing between what holds for the firm and what holds for the market. Carefully describe the
various components of your graphical representation.
3. Use graphs to illustrate how a decrease in costs changes the long run equilibrium of a competitive market.
Carefully describe the various components of your graphical representation.

7.11 SUMMARY

in summary we have learnt about;

 Firms in a perfect completion are price takers.

 A firm faces a horizontal demand curve
 A firm sets output at P=MC.
 The supply curve is the marginal cost curve above the average variable cost

In the next chapter we look at imperfect competition.

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7 UNIT SEVEN: IMPERFECT COMPETITION

8.1 INTRODUCTION

Most firms in the real world do not operate within markets described by the textbook definitions of
perfect competition. This unit introduces a theory of market structure and some models of imperfect
competition. These models help to explain some of the phenomena we see in real world markets such as
advertising, price wars and product differentiation. Game theory is introduced as a useful tool for
analysing strategic interactions.

8.2 AIM

This unit aims to introduce you to the market structures such as monopoly, monopolistic competition,
oligopoly and game theory.

8.3 OBJECTIVES

At the end of this unit you should be able to do the following

 recognise how output compares under monopoly and perfect competition

 describe how price discrimination affects a monopolist’s output and profits.
 identify equilibrium in monopolistic competition
 • recognise the tension between collusion and competition in a cartel
 • describe game theory and strategic behaviour
 • define the concepts of commitment and credibility
 • analyse reaction functions and Nash equilibrium
 • describe Cournot and Bertrand competition
 describe Stackelberg leadership

8.4 TIME REQUIRED

The minimum number of hours that the student should spend on this unit is 2 hours

8.5 REFLECTION

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 why do firm merge and make cartels?Write your answer in the spaces provided

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

8.6 READING
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 8 sections 5 to 10 and chapter 9

8.7 Monopoly.
Pure monopoly exists when a single firm is the sole producer of a product for which there are no close
substitutes.

Characteristics
1. A single seller: the firm and industry are synonymous/the same.
2. Unique product: no close substitutes for the firm’s product.
3. The firm is the price maker: the firm has considerable control over the price because it can control the
quantity supplied.
4. Entry or exit is blocked. Barriers to Entry
• High start-up costs. These may cause it to take a very long time for new firms to enter the market,
during which time the market is less competitive than it otherwise would be.
• Brand loyalty. If people are reluctant to consider new alternatives, the established firms in an industry
face less of a threat from new competitors.
• Government restrictions. These restrict the ability of competitors to contest the market.
The high start-up costs are due to Economies of scale, the major barrier. This occurs where the lowest unit
cost is attained at a high output. A very large firm with a large market share is most efficient, new firms
cannot afford to start up in industries with economies of scale. Legal barriers also exist in the form of
patents and licenses. Ownership or control of essential resources is another barrier to entry. It has to be
noted that barrier is rarely complete. Think about the telephone companies a couple decades ago; there was
no substitute for the telephone. Nowadays, cellular phones are very popular. It creates a substitute for your
house phone, causing the traditional telephone companies to lose their monopoly position.

Demand Curve

Monopoly demand is the industry or market demand and is therefore downward sloping. Price will exceed
marginal revenue because the monopolist will lower price to boost sales. The lower price of the extra unit of
output also applies to the previous units of output. The firm could have sold those previous units at a higher
price if it had not produced and sold the extra output. The added revenue will be the price of the last unit
less the sum of the price cuts which must be taken on all prior units of output. The marginal revenue curve
is below the demand curve.

Profit –Maximizing Output:

The MR = MC rule will still tell the monopolist the profit – maximizing output. The monopolist cannot
charge the highest price possible; it will maximize profit where TR minus TC is the greatest. This depends
on quantity sold as well as on price.

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The monopolist can charge the price that consumers will pay for that output level. Therefore, the price is on
the demand curve. Losses can occur in monopoly, although the monopolist will not persistently operate
at loss in the long run.

Monopolies will sell at a smaller output and charge a higher price than would pure competitive producers
selling in the same market.

Marginal conditions Short run Long run

MR>MC MR=M MR<MC P>SAV P<SAVC P>LAC P<LAC

C C

Output decision Raise out optimal lower produce shutdow stay exit
put n

The intuition on the calculation of marginal revenue; P=a−bQ

TR=P×Q
∴ ΔTR=PQ+QΔP

Therefore we can write

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 ΔTR ΔP
MR= =P+Q
ΔQ ΔQ

ΔQ P
ε=
Elasticity of demand is given as ΔP Q ,we therefore substitute in the marginal revenue function and
we have

1
MR=P 1−
( ) |ε|

When demand is inelastic (lies between 0 and -1), a rise in output reduces revenue. Marginal revenue is
negative. This is because a fall in price exceeds the rise in output.

When demand is elastic (greater than 1), a rise in output increases revenue and marginal revenue is positive.

Since MC=MR and MC is positive therefore MR must be positive. A monopolist output must lie on the
elastic part of the demand curve. The monopolist never produces on the inelastic part of the demand curve.

The more inelastic the demand for a monopolist, the more the marginal revenue is below the price, the
greater the excess of price over marginal cost and the more monopoly power it has.

Comparative statics.
Suppose there is rise in costs and shifts the MC and AC curves upwards. The higher MC will cross the MR
curve at a lower output. If the monopolist can sell this output at a price thatr covers average cost, the effect
of the cost increase must reduce the output and a higher equilibrium output.

A shift in the demand curve outwards will result in a shift in the MR curve too. MR will cross MC at a higher
output and lower price.

Exercise Draw the graphs to shows the changes above.

A MONOPOLY HAS NO SUPPLY CURVE

Given the marginal cost and marginal revenue of the monopolist, it is easy to get the maximizing output it
will produce. Then with a demand curve we can know how much it would sell at. But to know how much
the monopolist will produce at a particular price is quiet not certain. It all depends on the demand curve its
faces.

From the graph below, when demand is DD the firm produces Q1 at price P1. If the demand is D’D’, the
firm produces Q2 but still at price P1. ( see figure 8.14 on page 189 in Begg etal)

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 MC

P
D’

MR’

D
MR
Q

Q1 Q2

Therefore, a monopolist does not have a supply curve independent of the demand condition. The
monopolist costs are different from the perfect competitive firms. They may be larger or smaller. The four
reasons why the costs differ are;

1. Economies of scale; a firm with economies of scale can supply the entire market and meet the demand
than a number of firms in a competitive market. As the firm expands its cost reduces. Cost can also
reduce due to simultaneous consumption and network effects. Simultaneous consumption is the ability
of a product to satisfy a number of consumers at the same time. Network effects are present if the value
of a product to each user, including existing ones, increases as the total number of users arises. This
drives the market towards monopoly because the consumers tend to choose standard products that
everyone is using.
2. X-inefficiency occurs when a firm produces output at a higher than the lowest possible cost of
producing it. This is because of managers having different goals. Monopolies tend more toward x-
inefficincy than perfect completion. Firms under perfect completion are under pressure from rivals,
forcing them to be internally efficient to survive.
3. Rent seeking expenditures; an activity that is designed to transfer income or wealth to a particular firm
or resource supplier at someones or societys expense is called rent seeking behavior. A monopolist can
go to a great extent to acquire or maintain a monopoly granted by government through legislation or
exclusive license. Such rent seeking , add nothing to the firm output but it increases its costs.
4. Technological advances. In the LR firms can reduce costs through discovery and implementation of
new technologies. But a monopoly will not be technologically progressive due to lack of competition it
has no incentive to implement new techniques. However Schumpeter argues that a monopolist will
invest in research and developemnet to lower its costs.
Price discrimination

This whole time we have assumed that the monopolist is charging the same price but in certain conditions it
can increase its profit by charging different prices to different buyers. Price discrimination is selling a good
or service at a number of different prices, and the price differences is not justified by the cost differences. In
order to price discriminate, a monopoly must be able to

1. Be able to segregate the market. The monopolist must be able to segregate the buyers into distinct
classes; each has a different willingness and ability to pay for the product. This is based on different price
elasticities of demand.

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2. Make sure that buyers cannot resell the original product or services. If the buyers in the low price
segment are able to resell the product to the high price segment, the monopolist price discrimination
strategy would create competition in the high price segment. This completion would reduce the price and
undermine the discrimination policy. Examples of products where resell would be impossible are
transportation, medical and legal services. Goods that can discriminated are those goods consumed on a
spot. Standardized commodity are not likely.
Let us look at one example. If a Microsoft has two types of customers, students and small business
customers. The business customers have a very inelastic demand and the student have an elastic demand.
The more inelastic the demand curve is the more the MR curve lies below the demand curve. To sell an
extra unit requires bigger price cuts. Charging the same price to consumers with different demand
elasticities means that the marginal revenue from the last business customer is less than the marginal
revenue from the student. The firm will gain revenue with no cost by selling computers to one more student.
The firm has to mix the combinations of the two types until the marginal revenue from the types is equal.

Let’s assume the MC=ATC and is constant. The graph below shows that the monopolist will charge a high
price to the business customers and a lower price to the students. The student benefit from the lower prices
and the monopolist maximizes his profits. This is called third degree price discrimination. There is no
incentive to rearrange the mix by altering the price differentials between the two groups. The level of price
and output is determined by equating marginal cost to the respective marginal revenues

PB
PS
MC=ATC
DS
MRS
DB
MRB

QS
QB

Perfect price discrimination is a price discrimination that extracts the entire consumer surplus by charging
the highest price that consumers are willing to pay for each unit.this is called first degree price
discrimination. Each customers pays a different price for the same good. They pay according to their
willingness to buy. Charging the same price, the profit maximizing output is at Q1 ant P1 price and
MC=MR. but if it is perfectly discriminating , the very first unit can be sold at price E. this is sold to the
highest bidder most desperate for the good, the next unit will be sold to the next highest bidder. Moving
down the demand curve we read off the price for each extra unit sold. The demand curve is the marginal
revenue curve under perfect price discrimination.

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 MC
E

A
P1
C
P2

B D

MR

Q1 Q2

From the graph above, taking demand curve as MR, the monopolist produces at point c Q2 where MC=MR.
moving from the uniform pricing point A to the price discriminating point C, the monopolist adds the area
ABC to profits when output is increased. The monopolists makes a second gain, the Q1 output earns more
under price discrimination.

He gains area EP1A by charging different prices on the first Q1 units rather than the single price.

Monopoly and efficiency.

The efficient outcome of pure competition P=AR =MC=ATC. The MC=S marginal cost=supply curve. This
result in productive and allocative efficiency achieved because of free entry and exit. However, monopolist
do not result in neither productive nor allocative efficiency because they set MC=MR and p>MC. the output
is less than the output at which average total cost is lowest. Thus the monopolists profit maximising output

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 results in under allocation of resources, because the find it profitable to restrict output and employ fewer
resources. P>MC, P>ATC.

Due to their market power, monopolist, charge a higher price (P2) than pure competition (P1) thus
transferring income from consumers to the owners of the monopoly. These stakeholders tend to benefit at
the expense of the consumers. Monopoly brings about inequality because the stakeholders are wealthier than
the consumers.

The consumer surplus reduces whiles the producer surplus increases. There is a net loss is surplus which is
not attributed to neither consumers nor suppliers. This is called the deadweight loss.

8.8 Monopolistic competition

Monopolistic competition refers to a market situation with a relatively large number of sellers offering
similar but not identical products. Examples are fast food restaurants and clothing stores.
Characteristics

1. A relatively large of firms: each has a small percentage of the total market. Monopolistic competition
requires not only product differentiation but also limited economies of scale. With lots of producers each
can neglect its interdependence with any particular rival. Each firm can determine its own pricing policy
without considering the possible reactions of rival firms. It can lower its price but it will trigger no reaction
from competitors. The firms are fewer than those in perfect competition, and the pricing power is little
compared to monopoly.

2. Differentiated products: variety of the product makes this model different from pure competition model. Product
differentiation is when the products have slightly different characteristics, offer degrees of customer service,
provide varying amounts of locational convenience or proclaim special qualities etc. Product differentiated is done
in style, brand name, location, advertisement, packaging, pricing strategies, etc. the special feature of a particular
shop lets it charge slightly different price from others without losing all its customers.
• Product attributes; entails physical or qualitative differences. real differences in functional features, material
designs and workmanship. E.g computers differ in storage capacity, speed etc. debonairs pizza and pizza
inn are different by quality.
• Service. The service and the condition surrounding the sell of a product are vital.e.g restuarants, dry
cleaning etc
• Location. Products are differentiated by location and accessibility of the store that sell them.
• Brand names and packaging. Trademarks and brand names and celebrity connections. Some goods are
differentiated by celebrity names such as perfume, watches, clothes etc.
• Advertising is the key to product differentiation. It would be wasteful if customers do not know about the
product. Advertising makes price be less of a factor and product differences a greater factor.
3. Easy entry or exit.
4. No collusion. The presence of a relatively large number of firms ensures that collusion by a group of firms to
restrict output and set prices is unlikely.
Monopolistic competition describes an industry in which each firm can influence its market share to some
extent by changing its price relative to its competitors.

Demand Curve

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Indeed, the main difference between monopolistic competition and other market structures lies in the type of
demand elasticity which each firm confronts.The firm’s demand curve is highly elastic, but not perfectly
elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing
close substitutes; it is less elastic. the demand curve is down ward sloping. The firms have some market
power and are price setters. A lower price attracts some customers from another shop but each shop always
has some local customers from whom convenience is more important than a few pence off the price. e.g hair
dressers. The demand curve shows the total quantity demanded at each price if all firms charge that price.
The market share of the firm depends on the price it charges and on the number of firms in the industry. For
a given number of firms , a shift in the industry demand curve shifts the demand curve for the output of each
firm. For a given industry demand curve, having more firms will shift the demand curve for each firm to the
left as its market share falls and having fewer firms will shift the demand curve of each firm to the right as
its market share rises.

The MR = MC rule will give the firms the profit – maximizing output. The price they charge would be on the
demand curve.

In the short run the monopolistically competitive firm can maximize its profits or minimize its losses.
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In the long run, the situation will tend to be breaking even for firms. Firms can enter the industry easily and
will if the existing firms are making an economic profit. As firms enter the industry, the demand curve
facing by an individual firm shift down, as buyers shift some demand to new firms until the firm just breaks
even. If the demand shifts below the breakeven point, some firms will leave the industry in the long run.

Therefore, most monopolistic competitive firms should experience break-even in the long run theoretically.
In reality, some firms experience profit as they able to distinguish themselves from the others and build a
loyal customer base; such as some name brand apparel companies. Some firms experience lost in long run
but may continue the business as they are still earning normal profit. These firm owners usually like the
flexible life style and willing to earn a normal profit that is lower than their opportunity cost.

8.9 Oligopoly
Oligopoly exits where few large firms producing a homogeneous or differentiated product dominate a
market. Examples are automobile and gasoline industries. Firms in oligopoly have considerable control over
price but each firm has to consider the possible reactions of rivals to its own pricing, output and advertising
decisions. It is characterized by strategic behavior and .mutual interdependence is a situation in which each
firms profit depends not only on its own price and sales strategy but also on those of others.

Characteristics

1. Few large firms: each must consider its rivals’ reactions in response to its decisions about prices, output,
and advertising.
2. Standardized or differentiated products.
3. Entry is hard: economies of scale, huge capital investment may be the barriers to enter.
Some oligopolies have merged mainly through growth of dominant firms in a given industry. The
combining of two or more firms in the same industry significantly increase market share, which allow the
new firm to achieve greater economies of scale. Merging also increase monopoly power (pricing power)
through greater control over the market supply. The firm becomes a large buyer of inputs; it may be able to
obtain lower prices on its production inputs thus cost of production lowers.

This suggests that oligopolists can benefit from collusion, that is cooperating with rival firms. Collusion
occurs when the firms in an industry reach an agreement to fix prices, divide up the market, share
profits and restrict competition amongst them.

If the two firms collude they become like a monopolist.

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PM

MC=ATC
PC

MR

QM QC
From the graph Qc and Pc is the competitive output and price, assuming constant costs. The monopoly
will produce at Qm, therefore, if the two firm collude to produce Qm, they will charge price Pm and
they will share the market and profits.

However, there are incentives for one firm to cheat. One firm can expand its output to Qc and charge a
lower price than the agreed Pm and make extra profits. This firm will gain at the expense of the other
firm since it charges a lower price it increases its market share while the other firms’ market share
reduces and it suffers. Oligopolists are torn between the desire to collude, in order to maximize joint
profits, and the desire to compete in order to raise its market share and profits at the expense of rivals.
Collusion is hard if there are many firms in the industry, if the product is not standardized and if
demand and cost conditions are changing rapidly.

Demand Curve

Facing competition or in tacit collusion, oligopolies believe that rivals will match any price cuts and not
follow their price rise. Firms view their demands as inelastic for price cuts, and elastic for price rise.
Firms face kinked demand curves. This analysis explains the fact that prices tend to be inflexible in
some oligopolistic industries.

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 MC=ATC

PB

MR

D
MR
Q
Q

The upper part (above A) of the demand curve is elastic, such that any price increase, the rivals will not
follow suit and the firm will lose its market share. From A, the demand curve is inelastic, this is any
price cuts will make all the rival firms to cut their prices as well. Therefore there is no gain or profits
made. This results in lower prices and higher sales. Its good for the consumer but not good for the firms
as they lose profits.

The MR curve is discontinuous for the two parts of the demand curve. The firm jumps from one part of
the MR to the other when it reaches Qo output. If a firm produces below Qo additional output will not
depress the price of existing sales. At Qo the firm hits the inelastic demand and marginal revenue
becomes much lower. Now that demand is inelastic further output increases require much lower prices
to sell the extra output. Qo is the profit maximizing output.

If MC shifts up or dowm Qo and Po are still optimal.

One disadvantage of the kinked demand is that it does not explain what determines the initial price Po.
What is known is that it’s a collusive monopoly price. If one firm cheats, the other firms cooperate and
retaliate.

Therefore, if the MC of an industry changes then the collusive price and Quantity will change. And each
firm’s kinked demand shifts up since the monopoly price has risen.

8.10 Game theory

A game is a situation in which intelligent decisions are necessarily independent. In a game we have players, list of
actions and payoffs. The players in the game try to maximize their own payoffs. In oligopoly the firms are the
players and their payoffs are the profits in the long run. Each player must choose a strategy by considering what the
other players strategy would be. A strategy is a game plan describing how a player acts or moves in each possible
situation. When each players chooses the best strategy given the strategies being followed by other players then we
have a Nash equilibrium.

Sometimes a player’s best strategy is independent of those chosen by others. This is called dominant strategy. The
best strategy whatever the strategies on the rival.

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Since the firms in oligopoly have to guess what the other firms will react and decide, the involve strategic
behavior of game theory.

Example;

Two firms are playing a game. Each firm can select a high output or low output. The payoffs are given in the table
below. The first number is a payoff for firm A and the second for firm B.

Firm A Firm B

high low

high 1 1 3 0

low 0 3 2 2

When both players select high, industry’s output is high, the price is low and each firm makes a small profit of
1.when each player selects low the outcome is like a collusive monopoly. Prices are high and each firm makes a
profit of 2.. each firm does best when it is the only one playing high with a profit of 3. While the other playing low
gets zero.

Firm A dominant strategy is play high regardless what firm B does. Firm B dominant strategy is play high whatever
the strategy of firm A. so the Nash equilibrium is both playing high and earn a profit of 1. Playing low for both
players is beneficial for them but if firm A played low, there is a possibility of firm B cheating and play high. This
makes the output restricting cartel not to work out because each player forsees an incentive for the other o cheat.
One possibility is to make a binding commitment. A commitment is an arrangement entered into voluntarily that
restricts future actions.

Cournot behavior is where the firms treat the output of the other firm as given. This game players make output
decision simultaneously. The decision is based on what output you think your rival will produce.

Stackelberg behavior, firm B can observe the output already fixed by firm A. in choosing output firm A must
anticipate the subsequent reaction of firm B. the first mover advantage means that the player moving first achieves
higher payoffs than when decisions are simultaneous..

Betrand behavior is where the decision to be made is on what price to charge. The prices can be set simultaneously
and firm end up setting prices equal to marginal cost.

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8.11 ACTIVITIES
EXERCISE

1. In what circumstances would government give a firm to be a

monopoly?
2. Why is there an incentive for firms to cheat in an oligopolistic market? Illustrate
with a graph.
3. Why is the demand curve in an oligopolistic market kinked? Use a graph to
illustrate.
4. Explain first and third degree price discrimination?
5. A firm in a perfect competition market is earning abnormal profits in the short
run.
With the aid of the diagram, explain its long run position and how it finds itself
there.
6. How is a monopolistic market different from a perfect competitive market?

8.12 SUMMARY
In summary you have learnt;

• In a competitive industry each buyer and seller is a price

taker, individual actions have no effect on the market.

• A pure monopoly is the only seller or potential seller of a

good and need not worry about entry.

• A discriminating monopolist charges different pries to different customers.

In the next unit we will be looking at labour market

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8 UNIT EIGHT: LABOUR MARKET

9.1 INTRODUCTION

We have looked at how firms use labour, capital land and raw materials to product
goods and services. In this unit we want to look the demand for labour. How firm
des decide on how many units of labour they will employ to produce the given
output.

9.2 AIM

The aim of this unit is for students to understand how firms decide on the units of
labour to hire and how individuals as well as the market decide on how many
hours of labour they will supply to the firms at a particular wage.

9.3 OBJECTIVES

At the end of this unit you should be able to do the following

• analyse a firm’s demand for inputs in the long run and short run
• recognise marginal value product, marginal revenue product and marginal cost
of a factor
• define the industry demand for labour
• analyse labour supply decisions
• define economic rent
• define labour market equilibrium and disequilibrium
• demonstrate how minimum wages affect unemployment.

9.4 TIME REQUIRED

The minimum number of hours that the student should spend on this unit is
2hours.

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9.5 REFLECTION

If you had all the money in the world, would you want to work? Explain
why the answer you have given.Write your answer in the spaces provided

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

9.6 essential reading

Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 10.

9.7 Demand for labour

Demand for labour is not direct or final demand, it is derived demand. This means that firms
demand inputs only because they want to produce output. We look at demand for labour in
the long run;

Firms think of the least cost way of making each possible output and then selects the output
that maximizes profit. In producing any output by the cheapest available technique, a rise in
the price of labour relative to capital makes the firm switch to a more capital intensive
technique. Conversely ,if capital becomes relatively expensive , the least cost technique for a
given output is now more labour intensive. The firm substitutes away from the factor of
production that has become relatively expensive.

A higher wage makes the firm substitute capital for labour in making a given output. But it
also rises the total cost of producing any output. With higher marginal costs, but unchanged
demand and marginal revenue curves, the firms chooses to make less output. A rise in the
price of of one factor not merely changes factor intensity at a given output, but also changes
the profit maximizing level of output. There is a pure substitution effect at a given level of
output. A higher relative price of labour compared with capital leads to firms to substitute
capital for labour. But there is also an output effect. By raising marginal costs of producing
output, a rise in the price of labour lowers output.

In the long run a rise in the wage will reduce the quantity of labour demanded.the substitution
effect leads to less demand for labour and each output, and output effect reduces the demand
for all inputs. A rise in the wage also affects the demand for capital and other inputs.

The demand for factors of production is a derived demand, it depends on demand for the
firms output. The output demand curve affects the output effect on the demand for inputs
when an input price changes.

See figure 10.1 in Begg, Vernasca,Fischer and Dornbush page 225

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A rise in the wage rate increases the long marginal costs and pushes the cost curve upward.
This means the profit maximizing point (MR=MC) is now met at a lower output than before.

In the short run the firm has some fixed factors of production. If wages are high, firms would
shift from labour intensive to capital intensive, but in the short run capital is considered
constant or rather fixed.

The firm can calculate the optimal amount of capital and labour to use as inputs in the
production process using marginal analysis or principle. In the short run diminishing
marginal productivity of labour sets in because capital is fixed. So the least cost option lies in
answering the question does the cost of a new worker exceed the benefit of a new worker?
Where the cost of a new worker is the amount to pay the worker a wage and the benefit of a
new worker is the value of the productivity of this worker. Thus profit maximising input
output combination is where the extra value gained from one more unit of the input equal to
the unit price of that input. The extra value gained from one more unit of the input is, in turn,
the marginal physical product of the input multiplied by how much the firm gets, per unit,
from selling that extra output. In the case of a price taking firm, only considers competitive
firms, the marginal physical product is just multiplied by the price of output, which is of
course constant for the firm. In the case of a firm facing a downward sloping demand curve
for its product, a monopolist for example, we cannot just multiply MPL by the original
product price to get the monetary value to the firm of the extra output. Why not? Because to
sell more output the price will have to fall, not just for the marginal unit but for all units. If
you don’t remember why this is, revise the monopoly block and chapter. When the demand
curve is downward sloping the optimal rule for hiring an input is, in the case of labour, to hire
labour until the wage is equal to the marginal revenue product of labour (MRPL)1, i.e. until
W = MRPL = MRQ × MPL
where MRQ is the marginal revenue that the firm gets from selling an extra unit of output.
The demand curve for labour is downward sloping. The graph below shows that demand for
labour is determined by the real wage rate and marginal productivity of labour. Firm will
employ more labour for all wages that are less than MPL, they will stop employing upto a
point where wage is equal to MPL.

The industries demand curve is the horizontal summation of the marginal product of labour
for each firm. At a given wage and price of the product, the summation of the MPL gives the
industries demand curve.

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9.8 Supply for labour
We analyse labour supply in two stages; how many hours people work once in the labour
force and whether people join the labour force at all. Labour force is all individuals in work
or looking for a job. Peoples decision on the hours to work depends on the real wage (W/P),
which shows the quantity of goods that labour effort will purchase.
Labour supply curve traces the relationship between real wage and labour hours supplied.
Below is the graph that is showing two types of labour supply curves panel A shows an
upward sloping supply curve, that shows the higher the real wage the more people will work.
In panel B we get a backward bending supply curve. High wages beyond a certain wages will
make people want to work less.

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The alternative to working another hour is staying at home and having fun. Each of us has 24
hours in a day to divide between work and leisure. More leisure is nice but by working longer
we can get more real income with which to buy consuer goods. So the choice is between
goods and leisure. An individual will want to work until the marginal utility derived from the
goods that an extra hour of work wil provide is just as equal to the marginal utility from the
last hour of leisure.
A higher wage increases the quantity of goods an extra hour of work will purchase. This
makes working more attractive than before and tends to increase the supply of labour.
Suppose you work to get a target bundle of goods that is enough to be able to eat, pay rent
and run a car. With A higher real wage you need to work fewer hours to earn the same target.
These two effects are the substitution and income effect. An increase in real wage increases
the relative return on working. It leads to a substitution effect or pure relative price effect that
makes people want to work more. But a higher real wage also tends to raise peoples real
income. This is pure income effect. The quantity of leisure increases when real income
increases. The income effect tends to make people work less when there is a higher income.
We are looking at an upward sloping supply curve. Market equilibrium happens at the
intersection of the labour demand and supply curves. The figure below shows market
equilibrium.

1. A recession in the industry would shift downwards in the demand curve for the product which
will reduce the marginal value of labour, thus shifting the demand curve for labour
downwads.
2. Suppose that there is an increase in investment in new machinery in other industries, labour
becomes more productive in other industries and have a higher marginal value product thus
attract a higher wage. This will shift up the supply curve for labour in the industry in question.

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9.9 ACTIVITIES

1. What is demand for labour? Explain how the demand curve is derived.
2. What factors would lead to a shift in the demand for labour?
3. Describe, in words and using graphs, the impact of a change of hourly wage on a
person’s labour supply decision, regarding both hours of work and their participation
decision.
4. Alisha earns £20 per hour for up to eight hours of work per day and is paid £25 for
every hour in excess of this. She receives £20 per day from the government in child
benefit (regardless of whether or not she works) and pays £8 per hour for childcare for
each hour she works. If she works, she pays £5 per day for an all day bus ticket. Find
how many hours she needs to work to meet her expenses and Calculate how much she
has for consumption .

9.10 SUMMARY

In summary we have learnt of

 In the short run the firm has fixed factors, thus the firm vary output by
varying the variable input, labour. This is subject to diminishing
returns when other factors are fixed.
 A profit maximizing firm produces the output at which marginal output cost equals
marginal output revenue.
 The downward sloping marginal product of labour is the short run demand curve of
laabour
 A rise in the price of labour has a substitution and output effect.
 The supply curve of labour depends on the wage paid relative to thee wages in other
industries using similar skills

In the next chapter we will be looking at welfare economics

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10 UNIT NINE: WELFARE ECONOMICS

10.1 INTRODUCTION

In this unit we look at what happens when markets fail to allocate resources

10.2 AIM

The aim of this introduce you to

• Externality

• Public goods

• Asymmetric information

• Forms of government interventions

10.3 OBJECTIVES

At the end of this unit you should be able to do the following

• Define and draw graphs for negative and positive externality in consumption
and production

• Explain the difference between public goods and private goods

• Calculate the impact of a subsidy and tax on consumer and producer welfare.

10.4 TIME REQUIRED

You take a minimum of 4hours to finish this module.

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10.5 REFLECTION

Why is it hard to pay for services like police,

national defense security?

10.6 READINGS
Begg etal. Chapter 13. Page 315 , Sloman and Garratt, chapter 7. Page 194

10.7 EQUITY AND EFFICIENCY

This section introduces the twin notions of equity and efficiency. It is particularly important
to understand clearly the definitions of Pareto optimality (an allocation of resources is Pareto
efficient if any reallocation would make at least one person worse off) and Pareto
gain/improvement (a reallocation of resources that makes at least one person better off
without making anyone worse off).

While the notions of Pareto efficiency and Pareto improvements are useful principles, they do
have their shortcomings when applied to actual policy decisions, for at least two reasons.
Firstly, there are generally many Pareto optimal allocations so further value judgements are
required to choose the best allocation from the set of such efficient allocations. Secondly,
many policy decisions have both winners and losers; adopting policies of this kind are not
Pareto improvements because some people are made worse off.

Equity can be broken down into horizontal and vertical equity. Horizontal equity is ‘the
identical treatment of identical people’ while vertical equity has to do with treating people in
different situations differently so as to reduce inequalities between them. Vertical equity is
the more contentious of these two principles; it is hard to see why one would not want to treat
identical people identically, while the optimal amount of vertical equality is a matter of
considerable debate.
Efficiency has to do with making the best use of scare resources to satisfy people’s needs and
desires and can be broken down into productive and allocative efficiency. To discuss
efficiency further, it is useful to come back to the production possibility frontier PPF
introduced in unit1 and illustrated below.

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Productive efficiency is represented by any point on the PPF. Points beyond the frontier (such
as F) are unattainable and points inside (such as A) are inefficient. Productive efficiency
implies that goods and services are produced at their lowest cost. More output of one good
can only be obtained by sacrificing output of other goods.
Allocative efficiency has to do with the choice between different combinations of output –
only one point on the PPF is allocatively efficient. This is the point that aligns the efficient
production possibilities with the needs and preferences of society. A point on the PPF is
allocatively efficient when it is not possible to move to a different point on the PPF and make
someone better off without making someone else worse off. Allocative efficiency is achieved
when P = MC, since this means that benefit and cost are equated. Allocative efficiency occurs
when the marginal benefit equals the marginal cost of producing one extra unit.
An equilibrium may be productively efficient without being allocatively efficient. In other
words, a market where the output generated is being maximised isn’t necessarily maximising
social welfare.
As stated above, a Pareto efficient allocation is an allocation there is no other feasible
allocation that makes someone better off without making anyone else worse off. It relates to
both productive and allocative efficiency.
Equity and efficiency are separate concepts. Efficiency doesn’t automatically imply equity.
For example:
An economy contains two people and two goods, oranges and bananas. Both people like both
goods, but value them differently. For person 1, one orange is exactly equivalent to two
bananas, while for person 2, two oranges are exactly equivalent to one banana. In this case,
the three following allocations are all Pareto efficient:
• Person 1 has all the oranges and person 2 has all the bananas.
• Person 1 has all the oranges and all the bananas.
• Person 2 has all the oranges and all the bananas.2
It is clear that while options 2 and 3 are both Pareto efficient, they are also highly inequitable!
First theorem of welfare economics states that;
When all markets are perfectly competitive, the economy will attain a Pareto efficient
allocation. A perfectly competitive economy induces selfish individuals independently
maximising their private well-being, to bring the economy to a socially optimal state.
Second theorem of welfare economics states that:
A planner can achieve any desired Pareto optimal allocation by appropriately redistributing
wealth in a lump-sum fashion and then letting the market work.

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10.8 Distortions
Distortions; A distortion exists whenever society’s marginal cost of producing a good
does not equal society’s marginal benefit from consuming that good. Taxation is a
distortion in the market. For example if the government wants to finance a subsidy to
the poor, they must tax the incomes of the rich or the goods rich people buy.

When there is no distortion in the market for one good, a tax in the market for another
good will lead to inefficient allocations. If we could abolish the tax there would not
be any distortion. This is the first best allocation.

The theory of the second best says that if there must be a distortion, it is a mistake to
concentrate the distortion in one market. It is more efficient to spread its effect more
thinly over a wide range of markets.

10.9 Market failure

We use the term market failure to cover all the circumstances in which the market
equilibrium is not efficient. In general, conditions causing market failure are classified
into four categories
 Monopoly power
• Exists when one firm exert some market power in
determining prices
 Externalities
• An interaction among agents that are not adequately
reflected in market prices—effects on agents are external to
market. e.g. Air pollution is classic example of an externality 
Public goods
• One individual’s consumption of a commodity does
not decrease ability of another individual to consume it. E.g.
Examples are national defense, and street lights  Asymmetric
information
• When perfectly competitive assumption of all
agents having complete information about commodities offered in
market does not hold Incomplete information can exist when cost
of verifying information about a commodity may not be universal
across all buyers and sellers
For example, sellers of used automobiles may have information about quality of
various automobiles that may be difficult (costly) for potential buyers to acquire

• When there is asymmetry in information buyers

may purchase a product in excess of a given quality
Existence of monopoly power, externalities, public goods, and asymmetric
information are justification for establishment of governments to provide
mechanisms to address resulting market failures

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  Governments can regulate firms with objectives of mitigating monopoly
power and negative externalities
 Governments can provide for public goods either by direct production or
private incentives
 Governments can generate information, aid in its dissemination, and
mandate that information be provided in an effort to reduce asymmetric
information
• The more a government must intervene in
marketplace to correct these failures. The less dependent will the
economy be on freely operating markets

10.10 Externalities and public goods.

The activities of an individual, society or a firm has an effect on another
individual, society or firm is what is called externalities (side effects).externalities
can as a result of production and consumption. When externalities are beneficial
is called external benefits. When they are hazardous it’s called external cost.

Social cost to society for the production of any good is the private cost faced by
the firms plus any externalities (positive or negative). Social benefit is the private
benefit enjoyed by consumers plus any externalities.

External costs of production. (MSC>MSB)

When a chemical firm dumps wastes into the river or pollutes the air, the
community bears costs additional to those borne by the firm. MSC>MPC.
Marginal social cost are greater than marginal private cost.

The Effect of a Negative Externality

Cost Marginal social cost

Marginal private cost
Marginal cost
P1 from externality

P0

Marginal social
benefit

0 Q1 Q0 Quantity

The firm is maximising profits at price Po and quantity Qo. This is where
MSB=MPC. Now there is negative externality to society which makes the,
marginal social costs higher than the private costs. The MBC curve is above the
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MPC. We assume no externalities from consumption, we equate MSB=MSC and
we have a socially optimum output Q1 and price P1. The marginal benefit to
consumers is the same as the marginal social benefit. Meaning at (Po,Qo) the firm
will produce more than what is socially optimum. They are producing more than
society’s point of view. By producing less, society saves more in social cost than
it loses in social benefit. It would make some people better off without making
anyone worse off. Producing at Qo is inefficient. The difference between MSC
and MPC shows the marginal social loss of producing the last unit of output by
expanding output from Q1 to Q0 society losses the triangle area.

This problem arises in a free market economy because no one has legal ownership
of the air or rivers and no one can prevent anyone from using them as a dump.
Therefore control must be left to the government.

External benefits of production

If for example a timber processing company plants new trees, there is a benefit to
society as the trees help reduce carbon dioxide in the atmosphere. The MSC of
providing timber is less than the MPC to the company.

The below shows that MSC is below MPC. Qo is what the company is producing. Q1
is what society deems optimum. The firm is producing less than what is socially
optimal.

The Effect of a Positive Externality on production

Marginal private
Cost cost
Marginal social
cost
Marginal benefit
P1 from externality

P0

Marginal social
benefit

0 Q 0 Q1 Quantity

External costs of consumption

Let us consider an individual who buys a car which emits CO 2. The marginal
benefit to society will reduce as the motorist travels. The optimum distance
travelled by the motorist will be Q1 miles. This is where MPB=MSC/MPC. If the
marginal benefit of consuming a good exceeds its price then the consumer will

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buy ad consume more. If the marginal benefit is less than the price, the consumer
gains by consuming less. When people use their cars, other people suffer from the
exhaust fumes, the congestion, the noise etc. These negative externalities make
the social benefit of using the car less than the marginal private benefits. The
MSB is less MPB. Assuming no externalities in production. The socially optimum
output is Qo which is less than Q1. Other examples are noise pollution from the
radio, cigarretes and

A negative Externality

S = Marginal private and social cost

Cost
P1
D1 = Marginal
privatebenefit
Marginal
costof an externality
P0

D0 = Marginalsocialbenefit

0 Q0 Q1 Quantity

litter.

External benefits of consumption

The figure below shows a beneficial consumption externality. Planting roses in

your garden makes your neighbour happy. With no production externality, MPC
is both the private and marginal social cost of planting roses. It is the cost of the
plant and the opportunity cost of your time. Comparing your our cost and benefit
you plant Qo roses. The marginal social benefit exceeds your private benefit. The
socially optimum quantity is Q1. Therefore, society could gain the triangle area,
the excess of social benefits over social costs, by increasing the quantity of roses
from Qo to Q1.

A Positive Externality

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 S = Marginal private and social cost
Cost
P1
D1 = Marginal social benefit
Marginal benefit of an externality
P0

D0 = Marginal private benefit

0 Q0 Q1 Quantity

COASE THEOREM

According to Ronald coase, externality problems can be resolved through private

negotiations by the affected parties when property rights are clearly established.
He says government is not needed to remedy negative or positive externality as
long as property rights are clearly defined, the number of people involved is small
and the bargaining cost are negligible. However, many externalities involve huge
number of people affected, high bargaining costs and community property such as
air and water cannot be priced.

Private goods.

Private goods are goods that are produced through the competitive market system.
Private goods encompass the full range of goods offered for sale in stores. These
are goods people individually buy and consume and private firms can profitably
provide because they keep people who do not pay from receiving the
benefits.These goods have two characteristics; rivalry and excludability.

• Rivalry in consumption means that when one person buys and consumes a
product, it is not available for another person to buy and consume. E.g.
buying and consuming a bar of candy.
• Excludability means that sellers can keep people who do not pay for a
product from obtaining its benefits. Only people who are willing and able to
pay the market price for bottles of water can obtain these drinks.

The demand we have look at in the beginning was demand for a private good.
Consumers demand for private goods is expressed by the desire and ability to pay
for the product. The demand is an inverse relationship, meaning when the price of
a product increases the demand for it will reduce.

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10.11 Public goods.
Public goods have the opposite characteristics to private goods. They are 1) non
rivalry, 2) excludability. They cannot be provided for by a private firm because of their
nature.

• Non rivalry is where the consumption of the good or service by one person
will not prevent others from consuming it.
• Non excludability is where it is not possible to provide a good or service to
one person without it being available to others. E.g. roads, national defence.

Public goods have larger external benefits relative to private benefits but are
unprofitable. No one is willing to pay for a public good. For example paying to
build a pavement along your street. This is because the private benefit will be too
small compared to the cost and yet social benefit is much more. These two
characteristics create a free rider problem. Once a producer has provided a
public good, everyone including non payers can obtain the benefit. Most people
do not voluntarily pay for something they can obtain for free.

EXAMPLE; If I own a farm and build a tarred road to my farm, my neighbours

too will benefit from using that road and I cannot prevent them from benefiting,
therefore they will have no incentive to pay. This is what is called a free rider
problem. Such goods only the government can provide or by subsidising the
private firms. Note that not all goods produced by the public sector fall in the
category of a public good e.g education and health.

With this problem, the demand for public good is not expressed in the market.
With no market demand, there is no potential firm to tap the demand for revenues
and profits. If society wants a public good, government will have to provide it.
They government can estimate the demand through surveys or public votes, then
it can compare the marginal benefit t of an added unit of the good against the
govts marginal cost of providing it.

They demand that can be derived from consumers would should their willingness
to pay. If a survey was conducted to find out how much each individual would
pay for a road to be built, the people would indicate how much they would be
willing to pay for an extra unit. But once govt provides the good, because of non-
rivalry and non excludability, they would not be able to pay for it. The only curve
that can be derived is a willingness to pay schedule. This curve is different from
the demand curve because its shows the price the consumer would be willing to
pay for an extra unit of a product to be provided, whereas the demand curve
shows us the quantity that would be demanded at each price given.

10.12 Monopoly.
It’s a case of one firm existing in the industry. It’s the power it poses in the market
which depends on the closeness of substitutes produced by rivalry industries. Its
characterised by

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 1. Single seller
2. No close substitutes
3. Price maker
4. Blocked entry

For a firm to maintain power there must be barriers to the entry of new firms

1. Economies of scale. Is minimum cost of production due to advanced

technology, cheap resources etc in other words its declining average total
cost with added firm size.. this serves as a barrier to entry because firms that
enter as small scale producers cannot realise the cost economies of the
monopolist. They will be cut out of the market because a monopolist can
afford to sell at a low price and still make a profit
2. Network economies. When a product or service is used by everyone in the
market there are benefits to all users from having access to others. E.g ebay.
3. Economies of scope. A firm that produces a range of products is also likely
to experience lower average cost of production.
4. Product differentiation and brand loyalty. When a firm produces a clearly
differentiated produced associated with a brand by consumers, it will be very
difficult for a new firm to break the market e.g Colgate
5. Lower cost for an established firm
6. Ownership of, control over, key inputs or outlets. If a firm has control over
major inputs it can deny access to these inputs to potential rivals. A firm can
have control over the outlets through which the product must be sold.
7. Legal protection. Monopolies may be protected by patents on essential
processes, by copyright and by various licensing and by tariffs and other
trade restriction to keep away foreign competitors.
8. Mergers and takeovers. A firm can put in takeover bids for every new
entrant.

In a monopoly the single firms demand curve is the industry demand curve. The
demand is less elastic at each price. Though it’s a price maker its constrained by
the market demand. It maximises profit where MR=MC.

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 ATC
price

D
MC MR
Quantity

The efficient outcome of pure competition P=AR =MC=ATC. The MC=S

marginal cost=supply curve. This result in productive and allocative
efficiency achieved because of free entry and exit. However, monopolist do
not result in neither productive nor allocative efficiency because they set
MC=MR and p>MC. the output is less than the output at which average total
coat is lowest. Thus the monopolists profit maximising output results in
underallocation of resources, because the find it profitable to restrict output
and employ fewer resources. P>MC, P>ATC.

Due to their market power, monopolist ,charge a higher price than pure
competition thus tranfering income from consumers to the owners of the
monopoly. These stakeholders tend to benefit at the expense of the consumers.
Monopoly brings about inequality because the stakeholders are wealthier than
the consumers.

Lets us analyse the welfare loss of a monopoly using the concept of consumer and
producer surplus. See figure below.

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 Consumer surplus is the excess of consumer’s total benefit from consuming a good
over their total expenditure on it. While producer surplus is the firms profit.

Consumers total benefit is given by the area under the demand curve.

Consumers expenditure is Pc* Qc

Consumer surplus is the difference between the benefit and the expenditure.

Producer surplus the the difference between total revenue and total cost

Cost is the area under the MC curve.

Revenue is Pc*Qc

Producer surplus is the area between price and MC curve.

Effects of monopoly

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 The consumer surplus reduces whiles the producer surplus increases. There is
a net loss is surplus which is not attributed to neither consumers nor suppliers.
This is called the deadweight loss.

10.13 Imperfect information.

• Perfectly competitive markets assume perfect information.

• Real-world markets often involve deception, cheating, and inaccurate

information.

• When there is a lack of information, buyers and sellers do not have equal
information, markets may not work properly.

• Asymmetric information is where one party in an economic relationship has

more information than another. Asymmetric information brings about the
principal agent problem. An example would be an employer and the employee.
The employer is the principal and the employee is the agent. The employer
wants a person who will work to meet the firms’ objective; he doesn’t know the
capabilities of the employee. The employee knows his capabilities. The seller of
a second hand car(agent) has the information on the state of the car than the
buyer. The agent may not act in the best interest of the principal and can get
away with it due to imperfect knowledge the principal has.

HOW CAN WE TACKLE THE PROBLEM?

• The principal must have some way of monitoring the performance of their
agents. Thus a company might employ efficiency experts to examine the
operation of its management.

• There must be incentives for agents to behave in the principal’s interest. thus
managers salaries could be more closely linked to the firms profitability.

• One policy alternative to deal with information market failures is to regulate the
market and see that individuals provide the correct information. E.g. credit
bureaus

• Another alternative is for the government to license individuals in the market

and require them to provide full information about the good being sold. E.g.
doctors and medical personnel licence
• A market in information is one solution to the information problem.
Information is valuable, and is an economic product in its own right. Left on
their own, markets will develop to provide information that people need and are
willing to pay for it.

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10.14 ACTIVITIES

1. A firm producing plastic bags is polluting the air of the neighborhood.

In the following table the marginal private costs (MPC) of the firm for
different quantities of plastic bags are reported together with the inverse demand
for plastics bags.
2.4 Quantity 2.4 MPC (£) 2.4 Selling price (£)
2.4 1 2.4 11 2.4 28
2.4 2 2.4 12 2.4 26
2.4 3 2.4 13 2.4 24
2.4 4 2.4 14 2.4 22
2.4 5 2.4 15 2.4 20
2.4 6 2.4 16 2.4 18
2.4 7 2.4 17 2.4 16
2.4 8 2.4 18 2.4 14
2.4 9 2.4 19 2.4 12
2.4 Polluting the air creates an externality. We know that the value of the externality
is £20 for each quantity level. On a graph with Q on the horizontal axis, plot
the MPC, the marginal social costs and the demand. Show the equilibrium in
the market. Why is the equilibrium inefficient?

2. What protection do private property rights in the real world give to sufferers of
noise, a) from neighbors b) from traffic?

3. Assume that a firm discharges waste into a river. As a result the marginal social
cost (MSC) is greater than the firm’s marginal private cost (MPC). The
following table shows how MPC, MSC, AR, TR and MR vary with output.
output 1 2 3 4 5 6 7 8

MPC 23 21 23 25 27 30 35 42

4MSC 35 34 38 42 46 52 60 72

TR 60 102 138 168 195 219 238 252

AR 60 51 46 42 39 36.5 34 31.5

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 MR 60 42 36 30 27 24 19 14

Assume that the marginal private benefit (MPB) is give by the price AR. Assume
also that there are no externalities on the consumption side,and that therefore
MSB=MPB.

a) How much will the firm produce if it seeks to maximize profits?

b) What is the socially efficient level of output (assuming no externalities on the

demand side?

c) How much is the marginal external cost at this level of output?

d) What size of tax would be necessary for the firm to reduce its output to the
socially efficient level?

e) Why is the tax less than the marginal externality?

f) Why might it be equitable to impose a lump-sum tax on this firm?

10.15 SUMMARY

In summary you have learnt;

• Production externalities occur when actions by ne

producer directly affect the production costs of another
producer, as when firms pollutes
another’s water supply.

• Consumption externality mean ones persons decision affects another’s

consumers utility directly, as when a garden gives pleasure to
neighbours.

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