NASARAWA STATE UNIVERSITY, KEFFI

PRINCIPLES OF ECONOMICS I
ECO 111
COURSE MATERIAL

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Published and Printed by
NSUK Press

Printed 2023

ISBN:

All Rights Reserved

Nasarawa State University Keffi

Main Campus
Along Akwanga Road,
Keffi, Nasarawa State

e-mail:
website:

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 Course Development Team
Course Team Dr. Ajidani S. Moses (Course Developer) _______ NSUK

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Vice Chancellors Message

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Foreword

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 Table of Contents
CONTENTS PAGE
Course Development Team
Vice Chancellors Message
Forward
Table of Contents
Course Study Guide
Course Introduction……..………………………………………………………….………… iv
Course Aims……………………………………………………………………...……….… iv
Reading through this Course……………………………………………………………........v
Course Materials………………………………………………………….………………….v
Study Units…………………………………………………………………..………………vi
Assessment File……………………………………………………………………………....ix
Tutor-Marked Assignment (TMA)…………………………………………………………...ix
Final Examination and Grading………………………………………….………….………..x
Course Marking Scheme……………………………………………………………………...x
Course Review……………………………………………………………………………......x
Facilitator/Tutors and Tutorials……………………………………………………………....xii
Summary………………………………………………………….…..………………………xii
Module 1 Definition and Basic Concepts in Economics
Unit 1 Meaning of Economics and the Basic Concepts in Economics
Unit 2 Basic Economics Problems and Systems
Module 2 Theory of Demand
Unit 1 Concept of Demand, Factors That Affect Demand, and Types of Demand
Unit 2 Elasticity of Demand, and Factors that Affect Elasticity of Demand
Module 3 Theory of Supply
Unit 1 Concept of Supply, Factors That Affect Supply, and Types of Supply
Unit 2 Types of Supply, and Elasticities of Supply
Module 4 Price Determination
Unit 1 Market Equilibrium

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Unit 2Price Ceiling and Price Floor

Module 5 Theory of Production and Related Concepts

Unit 1 Factors of Production, Production Process and Cost Concepts

Module 6 Theory of Firm

Unit 1 Perfect Competition
Unit 2 Monopoly

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 Course Study Guide
Course Introduction
ECO 111: Principle of Economics I, is a three-credit and one-semester undergraduate course for
Economics, other social sciences, and management students. The course is made up of 11 units
spread across eleven lectures weeks. This course guide tells you what economic problems are and
how they are used to solve households, firms, and government economic needs. It tells you about the
course materials and how you can read through these materials. It suggests some general guidelines
for the amount of time required of you on each unit in order to achieve the course aims and
objectives successfully. Answers to your tutor marked assignments (TMAs) are therein already.
Recommended Study Time
This course is a three unit course divided into six modules and 11 units. Each unit constitutes a study
session and you are expected to spend at least 3 hours studying each of the units for better
understanding.
Calendar
This is a 15 weeks course. You will spend 33 hours of study over the first 11 weeks of virtual
interaction and 6 hours over the following 2 weeks of face – to- face interaction. The formal study
times are scheduled around online discussions/charts with your course facilitator and or e-tutor to
enhance your learning. Please, refer to the course calendar on your website for scheduled dates. You
will still require independent /personal study time for reading through the course materials.
Course Content
This course is an introductory course on the two broad areas of economics, namely; microeconomics,
and macroeconomics. The topics covered includes the subject matter of economics and basic
economics problems; the methodology of economics science; and the general principles of resource
allocation; market mechanism-demand and supply; price determination and elasticity, theory of
consumer behavior; theory of production; market structure price and output under perfect
competition; monopoly; monopolistic competition and oligopoly. It takes you through meaning of
economics and its various definitions. Since economics is defined based on the two assumptions, the
assumptions were elaborated on in relation with some other concepts that are interwoven. Thereby
interdependency and complexity of economics become obvious through real life scenario given in
the units.
Course Aims
The aim of this course is to give you in-depth understanding of the economics as regards:
i) basic concepts and practices of economics
ii) to familiarize students with scarce economics resources which form the basis for rational
decision by households and firms
iii) to stimulate student’s knowledge of decision making within the households and firm
iv) to show the circular relationship between households and firm, input and output and flow of
resources within the economy system
v) to expose the students to economic history and behaviors of households and firms in allocation of
resource and in manipulation of factors of production for profit maximization

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 Course Objectives
To achieve the aims of this course, there are overall objectives which the course is out to achieve
though, there are set out objectives for each unit. The unit objectives are included at the beginning of
a unit; you should read them before you start working through the unit. You may want to refer to
them during your study of the unit to check on your progress. You should always look at the unit
objectives after completing a unit. This is to assist the students in accomplishing the tasks entailed in
this course. In this way, you can be sure you have done what was required of you by the unit. The
objectives serve as study guides, such that student could know if he is able to grab the knowledge of
each unit through the sets of objectives in each one.
At the end of this course, you should be able to:

i) define economics, state its importance and enunciate on assumptions upon which the
definitions are based
ii) state why and how available choices leads to decision making and relate basic
economic concept and problems
iii) enumerate the importance of basic economics question and know how to apply
rationality to answering the questions in the decision-making process
iv) list different methods of solving economic problem which lead to different types of
economies. Differentiate between different types of economies and know the
weaknesses and strength of each method of economy
v) explain how firms transforms resources allocated (input) into product (output) and
understand thecircular flow of supply and demand between households and firm
vi) discuss price mechanism, explain demand for a commodity in relation to changes in
price and elucidate on factors that determines quantity demanded and supplied. Define
elasticity in relation to demand and supply
vii) explain why government interfere in the market price
viii) determination and how government interfere in the market
ix) explain the concept of utility, marginal and tot utility
x) describe how input are employed in satisfying human wants, consumer’s preference
and indifferent curve and consumer equilibrium point on the budget line
xi) discuss factors of productions and their specific contribute to process of production
xii) explain Cost concepts and their definitions, different market structures and behaviour
of firms.

Reading through the course

To successfully complete this course, you are required to read the study units, referenced books and
other materials on the course. Each unit contains Self-Assessment Exercises. At some points in the
course, you will be required to submit assignments for assessment purposes. At the end of the course
there is a final examination. This course should take about 15weeks to complete and some
components of the course are outlined under the course material subsection.

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Course Materials
The major component of the course, what you have to do and how you should allocate your time to
each unit in order to complete the course successfully on time are listed as follows:
1. Course Guide
2. Study Unit
3. Textbook
4. Assignment File
5. Presentation Schedule

Study Units
There are six modules in this course broken into 11 units which should be carefully and diligently
studied.
Each study unit will take at least two hours, and it include the introduction, learning outcomes, main
content, conclusion, summary and references. Other areas border on the Tutor-Marked Assessment
(TMA) questions. Some of the self-assessment exercises will necessitate discussion, brainstorming
and argument with some of your colleagues. You are advised to do so in order to understand and get
acquainted with daily economic activities.

There are also textbooks under the references and other (on-line and offline) resources for further
reading. They are meant to give you additional information if you can lay your hands on any of them.
You are required to study the materials; practice the self-assessment exercises and tutor-marked
assignment (TMA) questions for greater and in-depth understanding of the course. By doing so, the
stated learning objectives of the course would have been achieved.

Textbooks and References

For further reading and more detailed information about the course, the following materials are
recommended:
Friedman, D. D. (1990). Price Theory: An Intermediate Text. South-western Publishing Co.
Foley, D. K. (2003). Rationality and Ideology in Economics. November 30th,
http://homepage.newschool.edu/~foleyd/ratid.pdf.
Marshall, A. (1920). Principles of Economics. Library of Economics and
Liberty. Assessed November 29, 2011
http://www.econlib.org/library/Marshall/marP4.html.
Reynolds, L. R. (2005). Alternative Microeconomics.
November 25, 2011, from
http://www.boisestate.edu/econ/Ireynol/web/Micro.htm.
Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations.

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North, D. C. (1990). Institutions, Institutional Change and Economic Performance. Cambridge:
Cambridge University Press.
Welch, P. J. and Welch, G. F. (2010). Economics: Theory and Practice. (pp.1-560). United State of
America: John Wiley & Sons Inc.
Mahadi, S. Z. (2006). Understanding Economics. Kuala Lumpur: CosmopointSdn. Bhd.
Samuelson, P. A. and Nordhaus, W. D. (2010). Economics. (9th ed.). New York: McGraw Hill
Companies.
O’Sullivian, A. and Sheffrin, S. M. (2003). Microeconomics Principles and Tools. (3rd ed.). New
Jersey: Pearson Education Inc.
Ojo, O. (2002). ‘A’ Level Economics Textbook for West Africa. (5th ed.). Ibadan: Onibonoje
Publishers.
Case, K. E. and Fair, R. C. (1999). Principles of Economics. New Jersey: Prentice Hall.
Hal, R. V. (2002). Intermediate Microeconomics: A Modern Approach. (6th ed.). New York: Norton.

Assignment File
This file presents to students with details of the work students must submit to their tutor for marking.
The marks they obtain from these assignments shall form part of their final mark for this course.
Additional information on assignments will be found in the assignment file and later in this Course
Guide in the section on assessment.
There are three assignments in this course. The three course assignments will cover:
Assignment 1 - All questions in Module 1 Units 1 –2, Module 2 Units 1-2
Assignment 2 - All questions in Module 3 Units 1 –2, Module 4 Units 1-2
Assignment 3 - All questions in Module 5 Units 1, Module 6 Units 1-2

Presentation Schedule
The presentation schedule included in this course material gives you the important dates for the
submission of Tutor-Marked Assignments and attending tutorials. Remember, students are required
to submit all their assignments by due date. The students should guide against falling behind in their
work.

Assessment
There are two types of assessment in this course. First are the Tutor-Marked Assignments; second,
there is a written examination. In attempting the assignments, students are expected to apply
information, knowledge and techniques gathered during the course. The assignments must be
submitted to their tutor for formal Assessment in accordance with the deadlines stated in the
Presentation Schedule and the Assignments File. The work students submit to their tutor for
assessment will count for 30 % of their total course mark. At the end of the course, you will need to

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sit for a final written examination of three hours' duration. This examination will also count for 70%
of your total course mark.

Tutor-Marked Assignment
There are three Tutor-Marked Assignments in this course. Students will submit all the assignments.
You are encouraged to work all the questions thoroughly. The TMAs constitute 30% of the total
score. Assignment questions for the units in this course are contained in the Assignment File.
Students should be able to complete their assignments from the information and materials contained
in their set books, reading and study units. However, it is desirable that students demonstrate that
students have read and researched more widely than the required minimum. Students should use
other references to have a broad viewpoint of the subject and also to give them a deeper
understanding of the subject.

When you have completed each assignment, send it, together with a TMA form, to your tutor. Make
sure that each assignment reaches your tutor on or before the deadline given in the Presentation File.
If for any reason, you cannot complete your work on time, contact your tutor before the assignment
is due to discuss the possibility of an extension. Extensions will not be granted after the due date
unless there are genuine reason(s).
Final Examination and Grading
The final examination will be of three hours' duration and have a value of 70% of the total course
grade. The examination will consist of questions which reflect the types of self-assessment practice
exercises and tutor-marked problems you have previously encountered. All areas of the course will
be covered
Revise the entire course material using the time between finishing the last unit in the Module and
that of sitting for the final examination too. Students might find it useful to review their Self-
Assessment Exercises, Tutor-Marked Assignments and comments on them before the examination.
The final examination covers information from all parts of the course.
Course Marking Scheme
The table presented below indicates the total marks (100%) allocation.

Assignment Marks

Assignments 30%

Final Examination 70%

Total 100%

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Course Overview
The table below indicates the units, number of weeks and assignments to be taken by students to
successfully complete the course-Principles of Economics (ECO 111).

Units Title of Work Weeks Assessment

Activities (End of Unit)

Course Guide

Module 1Definition and Meaning of Economics

1 What is Economics? Week 1 Assignment 1

2 Basic Concepts in Economics Week 1 Assignment 1

3 Basic Economic Problems Week 2 Assignment 1

Facing Societies

4 Economic Systems Week 2 Assignment 1

Module 2Theory ofDemand

1 Concept of Demand Week 3 Assignment 1

2 Factors that affect Demand Week 3 Assignment 1

3 Types of Demand Week 3 Assignment 1

4 Elasticities of Demand Week 4 Assignment 1

Module 3Theory of Supply

1 Concept of Supply Week 5 Assignment 2

2 Factors that affect Supply Week 5 Assignment 2

3 Types of Supply Week 6 Assignment 2

4 Elasticities of Supply Week 6 Assignment 2

Module 4 Price Determination

1 Market Equilibrium Week 7 Assignment 2

3 Price Ceiling and Price Floor Week 7

5 Factors that affect Elasticity of Week 8 Assignment 2

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 Demand

4 Factors that affect Elasticity of Week 8 Assignment 2

Supply

Module 5 Theory of Production

1 Factors of Production Week 9 Assignment 3

2 Production Process and Cost Week 9 Assignment 3

Concepts

3 Law of Production Week 9 Assignment 3

Module 6Theory of Firm

1 Perfect Competition Week 10 Assignment 3

2 Monopoly Week 10 Assignment 3

3 Monopolistic competition and Week 11 Assignment 3

oligopoly

4 Market Structure Comparison Week 11 Assignment 3

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Course Marking Scheme
The work you submit will count for 30% of your total course mark. At the end of
the course however, you will be required to sit for a final examination, which will
also count for 70% of your total marks. The grand total for the course would
remain 100%.

How to get the most from this Course

In distance learning, the study materials are specially developed and
designed to replace the lecturer. Hence, you can work through these materials at
your pace, and at a time and place that suits you best. The course materials are
interactive enough and allow you to fill the gap created by the absence of the
teacher in a face-to-face encounter. However, the online synchronous facilitation
and instructional video supplements are also meant to bridge this gap.
Visualize it as reading the lecture instead of listening to a lecturer.

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Each of the study unit follows a common format. The first item is an introduction to the subject
matter of the unit and how a particular unit is integrated with the other units and the course as a
whole. Next is a set of learning objectives/outcomes. These objectives let you know what you should
be able to do by the time you have completed the unit. Use these objectives to guide your study.

On finishing a unit, go back and check whether you have achieved the objectives. If made a habit,
this will further enhance your chances of completing the course successfully.

The following is a practical strategy for working through the course:

 Read this course guide thoroughly.
 Organize a study schedule, which you must adhere to religiously. The major reason students
fail is that they get behind in their course work. If you encounter difficulties with your
schedule, please let your tutor/ facilitator know promptly.
 Turn to each unit and read the introduction and the objectives for the unit.
 Work through the unit. The content of the unit itself has been arranged to provide a sequence
for you to follow.
 Review the objectives of each study unit to confirm that you have achieved them. If you feel
unsure about any of the objectives, review the study material or consult with your tutor.
 When you are confident that you have achieved a unit’s objectives, you can then start on the
next unit. Proceed unit by unit through the course and try to pace your study so that you keep
yourself on schedule.
 After submitting an assignment to your facilitator for grading, do not wait for its return before
starting on the next unit. Keep to your schedule. When the assignment is returned, pay
particular attention to your facilitator’s comments.
 After completing the last unit, review the course and prepare yourself for final examination.
Check that you have achieved the units objectives (listed at the beginning of each unit) and
the course objectives listed in this course guide.

Facilitators/Tutors and Tutorials

There are some hours of tutorials (2-hour sessions) provided in support of this course. Students will
be notified of the dates, times and location of these tutorials. Together with the name and phone
number of the tutor, as soon as students are allocated tutorial groups.

The tutor will mark and comment on students’ assignments, keep a close watch on their progress and
on any difficulties, they might encounter, and provide assistance to them during the course. Students
must mail your Tutor Marked Assignments to their tutor well before the due date (at least two
working days are required). They will be marked by their tutor and returned to them as soon as
possible.

Students should not hesitate to contact their tutor by telephone, e-mail, or discussion board if need
for help arise. The following might be circumstances in which students may need help.

Contact your tutor if you:

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• do not understand any part of the study units or the assigned reading
• have difficulty with the Self-Assessment Exercises
• have a question or problem with an assignment, with your tutor's comments on an assignment or
with the grading of an assignment.

Students should try their best to attend the tutorials. This will provide an opportunity for them to
have face to face contact with their tutor and to ask questions which are answered instantly. Students
can raise any problem encountered in the course of their study. To gain the maximum benefit from
course tutorials, prepare a question list before attending them. You will learn a lot from participating
in discussions actively.
Summary
The course, Principle of Economics (ECO 111), expose students to basic concepts in economics and
production, production process; and factors of production. This course also gives students insight
into price determination by invisible hand of the market through interaction of demand and supply
for output. Thereafter it shall enlighten the students about decision making by households and firms,
theory of firm. Conclusively it explicates on how different behaviour of firms lead to different
market structures and also make comparison between these different structures.

On successful completion of the course, students would have developed critical thinking skills with
the material necessary for efficient and effective discussion of economic issues, factors of production
and behaviour of firms and households. However, to gain a lot from the course students should try
and apply all that they learn in the course to term paper writing in other economic development
courses. We wish students success in the course and hope that they will find it interesting and useful.

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 Study Session 1
Meaning of Economics and the Basic Concepts in Economics

Introduction
This unit starts with difficulty of having a single and universally acceptable definition of
economics as a result of the puzzling nature of economics. This is followed by the meaning
of economics and its various definitions as propounded by some famous Economists. Since
economics is defined based on the two assumptions namely; the assumptions were elaborated
on in relation with some other concepts that are interwoven. Thereby interdependency and
complexity of economics become obvious through real life scenario given in this unit. The
benefit of studying economics and understanding its principles are also part of what we shall
find out from this unit.
This unit also explains some basic concepts and principles in economics. These concepts and
principles form the basis for decision making and consideration for a particular choice by
individuals, businesses and firms. The interrelationship between these concepts as well as the
interdependency of individual, businesses and government in an economy are better
understood when the effects of their decisions are examined in relation to the economy.
Learning Outcomes of Study Session 1
When you have studied this session, you should be able to:
1.1 define economics in various forms
1.2 list at least 4 benefits of studying economics
1.3 explain the concept of scarcity of resources
1.4 explain how available choices leads to best decision making
1.5 state how not only the explicit or out-of-pocket cost form the cost of a particular
choice but the implicit or opportunity cost of the best alternative forgone is also part of
the total cost

1.1 Definitions of Economics

What is Economics?
Economics has no universally accepted definition. But, it has generally accepted definition
as “the science which studies human behaviour as a relationship between ends and scarce
means which have alternatives uses”.

Economics is a science which deals with wealth creation through production of goods and
services, their distributions as well as consumption. The process plays a huge task in the
society because it influences the majority of our decisions in our day-to-day activities.
However, defining economics has pose difficulties because there is no single acceptable
definition. Therefore, different economists have given economics different definitions.
Famous among these economists were: Adam Smith, David Ricardo, Thomas Malthus, J.S.

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Mill, John Stuart Mill., Karl Marx, Alfred Marshall, J. B. Say, James Henderson, John
Keynes, Irving Fisher, Lionel Robbins and host of others. Each of these famous economists
either gave a definition which others think it is either too narrow or too broad to describe
economics. Brooks (2012) is of the view that economics can be confusing, and therefore it is
difficult to find a single or clear definition of it.
Thus, it was defined differently by different people. For instance:
(i) Adam Smith (1776) in his book entitled’ “An Enquiry into the Nature and Causes of the
wealth of the Nations”, defined economics as ‘the Science of Wealth.’
(ii) Marshal (1890) defined "Economics as the study of people in the ordinary business of
life." It examines that part of individual and social action which is most closely
connected with the attainment and with the use of material requisites of well- being.
(iii) John Stuart Mill looked at economics as the practical science of production and
distribution of wealth.
(iv) Robinson (1932) defined "Economics is the science which studies human behavior as a
relationship between given ends and scarce means which have alternative uses."
(v) According to Harper (2001), Economics is the social sciences that analyzes the
production, distribution, and consumption of goods and services.
(vi) Iannaccone (1998) defined economics as a social science that studies society, in
business, finance and government, but also in crime, education, the family, health, law,
politics, religion, social institutions, war, and science. The expanding domain of
economics in the social sciences has been described as economic imperialism.
(vii) According to Allen (1977), economics is a social science that analyzes and describes
the consequences of choices made concerning scarce productive resources. Economics
is the study of how individuals and societies choose to employ those resources: what
goods and services will be produced, how they will be produced, and how they will be
distributed among the members of society. Economics is customarily divided into
microeconomics and macroeconomics. Of major concern to macroeconomists are the
rate of economic growth, the inflation rate, and the rate of unemployment. Specialized
areas of economic investigation attempt to answer questions on a variety of economic
activity; they include agricultural economics, economic development, economic
history, environmental economics, industrial organization, international trade, labour
economics, money supply and banking, public finance, urban economics, and welfare
economics. Specialists in mathematical economics and econometrics provide tools used
by all economists. The areas of investigation in economics overlap with many other
disciplines, notably history, mathematics, political science, and sociology.
(viii) Rutherford, (1996) opined that economics is a study of the economy. Classic
economics concentrates on how the forces of supply and demand allocate scarce
product and service resources. Macroeconomics studies a nation or the world's
economy as a whole, using data about inflation, unemployment and industrial
production to understand the past and predict the future. Microeconomics studies the
behavior of specific sectors of the economy, such as companies, industries, or
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 households. Over the years, various schools of economic thought have gained
prominence, including Keynesian Economics, Monetarism and Supply-Side
Economics.
(ix) The study of the relation of available scarce means to supply for a proposed end;
economists assume that people have wants and needs, and then study how societies are
organized to supply them, trying to establish whether one method is better than another.
Micro-economics explains how demand and supply affect prices, wages, rentals, and
interest rates. Macroeconomics focuses on the aggregate (large-scale) demand for
goods and services, and especially on the relationship between unemployment and the
economy. Marxist economics sees the economy as a reflection of the history and
sociology of a society. In particular, it focuses on the historical evolution of, and the
conflict between, classes.
(x) Samuelson (1948) Economics is the "study of how societies use scarce resources to
produce valuable commodities and distribute them among different people." Economics
is the study of how men and society choose, with or without the use of money, to
employ scarce productive resources which could have alternative uses, to produce
various commodities over time and distribute them for consumption now and in the
future amongst various people and groups of society.
(xi) Economics is the study of labor, land, and investments, of money, income, and
production, and of taxes and government expenditures. Economists seek to measure
well-being, to learn how well-being may increase overtime, and to evaluate the well-
being of the rich and the poor. The most famous book in economics is the Inquiry into
the Nature and Causes of The Wealth of Nations written by Adam Smith, and published
in 1776 in Scotland.
(xii) Mark (2007) defines economics as the branch of social science that deals with the
production, distribution and consumption of goods and services and their management.
Economics therefore is the social science that examines how people choose to use
limited or scarce resources in attempting to satisfy their unlimited wants. It also studies
how the forces of supply and demand allocate scarce resources.
(xiii) Mill defined economics as ‘the practical science of production and distribution of
wealth.’
(xiv) But, of particular interest to note is the definition of economics given by Professor
Lionel Robinson in his book, An Essay on Nature and Significance of Economic
Science, as "the science which studies human behaviour as a relationship between ends
and scarce means which have alternatives uses'. The Robinson's definition of
economics is generally accepted because it covers some basic concepts in economics,
including, ends (i.e. human wants/desires or needs), and scarce means' (which refers to
inadequate resources to satisfy the ends) and the 'alternative uses' (which mean that the
scarce resources can be used for different purposes). Thus, we can deduce from the
definition by Robinson that available resources are scarce relative to human wants.
Therefore, choice has to be made in order to derive maximum satisfaction out of the available
scarce resources.

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 Economics, study of how human beings allocate scarce resources to produce various
commodities and how those commodities are distributed for consumption among the people
in society (see distribution). The essence of economics lies in the fact that resources are
scarce, or at least limited, and that not all human needs and desires can be met. How to
distribute these resources in the most efficient and equitable way is a principal concern of
economists. The field of economics has undergone a remarkable expansion in the 20th
century as the world economy has grown increasingly large and complex. Today, economists
are employed in large numbers in private industry, government, and higher education (see
economic planning). Many subjects, such as political science and sociology, which were
once regarded as part of the study of economics, have today become separate disciplines,
although the study of any one generally implies a working knowledge of the other.
Basically, economics is a social science subject. It deals with various aspects of human
behaviour in the area of product ion, distribution and consumption of goods and services for
the satisfaction of wants. However, there is one problem facing economists, as social
scientists. That is, the behaviour of human beings cannot be the same at. all times. This is due
to the fact that human beings have feelings and think differently. Hence, it does not have the
level of accuracy and precision as in any of the pure or natural sciences.
Economics can be regarded as a science because its studies adopt scientific method
including: hypothesis, collection of data, analysis of data, and conclusions well as
generalization of theories. The difference between economics and pure science is that the
economists cannot experiment under controlled conditions' as is done by pure scientists in a
laboratory.

In-Text Questions (ITQ) 1.1

Lionel Robinson defined economics as -----------------------------------------

In-Text Answer (ITA) 1.1

“The science which studies human behaviour as a relationship between ends and scarce
means which have alternatives uses”

1.2 Importance of Economics

The decisions made by individuals, corporations and governments are vital to their survival.
Therefore, studying economics and understanding its principles is imperative. Studying
economics provides many helpful benefits.
(i) For instance, an individual is assisted in understanding the decisions on household issues; it
assists business outfit in understanding the financial sector, the impact of government
decision making on their business and latest development in business society and the global
economy.
(ii) It also teaches the concept of relative scarcity as a result of limited resources, supply and
demand, choices, opportunities, opportunity cost and benefits and how all these can impact
the decision making of individuals, businesses and government.
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(iii) It also teaches how these decision-making processes affect the society.
(iv)It is an approach in understanding behaviour that starts from the assumption that people have
objectives and tend to choose the correct ways of achieving them. The first half of the
assumption is that people have objectives (it is assumed that the objectives are reasonable and
by extension, simple) and the second half of the assumption, that people tend to find the
correct way to achieve their objectives, is called rationality. The term rationality is somewhat
deceptive according to Friedman (1990). He posited that the fact that this term suggests that
the way in which people find the correct way to achieve their objectives is by rational
analysis does not translate to the fact that the decision is rational. Sometimes somewhat
complicated objective can lead to apparently irrational behaviour and decision.
(v) There are main questions which economic science has to directly deal with, and with
reference to which its main work of collecting facts, of analyzing them and of reasoning
about them should be arranged. The greater part of the practical issues may be lying outside
the range of economic science, yet it supplies principal objectives in the milieu to an
economist work. This varies not only from time to time but also from place to place. For
instance, questions like: what are the causes, in the contemporary world, that affect the
production, the distribution, consumption and exchange of wealth? What effects are these
having on the group of industry and trade; on the money and capital markets; wholesale and
retail businesses; foreign trade and exchange, and the relations between employers and
employed? How do all these movements act and react upon one another? How do their
ultimate differ from their immediate tendencies? Marshall (1920).
(vi)It teaches individuals how diverse alternatives or choices are appraised in order to best
achieve a certain objective. The sphere of economics is the study of processes by which
scarce resources are allocated to satisfy unlimited wants. Ideally, the resources are allocated
to their highest valued uses. Supply, demand, preferences, costs, benefits, production
relationships and exchange are tools that are used to describe and evaluate the market
processes by which individuals allocate scarce resources to satisfy as many wants as possible
(Reynolds, 2005). For example, let consider Mr. A who is stuck in making two decisions: 1.
What type of car to buy? 2. Which area to live taking into consideration his place of work?
(Note that an individual decision will affect two businesses, one is the car business and two is
the estate management business). In either case, Mr. A can perk up his decision by devoting
time and effort in studying the alternatives available in each case. In the case of the car, if he
considered fuel-efficiency of the cars in his list of choices, then his decision determines with
certainty which car he gets and this is considered a rational decision. In the case of which
area to live, in his decision (on the choice of house), he may be considering closeness to his
office, the traffic in the route from the area to his office, road linkages and networks etc. If
the area is far from his office and the road is always with traffic problems, but he choose the
area because the house is beautiful; then he has wasted his time and efforts on considering
better alternatives and maximizing them; if he choose a house nearer to his office with less
traffic problem, then his time is not wasted and the decision may be considered rational.
Though we can predict his correct decision but his mistake in this situation which he may
consider rational is not easily predictable.
22
 Meanwhile, introspection or rather self-examination does not enable Mr. A to measure what
is going on in B's mind, nor Mr. B to measure what is going on in Mr. A's mind. Therefore,
comparing the satisfactions of different people is somehow complex. More so, we continually
assume that the comparison can be made in daily life. However, the very multiplicity of the
assumptions actually made at different times and in different places is a confirmation of their
conventional nature. Conventionally, we usually assume for certain purposes that people in
comparable circumstances are proficient to have equal satisfactions. Just as for purposes of
justice we assume equality of responsibility in similar situations as between legal subjects.
Subsequently for purposes of public finance, we agree to assume equality of capacity for
experiencing satisfaction from equal incomes in similar circumstances as between economic
subjects. But, although it may be suitable to assume this, there is no way of proving that the
assumption rests on establish-able reality.
(vii) It teaches people on how the available but inadequate resources would be allocated, to get
maximum satisfaction. Basically, economics is important in order to study how people react
to and allocate limited resources. However, in the process of taking full advantage of one's
own benefit there is the broader benefit of efficient allocation of resources across society.
In-Text Question (ITQ) 1.2
List any 4 importance of economics

In-Text Answer (ITA) 1.2

 Individual is assisted in understanding the decisions on household issues,
 It also teaches the concept of relative scarcity as a result of limited resources, supply
and demand, choices, opportunities, opportunity cost and benefits and how all these
can impact the decision making of individuals, businesses and government.
 It also teaches how these decision-making processes affect the society.
 It teaches people on how the available but inadequate resources would be allocated, to
get maximum satisfaction.

1.3 Basic Concepts and Principles of Economics

There are several basic concepts in economics, including the following:
i. Wants: Want many be defined as insatiable desire by human being to own goods and/or
services that give satisfaction. These include food, housing, clothing; tailoring, teaching, etc.
ii. Scarcity: Scarcity means Inadequate or (limited) supply of goods and which could be used to
satisfy unlimited human wants. The resource (or means) available for any human being can
never, at any moment be enough to satisfy his wants. Thus, there is the need to make choice
and arrange the wants in order of preference.
iii. Scale of Preference: It is the arrangement of selected wants in order of importance. This
arrangement, the more pressing want(s) will be top on the list while the least pressing one(s)

23
 will be at the bottom. It is however important to note that individual's choice made to satisfy
his wants follow his scale of preference.
iv. Choices: Choice is the art of picking the best out of several alternatives. With regard to
human wants, choice is the art of selecting want(s) to satisfy first and which to satisfy last. It
could be either to take one thing and forego the other or to take more of one good/ service
and less of the other or to take equal amounts of both goods/ services. In our day-to-day life,
we are usually faced with one objective or the other that requires decision making. Every
decision involves choices and by extension having more of one good means having less of
another good. Therefore, there is usually a trade-off between the two choices. This is
applicable not only to individuals but also to families, corporations, government and
societies. Take for instance, if Ade has N20 and is stuck between buying an ice-cream or
chocolate candy. He must take a decision whether to buy chocolate candy or go for the ice
cream. His decision might be influenced by some other factors. For example, if it is a sunny
day and Ade is thirsty, he might prefer ice-cream to chocolate candy. If he has discovered
that taking chocolates stimulate him to a good sleep, he might go for chocolate because he
needs a good sleep thereafter or leave that choice because he must study thereafter. He will
thus go for one of the choices which he believes is the correct one to maximize his
satisfaction.
v. Opportunity Cost: It is the satisfaction of one want at the expense of another. It refers to the
want(s) foregone in order to satisfy the more pressing one(s).For instance, if Mr. A has
N200.00 and he is faced with a Choice to make between buying a pair of shoes or a wrist
watch (each cost N200. 00). Supposing Mr. A decide to buy the pail' of shoe, instead of the
wrist watch, then, the wrist watch is- the alternative foregone- otherwise referred to as
opportunity cost or real cost. The N200.00 exchanged for the pair of shoe is called money
cost or exchange value.
In making a decision, we implicitly compare the costs and benefits of our choices over the
other one. Opportunity cost is whatever must be given up to obtain something. Let us refer
back to the case of Ade above, assuming he chooses chocolate candy because he needs it to
stimulate him to a deep sleep. The ice-cream becomes the opportunity cost of buying
chocolate candy. An out-of-pocket expense is the price of the chocolate i.e. N20 which is an
obvious cost. Opportunity cost is an implicit cost and other less obvious costs given up to
have the best alternative. So implicit costs are cost that includes next best opportunity given
up, this must be included in aggregate opportunity cost.

In-Text Question (ITQ) 1.3

List any 2 wants
In-Text Answer (ITA) 1.3
 Food
 Housing
24
Summary of study session 1
In study session 1, you have learned that:
1. Economists are concerned with choosing the correct way to achieving an objective which
may allow us to be able to predict human behavior while their mistake may not be easily
predictable.
2. Not all decision are rational though it is expected that individual goes through the
decision-making process for the purpose of maximizing the scarce resources.
3. Studying economics is important to assist individuals, government and businesses in their
day-to-day decision making for overall benefits of the economy.
4. Economics studies how decisions are made by individual, businesses and government on
wealth creation through production of goods and services.
5. Decision on distributions of goods as well as their consumption affect our day-to-day
activities and the overall economy.
6. Careful review of objectives and choices, the opportunity cost of the best alternative
forgone and rational decision are vital economic concept that are imperative in the study
of economics.

Self-Assessment Question (SAQs) for Study Session 1

Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.
Self-Assessment Question 1.1 (Test Learning Outcome 1.1)
1. Give any 4 definitions of economics.

Self-Assessment Question 1.2 (Test Learning Outcome 1.2)

2. Is it important to study economics? Briefly substantiate your answer.

Self-Assessment Question 1.2 (Test Learning Outcome 1.3)

3. Why do you think that individual, corporation and government make choices?
4. The basic economic problems arise because of scarcity of resources. Discuss.
5. Opportunity cost is an implicit cost and other less obvious costs given up to have the best
alternative. Expantiate on this statement.

Glossary of Terms

Behaviour

This is the way in which one acts or conducts oneself, especially towards others.

25
Wants

This is a lack or deficiency of something.

Desire

A strong feeling of wanting to have something or wishing for something to happen.

Need

A thing that is wanted or required.

Choices

Selecting between things, circumstance and situation.

Demand

Demand is a principle of economics that captures the consumer’s desire to buy the product or
service

Supply

To provide or make (something needed or wanted) available to someone; provide.

References/Further Reading
Friedman, D. D. (1990). Price Theory: An Intermediate Text. South-Western Publishing Co.
Foley, D. K. (2003). Rationality and Ideology in Economics. Accessed November 30,2011
from http://homepage.newschool.edu/~foleyd/ratid.pdf.
Marshall, A. (1920). Principles of Economics. Library of Economics and Liberty. Assessed
November 29, 2011 http://www.econlib.org/library/Marshall/marP4.html.
Reynolds, L. R. (2005). Alternative Microeconomics. Accessed November 25,
2011 from http://www.boisestate.edu/econ/Ireynol/web/Micro.htm.
Smith, A. ((1904). An Inquiry into the Nature and Causes of the Wealth of Nations.
Edwin Cannan (Ed). London: Methuen & Co. Ltd.
Chad, B. (2012). What is Economics? Accessed January 29, 2023
fromwww.businessnesdaily.com/2639-econ.

Possible Answers to Self-Assessment Exercise(s)

1. Give any 4 definitions of economics.

There are different definitions of economics by different economists. Four of them are:
(i) Adam Smith defined economics as an enquiry into the nature and causes of wealth of
nations

26
(ii) Alfred Marshal described economics as a study of mankind in the ordinary business of
life.
(iii) John Stuart Mill looked at economics as the practical science of production and
distribution of wealth.
(iv)Professor Lionel Robinson defined economics as "the science which studies human
behaviour as a relationship between ends and scarce means which have alternatives uses.'

2. Is it important to study economics? Briefly substantiate your answer.

The answer is ‘yes’. The importance of studying economics is explained as follows.
(i) It assists individual to understand the decisions on household issues; it assists business
outfit in understanding the financial sector, the impact of government decision making on
their business and latest development in business society and the global economy.
(ii) It teaches the concept of relative scarcity as a result of limited resources, supply and
demand, choices, opportunities, opportunity cost and benefits and how all these can
impact the decision making of individuals, businesses, governments, and the society in
general.
(iii) It also teaches how these decision-making processes affect the society.
(iv)It teaches individuals to be rational in their thinking and behaviour. The term rationality
is somewhat deceptive according to Friedman (1990). He posited that the fact that this
term suggests that the way in which people find the correct way to achieve their
objectives is by rational analysis does not translate to the fact that the decision is rational.
Sometimes somewhat complicated objective can lead to apparently irrational behaviour
and decision.
(v) It enable individuals to deal with questions like: what are the causes, in the contemporary
world, that affect the production, the distribution, consumption and exchange of wealth?
What effects are these having on the group of industry and trade; on the money and
capital markets; wholesale and retail businesses; foreign trade and exchange, and the
relations between employers and employed? How do all these movements act and react
upon one another? How does their ultimate differ from their immediate tendencies?
(vi)It teaches individuals how diverse alternatives or choices are appraised in order to best
achieve certain objectives which include; utility maximization, profit maximization,
expenditure minimization, cost minimization, etc.
(vii) It teaches people on how the available but inadequate resources would be allocated, to
get maximum satisfaction.

3. Why do you think that individual, corporation and government make choices?
Choice is the art of selecting want(s) to satisfy first and which to satisfy last. It could be
either to take one thing and forego the other or to take more of one good/service and less of
the other or to take equal amounts of both goods/services. In our day-to-day life, we are
usually faced with one objective or the other that requires decision making. Every decision
27
involves choices and by extension having more of one good means having less of another
good. Therefore, there is usually a trade-off between the two choices. This is applicable not
only to individuals but also to families, corporations, government and societies. Individuals,
corporations and governments make choices because each want to derive maximum
satisfaction from its limited resources.

4. The basic economic problems arise because of scarcity of resources. Discuss.

The basic economic problems which include: what to produce; how to produce; for whom to
produce; and is the society growing; arise because of scarcity of resources Scarcity means
inadequate or (limited) supply of goods and which could be used to satisfy unlimited human
wants. The resource (or means) available for any human being can never, at any moment be
enough to satisfy his wants.

5. Opportunity cost is an implicit cost and other less obvious costs given up to have the
best alternative. Expantiate on this statement.
Opportunity Cost is the satisfaction of one want at the expense of another. It refers to the
want(s) foregone in order to satisfy the more pressing one(s).In making a decision, we
implicitly compare the costs and benefits of our choices over the other one. Opportunity cost
is whatever must be given up to obtain something. So implicit costs are cost that includes
next best opportunity given up, this must be included in aggregate opportunity cost of
obtaining another thing.

28
 Study Session 2
Basic Economic Problems and Systems

Introduction
All economies are usually faced with basic economic problems that have to do with
production, distribution and consumption of goods and services in the economy. The basic
economic problems arise as a result of resources that are relatively scarce when compared
with the objectives for which they should be used. Human wants are unlimited but the
resources that can be used to satisfy them are limited. Basically, the resources can be
categorized into two: 1. Human resources 2. Natural (physical) resources. As said earlier,
there arises the need to make choices as a result of the limited resources (scarcity) which
individual intends to maximize. There is the need to strike a balance between scarce
resources and unlimited and insatiable human wants. Consequently, decision making on
choices assist individual, businesses and government to allocate scarce resources efficiently.
These problems led to the basic economic problems facing all societies, and which must be
answered.
Learning Outcomes of Study Session 2
When you have studied this session, you should be able to:
2.1 Explain the basic economic problems facing societies
2.2 Explain the concept of economic system,
2.3 State different methods of solving economic problems in different economic systems,
2.4 Differentiate between different types of economies,
2.5 Explain the weaknesses and strengths of each economic system.

2.1 Basic Economic Problems Facing Societies

The basic economic problems facing societies can be identified as follows;

What to Produce
What to produce - thorough evaluation and rating of goods and services from most valued to
least valued is a required step in arriving at a decision of what to produce. This is a vital
stride to support the assumption that there is usually a trade-off between the choices and
because of the comparability of different things that we valued.
How much to Produce
How much to produce-since there are different goods and services in the marketplace
competing, there is the need to determine how much of the goods or services of our choice
29
we should produce. Demand for comparable goods or services may affect the decision-
making process on how much to produce. If the decision on how much to produce shows that
large quantity should be produced then cost and benefit of large-scale production may as well
influence the decision on how to produce?
How to Produce
How to produce-there are different methodologies for production of goods, if the decision on
how much to produce shows a large quantity it may influence the method of production to be
adopted. There are other factors that may affect the decision on how to produce such as
availability of raw material.
For whom to produce
For whom to produce- this is shaped by the principles governing how goods are distributed
among the members of a society. The distribution method may modify incentives that
influence the behavior of individuals.
When to Produce
When to produce- The timing of production and the time that the final output of a good (or
service) is available in the market may affect its value. By and large, goods to be consumed at
some future date are perceived to have relatively lower value than those available currently
for consumption. More so, producers of seasonal goods must have their new equipment and
input materials ready for the next season.
In-Text Question (ITQ) 2.1
List any 2 economic problems facing societies
In-Text Answer (ITA) 2.1
 What to produce
 How to produce

2.2 Economic System

An economic system consists of individual, institutions and their interaction in the process of
answering basic economic problems. Individual and institutions work together to answer
basic economic problems in relation to the resources in the society, its scarcity and how these
scarce resources can be allocated to meet conflicting and diverse objectives. The mechanism
of production, distribution and consumptions varies in our society. This is because each
society answers the basic economic problems in different ways. How each society answered
the basic economic problems; that is the economic decisions they make; determines the type
of economic system they will operate. In the economic decision making, we have the
households as the major actor followed by the institutions and then the government. North
(1990) posited that institutions are the rules of the game in a society. Formally, they are the
humanly devised constraints that shape human interaction which means they influence human
behaviour. In consequence they structure incentives in human exchange, whether political,
30
social, or economic. Institutional change shapes the way societies evolve through time and
hence it is the key to thoughtful historical change. An economic system must be able to
answer basically three of the economic problems such as what to produce? That is what types
of goods and services to produce. How to produce? That is what the resources available that
can be employ for production of goods and services. For whom to produce? That is; who is
the receiver of the final products from production. Hence an economic system encompasses
various processes of organizing and motivating labor, producing, distributing, and circulating
of the fruits of human labor. Fruit of labor refers to products and services, consumer goods,
machines, tools, and other technology used as inputs to future production, and the
infrastructure within and in the course of which production, distribution, and circulation
arises.
2.3 Types of Economic Systems

Economic decision made by a society shapes the economic system of that Country. The
Figure 1.3 shows the basic economic systems:

• Traditional economy
• Centrally-planned economy
• Free market Economy
• Mixed economy

Controll
Basic
System

Free
Traditional
Economic Market
Economic
Systems Economic
System
System

Mixed
Economic
System

Fig.2.1 Economic Systems

31
Traditional Economy
In a traditional economy, the economic decisions are made based on believes, norms religion
and customs of that society. Specifically the economic decision on economic questions of
what to produce, how to produce, for whom to produce, where to produce etc. are made based
on believes, religion, customs, habit and norms of that society. For instance, the economies of
some countries are believed to be traditional. Arab and African Countries such as Saudi
Arabia, Nigeria, Iran, Pakistan, Kenya, Ghana, Qatar, etc where people produce what they
learnt their forefathers produced, following their custom of producing it; sell products that are
produced the same way their forefathers produced it are traditional economies. For instance
in Nigeria, people of Abeokuta is known for the ‘adire’ cloth business while the Oke-ogun
people continue to produce the ‘ofi’ traditional attires.

Barter-direct exchange of goods and services with other goods and services are part of the
norms. For instance in Yoruba land, an exchange of food for services called ‘agbaro’ is still
in operation in some part of the land. ‘Agbaro’ means that a group of friend will assist a
member of the group to clear a portion of land while they receive in turn, food for their
services instead of money. This is done based on custom of friendship.
Strengths of Traditional Economy
There is usually a strong family or societal relationship between the individuals in the
traditional economy. Hence, there may be economic securities and safety for members of the
society. This in turn may promote economic stabilities in the traditional economy.
Weaknesses Traditional Economy
Lack of innovation or resistance to innovations. Such technical knowhow may be
monopolized by the family that specialized in a certain profession. Modern ideals may not be
welcome because they usually want to do things the same way it was done before they were
born.
Centrally-planned Economy
In a controlled economy, it is the government that makes the economic decision and it is
solely done meaning that there are no private sector initiatives. Government planners decide
on what to produce, how many shoe industry will produce the number of shoes the
government decided should be produced. How to allocate resources to the producer is the
business of the government planners. Controlled or Planned economies are usually associated
with Socialism and Communism where government determines the wages of workers, the
prices of goods and services and level of output. Former Soviet Union, Cuba, Germany,
Russia, North Korea etc are close examples of Controlled or Planned economies. Albeit,
Germany and Russia seems to have move to mixed economy as it is the case with countries
under other economic system.
Strengths of Centrally-Planned Economy
32
Ability to accomplish social goals quickly. Planning for more labor in production in a control
economy can reduce unemployment. There is plausible provision of more economic
securities to the participant in this economy. This type of economy may be able to provide an
equal distribution of income and goods and services.

Weaknesses of Centrally-Planned Economy

It is difficult for Controlled economy to match consumer’s wants and needs with the
productions. Complexity of production may lead to production problems. The economic
participants may have to depend on a small number of economic choices as provided by the
government planners. There may be overproduction of some products and underproduction of
other products.

Free Market Economy

A free-market economy basically refers to an economic system in which economic decisions
and the pricing of goods and services are guided solely by the aggregate interactions of a
country's citizens and businesses. In a purely free market economy, buyers and sellers arrive
at prices based only on supply and demand. Characteristics of a Market Economy (free
enterprise)

 Private Property.
 Economic Freedom.
 Consumer Sovereignty.
 Competition.
 Profit.
 Voluntary Exchange.
 Limited Government Involvement.

Strengths of Free Market Economy

There may be a good opportunity for innovation and incentive to produce. There is usually
economic freedom in a free market economy. There may be a direct link between the buyer
and the seller through price mechanism.
Weaknesses of Free Market Economy
There may be few incentives to protect the environment. Market power may be concentrated
in the hand of few. People without marketable skill may lack adequate protection.
Mixed Economy
The economic decision on what to produce; how and where to produce; for whom to produce;
is made jointly by the government and the private sectors in the economy. This is achieved
through the demand and supply mechanism (price and profit) based on free market enterprise.
Mixed economy is a combination of controlled economy and market economy.

33
Most economies of the world show evidence pointing to characteristics of mixed economy.
Therefore, we may conclude that there is no pure controlled; traditional or free market
economy. Countries like Nigeria, United State of America, United Kingdom, Malaysia, China
and all modern economies are mixed economies. It should be noted that in a mixed economy,
government intervention is limited somehow to market regulation in the business and
household sector as well as input and output market. This is because businesses own
resources, they also determines how the resources are put into use. That is what to produce, to
whom to produce and how to produce. There should not be government intervention in a truly
free-market economy. But as a result of the mixed economy, government serves as regulators
to some sectors or industries in the economy.
Strength of Mixed Economy
There is effectiveness in achieving social goal. There is likelihood of providing economic
security
Weaknesses of Mixed Economy
There may be lack of incentives to create quality goods and services. There may also be lack
of environmental protection.

In-Text Question (ITQ) 2.2

List 4 types of Economic Systems

In-Text Answer (ITA) 2.2
 Free market Economy
 Mixed economy
 Traditional economy
 Centrally-planned economy

Summary of study session 2

In study session 2, you have learned that:
1. An economic system consists of individual, institutions and their interaction in the
process of answering basic economic problems. Individual and institutions work
together to answer basic economic problems in relation to the resources in the society,
its scarcity and how these scarce resources can be allocated to meet conflicting and
diverse objectives.
2. The mechanism of production, distribution and consumptions varies in our society.
This is because each society answers the basic economic problems in different ways.
How each society answered the basic economic problems; that is the economic
decisions they make; determines the type of economic system they will operate.
3. This session also discussed four basic economic systems in the world which were
determined by how a country answered the basic economic question especially
34
 questions on what to produce and how to produce. Traditional economy is based on
answering economic problem of what to produce by producing what their forefathers
produced employing also the way they produced it. In command economy,
government answer the basic economic problems and determines how and what to
produce without private sector initiative. Market economy allows forces of demand
and supply to determine what and how to produce, with protection of economic
freedom. While mixed economy combines market and controlled economies ideas.
Most modern economies tend to adopt mixed economy system.
Self-Assessment Questions (SAQs) for Study Session 2
Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.

Self-Assessment Question 2.1 (Test Learning Outcome 2.1)

Elucidate on the basic economic problems with relevant examples.
Self-Assessment Question 2.2 (Test Learning Outcome 2.2)
What determines the type of economic system a society practices?

Self-Assessment Question 2.3 (Test Learning Outcome 2.3)

List and discuss briefly the basic economic systems.
Self-Assessment Question 2.4 (Test Learning Outcome 2.4)
Explain in detail how can the basic economic problems facing societies be solved in mixed
economies

Glossary of terms

Economy

An economy is a social domain that emphasis the practices, discourses and material
expression associated with the production, use, and management of scarce resources
Resources
Resources refers to all the materials available in our environment which are technologically
accessible, economically feasible and culturally sustainable and help us satisfy our needs and
wants.
Produce
To make something or bring something into life
System

35
A set of principles or procedures according to which something is done; and organize scheme
or method
Market
Market is a place where buyers and sellers meet

References/Further Reading
Foley, D. K. (2003). Rationality and Ideology in Economics. Accessed November
30,2011from http://homepage.newschool.edu/~foleyd/ratid.pdf.
Friedman, D. D. (1990). Price Theory: An Intermediate Text. South-Western Publishing Co.
Liberty. Assessed November 29, 2011
http://www.econlib.org/library/Marshall/marP4.html
Mahadi, S. Z. (2006). Understanding Economics. Kuala Lumpur: Cosmo point.
Marshall, A. (1920). Principles of Economics. Library of Economics and
North, D. C. (1990). Institutions, Institutional Change and Economic Performance.
Cambridge: Cambridge University Press. Pp. 1-560. United State of America: John
Wiley and Sons Inc.
Reynolds, L. R. (2005). Alternative Microeconomics. Accessed November 25, 2011

fromhttp://www.boisestate.edu/econ/Ireynol/web/Micro.htmhttp://tutor2u.net/economics/.

Welch, P. J. & Welch, G. F. (2010). Economics: Theory and Practice.

Possible Answer to Self-Assessment Exercise(s)

1. Elucidate on the basic economic problems with relevant examples.
The basic economic problems are elucidated as follows. There has been the problem of what
to produce. This problem arise because there are two types of goods, capital goods or
consumer goods. There is usually a trade-off between the choices due to comparability of
different things that we valued. So, a choice have to be made between capital goods and
consumer goods.
Next, the problem of how much to produce has to be resolved. There is the need to determine
how much of the goods or services of our choice be produced. In case we decide to that large
quantity should be produced, then cost and benefit of large scale production may as well
influence the decision on how to produce.
Next, the problem of how to produce must be resolved. There are different methodologies for
production of goods, if the decision on how much to produce shows a large quantity it may
influence the method of production to be adopted. There are two methods of production
namely, labor intensive method or capital intensive method.
36
Next, the problem of for whom to produce which is shaped by the principles governing how
goods are distributed among the members of a society has to be resolved. The distribution
method may modify incentives that influence the standard of living of individuals.
Finally, the problem of when to produce has to be resolved. The timing of production and the
time that the final output of a good (or service) is available in the market may affect its value.
2. What determines the type of economic system a society practices?
Economic decision made by a society shapes the economic system of that Country.
Individuals and institutions work together to answer basic economic problems in relation to
the resources in the society, its scarcity and how these scarce resources can be allocated to
meet conflicting and diverse objectives. The mechanism of production, distribution and
consumptions varies in our society. This is because each society answers the basic economic
problems in different ways. How each society answered the basic economic problems; that is
the economic decisions they make; determines the type of economic system they will operate.

3. Discuss briefly the basic economic systems.

The basic economic systems are as follows.
i. Traditional economy
ii. Centrally-planned economy
iii. Free market Economy
iv. Mixed economy

i. In a traditional economy, the economic decisions are made based on believes, norms
religion and customs of that society. Specifically the economic decision on economic
questions of what to produce, how to produce, for whom to produce, where to produce
etc. are made based on believes, religion, customs, habit and norms of that society.

ii. In a controlled economy, it is the government that makes the economic decision and it is
solely done meaning that there are no private sector initiatives. Government planners
decide on what to produce, how many shoe industry will produce the number of shoes
the government decided should be produced. How to allocate resources to the producer
is the business of the government planners.

iii. In free market economy, the basic economic decisions are made by the buyers and
sellers, individual households and businesses in the economy through the price
mechanism. Unlike the controlled economy where private sectors are nonexistence; free
market economy allow individuals to operate their own businesses and answer economic
problems using their owned resources, make profits and determine the prices of goods
and services.

37
iv. The economic decision on what to produce; how and where to produce; for whom to
produce; is made jointly by the government and the private sectors in the economy. This
is achieved through the demand and supply mechanism (price and profit) based on free
market enterprise. Mixed economy is a combination of controlled economy and market
economy.

4 Explain in detail how can the basic economic problems facing societies be solved in
mixed economies.
In mixed economy, decisions on what, how, for whom, and, when, to produce; are made
jointly by the government and the private sectors in the economy. This is achieved through
the demand and supply mechanism (price and profit) based on free market enterprise. Mixed
economy is a combination of controlled economy and market economy. It should be noted
that in a mixed economy, government intervention is limited somehow to market regulation
in the business and household sector as well as input and output market. This is because
businesses own resources, they also determines how the resources are put into use. That is
what to produce, to whom to produce and how to produce. There should not be government
intervention in a truly free-market economy. But as a result of the mixed economy,
government serves as regulators to some sectors or industries in the economy.

38
 Study Session 3
Theory of Demand
Concept of Demand, Factors That Affect Demand, and Types of Demand
Introduction
Demand is the ability to buy goods and/or services at a given price at a time. It depends on
buyer’s income and the price(s) of the goods and services. There are several factors that affect
demand for goods and services. Usually consumer tends to buy less when there is an increase
in the price of a commodity but buy more when there is a decrease in the commodity price. It
can be inferred that price and quantities are inversely related. In other words, quantity
demanded will decrease when there is a rise in price and it increases when there is a fall in
price. In essence, price affects quantity demand for a commodity. It should be recall that in
the last unit, we understand that income of households also determines what they consume.
Whatever quantity they wish to demand for is regulated by their limited resources to
purchase. However, price and income are not the only factor that can affect quantity
demanded. One other factor earlier mentioned is the preference of households.
Commodities relate with one another in many ways. The relationship may be positive,
negative, or competitive. Demand for one commodity may/may not lead to the demand for
one or more commodities. In this unit we will explain how commodities relate with one
another.

Learning Outcomes of study session 3

When you have studied this session you should be able to:
3. 1 Explain the concept of demand,
3. 2 Give example of demand schedule,
3. 3 Draw demand curve,
3. 4 Elucidate on factors that determines quantity demanded,
3. 5 Explain abnormal demand curve.
3. 6 Explain different types of demand

3.1 Concept of Demand?

What is Demand?

Demand is defined as the quantity of a good or service that consumers are willing and able to
39
 buy at a given price at a particular time.

From this definition, This is quite different from ‘want’ or ‘need’ in the sense that while want
or need is mere desire, demand is always backed up by willingness and ability to pay for a
good or service. However, there is close relationship between demand and want. A consumer
may not demand (or pay) for a commodity he does not want. But though he may be willing to
pay for all goods he want, he may not be able to pay. This ability to pay is the main
distinction between want and demand.
The Law of Demand states that "ceteris paribus" the lower the price, the higher the quantity
of goods or services that will be demanded or vice versa. The term "ceteris paribus” means
“all things being equal”, that is, all determinants of demand (except price) remain constant.
This law can be explained with the use of schedule (table) and curve as explained in table 2.1
below.
Demand Schedule
Demand schedule is the tabular presentation of the relationship between price and quantity
demanded of a good. It is presented as below for Mr. A.

Table 2.1.1: Demand Schedule for Mudus of maize

Price per Mudu (Naira) Quantity Demanded (No. of

Mudu per day)
90 5
70 15
50 25
30 35
10 45

The Demand schedule above showed that at the price of ₦90.00 the quantity demanded of
maize is five mudus. As the price falls to ₦ 70.00 and to ₦ 10.00, the quantity demanded
increases to fifteen mudus and to forty-five mudus in that order. This demand schedule can be
translated to Demand curve as demonstrated on figure 2.1 below.

Demand Curve
Demand curve is the graphical presentation of the relationship between price and quantity
demanded of a good. It is presented on graph below.

40
Fig. 1.1: An Individual Demand Curve
In fig. 2.l above, it can be seen that the demand curve slopes downward from left to right,
indicating that there is a negative (inverse) relationship between the price and quantity
demanded of the particular good. This confirms the demand law. The basic explanation for
this relationship is the fact that consumer gets more and more satisfied (total utility) but less
and less extra satisfaction (marginal utility) as he consumes more quantity of a good. Thus,
he would prefer to buy more quantity of the good only if its price falls.
In-Text Question (ITQ) 3.1
Demand can be defined as-----------------------
In-Text Answer (ITA) 3.1
“Demand is define as the quantity of a good or service that consumers are willing and able to
buy at a given price at a particular time”.

3.2 Factors That Affect Demand

Price of the Commodity
A sudden increase in price of a commodity means a reduction in the consumption power of
the consumer; as a result of fall in their real income. This situation is referred to as income
effect. Income effect is the effect of a change in price on quantity demanded as a result of
price changes which made them worse off. In a situation like this people will feel poorer
because they will not be able to buy so many goods that the same money was buying before
the increase in price. Household therefore may have to cut down the amount of items they
always consume. For instance, sudden increase in the petrol price on January 1 st, 2012 in
Nigeria has affected prices. Cost of transportation had not only gone up by almost 50 per cent
but prices of other items has sky rocket too. Household that consumes may be 10 liters of
petrol that use to cost 650 naira on their generator will now have to pay 970 naira to get the
same liters of petrol. This household has three options:

41
(i) Either they reduce the use of the generating set so as to continue to buy 650 naira petrol.
That means cutting down the numbers of liters they use to buy.
(ii) They may have to spend 970 naira to buy 10 liters but cut down on may be the food
items, drinks, beverages or whatever they think they can afford to cut down so as to
spend same real income wisely.
(iii) The last option is to switch to alternative products or substitutes. Since the substitutes
will be cheaper in price. This option is referred to as substitution effects. Substitution
effectis the effect of a change in price on quantity demanded as a result of switching by
consumers to alternative or from alternative products. By implication, quantity
demanded of some items the household is consuming must be cut back as a result of
price increase. This shows a general relationship between price and consumption.
Other factors that affect Demand

i. Income of consumer: As the consumer’s income increases, his ability to buy rises, and
hence the quantity demanded will increase, or vice versa.
ii. Prices of other commodities: Prices of other commodities can affect quantity
demanded of a particular commodity. In the case of substitutes such as meat and fish, a
rise in the price of meat will cause an increase in quantity demanded of fish. This is
because some consumers of meat will change from buying it in favor of fish. Therefore,
the cross elasticity of demand is positive. On the other hand, in the case of
complimentary goods such as car and petrol, a fall in the price of car will cause an
increase in the demand for more cars and hence a rise in quantity demanded of-petrol.
Therefore, the cross elasticity of demand is negative.
iii. Population: As the population of consumers (or in a particular place) increases, the
quantity demanded of commodities rises, and vice versa.
iv. Weather: Demand for goods also changes with weather. For instance, thick and black
clothes as well as hoi drinks that retain heat in human body are mostly demanded in cold
regions (or seasons).On the other hand, light and white clothes as well as cold drinks are
highly demanded in hot environments (or seasons).
v. Tastes/Preference/Fashion: Some goods are fashionable at some times and therefore,
are highly demanded at that time. Similarly, if consumers change their tastes and
preferences for a particular good, its demand will rise, and vice versa.
vi. Festivities: Demand for some goods increase during festivities For example, quantity
demanded of food items and clothes usually rise during Christmas, and New Year as
well as Sallah celebrations.
vii. Age Structure: If a population contains more children than adults (i.e, growing
population) the demand for children's goods will increase. On the other hand, in ageing
population, the demand for adult's communities will rise.
viii. Government policy: Government policy of taxation and subsidies can affect the price
and quantity demanded of commodities. For instance, an increase in income tax will
reduce consumers' disposable income and hence his demand for goods and/or services,
and vice versa.
42
ix. On the other hand, an increase in subsidies will reduce the cost of production and price
of goods and hence lead to a rise in demand for them.
x. Advertisement: Advertisement can increase consumers’ preferences for a good and
hence cause a rise in its demand by the consumers.
xi. Culture: If the consumption of some commodities is not culturally allowed in a
particular place, the demand for such commodities will fall or be low.

In-Text Questions (ITQ) 3.2

List 5 factors that affects Demand

In-Text Answer (ITA) 3.2

 Price of the Commodity

 Income of consumer
 Prices of other commodities
 Government policy
 Tastes/Preference/Fashion

3.3 Abnormal Demand

Abnormal (or exceptional) demand is a situation in which consumers tend to buy more of a
commodity as its price rises. If consumers expect that there will be a rise in price in the
future, they will tend to buy more of goods now even at the high price, and hence demand for
goods will rise, and vice versa. This is one of the causes of abnormal demand. In this case,
there is a positive relationship between price and quantity demanded of a good, and thus the
demand curve slopes upward from left to right as shown in the graph below:

Price

P0 D

P1

P2

P3
D
Quantity

Q3 Q2 Q1 Q0
43
 Fig. 1.2 An abnormal Demand Curve.

In fig.1.2 above it can be seen that at price PO the" quantity demanded is Q0. As the price
falls from P0 to P1, P2 and to P3, quantity demanded increases from Q0 to Q1, Q2 and to Q3
respectively.

Besides expectation for future rise in price, other determinants of abnormal demand are:
i. Conspicuous Consumption: Some consumers who want to show that they are rich will buy
more goods even at higher prices.
ii. Necessities: Some goods are so necessary that they must be consumed, e.g. food items. Thus,
consumers tend to sacrifice the consumption of other (or unnecessary) goods for necessary
goods. Therefore, the higher the prices of these necessary goods the higher will be the
demand for them.

In-Text Questions (ITQ) 3.3

List 2 determinants of abnormal demand

In-Text Answer (ITA) 3.3

 Conspicuous Consumption
 Necessities

3.4 Types of Demand

Derived Demand
This is the type in which the demand for a good is for the purpose of' using it to produce
other good(s). For example, the demand for cassava is for the production of starch 'gari' or
cassava flour. Thus, the demand for cassava increases as the demand for starch, gari or
cassava flour rises, and vice-versa. These are shown in the graph below:

Price
(a) GARI
D
D
P0 1

D
0
D
Q1(a) Q2(a)Quantity

Price
(b) Cassava
D
44
 D
P0 1

0 D
D

Q1(b) Q2(b) Quantity

Fig.1.3 Derived Demand

Fig.1.3 shows that an increase in the demand for gari from OQ1a, to OQ2a has caused a rise in
the demand for cassava from OQ1b to 0Q2b .
In sum, the demand for all raw materials is a derived demand for the finished or semi-
finished goods they are used to produce.
Joint or complementary Demand
This is the demand for two or more commodities that must be consumed together to satisfy a
particular want. Example, the demand for car and petrol. Increase in the demand for car will
lead to a rise in the demand for Petrol. This is shown in the figure below:

Quantity

Price

Petrol

Quantity

Fig.1.4: Joint or complementary Demand

Fig. 1.4 indicates that the demand for petrol increased from OQI b to OQ2b as a result of a rise
in the demand for car from OQla to OQ2a.

Competitive Demand
This is the demand for goods which are close substitutes. Examples of such goods include:
meat and fish; tea and coffee; egg and beans; etc. An increase in the price of one will lead to
45
an increase in the quantity demanded of the other. Competitive demand for meat and fish is
shown in figure 2.5 below.
Price

Prlce

Quantity

Fig.1.5: Competitive Demand,

It is observed in fig.1.5 that an increase in the price of fish leading to a decrease in its demand
from DI DI to D2D2 has caused an increase in the demand for meat from D] DI to D2D2.

Composite Demand
This is the demand for a commodity for different purposes. Example, the demand for salt for
domestic consumption, and for industrial uses.
In-text Question (ITQ) 3.4
List 4 types of Demand
In-Text Answer (ITA) 3.4
 Derived Demand
 Composite demand
 Join and complementary demand
 Competitive demand

Summary of study session 3

In study session 3, you have learned that:
1. Demand is the ability to buy goods and/or services at a given price at a time. It
depends on buyer’s income and the price(s) of the goods and services. There are
several factors that affect demand for goods and services.

46
 2. Demand was explained in this session in such terms as; demand schedule, demand
curve were explained. And factors that affect demand, other factors that affects
quantity demanded aside price were explained.
3. The various types of demand such as derived demand, joint demand, competitive
demand, and composite demand
Self-Assessment Questions (SAQs) for study session 3
Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.
Self-Assessment Question 3.1 (Test Learning Outcome 3.1)
Briefly define the term demand, and state the law of demand.
Self-Assessment Question 3.2 (Test Learning Outcome 3.2)
With appropriate table, explain the term demand schedule.
Self-Assessment Question 3.3 (Test Learning Outcome 3.3)
Explain the factors that affect demand for a commodity.
Self-Assessment Question 3.4 (Test Learning Outcome 3.4)
What is income effect and substitution effect?
Self-Assessment Question 3.5 (Test Learning Outcome 3.5)
Explain the determinants of abnormal demand for a particular good.
Self-Assessment Question 3.6 (Test Learning Outcome 3.6)
With the aid of figures, explain any two types of demand you know

Glossary of Terms

Demand

Demand is a principle of economics that captures the consumer’s desire to buy the product or
service

Price
Price is the quantity of payment or compensation expected, requires or given by one party to
another for goods or service.
Commodity
A commodity is a substance or product that can be traded, bought or sold

1.5 References/Further Reading

47
Awodun, M. O. (2000). Economics: Microeconomics Theory and Applications. Chapter 7 and
8.
Case, K. E. & Fair, R. C. (1999). Principles of Economics. New Jersey:
Obafemi, F. et al. (2005). Principles of Economics. Lagos: El-Sapphire Ltd. Prentice Hall.
Sloman, J. (2006). Economics. (6th ed.). England: Pearson Education Limited.

1.6 Possible Answers to Self-Assessment Exercise(s)

1. Briefly define the term demand, and state the law of demand.
Demand is defined as the quantity of a good or service that consumers are willing and able to
buy at a given price at a particular time. Demand is always backed up by willingness and
ability to pay for a good or service.
The Law of Demand states that "ceteris paribus" the lower the price, the higher the quantity
of goods or services that will be demanded or vice versa. The term "ceteris paribus” means
“all things being equal”, that is, all determinants of demand (except price) remain constant.

2. With appropriate example, explain an individual demand curve.

An individual demand curve, for say commodity X, slopes downward from left to right,
indicating that there is a negative (inverse) relationship between the price and quantity
demanded of the commodity. The basic explanation for this relationship is the fact that
consumer gets more and more satisfied (total utility) but less and less extra satisfaction
(marginal utility) as he consumes more quantity of commodity X. Thus, he would prefer to
buy more quantity of commodity X only if its price falls

3. What is income effect and substitution effect?

Income effect is the effect of a change in quantity demanded as a result of price changes
which made consumers better or worse off depending on the direction of price change. A
sudden increase in price of a commodity means a reduction in the consumption power of the
consumer; as a result of fall in their real income. This situation is referred to as income effect.
Substitution effect is the effect of a change in price on quantity demanded as a result of
switching by consumers to alternative or from alternative products. By implication, quantity
demanded of some items the household is consuming must be cut back as a result of price
increase.
4. Explain the factors that affect demand for a commodity.
There are many factors that affect demand for a commodity. They include:
i. Income of consumer: As the consumer’s income increases, his ability to buy rises, and
hence the quantity demanded will increase, or vice versa
48
 ii. Prices of other commodities: Prices of other commodities can affect quantity demanded
of a particular commodity. In the case of substitutes such as meat and fish, a rise in the
price of meat will cause an increase in quantity demanded of fish. This is because some
consumers of meat will change from buying it in favor of fish. Therefore, the cross
elasticity of demand for substitutes is positive.On the other hand, in the case of
complimentary goods such as car and petrol, a fall in the price of car will cause an
increase in the demand for more cars and hence a rise in quantity demanded of-petrol.
Therefore, the cross elasticity of demand for complimentary goods is negative.
iii. Population: As the population of consumers (or in a particular place) increases, the
quantity demanded of commodities rises, and vice versa.
iv. Weather: Demand for goods also changes with weather. For instance, thick and black
clothes as well as hoi drinks that retain heat in human body are mostly demanded in cold
regions (or seasons).On the other hand, light and white clothes as well as cold drinks are
highly demanded in hot environments (or seasons).
v. Tastes/Preference/Fashion: Some goods are fashionable at some times and therefore,
are highly demanded at that time. Similarly, if consumers change their tastes and
preferences for a particular good, its demand will rise, and vice versa.
vi. Festivities: Demand for some goods increase during festivities For example, quantity
demanded of food items and clothes usually rise during Christmas, and New Year as well
as Sallah celebrations.
vii. Age Structure: If a population contains more children than adults (i.e, growing
population) the demand for children's goods will increase. On the other hand, in ageing
population, the demand for adult's communities will rise.
viii. Government policy: Government policy of taxation and subsidies can affect the price
and quantity demanded of commodities. For instance, an increase in income tax will
reduce consumers' disposable income and hence his demand for goods and/or services,
and vice versa.
ix. On the other hand, an increase in subsidies will reduce the cost of production and price of
goods and hence lead to a rise in demand for them.
x. Advertisement: Advertisement can increase consumers’ preferences for a good and
hence cause a rise in its demand by the consumers.
xi. Culture: If the consumption of some commodities is not culturally allowed in a
particular place, the demand for such commodities will fall or be low.
5. Explain the determinants of abnormal demand for a particular good.

Abnormal (or exceptional) demand is a situation in which consumers tend to buy more of a
commodity as its price rises.
i. If consumers expect that there will be a rise in price in the future, they will tend to buy
more of goods now even at the high price, and hence demand for goods will rise, and vice
versa. This is one of the causes of abnormal demand. In this case, there is a positive

49
 relationship between price and quantity demanded of a good. Besides expectation for
future rise in price, other determinants of abnormal demand are:
ii. Conspicuous Consumption: Some consumers who want to show that they are rich will
buy more goods even at higher prices.
iii. Necessities: Some goods are so necessary that they must be consumed, e.g. food items.
Thus, consumers tend to sacrifice the consumption of other (or unnecessary) goods for
necessary goods. Therefore, the higher the prices of these necessary goods the higher will
be the demand for them.

6. With the aid of figures, explain any two types of demand you know
There are four types of demand. They are:
i. derived demand,
j. joint or complementary demand,
k. explain competitive demand,
l. explain composite demand
Two types of demand are explain below

Joint or complementary Demand

This is the demand for two or more commodities that must be consumed together to satisfy a
particular want. Example, the demand for car and petrol. Increase in the demand for car will
lead to a rise in the demand for Petrol.This is shown in the figure below:

Quantity

Price

Petrol

Quantity

Joint or complementary Demand

50
The figure indicates that the demand for petrol increased from OQI b to OQ2b as a result of a
rise in the demand for car from OQla to OQ2a.
Competitive Demand
This is the demand for goods which are close substitutes. Examples of such goods include:
meat and fish; tea and coffee; egg and beans; etc. An increase in the price of one will lead to
an increase in the quantity demanded of the other. Competitive demand for meat and fish is
shown in figure 2.5 below.

Price

Prlce

Quantity

Competitive Demand,
It is observed in the figure that an increase in the price of fish leading to a decrease in its
demand from DI DI to D2D2 has caused an increase in the demand for meat from D] DI to
D2D2.

51
 Study session 4
Price Elasticity of Demand, and Factors that Affect Elasticity of Demand
Introduction
Elasticity of demand is the degree of responsiveness (or reaction) of commodity to changes in
factor(s) that affect its demand. There are as many types of elasticity of demand as there are
many factors that affect demand. In other words, elasticity of demand can be discussed with
respect to each factors that affect demand. However, in this lecture, we will limit ourselves to
three types of elasticity of demand. These are explained in sections below.

Learning Outcomes of Study Session 4

At the end of this session, you should be able to:
4.1 Explain Price elasticity of demand
4.2 Elucidate cross elasticity of demand
4.3 Explain income elasticity of demand.
4.4 Discuss elasticity of demand
4.5 Explain the factors that affect elasticity of demand

4.1 Price Elasticity of Demand

Price elasticity of demand is the degree of responsiveness of quantity demanded to changes
in price. There are five ways in which demand for a particular good respond to changes in its
price. They are:

Perfectly Inelastic:
This is a situation when changes in price have no effect on quantity demanded of a good, as
shown in fig. 2.1

Fig. 2.1: Perfectly Inelastic Demand.

52
In fig. 2.1, it can be seen that at the original price P O, the quantity demanded is Q0. But, as
the price falls (or increases) from P O to PI, (or P2) the quantity demanded remains constant at
Q0.In this case, the coefficient of price elasticity of demand is Zero, i.e Ed = 0.

Fairly Inelastic Demand:

This is a condition in which a change in price lead to a less than proportionate change in
quantity demanded. In this case, the coefficient of price elasticity of demand is less than
unity, i.e Ed< 1. It is shown in figure 2.1 below:

Fig 2.1: Fairly inelastic Demand

Fig. 2.1 shows that the increase in quantity demanded is less than the fall in price of the
commodity.

Unitary elastic Demand:

This is a situation in which change in price will cause an equal proportionate change in
quantity demanded of a commodity. In this case the coefficient of price elasticity of demand
is Unity, i.e., Ed = 1. It is depicted in the figure 2:2 below

Quantity

53
Fig. 2.2: Unitary elastic Demand

Fig. 2.2 shows that change in price has led to an equal proportionate change in quantity
demanded.

Fairly Elastic Demand

In this situation a change in price will cause a more than proportionate change in quantity
demanded of a commodity. Here, the coefficient of price elasticity of demand is greater than
unity, i.e., Ed > 1. It is shown in fig. 2.9 below:

Fig. 2.3: Fairly elastic Demand

In fig. 2.3, it can be seen that a fall in the price of commodity from P 0 to P1 has led to a more
than proportionate increase in the quantity demanded Qo to Q1. The change in quantity
demanded is greater than the change in price.
Perfectly Elastic Demand:

Here, a small change in price lead to a very large (or far greater) change in quantity
demanded of a commodity. In this case, the coefficient of price elasticity is infinity, that is,
Ed = ∞ .
See fig. 2.4 below:

Price

54
 Qi Quantity

Fig. 2.4: Perfectly Elastic Demand

Fig. 2.4 shows that a very small increase (or decrease) in price will cause a very large fall (or
rise) in quantity demanded of the commodity. Note that the change in price is so small that it
cannot be shown on the figure.

Coefficient of elasticity of demand

The coefficient of elasticity of demand can be calculated by using two formulae as indicated
below:
(1) Ed = Percentage change in quantity demanded Divided by percentage change in price where:
Ed Coefficient of price elasticity of demand.
(2) Ed =∆ QD ÷∆ P
Q0P0

Where:

Ed = Coefficient of price elasticity of demand

∆ QD = Change in quantity demanded measured as QI- Q0
Q0 =Initial (or first) quantity,
Q1 =Later quantity
∆ P= Change in price measure as P1 – P0;
P0 = Initial (or first) price and
P1 = Later price.

Example l
Given that when the price of one bag of maize was N40.00, ten bags were purchased. But
when the price was raised to N60.00 the quantity purchased of maize fall to six bags.
Calculate the price elasticity of demand.

Solution

55
(l) Using the first formula
Q0 = 10
Q1 = 6
Change in quantity is

∆ Q = Q1 – Q0
= 6- 10 = -4

Thus, percentage change in quantity is:

% ∆Q = ∆ QD x
Q

= -4x100
10

% ∆Q = -4

Hence, percentage change in price is

% ∆P = ∆ P x 100
Po

= 20 x 100
40

% ∆P = 50

Therefore, price elasticity of Demand in this case is

Ed =% ∆Q
% ∆P

= -40
50

= -0.8 < 1

Interpretation: The absolute value of the coefficient (0.8) is less than unity. Thus, demand is
inelastic. The presence of' minus (-) sign attached to the coefficient of elasticity shows
thenegative relationship between price and quantity demanded of' the commodity.

(2) Using the second formula:

P0 = 40
p1 = 60
56
Also,

∆ P = P1 – P 0
= 60 - 40 = N20:00
Q0 = 10
Q1 = 6
= 6-10

⸫ ∆ Q1 – Q0 = 6-10
∆Q ∆ P
Thus, Ed =
Q0
÷
P0

−4 40
= 10 ÷ 20

−4
= 5

∴ ED = -0.8 < 1

The Demand is inelastic

The calculations above showed that using any of the formulae will give you the same result.

Other Types of Elasticities of Demand

(a) Income Elasticity of Demand:

Income elasticity of demand is the degree of responsiveness (or reaction) of change in
quantity demanded to change in income. The coefficient of income elasticity of demand can
be computed by using any of the following formulae:
EY = (
%∆Q
%∆Y )
Where:
Ey = Income elasticity of demand
%∆ Q = percentage change in quantity demanded measured by
Q1 Q0 X 100
Q0
∆ Q = Q1 – Q0
% ∆Y = percentage change in income measured by
Y 1−Y 0 X 100
yo
∆ y = y1 –y0
57
 Q0 = Initial quantity
Q1 = Later Quantity
y0 = Later income
y1 = Later income
∆Q ∆Y
(i) Ey = ÷
Q0 Y 0

Example 1:
The monthly income of a clerk was increased from N200.00to N250.00 due to his promotion
in his of office while his demand for gari rose from 10 mudus to 15 mudus.
a. Compute the coefficient of income elasticity of demand
b. Interpret the result.

a. Q0 = 10 (given in the question)

Q1 = 15 (given in the question)
⸫∆ Q = Q1 – Q0
= 15 – 10
⸫∆ Q = 5

( Q1−Q 0 ) X 100
Hence; %∆ Q =
Q0

( 15−10 ) X 100
=
10

5 X 100
=
10
⸫%∆ Q = 50

( Y 1−Y 0 ) X 100
%∆ Q =
Q0
= (250-200) x 100
200
= 50x100
200
⸫%∆ Q = 25
Ey = 50
25
Therefore, Ey =2.0.

The income elasticity of demand is more than unity.

Thus, it is elastic

(c) The goods are substitutes since the coefficient of cross elasticity is positive.

58
If the coefficient of cross elasticity is negative then the goods are complementary.

In-Text Question (ITQ) 4.1

List 3 way in which demand for particular goods respond to change in its price.
In-Text Answer (ITA) 4.1

 Perfectly inelastic demand

 Fairly inelastic demand
 Unitary elastic demand
 Fairly elastic demand
 Perfectly elastic demand

4.2 Determinants of Price Elasticity of Demand

Different people react different to changes in price as a result of their differences when their
preference is compared. Thus elasticity that measures how people react to changes in price
through changes in their demand for such product can be view as measuring human behavior.
Though consumers have differing preferences but they are unified sometimes by some
common principles which can be seen as determinants of demand elasticity. For instance,
income of consumers, habit and uses of a commodity etc. are common factors just like factors
that determine elasticity of demand. The various degrees of reaction of demand to changes in
price above have fundamental determinant. These include:

Availability of Substitutes

Availability of substitutes for a commodity is one of the most apparent factors that can affect
its demand elasticity. The closer the substitute the more elastic will be the commodity. For
example if price of close-up tooth paste went up, if the prices of other tooth pastes like Dabur
herbal, MyMy tooth paste, Maclean, oral B, Pepsodent tooth pastes remain the same; then
they are cheaper than close-up. Consumer will shift easily to any of the other tooth pastes.
Hence the demand elasticity of close-up will be very elastic such that a little increase in price
will drive down the quantity demanded for it rapidly.

Consumers’ Income/Price of the Commodity

The higher the income of the consumer the more inelastic his demand for goods will be.
Thus, a richer person reacts less violently to changes in prices of goods and serice than the
poorer.
On the other hand, poorer people react more sharply to changes than the richer ones.
Thus, poorer people have elastic demand for goods and services.

59
The larger the amount of consumer’s income a commodity will consume the more elastic the
demand for such commodity. On the other hand, the smaller the amount of consumer’s
income a commodity consumes the less elastic its demand. Take for instance if there is
increase in the price of chewing gum sweet which people seldom takes up, its price increase
may have little response to quantity demanded as people would not mind to buy because its
price is small and its takes negligible part of consumers’ income compare to buying a car for
instance. In essence, consumers are likely to be responsive to a hike in car price such that
quantity demanded will fall. By implication demand for car is elastic because buying a car
will consume larger part of consumers’ income, thus any increase in price that will increase
what it will consume from consumers’ income will lead to a fall in demand for car.

Consumer’s habit

People that are addicted to some product consumed out of their habit which ‘die hard’ are
another factor that can determine demand elasticity. Smokers and drunkards who consume
cigarette and alcohols out of habit will not budge from buying their brands despite increase in
price. As such, elasticity of demand for these products will be inelastic.

Nature of the commodity

Commodities which are necessities have inelastic demand since consumer cannot do without
them. E.g demand for food items. How important a commodity is determines its elasticity;
the grater it’s uses the more its price elasticity. For example, ginger powder is not only use
for soup seasoning, but can be included in jollof rice, fried rice, beans porridge, oat meal,
yam porridge and can even be added to black tea, green tea or used to make pure ginger tea.
For these alternative uses it can be put to, its demand becomes very elastic. Increase in price
of ginger may lead to decrease in quantity demanded.

In-Text Questions (ITQ) 4.2

List 3 determinants of elasticity of demand

In-Text Answer (ITA) 4.2

 Availability of substitute
 Consumers’ income/price of the commodity
 Consumers habit
 Nature of the commodity

4.3 Importance of Elasticity

Previous sessions detailed on responsiveness of demand as well as supply to changes in price.

However, you would have noticed that price is not the only determinant having discussed
other determinant factors either under demand or supply. We have been able to establish that
elasticity is a measure of how responsive a variable is to a change in the other variable. Also,
60
we have seen from different calculations under demand and supply that the more elastic a
product is, the more the market will respond to changes in its price, quantity demanded or
supplied. Therefore we shall look at two factors that can also affect the demand curve. One is
the responsiveness of quantity demanded to income and two, responsiveness of demand for
one product when there is a change in price of another product –substitute or complimentary
goods.

Income elasticity of demand

Income elasticity of demand is the percentage change in quantity demanded as a result of

percentage change in households’ income. When the income elasticity of a product is less
than one, it is an indication that household consumption of the product does not increase
despite the increase in households’ income. To measure income elasticity of demand, we
divide percentage change in quantity demanded by the percentage change in income. The
formula is given below:

Income elasticity of demand =

Cross elasticity

Cross elasticity of demand is used to measure the percentage change in quantity demanded of
one product when there is a change in the price of another close product. For this reason it is
sometimes referred to as cross-price elasticity of demand. For example, if the price of X
increases and the quantity demanded of Y decreases; it indicates that X and Y are
complimentary goods. In this case, cross-price elasticity will be a negative figure. A good
example of complimentary goods is bread and butter. If the price of bread increased by 7
percent which led to 4 percent decrease in demand for butter, then cross-price elasticity of
demand will be:
Cross elasticity of demand =

Cross elasticity of demand =

Cross elasticity of demand = -0.57

In contrast, if the increment in price of X causes the quantity demanded of Y to increase, it
indicates that X and Y are substitutes. In this case cross elasticity of demand will be
positive. Example of substitute goods is butter and margarine, if the price of margarine

61
increased by 10 percent and the quantity demanded of butter increased by 2 percent then we
have:
Cross elasticity of demand =

Cross elasticity of demand =

Cross elasticity of demand = 0.2

In-Text Question (ITQ) 4.3

Income elasticity of demand is explained as ----------
In-Text Answer (ITA) 4.3
Income elasticity of demand is explained as the percentage change in quantity demanded as a
result of percentage change in households’ income.

Summary of study session 4

In study session 4, you have learned that:
1. Elasticity of demand is the degree of responsiveness (or reaction) of commodity to
changes in factor(s) that affect its demand.
2. There are as many types of elasticity of demand as there are many factors that affect
demand. In other words, elasticity of demand can be discussed with respect to each
factors that affect demand.
Self-Assessment Questions (SAQs) for Study Session 4
Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.

Self-Assessment Question 4.1 (Test Learning Outcome 4.1)

List the various degrees of elasticity of demand, and explain two of them.

Self-Assessment Question 4.2 (Test Learning Outcome 4.2)

The monthly income of a clerk was decreased from N400.00 to N350.00 due to his demotion
in his of office while his demand for gari falls from 20 mudus to 15 mudus.
Compute the coefficient of income elasticity of demand, and interpret it.

Self-Assessment Question 4.3 (Test Learning Outcome 4.3)

List the determinants of elasticity of demand, and explain any two of them.

Glossary of terms
62
Income
Income is money that individual or business receive in exchange for providing labour,
producing a good or service or investing capital.
Consumer
A consumer is a person or group who intend to order, or use purchased goods, product, or
services, primarily for personal, social, family, household and similar needs who is not
directly related to entrepreneur or business activities.

Elasticity
Elasticity is a term used to describe a change in the behaviour of buyers and sellers in
response to a single variable like a change in price or other variable for a goods or service.

References/Further Reading

Hakes, D. R. (2004). Study Guide for Principle of Economics. In Makwin, G. N. (Ed.).

United State of America: Thomson Southwester.

Awodun, M. O. (2000). Economics: Microeconomics Theory and Applications. Chapter 7 &

8.

Obafemi, F. et al. (2005). Principles of Economics. Lagos: El-Sapphire Ltd.

Case, K. E. & Fair, R. C. (1999). Principles of Economics. New Jersey: Prentice Hall.
Possible Answers to Self-Assessment Exercise(s)

1. List the various degrees of elasticity of demand, and explain two of them.
2. The monthly income of a clerk was decreased from N400.00 to N350.00 due to his
demotion in his of office while his demand for gari falls from 20 mudus to 15
mudus.Compute the coefficient of income elasticity of demand, and interpret it.
3. List the determinants of elasticity of demand, and explain any two of them.

1. List the various degrees of elasticity of demand, and explain any two of them.
The various degrees of elasticity are:
i. Perfectly inelastic,
ii. Fairly Inelastic Demand
iii. Unitary elasticity
iv. Fairly elastic
v. Perfectly elastic

Fairly Elastic Demand

63
In this situation a change in price will cause a more than proportionate change in quantity
demanded of a commodity. Here, the coefficient of price elasticity of demand is greater than
unity, i.e., Ed > 1. It is shown in fig. 2.9 below:

Fairly elastic Demand

In the figure above, it can be seen that a fall in the price of commodity from P 0 to P1 has led
to a more than proportionate increase in the quantity demanded Qo to Q1. The change in
quantity demanded is greater than the change in price.

Perfectly Elastic Demand

Here, a small change in price lead to a very large (or far greater) change in quantity
demanded of a commodity. In this case, the coefficient of price elasticity is infinity, that is,
Ed = ∞ .

See figure below:

Price

Qi Quantity

Perfectly Elastic Demand

The figure above shows that a very small increase (or decrease) in price will cause a very
large fall (or rise) in quantity demanded of the commodity. Note that the change in price is so
small that it cannot be shown on the figure.

64
2. The monthly income of a clerk was decreased from N400.00 to N350.00 due to his
demotion in his office while his demand for gari falls from 20 mudus to 15 mudus.
Compute the coefficient of income elasticity of demand, and interpret it.

Q0 = 20 (given in the question)

Q1 = 15 (given in the question)
∆ Q = Q1 – Q0 = 15 – 20
∆ Q = -5

( Q1−Q 0 ) X 100
Hence; %∆ Q =
Q0

( 15−10 ) X 100
=
10

5 X 100
=
10
⸫%∆ Q = 50

( Y 1−Y 0 ) X 100
%∆ Q =
Q0
= (250-200) x 100
200
= 50x100
200
⸫%∆ Q = 25
Ey = 50
25
Therefore, Ey = -2.0.

The income elasticity of demand is more than unity. Thus, it is elastic

3. List the determinants of price elasticity of demand, and explain any two of them.
The determinants of price elasticity of demand are
i. Availability of substitutes
ii. Consumers’ Income/Price of the Commodity
iii. Consumers Habit
iv. Nature of the commodity

Any two of them

Consumer’s habit
People that are addicted to some product consumed out of their habit which ‘die hard’ is a
factor that can determine demand elasticity. Smokers and drunkards who consume cigarette
and alcohols out of habit will not budge from buying their brands despite increase in price.
As such, elasticity of demand for these products will be inelastic.

65
Nature of the commodity
Commodities which are necessities have inelastic demand since consumer cannot do without
them. E.g demand for food items. How important a commodity is determines its elasticity;
the greater its uses the more its price elasticity. For example, ginger powder is not only use
for soup seasoning, but can be included in jolof rice, fried rice, beans porridge, oat meal, yam
porridge and can even be added to black tea, green tea or used to make pure ginger tea. For
these alternative uses it can be put to, its demand becomes very elastic. Increase in price of
ginger may lead to decrease in quantity demanded.

Study Session 5

Theory of Supply
Concept of Supply, Factors That Affect Supply, and Types of Supply
Introduction

Relationship between price and quantity demanded is referred to as demand. The opposite of
this is what is known as supply. The relationship between the price and quantity of a good
offered to the market for sale is known as supply. In the last section, discussion on quantity of
commodity demanded and factors that can reduce or increase quantity demanded by
households are discussed. The effects of price on the demand curve known as ‘movement on
the demand curve’ as well as the effects of other factors which are known as ‘the shift on the
demand curve’ were explored. Similarly under this unit, a link between supply and price;

66
supply curve and factors that can cause a movement on the curve and or a shift on the curve
shall be discussed.
Price of the commodity is the first factor considered to be a major factor that can affect
supply while other factors are held constant. However, we have seen from the discussion on
supply and supply curve that these factors do change too. When these occur the focus
changed from movement along the supply curve to a bodily shift in the supply curve. This is
for supply curve, there are other factors aside price that can affect supply curve such as cost
of production, change in production techniques, change in price of factor of production, price
of alternative goods, price and future expectation, number of buyers and sellers. How each of
these factors affects the supply curve is discussed below.

Learning Outcomes of Study Session 5

At the end of this session, you should be able to:

5.1 Explain the concept of supply
5.2 Elucidate on supply schedule
5.3 Explain supply curve.
5.4 Explain factors of supply
5.5 Explain Abnormal Supply

5.1 What is Supply?

What is supply?
Supply is a fundamental economic concept that describes the total amount of a specific
good or service that is available to consumers.

When the price of a commodity is high may be as a result of the demand for it, which
informed the firm’s decision to produce more. Then the quantity supply to the market will
increase. Firm’s decision to increase number of output of the product requires that the firm
put in additional input. These additional inputs shall increase the firm’s cost of production.
For instance, increase in wages to the labor for overtime work to meet the targeted number of
output and other cost on factor of productions. Therefore, consumers should be ready to buy
at the new price if the firm is to supply outputs that will meet their market demands. The
increase in price however indicates that the firm which has incurred additional cost of
production should have additional profit. Consequently, firm shall be encouraged to produce
more so as to earn more profit. As a matter of fact, firm may have to prioritize such product
for production while less profitable product may suffer for it. Supply is defined as quantity of
commodity a producer is able to produce and willing to sell at a given price in a given place
at a particular point in time. Meanwhile, as prices fall in the market; may be as a result of
oversupply by many firms who wants to make more profit while meeting the market demand;
then supply will fall. This is known as the ‘Law of Supply’. The higher the price the higher
the quantity supplied, the lower the price the lower the quantity supplied.
67
In-Text Question (ITQ) 5.1
State the Law of supply

In-Text Answer (ITA) 5.1

“An increase in the price of goods or services results in an increase in the quantity that
suppliers make available to the market”.

5.2 Supply Schedule

Supply schedule is the tabular presentation of quantities and their prices at various levels.
Look at the example below.
Table 1.1: Quantity Supplied of tubers of Yams and Their respective Prices
Price per tuberNo. of tubers
(N) Supplied

10 20
20 35
30 48
40 50
50 63

The supply schedule above showed that at the price or N 1 0.00, the quantity of yams
supplied is 20 tubers. But, as the price increases to N20.00, N30.00 and to N 50.00, the
quantity of yan1S supplied rose to 35, 48, and 63 tubers respectively.

Supply Curve

This supply schedule can be translated to supply curve as below. The relationship between
quantity supplied and prices shown in a supply schedule can be graphically presented with
price on the vertical axis and quantity supplied on the horizontal axis.

Price

20

68
Fig. 1.1 An individual supply curve

That is quantity supplied of a commodity is represented in a graph known as supply curve. In

short supply curve is a graphical representation of supply schedule. A graphical
representation showing the relationship between price and quantity supplied of a good at a
particular point in time is called supply curve. A supply curve may be individual firm supply
curve or a market supply curve

In-Text Question (ITQ) 5.3

Explain supply schedule and supply curve

In-Text Answer (ITA) 5.3

Supply schedule is the tabular presentation of quantities and their prices at various levels
while supply curve is the graphical representation of the relationship between quantity
supplied and prices shown in a supply schedule, presented with price on the vertical axis and
quantity supplied on the horizontal axis
5.4 Factors That Affect Supply
Price of the Commodity
Producers generally tend to sell more quantity of a good when its price rise and vice versa.
This is shown in the figure 1.2 below.

Price

30

28

25

20

15

0 400 500 600 700 800 Quantity

Fig. 1.2: Supply Curve of Beans (Monthly)
Joining together the points f, g, h, i, j, and k will produce an upward sloping supply curve.
The curve is upward sloping because when the price is too high, only then will firms be
69
willing to produce more to make more profit. Meanwhile, a fall in price make consumption
easier and many consumers shall be willing to buy the product then the firm will reduce
supply and the market supply will fall.

5.5 Other factors that affect Supply

Cost of production
Change in input price, government policy, organizational change may lead to higher cost of
production for a firm. Higher cost of production may bring down the profit of the firm. Hence
a cut back on such product due to higher cost of production. This will reduce the quantity the
firm can supply to the market and will shift the supply curve to the left.
Change in production techniques
Method of production is essentially affected by technological advancement. Therefore
technological advancement changes the technique or method with which products are
produced. Efficient technique will readily increase supply of the product. In contrast,
inefficient method of production will reduce production capacity and in turn the quantity that
can be supply to the market.
Change in price of factors of production
Any increase in cost of factors of production such as wages to labour, rent to land, and high
cost of input factor such as raw material will increase the overall cost of production and
reduces quantity to be produced thereby supply will fall.
Prices of alternative goods
If the price of substitute goods falls as a result of fall in cost of productions, rise in its prices
which make it become more profitable or as a result of fall in its raw materials; then the
producer will increase the supply of the substitute good because it will be more profitable.
Thereby there would be increase in supply of substitute good while the first commodity
which it can be substituted for will fall in supply.
Numbers of buyers and sellers
Entrance of new firms into the industry will increase quantity supply to the market. While
exit of some firms from the market may be as a result of closing down that line of business by
such firms or they foresee cheaper input factors for substitute and a higher profit; will reduce
supply to the market.

5.6 Abnormal Supply

Abnormal supply is a situation in which a fall in the price of a commodity lead to increase in
the quantity supplied of the commodity. On the other hand, speculation about increase in
price of a commodity may lead to a fall in supply to the market as the firm stockpile and
increase supply after the speculation becomes a reality. Again, the firm may increase
production in other to increase quantity supply and take advantage of the new price increase
speculated. This is shown in the figure below.
70
 Price

(N)
S
90

70

50

30

10
S

0 5 15 25 35 45 quantity supply

Fig. 1.3: An Abnormal Supply Curve

In fig. 1.3 above, it can be seen that the supply curve slopes downward from left to right,
indicating that there is a negative (inverse) relationship between the price and quantity
supplied of the particular good. This is not in line with the supply law. The basic explanation
for this relationship is the fact that sellers will sell more and more and get more income.
Thus, he would prefer to sell more quantity of the good only if its price falls.

In-Text Question (ITQ) 5.6

1. List 5 factors that affect supply

2. Abnormal supply curve is defined as-------------
In-Text Answer (ITA) 5.6
1. Factors that affect supply
 Numbers of buyers and sellers
 Prices of alternative goods
 Change in price of factors of production
 Change in production techniques
 Cost of production
2. Abnormal supply is a situation in which a fall in the price of a commodity lead to
increase in the quantity supplied of the commodity.

Summary of study session 5

In study session 5, you have learned that:

71
 1. When the price of a commodity is high may be as a result of the demand for it, which
informed the firm’s decision to produce more. Then the quantity supply to the market
will increase. Firm’s decision to increase number of output of the product requires
that the firm put in additional input.
2. Supply schedule is explained as tabular presentation of quantities and their prices at
various levels, and supply curve is explained as the relationship between quantity
supplied and prices shown in a supply schedule which can be graphically presented
with price on the vertical axis and quantity supplied on the horizontal axis.
3. Abnormal supply was explained which is a situation in which a fall in the price of a
commodity lead to increase in the quantity supplied of the commodity.

Self-Assessment Questions (SAQs) for Study Session 5

Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.

Self-Assessment Question 5.1 (Test Learning Outcome 5.1)

State the law of supply

Self-Assessment Question 5.2 (Test Learning Outcome 5.2)

Explain how price and supply of a particular good interact.

Self-Assessment Question 5.3 (Test Learning Outcome 5.3)

Explain the term supply curve.

Self-Assessment Question 5.4 (Test Learning Outcome 5.4)

Explain how price and supply of a commodity interact.

Self-Assessment Question 5.5 (Test Learning Outcome 5.5)

Explain any three factors that supply.

Self-Assessment Question 5.6 (Test Learning Outcome 5.6)

With appropriate examples explain the concept of abnormal supply.

Glossary of terms
Supply
Supply is a fundamental economic concept that describes the total amount of a specific good
or service that is available to consumers
Production
Is the process in which various inputs such as land, labour, and capital are used to produce
the output in form of product or service.
72
References/Further Reading
Case, K. E. & Fair, R. C. (1999). Principles of Economics. New Jersey: Prentice Hall.
Obafemi, F. et al. (2005). Principles of Economics. Lagos: El-Sapphire Ltd.
Awodun, M. O. (2000). Economics; Microeconomics Theory and Applications. Chapter 7&8.

Possible Answers to Self-Assessment Exercise(s)

1. Explain how price and supplyof a commodity interact.
2. Explain any three factors that supply.
3. With appropriate examples explain the concept of abnormal supply.

1. Explain how price and supply of a commodity interact.

Supply of a commodity and its price interact positively. This is shown in the figure below.

Price

30

28

25

20

15

0 400 500 600 700 800 Quantity

Fig. 1.2: Supply Curve of Beans (Monthly)
Joining together the points f, g, h, i, j, and k will produce an upward sloping supply curve.
The curve is upward sloping because when the price is too high, only then will firms be
willing to produce more to make more profit. Meanwhile, a fall in price make consumption
easier and many consumers shall be willing to buy the product then the firm will reduce
supply and the market supply will fall.
2. Explain any three factors that supply.
There are many factors that affect supply. Some of them are:
Change in price of factors of production

73
Any increase in cost of factors of production such as wages to labour, rent to land, and high
cost of input factor such as raw material will increase the overall cost of production and
reduces quantity to be produced thereby supply will fall.

Prices of alternative goods

If the price of substitute goods falls as a result of fall in cost of productions, rise in its prices
which make it become more profitable or as a result of fall in its raw materials; then the
producer will increase the supply of the substitute good because it will be more profitable.
Thereby there would be increase in supply of substitute good while the first commodity
which it can be substituted for will fall in supply.

Numbers of buyers and sellers

Entrance of new firms into the industry will increase quantity supply to the market. While
exit of some firms from the market may be as a result of closing down that line of business by
such firms or they foresee cheaper input factors for substitute and a higher profit; will reduce
supply to the market.

3. With appropriate examples explain the concept of abnormal supply.

Abnormal supply is a situation in which a fall in the price of a commodity lead to increase in
the quantity supplied of the commodity or vice versa. In this case there is inverse relationship
between price and quantity of the commodity as shown in the figure below.

Price

(N)
S
90

70

50

30
74
 10

S
0 5 15 25 35 45 quantity supply

An Abnormal Supply Curve

In the figurel above, it can be seen that the supply curve slopes downward from left to right,
indicating that there is a negative (inverse) relationship between the price and quantity
supplied of the particular good. This is not in line with the supply law. The basic explanation
for this relationship is the fact that sellers will sell more and more and get more income.
Thus, he would prefer to sell more quantity of the good only if its price falls.

STUDY SESSION 6
Types of Supply and elasticities of Supply

Introduction
Commodities relate with one another in many ways. The relationship may be positive,
negative, or competitive. Supply of one commodity may/may not lead to the supply of one or
more commodities. In this unit we will explain how supply of commodities relate with one
another.

75
Elasticity of supply is the degree of responsiveness of quantity supply to changes in price.
Elasticity of supply is discussed with respect to all determinants of supply. But, in this unit
we shall concentrate on price elasticity of supply. Supply reacts to changes in price in many
ways.
Learning Outcomes of Study Session 6
At the end of this unit, you should be able to:
6.1 Explain types of Supply
6.2 Explain elasticities of supply

6.1 Types of Supply

Joint or Complementary Supply
This is the supply of two commodities from the same source. For example, the supply of Beaf
and skin from cow.
Competitive Supply
It is the supply of two commodities such that a rise in the production and supply of one leads
to a decrease in the production and supply of the other. For instance, an increase in the
production of beef will lead to a fall in the supply of milk. This is shown in the graph below.

Price

s,

Milk

Quantity

76
 Fig2.1 Competitive supply

Fig.2.1 showed that as the quantity supplied of beef increased from Q1a to Q2a, the supplied
of milk fall from Q1b to Q2b respectively.

Composite supply
This is the total supply of a group of goods which serve the same purposes. For instance, the
supply of a pair of' trouser, a pair of shoes, a part of shirt etc„ provide a composite supply of
clothing.

In-Text Questions (ITQ) 6.1

List 3 types of supply
In-Text Answers (ITA) 6.1
 Joint and complementary supply
 Competitive supply
 Composite supply

6.2 Price Elasticity of Supply

There are five degrees of price elasticity of supply, namely:
Perfectly Inelastic Supply
This is a condition when change in price has no effect on quantity supplied. That is, even
though price changes, quantity supplied remains constant. In this case the coefficient of price
elasticity of supply is zero that is Es = 0.This is shown in fig. 4.4 below.

77
Quantity
Fig. 2.2 Perfectly Inelastic Supply

Fig. 2.2 shows that even though price rise from P0 P2 or fall fromP0 P1 quantity supplied
remains fixed at Q

Fairly Inelastic Supply

This is the condition in which a change in price cause less than proportionate change in
quantity supplied, as shown in fig. 2.3 below. Here the coefficient of price elasticity of
supply is less that Unity, i.e Es < 1

Price

P2

P1

E<1

Q1 Q2 Quantity

Fig.2.3: Fairly Inelastic Supply

78
It can be seen from fig. 3.5 that the change in price P1, P2 is greater than the change in
quantity Q1 Q2.

Unitary Elastic supply:

Here, the change in price lead to equal proportionate change in quantity supplied.
Thus,coefficient of price elasticity of supply is equal to i.e. Es = 1. This is depicted in figure
4.6 below.

Fig.2.4: Unitary Elastic supply.

Fig. 2.4 above showed that the change in price P0PI, is equal to the change in quantity
supplied Q1Q2.

Fairly Elastic supply

This is the type in which a change in price leads to more than proportionate change in
quantity supplied. In this case, the coefficient of price elasticity of supply is greater than 1,
i.e. Es> 1.

Fig. 2.5: Fairly Elastic Supply.

79
Fig. 2.5 above indicated that change in quantity supplied Q1Q2 is greater than the change in
price P1P2.
Perfectly Elastic supply

This is a condition in which a small change in price lead to a very large change in quantity
supplied.

This is shown in fig. 2.6 below:

Price

Quantity

Fig. 2.6: Perfectly Elastic supply

Fig. 2.6 indicated that a small change in price leads to a very large change in quantity
supplied. Note that the change in price is so small that it cannot be shown in the graph.
In-Text Question (ITQ) 6.2
There are five degrees of price elasticity of supply, namely?
In-Text Answer (ITA) 6.2
 Perfectly inelastic supply
 Fairly inelastic supply
 Unitary elastic supply
 Fairly elastic supply
 Perfectly elastic supply

6.3 Determinants of Price Elasticity of Supply

Elasticity of supply is determined by two major factors namely:

80
(i) Time: In the very short period, supply is fixed and thus supply is inelastic. In the short-
run, supply of agricultural goods is fixed and hence their supply is perfectly inelastic. But
in the long-run, in which all factors are variable, supply is not fixed. Thus, supply is
elastic.
(ii) Cost of production/substitution: The ease with which one factor can be substituted for
another determined the elasticity of supply. If it is easy to substitute one factor for
another, then supply is elastic, and vice versa. Increase (decrease) in cost of production
can cause supply to change (or to be elastic).

In-Text Question (ITQ) 6.3

List 2 determinants of Price Elasticity of Supply
In-Text Answer (ITA) 6.3
 Cost of production/substitution
 Time

Summary of study session 6

In study session 6, you have learned that:
1. Elasticity of supply is the degree of responsiveness of quantity supply to changes in
price. Elasticity of supply is discussed with respect to all determinants of supply.

2. The types of supply were explained namely; joint supply, competitive supply, and
composite supply.

3. It is important to know that the nature of elasticity determines its name and hence, its
numerical value. When quantity supplied does not respond to changes in price, then
there is zero elasticity of supply or we say supply is perfectly inelastic. When the
percentage change in quantity supplied is equal to the percentage change in price, we
have unitary elasticity of supply. When the percentage change in quantity supplied is
less than the percentage change in price, we have inelastic supply but when the
percentage change in quantity supplied is greater than percentage change in price, it is
referred to as elastic supply. This is exactly opposite to inelastic supply.

Self-Assessment Questions (SAQs) for Study Session 6

Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.
81
Self-Assessment Question 6.1 (Test Learning Outcome 6.1)
With appropriate examples explain the concept of competitive supply.

Self-Assessment Question 6.2 (Test Learning Outcome 6.2)

With the aid of graphs, explain price elasticity of supply.

Self-Assessment Question 6.3 (Test Learning Outcome 6.3)

Explain the factors that affect Elasticities of supply

Glossary of Term
References/Further Reading

Awodun, M. O. (2000). Economics; Microeconomics Theory and Applications. Chapter 7&8.

Case, K. E. & Fair, R. C. (1999). Principles of Economics. New Jersey: Prentice Hall.
Obafemi, F. et al. (2005). Principles of Economics. Lagos: El-Sapphire Ltd.
Sloman, J. (2006). Economics. (6th ed). England: Pearson Education Limited.

Possible Answers to Self-Assessment Exercise(s)

1. With appropriate examples explain the concept of competitive supply.
2. With the aid of graphs, explain price elasticity of supply.
3. Explain the factors that affect Elasticities of supply

1. With appropriate examples explain the concept of competitive supply.

Competitive Supply
It is the supply of two commodities such that a rise in the production and supply of one leads
to a decrease in the production and supply of the other. For instance, an increase in the
production of beef will lead to a fall in the supply of milk. This is shown in the graph below.

82
 Price

s,

Milk

Quantity

Competitive supply

Fig.3.3 showed that as the quantity supplied of beef increased from Q1a to Q2a, the supplied
of milk fall from Q1b to Q2b respectively.

2. With the aid of graphs, explain price elasticity of supply.

Perfectly Inelastic Supply
This is a condition when change in price has no effect on quantity supplied. That is, even
though price changes, quantity supplied remains constant. In this case the coefficient of price
elasticity of supply is zero that is Es = 0.This is shown in fig below.

83
 Q Quantity
Perfectly Inelastic Supply

The figure above shows that even though price rise from P 0 P2 or fall fromP0 P1 quantity
supplied remains fixed at Q

3. Explain the factors that affect Elasticities of supply

The factors that affect elasticity supply are explain below
i. Time: In the very short period, supply is fixed and thus supply is inelastic. In the short-
run, supply of agricultural goods is fixed and hence their supply is perfectly inelastic. But
in the long-run, in which all factors are variable, supply is not fixed. Thus, supply is
elastic.
ii. Cost of production/substitution: The ease with which one factor can be substituted for
another determined the elasticity of supply. If it is easy to substitute one factor for
another, then supply is elastic, and vice versa. Increase (decrease) in cost of production
can cause supply to change (or to be elastic).

84
 STUDY SESSION 7

PRICE DETERMINATION

Market Equilibrium

Introduction

Market operation obviously depends on interaction between demand and supply. Under the
previous sections we have discussed some factors that determine each of them. We identified
factors that determines or influence the amount or quantity of a commodity that the
households as a consumption unit in the economy shall be willing to buy. Also we identified
and stated Factors other than price that influences firms’ decision on quantity to be supplied
to the market. It can be deduced from the discussion that market price play a predominant
role in determining quantity demanded and quantity supplied. Carefully, each unit i.e. the
households (consumption unit) and the firms (producing units) had been operating separately
in our line of discussion. However, this section will focus on how the interaction of the two
units in the market as a demanding unit and supplying unit determines the final market price

85
of a commodity. We shall also be discussing how one of the prevailing market conditions can
lead to the market equilibrium and the three market conditions shall also be discussed. This
interaction leads to price determination in a free perfect competitive market. If the consumers
are willing to buy more that is there is increase in demand in the market, it should follows
that producers shall be willing to produce and supply more to the market. In the short run, the
price may rise as the demand increase before the producers are able to increase supply. After
increased supply to the market and the market is flooded with the goods, price falls and
demand rises again as this will encourage buyers to buy more. Consequently, price
coordinates the quantity demanded and quantity supplied.

Learning Outcomes of Study Session 7

At the end of this unit, you should be able to:

7.1 Explain the usual prevailing market conditions
7.2 State what excess demand is
7.3 Explain what is referred to as excess supply
7.4 Explain market equilibrium.

7.1 Excess Demand

What is Excess Demand?

Excess demand is define as market condition that exists when quantity demanded exceeds
quantity supplied at the current market price.

When quantity demanded is greater than quantity supply then we have what is called
“shortage” or ‘excess demand’. This is one of the three market conditions, this condition
associated with limited supply can lead to a rise in price as consumers compete with one
another to have the limited supply. The rise in price may persist until the demand is equal to
supply in the market. Take for instance the supply of baby toy by a toy firms at #100 per unit.
The demand at that price was 40,000 units but that industry was able to supply 20,000 units.
The excess demand situation led to a rise in price of baby toy per unit from #100 to #175. The
rise in price in turn led to a fall in demand because buyers dropped out of the market. Perhaps
the consumers are looking for alternatives to baby toys or its substitutes that are likely to be
cheaper. This can be represented in a graph as presented in Figure 1.1.

86
 Fig. 7..1: Excess Demand

From the above graph, there was a rise in price of baby toy per unit as a result of excess
demand by consumers. The price went up from #100 to #175. The toy firms supplied 20,000
units and the demand for this product is 40,000 units. Note that at 30,000 units, the new price
is #175; this is the market determined price. At 30,000 units, demand for the baby toy is equal
to its supply. As consumer leave the market due to high price, this situation continues until
the shortage is eliminated at the new market price where demand fall from 40,000 to 30,000
at the current market price of #175. In the same vein, supply increased from 20,000 to 30,000
units per year. The point at which the demand and the supply curve intersect each other i.e. at
30,000 units and #175 per unit is known as the equilibrium point. Equilibrium point is the
point at which there no more natural tendency for further adjustment. At this point (from the
above graph) demand is equal to 30,000 and supply is also equal to 30,000. Before the
equilibrium point, demand was 40,000 and supply was 20,000. However at the equilibrium
price and units; there is neither shortage nor surplus. Any time there is shortage or surplus as
a result of a shift in the demand or supply curve, a new equilibrium will be form after a while.

In-Text Questions (ITQ) 7.1

Excess demand is define as----------

In-Text Answer (ITA) 7.1

Excess demand is define as market condition that exists when quantity demanded exceeds
quantity supplied at the current market price.

7.2 Excess Supply

When the quantity demanded; for a commodity; by the households is less than the quantity
supplied by the firm then we have excess supply. Excess supply is the opposite of excess
87
demand. It is the second market condition that usually prevails in the market. Excess supply
is a market condition where quantity supplied exceeds quantity demanded at the current
market price. When this occurs, the price of the goods falls and become cheaper because
consumers can get more than they needed of the goods. A fall in price will force firms to
reduce their supply to the market. Then quantity demanded will rise until it is equal to
quantity supplied and equilibrium price is achieved. For example table water industry in
Nigeria usually supplies 500,000 tons of bottled table water at #70 per bottle. This year, there
have been excessive rains such that there are few sunny days. Demand for bottled table water
fell drastically to 200,000 units. The firms were forced to reduce supply to the market due to
a fall in price from #70 to #40. As more firms reduce quantity supplied to the market, supply
also fall. Fall in quantity demanded and quantity supply meet at a new price and the figure for
quantity supplied and quantity demanded is 300,000 at #40 per bottle. Let see these
diagrammatically (Figure 1.2).

D S

# Excess SS
70
Equilibrium

200 300500

Fig. 7.2: Excess Supply of Tons of Bottled Table Water

The equilibrium point reached after a fall in quantity supplied has shown below has 300,000
tons of bottled table water at the current market price of #40. This point is where quantity
demanded is equal to quantity supplied at a figure that stood at 300,000 tons of bottled table
water. This price was reached after a fall in supply as a result of surplus in the market. This
condition changes as soon as there is a movement along the demand or supply curve
producing another equilibrium point.

In-Text Questions (ITQ) 7.2

What is excess supply?

88
In-Text Answer (ITA) 7.2
When the quantity demanded; for a commodity; by the households is less than the quantity
supplied by the firm then we have excess supply

7.3 Market Equilibrium

In the previous section, movement along the demand curve when plotted with the supply
curve depicted the excess or shortage in the market when quantity supply is less than quantity
demanded. We have seen how this market condition has led to increase in price and exit of
some consumer from the market until the quantity supplied equals to quantity demanded.
Also, we have seen another market condition where quantity supplied is more than quantity
demanded. This has led to a decrease in price of the commodity and a reduction in the supply
until the quantity supplied equals to quantity demanded. All these have to do with movement
along the demand and the supply curve. Under this section we shall be looking at how
quantity supply or quantity demanded cause a shift in their curves and how this will affect the
equilibrium point. Remember market will be at equilibrium when quantity supply is equal to
quantity demanded. Let look at the case of cocoa supply by Nigeria. Let assume that Nigeria
is number one producer of cocoa in the world such that any reduction in Nigeria supply to the
world market is enough to affect the equilibrium of cocoa market and the price of cocoa in
the world market is affected. The cocoa market was at an equilibrium price of say $5 and
equilibrium quantity of 950 billion pounds. Unfortunately something happened in Nigeria
that affected cocoa harvest so much that the world price of cocoa was affected due to low
supply. The new price now stood at $10 and the supply to the market is 650 billion pounds of
cocoa. Shortage in the market shifts the cocoa supply curve from right to left- S0 to S1. When
there is shift in the supply curve then there will be a movement along the demand curve. Also
when there is shift in the demand curve then there would be a movement along the supply
curve.
The above scenario is depicted in Figure 1.3.

D
S1
$10

$5 S0
Initial
equilibrium
Excess demand

89

330 650 950

Billion pounds of cocoa

Fig. 1.3: Shift in the Supply Curve

Figure 1.3 Illustrates how Nigerian supply of cocoa to the world market has affected the
equilibrium in the market. Initially, the market was at equilibrium price of $5 and the demand
was equal to supply at 950 billion pounds. But inability of the highest producer to supply
large quantities as usual shifted the supply curve from the right S0 to the left S1. That is the
quantity supplied reduced from 950 billion pounds to 650 billion pounds. The shortage or
excess demand usually will lead to a rise in price and this happened. The current market price
at a new equilibrium is $10. Note that with a rise in price, the quantity demanded fall to 650
may be because consumers switch to consuming alternatives like coffee or black tea causing
a movement along the demand curve. Note also that at the new equilibrium, there is still
excess demand if cocoa’s price remains at $5.

Assuming that it was demand for Nigeria cocoa that rise leading to excess demand, there
would be shortage in the market. When this happened, a rise in price would follow as well as
a shift in the demand curve. From the graph below, note a movement along the supply curve
in response to the increase in the demand for cocoa. The initial equilibrium where demand
equals to supply was at a point where demand curve D0 intersect supply curve S. At that
point, the current market price was $5 and quantity demanded and supplied was 330 billion
pounds of cocoa. However increase in demand rose to 650 billion pounds and there was
additional increase in supply in order to take advantage of the higher price i.e. the new
equilibrium price occurs where the demand curve D1 intersect the supply curve S. The new
equilibrium price is $10 after a shift in the demand curve from D0 to D1. The area labeled E
is the excess demand or shortage which the market supply cannot take care of. The new
market demand figure is 950 billion pounds and only 650 billion pounds of cocoa was
supplied at the new equilibrium. Therefore there is shortage in supply as the consumer
demand for additional 300 billion pounds of cocoa (This figure is obtained by deducting the
650 from the 950 billion pounds after the second equilibrium).

90
 D0 D1
S

P
R $10
I
E
C $5
E

330 650
Quantity in Billions of pounds

Fig. 1.4:Shift in the Demand Curve

The fundamental way of interaction between the forces of supply and demands is
unambiguous. We shall quickly go through how these forces work through various examples
diagrammatically. Then one can appreciate the beauty of studying economics through our
day-to-day dealings and economic activities. For instance, if we read in the paper that Ogun
state government mechanized farm is to increase supply of yam tubers to the market by 40
per cent, one can expect a fall in the price of yam. If Kano state announced that excessive rain
this year has affected tomatoes’ harvest by 30 per cent, it is expected that tomatoes’ price will
rise. If association of cow dealers or national association of road transport workers should go
on strike, a hike in cow meat and transport prices are expected to rise. Therefore, carefully go
through the graphs and understand each and every one of them.

Increase in income Y: Increase in income Y:

X is a normal good X is an inferior good

D0
D1 S D1
D0 S
P

R P0
P1
I
P1
P0
C

Q0
Q1 Q 1
Q0 91
Quantity Quantity
Fig.1.5a: Different Shift in demand Curve

Decrease in income Y: Decrease in income Y:

X is a normal good X is an inferior good Increase in the price

D0
D0 S D1
D1 S
P

R P1
P0
I
P0
P1
C

Q1
Q0 Q 0
Q1
Quantity Quantity
Fig.1.5b: Different Shift in demand Curve
Increase in price of Substitute for X of complementary for X

D0
D1 S D1
D0 S
P

R P0
P1
I
P1
P0
C

Q 0
Q1 Q 1
Q0
Quantity Quantity

Fig.1.5c: Different Shift in demand Curve

Decrease in price of Decrease in price of

A substitute for X complementary for X

92
 D0
D0 S D1
D1 S
P

R P0 P1

I
P0
P1
C

Q1
Q0 Q 0
Q1
Quantity Quantity

Fig.1.5d: Different Shift in demand Curve

Increase in Cost of Decrease in Cost of Production of X

S0
D S1 S1
D

P S0

R P1 P0

I
P1
P0
C

Q 1
Q 0

Quantity Quantity
Fig. 1.6: Different Shift in Supply Curve
Production of X

Numerical Example

93
Given the Demand function as Qd = 154/3 P and the supply
function as Qs = 5+2/3 P.
a. Find the equilibrium price and
quantity.
b. Show the result geometrically.
Solution
(a) At equilibrium Qd = Qs

Collect like terms

2
= 15-5 = + 1/2P
3

= 10 = P
= 1 5 1/3 (10)
: - Qd = Q s
10 10
= 15 =5+
3 3
1 2
= 15 3 = 5 + 6
3 3
2 2
= 11 = 11
3 3

Quantity

In-Text Question (ITQ) 7.3

Market Equilibrium can be define as----------------------
94
In-Text Answer (ITA) 7.3
“A market is said to be at equilibrium when quantity supply is equal to quantity demanded
and as a result prices become stable”.

Summary of study session 7

In study session 7, you have learned that:

1. There are three conditions - the excess demand market condition, excess supply
market condition and market equilibrium condition.
2. A movement along the demand curve is when the demand curve remains unchanged
but there is a shift in the supply curve. Shift in the demand curve to the left means a
fall in demand and to the right means a rise in demand.
3. A movement along the supply curve is when supply curve remain unchanged but
there is a shift in the demand curve. Shift in the supply curve to the left means a
decrease in supply and a shift towards the right means increase in supply.
4. A decrease in demand will lead to a fall in price while an increase in demand usually
will lead to a rise in price. A decrease in supply will lead to a rise in price (opposite of
what happened when there is a decrease in demand). An increase in supply will bring
the price down (opposite of what happens when there is increase in demand). Shift in
the demand curve or shift in the supply curve will shift the equilibrium price and
quantity to a new equilibrium price and quantity.

Self-Assessment Questions (SAQs) for Study Session 7

Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.

Self-Assessment Question 7.1 (Test Learning Outcome 7.1)

Farmers in Nigeria usually produced 100,000 bushels of soya beans per year at a market
price of #50. The demand for this year is 150,000, calculate the excess demand for the Soya
beans.

Self-Assessment Question 7.2 (Test Learning Outcome 7.2)

What do you think will happen to the supply curve of bread if the demands for bread remain
the same and the supply of bread is increased?
95
Self-Assessment Question 7.3 (Test Learning Outcome 7.3)
What is market equilibrium?

Glossary of Term

References/Further Reading

Awodun, M. O. (2000). Economics: Microeconomics Theory and Applications. Chapter 7 &

8.

Case, K. E. & Fair, R. C. (1999). Principles of Economics. New Jersey: Prentice Hall.

Hakes, D. R. (2004). Study Guide for Principle of Economics. Makwin, G. N. (Ed.). United
State of America: Thomson Southwestern.

Obafemi, F. et al. (2005). Principles of Economics. Lagos: El-Sapphire Ltd.

Possible Answers to Self-Assessment Exercise(s)

1. Farmers in Nigeria usually produced 100,000 bushels of soya beans per year at a market
price of #50. The demand for this year is 150,000,calculate the excess demand for the
Soya beans.
3. What do you think will happen to the supply curve of bread if the demands for bread
remain the same and the supply of bread is increased?
4. What is market equilibrium?

1. Farmers in Nigeria usually produced 100,000 bushels of soya beans per year at a
market price of #50. The demand for this year is 150,000, calculate the excess
demand for the Soya beans.

1. The excess demand is calculated as:

EDD = DD - SS
= 150,000 – 100,000
= 50

96
2. What do you think will happen to the supply curve of bread if the demands for
bread remain the same and the supply of bread is increased?
The supply curve of bread will shift to the right. This is shown in figure below.
Increase in Cost of Decrease in Cost of Production of X

S0
D S1 S1
D

P S0

R P1 P0

I
P1
P0
C

Q 1
Q 0

Quantity Quantity
Different Shift in Supply Curve
As can be seen from fig. 3.6, the supply curve shifted from SoSo to S1S1 (the right hand
panel)

3. What is market equilibrium?

Market equilibrium is a condition in the market in which demand is equal to supply. This is
shown in the figure below.

Quantity
97
Market Equilibrium.
In the figure, market equilibrium is at where demand curve intersect supply curve.

STUDY SESSION 8
Prices Ceiling and Price Floor
Introduction

So far we have seen how price is determined in the equilibrium through the interaction
between the force of demand and supply in a free market. These interactions sometimes lead
to movement along the demand or supply curve and sometimes it might lead to a complete
bodily shift of either the demand or supply curve. However, in a free market economy, there
98
is sometimes government interference in the market especially regarding price determination
in certain market. Why do governments interfere in the determining prices in some market
and how does the government go about it? These questions are answered by the discussion on
price ceiling and price floor under this unit.
Learning Outcomes of Study Session 8

At the end of this unit, you should be able to:

8.1 Explain why government interfere in the market price determination

8.2 Highlight how government interfere in the market
8.3 Explain price ceiling and understand price floor.

8.1 Price Ceiling

Price ceiling also referred to as Upper Price Limit occurs when the government set a
maximum price that can be charged for a product in the market. For instance, if 20,000
students wanted to enroll for B.Sc. Public Administration at the Nasarawa State University
Keffi (NSUK), the university is in the habit of admitting 14,000 per semester and may be
willing to admit the 20, 000 students at a fee of N60, 000 per student. The federal government
directive is that NSUK should accommodate 17,000 students. It means there would be a
shortage of 3,000 students. Fourteen thousand (14,000) students are below the ceiling of
17,000 students that NSUK will admit. The ceiling in the market has no effect. However,
when NSUK admits 17,000 students then the ceiling becomes effective because this figure
becomes the new equilibrium figure and it must not go beyond this limit. Let apply this to
market price of B.Sc. at NSUK. If the cost of enrolment for B.Sc. Economics is N40, 000, the
fees can rise to N60, 000 if NSUK is to admit up to 20,000 students. The federal government
therefore places a price ceiling on the school fees at N50, 000 if NSUK is to admit up to
17,000 students. The price ceiling of N50, 000 has no effect if NSUK admits only 14,000
students with N40, 000 school fees. This is because the N40, 000 is less than the ceiling at
N50, 000. However if 17,000 students were admitted at school fees of N50, 000 per student,
then there will be shortage (3,000 will not be admitted) due to price ceiling. The equilibrium
price of NSUK of N60, 000 is above the price ceiling of N50, 000 (Figure 2.1).

99
 D S
D S
Fees Limit Fees

50,000 60,000

Shortag

14, 000 17,000

20,000 Students
Equilibrium Price is below Equilibrium Price above
is
the Ceiling- No Effect the Ceiling
- Ceiling is

Fig.2.1: Price Ceiling Graph

8.2 Price Floor

Price floor is the direct opposite of price ceiling. This is when the government interferes in
the market by setting a minimum price that can be charged on a particular product or
services. Let us take a look at a hypothetical price floor on chicken in Lagos state. The
government discovered that demand for chicken per day run up to 2 million chickens at a
control price of N5 per chicken. The equilibrium price of chicken is N7 in the chicken market
is greater than the minimum price of N5. Hence the effect of price floor or minimum price is
not felt. Meanwhile the government has increase the minimum price of chicken to N10.
Consequently the demand for chicken decreased to 1.7 million chickens per day. The
minimum price has effect in the market because demand for 0.3 million chickens could not be
met, thereby creating shortage in the market (Figure 3.8).

Summary of study session 8

In study session 8, you have learned that:
1. Price ceiling or upper price limit is when a maximum price at which a product should
be selling in the market is set by the government as a control price. The opposite of
price ceiling is price floor. Price floor or lower price limit occurs when the
government set a minimum price at which a product should be selling in the market.

100
 The mechanism of price determination through forces of demand and supply in a free
market is interjected by intervention.
2.

Self-Assessment Questions (SAQs) for Study Session 2

Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.

Self-Assessment Question 8.1 (Test Learning Outcome 8.1)

Differentiate between price ceiling and price floor

Glossary of Term

References/Further Reading

Case, K. E. & Fair, R. C. (1999). Principles of Economics. New Jersey: Prentice Hall.

Friedman, D. D. (1990). Price Theory: An Intermediate Text.: South-Western Publishing Co.

Sloman, J. (2006). Economics. (6th ed.). England: Pearson Education Limited.

Welch, P. J. (2009). Economics: Theory and Practice: Wiley Publisher.

Possible Answers to Self-Assessment Exercise(s)

1. Differentiate between price ceiling and price floor

1. Differentiate between price ceiling and price floor

Price ceiling occurs when the government set a maximum price that can be charged for a
product in the market. It is the maximum above which seller is not allowed to sell his or her
commodity. It happens when there is shortages of goods and services.
Price floor is when the government interferes in the market by setting a minimum price that
can be charged on a particular product or services. It is the minimum price below which seller
is not allowed to sell. It happens when there is excess supply of goods and services.

101
 STUDY SESSION 9

THEORY OF PRODUCTION AND RELATED CONCEPTS

Factors of Production, Production Process and Cost Concepts

Introduction

Consumers aim at maximizing his satisfaction given his income and market prices of goods
and services. In the same vein, a firm aims at maximizing profit given the available economic
resources as input and method of converting the inputs into goods and services that will
satisfy consumers’ want.In the same vein, households usually employ factors of production in
many different ways and different transformation. So also is the firm. However it is worth to
note that basic economic problems discussed in the first module on “what to produce and
how much to produce” was answered through demand (what to produced is determined by
what people wants) and supply (how much to supply is determined by how much is
produced). Now we want to see how another basic economic problem on how to produce will
be solve by production theory.
This firm needs to identify and determine the availability of inputs for the above grocery,
soft drinks and other household products in its line of business as well as identify the
technology it will require to maximize profit and minimize cost of production. Therefore,
theory of production is an analysis of how inputs (factors of production) are combined
efficiently by firms and entrepreneurs for the purpose of obtaining output (end product
known as goods or services). Consequently, we’re moving into studying firm’s behavior just
like we studied consumer’s behavior. What inform firm’s decision on how to produce are
basically available technology and inputs. This unit also describes basic factors of
production and production process. It also explicates on production process and how
different inputs are combined under different production method.
This unit describes basic factors of production and production process. It also explicates on
production cost.

Learning Outcomes of Study Session 9

At the end of this unit, you should be able to:

9.1 Identify factors of productions

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9.2 State their specific contribution to process of production
9.3 Explain production functions
9.4 Discuss the role of firm and entrepreneur in productivity.
9.5 Enumerate cost concepts and their definitions
9.6 Differentiate between total cost schedule and cost curve schedule
9.7 Explain marginal cost and average cost relationship
9.8 Discuss short-run and long-run average costs relationship.

9.1 Key Concepts in Production

Inputs

Basically, they are resources used in production process; these are factors of production i.e.
land; labour, capital and entrepreneur.

Fixed and Variable Factor

Factors of production which cannot be varied in the process of production are referred to as
fixed factors. While those factors that can be varies in accordance with the availability of raw
materials is called variable factors. Example of fixed factor includes building, machinery,
land etc while that of variable factors includes labor, working capital, raw materials etc.
Output

Transformation of factor of production into goods and services that are used in satisfying
consumer’s want is referred to as output.

Firm

A technical outfit that engages in efficient transformation of input (factors of production) into
output (goods and services). For instance, a bread bakery factory will combine land, labor,
machines, raw materials like flour, sugar and other factors of production to engage in bread
Entrepreneur

A person who manage and or own a firm; who also assume risk of operating and organizing a
business outfit is referred to as entrepreneur.
The Short-run

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 This is a period of time in production process when changes in variable factors of production
determines the firm’s output while one or more of the firm’s input is fixed.
The Long-run

This is a period of time in production process when all factors of production are varied that is
no fixed factor. Increase in all factor of production is required to increase the firm’s output.

9.2 Factors of Production

There are four factors of production, namely:
A. Land
B. Labor
C. Capital
D. Entrepreneur

A. Land:
Land refers to all resources provided by nature. They include stones, hills, valleys, trees,
grasses, rivers, sky, sunshine, liquid and solid minerals, etc. Characteristics of Land include:
i. It is immobile: land cannot be moved from one geographical area to another.
ii. It is fixed in supply: The quantity of land can neither be increased nor decreased.
iii. It is the gift of nature: No man has contributed to the existence of land. It is provided by
nature alone.
iv. Its value varies with location: Lands in the urban areas are costlier than those in rural
areas.
v. Its uses: It provide the site necessary for production and the raw material used for
production.
vi. Its reward: The reward for land is called rent, which is the money paid for the use of a
piece of land.
vii. It is subject to the law of diminishing returns (see section 4.4) of this chapter.
viii. It is heterogeneous: No two pieces (or plot) of land are the same in value or in contents.
ix. Its value always appreciates.

B. Labor:

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Labor is defined as human effort, both physical and mental, used in production for a reward.
This "human" aspect of labor makes it distinct from other factors of production. Labor is
characterized by:
i. It is mobile: Labor can move from one area to another and from one occupation to
another. For instance, a primary school teacher can be transferred from rural to urban
primary school or vice versa. On the other hand, a lecturer in economics may decide to
resign and take up appointment as a banker.
ii. The supply of labor is not fixed: A worker can be influenced to increase or decrease his
services by the rate of payment. The higher the rate of payment, the more the number of
hours (or days) a worker will put into work, and vice versa. On the other hand,
unemployment and underemployment can diminish knowledge overtime and hence
lead to reduction of labour.
iii. The reward for labor: The reward for labour is wages or salaries.
iv. The role of labour: It controls other factors of production to make them more useful to
the society.
v. It is heterogeneous: labour exist in three forms namely: unskilled, semi-skilled and
skilled labour,
vi. The quality of labour can be improved by education, training, etc.
vii. It is not inheritable viii. It can be transformed from one form to another.
C. Capital:
Capital is a resource used for further production of goods and services. It is man-made wealth
used to produce other goods and services. They include: cash, machines, raw materials,
buildings, semi-finished goods, etc. Capital is characterized by:
i. It is heterogeneous: It exists in different forms, namely: fixed capital like buildings,
machineries, floating capital such as cash at hand; floating capital, including motor
vehicles, etc; and social capital like roads, schools, etc.
ii. It can be transformed from one form to another: For example, car can be converted to raw
cash by selling it.
iii. It is mobile: factory building in Abuja can be moved to Kaduna by selling it and used the
money to build the same or similar factory in Kaduna.
iv. It is inheritable.
v. Its reward is called interest,

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vi. It is subject to depreciation. The value of capital can reduce overtime.

(D) Entrepreneurship

It is the combination of the other factors of production with the view to accept risk and
benefitsof production.

Thus, an entrepreneur is the person who decides what to produce, organizes and coordinates
other factors of production in order to produce goods and services. They include: farmers,
traders, shareholders, etc. Entrepreneurship is characterized by the following:

i. It is mobile: It can be changed from one area or occupation to another.

ii. It is heterogeneous: There are different forms of entrepreneurship, including: Managers,
investors, etc.
iii.It organizes and controls other factors of production.
iv.The reward for entrepreneur is profit.
In-Text Questions (ITQ) 9
Identify 2 factors of production
In-Text Answer (ITA) 9
 Land
 Labour

9.3 Production Function

Production is a process of transforming input (factor of production) into output (goods and
services) that satisfy human wants. When the inputs are economically and efficiently
combined given the available level of technology, a relationship between input and output is
established. This relationship could be described as production function. Therefore,
production function is the minimum quantity of physical input required to produce efficiently
a certain level of output. Production function is a function of available technological level,
land, labour, equipment and other factors of production of a firm. New development in
technology, training that enhances labor’s efficiency and other improvements on other factors
of production usually will lead to a new production function. Let consider traditional farming
system in Nigeria, 20 laborers may be working on a piece of land for 3 days to clear the land;
pack the cut grasses and make heaps for planting cassava. In developed country like America
or Britain, a mower or farm tractor will clear the grass and pack it off the piece of land within
one hour. Another farm machine will assist in planting the cassava. These two farm machines
need two operators and may be one supervisor. The task which takes three days in Nigeria is

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taken one day in another country. The two methods are part of production function of
cassava. One is labor-intensive and the other is capital-intensive. Given the available inputs
and the production function; it is assumed that both farms will produce at maximum level of
output.

In-Text Question (ITQ) 9.3

Production function is defined as---------

In-Text Answer (ITA) 9.3

Production is a process of transforming input (factor of production) into output (goods and
services) that satisfy human wants.

9.4 Description of Basic Factors in Production

Defining some basic concept in production may lead to better understanding of production
process. They are as follows:

Total output (TO): this is the total amount of output produced from combination of certain
inputs with a particular production technology.

Total revenue (TR): Overall sum of revenue generated from total product sold (Q x P).

Total cost (TC): overall sum of total fixed and variable costs incurred in the production
process (TFC +TVC).

Average product (AP): this is the average amount of product produced by one unit of a
variable factor of production or total product from the input divided by the amount of input
employed to produce that total product.

Marginal Cost: a change in total cost of production that results into one unit change in
output.

Marginal product (MP): marginal product is the additional product to total product resulting
from additional use of one unit of variable input. For instance if initial total product of wallet

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was 10, however the firm raised the total product by 3 by incurring more cost on one of the
variable input. Then the MP is 3.

Fixed Cost (FC): these are cost that varied not with the firm’s total product. For instance,
cost of all fixed assets in the ice-cream factory per unit of output of ice-cream. It is usually
spread over the unit of output and it‘s remain constant.

Average Fixed Cost (AFC): total fixed cost (TFC) divided by total output (TO) will give us
AFC (TFC/TO).

Average Cost: total cost divided by total output (TC/TO)

Variable Cost (VC): Costs inquire in the production process that varies with the quantity
produce.

Total Variable Cost (TVC): costs incurred by the firm that varies with the firm’s total
product.

Average Variable Cost (AVC): this is obtained by dividing the variable cost at a particular
production output by the output at that point (TVC/TO).

Profit: the different between the total revenue minus total cost is known as profit. Profit is
the reward to an entrepreneur.

Total Cost Schedule and Cost Curve: A table showing the units produced and the amount
of fixed and variable costs input into its production at different output depict the Total cost
schedule. While a Table showing average fixed cost, average variable cost, average cost and
marginal cost depicts the Cost schedule (see an example of a Total Cost Schedule and Cost
Curve Tables 1.1 and 1.2).

Table 1.1: Hypothetical Total Cost Schedule

UNITS TOTAL FIXED TOTAL TOTAL

COST (TFC) VARIABLE COST COST
(TVC) (TC)=TFC+TVC

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0 150 7 157
1 150 15 165
2 150 18 168
4 150 52 202
6 150 97 247
8 150 166 316
10 150 201 351
13 150 279 429
14 150 401 551
20 150 421 571

Table 1.2: Hypothetical Cost Curve

UNITS AVERAGE AVERAGE AVERAGE MARGINAL

FIXED VARIABLE COST COST (TVC
COST COST (TC/TO) of unit 2- TVC
of unit
(TFC/TO) (TVC/TO)
1(next- tvc of
unit 3-tvc of
unit 2 in that
order))
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0 ∞ -7 ∞ -7
1 150 7.5 157 8
2 75 4.75 82.5 3
4 37.5 8 42 34
6 25 12.13 34 49
8 18.75 16.6 30.88 69
10 15 15.46 31.6 35
13 11.54 19.93 27 78
14 10.71 20.05 30.64 122
20 7.5 27.55

Note: TO is equal to quantity, ‘q’. Therefore, instead of saying that AVC = TVC/TO,
it can be rewritten as TVC/Q. Ditto for other formula.

In-Text Question (ITQ) 9.4

1. List 4 Basic Factors in Production
2. Discuss the differences between total cost schedule and cost curves
In-Text Answer (ITA) 9.4
1. Average product (AP): this is the average amount of product produced by one unit of
a variable factor of production or total product from the input divided by the amount
of input employed to produce that total product.
Marginal product (MP): marginal product is the additional product to total product
resulting from additional use of one unit of variable input. For instance if initial total
product of wallet was 10, however the firm raised the total product by 3 by incurring
more cost on one of the variable input. Then the MP is 3.
2. Total Cost Schedule and Cost Curve: A table showing the units produced and the
amount of fixed and variable costs input into its production at different output depict
the Total cost schedule. While a Table showing average fixed cost, average variable
cost, average cost and marginal cost depicts the Cost schedule

9.5 Production process

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Outputs are produced by certain number of input combined under different methods
of
Fig. 1.1: Total Fixed Costs (TFC) and Total Variable Cost (TVC)
production. These input as earlier mentioned are the factors of production. The higher

600
TC
500

400
Cost
300 Total Cost

200
Variable Cost

150

Fixed Cost
q
1 2 3 4 5 6 7 8

The cost of factors of production to be input into the production function the higher
will be the cost of production. If productivity is very high, quantity needed to produce
a certain output will be small thereby cost of output shall be reduced. Let examines
the relationship between all cost concepts derivable from a typical Cost Curve. We
shall begin with a diagrammatical representation of the Total Fixed cost and Total
Variable Cost.
Next, we shall look at the relationship between Average Cost and Marginal cost. What
happens when Average Cost –AC is below, equal to or above Marginal Cost-MC? Three
closely related links had been identified in the literature:

1. When MC <AC, it pulls AC down

2. When MC>AC, it pulls AC up and
3. When MC=AC, AC remains constant.

The third relationship usually occurs at the bottom of the U-shaped AC curve. That is where
minimum AC is achieved in the production process (Figure 1.2).

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 90 AC

80
AV
70
Cost
60
B
50

40

30 AFC

20
q
1 2 3 4 5 6 7

Total Output
Fig. 1.2: Average Cost and Average Revenue Curves

The above graph shows that while AC was declining MC was below AC for the first five
units while. That is a falling AC curve will satisfy the first relationship because MC curve
will be below AC curve. However, at exactly unit six, MC was equal to AC, which is at a
point where AC curve has fallen flat before rising. This is the AC minimum point. By
implication, rising MC curve is expected to intersect the AC curve at AC’s minimum point
denoted as point B from the graph above. And above unit six, MC will be above AC therefore
pulling AC curve upward. In the long run, the entrepreneur has several plants and can choose
any point on the long run average cost to increase his profit. If he thinks that point A as
shown in the graph below is the point at which the unit cost could be reduced by increasing
the output quantity. However, if output at point B becomes profitable and desirable as a result
of change in demand; then entrepreneur could easily reduce unit cost and make more profit.

SAC
4
SAC
1
3
A
B
SAC2

C
D

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 Unit of Output

Fig. 1.3: Long Run Average Cost Curve

Note that unit cost of production is reduced at point B, however expanding to produce at
point C lowers the unit cost further on plant with Short Run Average Cost-SAC2.
Meanwhile, as production scale become larger due to plant expands, cost of producing a
unit of output decreases further and the minimum cost of producing a unit is achieved at
point D. where SAC3 touched Long Run Cost curve-LAC.
Conversely, any further increase in plant’s size will push the cost of production upward
such that the cost of producing a unit of output increases. Production at the tangent
between SAC4 and LAC reveal upward unit cost of production.
Summary of study session 9
In study session 9, you have learned that:
1. The basic concepts are basically four- the input, output, firm and the entrepreneur.
The input refers to all the factors of production such as land, labour, capital and
entrepreneur. Each of them has their specific reward for partaking in the production
process. Output is the final product that is the goods and services from the production
process. Firm engages in efficient transformation of input to output with the decision
on how to achieve that resting on the entrepreneur. The decision maker and controller
of production process are referred to as entrepreneurs. Process of transforming input
to goods and services (output) that can satisfy human’s want is known as production
function.
2. Under this unit, we have discussed on process of production, some basic concepts in
production process; units produced and the amount of fixed and variable costs input
into its production at different output was presented under the Total Cost Schedule
while the relationship various cost concepts were examined under Cost Curve. Costs
related to production incurred on the input which are factors of production are good
consideration under production process.
3. Therefore, we discussed on total cost schedule that shows unit product given a certain
fixed and variable cost. In the same vein we discussed on cost schedule which
detailed average fixed cost, average variable cost and marginal cost at each level of
production. In addition, the relationship between short run average cost and marginal
cost were also examined. This shows the effect of additional variable cost in the
process of production on the average and marginal costs. Relationship between
Average cost and Marginal cost was examined with the implications on the firm’s
profit. When Marginal cost is less than Average Cost –AC it pulls AC up, when MC
is above the AC, it pulls the AC upward and before the MC rise above AC it will be
equal to AC at a point. Different plants available to a producer in the long run were
shown under the relationship between short run and long run average cost. In the long
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 run, when all factors are varied the short run average costs cuts the long run cost
curve at it minimum.
Self-Assessment Questions (SAQs) for Study Session 9
Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.

Self-Assessment Question 9.1 (Test Learning Outcome 9.1)

List all factors of production and briefly explain one.

Self-Assessment Question 9.2 (Test Learning Outcome 9.2)

What is production function?

Self-Assessment Question 9.3 (Test Learning Outcome 9.3)

Differentiate between Total Cost Schedule and Cost Curves.

Self-Assessment Question 9.4 (Test Learning Outcome 9.4)

Show graphically the relationship between Total Fixed Cost and Total Variable Cost.

Self-Assessment Question 9.5 (Test Learning Outcome 9.5)

Graphically show where minimum AC is achieved in the production process.

Glossary of Terms

References/Further Reading

Alfred, M. (1961). Principle of Economics. (9th ed.). New York:

Macmillan.
Sloman, J. (2006). Economics. (6th ed.). England: Pearson Education Limited.
Case, K. E. & Fair, R. C. (1999). Principles of Economics. New Jersey:
Prentice Hall.
Obafemi, F. et al. (2005). Principles of Economics. Lagos: El-Sapphire Ltd.
Awodun, M. O. (2000). Economics: Microeconomics Theory and Applications. Chapter 7 &
8.
Edwin, M. & Gray, Y. (2000). Microeconomics: Theory and Applications. (10th ed.). New
York: Norton.
Hal, R. V. (2002). Intermediate Microeconomics: A Modern Approach. (6th ed.). New York:
Norton.
Samuelson, P. A. and Nordhaus, W. D. (2010). Economics. (9th ed.). New York: McGraw Hill
Companies.

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Possible Answers to Self-Assessment Exercise(s)

1. List all factors of production and explain one briefly.

2. What is production function?
3. Differentiate between Total Cost Schedule and Cost Curves.
4. Show with the aid of a diagram the relationship between long-run and short-run average
cost.
5. Below is a hypothetical Total Cost Schedule, calculate and fill in the missing figures.

1. List all factors of production and explain one briefly.

i. Land
ii. Labor
iii. Capital
iv. Entrepreneur

i. Land:
Land refers to all resources provided by nature. They include stones, hills, valleys, trees,
grasses, rivers, sky, sunshine, liquid and solid minerals, etc. Characteristics of Land include:
a. It is immobile: land cannot be moved from one geographical area to another.
b. It is fixed in supply: The quantity of land can neither be increased nor decreased.
c. It is the gift of nature: No man has contributed to the existence of land. It is provided
by nature alone.
d. Its value varies with location: Lands in the urban areas are costlier than those in rural
areas.
e. Its uses: It provide the site necessary for production and the raw material used for
production.
f. Its reward: The reward for land is called rent, which is the money paid for the use of a
piece of land.
g. It is subject to the law of diminishing returns (see section 4.4) of this chapter.
h. It is heterogeneous: No two pieces (or plot) of land are the same in value or in
contents.
i. Its value always appreciates.

2. What is production function?

115
Production function is the technical relationship between inputs and outputs. When the inputs
are economically and efficiently combined given the available level of technology, a
relationship between input and output is established. This relationship could be described as
production function. Therefore, production function is the minimum quantity of physical
input required to produce efficiently a certain level of output. Production function is a
function of available technological level, land, labour, equipment and other factors of
production of a firm.

3. Differentiate between Total Cost Schedule and Cost Curves.

Total Cost Schedule and Cost Curve: A table showing the units produced and the amount of
fixed and variable costs input into its production at different output depict the Total cost
schedule. While a graph showing average fixed cost, average variable cost, average cost and
marginal cost depicts the Cost schedule

4. Show with the aid of a diagram the relationship between long-run and short-run
average cost.
In the long run, the entrepreneur has several plants and can choose any point on the long run
average cost to increase his profit. If he thinks that point A as shown in the graph below is the
point at which the unit cost could be reduced by increasing the output quantity. However, if
output at point B becomes profitable and desirable as a result of change in demand; then
entrepreneur could easily reduce unit cost and make more profit.

Unit of Output

SAC
4
SAC
1
SACS
A AC 3
B
SAC2

C
D

Fig. 5.3: Long Run Average Cost Curve

116
Note that unit cost of production is reduced at point B, however expanding to produce at
point C lowers the unit cost further on plant with Short Run Average Cost-SAC2.
Meanwhile, as production scale become larger due to plant expands, cost of producing a unit
of output decreases further and the minimum cost of producing a unit is achieved at point D.
where SAC3 touched Long Run Cost curve-LAC.

5. Below is a hypothetical Total Cost Schedule, calculate and fill in the missing figures.

UNITS TOTAL FIXED TOTAL TOTAL

COST (TFC) VARIABLE COST COST
(TVC) (TC)=TFC+TVC

0 150 -7 150
1 150 ……. …….
2 150 18 165
4 ……. 52 168
6 150 ……. …….
8 150 247

STUDY SESSION 10

THEORY OF MARKET

Perfect Competition
Introduction

Firm’s decision on what to produce and how much to produce are usually to answer the
demand and supply question. Supply and demand are the two sides of the market which
makes market mechanism work through the price determination. However, type of available
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market structure usually influences firm’s behavior as regards pricing and output in order to
maximise profit. Under perfect competitive market that is a market structure where there
exists many buyers and sellers, we may look further into what price is the firm going to
charge, shall it be low or high price? What determines the firm’s profit? Is it small or large
profit? How will the firm’s decision affect the customers? Will the firm be producing
efficiently or at low or high level of output? Therefore, we shall take a look at the behavior of
the firm and perfect competitive market.

A perfect competitive firm that sells identical products sold by others in the industry is
defined as homogenous product. The size of this firm is small compare to its market.
Therefore, it cannot influence the market price. Thus, it becomes a price-taker. In that case,
what is the effect of this on the firm’s profit? Recall that firms aimed at maximizing profit
and this is achieved when marginal cost of the firm equals to its marginal revenue. When
there is no competition, a firm can influence the market price in order to maximise its profit.
However, when a firm faces competition from other firms in the industry producing the same
product, the firm is forced to become a price-taker thereby, keeping its price low as
determined by the market in order to survive in the competitive environment. Consequently,
discussions on perfect competitive market are based on assumptions that the firm is a profit
maximizing firm and small firms that are price-taker.

Learning Outcomes of study session 10

At the end of this unit, you should be able to:

10.1 Explain how perfectly competitive market behave

10.2 Discuss what determines the firm’s profit?
10.3 State assumptions of perfect competitive market
10.4 Explain short and long-run equilibrium of a firm in perfect competition market.

10.1 Perfect Competition

Basic Assumption of Perfect Competition
The input and output market operate dependently so also the firms and the households.
Decision of firms and households to buy and sell in the input and output markets determines
the quantity of supply and demand in these markets and hence the price of either input or
output. Examining the operation of the whole system shows different market structure of
which perfect competition is one. Classical Economists opined that assumptions underlying
perfect competitive market are far away from real life scenario. They are purely theoretical;
however they agreed that these theoretical assumptions can assist in better understanding of
the real world economy. Let us examine the assumptions one after the other.

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a. Large Buyers and Sellers
b. Homogenous Products
c. Free Entry and Free Exit
d. Perfect Factor Mobility
e. Perfect Knowledge of Market condition

Large Buyers and Sellers

In perfect competition or pure competition, assumption of large buyers and seller implies that
the size of each firm in comparison to the total market is small. This is ditto for individual
buyers in the market. Therefore individual buyers and sellers only buy or sell a tiny fraction
of the total exchange in the market place and by implication they have no discernible
influence on the market price, in other words they are pricetakers. Take for instance, there is
fewer bread factories compare to the total bread market itself. Retail bread sellers are usually
many compare to the bread producer. In the same context, bread consumers and buyers are
many and both sellers and buyers in the bread market have no influence on the price of the
bread. They are price-takers because the seller must sell N200 bread at that price and buyers
have no option to reduce the price. Any seller, who may attempt to sell such bread at a price
higher than N200, may be shown the way out of the market when demand for his own bread
fell below supply. Also there is no need to lower the price because buyers already have
information about the market price and may think such product is substandard.

Homogenous Products

Interaction between the demand and supply in a perfect competition market determines the
price of goods and market output; hence market players have no control over price. So also
there is no comparison between the products because they are identical. Flour that is an input
into bread production is identical; no buyer can differentiate whether it is from this producer
or that producer. There is no advertisement in the bread market therefore market product is
homogeneous. There is standardization in the market product.

Free Entry and Free Exit

In a perfect competitive market, the size of what a firm produce has no effect on the market
price. Other firms are free to enter into the market while any other firm is also free to exit the
market. Therefore no firm will dominate the market or influence price thereof nor drive other
firm away from the market through its dominance. Our bread factory is a good example; no
bakery can dominate the bread market as such, no bakery can evict any other bakery nor stop
another interested bakery from entering the bread industry. A bakery can decide to stop
production and its decision has no effect on the bread market. Another bakery willing to

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come into the bread market is as well free to do so. In essence, there is free entry and free exit
into a perfect competition market.

Perfect Factor Mobility

Factor of production mobility in a perfect competition market is another assumption in this

market. Resources such as land and labor are free to move among alternative uses. For
instance, labor can move between different jobs without any constraint if that will increase its
returns.
Bread factory worker is free to move from one factory to another if his returns will appreciate
by so doing.
Perfect Knowledge of Market condition

This assumption is the dichotomy between pure competition and perfect competition market.
That is when the first four assumptions hold, such market is pure competition. However,
when the five assumptions hold; then that market is a perfect competition market. For a
market to be perfectly competitive, producers and consumers must have perfect knowledge of
the market condition; that is such information about price. The producer must be aware of
latest price and market opportunities and adjust to the changing market conditions.
Consumers must be fully aware of not only price but also market supply of the product and
its quality. This is to avoid exploitation by any market player.

In-Text Question (ITQ) 10.1

List 3 basic assumption of perfect competition
In-Text Answer (ITA) 10.1
 Homogenous Products
 Perfect Knowledge of Market condition
 Perfect Factor Mobility
 Free entre and free exit

10.2 Short-Run Equilibrium of Perfect Competition

Demand and supply in the industry determines the market price, market output and firm’s
profit. Remember, firms are price-taker due to homogeneous products in the market.
Remember also that it is absurd for a firm to sell below or above the market price.
Consequently, a firm in the perfect competition market faces a perfectly elastic demand
because if its raises its price buyers who have perfect information on market condition will
not buy its product. Also if the firm lowers its price, it will affect its profit and market
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opportunity to sell at the current market price. Recall that under the discussion on demand
and supply in the previous sections we stated then that ‘the lower the price in the industry the
higher the demand; the higher the price the lower the demand’. As such, firms’ aggregate
market demand which is the industry’s demand curve is downward sloping because more will
be bought at lower price. Meanwhile, its supply curve is upward sloping. Therefore, short-run
equilibrium under perfect competition market is a period when there is too little time for
other firms to enter into the industry. Let examines the short-run equilibrium through the
demand and supply curve and through the marginal curve and marginal revenue curves as
shown below. Let assumes that a toy factory produce 10 units of toy a day and the total
market supply is 20000 units of toys per day. The toy is selling at N5 per one, if aggregate
supply is S and aggregate demand is D1 then there will be equilibrium in the market (Figure
1.1).

Price D1
S1

Initial
$5
equilibrium
Price .It is
same as
S1 Average
D1

1 2 4 6 8 10 12 14 16
20

Fig. 1.1: Market Equilibrium under Perfect Competition

A rise or fall in price of toy will cause a fall or rise in demand and supply thereby leading to
change in the equilibrium. Let assume that the price of toy rises from N5 to N10 and when
the price decreases, it moves from N5 to N2. How will this affect the equilibrium in the
market? How will the demand curve shift, where is the new equilibrium? What will happen to
the industry’s supply? Will there be a shift in the supply curve? (Figure 1.2).

121
 D2

Increase in demand led

Price D1
to rise in price, supply S
increases

N10

D3
N5

D
2

N2
Decrease in demand
led to fall in price,
supply decreases D1
D3

1 2 4 6 8 10 12 14 16 20

Quantity of Toy (in thousands)

Fig. 1.2: Shift in Supply Curve under Perfect Competition

Market works efficiently because of the assumption of perfect information which give
producers and consumers full knowledge of market price, product availability and other
opportunities in the market. From the above diagram, knowledge of increase in demand
from D1 to D2 by the producer push them to increase output so as to take advantage of a
new rise in price from N5 to N10 thereby there was a movement along the upward sloping
supply curve. In contrast, information about a fall in demand from D1 to D3 necessitated a
decrease in output produced by the firm. Thereby supply decreases and price fell.

122
Having assumed that firm’s objective is to maximize profit, at what level of output will a
firm maximize profit? Profit which had been defined earlier as the difference between a
firm’s total revenue and total cost can also be derived by taking the difference between
Average Marginal cost and Revenue (MC and MR). This approach to Profit Maximization
in perfect competition market is achieved at an output level where the difference Average
Marginal revenue is highest and Average Marginal cost is lowest. Remember that a firm
will increase output in the short run when demand moved from D1 to D2. At this juncture,
there would be a change in the total cost due to additional unit of output produced. In the
same vein, there would be change in total revenue due to increase in sale of that unit of
output. An efficient condition is that MC must intersect Demand D, Average Cost curve
from below and MC must be equal to MR. That is MC=MR=P (refer to Figure 1.3).

Price SMC

SATC

P0 c
P=MR=A

b
a

0 Quantity

Fig. 1.3: Profit Maximization under Perfect Competition

Excess or Supernatural Profit in Perfect Competition in Short-run

Price is not affected by the firm’s output which means the firm faces a horizontal demand,
consequently, marginal revenue MR will be equal to price P. This is the first order condition
which is a necessary condition for equilibrium that determines firm’s profit maximizing level
of output that is MC=MR. However, when MR>MC, there is room for output expansion by
the firm because additional or Marginal cost incur on increased unit of output is lower than
additional or Marginal Revenue. Hence firm’s profit can be increased. The area P0abc is the
area where firm earn excess or supernatural profit. Moreover the sufficient condition is that
the slope of MC should be greater than the slope of MR that is MC should be rising at it
intersect with MR (see the graph above). To the right of c above, MC continue to rise and till
it is greater than MR. Firm may need to reduce variable input employed as well as output

123
produced. Why do the firm needs to do this? The firm cannot make profit as soon as the ATC
is above the MR=AR (Figure 1.4).

Price SMC TC

a c

b
P=MR=A
P0

0 Q0 Quantity
Profit of a Perfect Competit Firm

Loss in Perfect Competition in Short-run

Area aP0bc represent the loss incurred by a firm in perfect competition market. The sensitive
question we must ask at this point is, should the firm continue to produce? If yes how long
can the firm continue to survive in the market? At point c, what the firm is earning is less
than normal profit i.e. loss. This point is known as loss minimizing point. However, the firm
may need to take its exit from the market at a point when the firm is unable to cover its TVC
i.e. when price is below the AVC. When average revenue is lower than average variable cost
and the firm is not able to pay for its fixed cost; then it is advisable for the firm to close
down. It can exit the industry because it makes no economic sense to continue in business.
Let show graphically (Figure 6.5) the above explanations.

124
 Price SMC SATC

SAVC

d
P0 c

SAFC

0 Q0 Quantity
Fig. 1.5: Close-down Point in Perfect Competition in
Short-Run

Point c is the close down point where the AVC is above P. the firm cannot neither cover its
AVC nor make payment for its fixed assets. It will maximize profit by shutting down. Point d
is the zero-profit point.

1.3.3 Long-Run Equilibrium of Perfect Competition

Continuation of Supernatural profit made by firm will encourage thus they can expand their
production capacity because all factors of production are variable in the long-run. This may
attract new firms who may want to share from the supernatural profit into the industry.
Whether the old firm increases production of the new firms comes into the industry to take
advantage of the excess profit, market supply curve will be affected. These actions and
decisions will increase market supply shifting the supply curve to the right. This in turn will
lead to a fall in price and firms in the industry make just normal profit because there is an
optimum allocation of resources among firm’s competing uses.

125
 SM

S0
Price Price SAC
LRA
D S1

P0 D=AR=M

P1

Quantity Quantity
Fig. 1.6: Long-Run Equilibrium of the Firm under Pe rfect
Competition

Summary of study session 10

In study session 2, you have learned that:

1. Perfect market assumptions include; having many buyers and sellers; homogeneous
product; free entry and exit and perfect market information. Supernatural or excess
profit earn by existing firm in the market in the short-run is shared with new firms
entry into the market in the long run. In the long-run, the market price is equal to the
firm’s long run average cost; this is where equilibrium is achieved in the long-run.

2. Competition of small firm having high-cost of production with large firm having low
cost of production due to economic of scale is an indication that new firm entering the
firm needs to be efficient to stay in business.

Self-Assessment Questions (SAQs) for Study Session 2

Now that you have completed this study session, you can assess how well you have achieved
its learning out comes by answering the following question. You can check your answer with
the Notes on Self-Assessment at the end of the sessions.

Self-Assessment Question 10.1 (Test Learning Outcome 10.1)

What are the basic assumptions of perfect competition?

Self-Assessment Question 10.2 (Test Learning Outcome 10.2)

126
Differentiate between normal and supernatural profit in a perfect competitive market.

Glossary of Terms

References/Further Reading

Sloman, J. (2006). Economics. (6th ed.). England: Pearson Education Limited.

Ojo, O. O. (2002). ‘A’ Level Economics Textbook for West Africa.
Ibadan: Onibonoje Press.
Samuelson, P. A. & Nordhaus, W. D. (2010). Economics. (19th ed.).
Singapore: -Hill International. McGraw.

Awodun, M. O. (2000). Economics: Microeconomics Theory and Applications. Chapter 7 &8.

Case, K. E. & Fair, R. C. (1999). Principles of Economics. New Jersey: Prentice Hall.

Obafemi, F. et al. (2005). Principles of Economics. Lagos: El-Sapphire Ltd.

Possible Answers to Self-Assessment Exercise(s)

1. What are the basic assumptions of perfect competition?
2. Differentiate between normal and supernatural profit in a perfect competitive market.

1. What are the basic assumptions of perfect competition?

The input and output market operate dependently so also the firms and the households.
Decision of firms and households to buy and sell in the input and output markets determines
the quantity of supply and demand in these markets and hence the price of either input or
output. Examining the operation of the whole system shows different market structure of
which perfect competition is one. Classical Economists opined that assumptions underlying
perfect competitive market are far away from real life scenario. They are purely theoretical;
however they agreed that these theoretical assumptions can assist in better understanding of
the real world economy. Let us examine the assumptions one after the other.

f. Large Buyers and Sellers

g. Homogenous Products
h. Free Entry and Free Exit
i. Perfect Factor Mobility
127
j. Perfect Knowledge of Market condition

2. Differentiate between normal and supernatural profit in a perfect competitive

market.

Profit is maximized where MC intersect MR Demand D, Average Cost curve from below
and MC must be equal to MR. That is MC=MR=P (refer to Figure 6.3).

Price
SMC

SATC

P0 c
P=MR=A

b
a

0 Quantity

Profit Maximization under Perfect Competition

However, when MR>MC, there is room for output expansion by the firm because additional
or Marginal cost incur on increased unit of output is lower than additional or Marginal
Revenue. Hence firm’s profit can be increased. The area P0abc is the area where firm earn
excess or supernatural profit. Moreover the sufficient condition is that the slope of MC
should be greater than the slope of MR that is MC should be rising at it intersect with MR
(see the graph above). To the right of c above, MC continue to rise and till it is greater than
MR. Firm may need to reduce variable input employed as well as output produced. The firm
cannot make profit as soon as the ATC is above the MR=AR (Figure 6.4).

128
 Price SMC SATCSA

a c

b
P=MR=A
P0

0 Q0 Quantity
Supernatural Profit of a Perfect Competitive firmFig. 1.4: Supernatural
ive Firm ive

129
 STUDY SESSION 11
Monopoly

Introduction

In the previous section, we discussed about perfect competition market and how perfect the
market is by examining the basic assumption with it benefit despite that the assumptions are
far from real world realities. Violation of one or two of the perfect competition market will
give birth to imperfect competition. For instance when firms are not just making decision on
output alone but also on the price; i.e. they are no more price-taker. Firms can change the
equilibrium price by increasing or decreasing output. In the same vein, monopolistic
competition firm’s product has no close substitute. That is there is only one firm in the
industry, thus the firm is large enough to affect market price of it output because of its ability
to enjoy economic of scale and its technological innovation that can drive growth in the long
run. However, this does not mean that the firm has absolute control over the price of its
product because it cannot control demand for its product. Understanding the modalities of
monopolistic competition may assist us in understanding the workings of modern industrial
economies. Monopoly, oligopoly and monopolistic completion are the major kinds of
imperfect competition.

Learning Outcomes of Study Session 11

At the end of this unit, you should be able to:

11.1 Define monopolist competition

11.2 Explain what determines price and output in monopoly market
11.3 State why firm leaves or enter monopoly market
11.4 Explain long-run equilibrium in monopoly
11.5 Compare perfect and monopolistic competition.

11.1 What is Monopoly?

Monopoly market is the type in which there is a single seller of a commodity which has no
close substitute. In a monopoly situation, the power of seller is limited only by the tastes and
incomes of consumers. The monopolist can influence the quantity and price of his product
in the market (but not both at the same time). Thus, monopolist is a price-giver. He can
increase or decrease the price or flood or starve the market of supplies of his good according
to his wishes.

130
If there is no new firms (rivals) who enter market Mid no drastic changes in and conditions
can occur, then the position of the monopolist becomes ABSOLUTE. Such a condition is
described as pure monopoly, and that is, one firm constitutes the industry and hence the
firm’s demand curve is the same as the market demand curve (which is downward sloping
from left to right.)

Characteristic of Monopoly market:

Monopoly market has the following characteristics:

i. Single Seller Many Buyers: The market has one seller but many buyers such that
the single seller can influence the price in the market.
ii. Different There are different prices at which the monopolist's product is bought
and sold and the monopolist can alter it.
iii. Entry Barriers: - There are various barriers to er y such as: patent right. copyright
etc.
iv. Imperfect Knowledge: - There is no perfect knowledge of market conditions by
the buyers. Profit
v. Profit maximazation:- The goal of monopoly firm is profit maximization.
vi. Perfect Immobility of Factors of Productions: There is immobility of factors of
production between firms, i.e. raw materials are monopolized by the suppliers and
labour is unionized.
vii. Government Regulation: - Sometimes there is government intervention such as:
tariffs, subsidies, etc.
As a result of the features above, the monopolist is a price-giver and hence has a downward
sloping demand curve (see fig.6.7).

In-Text Question (ITQ) 11.1s

List 3 characteristics of a monopolistic market
In-Text Answer (ITA) 11.1
 Imperfect Knowledge.
 Profit maximazation.
 Perfect Immobility of Factors of Productions

131
11.2 Price and Quantity Determination in a Monopoly Market
The price and quantity in monopoly market are fixed by the monopolist (but not both at the
same time) according to his wishes, Thus, the monopoly firm is price-giver, and faced with a
downward sloping demand curve. It sets price at the quantity level which will maximize
profits.

The monopolist maximizes his short-run profits if the following conditions are fulfilled:

1. If the MC is equal to the MR; and

2. If the slope of MC is greater than the slope of the MR9 at the point of intersection.
These are shown in fig. 6.7 below:

PRICE
COST

Fig. 2.1: Short-run Equilibrium of Monopoly Firm.

In fig,2.1, the equilibrium of the monopolist is at 'e' where MC curve cuts MR curve from
below. Thus, both Conditions for short run equilibrium are fulfilled. The profit maximizing
price is pi and the quantity is Qe. The excess profit of the monopolist is the shaded portion
which is equal to PO PI AB. Therefore, the profit is

II= TR TC

II = (OP1 X OQeOP0 X OP0 X OQe

The monopolist may be in breakeven position in which he is neither making profit nor
making loss.

In this case, the SAC' curve is tangential to the monopolist's demand curve as shown in fig.
2.2 below:
132
 Price and cost

Fig. 2.2: Short-run breakeven position of monopoly firm.

In fie. 2.2, it can be seen that the SAC curve is tangent to the SAR curve. This means that at
quantity 'Qe’ and Pe price the monopoly breaks even, indicating that it is neither making
profit nor making a loss. But. in a case where all the cost curves-SMC and SAC are above the
demand or short-run average revenue (SAR) curve. The monopoly firm will make loss, and
thus, it is better for it to close down. This is depicted in fig, 2.3

Price and
cost

133
 Price

LAR
Quantity

Fig.2.3: Monopolist with optimal plant and full capacity.

Fig. 2.3 above showed that the monopolist's plant is optimal and he is operating on a Pull
capacity. This is because all conditions for profit maximization are fulfilled. "that is:

(i) LMC = LMR

(ii) LAC cut LMR from below.
(iii) The slope of LMC is greater than the slope of LMR.

Thus. Pc is the equilibrium price while Qe is the equilibrium quantity.

Causes/Sources of Monopoly

Monopoly power can arise from various ways including the following:
(i) Natural causes: This type of monopoly power Wises as a result of the possession of land
containing natural resources like coal, gold, crude oil, or possession of natural skills and
talents, e.g. musicians ’dancers’ footballers, e.t.c
(ii) Licensing: This arises from government creation or permission through licensing laws. E.g.
laws permitting only NEPA to produce electricity in Nigeria.
p
(iii) Patent Laws: These laws confer a special privilege on a firm to protect its new
invention and prevent its competitors from entering the market
(iv)Merging of Producers: This will make them stronger to be able to eliminate other competitors
from the market.
(v) Level of Technology: When a producer developed a high-level technology which Makes
goods cheaper, it will force other competitors out of production.
(vi)Restriction on Entry to Certain Professions: Some professions like legal, accounting,
medical, etc. restrict entry by insisting on lengthy training, high entrance fees, etc.

134
(vii) Tariffs: When the government wants to allow monopoly power for producers of goods for
domestic market it usually imposes tariffs on similar imported goods to prevent their
importation.
Advantages of Monopoly
The advantages of monopoly include the following:
(i) Standardization: Standardization, which is the basis of cheaper production, is
better practiced under monopoly.
(ii) Centralized Management: There is effective and proper central management
under monopoly.
(iii) Economies of large scale production: Economics of large scale production is
possible under monopoly since it has no competitors.

(iv)Greater efficiency: There is greater efficiency resulting from an assemblage

or pool of specialized managerial skills.
(v) Better use of resources: resources available to a monopolist arc better
utilized to maximize production.

(vi)It leads to invention: Monopolists, in an attempt to have full control of the

market, do engage in intensive research, leading to inventions.
(vii)Avoidance of duplication: There is avoidance of duplication and waste often
associated with perfect competition, especially in the supply of social services.
(viii) Greater opportunity to expand operations: A greater opportunity to expand
operations because the uncertainty usually associated with a state of free
competition has been eliminated.

Disadvantages of Monopoly
The disadvantages of monopoly include the following:
(i) Danger of exploitation: Monopoly leads to exploitation of the consumers.
(ii) It leads to hoarding: The desire for supernormal profit by the monopolist may lead to
restriction in output thereby causing hoarding of the good (s).
(iii) Decline in efficiency: Absence of competition often leads to decline in efficiency.
(iv)Over production and waste: A monopolist may over produce, leading to wastage.
Loss of freedom of choice: There is a complete loss of freedom of choice by consumers.

135
In-Text Questions (ITQ) 11.2
List 4 disadvantages of Monopoly market.
In-Text Answer (ITA) 11.2
(v) Danger of exploitation: Monopoly leads to exploitation of the consumers.
(vi)It leads to hoarding: The desire for supernormal profit by the monopolist may lead to
restriction in output thereby causing hoarding of the good (s).
(vii) Decline in efficiency: Absence of competition often leads to decline in efficiency.
(viii) Over production and waste: A monopolist may over produce, leading to wastage.
Loss of freedom of choice: There is a complete loss of freedom of choice by consumers.

11.3 Long-Run Equilibrium in Monopoly

There is likelihood of rival firm coming in to the industry as a result of monopolist’s

supernatural profit. In order to distract new firms from entering the industry, a monopolist
may reduce price of a unit output. This action will protect monopolist long-run profit even if
that price is below short-run profit maximizing price. This is called ‘limit pricing’. Limit
pricing occurs when a monopolist set a price limit that is below the short-run profit
maximising level in order to dissuade new entries into the industry. Competing firm that
wants to enter the industry will be discouraged because they will not be able to make excess
profit (Figure 6.10)

ACNew Firm
PL

ACMonopolist
0 Quantity

Fig. 2.4: Monopolist Limit Pricing Curve

136
Summary of study session 11.2
In study session 2, you have learned that:
1. Monopoly market is the type in which there is a single seller of a commodity which
has no close substitute. In a monopoly situation, the power of seller is limited only by
the tastes and incomes of consumers. The monopolist can influence the quantity and
price of his product in the market (but not both at the same time).
2. In real life, it may be difficult to determine if monopoly exists because monopoly is
when there is only one firm in the industry. Monopolist create barrier to entry for new
firms to keep away competitors and to enjoy supernatural profit in the short-run and
long-run.
3. Monopolist maximizes profit at a point where MR=MC. However, the price of a
monopolist is relatively higher at this point when compare to other firms especially
under perfect competition. Supernatural profit of monopolist may be sacrifice by
setting a price below short-run profit maximizing price to keep new entrant away
through i.e. limit pricing technique.

Glossary in Terms

References/Further Reading

Sloman, J. (2006). Economics. (6th ed.). England: Pearson Education Limited.

Ojo, O. O. (2002). ‘A’ Level Economics Textbook for West Africa.

Ibadan: Onibonoje Press.

Samuelson, P. A. & Nordhaus, W. D. (2010). Economics. (19th ed.).

Singapore: McGraw-Hill International.

Awodun, M. O. (2000). Economics: Microeconomics Theory and Applications. Chapter 7 &

8.

Case, K. E. & Fair, R. C. (1999). Principles of Economics. New Jersey: Prentice Hall.

Obafemi, F. et al. (2005). Principles of Economics. Lagos: El-Sapphire Ltd.

137
Possible Answers to Self-Assessment Exercise(s)

1. Monopolists are price-makers. Discuss.

2. What is limit pricing? Explain with the aid of a graph.
3. Graphically show profit maximization under monopoly market structure.

1. Monopolists are price-makers. Discuss.

As a result of the features above, the monopolist is a price-giver and hence has a downward
sloping demand curve (see fig.6.7).The price and quantity in monopoly market are fixed by
the monopolist (but not both at the same time) according to his wishes, Thus, the monopoly
firm is price-giver, and faced with a downward sloping demand curve. It sets price at the
quantity level which will maximize profits.
The monopolist maximizes his short-run profits if the following conditions are fulfilled:
1. If the MC is equal to the MR; and
2. If the slope of MC is greater than the slope of the MR9 at the point of intersection.
These are shown in fig. 6.7 below:

PRICE
COST

Short-run Equilibrium of Monopoly Firm.

In the fig, the equilibrium of the monopolist is at 'e' where MC curve cuts MR curve from
below. Thus, both Conditions for short run equilibrium are fulfilled. The profit maximizing
price is pi and the quantity is Qe. The excess profit of the monopolist is the shaded portion
which is equal to PO PI AB. Therefore, the profit is
II= TR TC

II = (OP1 X OQeOP0 X OP0 X OQe

The monopolist may be in breakeven position in which he is neither making profit nor
making loss.

138
2. What is limit pricing? Explain with the aid of a graph.
Limit pricing occurs when a monopolist set a price limit that is below the short-run profit
maximising level in order to dissuade new entries into the industry. Competing firm that
wants to enter the industry will be discouraged because they will not be able to make excess
profit

ACNew Firm
PL

ACMonopolist
0 Quantity

Monopolist Limit Pricing Curve

3. Explain the advantages of monopoly market.

The advantages of monopoly include the following:

(iv) Standardization: Standardization, which is the basis of cheaper production, is
better practiced under monopoly.
(v) Centralized Management: There is effective and proper central management
under monopoly.
(vi) Economies of large scale production: Economics of large scale production is
possible under monopoly since it has no competitors.

(ix)Greater efficiency: There is greater efficiency resulting from an assemblage

or pool of specialized managerial skills.
(x) Better use of resources: resources available to a monopolist arc better
utilized to maximize production.

139
 (xi)It leads to invention: Monopolists, in an attempt to have full control of the
market, do engage in intensive research, leading to inventions.
(xii)Avoidance of duplication: There is avoidance of duplication and waste often
associated with perfect competition, especially in the supply of social services.
(xiii) Greater opportunity to expand operations: A greater opportunity to expand
operations because the uncertainty usually associated with a state of free
competition has been eliminate.

140