Micro-

Economics
Prepared by
Mr. Joseph B Ndawi (MSc ,BSc Economics (Project
Planning and Management)
COURSE REC 101,RAC 112,RFN 112
TOPIC 1

INTRODUCTION
 1.0 INTRODUCTION
 Economics- we study the allocation of scarce resources.

1.1 What is Economics?

 Economics is best described as the study of human’s behavior in
response to limited resources to fulfill unlimited wants and needs.
 According to Robins, Economics as social studies behaviour of the
people and its consequences. Economics behaviour is essentially the
process of evaluating Economics opportunities open to an individual or
society and, given the resources, making choice of the best of the
opportunities
 The objective behind this economics behaviour is to maximise gains from
the available resources and opportunities.
 Cont…
 The basic function of economics is to observe, explain and predict how
people (Individual, households, firm and government) as a decision makers
make choices about the use of their resources (Land, Labour, Capital, time and
technology etc) to maximise their income, total utility (as consumer).
 Economics is the fundamentally the study of choice-making behaviours of the
people.
 This gives Economics the status of social science.

 Economic behaviour of the individuals, households, firms, government and

society as whole which is the central theme of economics as a science.

 Thus economics is fundamentally the study of how people allocate their limited
resources to produce and consume goods and service to satisfy their endless
wants with the objective of maximising their gains
 Cont…
1.2 The scope of economics/Branches
 The scope of Economics as it is known in a modern economics is divided
into two branches i.e. Microeconomics and Macroeconomics

 Microeconomics is the branch of economics that studies the behavior of

individual decision- making units such as consumers, resource owner and
business firms as well as individual markets.
 Microeconomics studies how consumers and producer make choices, how
their decisions and choices affect the market demand and supply
condition, how consumer and producers interact to settle the prices of
goods and services in the market, how prices are determined in different
market settings and how total output is distributed among those who
contributed to production i.e., landlords, labour, capital supplier and the
entrepreneurs
 Cont..

Macroeconomics
 is the study of the behaviour of the economy as a whole whereby the
relationship is considered between broad economic aggregates such as
national Income, employment and prices. Macroeconomics studies the
working and performance of the economy as a whole.
 It analyses behaviour of the national aggregates including National income,
aggregate consumption, savings, investment, total employment, the general
price level and country balance of payments.
 Therefore “macroeconomics” is the study of the nature, relationship and
behaviour of aggregates and average of economics quantities.
 Cont…
1.3 Normative Vs Positive Economics
(i) Positive Economics
 Economics as a positive science seeks to analyse systematically and explain
economic phenomena as they actually happen; studies the common
characteristics of economics events, bring out the cause and effect
relationship between the economics variables, if any and generalize this
relationship in the form of theoretical proportion.
 Cont..
ii) Normative Economics
 Economics as a normative science is concerned with ideal
economic situation, not with what actually happens. Its
objective is to examine “what actually happens” from moral
and ethical points of view and to judge whether “what
happens” is socially desirable.
 It examines also whether economics phenomena like
production, consumption, distribution prices, etc are socially
desirable or undesirable. Desirability or undesirability of
economic happenings are determined on basis of socially
determined values. Thus normative economics involves value
judgement and values are drawn from moral and ethical values
and political aspirations of the society.
 1.4 Scarcity and choice
(Why does the Problem of making choice
arise?)
 The concepts of scarcity and choice are central to the
discipline of economics
 The need for making choice arises because of some “
basic facts of economic life”. The history of human
civilization bears evidence to the fact that
(i) Human desire, wants and aspiration are unlimited.
Human’s wants, desire and needs are endless
(unlimited) in the sense that they go on increasing with
increasing in peoples’ ability to satisfy them.

(ii) Resources are scarce and limited. The need

making choice between the various goods that people
want to produce and consume arises mainly because
resources that are available to the people at any point of
time for satisfying their wants are scarce and limited.
 Cont..
iv) Gain maximisation behavior is another
aspect of human behaviour that leads to the
choice-making behaviour. Most people aim at
maximising their gain from the use of the limited
resources.
 A rational consumer wants to maximize his/her
utility or satisfaction, a producer wants to
maximize their output/profit and as factor owner
wants to maximise their earnings. If the people
were not to maximise their gains, the problem of
choice making would not arise.
 Resources
classification
a) Natural resource (Land, lakes, rivers, minerals, forest
b) Human resource (manpower, human, energy, talent, professional
skills etc)
c) Manmade resource/ capital (machinery, equipments, tools,
technology etc)
d) Entrepreneurship
 All these resources are scarce. It is scarce in relative terms. It
implies that resources are scarce in relation to the demand for
resources.
 The scarcity of the resources is the mother of all economics
problems. It is the scarcity of resources in relation to human wants
that forces people to make choice
 Opportunity cost
 This is the one of the most fundamental concepts in
economics.
 The opportunity cost of an action is the value of the best
forgone alternative action. The opportunity cost arises
because many resources are scarce and have
alternative uses. The choice of one action, therefore,
often implies that an alternative action will be foregone.
Thus, for example, if a consumer has 20,000 shillings to
spend and has choice between going for a movie and
buying a book, the opportunity cost of going for the movie,
if he decides to make that decision, would be the book
forgone.
 The concept of opportunity cost applies to individual firms
deciding what combinations of goods and services to
produce.
 Cont..
1.5 The Production Possibility’s Frontier
(PPF)
 PPF- Refers to the alternative combination of goods
and services that a society is capable of producing
with its given resources and state of technology
See table 1
 The PPF show all the alternative combinations of two
goods ( food and clothing ) that can be produced by
making full use all the available resources (labour
and capital) given the state or technology
 Cont..

Table alternative production possibilities

Alternative Foods(‘000 tons) Clothiong(ooo ’

ooo metres)
P 8 0
A 7 40
B 6 55
C 5 64
D 4 71
E 3 76
F 0 80
 Cont…

Food P
‘000 8 A .H
tons 7
6 B
5 C

4 .G
3 D
0 E
40 55 647176 80F
clothing 000’000 tons
 Cont..

 Each point in the PPF show a different combination of two

goods e.g. if a country choices point P on the PPC , it can
produce 8000 tons of food and no clothing.
 Similarly, point F shows that the country can produce 80
million meters of clothing but no food

Implications of points away from PPF

 The PPF shows the alternative combination of two goods
under the conditions that all the resources (labour and
capital) are fully employed.
 Any point below PPF e.g. point G implies underutilization
or unemployment of resources.
 Cont..
 Point ‘H’ is unattainable for lack of
resources. The scarcity of resources does
not permit production of any combination of
food and closing indicated by a point outside
the PPF.
 PPF also indicates the opportunity cost of
one commodity in terms of the other
 Along PPF/PPC the opportunity cost is not
the same. From the figure above movement
from Point “A” downwards to point “B, C, D, E
and F” shows increasing opportunity cost of
closing in terms of lost output of food.
 Shift in PPF is caused by
 Expansion or resources (labour and
capital )
 Cont..

 Shift of PPF
 Cont..
1.6 Methodology of Economics
 The basic function of economist is to observe and analyse
economics phenomena and formulate economics theories
 An economics theory is the statement of a general tendency.
Specifically, an economic theory is the statement of cause and effect
relationship between two or more observed facts of real economic
life.
 To formulate an economic theory, economists use a scientific method
of study. Scientific method of investigation involves observation of
economic phenomena or events, collection and analysis of relevant
data and prediction of economic phenomena
 Predictive statements give the cause-effect kind of relationship
between two or more economic variables.
 When the relationship between the selected variable is established
with a high degree of confidence, it is presented in form of a theory
 This process is called theorization or formulation of theory
 Cont.. 1.6.1
Model building and formulation of
economics theory
 A model is an abstraction from reality. It represents reality in a simplified form.
 Practically, a model is a logically consistent analytical framework made for
analysing facts of life in an abstracted form. Economic models may take the
form of a logical statement, graph or mathematical equations specifying
relationship between the economic variables.
 Steps of model building and economic theorization
1. Specifying the problem of study
2. Formulating a testable hypothesis
3. Making assumptions and making postulates
4. Collection of related data and other relevant facts
5.Deducing the testable predictions
6. Testing the validity of prediction
Supplement notes
What is a theory?
 A theory is an unproven idea or speculation. It is a set of statements
or principles devised to explain a group of facts or phenomena.
Theories enable us to predict unobserved events.
A theory consists of:
• A set of definitions describing variables to be used
• A set of assumptions outlining conditions under which the theory
applies
• Hypotheses/hypothesis about the behaviour of variable
• Predictions deduced from assumptions of theory
• Testing against data
 Cont..
 A variable is a magnitude that can take on different values. There are two
types of variables; endogenous and exogenous variables. Endogenous
variables are those which are explained within the model and exogenous
variables are those which are explained outside the model.
 Assumptions are significant factors/propositions that are taken into
consideration in a theory
 A hypothesis is a proposed explanation about the relationship between
variables. It is a specific, testable prediction about what you expect to
happen; for example ‘there is a positive/negative relationship between
variable A and B.
 Predictions are propositions that can be deduced from a theory
 A theory is tested by evidence to see if the predictions are true or not
 Cont..
A good theory:
• Must make predictions that match our observations
• Should have a good chance of being right
• Should stand the test of time
• Should be backed up by other theories with proof
• Is often simple to accept
• A good theory is always close to the reality of a situation; for example
price and demand. The law of demand says that as price increases
demand falls, this is observable in many situations in the economy. It is
easily applicable to the real world situation in many instances.
• Economic theories provide an outlet for research in many areas to refute
or approve a theory.
 Cont..

Economic Models
 A model is a specific quantitative formulation of a theory. Specific
numbers are attached to mathematical relationships in a theory. The
specific form of the model can then be used to make precise predictions.
 Models can be expressed as words, diagrams, or mathematical equations
depending on the audience and the point of the model. You cannot present
to a local uneducated society models in mathematical form.
 Cont..

Economic models are used for different purposes in economics:

• Forecasting economic issues with conclusions which are logically related
to assumptions
• Economic policy making and recommendations
• Presenting arguments to justify economic policy in politics, company
strategy at firm level or advice to households
• Planning and resource allocation
 Why studying economics
1) Economics provides the underlying principles of optimal resource
allocation and thus enables individuals and firms to make
economically rational decisions. e.g, the preparation of budgets
involves knowledge of demand and elasticity analysis.
Additionally, the theory of production in economics is concerned
with the principles that facilitate the optimal combination of factors
of production.
2) A study of economics enables individuals and organizations to
appreciate the constraints imposed by economic environment
within which any entity operates. The student of economics is able
to analyse the effects of such economic variables such as
inflation, exchange rates, interest rates etc.
3) The area of development economics is fundamentally concerned
with the reasons why society develop and means of accelerating
development
4) Economics is an analytical subject and its study can help to
develop logical reasoning
 1.7 CONSUMER
SOVEREIGNITY
 The power of consumers to determine what goods
and services are produced.
 The theory suggests that consumers ,not producers,
are the best judge of what products benefits them the
most.
 Due to the fact that consumer markets depend so heavily
on demand, producer must monitor the needs of these
individuals if they want their products to have any chance
at success.

 The authority of consumers to determine what goods and

services are produced is often referred to as consumer
sovereignty.
THREE BASIC ECONOMIC
QUESTIONS
 Economic theory is concerned with how society answers the basic
economic questions of WHAT goods and services should be
produced, and in what amounts, HOW these goods and
services should be produced (i.e., the choice of the appropriate
production technology), and FOR WHOM these goods and
services should be produced.
1.WHAT GOODS AND SERVICES SHOULD BE PRODUCED?
 In market economies, what goods and services are produced
by society is a matter determined not by the producer, but rather
by the consumer.
 Profit-maximizing firms produce only the goods and services that
their customers demand Consumers express their preferences
through their purchases of goods and services in the market.
 The authority of consumers to determine what goods and services
are produced is often referred to as CONSUMER SOVEREIGNTY
 Cont..
2. HOW ARE GOODS AND SERVICES PRODUCED?
 How goods and services are produced refers to the
technology of production, and this is determined by the firm’s
management.
 Production technology refers to the types of input used in the
production process, the organization of those factors of
production, and the proportions in which those inputs are
combined to produce goods and services that are most in
demand by the consumer.

3. FOR WHOM ARE GOODS AND SERVICES PRODUCED?

 Those who are willing, and able, to pay for the goods and
services produced are the direct beneficiaries of the fruits of the
production process.
 While the what and the how questions lend themselves to
objective economic analysis, answers to the for whom
question are fraught with numerous philosophical and analytical
pitfalls.
 Cont..
In market economies, the returns to the owners of
these factors of production are largely determined
through the interaction of supply and demand.

Production is made for someone to consume

somewhere. What is the final destination of the
product is the key question here. Is a free market
this is determined by who is able to afford at the
market price. If you do not know for whom you are
producing, it will be difficult for you to decide what
to produce because you might not be able to sell
your products.
 TOPIC 2

CONSUMER BEHAVIOUR
 Consumer Behaviour
Theory

2.0 Introduction
 The theory of consumer behavior tries to explain the
consumption behavior of consumers.
 Is divided into three major elements
1. Rational Behavior : A consumer as an individual or a household is
an utility maximising entity and all decisions are directed towards
maximisation of total utility.
2. Preferences: The consumer’s preferences are known, and can, at
least, be ranked.
3. Budget Constraint: Consumers’ “money” is limited, or scarce
relative to their wants. Therefore the consumer will maximize total
utility given his or her limited budget, or “money” income.
 2.1 Introduction
 Consumer behavior is the study of individuals, groups, or
organizations and the processes they use to select, secure,
and dispose of products, services, experiences, or ideas to
satisfy needs and the impacts that these processes have on
the consumer and society.
 It attempts to understand the decision-making processes of
buyers, both individually and in groups.
 According to Hamansu (2008), “the main objective of the
study of consumer behaviour is to provide marketers with
the knowledge and skills that are necessary to carry out
detailed consumer analyses which could be used for
understanding markets and developing marketing
strategies’’.
 2.2 The Concept of Utility
 Utility refers to satisfactions derived from all the units of that
product consumed.
 It’s the satisfaction which is derived by the consumer by
consuming the goods. For example, cloth has a utility for us
because we can wear it. Pen has a utility for a person who can
write with it
 Therefore, Utility is subjective in .nature. It differs from person
to person. The utility of a bottle of wine is zero for a person who is
non drinker while it has a very high utility for a drinker
 Total Utility is the total satisfaction that a consumer gets from
consumption of a certain product/commodity
 Marginal utility is extra/additional utility derived from the
consumption of one more (additional) unit of a
commodity/products, the consumption of all other goods
remaining unchanged.
 Cont…
 Total utility (TU) from a single commodity may be defined as some of utility
derived from all the units consumed of the commodity. Example consumer
consumes 4units of commodity and derive U1,U2,U3 and U4 utils from
successive units
TU=U1+U2+U3+U4
 Marginal Utility can be defined as the utility derived from the marginal or
last unit consumed
 Marginal utility is the additional of total utility derived from the consumption
or acquisition of one additional unit. More precisely Marginal utility (MU) is
the change in total utility resulting from the consumption of one additional
unit
i.e. MU=ΔTU/ΔC ,where MU=Marginal Utility, ΔTU=change in total utility,
and ΔC =change in commodity

Also, MU=TU n – TUn-1

 Cont..
 For example, one hamburger per day (or, more generally, one unit of good
X per period of time) gives the consumer a total utility (TU) of 10 utils,
where
 A Util is an arbitrary unit of utility. Total utility increases with each
additional hamburger consumed until the fifth one, which leaves total utility
unchanged. This is the saturation point.
 Therefore consuming the sixth hamburger then leads to a decline in total
utility because of storage or disposal problems.
 The extra or marginal utility resulting from the consumption of each
additional hamburger. Marginal utility is positive but declines until the
fifth hamburger, for which it is zero, and becomes negative for the sixth
hamburger.
 The negative slope or downward-to-the-right inclination of the MU
curve reflects the law of diminishing marginal utility.
 2.3 Approaches of
Analysing/Measuring Utility
 The concept of utility discussed in the previous section was introduced in
the early 1870s, by William Stanley Jevons of Great Britain, Carl Menger of
Austria, and Léon Walras of France.
 They believed that the utility an individual receives from consuming each
quantity of a good or basket of goods could be measured cardinally just
like weight, height, or temperature. An actual measure of utility, in util.
 In contrast, ordinal utility only ranks the utility received from consuming
various amounts of a good or baskets of goods. Ordinal utility specifies
that consuming two hamburgers gives the individual more utility than when
consuming one hamburger, but it does not specify exactly how much
additional utility the second hamburger provide.
 In short, ordinal utility only ranks various consumption bundles, whereas
cardinal utility provides an actual index or measure of satisfaction
 Cont…
(i) Cardinal approach
 The cardinal’s approach assumes that the consumer’s satisfaction can be
measured in a unit known as Utils. Up to a point, the more units of commodity
the individual consumes per unit time the greater the greater total utility
received.
 The Cardinal utility approach is adopted by the neo-classical economists,
widely known as Marshalling approach
 The cardinalists assume that utility is quantitatively/cardinally measurable. i.e it
can be measured in absolute terms.
 It can be measured like heights, weight, length and temperature.
 The cardinalists used util as a measure of utility/satisfaction under the
assumption that one unit of money equals to one util.
 It implies that price that a consumer pays for a commodity equals the utility
derived from the commodity
 Select this paragraph to edit
 Consider an individual’s consumption of a particular commodity X
over a period of time. The table shows what happens to the
consumer’s total utility and marginal utility as he/she consumes more
units of the goods.
 Cont..
Table 2.1 the total and marginal utility of a consumer

Quantity of X Total utility(Units per Marginal utility (Utils )

consumed per week week)

0 0 0
1 20 20
2 50 30
3 60 10
4 62 2
5 60 -2
 Law of Diminishing
Marginal Utility
 The law of diminishing marginal utility states that “as the quantity of a good
consumed by an individual increases, the marginal utility of the good will
eventually decrease”.
 Its any additional consumption of commodity will lead to a decline in total utility.
Tables 2.1 illustrate the operation of the law of diminishing marginal utility. As
the consumer initially increases his consumption of the commodity X, the
additional satisfaction derived from consuming one more unit (marginal utility)
increases and beyond a certain level, the marginal utility decline.
 Cont..

Utility

TU

Normal goods
Assumptions of law of
Diminishing of Marginal Utility

The law of diminishing Marginal utility holds only under

certain given conditions.
1) The consumers taste and preference remain
unchanged during the period of consumption
2) Time period must be specified for law
3) There must be continuity in consumption
4) The unit in consumption must be standard one,
example a cup of tea, a glass of water etc.
5) The mental state of an individual has to remain
constant during consumption
 Cont..
(2) The ordinal
 The underlying assumption in the ordinal approach is that
utility is not measurable but approach is ordinal
magnitude.
 This approach does not require the consumer to know in
specific units the utility of the various commodities in order to
make a choice.
 It is sufficient for him/her to be able to rank the various
combinations according to the satisfaction derived from each
bundle.
 The basic difference between the cardinal approach and
the indifference curve (ordinal) approach is that the
cardinal approach rests on the unrealistic assumption that
utility is measurable in a cardinal sense, while the
indifference curve approach requires only an ordinal
measure of satisfaction.
 2.4 Indifference Curve
Analysis
What do they show?
 Consumers tastes can be examined with ordinal utility. An ordinal
measure of utility is based on Three assumptions.
1 First, we assume that when faced with any two baskets of goods, the
consumer can determine whether he or she prefers basket A to basket B,
B to A or whether he or she is indifferent between the two.
2. Second, we assume that the tastes of the consumer are consistent or
transitive. That is, if the consumer states that he or she prefers basket A
to basket B and also that he or she prefers basket B to basket C, then
that consumer will prefer A to C
3. Third, we assume that more of a commodity is preferred to less;
that is, we assume that the commodity is a good rather than a bad, and
the consumer is never satiated with the commodity. E.g. pollution

 The three assumptions can be used to represent an individuals tastes

with indifference curves. In order to conduct the analysis by plane
geometry, we will assume throughout that there are only two goods, X
 What is Indifference curve

 An indifference curve may be defined as the locus of points each

representing a different combination of the two goods but yielding the same
level of utility/satisfaction, or
 An indifference curve is a graph showing a combination of different
commodities that yield the same level of satisfaction or utility to the consumer.
 Since each combination of two goods yield the same level of utility, the
consumer is indifferent between any two combinations of goods when it
comes to making a choice between them.
 Indifference curve is also called Iso- utility curve or equal utility curve.
 Cont..
 A higher indifference curve refers to a higher level of satisfaction, and
a lower indifference curve refers to less satisfaction.
 However, we have no indication as to how much additional
satisfaction or utility a higher indifference curve indicates. That is,
different indifference curves simply provide an ordering or ranking of
the individuals preference.
 The entire set of indifference curves is called an indifference map
and reflects the entire set of tastes and preferences of the consumer.
 Cont..
The following figure 2.2 illustrate indifference curve

Commodity Y

I3

I2

I1

X1 X2 Commodity X
 Cont…
Assignment 1:
I. Find out the limitation of the Cardinal approach.
II. What is Consumer surplus, justify your explanation with the use of
graph
III. What are the distinction between ordinal and cardinal approaches
of utility
 Properties of indifference curves
Indifference curve have the following 4 basic properties
1. Indifference curve are convex to the origin
 As more and more units of one good, say Y, are given, it is
reasonable to suppose that successively bigger quantities of X
must be obtained to compensate the consumer for his loss of
satisfaction and leave him/her at the same level of utility.
 The assumption that indifference curves are convex to the
origin implies that the two commodities under consideration can
substitute one another, but they are not perfect substitute
 Indifference curves are usually convex to the origin; that is, they
lie above any tangent to the curve. Convexity results from or is
a reflection of a decreasing Marginal Rate of Substitution (MRS)

2. Indifference curves never intersect

 Consider the figure 2.3 below which shows two intersecting
curves. Since both combinations D and E are on the same
indifference curve, the consumer must be indifferent between
them. Combinations E and F also lie on the same indifference,
so the consumer must be indifferent between them as well.
 Cont..
 If however, the consumer is indifferent between D and E, and
between E and F, he/she must (by rule of transitivity) be indifferent
between D and E. This, however, would be absurd since D
contains more Y and the same amount of X as F and so must
preferred to it. We therefore, conclude that indifference curves
never intersect.
 Cont…
Commodity Y
D
Fig.2.3

Commodity X
 Cont..
3.Indifference curves slope downwards towards from left to right
 If both X and Y are goods, and if the consumer is not satisfied with
either X or Y, then as some of one good is given up, more units of
other good must be obtained if the consumer is to remain at the
same level of utility or satisfaction. This implies that movement on
same indifference curve. See figure 2.4
 Cont..

Commodity Y
Select this paragraph to edit

Commodity X
 Cont..
 The slope of indifference curve is called Marginal rate of
substitution.
 The Marginal Rate of Substitution (MRS) of X for Y refers to the
amount of Y that a consumer is willing to given up in order to gain
one additional unit of X (and still remain on the same indifference
curve/satisfaction).
 MRS=Δqi
Δq2
 As the individual moves down an indifference curve, the marginal
rate of substitution of X for Y diminishes.
4. Upper indifference curve indicates a higher level of satisfaction than
the lower ones.
 Marginal Rate of Substitution
(MRS)
 The amount of a good that a consumer is willing to
give up for an additional unit of another good while
remaining on the same indifference curve.
 For example, the marginal rate of substitution of good
X for good Y (MRS) XY refers to the amount of Y that
the individual is willing to exchange per unit of X and
maintain the same level of satisfaction.
 Note that: MRSxy measures the downward vertical
distance (the amount of Y that the individual is willing
to give up) per unit of horizontal distance (i.e., per
additional unit of X required) to remain on the same
indifference curve.
 That is, MRS XY=−∆X/∆Y
 Because of the reduction in Y, MRS XY is negative.
However, we multiply by −1 and express MRSXY as a
 MRS
 Is the rate at which an individual must give up "good A" in order to obtain one
more unit of "good B", while keeping their overall utility (satisfaction) constant
 MRS is given by the slope of the IC curve. The marginal rate of substitution is
calculated between two goods placed on an indifference curve, which
displays a frontier of equal utility for each combination of "good A" and "good
B".
 As such, the marginal rate of substitution is always changing for a given point
on the indifference curve, and mathematically represents the slope of the
curve at that point.
NOTE;
Upper indifference curve indicates a higher level of satisfaction than the lower
ones
 Cont…
For example, consider an indifference curve between coca
and safari at a picnic. If the marginal rate of substitution coca
for safari is 2, then the individual would be willing to give up 2
coca in order to obtain 1 extra safari.
The Law of Diminishing Marginal Rates of Substitution
states that MRS decreases as one moves down on the
standard convex-shaped curve, which is the indifference
curve.
The marginal rate of substitution is another way of
mathematically expressing the opportunity cost for one more
unit of something; in this case the opportunity cost is the
giving up of some other specific good.
 Cont…
 Suppose a consumer consumes two goods
X and Y and that utility function of the
consumer is given as;
 U = f (X,Y)
where X and Y are substitute
 As a consumer can substitute X for Y Such
that his total utility remains the same. When
consumer sacrifices some units of Y, his
stock of Y decreases by ∆Y and he looses a
part of his total utility. His loss of utility may
be expressed as
 Cont..
- ∆Y . MUy
On the other hand, as a result of substitution, his stock of X Increases by
∆X. His gain of utility from ∆X equals

+∆X. Mux
The total utility remains the same, only when
- ∆Y . MUy = +∆X. MUx

Rearranging; -∆Y/ ∆X = MUx/MUy

 Cont…
Here , -∆Y/∆X is simply the slope of the indifference
curve, which gives the MRSx,y ,when X is substituted for Y.
Similarly, -∆X/∆Y gives MRSx,y when Y is substituted for
X.
MATHEMATICALLY
MRSx,y = -∆X/ ∆Y = MUy/Mux and }
MRS y,x = -∆Y/ ∆X = MUx/Muy } Slope 0f
indifference curve
Note: The diminishing marginal rate of substitution causes
the indifference curve to be convex to the origin.
 Quiz

1. Why does MRS diminish?

 2. 5 The Budget Line
 We now introduce the constraints or limitations that a consumer
faces in attempting to satisfy his or her wants. The amount of
goods that a consumer can purchase over a given period of time
is limited by the consumer’s income and by the prices of the
goods that he or she must pay.
 In what follows we assume (realistically) that the consumer
cannot affect the price of the goods he or she purchases. In
economics jargon, we say that the consumer faces a budget
constraint due to his or her limited income and the given prices of
goods.

 A budget line is a graphical description of the basket a

consumer can buy, given a certain budget.
 A utility maximizing consumer would like to reach the highest
possibilities indifference curve on his/her indifference map. But
the consumer is assumed to have a limited income, which set
limits to which a consumer can maximize his/her utility.
 The limitedness acts as a constraint (Budgetary constraints).
 The indifference curves only do not tell us which combination a
 Cont..

 Budget constraint is the limitation on the amount of

goods that a consumer can purchase imposed by his or
her limited income and the prices of the goods
 Budget line is a line showing the various combinations
of two goods that a consumer can purchase by spending
all income
 Cont…

 In addition, consumer’s preference is limited by income

and prices of the two goods.
 Given this information and assuming that the consumer
will choose the combination of the two goods which will
yield him greatest utility (i.e., put him/her in the highest
attainable indifference curve). One can determine the
combination of X and Y that a consumer will choose.
e.g. Suppose the price of commodity X is Tshs. 200, the
price of commodity Y is 100 and suppose a consumer’s
income is Tsh.1000, 000.
 Cont..

Table 2.2

Quantity of X Quantity of Y
(prices= Tsh. 200) (Prices= Tsh 100)
0 1000
1000 8000
2000 6000
3000 4000
4000 2000
5000 0
 Cont..

 If these points are plotted on the same graph as the indifference map, we
obtain what is called a budget line.

Commodity Y

10,000

5000 Commodity X
 Cont..

 Assume there are only two possible types of object

that our consumer wants to buy. We will call them
goods 1 and 2, known as guns and butter. We
therefore have the first part of the optimization
problem:
 The objects of choice are the amount of these two
good that the consumer wants to buy. We will call
these x1 and x2. We can illustrate the commodity
space graphically with good 1 on the horizontal axis
and good 2 on the vertical axis ( Figure 1).
 Cont…
 The world we are thinking of has three parameters or things that the
consumer cannot control the price of the two goods (which we call P1 and
P2) and the amount of money that the consumer has to spend (which we
will call M).

 The constraints that consumer is operating under should now be obvious.

They can only choose bundles of goods that they can afford. This is called
the budget constraint, and can be written as follows;

 P1X1 +P2X2 ≤ M
 Cont…

We can now illustrate the budget constraint in the graph of

commodity space.
In order to do so we want to graph the line for which the
budget constraint holds with equality, which is called the
budget line.

P1X1 +P2X2 = M

Rearranging this equation gives

P2X2 = M −P1X1
X2 = M/P2 – P1/P2*X1.
 Cont…

 The budget line is therefore a straight line in the

commodity space, with the slope –P1/P2. This
is the rate at which the consumer can exchange
one good for another Marginal Rate of
Transformation(MRT):

 If they give up 1 unit of good 2 they will get

P1/P2 units of good 2. The budget set, or set of
objects that the consumer can afford, are the
objects on the ‘inside’ of the budget line.
 Cont..

Y
M/Py
Qy
=M/Px-Px/Py(Qx)

.B

NON FEASIABLE ARE

.A

FEASIBLE AREA
Budget line

M/Px X
 Cont…

 How do changes in the parameters (prices and

income) change the budget set? First, think about an
increase in price 2. This is going to flatten the slope
of the budget line (the rate at which good 1 can be
traded for good 2). However, it is not going to
change the amount of good 1 that can be bought if
all income is spent on that good. Thus, the budget
line pivots round the point where it touches the
horizontal axis (figure ). Similarly, an increase in
price 2 causes the budget line to steepen, and pivot
round the point where it touches the vertical axis

 An elementary of price and income substitution.

 Cont..
 The budget line shows the various combinations of two goods (say, X
and Y) that a consumer can purchase by spending all income (I) on
the two goods at the given prices (PX and PY). The vertical or Y-
intercept of the budget line is given by I/PY and −PX/PY is the slope.
The budget line shifts up if I increases and down if I decreases, but
the slope remains unchanged. The budget line rotates upward if PX
falls and downward if PX rises.
 A rational consumer maximizes utility when reaching the highest
indifference curve possible with the budget line. This occurs where an
indifference curve is tangent to the budget line so that their slopes are
equal (i.e. MRS XY = PX/PY).
 Government warnings or new information may change the shape and
location of a consumer’s indifference curves and the consumption
pattern. If indifference curves are everywhere either flatter or steeper
than the budget line
 Cont…
 By assuming that a consumer spends all of his or her income on good
X(hamburgers) and on good Y(soft drinks), we can express the budget constraint
as
PXQX +PYQY=I
Where, PX is the price of good
QX is the quantity of good
PY is the price of good
QY is the quantity of good
and I is the consumers money income.
 Equation postulates that the price of X times the quantity of X plus the price of Y
times the quantity of Y equals the consumers money income.
 That is, the amount of money spent on X plus the amount spent on Y equals the
consumers income
 Cont..
 With an income of I=$10, and PY= $1 and PX=$2, we get budget line JK.
This shows that the consumer can purchase 10 Y and 0X(endpoint J), 8Y
and 1 X (point L ), 6 Y and 2X (point B ),or...0Y and 5X (endpoint
K).I/PY= $10/$1= 10 is the vertical or Y-intercept of the budget line and−
PX/PY= −$2/$1= −2 is the slope
 Cont..
 A rational consumer maximizes utility when
reaching the highest indifference curve possible
with the budget line. This occurs where an
indifference curve is tangent to the budget line so
that their slopes are equal (i.e., MRS =YX or M/
Px= PY/PX).
M/Py

Thus, The slope of the budget line equal to the ratio

of the two goods.
 Cont…

 How do changes in the parameters (prices and income)

change the budget set?
 First, think about an increase in price 2. This is going to fl
atten the slope of the budget line (the rate at which good 1
can be traded for good 2).
 However, it is not going to change the amount of good 1 that
can be bought if all income is spent on that good.
 Thus, the budget line pivots round the point where it touches
the horizontal axis (figure ).
 Similarly, an increase in price 2 causes the budget line to
steepen, and pivot round the point where it touches the
vertical axis
BUDGET LINE CHANGES
 When prices and incomes changes, the set of goods that a consumer
can afford changes as well. These changes in turn affects the budget
line as follows:

 If the price of only one good changes the slope of the budget
constraint changes (pivots inward/outward).

 If the price of both goods changes by the same proportion the budget
constraints shifts parallel the original one (inward/outward)

 If income changes the budget constraint shifts parallel to the original.

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 EFFECTS
OF PRICE CHANGES ON THE
BUDGET LINE
 When price of good X increases, the quantity of good X is
reduced (by maintaining the quantity of Y) & vice versa.
 Points on the X axis shifted to the left (a small quantity of X)
 When the price of Y increases, the quantity Y is reduced (by
maintaining the quantity of X) & vice versa
 Point on Y axis move to the bottom (small quantity in Y)
 Cont…
 Changes in prices of goods X

Px x Px
Cont…
 Changes in the price of goods Y

Y
Py

Py

X
EFFECTS OF INCOME CHANGES
ON THE BUDGET LINE

 When M increases, QX and QY can be bought

even more, a point on the X axis shifted to the
right & a point on the Y axis move on; & vice
versa when M decreases.
FACTORS SHIFT THE BUDGET LINE

 Changes in income

Y
I

I x
 CONSUMER EQUILIBRIUM
 Consumer equilibrium can be defined as the point at which a
consumer reaches optimum utility or satisfaction from the
goods and services purchased given the constraints of
income and prices.
 With income (M) some combination of goods
that consumers choose the highest satisfaction.
 The point where the curve IC and BL tangent (Slope IC =
BL)
 Consumer choice influenced by income thus with
increased income, increased consumer equilibrium point.
 MAXIMIZE CONSUMER
SATISFACTION
Y
Consumer Equilibrium
M

C
F Indifference
Curves (IC)
E
B IC1
Budget line
IC2
A D
IC3 (BL)
IC4

O M1 X
Cont…
 The necessary condition for utility to be maximum requires
that MRSxy must be equal to the price ratio. Considering our
two-commodity model,
 The necessary condition may be expressed as
MRSx,y=Px/Py

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3
Price Consumption Curve (PCC)
Changes in Px
Y

(PCC)

I3
I2

I1

X
The Derivation of the Demand Curve

7 B

A
5

4 6 X
Px
5

3
Dx

4 6 X
Cont…

 With a fixed price for Y, an increase (say from $3 to

$5) in the price X will cause the bottom of the
budget line to fan/pivot inward to the left.
 The equilibrium position moves from A to B with the
decrease in the amount X from 6units 4units.
 The demand curve for commodity X is determined
by plotting the 4-6units and the $3-5 unit price-
quantity combinations for commodity X.
CHANGE IN INCOME AND CONSUMER
BEHAVIOUR
 We have been concerned so far with consumer behavior
under the assumption that consumers income and prices
of goods and services remain constant
 However in reality consumer income and commodity prices
don’t remain constant
 In this section will examine the effect of changes
consumers on his consumption behavior, assuming prices
of all goods and services and consumers taste and
preferences to remain constant.

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Income Effect on Normal Goods

 Normal goods are goods whose consumption increases with

increase in consumers income.
 When consumers income increases, price remain constant, his
budget line shift upwards, remaining parallel to the original budget
line and vice versa
 Graphically, as long as the prices remain constant, changing the
income will create a parallel shift of the budget constraint.

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 INCOME CONSUMPTION
CURVE (ICC)
 If a fixed price and income increases, the budget line shifts to the
right, thus shifting the equilibrium point higher.
 A line/curve joining all points of consumer equilibrium income
is referred is known as the income consumption curve (ICC).
 ICC shows the points for the combination of goods that can
be purchased when income change and fixed in price (all other
things remain constant).
INCOME CONSUMPTION CURVE (ICC)

Y
M ICC

IC3
IC2
IC1

O M1 M2 M3 X
Income Effect on Inferior Goods

 An inferior Good is one whose consumption decreases with increase

in consumers income.
 In other words income effect on consumption of commodity is
Negative
 Good X is an inferior good since the amount bought decreased as the income
increases.
 Sometimes it also happens that with the rise in income, the consumer
buys more of one commodity and less of another. For instance, he
may buy less of wheat and more of rice as is, illustrated in figures
3.13.

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3
Cont….

96
Cont….

 In diagram 3.13, the income consumption curve

bends back on itself. With the rise in income, the
consumer buys more of rice and less of wheat.
 The price effect for rice is positive and for wheat
is negative. The good which is purchased less
with the increase in income is called inferior
good.

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Ndawi, J- FBMS 97
3
Cont….
Income Effect When Rice is an Inferior Good:

98
ENGEL CURVE
 Is the curve/graphical presentation of the relationship between
equilibrium quantity purchased of a commodity and consumer
income
 Engel Curve and ICC are not the same
 While ICC shows relationship between consumers income
and quantity consumed of a commodity
 Engel curve shows the relationship between money income
and money expenditure on a particular good

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3
ENGEL CURVE

M Engel curve for x

40

30
20

10

O
12 16 20 22 X
 ENGEL CURVE
 Relationship of income to the quantity of an item
 Retrieved from ICC
 Get a quantity of goods X or Y that can be
purchased goods with an income
 Plot the quantity of X or Y against income
 Linking income changes with changes in demand for goods at a
fixed price
DERIVATION OF AN ENGEL CURVE

Y
M ICC

IC3
IC2
IC1

O x1 x2 x3 X
ENGEL CURVE

M Engel curve for x

M3

M2
MI

O
x1 x2 x3 X
PRICE EFFECT
Price Effect on the Consumption of a Normal Good
 We now discuss the reaction of the consumer to the
changes in the price of a good while his money income,
tastes, preferences and prices of other goods remain
unchanged.
 When there is change in the price of a good shown on
the two axes of an indifference map, there takes place a
change in demand in response to a change in price of a
commodity, other things remaining the same, is called
price effect.

104
PRICE EFFECT Cont….

105
PRICE EFFECT Cont….
 For example in fig. 3.15, AB is the initial budget line. It
is assumed that the price of wheat has fallen and the
price of rice and the income of the consumer remains
unchanged. The price line takes a new position AC and
the equilibrium point shifts from P to U.
 The consumer buys now OT quantity of wheat (the
amount demanded rises from OE to OT and OZ
quantity of rice. With further fall in the price of wheat,
the consumer is in equilibrium at point S, where the
budget line AD is tangent to a higher indifference curve
AC3.

106
PRICE EFFECT Cont….

 He buys now OF quantity of wheat and OR quantity of

rice.
 The rise in amount purchased of wheat (OE to OF) as a
result of a fall in its price is called price effect.
 The price effect on the consumption of a normal good
is negative. If we join the equilibrium points PUS, we
get price consumption curve (PCC) of the consumer
for the commodity wheat.

107
PRICE EFFECT
Price Effect When Commodity X is a Giffen Good:
 Giffen good is a particular type of inferior good. When
there is a decrease in the quantity demanded of a good
with a fall in its price, the good is called Giffen good
after the name of Robert Giffen.
 A British Economist Robert Giffen (1837-1910),
observed that sometimes it so happens that a decrease in
the price of a particular good causes its quantity
demanded to fall.

108
Cont..
 The consumer spends the money he saves (by
curtailing the demand) on the purchase of
increased quantity of the other good.
 The decrease in the price of Giffen good has an
effect similar to an increase in the income of a
buyer.
 This particular type of behavior of the consumer
to decrease demand for good when its price falls
is called Giffen Paradox.

109
PRICE EFFECT Cont….

110
PRICE EFFECT Cont….

 In fig. 3.16, the consumer is in equilibrium at

point E where the budget line AB is tangent to
the indifference curve IC1. The consumer
purchases OX1 quantity of Giffen good X and
OY1 quantity of good Y.
 When there is a reduction in the price of good X
but no change in the price of good Y, the budget
line AB/ will showing upward.

111
PRICE EFFECT Cont….

 The consumer is in equilibrium at point E/ where

the budget line AB/ is a tangent to the
indifference curve IC2. In the new equilibrium
position, the consumer purchases only OX2 units
of Giffen good X and OY2 units of good Y.
 We find that the decrease in the price of Giffen
good X, its quantity purchased has fallen from
OX1 to OX2 and the quantity demanded of Y
commodity goes up from OY1 to OY2.

112
Price Change: Income and
Substitution Effects
THE IMPACT OF A PRICE
CHANGE

 Economists often separate the impact of a price

change into two components:
 the substitution effect; and
 the income effect.
THE IMPACT OF A PRICE
CHANGE
 The substitution effect involves the substitution of
good x1 for good x2 or vice-versa due to a change
in relative prices of the two goods.
 The income effect results from an increase or
decrease in the consumer’s real income or
purchasing power as a result of the price
change.
 The sum of these two effects is called the price
effect.
THE IMPACT OF A PRICE
CHANGE
 The decomposition of the price effect into the
income and substitution effect can be done in
several ways
 There are two main methods:
(i) The Hicksian method; and
(ii) The Slutsky method
THE HICKSIAN METHOD

 Sir John R.Hicks (1904-1989)

 Awarded the Nobel Laureate in Economics (with
Kenneth J. Arrrow) in 1972 for work on general
equilibrium theory and welfare economics.
THE HICKSIAN METHOD

X2 Optimal bundle is Ea, on indifference

curve I1.

Ea

I1

X1
xa
THE HICKSIAN METHOD

X2
A fall in the price of X1

*
The budget line pivots out from P

Ea

I1

X1
xa
THE HICKSIAN METHOD

X2
The new optimum is Eb on I2.
The Total Price Effect is xa to xb

Eb
Ea I2

I1

X1
xa xb
THE HICKSIAN METHOD

 To isolate the substitution effect we ask….

“what would the consumer’s optimal bundle be if
s/he faced the new lower price for X1 but
experienced no change in real income?”
 This amounts to returning the consumer to the
original indifference curve (I1)
THE HICKSIAN METHOD

X2
The new optimum is Eb on I2.
The Total Price Effect is xa to xb

Eb
Ea I2

I1

X1
xa xb
THE HICKSIAN METHOD

Draw a line parallel to the new budget

X2 line and tangent to the old indifference
curve

Eb
Ea I2

I1

X1
xa xb
THE HICKSIAN METHOD

The new optimum on I1 is at Ec. The

X2 movement from Ea to Ec (the increase in
quantity demanded from Xa to Xc) is solely
in response to a change in relative prices

Eb
Ea I2
Ec I1

X1
xa xc xb
THE HICKSIAN METHOD

X2
This is the substitution effect.

Eb
Ea I2
Ec
I1

X1
Xa Substitution Effect Xc
THE HICKSIAN METHOD

 To isolate the income effect …

 Look at the remainder of the total price effect
 This is due to a change in real income.
THE HICKSIAN METHOD

The remainder of the total effect is due to

X2 a change in real income. The increase in
real income is evidenced by the
movement from I1 to I2

Eb
Ea I2
Ec
I1

X1
Xc
Xb
Income Effect
THE HICKSIAN METHOD

X2

Eb
Ea I2
Ec
I1

X1
xa xc xb

Sub Income
Effect Effect
HICKSIAN ANALYSIS and DEMAND CURVES
P
A fall in price from p1 to p1*

B
AC

P X1

P1 A Marshallian Demand Curve (A & B

)

B Hicksian Demand Curve (A &

C
P 1* C)

X1
HICKSIAN ANALYSIS and DEMAND CURVES

 Hicksian (compensated) demand curves

cannot be upward-sloping (i.e. substitution effect
cannot be positive)
THE SLUTSKY METHOD

 Eugene Slutsky (1880-1948)

 Russian economist expelled from the University of
Kiev for participating in student revolts.
 In his 1915 paper, “On the theory of the Budget of
the Consumer” he introduced “Slutsky
Decomposition”.
THE SLUTSKY METHOD

X2 Optimal bundle is Ea, on indifference

curve I1.

Ea

I1

X1
xa
THE SLUTSKY METHOD

X2
A fall in the price of X1

*
The budget line pivots out from P

Ea

I1

X1
xa
THE SLUTSKY METHOD

X2
The new optimum is Eb on I2.
The Total Price Effect is xa to xb

Eb
Ea I2

I1

X1
xa xb
 THE SLUTSKY METHOD
 Slutsky claimed that if, at the new prices,less
income is needed to buy the original bundle
then “real income” has increased
 more income is needed to buy the original
bundle then “real income” has decreased
 Slutsky isolated the change in demand due
only to the change in relative prices by asking
“What is the change in demand when the
consumer’s income is adjusted so that, at the
new prices, s/he can just afford to buy the
original bundle?”
THE SLUTSKY METHOD
 To isolate the substitution effect we adjust the
consumer’s money income so that s/he change can just
afford the original consumption bundle.
 In other words we are holding purchasing power
constant.
THE SLUTSKY METHOD

X2
The new optimum is Eb on I2.
The Total Price Effect is xa to xb

Eb
Ea I2

I1

X1
xa xb
THE SLUTSKY METHOD

X2
Draw a line parallel to the new
budget line which passes through
the point Ea.

Eb
Ea I2

I1

X1
xa xb
THE SLUTSKY METHOD
The new optimum on I3 is at Ec.
The movement from Ea to Ec is
X2 the substitution effect

Eb
Ea I2

Ec
I3

X1
xa xc xb
THE SLUTSKY METHOD
The new optimum on I3 is at Ec.
The movement from Ea to Ec is
X2 the substitution effect

Eb
Ea I2

Ec
I3

X1
xa xc

Substitution Effect
THE SLUTSKY METHOD
The remainder of the total price
effect is the Income Effect.
X2 The movement from Ec to Eb.

Eb
Ea I2

Ec
I3

X1
xc xb

Income Effect
 THE SLUTSKY METHOD for
NORMAL GOODS
 Most goods are normal (i.e. demand increases with
income).
 The substitution and income effects reinforce each other
when a normal good’s own price changes.
THE SLUTSKY METHOD for
NORMAL GOODS
The income and substitution
effects reinforce each other.
X2

Eb
Ea I2

Ec
I3

X1
xa xc xb
 THE SLUTSKY METHOD for
NORMAL GOODS
 Since both the substitution and income effects increase
demand when own-price falls, a normal good’s ordinary
demand curve slopes downwards.
 The “Law” of Downward-Sloping Demand therefore
always applies to normal goods.
 TOPIC 3

Price Mechanism:
Demand, Supply, Equilibrium Price
and Elasticity)
 Introduction

 The market mechanism plays crucial role in solving the

basic economic problems in free market economy and
the entire market system functions.
 The market system work orderly because its governed by
the law certain fundamental laws of markets known as
demand and supply.
 The laws of demand and supply interact to determine the
price of goods and services brought to the market.
 3.1 DEMAND

3.1 DEMAND
Definition of Demand
 Demand refers to the quantity of a commodity that consumers are willing
and able to purchase at any given price over a given period of time.
 It is important to realize that demand is not the same thing as want, need
or desire. Only when want is supported by the ability and willingness to
pay the price does it become an Effective demand and have influence on
the market price.
 A desire with resources but without willingness to spend is only a potential
demand.
 A desire accompanied by ability and willingness to pay makes a real or
Effective Demand
CONDITIONS FOR
EFFECTIVE DEMAND
 Willing to buy
 Ability to buy
 Specific price
 Specific period of time

 Demand is said to be effective if all the above four

conditions exist.
Features of a Demand Curve

 The demand curves slopes downwards

from left to right implying that at higher
prices lower quantities will be bought and
at lower prices more quantities will be
bought.
 It has a negative slope, due to inverse
relationship between prices and quantity
demanded.
 That is, when price increases then the
quantity demanded decreases and when
price is low more quantities are bought.
 LAW OF DEMAND

The law of Demand:

 The law of demand states the relationship between the quantity
demanded and price of commodity depends also on many factors
e.g. consumer’s income, price of related goods, consumers taste
and preferences, advertisement .
 Price is the most important and the only determinant of demand in
short run
 The law of demand states that, “Ceteris paribus (other things
remain Constant) the lower the price of a commodity, the
greater the quantity demanded by the individual and vice versa
”.
 This inversely relationship between price and quantity is reflected in
the negative slope of the demand curve
 Marshall states that the law of demand as ‘the amount demanded
increases with fall in price and diminishes with a rise in price.”
 Cont…

Select this paragraph to edit

Price of commodity

P2

P1

Q1 Q2 Quantity demanded
 Cont..

The figure above shows the law of demand. There fore the
law of demand can be illustrated through a demand
schedule and demand curve;
 A decrease in the price from P2 to P1, leads to an increase in
the quantity demanded from Q1 to Q2.
 The individual’s demand schedule is a tabular presentation
shows the alternative quantities of a given commodity that a
consumer is willing and able to purchase at various
alternative prices for that commodity.
 The individual demand defined as the quantity of a commodity
that a person is willing to buy at a given price over specified
period of time, say per day, per week, per month etc.
 Cont..

Example of A demand schedule for potatoes

Price of potatoes Quantity of potatoes
Tshs per kg (kg per week)
34 190
36 180
38 170
40 160
42 150
44 140
46 130
 Cont..

Price DD

DD
 Cont..

 The demand curve is graphical representation of

demand schedule.
 The market demand curve is the horizontal summation
of individual demand curve. Its obtained by plotting
demand a demand schedule
 In fact , market demand is the sum of is the sum of
individual demands
Assumption of the law of
Demand
The law of demand assumes the following;
 Income of consumers do not change. If consumer’s
income increases/decreases, the law will not hold good.
 Peoples taste and preferences remain the
same/unchanged and
 Prices of substitutes and complimentary goods do not
change
 Determinant of demand

3.1.3 The determinants of demand

 The market demand for a product is determined by a number of factors. These
factors affecting demand for a product includes; price of the product, price and
availability of the substitutes, consumer’s income, taste and preference etc
1. The price of the product
 The nature of relationship between price of the commodity and it quantity
demanded as discussed earlier on the law of demand; this shows the movement
along the same demand curve. i.e., if the prices of the commodity increases the
quantity demanded decrease and vice versa.

2. The price of related goods:

 The price of Substitutes or complementary goods may cause demand of
such goods to increase or decrease. Two goods X and Y are said to substitutes
if a rise in the price of one commodity, say Y, leads to rise in the demand of the
other commodity X. e.g., Meat Vs Bean, a mango Vs an orange. The
relationship of substitutes can be shown graphical by the diagram below:
 Cont…

Concept of substitute goods

P2
Price of

Meat

P1

Q1 Q2

Quantity of Beans
 Cont…

 Complementary goods are usually jointly demanded in

the sense that the use of one requires or enhanced by
the use of the other.
 Two goods A and B are said to be Complementary if a
rise in one of the goods, say A (Petrol), leads a fall in the
demand of another goods Say B (Car). E.g., Cars and
petrol, computers and software, bread and margarine.
 The relationship of complementary can be shown
graphical by the diagram
 Cont…

The concept of complementary

Price of Petrol goods.

P2

P1

Q1 Q2 Demand of Car
 Cont..
3. Change in Real Income
 An individual’s level of income can be said to have an important effect on his/her level
of demand for most products. If income increases the demand for most goods and
services will increase especially the demand of better quality goods and services.
However, a rise in income may cause the demand for some goods to fall. e.g., Inferior
goods
4. Taste and fashion:
 Change in taste and fashion may play an important role in governing a consumer’s
demand a certain commodity. For example preferring to consume imported
commodities despite their being much expensive than local commodity.
5. Level of advertisement
 Advertisement is very important determinants of demand. In highly competitive
markets, a successful advertisement campaign will increase the demand of a
particular product while at the same time decreasing the demand for competing
products.
6. The availability of credit to consumers
 This factor especially affects the demand for durable consumer goods which are
often purchased on credit. Change in the terms on which credit can be obtained will
have a marked effect on the demand for a certain products like furniture and home
appliance. Take example of TUNAKOPESHA Ldt
 Cont..

7. Government policy:
 The government may influence the demand of a given
commodity through legislation. e.g., making it mandatory to
wear seat belts. The consumer will then buy more seat belts
as a result
8. Population size of a country
 The total domestic demand for a product depends also on the
size of population. Given the price, per capita income, taste
and preferences etc., the larger the population, the larger, the
larger the demand for a product of common use.
9. Distribution of National Income ,the distribution pattern of
national income also affects the demand for commodity. If
national income is evenly distributed, market demand for
normal goods will be the largest
Why Demand Curve slopes Downward to
the Right
Why does it happen? The reasons behind the law of
demand are following:
i. Income Effect
 Among the cause behind the operation of law of
demand is income effect.
 As the price of a commodity falls, the consumer has to
buy the same amount of the commodity at less amount
of money. After buying his required quantity he is left with
some amount of money.
 This constitutes his rise in his real income. This rise in
real income is known as income effect. This increase in
real income induces the consumer to buy more of that
commodity. Thus income effect is one of the reasons
why a consumer buys more at falling prices.
 However, Income effect is negative in case of inferior
good (demand more at lower income)
 Cont…

ii. Substitution Effect, When the price of a commodity falls, it becomes

relatively cheaper than other commodities. The consumer substitutes the
commodity whose price has fallen for other commodities which becomes
relatively dearer.
 For example with the fall in price of tea, coffees. Price being constant, tea
will be substituted for coffee. Therefore the demand for tea will go up.
 Consequently a rational consumers tends to substitute cheaper goods for
costlier one within a range o normal goods-goods whose demand
increases with increase consumer ‘s income- other things remain the
same.
 Cont…

iii. Diminishing Marginal Utility

 Marginal utility is the utility derived from the marginal unit consumed of
commodity.
 Consumer always equalises marginal utility with price. (Muc=Pc) The law
states that a consumer derives less and less satisfaction (utility) from the
every additional increase in the stock of a commodity. When price of a
commodity falls the consumer's price utility equilibrium is disturbed i.e.
price becomes smaller than utility.
Cont…

 The consumer in order to restore the new

equilibrium between price and utility buys more
of it so that the marginal utility falls with the rise
in the amount demanded. So long the price of a
commodity falls, the consumer will go on buying
more amount of it so as to reduce the marginal
utility and make it equal with new price.
 Thus the shape and slope of a demand curve is
derived from the slope of marginal utility curve.
Exception of Law of
demand
 There are some demand curves that slope upwards from
left to right showing that as prices of a product rises more
is demanded and vice versa. This type of demand curves
are known as regressive, exceptional or abnormal
demand curves and occur in the following situations.
 However, the law of demand doesn’t apply in the
following cases;
1.Fear of a more drastic price changes in
future(Expectation regarding future price):
When a consumers expect that in the future price is
expected to increase drastically than it is now, s/he tends
to purchase more now even if the price is higher.
 Cont..

2. In the case of Giffen goods

In economics and consumer theory, a Giffen good is a product that
people consume more of as the price rises—violating the law of
demand. For any good, as the price of the good rises

3. Seasonality
The demand for a commodity such as an umbrella is higher during
the rain season. Even if the price is higher during rainy season, the
consumer tends to buy it.
4.Goods of ostentation (prestigious goods):
These are commodities whose prices fall in the upper prices ranges
and that have a snob appeal. These goods are demanded more
when the price is higher than when price is lower. e.g., jeweler
 3.1.4 Shift in the demand
curve
 A demand curve either shift to the right or left, due to changes taking
place in other factor and not price of commodity
 When demand curve changes its position retaining its shape (though not
necessarily), the change is known as shift in demand curve.
 The change in the position of demand curve due to these changes can be
termed as the increase and decrease in demand.
 When the demand curve shifts upwards or to the right, its called Increase
in demand
 Cont..

 Similarly, when less is demanded at the same price due

to changes in other factors, it is called decrease in
demand. Here, the demand curve gets shifted left ward
 Cont…

Select this paragraph to edit

D1

D
Price

Q1 Q2 Quantity
 Cont..

 The above figure shows, a rightward shift in the demand

curve from DD to D1D1. An increase in demand is
therefore caused by a factor other than the
commodity’s own price. The commodity’s price remains
constant at P while the amount purchased has been
increased from Q1 to Q2.

 A change in any of the determinants factors of demand

apart from own price causes the demand curve to shift
either to the left or to the right with more or less being
demanded at each of the original prices.
 REASONS FOR SHIFT IN
DEMAND CURVE
 Shifts in a demand curve may take place owing to the change
in one or more of the determinants of demand.
1. Income effect – If consumer's income falls, it implies that
consumer purchasing power is reduced. Thus demand curve
shift downward from it origin holding the price constant.
2. Substitution effect-arise due to change in the relative price of
substitute say Coke and Pepsi. When price of Coke
commodity decreases (or increases), it become relative
cheaper (costlier) than the demand for Pepsi . The consumer
have an inherent tendency to substitute cheaper goods for
relative costlier ones.
3. Change in taste and preferences – due to change may be to
fashion, religious values etc, consider the advertisement
made by the producer of a substitute good, changes
consumer’s taste and preferences
 Cont…

4. Price of complementary goods-These are goods that that

are consumed together, therefore Increase in the price of
complimentary good of X say car will lead to the fall in
demand for a petrol
5. Change in population size (number of consumers)
 The increase in population leads to increase in demand while
decline in population leads to a fall in demand in a market.
6. Change in consumer expectations, if consumers expects
the price of certain goods to increase in the future, they will
purchase more of those goods now. As the result demand in
the current period will increase, shifting the demand curve to
the right and vice versa is true.
 A MOVEMENT ALONG THE
DEMAND CURVE

 A movement along the demand curve occurs when a

change in amount purchased results from change in the
commodity’s own prices.
 In the case of normal goods, an increase in the commodity’s
price leads to a contraction along the demand curve or a
decrease in the quantity demanded and vice versa.
 Movement along the demand curve is simply termed as
change in quantity demanded i.e. change in demand due to
change to a change in the price of commodity other things
being equal
 Therefore movement along the demand curve takes place
when there is a change in price of a good, other things
remain constant. This is called extension and contraction in
demand.
 Cont…

 When quantity demanded of good rises due to the

decrease in price alone, its said that the extension of
demand have taken place
 And when quantity demanded falls due to rise in price; it
is called contraction in demand
 Therefore, the extension and contraction of demand
takes place only due to changes in the prices of a
commodity, other factors remaining constant. This shows
that people are normally willing to buy less of a product at
a high prices and more at a low price.
 Cont..

Price

Quantity
 3.5.1 The demand function

 Demand function states the relationship between demand for a product

(dependant variable) and its determinants (the independent variables).
Assume that the quantity demanded of commodity X depends only on its
price (Px), other factors remaining constant.
A simple mathematically demand function is
 Dx=ƒ(Px).
 Dx is a dependant and Px is independent variable.
 It implies that a change in price Px will cause change in demand Dx. When
a quantitative relationship between Dx and Px is known, the demand
function is expressed in the form of an equation, as
 Cont..
 Dx=a – bPx
 Linear demand function-A demand function is said to be
linear when the slope of demand curve remain constant
throughout its length
 Given this demand function, if value of parameters a-
intercept and b- slope are known, the total demand (Dx) for
any given price (Px) can easily be obtained and if a series of
alternative price is given, a demand schedule can be easily
prepared.
 Let assume that a=10 and b= 5, now the demand function can
be written as
 Dx=10 – 5Px therefore the value of Dx can be easily obtained for
any value of Px. Thus, a demand schedule can be prepared
assigning different values for P
QUESTION

 Which of the following is a demand function and why?

1. Q = 3p + 4
2. Q = -3p + 4
Interrelated Demand

 Sometimes, demand for one commodity is

affected by the demand for another
commodity.
 For instance, the demand for coffee is
related to the demand for tea because
when the price of coffee increases its
demand will decrease while the demand
for tea will increase.
Types of Interrelated Demand
 Joint (Complementary) Demand: This is
the demand for two or more commodities,
which are jointly needed to satisfy a
particular, want.
 Examples of joint demand are tea and
sugar, car and petrol, radio and battery,
etc.
 In this case an increase in the demand for
one commodity will lead to an increase in
the demand for another commodity.
 For example, an increase in the demand
for motor cars will lead to an increase in
the demand for petrol.
 CONT…
 Competitive demand/Substitute: This is a demand whereby
two or more commodities are substitutes and have the
same use, for example tea and coffee are substitute to each
other, and in this case an increase in the demand for tea
would lead to a decrease in demand for coffee
 Derived demand: Derived demand is the demand resulting
from the demand for another commodity that is when a
certain commodity is not needed for its own sake but as a
result of demand for another commodity.
 For example, demand for factors of production is a result of
demand for final goods for example the demand for cotton is
derived from the demand for clothes.
 In this case an increase in the demand for clothes would
lead to an increase in the demand for cotton.
 Also an increase in demand for education will lead to an
increase in the demand for exercise books, books, teachers
and pens.
 SUPPLY

 In a market economy, while buyers of a product constitute the demand

side of a market, sellers of that products make the supply side of the
market.
 3.2 SUPPLY

3.2 Supply
The nature of supply
 The amount of a product that firms are able and willing to offer for sale is
called the quantity supplied.
 Alternatively, Supply refers to the quantity of a given commodity that a
producer is willing and able to offer for sale at a given price over a specific
time period.

3.2.1 The Supply Schedule

 The supply schedule is a tabular presentation of the supply function/law
of supply.
 It shows alternative prices of a commodity and the corresponding quantity
that suppliers are willing to offer for sale.
 Cont..

Supply schedule for paddy

Price per bag Tshs. Quantity per week (Bag)

20,000 10
25,000 12
30,000 15
35,000 20
40,000 25
45,000 30
 The supply curve

 A supply curve is a graphical depiction of the supply

schedule. If the price – quantity relationship shown in the
table above is plotted in graphing, this is called supply
curve.
 The supply curve depicts the law of supply. The upward
slope of the supply curve indicates the rise in the
supply of paddy with the rise in its price and fall in the
supply with fall in its price.
 A supply curve has a positive slope. In fact, supply
curve is derived from the marginal cost curve
 Cont..

PRICE
45,000
40,000
35,000
30,000
25,000
20,000
10 12 15 20 25 30 Qty
 LAW OF SUPPLY

3.2.2 The law of Supply

 The supply of commodity depend on its price and cost of production. In
other words , supply is the function of price and production cost.

 The law of supply can be stated as the supply of a product increases

with the increase in its prices and decreases with decrease in its
prices, other things remaining constant.

 It implies the positive relationship between quantity of commodity supplied

and its corresponding price.
3.2.3 The Determinant of quantity
supplied;

1. The price of the product

 As the price of a given commodity say X rises, with all costs and
prices of all other goods remaining unchanged, the production of
commodity X becomes more profitable. The existing firms are
therefore likely to expend their output while new firms are likely to
be attracted into the industry. Also expectations concerning future
prices may motivate the producers in question.

2. . The price of inputs of production

 If price of inputs of production is low, producers are likely to
produces more and the supply curve will shift rightward. For
example in agricultural sector, if price of fertilizer, insecticides,
herbicides, pesticides etc. is some how low may be due to
government subsidies, supply of agricultural produce will be higher.
 Cont..

3. Prices of factors of production

 As the prices of factors of production used intensively by the
producers of a certain commodity rise, so do the firm’s costs.
This will cause the supply to fall since some firms will reduce
output while other less efficient firms will make losses and
eventually leave the industry.
4. The state of Technology
 Technological improvements or progress such as
improvement in machine performance, management and
organization or an improvement in the quality of raw materials
leads to a lowering of costs through increased productivity
and increases the profit margin on every unit sold. This should
lead to an increase in supply. E.g. Power tiller, tractors
 Cont…
5. Weather
 The supply of agricultural produces is considerably affected by
change in weather conditions. Output in agriculture is subject to
variations from one year to the next, which are independent of the
acreage planted and weather condition. An excellent growing
season associated with favourable weather conditions will result in a
bumper harvest leading to an increase in supply.

6. Indirect Taxes and subsidies

 A tax on a commodity can be regarded as an increased in the costs
of supply that commodity and supply curve will shift to the left as a
result. Subsidies usually take the form of payments by the
governments to the producers and will have the effect of the
lowering the cost of production and hence increasing the supply.
e.g. subsidies in agricultural inputs
 Cont..

7. Natural hazards or political disruption

 The occurrence of natural hazards (i.e. droughts, floods,
earth quakes etc) and political disruption (i.e. war and
political crisis) lead to stoppage of production activities
leading the production to the less production hence
decrease in supply and vice versa.
8. Number of producers/ sellers
 The number of producers that exists in a market has
great influence in the supply of the commodity. The
increase in the number of producers lead to the change
in supply.
 3.2.4 Shift in the supply
curve
 Although price of a commodity is the most important
determinant of its supply, it is not only determinant, there
are many other determinants influencing the supply of a
commodity.
 Therefore, whenever, there is change in other
determinants, the supply curve shifts rightward or
leftward depending on the effects of such changes.
 The change in any of factors other than price of
commodity causes supply curve to shift either upward
(leftward)or downward (rightward).
 Upward shift of the supply curve indicates a decrease in
supply while downward shift indicates an increase in
supply.
Shift in supply curve

Price s’ s s”

Quantity
 Cont..

 The shift from S to S” indicates an increase in supply by

downward shift of the curve while the shift from S to S’
indicates a decrease in supply by upward shift in supply
curve
Factors for the shift in
Supply Curve
1. Change in input (resources) prices
 When inputs go down the use of inputs increases or more inputs
can be used at a given total cost. As a result products supply
increases and the supply curve shifts to the right and vice versa.
Or An increase in the price of resources will lower the profit on each
unit sold at current price, there by reducing the supply of the good
and shifting the supply curve to left and vice versa

2. Technological progress:-
 Technological changes that reduce cost of production or increases
factor efficiency increases the product supply. For instance
introduction of high yielding varieties of paddy and new technology
of cultivation increases per acre yield of rice. Such changes make
the supply curve shift to the right
 Cont…

3. Price of related goods (substitute/complimentary):-

 Fall in price of one of the products substitutes may lead to the rise
in the supply of the other due to capacity utilisation for profit
maximization
 If price of substitute say tea rises ,it will result in the reduction in
production and supply of another product say coffee for the case of
substitute
 If the price of one good (car) rises induces the increase in
production of another good (petrol) hence increase in supply of
another good(petrol) for the case of complementary7 goods
4. Government policy:-
 When the government impose restrictions on the production e.g.,
import quota on inputs, excise taxation, etc. production tend to fall.
Such restrictions make supply to shift left ward
 Cont..

5. Subsidies
 Subsidies will have the effect of the lowering the cost of
production and hence increasing the supply
6. Non economic factors:-
 The factors like war, drought, flood, epidemic etc. also affects
adversely the supply of commodities. Therefore the supply
curves shift leftward.
7.Nature and size of industry, The supply of commodity
depends also on whether an industry is monopolised or
competitive.
 Under monopoly , supply is fixed. When a monopolized
industry is made competitive, the total supply increases.
Besides, if size of an industry increases due to new firms
joining the industry, the total supply increases and supply
curve shift rightward.
 Cont..

8. Change in future price expectation

 The expectation of prices to rise in future induces less
sales now thus decrease in supply while, the expectation
of further fall in price in future induces more supply now
thus an increase in supply of the commodity.
Movement along the
supply Curve
 A movement along the same curve simply indicates
changes in quantities offered for sale as result of a
change in the price.
 When supply changes not due to changes in the price of
the product but due to other factors, such as change in
technology, price of related commodities, change in price
of inputs etc. Its also called change in supply
 Quantity supplied of a good falls as the price likewise as
the price raise the quantity supplied increases too.
 Cont..

Price s
P1

Po

P2
s

Q2 Qo Q1
3.2.5 The supply
function
 The law of supply states only the nature of relationship between
the price and the quantity supplied. A supply function quantifies
this relationship.
 Supply function is a mathematical statement which states the
relationship between the quantity supplied of a commodity ( as
dependent variable) and its determinants ( as independent
variables).
 The supply function is based on the law of supply.
 Therefore, the supply of a commodity depends on its price, Cost of
production (Price of factor of production, price of inputs/raw
materials, indirect tax) and production technology.
 In other words, Supply of a product X is the function of its price (Px
), cost of Production (Cx) and Technology of its production (Tx).
 Cont…
 Qx =ƒ(Px, Cx ,Tx)
 In simple theory of supply, however, the law of supply is
expressed generally in terms of price-quantity relationship;
function is expressed as :
 Qx =ƒ(Px)
i.e. Recall, demand Qd=a –bPx,
hence,
Qs= a + b Px, where, b = slope of supply curve

Then, Qx = sPx

where Qx = quantity supplied of commodity x,

s= ∆Qx slope of supply curve
∆Px
Px=Price of a commodity x
 Cont..

 Given this supply function, schedule can be generated by

substituting numerical value for Px and assuming s= 10.
 if Px =2, Qx =10x 2
= 20 etc.
 3.3 Market Equilibrium
 In the context market analysis, Equilibrium refers to a state of
market in which the quantity demanded of a commodity equals to the
quantity supplied of the commodity.

 The equality of demand and supply produces an equilibrium price.

 At equilibrium price, demand and supply are in equilibrium. The

equilibrium price is also called market clearing price because at this
price, the quantity that a supplier wants to supply equals the quantity
that buyer are willing to buy.

Determinant of price in a Free Market

 A free market is one in which market forces of demand and supply

are free to their own course and there is no outside control of price,
demand and supply.
The Concept Of Market
Equilibrium
 In physical sense, the term equilibrium means
the “state of rest”
 In general sense, It means balance in opposite
forces.
 In the context of market analysis, Equilibrium
refers to a state of market in which quantity
demanded of a commodity equals to
quantity supplied of a commodity.
 Cont…

 A market is in equilibrium when both of these conditions

are fulfilled;
i. No agent wants to change her decision or strategy
ii. The decisions of all agents are compatible with each
other, so that they can be carried out simultaneously.
 Equilibrium price: The price that arise when there is
an equilibrium in the market
 Equilibrium quantity: The quantity that is brought and
sold when there is an equilibrium in the market.
 Cont..

3.3.1 Determination of market equilibrium price

 The equilibrium price in a free market is determined by
the forces of demand and supply.
 In order to analyse how equilibrium price is determined,
we need to integrate the demand and supply curve
 From the table below, there is only one price of shirts
(Tsh.3000) at which the market is in equilibrium. i.e.,
quantity demanded and the quantity supplied is equal at
40 shirts.
 That is, at equilibrium price, demand and supply are in
equilibrium. The equilibrium price is also called Market
clearing price. Market is cleared in the sense that there
is no unsold stock and no unsupplied demand.
 Cont…

 When the market is in state of disequilibrium, At other prices, the

shirt market is in disequilibrium as either demand exceeds supply
or supply exceeds demand.
 The disequilibrium is the state of imbalance between supply and
demand
 As the table show shows , all prices below Rs 3000, the demand
exceeds supply showing SHORTAGE of shirt in the market.
 Likewise, at all prices above RS 3000, supply exceeds demand
showing EXCESS SUPPLY

3.3.2 THE EFFECTS OF SHIFTS IN DEMAND AND SUPPLY ON THE

MARKET PRICES
 In the free market, disequilibrium it creates the condition for
 Cont..

Prices of Demand Supply Market Effect on

Shirt ( positions Price
Tshs)
1000 80 10 Shortage Rise
2000 55 28 Shortage Rise
3000 40 40 Equilibriu Stable
m
4000 28 50 Surplus Fall
5000 20 55 Surplus Fall
6000 15 60 Surplus Fall
 Cont..

Select this paragraph to edit

S
Price
S’’

3000

40

Quantity
The effects of shifts
supply , demand on the
market prices
 When there is an increase in supply/excess supply (i.e., rightward
shift of supply curve), it forces downward adjustments in the
prices and increase quantity supplied and vice versa.
 When there is excess demand, if forces upward adjustment in
the price and quantity demanded.
 Therefore , whenever there’s a shift in the demand and/or supply
curve, there’s also a shift in the equilibrium point
 The process of downward and upward adjustments in price and
quantity till the price reaches Rs 3000 and quantities supplied and
demanded balance at 40 thousands shirts. This process is
automatic.
 The process of price and quantity adjustments are called “Market
Mechanism” or is the process of interaction between the market
forces of demand and supply to determine equilibrium prices.
 Cont…

Shift in demand Curve

 The effect of the shift in demand curve on the equilibrium
is shown below. Suppose that the initial demand curve is
given by the curve DD’ and supply curve by SS’.
 The demand and supply curve intersect each other at
point P. The equilibrium price is determined at PQ and
equilibrium quantity at OQ.
 Let the demand curve now shift from its position DD’ to
DD”, supply curve remain the same. The demand curve
DD” intersect with supply curve SS’ at point M.
 Thus, shift in demand curve causes a shift in the
equilibrium from point P to point M
 Cont…

 At equilibrium, quantity demand and supplied increases

from OQ to ON and prices increases from PQ to MN.
Note: The supply curve remaining the same, a rightward
shift in the demand curve result in a higher equilibrium
price and quantity.
 Cont..

Shift in Demand Curve and Equilibrium.

Price DD” S’

DD’ M

S’
DD”

DD’
Q N
Quantity
 Cont..

Shift in supply curve

 Effect of shift in the supply curve on the equilibrium. Suppose
that the demand curve is given DD’ and initial supply curve
SS’.
 The curve DD’ and SS’ intersect at point P, determining
equilibrium prices at PQ and equilibrium quantity at OQ.
 Let the supply curve now shift from its position SS’ to SS”,
demand curve remaining unchanged.
 The new supply curve SS” intersects the demand curve at
point M. Thus, a new equilibrium takes place at point M
where equilibrium price is MN and equilibrium quantity ON
 Note that, a rightward shift in supply curve, demand curve
remaining the same, causes equilibrium price to fall and
output to increase.
 Cont..

Shift in Supply Curve and Equilibrium.

Price D’ SS’

P SS”
M

SS’
SS”
D”

Q N Quantity
 Simultaneous Sift in
Demand and Supply
 Curve
We have seen above that the right shift in demand curve
causes a RISE in market price and a rightward shift in
supply curve causes a FALL in the market price.
 Let us now look at the effect of simultaneous and parallel
shifts in demand and supply curve on the equilibrium
price and output.
 The effect of a simultaneous and parallel right ward shift
in demand and supply curve on the equilibrium price and
output depends on how big or small is the relative
shift in demand and supply curve.
 Cont…

 If the shift in the supply curve is a bigger than in the demand

curve, then the equilibrium price decreases and output
increases.
 For example, suppose that the initial demand and supply
curve are given by DD’ and SS’, respectively, intersect at point
E1 and determining equilibrium price at P1 and output at Q1.
 Let the demand curve shift to DD” and supply curve from SS’
to SS”’, intersect at point E3.
 Note that shift in supply curve is bigger than that in the
demand curves. As a result, equilibrium price FALL to Po and
output increases to Q3. BUT , if demand and supply curves
shift in equal measure, as shown in DD” and SS”, equilibrium
price remain unchanged though output increases to Q2.
 Parallel shift in Demand and
Supply curve and its effect
on the equilibrium price
Price SS’ and
output
DD” SS”
DD’ SS”’
P1 E1 E2
Po E3
SS’
SS”
SS”’

Q1 Q2 Q3 Quantity
 Cont…

 Similarly, the effect of bigger shift in demand curve on

the equilibrium price and output.
 It can be shown below that the shift in demand curve
from DD’ to DD” is bigger than the shift in supply curve
from SS’ to SS”. In this case both equilibrium prices and
output increases.
 Parallel shift in Demand
and Supply curve and its
effect on the
Price DD” equilibrium
SS’

price and output E2

DD’ SS”
P2
P1 E1
SS’
SS” DD”
DD’

Q1 Q2 Quantity
 Price Determination :
Numerical example
 In the previous section. We illustrated how equilibrium of
demand and supply is determined at the point of
intersection of demand and supply curves.
 If the demand and supply functions are known, the
equilibrium quantity and equilibrium price can also be
determined numerically.
 Cont..
Algebra of demand and supply equilibrium
 Let the demand function for a commodity X be given as
Qd= 150 - 5Px and

supply function Qs=10Px

Since we know that at the equilibrium, quantity supplied and quantity demanded is
equal
Therefore Qs= Qd

150 - 5Px=10Px
150 =10Px+ 5Px
150/15 =15Px/15
10= Px
 Cont..

 Thus price at equilibrium is Px=10, given this equilibrium price, the

equilibrium quantity demanded and the quantity supplied can be easily
worked out,

From Qs= Qd and Qs=10Px

 The equilibrium quantity supplied and demanded will be obtained by

substituting the price (Px=10) in any of two equation above.
 Qs=10(10)
 Qs=100
 Cont..

Px Dx Sx
Qd=150-5Px Qs=10Px

10 P

20 40 60 80 100 Quantity
3.3.3 Maximum Price
Control
 Maximum price control is situation whereby a
government imposes the price below the equilibrium
price. If a government imposes a maximum price control
given by Pmax, there will be a SHORTAGE of the
commodity given by (Q2-Q1).
 This shortage of commodity in the market will lead to the
increase in price in the market to attain it equilibrium
Pe. See figure below
 Cont..

Max Price control

Price

(shortage)
D
P* S

Price ceiling
Pe

P max
D

Q1 Qe Q2 Quantity
 Cont..

The effect of maximum price controls, e.g petrol, diesel market etc
3.3.4 Minimum price control
 Minimum price control is situation whereby a government imposes the
price above the equilibrium price, when government considers that the
price that is determined by force of demand and price is too low.
 Minimum price controls are geared to protecting producers from low
prices and thereby encouraging certain lines of production. The likely
effects of such decision are;- in case of producer it will create excess
supply in the market, price controls may contribute to industrial peace
especially if they constitute part of a comprehensive income policy e.g.
minimum wage legislation; price control may in a certain cases be
associated with a decrease in price and an increase in output.
 Cont..

The effect of minimum price controls.

Price D S
P min
Price floor
Pe
(price mini)
P*

Q1 Qe Q2
Quantity
 PRICE FLOOR

 A price floor is a government- or group-imposed price

control or limit on how low a price can be charged for a
product.
 A price floor must be greater than the equilibrium price in
order to be effective.
 When a "price floor" is set, a certain minimum amount
must be paid for a good or service. If the price floor is
below a market price, no direct effect occurs.
 If the market price is lower than the price floor, then a
surplus will be generated. Minimum wage laws are
good examples of price floors.
 Price floors, prohibit prices below a certain minimum,
cause surpluses, at least for a time
 Cont…

 A price floor exists when the price is artificially held above the equilibrium price
and is not allowed to fall .

Effect on the market

 A price floor set above the market equilibrium price has several side-effects.
 Consumers find they must now pay a higher price for the same product. As a
result, they reduce their purchases or drop out of the market entirely. Meanwhile,
 suppliers find they are guaranteed a new, higher price than they were charging
before. As a result, they increase production.

 Taken together, these effects mean there is now an excess supply (known as a
"surplus") of the product in the market to maintain the price floor over the long
term.
Cont..
 PRICE CEILING

 If the price ceiling is above the market price, then there is no

direct effect. If the price ceiling is set below the market price,
then a "shortage" is created; the quantity demanded will
exceed the quantity supplied.
 A price ceiling occurs when the price is artificially held below
the equilibrium price and is not allowed to rise.
 There are many examples of price ceilings. Most price
ceilings involve the government in some way. For example, in
many cities, there are rent control.
 Charging more than this maximum price would be guilty of
fraud. Price ceilings provide a gain for buyers and a loss for
sellers.
 Sellers would like to avoid the loss if they can. One way to do
so is called a black market.
 Cont…

 Price ceilings, which prevent prices from exceeding a

certain maximum, cause shortages
Effect of price ceiling in
market
Select this paragraph to edit

The End.
 3. 4 Elasticity of demand
and supply
Introduction
 The law of demand and supply state only the nature, do
not bring out the extend of the responsiveness of
demand and supply to the change in price,
 In simple words, the law of demand and supply don’t give the
measure of change in quantity demanded of supplied in
response to a certain percentage change in price
 For example, the law of demand does not tell us the
percentage change in quantity demanded due to a certain
percentage change in price.
 However, Price Elasticity Of Demand measure the extent of
relationship or degree of responsiveness of demand to
changes in its determinants.
 Cont..

 In this topic we shall discuss the following

 The concept of elasticity and different methods of
measuring elasticities of demand and supply and the
uses of elasticity concept
 Price elasticity
 Cross elasticity
 Income elasticity
 3.4.1 Price elasticity of

demand
THE ELASTICITY OF DEMAND
 Is a measure of responsiveness of demand for a commodity to the change in
any of its determinant, viz., price of commodity, price of substitute and
compliments, consumers income and consumer expectations regarding
prices.
 Accordingly, there are several kinds of elasticities of demand-Price elasticity,
cross elasticity, income elasticity

PRICE ELASTICITY OF DEMAND

 The price elasticity of demand is defined as the degree of responsiveness or
sensitiveness of demand for a commodity to the change in its price.
Or
 Price Elasticity of demand is the percentage change in quantity demanded of a
commodity as a result of a certain percentage change in its price.

 Percentage change in quantity demanded of commodity X

Percentage change in price of commodity X
 Cont…

 The measure of price elasticity ( ℓp) is called coefficient of

price elasticity
 General formula for calculating coefficient of price
elasticity is given as
ℓp =Q1-Q2 / P1-P2=
Q1 P1 = - ∆Q / ∆P
Q1 P1
= - ∆Q * P1
∆P Q1
 Cont..

Where
Q1 = the original quantity demanded
P1 = original price
∆Q = change in quantity demanded (Q2-Q1)
∆P = Change in price (P2 – P1)
Example: To measure price elasticity numerically by using given formula given, suppose
price of commodity X decreases from Rs 10units to Rs 8 and quantity demanded of X
increases from 50 units to 60 units per time unit.
Thus, ∆P =Rs 10-Rs 8=2Rs
∆Q= 50-60 =-10.
By using substituting these values in elasticity formula

ℓp = -10 * 10 = 1.0
2 50
Thus, the elasticity coefficient (ℓp)= 1
 Cont..

Note that: A minus sign (-) is inserted in formula with view to

making elasticity coefficient a non-negative value
 The coefficient of price elasticity calculated without minus
sign in the formula will always be negative, because either ∆P
or ∆Q will carry a negative sign depending on whether price
increases or decreases.
 But negative sign of elasticity is rather misleading because
elasticity can not be negative –less than zero.
 The minus sign is, therefore, inserted in the price-elasticity
formula as a matter of “linguistic convenience” to make a the
coefficient of elasticity a non –negative value.
 Sometime its advised to ignore the negative sign of ∆P or ∆Q
. The price elasticity measure is, however, always reported
with negative sign just to indicate inverse relationship
between price change and quantity demanded.
 3.4.2 Point and arc
elasticity of demand
 The elasticity measured on a finite point of a demand curve is called Point
elasticity and the elasticity measured between any finite points is called Arc
elasticity.

 The point elasticity of demand is defined as the proportionate change in quantity

demanded in response to a very small proportionate change in price-not
significantly different from zero

 Is the measure of price of price elasticity at a finite point on a demand curve

 The concept of point elasticity is useful where the change in price and the
consequent change in quantity demanded are very small. Besides it offers
alternative to the arc elasticity

The point elasticity may be symbolically expressed as

ℓp = - ∆Q * P
∆P Q
 Cont..

R P

O Q N Quantity
 Cont…

 To illustrate the measurement of point elasticity on a

linear demand curve, lets suppose demand curve is
given by MN
 That we need to measure elasticity at point P. Let us now
substitute the values, it obvious from the figure that
P=PQ and Q= OQ. What we find now are the value for Δ
Q and ΔP
 Cont..

 The value of can be obtained by assuming a very small

decrease in the price. But it will be difficult to depict these
changes in figure as ∆P O and hence ∆Q O.
 In fact, the derivative ∆Q gives the slope of the demand
curve MN. ∆P
 The slope of a straight line demand curve MN, at point P
geometrically is given by QN/PQ
 Cont..

 According to geometrical properties of similar triangle,

the ratio of any two sides of a triangle is equal to the
ratio of corresponding side of the other triangles
 Therefore, in ΔPQN and ΔMR
 QN=RP
PN PM
Note that, PN and PM are two lower and upper segments
of the demand curve, MN. It may be said that the price
elasticity at any point on a straight line demand curve is
given by
ℓp=Lower segment
Upper segment
 Cont..

b) Measuring Arc elasticity

 Arc elasticity is a measure of the

average of responsiveness of the
quantity demanded to a substantial
change in the price.
 Cont..

 In other words, the measure of price of demand between

two finite points on a demand curve is known as arc
elasticity.
 For example the measuring elasticity between point J
and K in thePricefigure below
25 J

K
10
D

30 50 quantity
 Cont…

 The movement from point J to K along the demand curve DD shows the fall in
price from tshs. 25 to tshs 10 so that change (Δ) in price = 25-10= 15. The
consequences increases in demand 30-50 = -20.
A formular for Arch elasticity is
ℓp =- ΔQ * (P1+P2)
ΔP (Q1+Q2)
ℓp = -20 * 10+25
15 30+50
=- 4 * 35
3 80
= - 140
240
pℓp = -(- 0.58)
ℓp = 0.58 inelastic
 Cont..

 Interpretation: Elasticity coefficient is interpreted as

percentage change in demand due to one percentage
change in price
 For example: Elasticity coefficient is 0.58. The elasticity
coefficient 0.58 will be interpreted as a 1 percentage
decrease in price of commodity x results in 0.58
percentage increase in demand for it.
 Price Elasticity Along the
Demand Curve
Nature of demand curves and elasticity
 Generally, elasticity of demand varies through out its length. It varies from
zero to infinite ∞.
Price
ℓp = Undefined

ℓp >1

ℓp = 1

ℓp <1

ℓp = 0
 Cont…

 ℓ> 1 elastic
 ℓ <1 = inelastic
 ℓ = 1 unitary elastic demand
 ℓ = 0 = A perfectly in elastic demand through its length
and is straight vertical line.
 ℓ = ∞ elastic demand curve along its length is infinity and
it is a straight horizontal line
 Constant elasticity
demand curve
 The elasticity of most demand curve is not the same throughout. It varies from
zero (0) to close to infinity, i.e., 0<ℓp<∞.
 In case of some demand curves, however, elasticity remains the same
throughout their length.

P p
ℓp=o P
ℓp=1
ℓp=∞

Q
Determinants of price elasticity
of demand

 Price elasticity of demand varies from

commodity to commodity. Some are highly
elastic and others are highly in elastic. The
main determinants of the price elasticity of
demand are:-
1) Availability of substitutes
 The closer the substitutes, the greater the
elasticity of demand for such commodities.
e.g., therefore if the price one of these goods
increases, its demand decrease more than
proportionate increases in its price because
consumer’s switch over to the relatively
cheaper substitutes.
 Cont..

2) Nature of commodity
 The nature of commodity also affects the price elasticity of its
demand.(Luxury, Normal and inferior goods)
 Normal goods are those which are demanded in increasing
quantities as consumers’ income rises.
 In economic terminology, however a commodity is deemed to
be inferior if its demand decreases with the increase in
consumers` income.
 The demand for luxury goods such gold is more elastic than
the kind of other goods, because consumption of it is higher
when price is high and vice versa.
 The demand for comfort is generally more elastic than that of
necessities. Consumption of necessary goods e.g., sugar, salt
is in elastic.
 Cont…

3) Proportion of income spent

 Another factor that influences the elasticity of demand for
a commodity is the proportion of income which
consumers spend on a particular commodity. If proportion
of income spent on a commodity is very small, its
demand will be less elastic and vice versa. e.g., salt,
matches, toothpaste, which claims a very small
proportion of consumer’s income. Demand for these
goods is generally inelastic because in the price of such
goods doesn’t substantially affect consumer’s
consumption pattern and the total purchasing power.
Therefore people continue to purchase almost the same
quantity even when their price increases.
 Cont…

4) Time factor, Price- elasticity of demand also depend on the

depends on time consumers take to adjust a new price: The
longer the time taken, the greater the elasticity.
For, consumers are able to adjust their expenditure pattern to
price changes over a period of time. For instance, if price of
TV sets is decreased, demand will not immediately increase
unless people possess excess purchasing power
5) Range of alternative uses of commodity, the wider the
range of alternative uses of a product, the higher the elasticity
of its demand. Therefore, the demand for such a commodity
generally increases more than proportionate decrease in its
price. For instance, milk can be taken as it is, it may be
converted in to curd, cheese, ghee and butter milk. The
demand for milk therefore is highly elastic
 Cont..

2. Cross-Elasticity of Demand
 Here we will discuss elasticities of demand with respect to its other determinants
often used in economic analysis
 Cross-Elasticity of demand is the measure of responsiveness of demand for a
commodity to the changes in the price of its substitutes and complimentary
goods.
eg. Cross- elasticity of demand for tea (T) is the percentage change in its
quantity demanded with respect to the change in the price of its substitute,
coffee(C).

ℓtc = Proportionate change in demand for tea (Qt)

Proportionate change in price of coffee (Pc)

ℓtc = ΔQt * PC
ΔPC Qt
 Cont..

e.g., Suppose that price of coffee (Pc)

increases from Tshs. 10/= to Tsh.15/= per kg
and as a result demand for tea increases from
20 tons to 30 tons per week, price of tea
remaining constant. Calculate the cross
elasticity of demand for tea with respect to price
of coffee.
ℓtc = 30 - 20 * 10

15- 10 20
ℓtc= 10* 1
5 2

ℓtc = 1.0
 Cont…

Interpretation of coefficients.
 If cross-elasticity between two goods is positive, the two
goods may be considered as substitutes for each other
.
 Also the greater the cross –elasticity the closer the
substitute.
 Similarly, If cross elasticity of demand for two related
good is negative, the two may be considered as
complementary of each other, the higher the negative
cross –elasticity the higher the degree of
complementarily.
 Cont..

3. INCOME ELASTICITY OF DEMAND

 A part from price of a product and its substitute, another important determinant of demand
for a product is consumer’s income
 As noted earlier ,the relationship between demand for normal and luxury goods and
consumer ‘s income is of positive nature, unlike the negative price-demand relationship
 The responsiveness of demand to the change in consumer’s income is known as Income
Elasticity Of Demand. Income elasticity of demand for a product, say X (i.e; ℓ y) is defined
as
ℓ y = DQx * Y
DY QX

Where QX = quantity of X demanded;

Y = disposable income;
ΔQx = change in Quantity demanded of X and
ΔY = change in income.
 Cont..

 In simple words, the demand for normal goods and

services increases with increases in consumer’s income
and vice versa.
 Unlike price elasticity of demand(which is negative
except in case of Giffen goods), income-elasticity
demand is positive because of positive relationship
between income and quantity demand of product.
 There is exception of this rule. Income elasticity of
demand for inferior good is negative, because of
negative income effect.
 The demand for inferior goods decrease with increase
in consumer income’s income and vice versa
 Cont..

Interpretation of income elasticity coefficient

 The good whose income elasticity is positive for all levels of income
are termed as “normal goods”. The good for which income
elasticity are negative beyond a certain level of income are termed
as “inferior goods”.
 THE USES OF
ELASTICITY
1. Decision makers
 The concept of elasticity of demand plays a crucial role in business
decisions regarding maneuvering of prices with a view to making
larger profits. E.g When cost of production is increasing, the firm
would like to pass incremental cost to the consumer by raising the
price.
2. Formulating of government policies
 The concepts elasticity can be used also in formulating
government policies particularly in its taxation policy meant to raise
revenue or to control prices, in granting subsidies, in determining
prices for public utilities, in determining export & import duties etc.
3. Economic analyst’s
 The concept of elasticity is useful in economic analysis, at least for
specifying the relationship between the dependent & independent
variables.
 Cont..
Summary of pattern: Price elasticity and marginal Revenue/total
revenue
Elasticity Nature of Change in Change in
coefficient Demand Price TR
ℓ> 1 Elastic Increase Decrease
Decrease Increase
ℓ< 1 In elastic Increase Increase
Decrease Decrease
ℓ=1 Unitary Increase No change in
TR
Decrease

ℓ=0 Perfect Increase Increase

inelastic
Decrease Decrease
ℓ=∞ Infinitely
 Cont..

Interpretation
 When ℓ= 0 the demand is said to be perfect in elastic. It
implies that no changes in quantity demanded when price is
changed. Therefore a rise in price will increase the total
revenue and vice versa.
 ℓ <1 an inelastic demand, quantity demanded increases less
than the proportionate decreases in price and hence the total
revenue falls when price falls. Total revenue increases when
prices increases because quantity demanded decreases less
than the proportionately.
 ℓ = 1 for a unitary elasticity, quantity demanded increases (or
decreases) in proportion of decrease (or increase) in the
production. Therefore total revenue remains unaffected.
Price Elasticity Of Supply

 The price elasticity of supply is the measure of responsiveness

of the quantity supplied of a good to the changes in its market price.
 The coefficient of price elasticity of supply (ℓp ) is the measure of
percentage change in quantity supplied of a good due to a given
percentage change in its price.

ℓp = % change in quantity supplied (Qs)

% change in price (p)
ℓp = ΔQ * P
ΔP Q
Note: The formula for measuring the Price elasticity of supply is the
same as for the price elasticity of demand, without a minus sign.
 Cont…
Example: Suppose that the supply curve for a commodity is given as SS’ and
we want to measure the price elasticity of the supply between point j and p
for the rise in price.

SS’
Price

7.5 P

5 J
SS’
60 100 Qs
 Cont…

 ℓp = ΔQ * P
ΔP Q

 ΔQ=60-100= -40
 ΔP= 5-7= -2.5
 P=5
 Q=60
ℓp = 1.33
 Cont..

The price elasticity of a supply curve, like demand curve,

may vary between zero and infinity depending on the
levels of the supply.
(1) ℓ > 1 elastic
ℓ <1 = in elastic
ℓ = 1 unitary elastic supply
ℓ = 0 = A perfectly inelastic supply through its length
and is straight vertical line.
ℓ = ∞ elastic supply curve along its length is infinity and
it is a straight horizontal line
Determinant of Price
Elasticity of supply
 The price elasticity of supply depend on the following
factors
i) Time period is the most important factor in
determining the elasticity of the supply curve. In a
short period, the supply of most goods is fixed and
inelastic. In long run, the supply of most of products
has maximum elasticity because of increase in and
expansion of firms, new investments, improvement of
technology and greater availability of inputs.
ii) Law of diminishing return, here if the law of
diminishing returns comes in force at an early level of
production, cost increases rapidly. As a result, supply
tends to become less and less elastic
Select this paragraph to edit

End of topic
THEORY OF THE FIRM

 A firm is the basic unit or organisation for productive activities. It

transforms inputs into outputs subject to the limitations of its technical
knowledge and guided by its objective.
 A producer uses raw materials, capital and labour and turns them into
outputs for sale in the output/product market.
 A producer is a consumer in the input/factor market.
 The desire to maximise profits is assumed to motivate all decisions taken
within a firm and such decisions are assumed to be unaffected by the
peculiarities of the person taking the decisions and by the organisational
structure in which they work.
 There are two key assumptions in this theory:
 i) All firms are profit maximizers
 ii) Each firm can be regarded as single, consistent decision taking unit.
Cont..

 Production of goods is essential to fulfill demand of

consumers.
 Output of goods depends on price of factors of production.
 The relation between price of factors of production and
amount of output are studied under the theory of firm
 Circular flow of income shows transaction of household and
firm.
 Firm- independent business unit/single production unit/single
business unit
 Plant-is the processing machine used to produce goods and
services in factory(building +machine )
 Industry- a group of firm produce/sell similar products
 Cont..

Market Household Firm

Market Supply factors of Use factors of
production to the firm production to produce
and use their income to goods and services
buy goods and services
Factor market Supply services i.e. Pay profit to household
labour to factor of and pay them for the use
production and receive of factors of production
income
Goods market Spend gods and Sell goods and services
services by firm of household
THEORY OF PRODUCTION

 We were concerned with the demand side of the market.

In this part we move to the supply side of the market.
Supply is created through production
 Production is an activity of transforming inputs in to
outputs. The rate at which a given quantity of inputs is
transformed into output is governed by the laws of
production
 The laws of production, are also called the law of return
or the theory of production
 Theory of production states the quantitative
relationship between inputs and outputs.
 It tells how output is more likely to change in response to
change in quantity of inputs, given technology.
 Cont…

 Inputs, are also called factors of production, include

everything that goes into the process of production, e.g.,
land, labour, capital, time, space, materials, water, power,
fuel and managerial skills.
 However, economist clarify factors of production as
labour, land, capital and entrepreneurship. None of these
inputs is available free of cost. All inputs have price.
 This means that production of commodity involves cost of
production. Cost of production is the main determinant of
supply of a commodity
 Cont..

 The rate at which cost of production change with the

change in output depends on cost-output relationship.
 This relationship is based on the law of returns to inputs.
 The relationship between production and cost of
production is studied under the theory of cost. To be
discussed later…..
 Production with one
variable input
4.0 Meaning of production
 The term Production means a process by which inputs
or factors of production (land, labour, capital etc) are
converted or transformed into an output.
 In other words, production means transforming inputs
(Labour, machines, raw materials) into an output. This
kind of production is called manufacturing.
 In the process of production, inputs may be intangible
(service) and output may be intangible too. e.g. in the
production of legal, medical, social and consultancy
services both input and output are intangible.
 Input -Output relations

4.1 Factors of production

 Factor of production refers to inputs or resources of
society used in the process of production. Classifications
of factors of production are:- Land, labour, Capital and
Entrepreneurship.
 Land is taken to refer to all the natural resources which
people have the power of disposal and which may be
used to yield an income. Land includes farming land,
building land, forests, rivers, lakes and mineral deposits.
The total supply of land in world is limited although the
supply of land for some particular use is not fixed.
 Cont..

 Labour refers to the exercise of human mental

and physical effort in the production of goods
and service
 Capital is a man-made input. It can be
classified as working capital or circulating
capital referring to stocks of raw materials,
partly finished goods and finished goods held
by producers. Fixed capital which consists of
building, machines etc.
Entrepreneurship refers to the organization of
all the factors of production with a view to
profit.
 4.2 Some
concepts
 An input is a good or service that is used
into the process of production.
 In other words of Baumol, “input is simply
anything which the firm buys for use in
its production or other process.
 An output is any commodity which the
firm produces or processes for sale”. An
output is any good or service that comes
out of production process. An output may
be tangible or intangible.
 Cont…

4.2.1 Fixed and variable inputs.

 For the sake of analytical convenience, inputs are further
classified into Fixed and variable inputs.
 A Fixed input is one whose quantity remains constant
for a certain level of output. e.g., Plant, building,
machinery etc, the supply of fixed inputs remains
inelastic, in short-run
 A variable input is defined as one whose quantity
changes with change in output. The supply of such inputs
(as labour and raw materials) is elastic in short-run.
 Cont..

4.2.2 Short–run and Long-run

 Short–run is refers to a period of time in which
the supply of certain inputs (e.g., plant, building
and machine etc) is fixed or inelastic. Therefore
production of a commodity can be increased by
increasing the use of variable inputs (labour
and raw material).
 Long-run refers to a period of time in which the
supply of all the inputs is elastic. Production of
a commodity can be increased by employing
more of both variables and fixed inputs
 4.2.3 Production Function

 A production function is the technological relationship between

output of a good and the inputs required to make that good. It
specifies the maximum quantity of commodity that can be produced
per unit of time with given quantities inputs and technology.
 A production function may take the form of;
i) A schedule or table,
ii) A graphed line or curve,
iii) An algebraic equation or of mathematical model.
A general empirical form of production can be expressed as
Q=ƒ (L, K,LB,M,T,t,e)
where
Q= Quantity, L= labour, K= capital, LB= Land/building, M =
materials, T= technology, t= time and e=managerial efficiency.
 Cont..

 All these variables enter the actual production function of

a firm.
 The economists have however reduce the number of
variables used in a production function to only two, viz.,
capital and labour, for sake of convenience and simplicity
in the analysis of input-output relations. i.e.,
 (i) Q=ƒ (L) in short-run ¯K is fixed and
 (ii)Q=ƒ (L, K) in long-run
 By definition, supply of capital is (fixed) inelastic in short
run and elastic (variable) in long run
Assumptions of Production
function
 The production functions are based on a certain assumptions:
i. Perfect divisibility of both inputs and output;
ii. Limited substitution of one factor for another;
iii. Constant/Given technology; and
iv. Inelastic supply of fixed factors in the short-run.

 When a production function is graphed, it takes a graphical form of

production function. The resulting curve is called Total product
(TP) curve. Horizontal axis shows number of workers (L) and
Vertical axis shows the quantity of output (Q).
 Total Product is the total amount of commodity produced during a
given period a given period time in a given number of factors of
production
 Cont…

 The total product (or total physical product) of a variable

factor of production identifies what outputs are possible
using various levels of the variable input.
 It can be estimated in two ways;
i. A summation of Marginal Product of various units of
factors i.e. T.P= ∑M.P
ii. As average product times number of units of factors
employed i.e. T.P=A.P * N
 Cont…

Select this paragraph to edit

Total
Product

TPL

0
Labour (on one acre of land)
 Cont..
4.2.4 Marginal Product( Incremental product)
 The concept of marginal product pays an important role in explaining the law of
returns. Therefore we will define the marginal product of variable input, labour and
derive margin product (MP) curve.
 The Margin products (MPL) may be defined as the change in output (Q) resulting
from a very small change (∂L) in labour employed, other factors held constant.
 In fact, the MPL is a partial derivative of the production function with respective to
labour.

i.e., Marginal product = Change in total output (output)

Change in quantity of labour employed (input)

Thus MPL= ∂Q
∂L
or ∆TQ = ∆TP
∆L ∆L

 Marginal Productivity of labour (MPL) it find trend in the contribution of the

marginal labour
 Cont..

 M.P is the change in T.P resulting from use of more unit

of variable factor.
 It measure the rate at which total product is changing as
one factor is changing.
 Geometrically, MPL is given by the slope of the curve,
TPL= Q= ƒ (L)
 Given the definition of MPL, the MPL, curve may be
derived from the TPL, as shown below
 Cont..

Select this paragraph

Total
to edit
Produ
ct

TPL

0
MPL Labour (on one acre of land)
 Cont..

4.2. 5 Average Product

 Another important concept used in discussion of production theory
is average product. The average product of labour (APL) may be
defined as a ratio of Output (Q) per labour (L)
Average product = Total output
No. of units of the variable factors
( e.g. labour)
 APL = TQ
L
 Average Productivity of labour (APL) it find the average contribution
of labour
 Is the T.P divide by number of unit of factor, Thus average means
per unit output
 i.e. A.P= T.P/L
 Cont…

A hypothetical production function for small scale maize farmer

can be shown in the following table

Land No. of Total Average Marginal

workers Product Product Product
(N) (TP) (AP) tons (MP)
1 0 0 0 -
1 1 29 29 29
1 2 72 36 43
1 3 133 44 51
1 4 186 46.5 53
1 5 233 47 47
1 6 274 45.7 41
1 7 297 42.4 23
1 8 298 37.3 1
 Cont..

Total
Produ
ct
I II III
TPL

Average Product Labour

Marginal product

APL

MPL Labour
 Cont..

 These curves show the relationship between the

Total product, average product and marginal product.
 The APL curve rises at first reaches a maximum, then
falls, but it also remains positives as long as the TPL is
positive. The MPL curve also rises at first, reaches a
maximum (before the APL reaches its maximum) and
then declines.

 The MPL becomes zero when the TPL is maximum and

negative when the TPL begins to decline. The falling
portion of MPL curve illustrates the law of diminishing
returns.
RELATION BETWEEN T.P and
M.P

i. When T.P increases at increasing rate, M.P also

increase
ii. When T.P increases at diminishing rate, M.P decline
iii. When T.P reaches its maximum, M.P becomes zero
iv. When T.P began to decline, M.P becomes negative
RELATION BETWEEN A.P
and M.P
i. When M.P is greater than A.P, The A.P rises
ii. When M.P=A.P, A.P reaches maximum
iii. When M.P< A.P, A.P start decline
iv. Both M.P and A.P increases in the beginning, after
reaching maximum start decline but maximum point of
M.P comes first than A.P
PRODUCTION WITH ONE VARIABLE
INPUTS

THE SHORT-RUN LAWS OF PRODUCTION(LAW OF

VARIABLE PROPORTION)
 The traditional theory of production analyses the marginal
input-output relationship under
i) Short run and
ii) Long run conditions
 In short run , input-output relations are studied with one
variables input (labour), the other input (capital) held
constant
 The law of production under these conditions are called “The
law of variable proportion”, the “law of return to variable
input” and the “Law of Diminishing Marginal Return”
 Cont..

 Law of Variable Proportion in short run, tells us what

happens when additional units of one variable factor of
production are combined with fixed stock of some factors
of production
 Cont..

 Long run production function (Return to Scale)

 In long run, Input-output relations are studied assuming
all inputs to be variable.
 The long run input output relations studied under “Laws
of return to scale”(Long run law of production)
 Law of return to scale, tells how output varies with
change in scale of production
Factors affecting
Production function
Production function depend on;
1. Quantity of resources used-S.R
2. State of technical knowledge-L.R
3. Size of the firm-L.R
4. Nature of firm Organization-S.R
5. Relative price of factors of production and manner in
which the factors of production are combined i.e. labour
intensive and capital intensive
 Cont..

4.3 LAW OF VARIABLE PROPRTION(The law of diminishing

Marginal Returns)
 According to Prof. Watson, the law of variable proportions also
known as Law of diminishing return which states that “When
total output of production of commodity increases by adding a unit
of variable inputs while quantity of other inputs held constant, then
increase in T.P becomes after some points smaller and smaller”
The law of diminishing Returns states that “ceteris paribus” as
additional units of variable factors are added to a given
quantity of fixed factor, total output will initially increase at an
increasing rate, but beyond a certain level of output it will
increase at a declining rate, and eventually decline.”
 The ultimate law is, the marginal increase in total output eventually
decreases when additional units of variables factors are applied to
a given of fixed factors.
 Cont..

 In other words of Hirshleifer, “if one factor (or group of

factors) is increased while another factor (or group of
factors) is held fixed, output or Total Product (Q) will at
first tend to rise. But eventually at least, a point will be
reached where the rate of increase, the marginal product
[MPl=ΔQ/ΔL] associated with increments of the variable
factor, begins to fall: this is the point of “diminishing
marginal returns”
 Baumol states the law of diminishing returns in similar
terms:” As more and more inputs i, is employed, all other
input quantities being held constant, eventually a point
will be reached where additional quantities of input I will
yield diminishing marginal contribution to the total output”
 Cont..

 Law of variable proportion or (Law of return to a

variable factor) state that “With the increase in variables
factors keeping other factors constant the M.P rising to
some extent and then becomes smaller and smaller

WHY IS IT LAW OF VARIABLE PROPORTION

1. The factor proportion/ratio varies as one inputs varies
and other are held constant
2. The return also varies with the change in factor ratio i.e.
when one factor is varied keeping other factor constant,
the input-output also undergo changes
 4.3.1 Key Assumptions of the
Law of Diminishing Returns
 The law of diminishing return is based on the following Assumptions:
 The state of technology is unchanged/given and organization i.e. other
wise the marginal and average curve will rise instead of diminishing
 Successive units of variable factors are assumed to be equally efficient i.e.
labour is homogeneous, mean all units of variable inputs are alike
 Production takes place in short run where at least one factor of production
is fixed, b/se in long run all inputs can be variable
 There is only one input of and other are held constant variable factor of
production under consideration
 Input price is given
 Law operates not only on land but to any factor whose supply is fixed
 Cont…

To illustrate the law of diminishing returns with the help of

our coal mining example, lets assume
i. That coal- mining firm has a set of mining machinery
as its capital (K), fixed in short run and
ii. That it can employ more mine-workers to increase its
coal production.
Thus , the short run production function for the firm will take
the following form.
Qc= f(L,¯K)
Where Qc= Quantity of coal produced
L= Labour and ¯K= Capital (held constant)
 Cont…

 Let’ s assume that labour-output relationship in coal production is given by

cubic production function of the following form.
Qc=-L3 + β L2 +αL
 When estimated with actual data, it takes the following form.
Qc= -L3 + 15L2 +10L
 Given the production function, we may substitute different numerical values
for L in the function and work out a series of Qc. i.e. the quantity of coal that
can be produced with different number of workers, given the mining
machinery and equipments.
 For example, if L=5, then by substitution,
 Qc= -L3 + 15L2 +10L
 = -53 + 15(5)2 +10(5)
=300
 A tabular array of output levels associated with different number of workers
from 1 to 12 in our hypothetical coal –production example
 What we need now is to work out marginal productivity of labour (MPl) to
 Table: Total, Marginal and Average
Product
No. of Total Product Marginal Average Stage of
workers (L) (TPl) tonnes Product *(MPl Product (Apl) return
)
(1) (2) (3) (4) (5)
1 24 24 24 I
2 72 48 36 Increasing
3 138 66 46 return
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66 II
8 528 66 66 Diminishing
9 576 48 64 return
10 600 24 60
11 594 -6 54 III
12 552 -42 46 -ve return
 Cont..

*MPl=TPn- TPn-1
MARGINAL PRODUCTIVITY OF LABOUR (MPl)
 MPL can be obtained by differentiating the production function
with respect to labour

MPL= ΔQc = -3L2 + 30L2 +10

ΔL
 By substituting numerical numerical value for labour (L), MPl can
be obtained at different levels of labour employed. However , this
method can be used only where labour is perfectly divisible and Δ
L O. Since , in our example , each unit of L=1, calculus method
can not be used. Alternatively, where labour can be increased at
least by one unit. MPl can be obtained as
 MPLn=TPL-TPL-1
 Cont..

AVERAGE PRODUCTIVITY OF LABOUR (APL)

 APL can be obtained by dividing production function by
L.
 APL=Qc = -L3 + 15L2 +10L
L L
= -L2 + 15L +10
 Now, APL can be obtained by substituting numerical
values for L
 4.3.2 The Three Stages of
Production
 The economists identify three stages of production on the
basis of the marginal and average returns to the variable
inputs, i.e. labour (L) in our case. The features of the
three stages of production may be described as follows.
 STAGE I: Marginal Product input (labour) is higher than
its average i.e., MPL > APL
 STAGE II: Marginal product of the variables inputs
(labour) falls below its average product, i.e., in stage II
MPL<APL, but both remaining greater than zero.
 STAGE III: Marginal product of the variable inputs
(labour) turn negative, while average product remains
greater than zero.
 Cont…

 The stages of production implied by the law of

diminishing returns can be illustrated in the diagram that
follows:
 Cont…

Select this paragraph to edit

II III
I

TPL

TPL
APL

MPL

APL

Labour
MPL
 Cont..

Stage I
 Stage I starts from origin, ends where MPL equals to APL when APL is
at maximum. In stage I there are increasing returns to the variable factor.
In this stage, TPL is increasing at increasing rate whole MPL and APL
are also rising with marginal product higher than the APL at any
point. This is an indication of the increasing efficiency of the
proportion in which the factors are combined since fixed factors are still
underutilised and there is scope for greater specialization.

Stage II
 Stage 2 represents decreasing returns to the variable factor, Total
product is increasing at decreasing rate. MPL and APL are positive but are
falling during this stage, with APL higher than the MPL. Stage II goes from
where the APL is at maximum level to the point where the MPL is zero.
Stage II is the only stage of production for the rational producer. This
shows decline in efficiency of labour.
 Cont…

Stage III
 This stage represents the stage of negative returns to
the variable factor. At this stage marginal product is
negative and as result Total product is declining. This
represents a stage of extreme inefficiency of labour
when factor of production are probably getting into each
other’s way. The producer will not operate in stage III,
even with free labour.
 Factors Behind the Laws
of Return
(CAUSES OF DIMINISHING RETURN TO OPERATE)
i. Indivisibility of fixed factors (capital)
The quantity of fixed inputs per unit of variable inputs, there fore it must
decrease amount of total output, as it result in under utilisation of capital if
labour is less than its optimum number.
i. Scarcity of factor, refer short in supply therefore if productive factors had not
been limited the law will cease to operate
i.e. Fall in quantity of fixed factor inputs per unit of variable factor inputs add
decreasing return to the total product. In other words fixed factors becomes too
small
i. Lack of perfect substitution between factors/ Imperfect substitution
between factors of production. Here since factors of production cant be
substituted fully, e.g. labour, capital cant be substituted in sphere of land
ii. Use beyond optimum capacity: After achieving optimum combination of
variable and fixed factors, efficiency start declining when more units of variable
factors are employed and MP starts declining
iii. Due to diseconomies beyond a certain stage, management and coordination
becomes difficult.
 Application of the law of
diminishing return
 The law of diminishing return is an empirical law, often observed in various
production activities. This laws, however may not apply universally to all
kinds of productive activities since the law is not as true as the law of
gravitation.
 In some productive activities, it may operate at early stage of production;
in some it operate in agricultural production.
 The reason is, in agriculture, natural factors play a predominant role where
as man-made factors play major role in industrial production.
 Despite the limitation of the law, if increase in unit of an input are applied
to the fixed factors, the marginal return to the variable inputs decrease
eventually
Limitation of the law of
Diminishing Return
i. Improved methods of cultivation i.e. uses of fertilizer,
crop rotation
ii. Virgin/immature soil, in new soil the law of diminishing
return doesn’t apply in the begin
iii. Insufficient capital, with sufficient capital at early stage
is exception of the law of diminishing return
Note: Samuelson regarded this law of diminishing return
natural law because its applicable in the field of
production that is why its called Universe of law of
production.
 THE LEAST COST FACTOR
COMBINATION

 The law of diminishing returns shows the tendency of

output per unit of the variable factor when the proportions
between the factors are varied.
 However, in order to determine the most profitable way of
combining factors of production, one has to consider their
prices as well as their productivity. Physical productivity
deals with technical efficiency. Entrepreneurs are more
concerned with economic efficiency.
 4.4 Production with two
variable inputs
 We discussed theory of production with one variable factor
(labour) i.e. the technological relationship between inputs and
output assuming labour to be the only variable input and capital
remaining constant.
 This is the short run phenomenon
 In a long run phenomenon we discuss theory of product with
two variable inputs (labour and capital)
 In the long run, supply of both the inputs (labour and capital) is
supposed to be elastic. There fore firm can increase the use of
both inputs to increase that level of output
 A firm’s long run production function is then expressed as Q=
f(L,K). With simultaneous increase in both the inputs (labour and
capital), a firm’s scale of production increases.
 The input-output relationship under increasing scale of production
is also known as laws of return to scale
 Cont..

 The graphical technique (showing TP,AP and MP curve) used to illustrate the
law of diminishing returns cannot be used conveniently to illustrate input-output
relationships with two variable inputs
 The long-run technological relationship between input and output is general
expressed in Isoquant curve. This is based on the assumption that two variable
inputs are combined to produce the same level of output.

4.4.1 The concept of an Iso quant

 The term “Isoquant” has been derived from a Greek word “ iso” meaning equal
and a Latin word “quantus” meaning quantity
 The ‘Isoquant curve’ is therefore also known as Equal Product Curve and
Production Indifference curve.
 Cont..

 An isoquanty curve is analogous to consumer

indifference curve with two differences:
i. While an indifference curve represents different
combination of two goods yielding the same level of
satisfaction, an isoquant curve represent different
combinations of two producer (labour and capital)
producing same quantity of commodity
ii. While an indifference curve represents immeasurable
“utility” i.e. level of satisfaction, an isoquanty
represents a measurable quantity
 Cont…

 An Isoquant curve is a locus of points representing the

various (different) combinations of two inputs- capital and
labour – yielding the same output.
 The fact that different inputs combinations can produce
the same output is based on the assumption that capital
and labour can be substituted for one another but at a
diminishing rate.
Assumptions of Isoquant
curve
 To draw an Isoquant curve, the following assumptions are
made:
i. A producer uses only two inputs, labour (L) and Capital
(K) to produce a commodity say X;
ii. The two inputs (L and K) can be substituted for one
another at a diminishing rate up to certain limit
iii. That the technology of production is given/constant for
the period under reference; and
iv. That the production function of the firm is continuous,
i.e., labour and capital are perfectly divisible and
substitutable in any small quantity.
 Cont….

Given the assumptions, the production function takes the

following forms:
Q=ƒ (L, K)
The production function being continuous, it cannot be
conveniently presented in a tabular form, however it can
be conveniently presented graphically
 Cont…

Select this paragraph to edit

Capital
(K)

I=300

I=200

I=100

0
Labour (L)
 Cont..

 It is important to note that movement along an Isoquant

means substitution of one factor for another.
e.g., movement from point A to B i.e. -ΔK/ ΔL

Capital

A
K2

c B
K1

L1 L2 Labour
 Cont..

 Means that L1 L2 (= CB) units of labour is substitute for K1 K2 (=CA) Unit or

capital can produce as much as L1 L2 unit’s of labour. The rate at which
one factor can substitute another is called Marginal Rate of Technical
Substitution.

4.4.2 Marginal Rate of Technical Substitution

 The slope (Marginal Rate of Technical Substitution) of an Isoquant
measures the rate at which capital can substitute for labour, keeping
output constant. Marginal rate of technical substitution (MRTS) of
capital for labour is refers to the amount of labour that a firm can give up
by increasing the amount of capital by 1 unit and still remaining on the
same Isoquant. Marginal Rate of Technical Substitution capital for labour
is also equals to MPk / MPL.
 Cont…
 Since the slope of an Isoquant moving down the Isoquant is given by
∆K/ ∆L =∂ K/∂ L
MRTS = ∆K/∆L
MRTS = Slope of the Isoquant

 The condition that the total output should remain constant; this Implies that
marginal product of capital (i.e., MPk) must be equal marginal product of Labour
(i.e., MPL).
 That is
(- ∆K x MPk) = (∆L x MPL)
By rearranging this - ∆K/ ∆L = MPL/MPk
Since - ∆K = MRTS
∆L
Therefore MPL/MPk = MRTS
Thus, MRTS of L for K is the ratio of the marginal product labour (MPL) to the
marginal product of capital (MPk).
 Cont…

A table below presents 5 alternative combinations of

capital (K) and Labour (L) that can be used to produce a
given quantity say 10 units of a commodity.
Alternative methods of producing 10 units of a
commodity

Capital Labour ΔK ΔL MRTS=ΔK/ΔL

10 2 - - -
8 4 -2 2 -1.0
5 10 -3 6 -0.5
1 20 -4 10 -0.4
 Cont..

 As we move down the table, the MRTS declines. This is

an important factor in determining the shape of the
Isoquant.
 The downward movement on an Isoquant indicates
substitution of capital for labour. The amount of
capital decreases while the number of workers (labour)
increases, so that output remains constant. The units of
labour which can substitute one unit of capital go on
increasing.
 As a result, the MRTS (- ∆K/ ∆L) decreases. This is
because both factors are subjected to the law of
diminishing marginal return.
4.4.3 Properties of Isoquant
Curves
Like indifference curve, Isoquants have the following properties.
They are explained below in terms of inputs and output, under
condition that the two inputs are not perfect substitute
a) Isoquants have a negative slope
 An Isoquant has a negative slope in the economic region or in the
relevant range. Economic region is the region on the Isoquant plane
in which substitution between inputs is technically possible. It is also
known as profit maximizing region. The negative slope of the
Isoquant implies that If one of the inputs is reduced, the other inputs
has to be increased, that output remains unchanged/unaffected.

b) Isoquants are convex to the origin

 Convexity of Isoquant implies not only the substitution of one factor
for another but also diminishing marginal rate of technical
substitution (MRTS) between iputs in the economic region.
 Cont..

 This rate is indicated by the slope of the isoquant. The MRTS

decreases for two reasons;
i. No factor is a perfect substitute for another
ii. Inputs are subject to diminishing marginal return
Therefore, more and more units of an inputs are needed to
replace each successive units of other inputs

c) Isoquants can not intersects or be tangent to each other

 The intersection or tangency of two Isoquants implies that a
certain quantity of a commodity can be produced with a
smaller inputs combination as well as with a larger input
combination. This is not consistent with the theory of
production so long as marginal productivity of an input is
greater than zero.
 Cont..

Capital
M
N

2000

1000

L1 L2 Labour
 Cont..

 The upper the isoquants represent a higher level of

output, Between any two isoquants, the upper one
represents a higher level of output than the lower one.
 The reason is that any point on an upper isoquant implies a
larger input combination, which in general, produces a large
output. Therefore, upper isoquants indicates a higher level of
output.

4.4.3 Isoquant map and Economic region.

 An Isoquant map is a set of Isoquants presented on a two
dimensional plane as shown by Isoquants Q1, Q2, Q3 and Q4
in the figure below.
 Cont..

Select this paragraph to edit

Upper
ridge
line
Lower
d ridge line
Capital c h

b Q4
g Q3

f Q2
a
e
Q1

Labour
 Cont…

 Each Isoquant shows various combinations of two inputs that can

be used to produce a given level of output. An upper Isoquant is
formed by a greater quantity of one or both of the inputs than that
indicated by lower Isoquants. Q1 > Q2 > Q3 > Q4. This implies that
the higher Isoquant, the higher output level than the lower. It is
noteworthy that the whole Isoquant map or production plane is not
technically efficient, nor is every point on Isoquants technically
efficient.
 Due to convexity of Isoquant, the MRTS decreases along the
Isoquant. The limits to which MRTS can decrease is zero. The zero
MRTS implies that there is a limit to which one input can be
substitute another. It determines also the minimum quantity of an
input which must be used to produce a given output.
 Beyond this point, an additional employment of one input will
necessitate employing additional units or the other input.
 Cont…

 The ridge lines are locus of points on the Isoquants where

the marginal products of the inputs are equal to zero.
 The upper ridge line implies that Marginal product of Capital
is zero along the line, od;
 The lower ridge line implies that Marginal product of labour
is zero along the line, oh.
 The area between the two ridge lines, od and oh is called
Economic Region or technical efficient region of
production. Any production i.e., capital-labour combination,
within the economic region is technically efficient to produce
a given output. And any production technique outside this
region is technically inefficient since it requires more of both
inputs to produce the same quantity.
 4.5 LAWS OF RETURNS
TO SCALE
 A long run phenomenon, supply of both labour and capital is supposed to
be elastic
 In long run, the laws of returns to scale explain how a simultaneous
and proportionate increase in both labour and capital affects the
total output at various levels of input combination.
 The concept of returns to scale refers to changes in output as all the
factors are changed by the same proportion. When a firm increases all its
inputs proportionately, technically there are three possibilities;-
 Total outputs may:-
 increases proportionately;
 More than proportionate;
 Or less than proportionately.
 Thus this kinds of input-output relationship gives Three Laws of Return
to Scale (i)Constant returns to scale, (ii)Increasing returns to scale and
(iii) Diminishing /Decreasing returns to scale.
 (I)Increasing Returns to
Scale (IRS)
i.e. When production increases more than proportionate increase in variable factors.
 If a proportionate change in both the inputs K and L leads to more than proportionate
change in output, it exhibits increasing returns to scale. e.g. if quantities of both the
inputs K and L, are doubled and the output is more than doubled, the returns to scale is
said to be increasing.
 Here Marginal product increase with increase quantity of variable factors
The Causes for operation of Law of IRS
1) Technical and managerial indivisibility:-
 Capital equipments and managerial skills used in production process can not be divided
in smaller size to suit a smaller scale production. Therefore, when scale of production is
increased by increasing all inputs, the productivity of indivisible factors increases
exponentially.

2) Higher degree of specialization

 Another factor causing increasing returns to scale is higher degree of specialization of
both labour and machinery, which becomes possible with increase in scale of
production. The use of specialized labour and machinery increases productivity per unit
of inputs. Their cumulative effects contribute to the increasing returns to scale.
 Cont…
3)Dimensional relations, when labour and capital are doubles, the output is more
than doubled over some level of output i.e. optimum combination of various
factors of production.

 Why Law of Increasing Return to scale

i) Economies of Scale (market economies)
 Advertising space(magazine and new papers) and Radio, TV and number of
sales man don’t have to rise proportionately with the sales. Hence the selling
cost per unit of output fall with scale.
ii) Labour economies i.e. economies of division of labour and specialization are
more and more in large scale i.e. labour acquire great skills by devoting his
attention to particular job. Thus quality of spend worker improve and increase
in specialization and increase in return to scale.
i) Managerial economies , large firm make possible the division of managerial
tasks thus increase the efficiency of management including high degree
mechanisation.
 Cont..

iv) Technical efficiency (principle of indivisibility)

By employ technique of production .i.e. size of capital
goods increased, its total output capacity increase far
more rapidly than cost of making it
v) Economies related to transport and storage cost
By using his own transport facilities per unit transport
cost will fall similarly storage cost.
 II) Law of Constant Returns
to Scale (CRS)
 i.e. When production increases in the same proportion as increased in
variable factor. i.e. With increase in variable factors M.P remain constant.
 When a proportional changes in output equals the proportional change in
inputs, it exhibits constant returns to scale. i.e., If quantities of both the
inputs K and L are doubled and output is also doubled. The constant
returns to scale are said to occur in the field where factor of
production are perfectly divisible.
Causes
 The constant returns to scale are attributable to the limits of economies
of scale. With the expansion in the scale of production, economies arise
from such factors as indivisibility of certain factors, greater possibility of
specialization of capital and labour, use of labour saving technique of
production etc. But there is a limit to the economies of scale.
 III)Diminishing Returns to
Scale
i.e. When the increase in output is less than proportionate to
a given increase in quantity of all factor inputs i.e.
doubling input cause less than doubling of output.

Labour Capital Output (bags)

(No. of people) (No. of people)
6 2 300
12 4 500
 Cont..

This arises where all inputs are increased in a given

proportion and output is increases less than
proportionately. For example if both labour and capital
are both increased by 20 percent, output rises by less
than 20 percent. See numerical illustration above.
 Causes of Diminishing
Return to Scale
i. Decreasing returns to scale may arise because as the scale of
operations increases, communication difficulties may arise which may
complicate the effective running of the business result into
diseconomies of scale.
ii. Also managerial efficiency decrease resulted from expansion of the
firm’s operation.
iii. Limitedness or exhaustibility of natural resources. e.g., doubling of
coal mining may not double the coal output, or doubling of fish
processing industry may not necessary double the output of fish output
iv. Sometimes weather condition may lead to decreasing return to scale
e.g., flood, drought may cause decreasing returns to scales.
 Comparison of Law of Variable Proportion
and Law of Return to Scale
There ‘s difference between return to variable factor and return to scale as
follows;
1. Return to variable factor
With the increase in the unit of variable factors keeping other factor
constant, the increase, the increase in total production becomes smaller
and smaller. i.e. M.P first increases, become constant and finally decline
and becomes negative.
Hence, the laws has three stages
a) Increasing marginal return
b) Diminishing marginal return
c) Negative return
 Operate in short run, where supply of capital is Inelastic
 Only one factor input is varied
 Cont..

(2) Return to scale, refers to change in output as all factor

input change in long run
 Thus , increasing in output be more than, equal to or less
than proportional to the increase in factor.
 So return to scale has three
a) Increasing return to scale
b)Constant return to scale
c) Diminishing return to scale
 It operate in long run, supply of all input is Elastic
 All factor inputs are varied
 Cont…

Review Questions
1. What is factor of production?
2. Brief discuss the factors which lead to increasing and
decreasing returns to scale in the production process
3. Discuss the difference between the laws of diminishing
marginal returns and the laws of returns to scale.
4. A typical production function has three stages” Explain
and illustrate the relationship between the production
function and the shape of Total Cost curve.
 OPTIMUM COMBINATION OF
INPUTS
 We have discussed the laws of return to scale assuming (implicitly) that firm
can expand the scale of production to any level, they have no resource
constraint.
 In reality however, firms have limited resources and are supposed to
maximize their profit from their given resources.
 A profit maximizing firm has to minimise its cost for a given output or to
maximise the output from given total cost
 Given the technology, a given output can be produced with different input
combinations. But all inputs combinations do not conform the least cost
criterion
 In our analysis it does not provide any rule or criterion for cost minimisation.
 We will now show how a firm finds the Least cost combination of inputs for
a given output and how it can maximize the output given the costs
 The problem now, is how to find the input-combination that gives the minimum
cost of production
 Cont…

 The least-cost combination of inputs can be

determined by the firms production and cost function
 We know that firm’s production function is represented by
isoquants.
 What we need here is to derive the firm cost function
and find possible input combinations with given cost.
Derivation of ISOCOST

 In order to construct cost function, lets assume that a firm

has limited money to spend as its total cost, C , on both K and
L and the price of capital (Pk) and the price of labour (Pl) are
given
 Given these conditions firm cost function can be expressed as
C=K*Pk +L*Pl
 The quantity of capital, K, and labour, L, that can be hired out
of the total cost, C, can be obtained as follows
K=C/Pk-Pl/Pk(L); and L=C/Pl-Pk/Pl(K)
 Yields of the curve represent the alternative combination of K
and Labour that can be hired from given total cost, C. This
curve is known as ISOCOST
 Cont..

 Isocost is also called budget line or the budget

constraints line
 Consider a set of three isocost, each is drawn on the
assumption that a firm has option to spend its total cost
(C) either on K or on L, or on both.
 For example consider, consider isocost K1L1. If total
resources are spent on K and nothing on L, then the
firms can buy, OK1 units of K and no units of L as shown
below:
OK1=C/Pk-Pl/Pk(L) (where L=0)
 Cont…

 Similarly, if the firm spends total C on L, it can buy OL1

units of L with K=0 as shown below

OL1=C/Pl-Pk/Pl (K) (where K=0)

 The total quantity of capital OK1 (where L=o) is marked
at point K1 and the total quantity of labour, OLL1 (where
K=0) is marked at point L1.
 By joining point K1 and L1 by line called isocost
 Isocost show all range of combination of K and L that
can be hired, given total cost and factor price
 Cont..

 An ISO COST is curve or locus of points showing the

combination of inputs that have that same market cost.

Properties of Iso costs:

 They are negatively sloping
 In an iso cost there is the same level of cost
 The higher the iso cost, the higher the cost
 Iso cost is a straight line
 Cont..

Isocost
Capial,
K3
K2
K1

Δk

ΔL

0 L1 L2 L3 Labour
 Cont..

 Given the factor prices, if cost increases larger quantities

of both K and L can be hired, making the isocosts shift
upward to the right as shown by K2L2 and K3L3.
 Its important to note here that the slope of the isocosts
(i.e. –ΔK/ΔL) gives the Marginal rate of Exchange
(MRE) between K and L, more important factor price-
ratio, PL/PK
 Since factor prices are constant, marginal rate of
exchange between the inputs is constant and equal to
the average rate of exchange all along the line
THE LEAST COST
CRITERIA
 There are two criteria, called first order and second order criteria
that must be fulfilled for the least combination of inputs
1. The first order criteria also called necessary conditions, for the
least-cost input combination, can be expressed in both physical
and value terms
 Given the two inputs K (capital) and L (labour), the first order
criterion in physical term can be stated as MRE must be equal to
Marginal productivity ration of labour and capital.
 i.e. –ΔK/ΔL=MPl/MPk
 Where –ΔK/ΔL is the exchange ratio between K (capital) and L
(labour) at market price and MPl/MPk is the ratio of Marginal
productivity of L and K i.e. Input combination at which factor
exchange ratio (given factor prices) and marginal productivity
ratio are equal, is the Least cost input combination
 Cont..

 In term of money value, the first order criterion for least cost
of optimal input combination may be expressed as;

MPl/MPk=Pl/Pk or MPl/Pl=MPk/Pk

Slope of Slope of
Isoquant Isocost
 Therefore it means that the least cost combination of inputs is
given by the point where isoquant is tangent to the isocost
5.0 THEORY OF COST OF
PRODUCTION

 Here we are going to discuss relationship between the output

and cost of production.
 Costs of production consist of payment to factors of
production and are therefore closely linked to the theory of
production.
 Cost of production refers to expenditure incurred by
producer .
 Cost of production affect supply in two ways;
(i) Determine the quantity to be produced by particular firm
(ii)Determine number of firms in production of commodity
Note: The knowledge regarding the cost of production is essential to understand
supply. (supply is nothing else than output)
 Concepts of costs
 In this section will know what are:- Actual cost and opportunity Business cost and full
cost, Explicit and implicit/imputed cost as well as Total average and marginal costs

Actual cost and opportunity cost

 Actual cost are the expenditure which are actually incurred by the firm in payment of
labour, material, plant, building, machinery, equipments, traveling and transport, fuel etc.
 The Total money expenses recorded in the books of accounts are actual costs.
 Opportunity cost as discussed earlier on, it is the returns expected from the second
best use of the resources which is forgone for availing the gain from the use of the
resources.
 It s the loss of income due to opportunity forgone. Its also called alternative or
economic cost/economic rent
 Economic rent is the difference between actual earning and opportunity cost
 Cont..

Business cost and full cost

 A business cost includes all the expenses which are
incurred in carrying out a business. This cost concept similar
to the actual or real cost.
 It includes all the payments and contractual obligations made
by the firm together with the books cost of depreciation on
plant and equipment.
 Both these concepts are used in calculating actual profits and
losses in the business, in filling returns for income-tax, and
for other legal purposes
 The concept of full cost includes two other costs:
opportunity cost and Normal profit.
 Normal profit is a necessary minimum earning, in addition to
opportunity cost, which a firm musts get to remain in its
present occupation.
 Cont..

 Total money cost includes;

i. Explicit cost (things paid directly)
Is the actual payment made by firm for purchasing or hiring resources from factor
owners
actual money expenses directly incurred for purchasing resources
i. Implicit cost (estimated cost owned by producer him/herself)
refer to the imputed cost of factors of production owned by producer himself which are
general left out in calculation of the expenses of the firm e.g. Rent of his own land,
interest of his own capital or salary of his own service as a manager.
i. Normal cost/Profit(minimum amount you get for service)
is the minimum amount required to keep an entrepreneur in the production
Or is the minimum amount required to induce
Where
AC=AR or TC=TR
 Cont…

Thus
 Total =Explicit+ Implicit+ Normal profit
money cost cost cost
 Economic =T.R- (Explicit+ Implicit cost)
Profit cost
 Accounting = T.R- Explicit cost
profit
 Cont..

Explicit and implicit/imputed costs

 Explicit costs are those which fall under actual
cost or business cost entered in books of
accounts. e.g., the payment of wages, salaries,
utilities, interests, rent, license fee, insurance
premium and depreciation charges.
 Implicit costs may be defined as the earning of
owner’s resources employed in their best alternative
uses. For example suppose an entrepreneur doesn’t
utilise his services in his own business and work as
a manager in some other firms on a salary basis. If
he joins his own business, he forgoes his salary as
manager.
 Total, Average and Marginal C
osts
Total Cost (TC)
 represents the value of the total resources used in the production of goods
and services.
 It refers to the total outlays of money expenditure, both explicit and implicit on
the resource used to produce a given output.
 TC=f(q)
 Can be obtained by adding T.F.C + T.V.C
 Average cost is of statistical nature. It is obtained simply by dividing the Total
cost (TC) by the total output (Q).
 A.C =TC/Q
 Marginal cost is the addition to the total cost on account of producing one
additional units of the product. Marginal cost is the cost of marginal unit
produced.
 MC = ∆TC
∆Q
 Fixed and variable costs

 Fixed costs are those which are fixed in volume for

certain given out put.
 Fixed costs do not vary with the variation in the
output between zero and a certain level of output.
e.g., managerial and administration staff,
depreciation of machinery, building and other fixed
assets etc.
 Variable costs are those which vary with the
variation in the total output. Variable costs are the
functions of the output e.g., running cost of the fixed
capital such as fuel, ordinary repairs, routine
maintenance expenditure, direct labour charges
associated with the level of output and the costs of
all inputs that vary with output.
 Private and Social costs

 Private costs are those cost which are actually incurred or

provided for by an individual or a firm on the purchase of
goods and services from the market. For a firm, all the
actual cost, both explicit and implicit are privates cost.
 Social costs are the cost society bear s on account
of production of commodity. Are all expenses fall which
fall in society during a course of producing commodity
e.g. externality like pollution, road maintenance, medical
 are those costs not paid by the firms including use of
resources freely available plus the disutility created in the
process of production. It implies the cost which a society
bears on account of production of commodity.
 Cont..

Since cost function is dependent of the production

function, it may change due to the change in production
function.
Short run cost function may be symbolically written as

 C= ƒ`(Q, T, Pf, K)
 C= Total cost
 Q= quantity produced
 T= Technology
 Pf= Factor prices
 K= Capital, the fixed factor
 Cost output relations

 The traditional theory of cost analyses cost behaviour in

response to change in production. Cost behaviour is
analysed under:
i. Short run conditions and
ii. Long run conditions
 The short run and long run conditions are the same
under which law of production are discussed
 Recall, Short run of certain inputs (capital) is fixed and
such that are used in fixed quantity while in long run,
supply of all inputs is variable and more and more of all
inputs can be used in the process of production, given
technology
 Cont..

 In short run therefore, cost output relations depends in

return to the variable factor
 In long run, cost- output relationship depends on return
to scale
 We will discuss
i. Short run cost-output relations, and
ii. Long run cost-output relationships
Short run cost- output
relations
 Cost functions depend on
i)Production functions, and
ii) Market supply function of inputs
 The inputs that are used in the process of production in the short
run can be classfied as
i. Fixed factor, include land, plant, building and equipment
ii. Variable factors, includes such inputs as direct labour, raw
material, fuel
 In short run total cost incurred in fixed inputs is called Fixed
cost and total cost incurred on variable inputs is called Variable
cost
Thus, the Total Short Run Cost (STC) consist of (i) Total Fixed Cost
(TFC) and Total Variable Cost (TVC)
i.e. STC =TFC + TVC
Distinction between V.C and
F.C
FIXED COST VARIABLE COST

Don’t vary with quantity of Varies with quantity of output

output
Related with fixed factor Related with variable factor

Never becomes zero Becomes zero when

production is closed
Firm continue on production Production continue only
even at the less of fixed when variable cost met i.e.
factor for production to take place it
depend on variable factors
 Cont..

 Since the basic cost concepts used in analysis of cost

behaviour are Total, average and marginal Costs,
 The Total Cost is defined as the total actual cost that
must be in incurred to produce a given quantity of output.
 The Short run, Total Cost (TC) is composed of two
major element, Total fixed cost (TFC), and Total
Variable Cost (TVC).
 Thus, TC= TFC + TVC
For a given quantity of output, (Q) the Average Total Cost
(ATC or AC) Average fixed cost (AFC) and average
variable cost (AVC) can be defined as follows:
 Cont..

 AC = Total Cost(TC)
Output (Q)

 AFC= Total Fixed cost (TFC)

Output (Q)
 AVC = Total Variable cost (TVC)
Output (Q)
Since TC= TFC + TVC
Note: TFC=Qf x P
TVC=Qv x P
 Cont…

 AC = TC = TFC + TVC
Q Q Q
 AC = AFC + AVC
 Marginal cost (MC) is defined as the change in the total
cost divided by the change in the total output
 MC = ∆TC
∆Q
 Since ∆TC = ∆TF + ∆TVC
 Cont..

 Because in short run ∆TFC = O

 ∆TC = 0 + ∆TVC

Thus in short run MC = ∆TVC

∆Q
For the matter of analysis let us see a table below
through hypothetical cost function which assumes
production of a single commodity with one variable input
 Cont..

Short cost-output relation

TC Q(unit) TFC TVC AFC AVC AC MC

140 0 140 0 - - - -
210 10 140 70 14.0 7.0 21.0 7.0
250 20 140 110 7.0 5.5 12.5 4.0
320 30 140 180 4.7 6.0 10.7 3.5
420 40 140 280 3.5 7.0 10.5 10.0
590 50 140 450 2.8 9.0 11.8 17.0
860 60 140 720 2.3 12.0 14.3 27.0
1260 70 140 1120 2.0 16.0 18.0 40.0
1820 80 140 168 1.8 21.0 22.8 56.0
0
 Cont…

The relationship between output & costs as

presented in the table above can be summaries
as follows
1.As out put increases the TFC remains constant (by assumption)
2.As Q increases, TVC increase first at decreasing rate (till Q = 20 unit) and then at increasing rate
3.As Q increases , The TC ( TFC + TVC) increasing first at a diminishing rate and then at an
increasing rate following the rates of increasing in the TVC
4.With increase in Q, the AFC decreases continuously, Because TFC remains constant for whole
range of output
5.As Q increases, the AVC decrease till the rate of increases in TVC decreases, beyond that it
increases
6The MC decreases till the output of 30 units and then increases. The MC also fall the TVC in the
short run
 Cont..

Graphical Representation

 TFC remains fixed for whole range of output and hence

takes the form of a horizontal line. As explain above the
pattern of TVC stem directly from the law of increasing
and diminishing return to the variable inputs
 Cont..

Select this paragraph to edit

TC
TC
TVC
TFC

TVC

TFC
140

Output
 Cont…

Select this paragraph to edit

MC
Cost
AC

AVC

AFC

Output
 Cont…

Interpretation
 As the figure above shows
 In the initial stage of production, both AFC and AVC are
declining because of internal economies of scale.
Since AFC and AVC are both declining, the AC is also
declining.
 But beyond a certain level of output (i.e. 20 units) while
AFC continuous to fall, AVC starts increasing because of
faster marginal increase in the TVC. Consequently, the
rate of fall in AC decreases.
 Cont..

 The AC reaches its minimum when output increases to

40 units. Beyond that level of output, AC starts increasing
rapidly due to law of diminishing returns coming into
operation; MC curve represents the pattern of change in
both the TVC and TC curve as output changes. A
downward trend in true MC shows increasing marginal
product of the variable input which mainly because of
internal economic resulting from increases in production.
 Cont..

5.2 The relation between AC & AVC

a) Since AC = AFC + AVC, AC falls when AFC & AVC fall.
b) When AFC falls but AVC Increases, change in AC depends
on the rates of change in AFC and AVC, on the following
pattern
i. If increase in AFC> Increase in AVC,
AC falls,
ii. If decrease in AFC = increase in AVC,
AC remains constant; and
iii. If decease in AFC < increase in AVC,
AC increases.
 5.3 The relationship between
MC and AC
i) When MC falls, AC falls too. But the rate of fall in MC is greater than that of AC,
because in case of MC, the decreasing marginal cost is attributed to a single
marginal unit, while in case of AC, the decreasing marginal cost is distributed over the
whole output. When MC curve lies below the AC curve, MC pulls AC downwards and
when MC is above AC, it pulls the AC upwards
ii) Similarly when MC increases, AC also increasing but at lower rate for reason given
above. MC increases while AC continuous to fall.

MC starts increasing, while AC continues to decrease. The reason is when MC falls; it

falls at a rate higher than the rate of fall in the AC. When MC starts increasing, it
does so at a relatively lower rate which is not sufficient to push the AC up. i.e., why
AC continues to fall over some range of output even if MC increases.

iii) MC intersects AC at its minimum. The reason is, when MC decreases it pull AC down
and when MC increases, it pushed AC up, and when AC is at its minimum, it is
neither being pulled down nor being pushed up; by MC. That is MC = AC at its
minimum
 Cont…

 Since A.C=T.C/Q or its per unit cost, while M.C is the incremental T.C that
increases from producing an increase of one unit of labour.
Cost

MC

AC

Output
 Cont…

CAN A.C FALL WHEN M.C IS RISING?

 Its clear from above schedule and diagram that A.C can
fall can fall even when M.C is raising
 The condition is that Mc may rise but it should remain
below A.C. So long M.C remain below A.C; A.C will fall
even when M.C is rising.
CAN A.C RISE WHEN M.C IS FALLING?
 No; Its not possible. When M.C is falling A.C can not rise
but it has to fall.
 5.4 Optimum Output and
Cost Curves.
 In Short run, optimum level of output is one which can be
produced at a minimum average cost of given
technology. The minimum level of AC is determined
by the point of intersection between AC & MC, curves
 At that level of output AC = MC , AC being the minimum
 Any other level of production, below or beyond this level
will be in-optimal.
Note: optimal level of output is not necessarily the
maximum profit output
 Cont..

TPL

TPL

Labour
Co
st AC

Output
 Cont..

Question one
a) Distinguish between fixed and variable costs

b) The data below shows a tabulation

on the production of a hypothetical
products
Output 0 1 2 3 4 5 6 7 8
(Q) units
Total Cost 25 32 38 42 48 58 67 78 98
(TC) ‘000
Tshs.
 Cont..

I. Total fixed cost

II. Average variable cost when output equals 6 units
III. Marginal cost of the 3rd unit of output.

Soln.
I. Total fixed cost = 25 000
II. Average variable costs(AVC)= TVC = (TC-TFC)
Q Q
= 67 000-25 000
6
= 42 000
6
=Tshs. 7 000
 Cont…

iii. Marginal cost of the 3rd unit of output

MC = ∆TC
∆Q
= 42 000- 38 000
3-2
= 4/1= 4
Tsh.4 000
The Short run Cost Curve and
The Law of Diminishing Return
Recall; Law of variable proportion states that, when more and
more units of a variable factor inputs are applied , other factor
inputs held constant, the returns from marginal units of the
variable inputs may initially increase but it decreases
eventually.
 The same law can also be interpreted, in term of decreasing
and increasing costs.
 The law can be more stated as, if more and more units of a
variable inputs are applied to a given amount of fixed inputs,
the marginal cost initially crease, but eventually increases
 Both interpretations of the law yield the same information
1. One, in terms of marginal physical productivity of the
variable inputs, and
2. Other , in term of marginal costs in money terms
 5.5 LONG RUN COST –
OUTPUT RELATION
 Long run is the period during which all the input becomes
variable
 Long run total cost is the horizontal summation of Short run
TC curves. Similarly Long run AC is the horizontal summation
of Short run AC curves
 There are three costs in longrun
1. Long run Total Cost (LRTC)
2. Long run Average Cost (LRAC)
3. Long run Marginal Cost (LRMC)
Long run curve
 The long run marginal cost curve (LMC) is derived from the
short run MC curves (SMCs)
 Cont..

1.LRTC
 Is the cost which varies with output since in long run all
factors are variable
2. LR A.C
 This show the lowest possible cost of producing different
levels of output given the productive function and the factor
price are reflected from the firm iso cost curve
 The shape of LRAC is U-shaped just like short run AC curve
but source of U-shaped is increasing and decreasing return
rather than diminishing return to the production factors
Note: LRAC curve decline the firm experiencing ECONOMIES
OF SCALE and when rising indicates firm face Diseconomies
of scale
 Cont..

1. LRMC
Is determined from LRAC curve arise below LRAC is
fallen and above the long run AC curve achieving its
maximum
 When a firm is producing at all output which is LRAC is
falling, LRMC is less than LRAC
 When LRAC is increasing , LRMC is greater than LRAC
NOTE:LRAC and LRMC curve are also U-shaped curve but
they are flatter than the short run cost curve
The reason is that, in the Long run, TFC can be varied to
consider able extent
Also, T.F.C can be reduced so as ATC may be lowed.
 Cont…
5.6 Optimum size and Long run cost curves
 An optimal size (or scale) of a plant is one which lead to the most efficient
utilization of resources at given state of technology over time.
 There is technically a unique size of the firm and level of output that
determine the optimal size of the firm. This can be obtained with the help
of LAC and LMC i.e., SAC = SMC = LAC=LMC. This assures the most
efficient utilization resources
 Cont..

Select this paragraph to edit

C
OS SAC
TS LAC
SAC
SAC

SAC
SAC

OUTPUT
 Cont..

5.7 Cost Function

Cost function may take a various forms yielding different kinds of cost curves

}
I.e. – Linear

- Quadratic Cost function

- Cubic

TC= a + bQ linear

Where TC = Total cost

a = Fixed cost
b = is constant /shape of the cost function
bQ = variable cost
 Cont…

 A quadratic cost function is of the following firm

Tc = a + bq + Q2

Ac = TC = a + b + Q
Q Q
And MC = ΔTC = b + 2Q
ΔQ
 Cont..

Review Questions
1.The total cost equation in the production of bacon at some hypothetical factory is
given as follows:

C= 1000+ 100Q- 15Q2 + Q3

Where C= cost measured in shillings, while Q =
quantity measured in kilograms

a. Compute the total and average costs at the output

level of 10 and 11 kilograms
b. What is the marginal cost of the 12th kilogram?
 Cont…

c. Explain the shape and relationship between AC,

AVC, MC and AFC curves using relevant diagrams
2. Suppose a cost for is given by as C= 135 + 75Q –
15Q2 + Q3
a) Prepare a cost schedule showing total cost,
marginal cost, average cost and average variable
cost.
b) Draw the cost curves on the basis of cost data
obtained from the cost function of firm X.
 5.8 Profit maximizing
condition
 Profit Maximization is the maximum amount of output of the firm can
produce without incurring any loses
 Total profit (∏) is defined as the difference between total revenue
received by the firm and the total costs it incurs.
i.e., ∏= TR – TC

 Where TR =Total revenue and TC = Total cost. There are two conditions
that must be fulfilled for TR – TC to be maximized.
 Profit maximization requires that the following two conditions are satisfied:
i) Necessary condition, (first under condition )
ii)Secondary or supplementary condition (second order condition)
 Cont..

 First order condition requires that for profit to be maximized,

marginal revenue (MR) must be equal to marginal cost (MR).
i.e. MR=MC

 By definition marginal revenue is the revenue obtained from

the production and sale of one additional unit of output and
MC is the cost arising due to the production of one additional
unit output.
 The second order condition requires that the necessary
condition must be satisfied under the condition of decreasing
MR and rising MC. The fulfillment of the two conditions makes
the sufficient condition.
 Cont…

 The sufficient condition states that, the slope of the Marginal Revenue
curves must be less than the slope of the Marginal Cost curve at the point
where they are equal. This implies that the Marginal Cost curve must cut
the Marginal Revenue curve from below.

 Technically profit maximizing firm seeks to maximize

∏= TR – TC

 Mathematical logical the first and 2nd order condition of profit maximization

a) First order condition

 The first order condition of profit maximization is that the first derivative of
the profit function ∏= TR – TC must be equal to zero. Differentiating the
total profit function and setting it equal to zero
 Cont..

we get
∂∏ = ∂TR – ∂TC
∂Q ∂Q ∂Q

Therefore ∂∏=0
∂Q
∂TR – ∂TC = 0
∂Q ∂Q

∂TR = ∂TC
∂Q ∂Q

Thus first order condition for profit maximization MR= MC

 Cont…

Select this paragraph to edit

Marginal revenue &

cost P1
MC

P2

MR

Output
 Cont…

b)Second order condition as stated above, the second order

condition of profit maximization requires that the first order
condition is satisfied under rising MC and decreasing MR.

 Since MC and MR curves intersect at two point P1 and P2.

Thus the first order condition is satisfied at both points, but
second order condition of profit maximization is satisfied only
at point P2. Technically, the second order condition requires
that its 2nd derivative of the profit function is negative

i.e. ∂∏= ∂2TR – ∂2TC

∂Q ∂Q2 ∂Q2
 Cont..
The second order condition requires that
∂2TR – ∂2TC <0
∂Q2 ∂Q2

Since ∂2TR gives slope of MR and

∂Q2

∂2TC gives slope of MC,

∂Q2

The 2nd order condition is

Slope of MR< slope of MC

Since we know
TR=P*Q and
Q = ƒ(P) i.e., demand function.
 Cont..

Suppose that demand function is given as Q= 50-0.5P and the price function
P= 100- 2Q

TR= (100-2Q)Q----------------------------equation (i)

Again suppose that the TC is given as TC=10+0.5Q2

∂TR = 100-4Q
∂Q

∂TC=0.5(2)Q2-1
∂Q
∂TC = Q
∂Q
 Cont…

MR=MC
100-4Q= Q
100=5Q
Q=20

2nd order condition

∂MR - ∂TR <0
∂Q ∂Q

-4-1<0

Therefore the 2nd order condition also satisfied at output 20.

 Cont..
Question one
a)Find out maximum profit output and b) Maximum profit from cost function
C= 50 + 6Q2 and price function P= 100 - 4Q. Also derive MC and MR.
Soln
C=50 + 6Q2 AND P=100 – 4Q

MC=MR Condition for profit maximization

MC = ∂TC =50 + 6Q2 = 12Q

∂Q

MR= ∂TR = (100-4Q)Q= 100-8Q

∂Q
Therefore, since MC=MR
 Cont…
12Q=100-8Q
20Q=100
Q=5
b) Since Q=5
TC=50 + 6Q2 TR=100Q – 4Q
50 + 6(5)2 100(5)-4(5)
=200 =400
Therefore , Since ∏= TR – TC
=400-200
=200
Cont..
Question two
Suppose cost (c) and revenue (R) functions are given as
C = 100 + 5Q2
R = 150Q – 2.5Q2

Find
a) п maximizing output
b) maximum profit and
c) profitable range of output
 Cont..

Soln

a) MC = ∂TC =100 + 5Q2 = 10Q

∂Q
MR= ∂TR = (150Q- 2.5Q2)= 150-5Q
∂Q
Therefore, since MC=MR
10Q=150-5Q
Q=10
 Cont.…

b)Since Q= 10
And ∏= TR – TC
Where
TC=100 + 5Q2
100 +5(10) 2
600
TR=150Q – 2.5Q2
150(10)-2.5(10) 2
1500 -250
1250
 Cont.….

Therefore ∏= TR – TC

TR – TC = 1250-600

∏ =650
 Cont…..

c) C = 100 + 5Q2
Since Q=10
Then 100
And 100 + 5Q2

100 +5(100)=600
Therefore C:(100<c<600)
TOPIC 6

MARKET
STRUCTURE
 6.MARKET STRUCTURE

 Market
According to Prof. Chapman is the situation where buyer and
seller come together to exchange commodities. Therefore in
market buyer and seller affect price of goods sold.
 Business organizations operates in two types markets
(i) For factors of production such as labour, and
(ii) For output.
 This topic deals with the output markets. The structure of the
markets in which firms operate may vary. The implications of
these variations are vital for an understanding of the
environment in which a business operates.
 6.1 The Market Structure

 The market structure, refers to nature and degree of

competition within a particular market.
 refers to the organizational feature of an industry that
influences the firm’s behavior in its choice of price and
output.
 Market structure is an economically significant feature of
the market. It affects the behavior of firms in respect of
their production and pricing behavior
 Market structure can be classified in number of ways
such as degree of competition, number of firms,
distinctiveness of plants, elasticity of demand and degree
of control over the price of the products.
 Cont..

 By a degree of competition we find the following market

structure
i)Perfect competition/market, is the market condition no
individual buyer/seller can influence market price.
Therefore price is operated automatically.
ii) Monopoly, is the market condition where supply of
product controlled by one firm.
Note: Pure monopoly firms has no competitors
ii)Imperfect competition
a)Monopolistic competition, situation where there many firm producing differentiated product
b)Oligopoly , Few firm dominated the market i.e. few seller many buyers e.g. GAPCO,BP
c)Duopoly , Here two seller dominate the market. It’s a special category of oligopoly
Kinds of Market Structure
Type of Market No. of firms Nature of Firm’s control
Product over price
1. Perfect Many firms Homogeneous None
Competition product wheat,
sugar
2. Imperfect
competition

a)Monopolistic many Real/perceived Some

competition difference in
product(most
retail trade)
b) Oligopoly Few i)Product without Some
differentiation,
e.g. bread, steel
and chemicals
ii) Differentiated
product e.g. tea,
toothpaste ,soaps
, detergent, auto
mobile
WHY MARKETS ARE
IMPERFECT?
(Source of Imperfect
Competition)
Imperfect competition arises mainly from the barrier to entry.
Barrier to entry are created by several factors
1. Large size firms which enjoy economies of scale can cut
down their price to the extent that can eliminate new firms or
prevent their entry to the industry , if they so decide
2. Licensing policy of the government creates barrier for the
new firms to enter in industry
3. Patent of rights to produce as well as established product
or a new brand of a commodity prevents new firms
producing that commodity.
4. Sometimes entry of new firms to an industry is
prevented by a law with view to enabling the existing so
that prices are low
6.2 PRICE AND OUTPUT
DETERMINATION

6.2.1 Perfect competition

 A perfect competition market is characterized by complete absence of
rivalry among individual firms
 Is the market situation where large number of buyer and sellers of
homogeneous product can’t influence market price. It’s a rare
phenomenon.

Features /characteristic of perfect competition

1. A large number of buyers and sellers
 There are many buyers and sellers so that the actions of an individual
cannot have significant impact on the market price. This is because each
buyer or seller is too small in relation to the market to be able to affect the
price of the commodity by his/her own action.
 Therefore Firms are price takers, not price marker, no single buyer or a
group of buyers can influence the market price e.g., water, sugar,
vegetables.
 Cont…

2. A homogeneous product
 The commodities supplied by all firms of an industry are
assumed to be homogeneous or approximately identical
i.e., buyers do not distinguish between products supplied
by various firms of an industry.
 This assumption eliminates the power of all firms
supplier to charge a price higher than the market price.
3. Perfect mobility of factor of production
 It assumes that factor of production (especially labour
and capital) are feely mobile between the firms. The
producers can enter and exit on the industry freely in
respond to the prices signal.
 Cont..

4. Free entry and fee exit

 There is no legal or market barrier on entry of new firm to the industry.
5. Perfect knowledge about the conditions
 All buyers and sellers have fully information regarding the prevailing and
future price and availability of the commodity. that is no price differential
will exist. As Marshal put it…though every one acts by himself, his
knowledge about what others are doing is supposed to be generally
sufficient. There is no uncertainty in the market

6. No government intervention
 Government doesn‘t interfere in any how with the functioning of the
market. There is no taxes or subsidies, no licensing system etc. i.e.
government follow free enterprises policy
7. No transport cost
 Cont..

8. Absence of collusion and independent decision making

There is no collusion between the firms i.e. they are not in
league with one another inform of cartel. There are no
consumer association
Perfect Vs. Pure competition
 The distinction between the two is a matter of degree. While
‘Perfect Competition’ has all features above, under ‘Pure
Competition’ there is no perfect mobility and of factors and
perfect knowledge about market conditions.
 Pure is pure in the sense that it has absolutely no element of
monopoly.
A firm in Perfect
Competitive Market
 In a perfectly competitive market structure an individual firm is one
among a very large number of firms producing an almost identical
commodity.
 Firm status in perfect competition is as follows;
(i)Firms have no control over price, the market share of an individual
firm is so small that firm can not influence the prevailing market
price by changing its supply.
(ii)Firms are price takers . Under perfect competition, an individual
firm do not determine the price of its product. The price of its
product is determined by the market demand and market supply.
At this price, a firm can sell any quantity. It implies that the demand
curve for an individual firm is a straight horizontal line with
infinitely elasticity. A horizontal AR=MR curve in perfect
competition
(iii) No control over cost, Because of its small purchase of inputs
(labour and capital) a firm has no control over input prices
 Market demand and supply

Price D S

0
Demand for and individual
firm

Price Perfect elastic

demand
(Infinity
elastic)
d P(AR)=MR
d
Cont..

 The shape of AR curve suggest that the firm under

perfect competition is a PRICE TAKER not PRICE
MAKER.
Note: Here firm don’t lower price because he will loose
buyer and he will not increase price because he will be
avoided in the competition because of homogeneous
product.
 Criticism /Justification of
Perfect competition
 In real world we can’t find such type of perfect market
Reasons
1. In real world we don’t have number of buyers who can’t determine the price
1. We cant have homogeneous products produced by all firm
2. In real world we don’t enjoy freedom of entry and exit and exit simply there
are some barriers
3. Buyer and seller cant have perfect knowledge
4. Transport cost will also be there
5. Perfect mobility of factors of production is also not possible because of
some barriers cf. skills, knowledge.
 Cont..

Perfect Competition is Imaginary Concept/Myth why

studying it?
Reasons:
1. Simple analysis, it furnishes us a simple and logic
analysis to understand the process of price
determination.
2. Ideal situation, price is fixed there fore assist in policy
formulation
3. Price control, helpful to the government fixation and
price control
Short run Equilibrium of the
firm
 A profit maximizing firm is in equilibrium at the level of
output which equates its MC=MR
 A firm is in equilibrium when its profit is at maximum. i.e.,
MR = MC where MC is rising
 The nature of cost and revenue function depends on
whether one is considering short- run and long-run
 The short run cost function is difference from the long run
cost function because in short run, some input e.g.
capital are held constant while all factors are variable in
long run
Assumption of short run
equilibrium firm
i. Capital is fixed but labour is variable
ii. Price of inputs are given
iii. Price of commodity are fixed
iv. Firm is faced with U shaped cost curve
 Cont..

Price determination in perfect competition

 Important thing to note in a perfect competition each firm
faces a demand curve that is horizontal (perfectly elastic)
because variation in the firm’s output have no noticeable
effect on price (individual firms have zero market power).
 A long as the market price is always which to the price at
which the output is sold
 Cont…
Quantity Price (P) TR=P*Q AR=TR/Q MR= ΔTR/
demande Tshs Tshs. (Tshs) ΔQ (Tshs)
d units
10 3 30 3 3

11 3 33 3 3

12 3 36 3 3

13 3 39 3 3
 Cont..

 The above table illustrates that as the quantity demanded

increases, the price remains unchanged. This implies
that each additional unit sold increases the revenue by
the amount equals to its prices. The relationship can be
illustrated graphically in figure below

Re
ve
nu
e

AR=MR

Output
 Cont…

 The demand curve for a perfectly competitive firm is

infinitely elastic. The price is determined by the market
and cannot influence by an individual firm whose output
is too small relative to total industry output. The market
prices apply to each firm and determined by the market
forces of demand and supply.

 The industry demand curve, unlike the individual demand

curve, slopes downward because if the industry as a
whole reduces its price it will sell more.
 Cont…

 Figure below shows demand curve for the product of an

individual firm is perfectly elastic whereas the market
demand curve for the out put of industry will be a normal
shape in that it slopes downwards from left to right. DD
and SS are the industry demand and supply curve
respectively.
 Cont…

Price D
S
Pric
e

P ------------------------------ D

S D
0 0
Q Quantity Quantity
 Cont…

The individual and market demand curve in perfect

competition
 Given the price OP in figure (a) individual firm can
produce and sell any Quantity at this price, but any
quantity will yield maximum profit. A firm can sell any
quantity at price OP, the demand for firm’s product is
given by a horizontal straight line AR = MR. Price being
constant, its average revenue (AR) and marginal revenue
(MR) are equal. Since we know maximum profit is
produce at point MR= MC when arising. The point Q2
indicates the profits maximization output
 Cont..

 In the short run (AR>AC) super normal profit

Assuming the objective of the firm is maximization of
profit. There fore condition for profit maximization
MC=MR , But AR (P) may be greater /less to AC
Thus, AR(P) >AC= Profit maximization
AR(P)< AC = Losses
 Cont..

MC

Revenue and Super normal AC

Cost Profit
P P=AR=MR

MC=MR

0
Q1
Q2
output
 Cont..

 Figure above shows, the necessary and sufficient

conditions for profit maximization.
 In the short run perfect competition firms can make
normal or supernormal profit or losses.

 Normal profits (AR(P)=AC) refer to the minimum level

of profits which a firm must acquire in order to induce it to
remain in operation. The level of normal profits will vary
from one industry to another. Normal profits may be
considered as a cost of production since production will
not continue unless at least this level of profit is attained.
See the figure below.
 Normal profit in short
run(AR=AC)
Select this paragraph to edit

MC
AC

P P=AR=MR

0
Q1
Output
 Cont..

Normal profits in perfect competition market

 The profit maximizing level of output is Q1 where the
necessary and sufficient conditions are satisfied.
 Normal profits are made when the price is equal to
Average cost, this implies that when price exceeds
average cost, the firm is said to be earning abnormal or
supernormal profits.
 Supernormal profits are used to categorise those firms
which are earning a return which exceeds the minimum
necessary to induce them to remain in the industry they
currently occupy.
Super Normal
Profit(AR>AC)

MC

AC

B
P /////////////// P=AR=MR

A C
C

Q2 output
 Cont..

Supernormal profits in perfect competition market

 When the level of output is Q2 the cost per unit is CQ2
while the price is equal to BQ2. Supernormal profit per
unit, is therefore, equal to BC. Total supernormal profit is
equal to APBC which is represented by the shaded area.
 Firm in perfect competition can also make losses in the
short run. Losses occur where firms operate under
conditions where the average cost exceeds the
average revenue. Figure below indicates losses under
perfect competition market.
Losses in short run(AR<AC)

MC
AC

E
D
///////////////
P P=AR=MR
F

0
Q3
output
 Cont…

Losses under perfect competition

 A firm may continue in production for a time even when it
sells at loss. Consider the above figure, the loss is shown
by the shaded area PDEF within the firm producing at the
loss minimizing level of output Q3.
 Cont..

MC

AC

P3
AVC

P2

A
P1
Break even

0
Q1 Q2 Q3
output
 Cont..

The break even price and shut-down price of the firm

 In order to maximize profits, the firm will produce output
Q3 because at that price and output, MR=MC.
 However, if the price falls to P2 the output will be reduced
to Q2. This is the firms break-even price since below
this level the firm will start to make loss as the price
fall below average cost. Even if the prices falls below P2
it may still be worthwhile to continue producing and
selling at a loss, at least in the short run. Provided the
price covers the variable cost
 Cont…

 loss will be less than the fixed costs the firm will incur if it
produced nothing, since prices contributes to the recovery of
fixed costs. The firm will cease production at the point when in
order to sell its goods; it has to reduce its price to P1. At this
point, the firm just covers its variable costs.
 The length of time for which a firm can sustain losses in the
short run depends on the extent to which the firm can cover
losses, e.g., through borrowing. Important considerations in
this regard are also the possibilities the firm has of reducing
costs or increasing its revenue in future.
 The portion above the point “A” relates the price to the output
the firm will produce. Since is this is the function of a supply
curve, the perfectly competitive firm’s marginal cost curve
above its average variable cost is its supply curve.
 6.2.2 Monopoly

 A MONOPOLY is the market structure where production is

under the control of single supplier.
 Is a market situation where single seller accommodate the
market with no close substitute.
 Since the monopolist is the sole source of supply in the
market, the individual curve is also the industry demand
curve. This implies that the monopolist faces a downward
sloping demand where if the monopolist wants to sell more he
must reduce the price. In this average revenue is not the
same as marginal revenue.
 Monopoly has power to determine either PRICE or OUTPUT
but not both at the same time. This is because he cant control
demand of people.
Price and output determination
under monopoly

 The term pure monopoly signifies an absolute power to

produce a product which has no close substitute .
 In other words a monopoly market is one in which there
is only one seller of a product having no close substitute
 The cross elasticity of dd for a monopolized product is
either zero or negative
The monopolist power to determine price depend on;
i. Non availability of close substitute
ii. Power to restrict entry of new producers
Features/characteristics of
Monopoly
1. Single producer
2. No close substitute
3. Barrier to entry, as new firm admitted to the market
monopoly breaks.
4. Firm and industry, since a monopoly is a single firm
therefore the industry will act as a monopoly. A
monopoly between firm and industry is dominant in
firms than industry
5. Down slope AR and MR curve, here monopolist lower
price in order to sell more output.
 Cont..

Px y

MR
AR(P)

0
X
 Cont..

 The down sloping AR and MR curve of the monopolistic

where MR remain below AR Thus, Down sloping curve
indicates a monopoly is a Price maker.
6.Price discrimination, this is possible under monopoly
where product produced by monopoly are bought to
different price.
Note: this is possible only with:
(i) Absence of close substitute
(ii) Restriction of entry
 Sources and Kinds of
Monopolies
 The emergence and survival attubated to the factors
which prevent the entry of other firm into the industry.
 The major sources of barriers entry to monopolized
market are ;
i) legal restrictions some monopolies are created by the
w in public interest. Most of the state monopolies in the
public utility sector including generation of distribution of
electivity railways, air lines and states roads . Some
monopolies are intended to reduce cost of production by
economies of scale and investing in technological
innovations ( franchise monopolies )
 Cont..

ii) Patent rights – this is the source of monopoly for a

product process patent right are granted by the
government to a firm to produce a commodity of
specified quality and character or to use a specified
technique of production.
 Patent rights gives a firm exclusive rights to produce the
specified commodity or to use the specified technique of
production i.e. Patent monopolies.
 Cont…

iii) Control over key raw materials, some firms acquire monopoly
power because are their nature control over certain and key raw
materials , which are essentially for the production of certain goods
e.g. Tanzanite in Tanzania ,
1v)Efficiency – A primary and technical reason for growth of
monopolies is the economies of scale . The large size firms finds it
profitable, in the long run, to eliminate competition by cutting down
its price for a short period. Once monopoly is established, it
become almost impossible for the new firms to enter the industry
and survive. Monopolies born out of efficiency are called Natural
monopolies
v)Product differentiation, Here a firm can create a monopoly position
through product differentiation, There are advertising to establish
brand name is very important process. High income countries such
as USA, UK, France the cost advertising and brand name are so
high thus new firm may find difficult to compete.
REVENUE CURVES UNDER
MONOPOLY
 The cost curves- the AC and MC curve- faced monopoly firm
are U shaped, just as those faced by the firms under perfect
competition.
 However, the demand or AR and MR curve that a monopoly
firms faces are different from those faced by firms under
competition.
 Under monopoly, however, there is no distinction between the
firm and the industry.
 The monopoly industry is a single- firm industry and industry
demand curve has a negative slope. Its important to note here
that, given the demand curve, a monopoly firm has the option
to choose between price to be charged or output to be sold.
 Once it chooses price, the demand for its output is fixed.
 Cont..

 The nature of revenue curves under monopoly depends

on the nature of dd curve a monopoly firm
 A monopoly firm faces a dd curve Z a negative slope,
monopoly pricing is result between firm’s SR curve and it
is MR curve. AR=D let as look at technical results up
between can be specified in the following way.
Recall TR = PXQ
= PQ
 Cont..

 This relationship can be proved as follows. Lets assume that a monopoly firm
faced with a price function or Average revenue function as
P= a-bQ
We know that TR=Q*P
By substituting P
TR=Q(a-bQ)
=aQ-bQ2
Since, MR equals the first derivative of the TR function,
MR=δTR/ δQ= δ(aQ-bQ2) =

δQ
= a-2bQ
Note that: slope of price function equals b where as slope of MR function equals
2b, it means the slope of MR function is twice that of AR function. It implies that
MR curve is always to the left of AR curve and MR bisects the demand at all
level of price
 Profit maximization

 Price and output determination by monopoly in the short run

has been discussed above theoretically by TR-TC and MR-
MC approaches
 Now we illustrate the determination of equilibrium price output
by a monopoly firm through a numerical l examples assuming
hypothetical demand and cost function
Demand function Q=100-0.2P
Cost function TC=50 +20Q+Q2
The problem before the monopoly firm is to find the profit
maximising output and price. The problem can be solved as
follows.
 We know that profit is maximum at a point which equalize MR
and MC. The first step is to find MR and MC functions from
demand and costs functions, respectively
 Cont…
 We have noted earlier that MR and MC are first derivative of TR and TC functions,
respectively. TC function is given but TR function is not.
 So, lets find TR function first
TR P*Q
since P=500-5Q
TR= P*Q
=(500-5Q)Q
TR= 500Q-5Q2

Now MR functions can be obtained by differentiating the TR function

MR= δTR/ δQ= 500Q-10Q
Likewise, MC function can be obtained by differentiating TC function
MC= δTC/ δQ=20+2Q
Now, that MR and MC function are known , profit maximizing output can be easily obtained.
The profit maximizing output can be obtained by equating the MR and MC functions given
above
 Cont…

 MC=MR
 5oo-10Q=20+2Q
 480=2Q
 Q=40
 The output Q=40 is the Profit maximising output
 Now profit maximising price can be obtained by
substituting 40 for Q in the price function
 Thus, P=500-5(40)
 300
 Profit maximizing price is Rs 300
 Cont…

 Given the price, total profit (∏) can be obtained by using

TR-TC approach as follows
 ∏= TR-TC
 By substituting
 ∏=500Q-5Q2) )-(50 +20Q+Q2
 =500Q- 5Q2 -50 -20Q-Q2
By substituting profit maximizing output (40) for Q, we get
∏ =500(40)- 5(40)2 -50 -20(40)-(40)2
=9550

Thus, the maximum profit is Rs 9550. No other output can

increase firms profit.
 Cont..

Quiz
1.What is price discrimination? Explain and distinguish
between the first, second and the third degree of price
discrimination.
 PRICE DISCRINATION BY A
MONOPOLY
 The theory of pricing under monopoly as discussed above, gives
the impression that once a monopolistic fixes the price of its
product, the same price will be charged from all the customers.
 This however is not the case generally. A monopolist, simply by
virtue of its monopoly position, is capable of charging different
prices from different consumers or group of consumers
 Price discrimination is the action of charging different prices from
consumers or groups with the same or slightly differentiated)
product consumers are discriminated in respect to prices on the
bases of their incomes or purchasing powers geographical location,
age sex, quantity they purchases, their association with the sellers
frequency of visit to the shop., the purpose of the use of commodity
or service and on other grounds which the seller may find suitable
 When a monopolist sells an identical product at different prices to
different buyers, its called a discriminatory monopoly
 Cont…

 Monopoly can employ price discrimination in two ways;

(i) By charging different price to different people for the same commodity. This
is possible when there is no competition
(ii)By charging different price in different markets. This can b applied to the
market which are separate, so that those who low price don’t resell
Note: Price discrimination is the process of charging different customers
different prices for the same commodity
MARKET SEPARATION (FOR DISCRIMINATION)
 Factors necessitate price discrimination
i. Geographically, here when exporters charge different prices to overseas
market than in home market
 Cont..

ii. Type of demand, for example demand for milk by

household differ from industry demand for milk for
cheese making, ice cream, here because industry
demand high will buy at high price hence price
discrimination
iii. Time, typically a lower price is charged in off risk period
incase of electricity, tel, travel industries (tourism)
iv) Nature of products, with medical treatment when one
person treated that unable to resell that treatment to the
other hence price discrimination
Necessary conditions for Price
discrimination to be of Benefit

1. The firm must conform to down ward sloping demand

curve
2. There must be two groups of customers whose “price
elasticity of demand differs” i.e. customers with
elastic demand that respond to price change hence
consume at low price and customers with inelastic
demand that don’t respond to price change hence
consume at high price
3. Seller must be capable to prevent customer who buy
from low price and resell to those buy at high price.
 Cont…

CUSTOMER WITH INELASTIC DEMAND

y
P MC=MR Profit max.
MC

MR
Qn X
 Cont..

Note: Here increase in price doesn’t affect demand

“Inelastic” hence consume at high prices.
CUSTOMERS WITH ELASTIC DEMAND
 Here demand of people respond to price change, also
the seller maximize profit by equating MC=MR Thus
customer purchase at lower price simply because high
price will generate low revenue
 Cont..

Elastic demand consumer

MC
Db
MR
 Cont..

Note: Because monopolist is the sole producer therefore

reduces the price in order to sell extra unit of output
AR>MR
ADVANTAGES OF MONOPOLY
1. Economies of scale (AC<AR), under monopoly AC is
less than AR because production is undertaken under
large scale e.g. elasticity supply
2. Large output low price of commodity, here monopolist
can reduce price and increase output
3. Advertising and brand cost, under monopolist
resources are not wasted on advertising and branding
because has no close substitute/ competition
DISADVANTAGE OF
MONOPOLY
(Why monopoly are
Undesirable)
i. Misallocation of resources (Po & Qm), Here
monopolist locate inefficiency therefore profit
maximization monopolist restrict output below the level
Smaller output monopolist restrict supply of goods and
services in the market.
The producer does not achieve best use of factors of
production hence misallocation of factors of production.
 Cont..

Price
Monopolist Output

Po Ideal output (MC (Opp. Cost)

P1 ATC
D(AR)
MR
QM QN Output
 Cont..

ii. Reduction of incentives, Here due to absence of

competition monopolist lack incentives
iii. Technological progress. Monopolist restrict entry of
innovation unless when there is competition.
iv. Charge High price (AR>AC), Monopolist is a price maker
therefore the price s/he determine is always higher i.e.
AR>AC or AR>MC
 Cont…

P Rev/cost ATC
Mc

PMc1
PM1

MR D(AR)
 Degree of Price
discrimination
 Degree of price discrimination refers to the extent of which a
seller can divide the market and can take advantage of market
division in extracting the consumer surplus.
 According to Pigou there are three degrees of price discrimination
practiced by monopolists
1. First degree Price discrimination(willing t0 pay)
The discriminatory pricing that attempts to take away the entire
consumer surplus is called first degree discrimination.
i.e. monopolist knows buyer’s demand curve for the product. What the
seller does is that he first sets price at the highest possible level
at which all those who are willing to buy, purchase at least none
unit each of the commodity.
This procedure is continued until the whole consumer surplus
available at the price where MR=MC is extracted. Also consider
the case of services of exclusive use, e.g. medical services
 Cont..

SECOND DEGREE PRICE DISCRIMINATION

 Is to charge different prices for the different quantities of
purchase. Is also called Block pricing system .
 A different price is charged from different category of
consumers
 The second degree price discrimination is feasible where;
(i) The number of consumers is large and price rationing can
be effective, as of utilities like telephones and natural gas
(ii) Demand curve of all consumers are identical
(iii)A single rate is applicable for a large number of buyers
 Cont…

THIRD DEGREE PRICE DISCRIMINATION

 Here, markets are segregated i.e. price difference across
different markets.
 When profit maximizing monopoly firm sets different
prices in different markets having demand curve with
different elasticity. Therefore, uniform price cannot be set
for all markets without losing the possible profits
 The monopolist is therefore required to allocate total
output between different markets so that profits can be
maximised in each market.
 Profit in each market would be maximum only when
MR=MC
 Cont…

Market A Market B Total Market

Cs/Rev.

A B MC

Da T AR=D

MRa MRb Db MR

Qa Qb Q=Qa+Qb Q
Distinction between Perfect
and Monopoly
PERFECT MARKET MONOPOLY MARKET
1. Large number of firm 1. Single firm
2.A firm can’t adopt 2. A firm has independent
independent price policy. Its price policy. Price maker thus
price taker under monopoly price is
higher. P>MC and P>AC
3.AR and MR curve are one 3. MR and AR are down
and the same and parallel to slope. MR remain down AR
axis i.e. P(AR)=MR curve i.e. MR<AR
4. Price discrimination is 4. Price discrimination is
possible possible
5. Full freedom of entry and 5. No entry
exit
6. Firm can get only normal 6. Firm can get supernormal
profit in Long run profit in Long run
 cont..

DEAD WEIGHT LOSS UNDER MONOPOLY

 Its argued that monopoly firms are less efficient than
competitive firms. Monopoly causes loss of welfare and
distortion in resources allocation.
 The suboptimal allocation of resources and loss of social
welfare are illustrated assuming a constant-cost industry
which has LAC=LMC.
 Given the cost and revenue conditions, a perfectly
competitive industry will produce OQ2 at which is
LAC=LMC=AR. Its price will be OP1.
 Monopoly firm produces an output that equalises its LMC
and MR. Thus monopoly firm produces OQ1 and charges
price OP2
 Cont..

Cost/Rev

P2 M Dead weight loss

P1 K L LAC=LMC
AR(D)

MR
Q1 Q2 Output
MONOPOLISTIC COMPETITION
Note: In real world its impossible to find perfect competition and pure
monopoly, the actual situation are some where between perfect and pure
monopoly since pure monopoly and perfect competition are unrealistic.
This is because there are many imperfect which cause the real market to
be imperfect
MONOPOLIST COMPETITION
 Is the market situation in which large number of sellers produce
differentiated products which are close substitute with each other on their
sell.
 It combines basic elements of both perfect competition and monopoly.
 Here each firm has power to measure his monopolist thus its POLYPOLY
 In other words Monopolist is the long run market in which there is entry in
the market
CHARACTERISTICS OF MONOPOLISTIC
COMPETITION

1.There is a large number of buyers of sellers in the market, here each firms
share small of total output of industry.
2. Independent price policy and downward sloping AR=MR, shows that
monopolist is a price maker
3. Each seller sells a product differentiated from the of others
4. The differentiated products are close substitute, here product save same
purpose but differentiated e.g. Cigarette, Sweet menthol, Aspen, Sports
5.There is free entry, free exit of firm.
6. The firm seek to maximize their profits in both short of long runs.
7.Selling cost, Unlike firm under perfect competition and monopolies , firm under
monopolistic make heavy expenditure on advertisement and other sales
promotions
8.Downward sloping demand curve. As in case of monopoly, monopolistically
competitive firm can, by exercising its monopoly power, increase the demand
for its product by decreasing price because of relatively higher cross
elasticity of the competitive products.
 IN SHORT RUN( AR>AC)

 Here monopolist enjoy supernormal profit since no entry in the market

MC
Cs/Rev AC
P C
A B
AR
MR
o M Q
 Cont..

At OM is equilibrium MR=MC
OP price sold where AR>AC
Hence super normal profit ABCP= AR>AC

IN LONGRUN (Normal Profit=AR=AC)

 Here, other monopolist attracted because of supernormal
profit and cause supply to increase hence Normal profit
where AR=AC
 Cont..

Cos/Rev
MC AC

P
AR
Other join
MR

M MI
Quantity
 OLIGOPOLY

 Is the market situation where there few sellers of products accommodate the
market
 Is the market structure where there are few seller selling homogeneous and
differentiated products
 Economists do not specify how few is the number of sellers in an oligopolistic
market.
 However, two sellers is the limiting case of oligopoly . When there are only two
sellers , the market is called DUOPOLY (smaller size oligopoly) hence
duopoly is a special case of oligopoly.
 Oligopoly is interdependence among the firms, this is due to small number of
firms. Thus each firms contributed significant portion of the total sell
 CHARACTERISTIC OF OLIGOPOLY

1. Few seller but many buyers

2. Every seller has perceptible effect on the other seller
Each firm has to take account of the action of other seller in the
market
3. Homogeneous/ differentiated products both are possible
4.Interdependence among various firms, here if one producer rice the
price the other must quote identical price.
5. Price war, might force price down to such level that looses would
result and price rigidity result kinked demand
6. No price competition, producer compete on giving out product but
not price.
Note: Price high don’t react because he will loose buyers and vice
versa
 Types of Oligopoly

1. PERFECT OLIGOPOLY
Is the oligopoly with homogeneous product. This incase
product sold are uniform e.g. petrol
 Under such situation the seller make agreement concern
the price change for their product.
 In order to earn a lot of revenue each oligopolist will make
attractive conditions, in order to attract more buyers e.g.
provide gift, bonus if buyer purchases more than certain
amount.
 Under perfect oligopoly price must be at level which allow
each firm to earn at least Normal profit i.e. AR=AC, other
firm would leave and industry become monopoly
2.Imperfect Oligopolist

Is the oligopoly with product differentiated.

 Here few sellers supply commodities which are
differentiated but save the same purpose as the result
commodities are substituted to one another e.g. Beer and
wisk
 Here monopolist determine the price of his product but he
must take in account the price offered by his rivals
 Under imperfect oligopoly there is relationship of a
CONCLUSIVE OLIGOPOLY (a CARTEL) in which firms
act together as monopoly
 Here adjust price and output to secure maximum revenue
and distribute the monopoly profit among their members
by output quotas
 Cont..

 BUT, CARTEL is likely breakdown in a Long run as

individual producers have incentives to cheate by
producing excess of their goods and undercutting the
agreed price.
 A CARTEL

Price

Profit

Pm A
Pc B AC=MR
AR
MR
Qm
 Cont..

 Above diagram show that a Cartel operating as monopoly

THE
END……