Topic 1: Introduction to Economics

Economics: is a social science that studies the allocation of limited resources to the production of
goods and services to satisfy consumers’ unlimited wants.

Islamic economics: is a social science which studies the economic problems faced by people. Islamic
economics is imbued with Islamic values that are based on the principles of Shariah.

Macroeconomics: is the branch of economics that studies the entire economics eg: Gross Domestic
Product (GDP), Inflation (Price level) and unemployment

Microeconomics: is the branch of economics that studies part of the economy eg: price of computer
and smartphone

Factors of production (Resources) :

1) Land : natural resources used to produce goods and services

2) Labor: human resources used to produce goods and services
3) Capital : is the synthetic resources used to produce goods and services
4) Entrepreneur: specialized skill of human resources that assume risk of combining the other
three factors of production of goods and services.

Markets: is the organized exchange of commodity (goods and services, resources) between buyers and
sellers.

Basic economic concepts:

Scarcity: is a condition that exists when there is insufficient quantity of resources to produce all of
goods and services desired by people.

Choice: involve a rational decision after considering several alternatives.

Opportunity Cost: is the highest value of goods or other benefits given up when a good is produced or
any action is taken.

Production Possibilities Curve: is a curve that illustrates the alternative combinations of 2 goods that
can be produced with the existing quantity and quality of resources and current level of technology.

Assumptions:

1) 2 products
2) Maximum efficiency
3) Fixed resources
4) Fixed technology

• PPC table and graph with calculation

• Relationship between types of opportunity cost and shape of PPC

Shapes of production possibility curves:

1) Concave to the origin - increasing opportunity cost

2) Convex to the origin – decreasing opportunity cost
3) Linear / straight line – constant opportunity cost
Shift of PPC:

1) Economic growth: is the process of increasing the economy’s ability to produce goods and
services
2) Technology improvement
3) Increase inputs and resources
4) Increased population

4 Basic Economic Problems (Questions of allocation)

1) What to produce?
2) How to produce?
3) For whom to produce?
4) How much to produce?

Four Types of Economic system

Two characteristics of Economic Systems:

Economic system: is an organized method of producing and distributing goods, services and
resources in a society that answers the basic economic questions of allocation.

1) Ownership of resources
2) Decision making

Capitalism: is an economic system that is primarily based on private ownership of resource and
allocative decision made through markets.

Characteristics:

• Private ownership of resources

• Freedom of enterprise and choice
• Consumers’ sovereignty
• Competition
• Minimum government intervention
• Price system

Advantages;

• Production according to the needs of consumers

• Economic freedom
• Efficient utilization of resources
• Greater variety of consumer goods
• Enhanced trade, business and R&D

Disadvantages:

• Inequality of distribution of wealth and income

• Inflation and high unemployment rate
 • Lack of social welfare
• Misallocation of resources

Socialism/Command economy/Central planning: is an economic system that is primarily based on

government ownership of resources and allocative decisions made by the government.

Characteristics:

• Public ownership of resources

• Central planning authority
• Price mechanism is less important
• Government makes all economic decisions
• Government owns all factors of production in the economy
• Equal distribution of income

Advantages:

• Production according to basic needs

• Equal distribution of income of wealth
• Better allocation of resources
• No serious unemployment or recession
• Social welfare

Disadvantages:

• Lack of incentives and initiative by individuals

• Loss of economic freedom and consumers’ sovereignty
• Absence of competition
• Waste of economic resources

Mixed economy/Regulated economy: is a combination of the public and private sectors.

Characteristics:

• Public and private ownership of resources

• Price mechanism and economic plans used to make economic decisions
• Government helps to control income disparity
• Government intervention in the economy
• Large cooperation between the government, public and business sectors

Advantages:

• Economic freedom and social welfare is fulfilled

• Efficient wealth allocation since public goods and private goods are produced at the same
time
• Existence of competition leading to the production of basic goods by the government
• Both public and private interest are served
Disadvantages:

• The government may have excessive control over business activities, hence discourage
investment
• Greater intervention by the government may lead to greater investment, hence heavier taxes
• The government may limit company sizes to reduce monopoly power, hence affecting the
entrepreneurial spirit

Islamic economic system: based on the principles of Islamic Shariah.

• Public and private ownership by God

• Price mechanism and limited government intervention
• Distribution of wealth
• Prohibition of interest (riba)
• Freedom of economic enterprise

Advantages:

• Production of goods and services depends on the classification of goods in Islam

• The poor’s interests are served first
• The best allocation of wealth and fair distribution of income through the concept of zakat, and
sadaqah.

Topics 2. Demand and Supply

Classification of goods in Conventional Economics

• Free Goods: Goods that have no production cost/Goods that are available without production
and usually referred to as “gift of nature” Eg: river water and air
• Economic goods: goods that involve cost of production /goods that are limited in supply and
man-made. Thus, consumers must pay for the goods. Eg. Clothes, houses
• Public Goods: goods that are commonly used and are of benefit to everyone. Eg. Public
clinic, schools

Classification of goods in Islamic Economics

• Dharuriyyah: Necessity goods: food, clothes and shelter

• Hajjiyah: comfort goods: washing machine, refrigerator
• Kamaliat: luxury goods: luxurious cars and bungalows
• Tarafiyyah: extravagant, waste: lavish furniture
Demand: the range of quantities of a commodity that buyers are willing and able to buy at different
prices in a given period of time.

Law of demand: The principle stating that an inverse (indirect) relationship exists between the price of
a commodity and the quantity of the commodity that buyers are willing and able to purchase in a
given period of time if other factors are held constant.

Individual Demand Curve: The demand curve of a person participating in the market for that
particular product.

Market Demand Curve: The demand curve of all people participating in the market for that particular
product.

Change in Quantity Demanded: The movement along demand curve caused by a change in a price of
the goods. A change in quantity demanded can only result from a change in the price of the goods.

• Movement from one point to one point

• Change due to change in price

Change in demand: A shift of the entire demand curve resulting from a change in any of the
determinants of demand.*

• Shift in the entire demand curve

• Changes not due to price but determinants of demand*

Determinants of demand:

1) Price of related goods

• Substitute: eg: Samsung and Apple
• Complementary: eg: Car and petrol
2) Consumers’ income
3) Consumers’ taste and preference
4) Number of buyers in the market
5) Expectation of future price

*Exceptional Demand: Against the law of demand where as the price increases the quantity demanded
increase.

Giffen goods (Inferior Goods): inferior goods normally consumed by those in the lower income
group.

Status Symbol goods(Luxury): purchased by people in higher income group

Supply: is the range of quantities of a commodity that sellers are willing and able to sell at different
prices in a given period of time.

Law of supply: is a principle that state a direct relationship exist between the price of a commodity
and the quantity of the commodity that sellers are willing and able to supply in a given period of time
if other factors are held constant.

Change in quantity supplied: is a movement along the supply curve caused by a change in the price of
the goods

Change in supply: is a shift in the entire supply curve resulting from a change in any of the
determinants of supply

The Determinants of Supply

• Factors of production price (cost of production) eg: oil price, wages

• Profitability of alternative products eg: rubber and palm oil
• Technological innovation: eg agricultural sector: machine, bioengineering
• Expectation of future price: Pe → supply ↓
• Number of sellers

*Exceptional supply: is against the law of supply where as the price increases, the quantity supplied
decrease – Backward bending labor supply curve

Topic 3: Elasticity

Price Elasticity of Demand: is the relative responsiveness to quantity demanded to a change in price

Ed = percentage change in quantity demanded of product X

Percentage change in price of product X

= Q1 - Q0 * P0
P1 - P0 Q0

Determinants of price elasticity of demand:

1) Availability of substitutes: ↑substitutability →↑ elasticity

2) Relative portion of the good in the budget: ↑portion of income →↑elasticity
3) The importance of the goods: necessity → ↓elasticity
4) Income level: ↑income → ↓elasticity
5) Habits:

Degree of elasticity:
• Inelastic: % change in quantity demanded is less than the % change in the price ,
Absolute value less than 1

• Elastic: % change in the quantity demanded is greater than the % change in the price,
Absolute value more than 1
 • Unit Elastic: % change in the quantity demanded is exactly the same as the % change in the
price, absolute value equal to 1

• Perfectly Inelastic: Quantity demanded is totally unresponsive to changes in price

Absolute value: 0

• Perfectly Elastic: An infinitely small change in price and the quantity demanded either falls to
zero or increase to an infinitely large value. Absolute value : infinity

Price Elasticity of Demand and its relations to Total Revenue

(Refer Figure: 20-2)

• In the area of elastic: ↓price → ↑ revenue

• In the area of inelastic:↑ price → ↑revenue

Income elasticity of demand: is the demand relative response of demand to changes in income. It
indicates whether a good is normal or inferior.

Ey = percentage (%) change in quantity demanded

Percentage ( %) change in income

Ey = Q1 - Q0 * Y0
Y1 - Y0 Q0
Type of good Income Elasticity (N)
Normal N>0
Inferior N<0
*

Cross Elasticity of demand: is the relative response of the demand of one good to changes in the price
of another goods.

Type of good Cross Price Elasticity (C)

Substitute C>0
Complement C<0

Ed = percentage change in quantity demanded of product X

Percentage change in price of product Y

E xy= Q1 x - Q0x * P0y

P1y- P0y Q0xy

Price Elasticity of Supply: The responsiveness of quantity supplied to a change in price

Es = percentage (%) change in quantity supplied of product X

Percentage (%) change in price of product X

= Q1 - Q0 * P0
P1 - P0 Q0
Factors influencing Price Elasticity of Supply:

• Time dimension: short-run → ↓elastic

• Nature of goods : eg agricultural (inelastic) vs manufactured (elastic)
• Cost and feasibility of storage: ↑cost of storage →↓ elastic
• Substitutability of factors of production:↑ substitutability →↑ elastic
• Perishability:↑ perishability →↓ elastic

Topic 4: Market Equilibrium

Market Equilibrium: is the condition when the quantity demanded equals the quantity supplied or the
state of the market that occurs when the demanders (buyers) and suppliers (sellers) come together and
exchange a mutually agreeable quantity at a mutually agreeable price. Graphically, equilibrium is
determined by the intersection of the demand and supply curve.

*Changes in demand and supply and effect on equilibrium price and quantity

*Subsidy and indirect taxes

Price ceiling: is a legally established maximum price below the market equilibrium, and is designed to
prevent the price of a commodity from becoming too high.

Price floor: is a legally established minimum price above the market equilibrium.

Shortage: the condition that occur when the commodity price is below the equilibrium price and
quantity demanded > quantity supplied.

Surplus: the condition that occur when the commodity price is above the equilibrium price and
quantity supplied > quantity demanded.

• Effects of changes in demand and supply on equilibrium price and quantity.

Problems of maximum prices/disadvantages:

• Shortage
• Black market

Problem of minimum prices/disadvantages:

• Surplus
• Inefficiency

Price control from Islamic Perspective

• In Islam, the equilibrium price and quantity are determined by market forces, as long as
responsible and honest.
• If the imported goods are few and rare (shortage), the price of these goods would increase and
considered fair in Islam. Transportation cost is one of the factor.
• Islam rejects the practice where price is fixed or controlled by anyone unless this is deemed
necessary, thereby the government might intervene for the benefit of society. i.e. prohibit
market manipulation, artificial shortage, hoarding.
Topic 5: Theory of Consumer Behavior

Topic 6: Production and cost theory

Production in the short run

Production: is the process of transforming resources, through changes in structure, location or time,
into goods and services used for the satisfaction of wants and needs.
An input: is a resource or factor of production used in the production of a good or service.
A variable input: is an input whose quantity can be changed in the time period under consideration.
A fixed input: is an input whose quantity cannot be changed in the time period under consideration.
Short-run:(Fixed Plant) is a period in which at least one input is variable and at least one input is
fixed. It is a period of time too brief for an enterprise to alter its plant capacity, yet long enough to
permit a change in the level at which the fixed plant is used.
Long-run:(Variable Plant) is a period in which all inputs are variable. It is a period of time extensive
enough for these firms to change the quantities of all resources employed including plant capacity.
Productivity: is an economic measure of output per unit of input. Inputs include labor and capital,
while output is typically measured in revenues and other gross domestic product.
Total product (TP): is the total quantity of output produced by a firm with the given quantity of inputs.
The total product curve: is a curve depicting the relationship between total product and the variable
input.
Marginal product (MP): is the change in total product resulting from a change in a variable input,
holding all other inputs unchanged.

MP = change in TP
Change in input

Average product (AP) = is the quantity of total product produced per unit of variable input, holding all
other inputs unchanged.

AP = total product
Variable input

Law of Diminishing Returns (Law of diminishing marginal product): as successive unit of a variable
resource (say, labor) are added to a fixed resource (say, capital or land), beyond some point the extra
or, marginal product attributable to each additional unit of the variable resource will decline. It is also
a principle stating that as more and more of a variable input is combined with a fixed input, eventually
the marginal product of the variable input declines.

Rationale: Increasing, diminishing and negative marginal returns.

*problems of overcrowding – workers are under-used
*Rational producer produces at stage 2.

The Cost of Production

Production cost in the Short-Run

Explicit cost: the monetary payments – the “out of pocket” or cash expenditures a firm make to
outsiders who supply labor services, materials, fuel, transportation services, and power.
Implicit cost: resources used which is owned by the firm itself, such self-employed.
Total variable cost: are costs that change as the quantity of output changes.
Total fixed cost: are costs that do not change with the quantity of output.
Total cost: is the sum of total variable costs and total fixed costs.

Average fixed cost: is total fixed cost per unit of output

AFC = FC
Q
Average variable cost: is total variable cost per unit of output
AVC = VC
Q
Average total cost: is total cost per unit of output.
ATC = TC ATC = AFC + AVC
Q
Marginal Cost: is the extra, or additional, cost of producing one more unit of output.
MC = change in TC
Change in Q

Production Cost in Long-Run

Economies of scale: as plant size increases, a number of factors will for a time lead to lower average
cost of production.
Factors:
1. Labor specialization
2. Managerial specialization
3. Efficient capital
4. By-products
Constant return to scale: over which long-run average cost is constant.
Diseconomies of scale: as the firm size expanding, it leads to a higher per unit costs.
Factors:
1. Management hierarchy leads to problems of communication, coordination, and bureaucratic
red tape-impaired efficiency and rising average costs.
2. Workers feel alienated and have little commitment to productive efficiency.
Topic 7: Theory of Firm and Market Structure

Market structure: the number and distribution size of buyers and sellers in the market for
particular goods and services.

Market structure: is the way in which an industry is organized. A market can be structured
with only one firm or with several thousand. Each firm can have a great deal of control over
the market price or no control at all.

1) Perfect Competition: is an ideal market structure characterized by a large number of small

firms, identical products sold by all firms, freedom of entry and exit into the industry, and
perfect knowledge of prices and technology.

The perfectly competitive firm’s demand curve: perfectly elastic.

2) Monopolistic Competition: is a market structure characterized by large number of relatively

small firms, similar but not identical product, freedom of entry and exit, and imperfect
information.

• Some buyers are willing to pay little more for a good, solely because it is produced by
one particular firm.
• The downward-sloping demand curve of the monopolistically competitive firm means
it determines the price and output in the same way as a monopolist.

Product Differentiation: is a real or perceived difference between goods, such that buyers are
willing to pay different prices

3) Oligopoly: is a market structure characterized by a small number of relatively large firms

supplying most of the output in the market.

Oligopolistic Behavior:

• Mutual interdependence: in which each firm makes its decision based on the reaction
of other firms in the industry
• Price rigidity: in which prices in the industry change very little over time.
• Non-price competition: This is any type of behavior designed to increase a firm’s
demand without changing the price. Eg. Advertising, product differentiation.

Kinked Demand Curve: is a demand curve with two distinct segments, one that is very elastic
and one that is very inelastic.

4) Monopoly: is a market structure characterized by a single firm supplying all output in the
market.

The monopolist’s demand curve is the market demand. (Negatively sloped)

Profit Curve: is a curve showing the relationship between profit and output.
Barriers to entry:

• Government franchise/license: is the legal right granted to a firm to produce and /or
sell a good in a particular market, subject to government control.
• Patent: is the exclusive control of an intervention awarded to its inventor for a certain
period
• Resource ownership or control over resources/raw materials
• Economies of scale

Three Degree of Price Discrimination:

Price Discrimination: occurs when firms charge different consumers different prices for the same
good or services.

1. First-degree (perfect price discrimination), in which consumers are charged the maximum
price they are willing to pay.
2. Second- degree, in which consumers are charged different prices based on characteristics of
their purchase, such as the quantity they purchase.
3. Third – degree, in which different groups of consumers are charged different prices based on
their own attributes such as age, gender, or location.

Profit Maximization (Equilibrium of a Firm):

Equilibrium of a firm is when it earns maximum profits or incurs minimum losses.

Total Revenue: is the revenue received by a firm for the sale of its output, calculated as price
time quantity.

Average Revenue: is revenue received per unit of output sold, which is the price of the good.

AR = total revenue = P*Q = P

Quantity Q

Marginal Revenue: is the change in total revenue resulting from a change in the quantity of
output sold.

MR = change in total revenue

Change in quantity

Short – run Output

Total Cost and Total Revenue

Breakeven output: is the quantity of output in which total revenue is equal to total cost, such
that a firm earns a normal profit, but no economic profit.

A profit curve is the relationship between economic profit and the quantity of output.
Types of profit:

1) Supernormal (Profit): Total Revenue (TR) > Total Cost (TC)

2) Subnormal (Loss): Total Revenue (TR) < Total cost (TC)
3) Normal Profit (Breakeven): Total Revenue = Total Cost (TC)

Shutdown: Price < AVC

Profit maximization in the short run: Two approaches.

1. Total-Revenue-Total-Cost Approach: A firm’s profits are maximized at the output at

which total revenues exceeds total cost by the maximum amount.
(For Perfect Competition market structure)

2. Marginal-Revenue-Marginal-Cost Approach: The firm will maximize profits or

minimize losses by producing at that point where marginal revenue equals marginal
cost.
(For all 4 market structures)

Total profit = Total Revenue – Total Cost

= (P x Q ) - (AC x Q )

Chapter 8: Theory of Distribution