Introduction to Micro-economics

Lecture notes
Course Outline
Purpose: To enable the learner understand and appreciate the importance of the various
economics activities. This will enable thee learner actively play a practical role in economic
activities in the society.
Course Objectives: By the end of the course unit the student should be able to:-
Define and understand terminologies and meaning of key concepts used in economics
Appreciate the relevance and importance of economics as a discipline
Relate knowledge of conomic to other discipline involved in economic growth and
development of a country
!plore how they can contribute to the development of society
Course Outline
Lesson 1 (Week 1- 3)
Introduction to economics
- Basic economics concepts
- "roduction "ossibility #rontier$%apacity &""#$""%'
- The main branches $scope of economics
- (hy study economics)
- The methodology of economics
- conomic systems
- (hy *ntervene in the economy
- +peciali,ation
- Review -uestions
Lesson (Week ! - ")
#em$nd $nd suppl%
- Definition of demand
- The law of negatively sloped demand and e!ceptions
- The determinants of demand
- .ovement along and shift in demand curve
- Definition of supply
- Determinants of supply
- .ovement along and shift in supply curve
- The concept of e-uilibrium and types of e-uilibrium
- The effect of a shift of demand and supply on market e-uilibrium.
- "rice control
- lasticity of demand
- lasticity of supply
Lesson 3 (Week & - ')
()eor% o* consumer
- %ardinalist marginal utility approach
- %onsumer e-uilibrium
- /rdinalist$ indifference curve approach
- %onsumer e-uilibrium
iv
- *ncome consumption curve
- Application of indifference curves
%AT 0
Lesson ! (Week + - 1,)
()e ()eor% o* Production
- #actors of production
- +peciali,ation
- "roduction function
- 1ong run changes in production
- The theory of cost
- /ptimum sei,e of a firm
- conomies of scale
- .ergers and ac-uisitions
Lesson ! (Week 11 - 1)
M$rket structures
- "erfect markets
- .onopoly
- .onopolistic competition
- /ligopoly
-ecommended (e.t /ooks:
2ardwick3 "hilip3 et al4 0n introduction to Modern 1conomies2 1ongman 5roup
+aleemi ..A &6770' 1conomics 3impli4ed (-evised 1dition) +aleemi
"ublishers. (e.t /ooks *or *urt)er -e$din5:
8outsoyiannis A4 &099:'3 Modern Microeconomics3 .acmillan ducation 1td
;icholson3 (alter &0996'3 Microeconomics ()eor%: /$sic Principles $nd
1.tensions2 Dryden "ress
Ot)er support m$teri$ls: <arious applicable manuals and =ournals4 variety of electronic
information resources as prescribed by the lecturer
v
LESSON ONE: INTRODUCTION TO ECONOMICS
Purpose: To introduce the learner to the tenets of economics3 as the building blocks for
studying and understanding economics.
Specifc Objectives
By the end of the lesson the learner should:
&i' Define the term economics
&ii' Differentiate between microeconomics and macroeconomics
&iii' Describe economics systems
1.1 Introduction to Econoics
conomics essentially studies the way in which mankind provides for the material well
being. *ts thus concerned with the way people apply their knowledge3 skills and effort to the
gift of nature in order to satisfy human their material wants. conomics is a social science
which studies the allocation of scarce resources which have alternative uses among
competing and usually limitless wants of the consumers in the society.
/$sic 1conomic Concepts
i' 6um$n 7$nts This refers to people desires for goods and services and
circumstances that enhance their material well being.
ii' 1conomic -esources These are ingredients that are available for providing goods
and services in order to satisfy the human wants. A resource must be scarce and
have money value. Resources can be categori,ed as natural3 or man made.
iii' 8$tur$l -esources refer to anything given by 5od or nature such as fertile soil3
rivers3 lakes3 mountains etc.
iv' M$n M$de -esources refers to anything created by man to assist in further
production such as tools3 e-uipments3 roads and buildings etc.
89/ 1conomics resources also refer to as factors of production which includes
land3 labour3 capital and entrepreneurship.
v) 3c$rcit% $nd C)oice if the resources available are not enough to produce goods and
services to satisfy all the wants then they are said to be scarce. As a result3
individuals and society cannot have all the things that they want. +ince resources
are limited3 c)oices have to be made. The choice to satisfy one want implies
0
others are forgone. *ndividuals have to make choices e.g. consumers with their
limited income and unlimited wants have to choose how they spend their income.
vi' Opportunit% Cost refers to the value of benefit e!pected from the best
second
alternative forgone. *t is based on the fact that resources being scarce have
competing alternative uses. The choice to satisfy one alternative means that
another is forgone. The value of the second best forgone alternative is the
opportunity cost.
Production Possibilit% :rontier9C$p$cit% (PP:9PPC)
*t provides a graphical illustration of the problem of scarcity and choice which is the
basic economic problem. The curve shows what a country produces with e!isting supply of
land3 capital and entrepreneurship ability. (ith limited supply of economics resources a
country has a wide variety of options and variety of goods and services it can produce.
Assume a simple hypothetical economy where a country produces two types of goods i.e.
agriculture and manufactured goods. The two e!treme possibilities are:
a' The country commits all its resources to the production of agriculture and non to
manufacturing.
b' All the resources are put to manufacture and non to agriculture.
These two e!treme cases are unlikely and the country will most likely choose to produce
goods of both commodities. The opportunity cost of producing either of them is
increasing which the law of diminishing return.
Agricultural >
5oods
? under
a
>
b
p
@tili,ation >
>
c ffective production
.anufactured goods
6
The ""# is a locus of all combination point which represents goods and services that a
country can produce if all resources are utili,ed fully and efficiently. "oints on the curve
such as A3 B and % show ma!imum possible combined output of the two commodities.
The economy can produce any combination inside the curve such as point ? where it
means some resources are unemployed. The resources in such a case will produce more
commodities by moving either to point B or point A. The points outside the curve are not
attainable with the countrys present productive capacity. The country can only achieve
this if its productive capacity has been increased and this will cause the curve to shift to
the right as shown by the dotted curve. A countrys productive capacity can increase if
there is advancement in technology or if there is a discovery of new resources. The
""#$% is concave to the origin indicating the concept of increasing opportunity costs.
1.! Scope o" Econoics
()e m$in br$nc)es o* economics $re:
Microeconomics which is the study of the smallest economic decisions making units of
the society. Microeconomics t)eor% is a branch of economics that studies the behavior of
individual decision making units such as consumers3 resource owners and business firm as
well as individual markets in a free market economy. The aim of microeconomics is to
e!plain the determination of prices and -uantities of individual goods and services.
.icroeconomics also considers the impact of government regulation and ta!ation of
individual markets. #or e!ample3 microeconomics analyses the forces that determine the
prices and -uantities of television sets sold. .icroeconomics can be considered as the
ultimate cellular structure of economics.
i) *t is the study of individuals3 households and firms. The ma=or areas are
- demand and supply analysis
- market e-uilibrium
- consumer theory
- theory of the firm
- market structure
- distribution theory
A
ssss
M$croeconomics is the study of bigger and comple! systems. M$croeconomic
t)eor% is
the study of the behaviour of the economy as a whole whereby the relationship is
considered between broad economic aggregates such as national income3 employment
and prices. The economy is disaggregated into broadly homogenous categories and
determinants of the behavior of these aggregates are integrated to provide a model to the
entire economy.
ii) .acroeconomics focuses on the economic stabili,ation whereby government
policy is used to moderate business cycles and encourages real economic growth.
.acroeconomics became a separate topic of discussion in the aftermath of Bohn
.aynard 8eynes and the great depression. The line between microeconomics and
macroeconomics is3 however3 blurred and there are many areas of overlap
between the two. 8ey areas of macroeconomics are:
- ;ational income
- conomic growth and development
- .oney and banking
- "ublic finance
- @nemployment
- *nflation
- *nternational trade
1.# $%& Stud& Econoics'
*t is useful to study economics for the following reasons
i' conomics provides the underlying principles of optimal resource allocation
and thus enables individuals and firms to make economically rational
decisions. Thus for e!ample the preparation of budgets involves knowledge of
demand and elasticity analysis. The making of price policy decisions draws
heavily on the concept of elasticity in economics. Additionally3 the theory of
production in economics is concerned with the principles that facilitate the
optimal combination factors of production.
ii' A study of economics enables individuals and organi,ations to appreciate the
constraints imposed by the economic environment within which any entity
:
operates. Thus an individual or firm is more fully enabled to appreciate the
implications of the annual budget considering how for e!ample the increased
liberation of the economy will affect a particular business entity and the
economy in general. Additionally3 the student of economics is able to
appreciate the effects of such economic variables as inflation3 e!change rates3
interest rates money supply and so on.
iii' The area of development economics is fundamentally concerned with the
Reasons why societies develop and means of accelerating development. *t is
vital for individuals as citi,ens to appreciate the parameters that determine the
development process so that they contribute more fully to facilitate and
%ontribute to solving the economic problems that characteri,e their society.
iv' conomics is an analytical sub=ect and its study can help develop logical
Reasoning which is never superfluous.
1.( T%e Met%odo)o*& o" Econoics
A useful insight into the methodology applied in economics can be gained by
distinguishing between positive and normative economics. This enables one to appreciate
the limitations and scope of economics.
Positive economics is concerned with what is3 or how the economic problem facing
societies are actually solved. "ositive statements therefore3 only deal with *$cts for
e!ample4 C8enya is a member of the ast African communityD and C@ganda is currently
8enyas ma=or trading partnerD are positive statements. #or e!ample a dispute over
whether @ganda is currently 8enyas ma=or trading partner can be settled by looking at the
statistics of 8enyas trade with its partners.
8orm$tive economics refers to the part of economics that deals with the value
of
=udgments. This implies that normative deals with what ought to be3 or how the economic
problems facing the society should be solved. ;ormative statements usually reflect
peoples moral attitudes and are e!pressions of what particular individuals group thinks
ought to be done. A statement such as C@ganda to should =oin the +outhern Africa
E
Development %ommunityD or Cupper incomes classes ought to be ta!ed heavilyD are
normative statements.
conomics makes use of the scienti4c met)ods to develop theories. +cientific in-uiry is
generally confined to positive -uestions. /ne of the ma=or ob=ectives of sciences is to
develop theories. A t)eor% is a general or unifying principle that describes and e!plains the
relationship between things observed in the world around us.
The purpose of a theory is to predict and e!plain. The search for a theory begins
whenever a regular pattern is observed in the relationship between two or more variables and
one asks why this should is so. A theory refers to a )%pot)esis that has been
successfully tested. *t is important to note that economics hypothesis is not tested by
realism of its assumptions but its ability to predict accurately and e!plain.
()e *ollo7in5 procedures $re $dopted in t)e scienti4c met)od:
i; ()e concepts $re de4ned in suc) $ 7$% t)$t t)e% c$n be me$sured in
order to be $ble to test t)e t)eor% $5$inst t)e *$cts.
(hereas these facts may seem superfluous3& #e4nition o* super+uous : W)en
somet)in5 is so unnecess$r% t)$t it could e$sil% be done $7$% 7it)2 like $ 4*t)
7)eel on $ c$r or $ 4*t) person on $ double d$te2) ... in practice it is -uite difficult
to define many concepts in economics in a way that is agreeable to all schools of thought.
*t is often correctly postulated that when you want to argue3 first define your terms.
ii; 0 )%pot)esis *ormul$ted A hypothesis refers to tentative untested statement3
which attempts to e!plain how one thing is related to another. 2ypotheses are based
on observation and upon certain assumptions about how the real world works.
The assumptions may themselves be based upon prevailing theories that have proved to
have a high degree of reliability. *n a social science3 the basic assumptions or paradigms
about reality are vital. A disciplines basic assumptions about reality determine what it
focuses on. *n economics for e!ample3 many theories are based on the rationality
assumption. The formulation of hypothesis is thus arrived at through a process of logical
reasoning using observed facts and certain assumptions. As mentioned earlier3 a
hypothesis is not tested by the realism of its assumptions but its ability to predict
F
Accurately. conomic hypothesis must be framed in a manner that enables scientists to
test their validity.
iii; ()e )%pot)esis is t)en used to m$ke predictions;
*f the hypothesis is correct3 then if certain things are done3 certain others will happen. #or
e!ample hypothesis may predict the rise in the price of a given commodity may lead in the
fall of the -uantity demanded of that commodity.
iv; ()e )%pot)esis is tested b% considerin5 7)et)er its predictions $re supported b%
*$cts;
*n order to test a hypothesis and arrive at a theory3 one must go to the real world and see
whether the hypothesis is indeed true for various situations. The social scientists however
cannot carry out controlled e!periments in the laboratory. The laboratory of the social
scientist is the human society and human beings cannot be put into a controlled situation
to see what happens. /bserved economic data is sub=ected to statistical analyses whose
techni-ues help the economist to determine the probability that particular events have
certain causes. *f a hypothesis is supported by factual evidence we have a successful
theory3 note that a theory can never be true in all circumstances and new theories are
developed as old ones are discarded because their predictions have become unreliable.
1., Econoic S&stes
These refer to the way in which different societies solve the three different basic
economic problems which are:
a (hich goods should be produced and in what -uantities)
b. 2ow should various goods and services be produced)
c. 2ow should various goods and services be distributed)
These in turn determine various political and economic structures in the society. The
economic systems are as follows:
($) :ree m$rket econom% Also referred to as capital system or laiser faire economy.
*t
refers to a system where decisions about allocation of resources are made by
individuals on the basis of prices generated by forces of market prices of demand
and supply. A free market economy has the following features
G
- Priv$te propert% individuals have the right to own or dispose off their
property as they may consider it fit.
- :reedom o* c)oice $nd enterprise *ndividuals have the right to buy or hire
economic resources3 organi,e them for production purpose and sell them in
the market of their choice. +uch persons are referred to as
entrepreneurs.
- 3el* interest the pursuant of personal goals. The individuals are free to do
as they wish and have the motive of economic activity in self interest.
- Competition There is a large number of buyers and sellers such that each
buyer and seller accounts for but is insignificant to influence the supply
and demand and hence prices.
- -eli$nce on price mec)$nism This is an elaborate system of commerce in
which numerous choices of consumers and producers are aggregated and
balanced against each other. The interaction of demand and supply
determine prices.
- 8o 5overnment intervention 2ence no price controls3 ta!es and subsidies.
- ()ere $re propert% ri5)ts provided and enhanced by the government
through copy rights patents3 trademarks etc.
0dv$nt$5es o* *ree m$rket econom%
- There is the matching of demand and supply. "roduction takes place in
response to demand hence a balance between what is produced and
consumed. ;o wastage.
- There is fle!ibility of the market in responding to changes in demand and
supply conditions.
- There are no resources wasted in planning as no planning is re-uired
- %onsumer sovereignty and competition gives rise to a wide variety of
goods and services giving consumers a wide range to choice from.
- 2igher rates of economic growth due to the incentive available for hard
work which is motivated by profits.
- ;o wastage of resources on unrealistic pro=ects because investment
decision are based on profits.
H
#is$dv$nt$5es
- Income ine<u$lit% the ability of some people and firms to ac-uire
e!cessive market power leads to greater ine-uality in income and wealth.
- Monopol% po7er refers to the ability of a firm to control its prices
- 1.tern$lities spill over refers to social costs and benefits not taken into
consideration when determining price levels.
- Public 5oods; The price mechanism on its own cannot allocate resources
to the production of public goods such as roads3 schools3 security etc.3
which have no rivals and no e!cludability.
- *nstability and unemployment due to the trade cycles of recession3
depression3 recovery and boom.
- The inability to deal with structural changes caused by wars3 natural
calamities among others.
- *nade-uate provision of merit goods. .erit goods are goods of importance
to the community such as health3 education3 security among others
(b) Pl$nned econom% Also referred to as command economy or government
controlled economy3 socialism or communism. *t refers to an economic system
where the crucial decisions are determined a body appointed by the state. The
body takes up the role of mechanism which prevails in a free market economy
:e$tures o* $ comm$nd econom%
- Le$ders)ip $nd control o* economies. All important means of production
&resources' are publicly owned such as land3 power generation3 housing
among others.
- -$tionin5 of certain commodities if supply of such fall bellow demand.
- !istence of production t$r5ets for different sectors of the economy. The
government determines how resources are allocated through planning.
- #i!ing of prices $nd 7$5es
- /ccasional e!istence of restricted labour market in which workers take up
=obs assigned to them.
- 5overnment decides what is to be produced
9
0dv$nt$5e o* pl$nned econom%
- Avoids economic instability
- .inimi,e negative e!ternalities
- .akes ade-uate provision of public and merit goods
- #acilitate the shift of resources in pursuant of grand schemes such rapid
industriali,ation
- "uts checks on monopoly power which are controlled by state monopolies
&"arastatals'.
#is$dv$nt$5es o* Pl$nned econom%
- There is wastage of resources in production because consumers demand is
=udged in advance without the use of price mechanism.
- The cost of gathering information for planning is e!pensive to the state.
- *n absence of profit motive in production there is no incentives for hard
work and innovation.
- The power of consumer sovereignty is curtailed
(c) Mi.ed econom% refers to an economic system where resource allocation
is
determined by the state and price mechanism. This form of economic system can
e!ist in two ways:
- (here the means of production are privately owned but the government
through fiscal and monetary policies regulate the working of price
mechanism towards desired levels.
- The government does not only regulate the working of the price
mechanism but also strategic resource thus taking part in production.
:isc$l polic% refers to the policies which the government uses to stabili,e the economy
through government revenue and e!penditure.
Monet$r% polic% refers to the policies implemented by the central bank to stabili,e
the economy by use of money supply and interest rates.
Both policies make up the budgetary policy of the government.
07
1.- $%& Intervene in t%e Econo&
- To create a framework of regulations and rules to ensure fair competition thus promote
competition between firms both small and big.
- Redistribute income through a system of ta!ation
- "revent market failure of price mechanism
- +tabili,e the economy
- .aintain competition by controlling monopoly
P$rti$l 1<uilibrium refers to the study of the behaviour of individual decisions making
units and the functioning of individual markets in isolation.
=ener$l 1<uilibrium is the analysis of the behaviour of all individuals decision making
units on all individual markets simultaneously.
1.. Speci/)i0/tion
This refers to the process where people concentrate on those activities where they are best
at. *t takes a form of division of labour which is dividing up of economic tasks of
production into tasks which people speciali,e into. Division of labour therefore leads to
speciali,ation which leads to increase in output.
0dv$nt$5es o* speci$li>$tion
- *t help individual development by e!ploring their talent
- *t is possible to use machines to do specific$ particular task
- *ncrease in skills result in increased e!pertise and performance
- Time saving as a worker will accomplish more by doing a particular task.
#is$dv$nt$5es
- 1eads to loss of craftsmanship. !tensive speciali,ation leads to increased
use of machines which are more automated leading to loss of basic skills
- "roduction of standardi,ed goods limiting the range of goods consumers
can choice from. *t does not cater for different tastes and preferences.
- .onotony and boredom due to repetitions of the same work. This leads
increased accidents3 absenteeism which are associated with lack of
motivation.
00
- *ncreased inter-dependence as a speciali,ed system of production
increases the e!tent to which different sectors of the economy rely on each
other. *f mistakes are made in one production unit it may cause the fall of
all or other organi,ation which depend on items from that production unit.
- *ncrease in risk of unemployment if ones skills are no longer re-uired in
the market they may get an alternative employment.
1.1 Revie2 3uestions
0. Briefly define the term Ieconomics
6. (hat is a production possibility frontier)
A. Distinguish microeconomics from macroeconomics
:. (hat is an economic system)
E. (hy is the study of economics important)
F. !plain the advantages and disadvantages of the three economic systems
G. (hy should the government intervene in the economy)
H. !plain the main advantages of speciali,ation
1.4 Re"erences
+aleemi ..A &6770' 1conomics 3impli4ed (-evised 1dition) +aleemi "ublishers 1td
&"ages 0-06'
8outsoyiannis A4 &099:'3 Modern Microeconomics3 .acmillan ducation 1td
06
L133O8 (WO: #1M08# 08# 3?PPL@
Purpose The theory of demand and supply enables us to understand the determination
of prices and -uantities in different markets. #or e!ample3 why the prices of
agricultural commodities such as tomatoes3 apples3 mangoes and cabbages increase
and decrease at certain times of the year3 why have the prices of computers3 music
systems and television sets been steadily declining over time. An understanding of
the working of the price system provides us with the answers to some of these
-uestions. The price system provides the basis for determining the prices of factors of
production.
3peci4c Objectives
At the end of this lesson you should be able to:
&i' /utline the key determinants of demand and supply
&ii' !plain the difference between a movement along a demand and supply curve
and shift of the curve.
&iii' !plain the concept of market e-uilibrium
&iv' Distinguish between ma!imum and minimum price controls and e!plain the
conse-uences of each
&v' %ompute e-uilibrium values in elementary market models.
;1 #e4nition o* #em$nd
#em$nd refers to the -uantity of a commodity that consumers are willing and able to
purchase at any given price over a given period of time. *t is important to reali,e that
demand is not the same thing as want3 need or desire. /nly when want is supported by
the ability and willingness to pay the price does it become an effective demand and have
an influence on the market price. 2ence demand in economics means effective demand.
*t is different from desire in that it has to be supported by the ability to purchase the
product$service.
The price of a commodity is most important factor$determinant of demand. All factors
affecting demand other than the price are referred to as conditions for demand. (hile
analy,ing the relationship between price and -uantity of demand economists assume that
all factors affecting demand remain constant. An individual demand for a given good can
0A
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e

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e
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i
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be presented in a form of a demand schedule. A demand schedule is a table showing
-uantity of a commodity that could be purchased at various prices. The Table 6.0 shows an
individuals demand for commodity J.
"rice per unit in 8shs %onsumers weekly demand
F FE
E G7
: H7
A 97
6 077
0 00E
Table 6.0 Demand schedule for an individual commodity
#rom the table3 FE units of commodity J will be demanded per week if the price is 8shs
F per unit.
A demand schedule can be represented in the form of a graph known as a dem$nd curve;
#igure 6.0 shows the demand curve for commodity J; The curve shows graphically the
relationship between -uantity demanded and the price of the commodity. A demand
curve has a negative slope. *t slopes downwards from left to right showing that as the
price of a commodity *$lls demand incre$ses. The inverse relationship between the price
of a commodity and the -uantity demanded is what is referred as the law of demand.
d
F
E
:
A
6
0
d
7
FE G7 H7 97 077 00E
?uantity demand
#igure 6.0 The law of negatively sloped demand
0:
This law states that3 Cceteris p$ribus (ot)er t)in5s rem$inin5 const$nt)2 t)e
lo7er t)e
price o* $ commodit% t)e 5re$ter t)e <u$ntit% dem$nded b% t)e
individu$l $nd vice
vers$D.
1.ceptions to t)e L$7 o* #em$nd
There are some demand curves that slopes upwards from left to right showing that as the
prices of a product rise more is demanded and vice versa. This type of demand curve is
known as regressive3 e!ceptional or abnormal demand curve and occurs in the following
situations:
i. (hen there is fear of a more dr$stic price changes in the future. This will
causes consumers to increase there -uantity demanded to avoid paying a
higher price in the future. This situation is often found in the stock e!change
where there is often an increase in the demand of shares of a company if its
shares are e!pected to increase.
ii. *n the case of 5iAen 5oods. This refers to basic foodstuffs that constitute a
high proportion of the budget of low income families. (hen the price of a
giffen good rises3 the proportion of the total income of individuals who
consumes these giffen goods rises and since such consumers are worse off in
real terms3 they can no longer afford to consume other more e!pensive
commodities like meat and fruits. To make up for the goods they can no
longer afford to buy3 they are more likely to purchase more of basic
foodstuffs4 conversely when the price of basic foodstuffs falls. They become
better of in real terms and are likely to buy more or relatively more e!pensive
foodstuffs and less basic foodstuffs.
5oods of ostent$tion (Beblen 5oods); These are commodities whose prices falls in
the
upper price ranges and that have a snob appeal. The wealthy are usually concerned about
status. Believing that only goods at high prices are worth buying and worth the effect of
distinguishing them from other consumers. *n the case of such commodities3 a firm
increasing its prices may find that the sales of its product increase and at lower prices less
of the commodity may be bought as the commodity is re=ected as being substandard.
%onsumers often in making comparisons between similar products with different prices
opt for relatively more e!pensive product believing it to be better. As prices increase
0E
demand increases this is referred to as sonob eAect; !amples of goods of ostentation are
e!pensive perfume3 =ewellery3 cars clothes3 etc. The demand curve will be positively
slopping as indicated in #igure 6.6.
d
"6
"0
d
?0 ?6 ?uantity
#igure 6.6 positively slopped demand curve
; ()e #etermin$nts o* #em$nd
The demand of the product can be considered from the standpoint of either individual
demand or market demand. Demand for any commodity can be considered from two
points of view:
($) Individu$l dem$nd is the amount the individual is willing and able to buy at
a
given price and over a given period of time. #actors affecting individual demand
are4
- "rice of the product
- "rice of other related goods
- %onsumers income
- %onsumers tastes and preferences
- #uture e!pectation in price changes
- Advertising
- /ther factors such as subsidies3 climate change etc.
()e price o* t)e product; (hen deciding whether or not to buy a particular product3
an
individual will compare the price of the product and the amount of utility or satisfaction
e!pected to be received from the product. *f the price is considered worth the anticipated
0F
utility the individual will buy the product and if not will not buy. A decrease in the price of a
product will probably increase individuals demand for it since the amount of utility obtained
is likely to be worth the lower price. %onversely a rise in the price of a product will probably
result in a fall in demand3 as the amount of utility received is less likely to be worth the higher
price to be paid. An e!ample of this phenomenon is the hotel industry in 8enya. There is
usually an increase in domestic tourism during the low season when many 8enyans consider
the lower hotel prices to be worth the level of satisfaction they are receiving. During the
high season when the hotel prices are high3 many do not consider the satisfaction they are
receiving to be worth.
*f the amount a consumer is willing and able to purchase due to change in the price3 a
change in the -uantity demanded is said to take place. *f on the other hand the amount the
consumer is willing and able to purchase changes because of a change in the price of a
given commodity leads to a change in the -uantity demanded will be undertaken later in
utility analysis and indifference curve analysis.
()e prices o* rel$ted 5oods. The demand for all goods is interrelated in that they
are competing for consumers limited income. Two peculiar interrelationships can be4
+ubstitutes goods such as tea and coffee butter and margarine3 beef and mutton3 a bus ride
and a matatu ride3 a mango and an orange3 %Ds and cassettes.
Two goods3 J and K are said to be substitutes if a rise in the price of one commodity3 say K3
leads to a rise in the demand of the other commodity J. *f the price of tea increases
consumers will find coffee relatively cheaper to tea as a result demand for coffee
increases. +ubstitutes are commodities that can be used in place of other goods. This
phenomenon is illustrated in #igure 6.A. The graph shows the relationship between the
prices of tea over the -uantity for coffee. *f the price of tea increases from "0 to "6 the
-uantity of coffee demanded increases from ?0 to ?6.
0G
"
r
i
c
e

&
t
e
a
'


"6
"0
?0 ?6
?uantity &coffee'
#igure 6.A Demand curve for substitutes
%ompliments goods such as shoe and polish3 pen and ink cars and petrol3 computers and
software3 bread and margarine3 hamburgers and chips3 tapes and tape recorders. Demand
for some commodities can also be affected by changes in the prices of the complementary
if a rise in the price of one of the goods3 say A leads to the fall in the demand of another
food3 say B. %omplimentary goods are usually =ointly demanded in the sense that the use
of one re-uires or is enhanced by the use of the other. #igure 6.: illustrates the
relationship between complementary goods graphically. #or e!ample if the price of cars
is lowered demand for petrol increases because more cars will be bought$demanded. The
curve shows the relationship between the price and of a car and -uantity demanded for
petrol. *f the price of cars falls from "6 to "0 the -uantity demanded for petrol increases
from ?0 to ?6.
C)$n5es in dispos$l re$l income; An individuals level of income has an important
effect on the level of demand for most products. *f income increases demand for the
better -uality goods and services increases. This relationship however3 depends on the type
of goods and level of consumers income. The three types of are goods4
8orm$l 5ods these are goods whose demand increases as income increases. The demand
for normal goods increases continuously with increase in income. *t tends to become
gently as people reach the desired level of satisfaction.
0H
"
r
i
c
e

&
c
a
r
s
'

"6
"0
?0 ?6
?uantity &petrol'
#igure 6.A Demand curve for commentary goods
In*erior 5oods re*er to goods for consumers with low income levels such that as
income increases its demand falls. At low level of income3 these individuals will tend to
consume large amount of these goods but as income increases they buy other goods
which they consider superior thus demanding less of the inferior goods. At very low level
of income an inferior good behave like a normal good only to behave inferior as income
increases. 8ecessities these are goods which consumers cannot do without such as salt3
match bo!es among others. Their income demand curve tends to remain constant other
than at the lowest levels of income as indicated in #igure 6.E
y
?uantity
#igure 6.E Demand curve for a necessity
C)$n5es in consumer t$stes2 pre*erences $nd *$s)ion "ersonal tastes play an
important
role in governing the consumers demand for certain goods. #or e!ample3 preferring to
consume imported commodities despite them being e!tremely e!pensive. "revailing
09
fashions are an important determinant of tastes. The demand for clothing for e!ample3
particularly is susceptible to changes in fashion.
Level o* $dvertisin5 is also an important determinant of demand. *n highly
competitive markets3 a successful advertising campaign will increase the demand of a
particular product while at the same time decreasing the demand for competing products.
*ncrease in advertising will increase demand in the following ways4
- it helps inform about the product of a firm
- %an introduce new products to the market.
- *nduce individuals to fre-uently use the product$service
#actors affecting advertising policies
- cost of advertising
- mode of advertising
- impact of advertising on the demand of the product
- The target group &old3 young'
- number of competitors and -uality of their products
- The market share of the firm and the degree of competition
- #uture e!pectations in price changes
- 5overnment policies and ta!es
- Appropriate time to make advertisements
- %ultural background
- 1anguage
()e $v$il$bilit% o* credit consumers; This factor especially affects the demand
for durable consumer goods which are often purchased on credit. #or e!ample a decrease
in availability of credit or the introduction of more stringent credit terms is likely to lead
to a reduction in the demand of some durable consumer goods.
()e 5overnment polic% The government may influence the demand of a
given commodity through legislation. #or e!ample making it mandatory for everyone
to wear seatbelts. The consumers inevitably get to purchase more seatbelts as a result.
3ubsidies its the opposite of ta!ation. (hen the government grants subsidies prices of
goods falls leading to increase in demand and vice versa.
67
Clim$te c)$n5e demand of various goods varies depending on weather. #or instance
there is high demand for woolen clothes during rainy reasons
(b) M$rket *$ctors $Aectin5 individu$l dem$nd
*ts a hori,ontal demand sum of the demands for individual consumers. *t refers to
-uantity demanded in the market at each price by individual consumers. #or this reason all
the factors affecting individual demand will affect market demand. The market demand
for a commodity can be derived graphically as in #igure 6.F.
.kt dd curve
L
"0 "6
?0
"A L "A
?6
M "mkt
?A ? .kt
#igure 6.F Derivation of market demand
(here "03 "6 and "A are individual prices ?03 ?6 and ?A are individual -uanties
demanded. "mk is the market price -mk is market -uantity demanded.
/ther factors affecting market demand
C)$n5e in popul$tion market demand is influenced by the si,e of the population3 the
composition of the population in terms of age se! as well as geographical distributions.
Distribution of income more evenly distribution of income may increase demand for
normal goods while at the same time it may lower the demand for lu!uries.
;3 Movement 0lon5 $nd 3)i*t in #em$nd Curve
Demand is a multi- variant function in the sense that it is influenced by so many factors
such as the price of the commodity3 the price of other related commodities3 consumer
incomes etc. The price of the commodity is the most important determinant of demand
and its relationship with the -uantity demanded give rise to a demand curve.
Movement $lon5 dem$nd curve is demonstrated by a change in the price of a
good as
shown in #igure 6.G by movement from one point to another on the same demand curve.
60
d
"
0
A
"rice !
"
6
B
d
?0 ?6 ?uantity J
#igure 6.G .ovement along a demand curve
A change in price of a good from "0 to "6 causes a movement from point A to B along the
demand curve. This movement along demand curve shows a change in -uantity
demanded which is an increase or a fall in the -uantity demanded. A shift in the demand
curve is caused as a result of a change in any factor affecting demand other than price
such as changes in consumer income tastes and preferences. #or this reason all other
factors affecting demand other than price of the product are also referred to as shifting
factors as illustrated in #igure 6.H
Any change in the shifting factors will cause changes in demand &an increase or a fall in
demand'. A shift to the right &dd to d0d0' shows an increase in demand while a shift from &dd
to d6d6' shows a decrease in demand.
d
0
d
d6
"rice
d0
d
d6
?6 ? ?0 ?uantity J
#igure 6.H +hift in demand curve
66
(erms used in dem$nd
&a' Coint dem$nd it is the demand whereby two commodities are always demanded
together. /ne good cannot be demanded in the absence of the other such as car
and petrol.
(b) Competitive9riv$l 5oods it is the demand for goods which are substitutes such
tea
and coffee.
(c) #erived dem$nd where goods are demanded in order to provide goods such as
cotton is re-uired to produce cotton wool
(d) Composite dem$nd (sever$l uses) where some goods are used for
different
purposes such as steel for cars machine etc
;! #e4nition o* 3uppl%
*ndividual supply refers to the -uantity of a given commodity that a producer is willing
and able to sell at a given price over a specific time period.
.arket supply refers to hori,ontal summation of individuals producers$firms supply in the
market.
The supply schedule and the supply curve demonstrate the relationship between market
prices and -uantities that suppliers are willing to offer for sale. +upply differs from
Ce!isting stockD or the amount available because it is concerned with amounts actually
brought to the market. The basic law of supply states that3 Ca greater -uantity will be
supplied at a higher price than at a lower priceD. An individual producers supply
schedule shows alternative -uantities of a given commodity that a producer is willing and
able to sell various alternative prices for that commodity ceteris p$ribus &other things
remaining constant'.
6A
"
r
i
c
e

J

"rice per unit in 8shs ?uantity supplied each week in units
A7 E77
A0 EE7
A6 F77
AA FE7
A: FGE
AE G77
AF G6E
Table 6.6 +upply schedule for commodity K
This can be represented by the use of a graph referred to as a supply curve as shown in
AG
AF
AE
A:
AA
A6
A0
E77 EE7 F77 FE7 G77 GE7 H77
?uantity J
#igure 6.9 +upply curve
A supply curve show the relationship between the price of the commodity and the
-uantity supplied. The relationship is a direct one as the supply curve slopes upwards
from left to right. The direct relationship is a graphical representation of the law of supply
which states that other things remaining constant a greater -uantity will be supplied at
higher prices and vice versa.
#etermin$nts o* 3uppl%
The supply of a good is influenced by the following factors
6:
- price of the commodity in the market
- the price of other related goods
- cost of production
- state of technology
- ob=ective of the firm
- future e!pectations of price changes
- climate
- government policy and ta!es
Price o* t)e 5ood as the price of a given commodity say J rises3 with the costs and
the
prices of all other goods remaining unchanged3 the production of commodity J becomes
more profitable. The e!isting firms are therefore likely to e!pand their profit and new
firms are to be attracted into the industry. *t should be noted however3 that not =ust the
current rise but also e!pectations concerning the future increases prices may motivate
producers. The total supply of goods is e!pected to increase as the prices rise.
Prices o* ot)er rel$ted 5oods changes in the prices of other commodities may affect
the supply of a commodity whose price does not change.
3ubstitutesD two goods J and K are said to be substitutes in production if the supply of
good J is inversely$negatively related to the price of K. #or instance barley and wheat or
tea and coffee. *f a firm producing both tea and coffee notices that the price of tea is
rising may decide to allocate more resources to tea at the e!pense of coffee. The supply
of coffee will therefore fall as the price of tea increases. 2owever3 the movement of
resource from one use to the other is dependent on the mobility of factors of production.
Compliment$r% 5oodsD two goods J and K are said to be compliments if an increase in
the price of J causes an increase in the supply of K such as a vehicle and petrol.
Cointl% supplied 5oodsD two goods J and K are said to be =ointly supplied if an increase
in the price of J causes an increase in the price of K such as petrol and paraffin. *f the
demand for petrol increases the supply of petrol will rise and at the same time the supply of
paraffin will increase.
89/ The e!tent to which firms can move from one industry to another in search of higher
profits depends on occupational and geographical mobility of the factors of production.
6E
Prices o* *$ctors o* production $s the prices of factors of production used
intensively by producers of a certain commodity rise3 so do the firm costs. This will cause
the supply to fall since some firms will eventually leave the industry. +imilarly3 if the
price of one factor of production3 say land3 increases3 some firms may move out of the
production of land intensive products into the production of goods that are intensive in
other factors of production which are relatively cheaper. #inally other less efficient
firms will make losses and eventually leave the market.
()e st$te o* tec)nolo5% is a societys pool of knowledge concerning industrial
activities and its improvements. Technological improvements or progress such as
improvements in machine performance3 management and organi,ation or an improvement in
-uality of raw materials leads to lower costs through increased productivity and increases
the profit margin in every unit sold. This leads to increase in supply.
:uture e.pect$tions o* price c)$n5e +upply of a good is not only influenced by
the current prices but future e!pected price as well. #or e!ample3 if the price of a good is
e!pected to rise the firm may decide to reduce the amount of supply in the current period. This
is to enable them pile stock which they can offer for sale when prices increase in the future.
This is known as )o$rdin5.
=overnment policies through ta! imposition on goods increases the cost of
production hence decline in production and supply
Through subsidies -a grant to citi,ens of a country which lowers the cost of production
hence encourages production and increases in supply.
Through price control can either by price minimi,ation where prices are fi!ed above
e-uilibrium encouraging producers to produce more hence increase in supply. *t may be
undertaken through price ma!imi,ation where prices are fi!ed below e-uilibrium
discouraging production hence decline in supply.
Though <uot$s where the government puts restriction or limit production of various
goods which leads to decline in supply.
We$t)er 9clim$te the supply of agricultural products is considerably affected by changes
in weather conditions. /utput in agriculture is sub=ect to variations in weather from year
to the ne!t. An e!cellent growing season associated with favorable weather conditions
6F
will result in a bumper harvest leading to an increase in supply. An unfavorable season
that results in a poor harvest may be viewed as an increase in the average costs of
production because a given e!penditure on inputs yields a lower input than it would in a
good$ favorable season. A bad harvest is represented by a leftward shift of the supply
curve.
Objectives o* t)e 4rm a business may pursue several ob=ectives such as
sales ma!imi,ation3 market leadership3 -uality leadership3 survival3 profit ma!imi,ation3
social responsibility. #irms with sales ma!imi,ation as an ob=ective aim at supplying
greater -uantities of its product than a firm aiming at profit ma!imi,ation where the
later supplies less -uantities but at a higher price in order to ma!imi,e the profit.
Incidence o* strikes le$d to a reduction in supply of a product. The supply
of manufactured goods is particularly likely to be affected by industrial disputes because of
generally stronger unions in the industrial sector.
M$rket suppl%
The market supply curve represents the alternative amount of a good supplied per period of
time at various alternative prices by all the producers of goods in the market. The market
supply of goods therefore will be influenced by all the factors that determine individual
producer supply and all the number of producers of goods in the market. This concept is
illustrated in #igure 6.07 *t therefore follows that the market supply curve will have a gently
slope than individual supply curves.
#igure 6.07 Derivation of market supply curve
s
L
"0
s
?0
"roducer 0
s
"6 L "A
s
?6
"roducer 6
s
M " mkt
s
?A
"roducer A
6G
.kt supply curve s
s
? .kt
.arket supply
;E Movement 0lon5 $nd 3)i*t in 3uppl% Curve
The relationship between price of a commodity and -uantity supplied give rise to a
supply curve. Any changes in the price of a good causes change in the -uantity supplied.
This can be traced by the movement along supply curve as shown in #igure 6.00
The movement from point A to B is caused by changes in price from "0 to "6 which
bring fourth the movement along the supply curve.
s
B
"6
"rice A
s
?0 ?6 ?uantity
#igure 6.00 .ovement along supply curve
A shift of supply curve is caused by a change in any other factors affecting supply other
than the price of the goods. This shift indicates changes in supply as a result of e.g.
advances in technology which makes it cheaper to produce goods and services and
therefore their supply will increase. +imilarly incase of increase in cost of production will
lead to a fall in -uantity supplies as shown in #igure 6.06. A shift to the right from +0+0 to
+A+A shows a fall in supply.
+A +0 +6
+A +0
+
6
?
A
?0 ?6
#igure 6.06 +hift in supply curve
6H
;" ()e Concept o* 1<uilibrium in 1conomics
-uilibrium in economics refers to a situation in which the forces determine the behavior
of variables are in balance and therefore e!ert no pressure on these variables to change. *n
e-uilibrium the actions of all economic agents are mutually consistent. .arket
e-uilibrium occurs when the -uantity of a commodity demanded in the market per unit
e-uals the -uantity of the commodity supplied to the market over the same period of
time. 5eometrically3 e-uilibrium occurs at the intersection point of the commoditys
market demand and market supply curve. The price and -uantity at the e-uilibrium are
known as the e-uilibrium price and e-uilibrium -uantity respectively. The price "e is also
referred to as market clearing point. At this e-uilibrium point the amount that producers
are wiling and able to supply in the market is =ust e-ual to the amount that consumers are
wiling and able to demand. Both consumers and producers are satisfied and there is no
pressure on prices to change and thus the market for goods is said to be at e-uilibrium.
This is illustrated in #igure 6.0A -uilibrium point
"e
"rice
d s
-uilibrium point
s d
?e
?uantity J
#igure 6.0A -uilibrium point
-uilibrium can be defined as a state of rest or balance in which no economic forces are
being generated to change the situation. These economic forces are e!cess demand and
supply and are illustrated in #igure 6.0:. At "03 the -uantity demanded by consumers is
?0 units but producers are willing to supply at price a -uantity of ?6 units. Therefore
there is an e!cess supply e-ual to &?6 -?0'. !cess supply refers to a situation where
-uantity demanded is less than -uantity supplied at prevailing market price. "roducers
may therefore react to the e!cess supply by lowering prices of their products so as to sale
the unsold stocks. !cess supply is referred to as a buyers market since suppliers may be
69
obliged to lower their prices in order to dispose of e!cess output a situation which is
favorable to buyers. !cess supply represents an economic force that e!erts downward
pressure on prices. At "6 the -uantity demanded is ?6 but producers are wiling to supply
?0 units of goods. Therefore3 there will be e!cess demand e-ual to &?6-?0'. This
situation of e!cess demand is referred to as sellers market because competition among
buyers will force up the price due to the e!isting shortage !cess supply is a situation
where -uantity demanded is greater than -uantity supplied at prevailing market prices.
d
"0
"rice "e e
"6
!cess supply &surplus'
!cess demand
?0 ?e ?A ?6 d
?uantity
#igure 6.0: .echanism of market e-uilibrium
*n this case3 the price of goods will rise because of competition among buyers. !cess
demand represents an economic force on prices which e!erts upward pressure. "rices "0
and "6 are dise-uilibrium prices and market is said to be at dise-uilibrium. Therefore3 the
general rule for e-uilibrium is that demand should e-ual supply represented by ?e and
"e.
;";1 M$t)em$tics #eriv$tion o* 1<uilibrium
1.ercise ;1
A7
Kou are given two functions4 the demand function and the supply function as follows:
Demand function ?d M AEE7 - 6FFp
+upply function ?s M 0E6F L 6:7p
-e<uired:
Determine the e-uilibrium market price and -uantity.
3olution
?d M ?s
AEE7 - 6FFp M0E6F L 6:7p
6EE7 - 0E6F M 6:7p -6FFp
676: M E7Fp
E7F E7F
: M p
?d or ?s M AEE7 -6FF&:'
M 6:HF
1.ercise ;
The following economic function has been derived by the finance manager of 8enya
Breweries ltd.
?a M Ap
6
- :p Fp - : - supply
?F - 6: - p
6
(here " represents prices and ? represents -uantity.
(hich of the two function could represent in demand curve and supply curve and why. At
what value of price and -uantity is the market in e-uilibrium)
N?a M Fp - : - supply curve
Np
N?b M -6" - Demand curve. The price is always negative
N"
?a M ?F
A"
6
- :" M 6: - "
6
A"
6
L "
6
- :" M 6:
:"
6
- :" - 6: M 7
:"
6
- :" - 6: M 7
M "
6
- " - F M 7
A0
"6 - A" L 6" - F M 7
" &" - A' L 6&" - A' M 7 "
M A or " M 6
? M A ! A
6
- : ! A M 0E
;";; (%pes o* 1<uilibrium
The are three types of e-uilibrium4 stable3 unstable and neutral.
(i) 3t$ble e<uilibrium *f there is a force that distracts market e-uilibrium then
there will ad=ustment that brings back the prices and -uantity demand to the
initial e-uilibrium. This is well e!plained in the previous section.
(ii) ?nst$ble e<uilibrium e-uilibrium is said to be e-uilibrium if there is
divergence from the e-uilibrium set by forces which push the prices further
away from the e-uilibrium prices. #or e!ample3 in case of a giffen good which
assumes a demand curve which is positive as indicated in #igure 6.0E
s
d
"0
"e
"6
d
s
?0 ?e ?A ?:
#igure 6.0E 8nife edge e-uilibrium
At "0 there is e!cess demand and this will e!ert an upward pressure on the prevailing
market thus push it further away from the e-uilibrium. At p6 there is e!cess demand
and this will e!ert an upward pressure on the prevailing market prices thus pushing it
further away from the e-uilibrium. This type of e-uilibrium is known as kni*e ed5e
e-uilibrium. A small in price will send the system further away from the e-uilibrium.
A6
(iii) 8eutr$l e<uilibrium occurs when initial e-uilibrium is disturbed and forces of
disturbances leads to a new e-uilibrium point. *t may occur due to a shift of
either demand or supply or through the effect of ta!es.
()e eAect o* $ s)i*t o* dem$nd $nd suppl% on m$rket e<uilibrium.
($) 3)i*t in dem$nd
Incre$se in dem$nd. %onsider #igure 6.0F which illustrates the effect of an
increase
on demand on market e-uilibrium. An increase in demand is represented by a shift of
the demand curve from d0d0 to d6d6. The immediate effect will be shortage and this
will force prices to rise leading to increase in -uantity supplied until e-uilibrium is re-
established at "e.
:$ll in dem$nd %onsider #igure 6.0G which illustrates the effect of a fall in demand
on the market e-uilibrium.
A fall in demand is represented by a shift of demand curve to the left from d0d0 to
d6d6. The immediate effect will be a surplus and this will force the producers to
lower the price in an attempt to get rid of e!cess stock. This fall in price will led to
decline in -uantity supplied until a new e-uilibrium is established at "e04 ?e0
d6
s
d0
"0
"e
d6
s
d0
?0 ?6
#igure 6.0F *ncrease in demand
AA
d0
s
"rice
d
6
"0
"e0
d0
s
d6
?e0 ?e
?uantity
#igure 6.0G fall in demand
(b) 3)i*t in suppl%
Incre$se in suppl% %onsider #igure 6.0H which illustrates the effect of an increase
of
supply on the market e-uilibrium. An increase in supply is represented by a shift of
supply curve to the right from +0+0 to +6+6. The immediate effect will be surplus
and this will force the producer to lower their prices in order to get rid of e!cess
stock. This fall will lead to an increase in -uantity demanded until a new e-uilibrium
is established at "e.
+0
"rice
"6
"e0
+0
d
+6
+6
d
?e ?0
?uantity
#igure 6.0H *ncrease in supply
A:
0 *$ll in suppl% %onsider the #igure 6.09 which illustrates the effect of a fall in supply
on the market e-uilibrium. A fall in supply is represented by a shift of supply curve to the
left from +0+0 to +6+6. The immediate effect will be shortage and thus will force the
prices to go up leading to a fall in -uantity demanded until a new e-uilibrium is
established at "e03 ?e6.
+6
"rice
d
+0
"e0
"e
+6
+0
d
?e6 ?e
?uantity
#igure 6.09 #all in supply
Multiple C)$n5es %onsider #igures 6.67 to 6.66 which shows a simultaneous
increase in cost of production and a fall in the price of a complimentary good. An
increase in cost of production will lead to a fall in supply. This is represented by a shift
of supply curve to the left. A fall in the price of a complimentary good will lead to an
increase in demand. This is represented by a shift of demand to the right.
+6
"rice
"e0
+0
"e
+6
+0
?e ?e0
?uantity
#igure 6.67 *ncrease in the cost of production
AE
"rice
"e0
"e
d0
"e0
"e
+6
d6 s
d0
d6
s
d0
?e ?e0
?uantity
#igure 6.60 #all in the price of complimentary
d6
+6
+0
d6
+0
d0
?e ?0
#igure 6.66 .ultiple changes
;& Price Control
This refers to a deliberate action by the government to artificially impose through
legislation the prices of certain goods and services. +uch imposed prices are referred
to as F$t prices. These flat prices may be a ma!imum or a minimum price. A
ma!imum price refers to that price above which a good or a service cannot be sold. A
minimum price refers to that price below which a good$service cannot be sold.
The government may find it necessary to control the prices of certain good$service
because:
AF
&i' C)e$pness *t may be ob=ective of the government to keep price of certain
goods and services at a level at which they can be afforded by most people
hence protecting the consumer being e!ploited by producers
&ii' M$inten$nce o* income; The government may want to keep the income of
certain producers at a higher level than that which would be supplied by
market forces demand and supply. Thus the government is able to maintain
the low income producers in the market.
&iii' Price st$bilit% if there is a wide variation in the price of product year to year
the government may wish to iron out these variations for the interests of both
producers and consumers. This price control will act as one of the methods to
curb inflation.
M$.imum price control9price ceilin5
%onsider #igure 6.6A3 if the government imposes a price ceiling3 given by "0 there will
an e!cess demand or shortage e<uiv$lent to G- G; @nder normal circumstances this
economic force of e!cess demand will e!ert an upward pressure prices. 2owever3 in this
case the price cannot go above "03 since "0 is the ma!imum price. This price is unable
to fulfill the rationing function leading to a demand for a centrally administered
system of rationing of the good in -uestion.
"rice d
"e
"0
s
s
.a!imum price $
price ceiling
d
?0 ?e ?6
?uantity
#igure 6.6A .a!imum price ceiling
Ot)er eAects o* Price controls
&i' Rise of bl$ck m$rket where goods are sold above legal price even above the
e-uilibrium price.
AG
&ii' 3)ort$5es are likely to become chronic as producers move away from
production of price controlled goods.
&iii' Research and development will be encouraged as the producers move from
the price controlled industry.
&iv' There will be incre$sed costs eHcienc% in production by firms as profits can
only be increased by reducing costs.
Minimum price9price Foor
This refers to the action taken by the government to set a price below which a
good$service cannot be sold. They are normally imposed above the e-uilibrium price
since the government feels that the price determined by forces of demand and supply is too
low as illustrated in #igure 6.6:
*f the government imposes a minimum price by "03 the immediate effect will be surplus
given by ?0 ?6. @nder normal circumstances e!cess supply e!erts a down ward pressure
on prices3 but in this case prices cannot go below "0 for it is a minimum price. The
government then has to intervene by buying e!cess stock or limiting it to prevent prices
from going down.
"rice
d
s
"0 "rice flour
"e
s d
?0 ?e ?6
?uantity
#igure 6.6: "rice four
Ot)er eAects o* price Foors
&i' *n the case of a minimum produce price floor3 &low income producers' will
have a stabili,ing effect on their income.
&ii' *n the case of minimum wages employed workers will be guaranteed an
income compatible with the cost of living.
AH
&iii' +ome producers may be wiling to dispose off their product below the
minimum legal prices especially in the case of labour.
&iv' *n the case of minimum wage rate3 it will lead to reduction in employment.
0dv$nt$5es o* price control
&a' "rotects consumers3 especially the low income consumers from price increases by
producers.
&b' nsures that producers have a reasonable income which is sub=ect to inflation
&c' %ontributes to industrial peace especially if they constitute part of the
comprehensive income policy and a ma!imum price is fi!ed on some basic goods.
&d' *t may be associated with a decrease in price and an increase in output such as the
case of a monopolist overcharging for its products and is forced to lower prices.
*n this case the monopolist may accompany the fall in price with an increase in
output in order to compensate for loss in revenue.
&e' *t may be used as one of the several counters of inflation.
;' 1l$sticit% o* #em$nd
*t can be defined as the ratio of the relative change of a dependent variable to changes in
another independent variable. lasticity can be analy,ed in terms of demand and supply.
*t can also be defined as a measure of responsiveness of -uantity demanded of a good in
to changes in income or prices of other related goods. There are three types of elasticity4
price elasticity of demand3 cross elasticity of demand and income elasticity of demand.
Price el$sticit% o* dem$nd its the measure of responsiveness of the -uantity demanded
of
a commodity to changes in its own price. *t is also referred to as o7n price elasticity. *t
abbreviated as "D$D.
*t is calculated as follows
A9
"D M "roportionate change in -uantity demanded
"roportionate change in price M
N?$?o
N"$"o
M N? O N"
?o "o
M N? ! "o
?o N"
"D M N?. "
N" ?
*f changes in prices cause more than proportionate change in -uantity demanded it is said
to be price elastic3 in this case D P0; *f changes in the price causes less than
proportionate change in -uantity demanded3 then demand is said to be price inelastic this
is represented by D Q 0. *f changes in price causes proportionate change inn -uantity
demanded then3 demand is said to be unit elastic or unitary elastic where DM 0.
To illustrate price elasticity consider the Table 6.A which shows demand schedule of
commodity J.
"rice ?uantity
07 077
E 0E7
%alculate the "D when the price changes from 8shs per unit 07 to 8shs E per unit.
"D M N? . " M ?6 - ?0 . "
N" ? "6 - "0 ?
M 0E7 ! 07 M A7 M -A absolute M $A$ M A
E 077 07
This price elastic because A P0
The price elasticity of demand is classified into two:
&i' "oint elasticity
&ii' Arc elasticity
The point elasticity of demand measures elasticity at a particular point along the demand
curve. *t is calculated using the formulae N? . "
N" ?
:7
5raphically illustrated as:
"rice
"
d
"oint elasticity
d
? ?uantity
#igure 6.6E "oint elasticity
%alculate the point elasticity of demand given that ?dM :" L6p
A
-A ? M :L6-A MA
(here " M0
3olution
"D M N?. " " M 0 ?d M : &0' L 6&0
A
'-A M A
N" ?
N? M :" L 6"A - A
N"
M : L F"
6
But " M 0
Therefore N? M : L F ! 06 M 07
N"
#rom the formular N? . "
N" ?
07 ! 0$A M A.A price elastic
%alculate point elasticity of demand given ?d M
0
$p M "6 L 0 when " M 6 ?d
M R L 6
6
L 0
? M AE.E
N? M "
-0
L "
6
L 0
N"
M -"6 L 6"
M -0 L 6"
6
6
M A.GE
#rom the formular N? . "
N" ?
M A.GE ! 6 M 0.AF
E.E
0rc 1l$sticit% o* dem$nd
:0
This measures the elasticity of demand between two points on the demand curve. Arc
elasticity is the coefficient of the price elasticity between two points on the demand
curve. *t is therefore an estimate of the elasticity along a range of the demand curve. This
estimate improves as the arc becomes small and approaches a point in the limit. Arc
elasticity can calculated for both linear and non-linear demand curves using the following
formula: *t is illustrated as in #igure 6.6F
d
"
0 A Arc elasticity
B
"6 d
?0 ?6
#igure 6.6F Arc elasticity of demand
N" . " where " M "0 L "6
N" ? ? 6
? L ?6
6
M "0 L "6 ! 6SSSS
6 ?0 L ?6
M "r L "6
?0 L ?6
Therefore N? . "0 M "6
N" ?0 L ?6
%alculate Arch lasticity of demand given by
?d M 6: - "6
(hen "0 M 6
"6 M A
+olution
"D M N? . "0 L "6
N" ?0 L ?6
? M 6: - 6
6
to get ?
M 67
? M 6: - A6 @se of "6 M ?6
M 0E
:6
N? M ?6 - ?0 M 0E - 67 M -E
N" "6 - "0 A -6 6
"D M -E ! 6 L A
67 L 0E
-E ! E M -E
AE G
M 7.G0: price inelastic since "D
1.ercise ;1
The demand for a commodity is E units when the price is +h.0777 per unit. (hen the
price per unit falls to +h.F77 the demanded rise to F units. %alculate the arc and price
elasticity of demand
"oint "D M N?. "
N" ?
M 0 ! 0777 M -6 M -0 M 7.E price inelastic
- :77 E : 6
Because D P 0
Arch "D M N- ! "0 L "6
N" ?0 L ?6
0SS ! 0777 L F77
- :77 E L F
M 0SS ! 0F77 -:S 7.AF
- :77 00 00
d
"rice
"0
"6 d
?0 ?6
?uantity
#igure 6.G 5raphical illustration of price elasticity of demand
:A
+lope $ gradient M NK which
N"
D M N? . "
N" ?
but N? M 0S
N" N"
N?
M 0SSSS
gradient
Therefore N? M 0SSSS
N" gradient
.aking "D 0SSSS "
gradient ?
;';1 (%pes o* el$sticit%
There are five types of elasticity of demand.
&i' Per*ectl% el$stic dem$nd; Demand is said to be perfectly elastic when the
consumers are willing to buy an amount of a commodity at a given price3 but non
at a slightly higher price. *n this case elasticity of demand is e-ually to infinity.
The will be a hori,ontal straight line as illustrated in #igure 6.6H. This is a case of a
commodity in a perfectly competitive market. (here an increase in price may lead
to a loss of all customers.
"rice
M T
" d
?0 ?6 ?uantity
#igure 6.6H "erfect elastic demand
::
(ii) 1l$stic dem$nd; Demand is said to be price elastic when a charge in price
causes more than proportionate change in -uantity demanded. *n this case the
value of elasticity of demand is greater than 0 and the demand curve will be
gently sloped as indicated in #igure 6.69. This implies that if prices increase
from "0 to "6 the -uantity demanded falls in greater proportion from ?0 to
?6 and vice versa. This is a case of lu!ury commodity which consumes can do
without or a case of a substitute.
"rice
"rice
d
"6 "6
"0 "0
d
?6 ?0 ?uantity
?6 ?0 ?uantity
#igure 6.69 lastic demand
(iii) ?nit% el$stic dem$nd; Demand is said to unit elastic if changes in price cause
proportionate change in -uantity demanded. *f price increase -uantity falls in
the same proportion and vice versa. D M 0 and the demand curve will be
rectangular hyperbola as illustrated in #igure 6.A7. This is a case of a good
that lies between a lu!ury and necessity such as soap opera film or movie.
d
"rice
"6
d
"0
?6 ?0 ?uantity
#igure 6.A7 @nity elastic demand
:E
(iv) Inel$stic dem$nd; Demand is said to be price inelastic if changes in price
causes less than proportionate change in -uantity demanded. *f prices
increases the -uantity falls in less proportion and if the prices falls the
-uantity demanded increases in less proportion D Q 0 as illustrated in #igure
6.A0. This is a case of a good which is a necessity. These are goods which
consumers can not do without but need not be consumed in fi!ed amount like an
absolute necessity such a staple food like ugali and milk. *t also applies in the
case of habit forming goods like beer and cigarettes.
d
"6
"0
d
?6 ?0 ?uantity
#igure 6.A0 *nelastic demand
(v) Per*ectl% inel$stic dem$nd; Demand is said to be perfectly price inelastic if
changes in price has no effect on the -uantity demand &DM 7'. *n this case
the demand curve will be vertical straight as illustrated in #igure 6.A6. This is a
case of a good which is an absolute necessity. A good that consumes cannot do
without and have to consume in fi!ed amounts such as salt.
"rice
d
"6
D M 7
"0
?uantity
:F
#igure 6.A6 "erfectly inelastic demand
:$ctors $Aectin5 price el$sticit% o* dem$nd
&i' 3ubstitut$bilit%. *f a substitute is available in the relevant price range3 -uantity
demanded will be elastic. The demand for a particular brand of cigarettes maybe
considered being elastic because if there is e!istence of other brands that are close
substitutes. 2owever3 the total demand for cigarettes may be inelastic because
there are no close substitutes for cigarette. *t can hence be said that the greater the
number of substitutes for a given commodity3 the greater will be its price
elasticity of demand.
&ii' ()e proportion o* $ consumerIs income spent on t)e commodit%. *f this proportion
is very small as in the case of match bo!es3 the -uantity
demanded will tend to be inelastic. /n the other hand if this proportion is
relatively large as for e!ample in the case of meat3 demand will tend to be elastic.
This implies that the greater the proportion of income which the price of the
product represents3 the greater price elasticity of demand will end to be.
&iii' ()e e.tent to 7)ic) t)e product is )$bit *ormin5. 2abit forming
products like
cigarettes or alcohol have a low price elasticity of demand. *n the case of in
addiction to3 say drugs3 the price elasticity of demand is likely to be even lower.
&iv' ()e number o* uses o* $ commodit%. The greater the number of uses
of the
commodity3 the greater the price of elasticity. The elasticity of alluminium for
e!ample is likely to be much greater than of butter because butter is mainly used
as food while alluminium has hundreds of uses such as electrical wiring and
appliances.
&v' ()e len5t) o* $djustments. The longer the period allowed for ad=ustment in
the
-uantity demanded as a commodity the greater its price elasticity is likely to be.
This is because it usually takes some time for new prices to be known and for
consumers to make the actual switch. %onsumers ad=ust buying habits slowly. &vi'
()e level o* prices; *f the ruling price is at the upper end of the demand curve3
-uantity demanded is likely to be more elastic than if it was towards the lower
end. This is always true for a negatively sloped straight line demand curve.
:G
&vii' 8ecessities $nd lu.uries Demand for lu!ury is likely to be price elastic
while the demand for necessities is generally price inelastic. 2owever3 this
depends with availability of close substitutes.
&viii' Widt)9si>e o* t)e m$rket the wide definition of the market of a good3 the
lower is the price elasticity of demand. Thus for wide markets demand will tend
to be price inelastic while for a small market demand will tend to be price elastic. &i!'
(ime demand for most goods and services tend to be more elastic in the long run
as compared to the short run period. This is because consumers will take some
time to respond to price changes. #or instance3 if the price of petrol falls relative
to diesel3 it will take long for motorists to respond because they are locked in
e!isting investment in diesel engines.
&!' #ur$bilit% o* t)e commodit% durable goods have low elasticity of demand or
they
are price elastic while perishable goods are price inelastic.
Import$nce o* price el$sticit% o* dem$nd9economic $pplic$tion o*
t)e concept o* el$sticit%
&a' ()e consumer needs knowledge of elasticity when spending income where more
income is spent on goods whose elasticity of demand is inelastic and vice versa.
&b' ()e 5overnment imposes ta!es with inelastic demand and vice versa.
Devaluation when a country devalues or lowers the value of its currency. The
currency is made cheaper relative to other currencies. This makes a countrys
e!ports cheaper for foreigners. *ts import e!pensive for the residents. #or a
country to benefit by increasing e!ports3 the elasticity of demand must be high.
&c' /usiness9producers They use elasticity of demand on deciding on whether to
charge high or lower prices or even deciding on commodities to bring to the
market especially those which are price inelastic.
;'; Income 1l$sticit% o* dem$nd
*t is the measure of responsiveness of demand due to change in income.
KD M N? U?
NKUK
:H
(here income elasticity is positive this is a norm$l good. (here income elasticity is
negative this is an in*erior good. (hen the demand of a good does not change with
increase in income then income elasticity is ,ero. *n wealthy countries for instance basic
clothes will tend to have low income elasticity of demand while foreign will have high
elasticity of demand as income increases. *n poor countries basic commodities will have
high income elasticity compared to manufactured e!pensive items.
Import$nce o* Income 1l$sticit% o* #em$nd
&i' /usiness 4rms- if demand of a commodity is elastic to price3 its possible to
revenue by reducing prices. Businesses use specific information to know
which price to increase to eliminate shortages or which price to reduce to
eliminate surpluses.
&ii' =overnment uses elasticity to determine the yield of indirect ta!es. *nelastic
commodities are highly ta!ed. 2owever3 if demand of a commodity is elastic an
increase in ta! will hinder production
&iii' Price el$sticit% is relevant for a country considering devaluation as a means of
rectifying balance of payment dise-uilibrium. Devaluation decreases imports
and increases e!ports. 2owever3 this will depend on demand of import and
e!port elasticities.
&iv' *t helps to e!plain price instabilities in the agricultural sector
&v' .onopolists apply price discrimination by understanding the demand
elasticities. 2igh price is charged to those markets with lower price elasticity
:$ctors $Aectin5 Income el$sticit% o* dem$nd
&i' ;ature of the need that the commodity covers. #or certain goods and services the
percentage of income spent declines as income increases such as food.
&ii' The initial level of income of a country&level of development' T< sets3
refrigerators3 motors vehicles are considered as lu!uries in underdeveloped
countries while they are considered as necessities in countries with high per
capita income.
:9
&iii' Time period. The demand for most goods and services will tend to be income
elastic in the long run as compared to short run period. This is because the
consumption pattern ad=usts with time and also with change in income.
Cross el$sticit% o* dem$nd
*t is the measure of responsiveness of -uantity demanded of a good due to changes in the
price of another related good. *t is abbreviated as JK where J and K are to goods. *t is
calculated as follows:
JK M "roportionate change in -uantity demanded of a good J
"roportionate change in -uantity demanded of a good K
N?! ."y
N"y ?!
The sign of cross elasticity of demand is positive if the good J and K are substitutes and
negative if J and K are complimentary. The higher the absolute value of cross elasticity
of demand the stronger the degree of substutability or complimentaribility. The main
determinant of cross elasticity is the nature of the commodity relative to their uses. *f
two goods can certify e-ually the same need the cross elasticity will be high and vice
versa.
Import$nce o* cross el$sticit% o* dem$nd
&i' "rotection of local industries. *f the government imposes a tariff on a good with
the intention of protecting a local industry then the local product and the
imported product must be close substitutes for the government to achieve it
ob=ectives
&ii' *f a firm is in a competitive market3 there a high positive elasticity of demand
between its products and those of competitors. #or such a firm3 it will not be in
its interests to increase the price of its product as this may result to more than
proportionate reduction in its sales. 2owever3 it might consider lowering the
prices of its products in the hope of attracting customers from other firms.
E7
&iii' #or product with high degree of complimentarity3 a fall in price of one of the
goods due to increase in supply will benefit the producers of a compliment
product due to an increase in sales. .g. if there is a fall in prices of vehicles3 due to
an increase in supply the suppliers of fuel e!perience an increase in sales
because more cars will be bought.
;+ 1l$sticit% o* 3uppl%
*t is the measure of responses of -uality supply of a commodity to change in the factors
affecting supply
"rice elasticity of supply
*t is the measure of responses of -uality supplied of a commodity to change in its two
prices. *t is abbreviated as + and calculated as:
"roportional change in -uality supplied
"roportional change in price
.+M N?s . "
N" ?s
+ will have appositive value because of the direct relationship between the price of the
product and -uality supplied.
*f + is greater than 03 then the supply is said to be price elastic *f
s Q0 then supply is price inelastic
*f s M0 then supply is unit elastic.
(%pe o* price el$sticit% o* suppl%
0. "erfectly elastic supply
6. lastic supply
A. @nit elastic supply
:. *nelastic supply
E. "erfectly inelastic supply.
:$ctors $Aectin5 price el$sticit% o* suppl%
E0
a' Mobilit% o* *$ctors o* production *f they are highly mobile then supply will be
price elastic since more factors can be employed -uickly when the prices increase
thus increase in supply
b' ()e level o* emplo%ment o* resources *t refers to the utili,ation and allocation of
resources. *f the factors are fully utili,ed supply will be price inelastic due to the
fact that all the facts are occupied and thus can not be mobili,ed in order to
increase supply. 2owever if they are under employed3 supply will be price
elastic.
c' Production period for product that take short period of time to produce their
supply tend to be price elastic. (hile thus that take a longer period will be price
inelastic because it will take a while before the products can reach the market. d'
8$ture o* t)e commodit% "rice elasticity of supply for perishable goods tend to be
inelastic due to the fact that the goods do not respond to price fall as they can not
be easily stored. /n the other hand supply for durable goods tend to be price
elastic since they can be store when the price falls thus contracting supply.
e' -isk t$kin5 *f the entrepreneurs are willing to take risk then supply of the products
will be price elastic. Risk taking will in return be determined by the prevailing
conditions in the economy. .g. "olitical stability3 security3 government
incentives3 infrastructure3 etc.
f' Level o* stock *f its high supply will be price elastic because if the price of a
good increases more of the good will is supplied from the stock
g' (ime period +upply for most goods and services will tend to be more elastic in the
long run than in the short run because producer need more time to reorgani,e
factors of production so that they can increase supply of the products.
Import$nce o* price el$sticit% o* suppl%
i' *f supply of a good is price elastic thus an increase in demand will benefit both
the producer and consumer of products because the producer will be in
apposition to supply relatively more of their products and consumer will
eventually pay a relatively lower price.
ii' *f the supply of commodity * price inelastic business may risk losing revenue
when there is a fall in the price of their products. This is because they will be
E6
forced to sell their products at a loss or a reduced price margin3 e.g. *n the case of
perishable goods3 however in the supply of the goods is price elastic the
business people may store their products when price fall thus contracting
supply e.g. the case of durable goods.
-el$tions)ip bet7een tot$l revenue $nd el$sticit%
a' 1l$stic dem$nd *ncrease in price will reduce the total revenue while a
fall
in price increase the total revenue
b' Inel$sticit% dem$nd *ncrease in price will reduce the total revenue while
a
fall in price causes reduction in total revenue.
c' ?nit dem$nd change in price will leave the price unchanged.
0pplic$tion o* el$sticit% in economic polic% decisions
i. "roducts$services pricing decisions
ii. %ustomer spending programmes
iii. "roduction decisions
iv. 5overnment policy orientation -Ta!ation policy
-valuation policies
-"rice control$minimum
v. "rice discrimination
vi. +hift of the ta! burden
;1, -evie7 Guestions
0. Define demand. !plain the law of demand by the help of a schedule and diagram
6. Discuss the assumptions and e!ceptions of law of demand
A. Distinguish between change in -uantity demanded and change in demand.
:. Discuss the factors of change in demand.
E. (rite short notes on the following
a' Abnormal demand curve
b' Boint demand
c' %omposite demand
F. (hat do you mean by elasticity of demand) !plain it with the help of diagrams
EA
G. Discuss factors which determine the elasticity of demand
H. 2ow is elasticity of demand measured) !plain with e!amples
9. !plain the importance of elasticity of demand
07. Discuss the concept and importance of income elasticity and cross elasticity of
demand.
00. Distinguish between point elasticity and cross elasticity.
06. Define supply. !plain the law of supply and its assumptions
06. Distinguish between change in -uantity supplied and change in supply
0A. Discuss factors which affect supply
0:. !plain the concept of elasticity of supply. 2ow is elasticity of supply measured)
0E. Discuss the factors of elasticity of supply
;11 -e*erences
+aleemi ..A &6770' 1conomics 3impli4ed (-evised 1dition) +aleemi "ublishers 1td
&"ages 0E-:6'
8outsoyiannis A4 &099:'3 Modern Microeconomics3 .acmillan ducation 1td
E:
L133O8 (6-11: (61O-@ O: CO83?M1-
3;1 Introduction
*t touches on satisfaction other than a customer desire from consuming a particular
commoditys. The satisfaction the consumers derives from consumption of commodity is
called utility. Average utility is the satisfactory per unit consumed on average. .arginal
utility is the incremental satisfaction brought about by consuming an e!tra unit of a
commodity. All this is assessed by two schools thought
a' %ardinality $ .arginal utility Approach
b' /rdinals Approach *ndifference
3; C$rdin$list M$r5in$l ?tilit% 0ppro$c)
This school of taught believes that utility satisfaction is measurable by use of cardinal
numbers. This theory assumes that the consumers satisfaction can be measured in a unit
known as utils; An individual demands for a particular commodity because of the
satisfaction$utility received from consuming it. The cardinalist approach assumes that the
consumers satisfaction or utility received from consuming a product$service. @p to a
point3 the more units of a commodity the individual consumes per unit time the greater
the total utility received. Total utility is the total satisfaction received from consuming a
commodity. .arginal utility is the e!tra utility derived from the consumptions of one
more unit of a commodity3 the consumption of all other goods remaining unchanged. *t
e!plains that individual demand slopes downwards from left to right because of law of
diminishing marginal utilities.
()e L$7 o* #iminis)in5 M$r5in$l ?tilit% (#M?)
This law states that holding other factors constant as more and more units of a product are
consumed one after another the marginal utility falls as the total consumption increases..
0ssumptions
0. The consumer is a rational being. As he$she consumes a commodity he goes for
those commodities that give ma!imum satisfaction.
EE
6. "rice of commodity is constant hence marginal utility of money in constant
A. ?uality of the commodity should be consumed in suitable and responsible unit
hence consumption should process commodity
:. Trend of the consumers consumption should remain constant.
1.emption o* t)e l$7 o* #M?
0' Desire for money3 the more money one gets the more satisfaction.
6' @se of li-uors-the more and more it is take the more the satisfaction
derived
A' Desire for knowledge
:' "ersonal hobbies$ habits3 more and more of this will give high satisfaction.
0pplic$tion o* t)e l$7
a' *t is applied on the bases of customers behavior analysis.
b' *t is applied in money whereby utility of money for poor people is greater than for
the rich.
c' *t used in the base of progressive ta!ation whereby the higher the income the
higher the ta! which led to dissatisfaction
89/ The law applies in many practical situations. #or e!ample a person on an e!otic
holiday to the .aasai .ara will e!perience increasing in total utility as his holiday
proceeds but he is likely to derive greater satisfaction during the earlier days of his
holiday than during the late days.
The law of diminishing utility applies provided other factors affecting the consumers level
utility3 apart from the -uantity consumed3 remain constant. *f any of these factors such as
taste of fashion change3 the law may be temporarily inapplicable until a stable situation is
re-established. #or e!ample a person may progress from an occasional buyer of paintings into
an obsessive collector or art.
EF
Illustr$tion o* tot$l utilit% $nd m$r5in$l utilit%
?uantity Total @tility
7 7
0 67
6 E7
A F7
: F6
E F7
Table A.0 Total @tility and .arginal @tility
.arginal utility M %hange in total utility
%hange in -uality
*.e. .u M DT@
D?
!
G7
F7 J J
.arginal @tility
7
67
A7
07
6
-6
Total utility
J
T.@
E7
J
..@
:7
A7
67
J
07
.arginal
utility
7
0 6 A : E F
y
?uantity
#igure A.0 Total @tility and .arginal @tility
EG
The above illustration shows the relationship between total and marginal utility.
A saturation point is reached when the utility is ma!imum and the marginal utility is at
minimum beyond which the total utility starts to decline while marginal utility becomes
negative yielding dissatisfaction.
()e Limit$tion o* ?tilit% (C$rdin$l ?tilit%)
0' *t is difficult to make inter-personal comparison of utility since satisfaction is
sub=ective
6' .easurement of utility is difficult since utility is a mental phenomenon even by
the help of any instrument hence difficult to determine e-uilibrium position of a
customer.
A' *t dose not consider other factors that determine utility such as environment
:' *ndivisibility of commodities is not possible to divide some goods into small units
in order to e-uali,e marginal utility
E' *gnorance of individual who are some times not aware of the substitute or
different goods3 e.g. cheap substitute leading items to have low satisfaction from
the commodity they consume.
F' Different behaviour of individual due to different customs and fashion
3;3 Consumer 1<uilibrium
A consumer is in e-uilibrium position when he$she achieves ma!imum satisfaction out of
the available resources. A consumer in an e-uilibrium position when he$she distributes
e!penditure on purchase of different goods in such a way that marginal utility of a
different good is e-ual to that of the good. This behaviour of customers is called the law
of e-ual marginal utility. Based on the mention assumption the consumer will ma!imi,e
this utility if he allocates his income in such a way that a shilling spent on one good yield
as much satisfaction as a shilling spent to any other goods. The marginal utility per
shilling spent on good J e-uals to the marginal utility spent on good K hence consumer
e-uilibrium is obtained when
.arginal utility ! M .arginal @tility of K
"rice of J "rice of K
EH
.u! M.uy
"J "K
The law of diminishing marginal utility is also based on the assumption that the consumer
is rational. An economic agent is said to be rational when the agent e!hibits behaviour
which is consistent with a set of rules governing preferences. *n the conte!t of consumer
behavior this would imply the following assumption or a!ioms4
i. The a!iom of dominance which implies that consumers will always prefer more
goods or less. This is also known as the $.iom o* non- s$ti$tion
ii. The $.iom o* selection which relates to the idea that the consumer aims for his or
her most preferred state.
iii. The $.iom o* completeness states that the consumer is able to order al the
available combinations of goods according to his or her preferences.
iv. The $.iom o* tr$nsivit% states that if in some combination of goods4 A is preferred
to B and B is preferred to % then &by transivity' A is preferred to %.
*mportance of 1aw of -ual .arginal @tility
0' *t is application in consumption .A consumer can achieve ma!imum satisfaction
when utility of different commodities is e-ual since the ob=ective is to achieve
ma!imum satisfaction.
6' Application in production. /b=ective of the firm is to ma!imi,e profit achieved
when cost of production is minimal and when marginal productivity of all factors
is e-ual.
A' Application is distribution. (hen share of different factors of production are
determine3 they are determined according to the principal of marginal utility
:' Application in saving and spending. A special part of the income is spent on
purchase of consumer good and the remaining saved for future use.
E9
%
o
m
m
o
d
i
t
y

y



3;! Ordin$list 9 IndiAerence Curve 0ppro$c)
This school of thought is opposed to the law that utility is measurable through cardinal
numbers. This school of thought maintains that customer behaviour can be e!plained in
terms of preference so that customers need to state the commodity they prefer without
assigning numeral values without the strength of their preferences. %onsumers are
e!pected to value their preferences of the entire service market of goods and service in
order to choose i.e. combination of two goods that can be chosen if the two goods are
ranked. This is e!plained by the use of indifference curves. The assumptions of this
approach are:
0. "rice of goods is constant
6. %onsumers are rational
A. %onsumer can rank his$her preferences over time
:. Their behavior must be transitive i.e. if a consumer prefer A to B to l % then he can
prefer A to % &a!iom of transitivity'
E. %ustomer always prefer more to less of every commodity &a!iom of non-station'
F. The slope of indifference curve gives the marginal rate of situation &..R.+'
G. The consumer is able to order all the available combination &a!iom completeness'
IndiAerence Curve
This is curve =oining together all different combination of two goods that yield the same
amount of utility to a consumer. *t is a locus of point of possible combination of two
alternative good that yield the same level of utility. The slope of indifference curve is
called the marginal rate of situation &.R%' i.e. the rate at which good K can be
substituted for by good J leaving the consumer at the same level of utility.
*ndifference curve
%ommodity !
#igure A.6 *ndifferent curve
F7
*ndifference curve
*%A
*%6
*%0
%ommodity !
#igure A.A *ndifferent map
*ndifference map indicate different indifference curves drawn on the same plane price
with different level of utility.
Properties o* IndiAerence
a' IndiAerence )$s $ ne5$tive slope; This shows if the -uality of one good say
decrease
the -uality of other good must increase if the consumer has to remain on the same
level of satisfaction
b' IndiAerence curve do not intersect; This is because if they did the
point of
intersection implies two levels of satisfaction which is not possible. consider the
#igure A.:
K
K0
A
K6
B
KA
%
@0
@6
J6 J0 JA !
#igure A.E *ndifference curves do not intersect
+ince combination A and % are on the same indifference come u6 the consumer must be
indifferent between them. Band % are on the same in difference curve u3 the consumer
%
o
m
m
o
d
i
t
y

y



F0
5
o
o
d

K


must be indifferent between then. *f the consumer is indifferent between A and % then the
he must be indifferent between A and B &considering the rule of transitivity'. This is
however3 absurd since the combination A contains more of K and more of J and thus
preferring A to B. To be consistent with consumption assumption of rationality it can be
concluded that indifference curve cannot intersect.
c' ()e% $re conve. to t)e ori5in$l This implies that if the slope of indifference
decrease
in absolute terms as we move longs the curve from left downwards to the right
therefore the marginal rate of the substance will be decreasing or diminishing as show
in #igure A.F.
K0
K6
KA
J0 J6 JA 5ood J
#igure A.F %onve! to the original
The theory of diminishing marginal rate of substitute e!presses the observed behavior
that as people consume more of a good3 the utility they gain from each e!cessive unit
decline. As the number of units of J the customer is will to sacrifice in order to obtain
additional unit of K decrease as the -uantity of K rises. Therefore it is difficult to
substitute J for K as the customer consume more of y and vice verse.
3;E Consumer 1<uilibrium
To e!plain the concept of consumer e-uilibrium the price of the two commodities should
be given as well as the customers income so as to derive the budget line. Budget line is a
curve or a line showing combination of two goods that can be afforded with a given level of
income. A consumer will be at e-uilibrium where the budgets line is a tangent to an
indifference curve as shown in #igure A.G.
F6
*% r
K
S
K
>
S
V Budget line
*%
*%0
B.1
J
J
#igure A.G %onsumer budget line &B.1'
K
%
>
B
A
#igure A.H %onsumer budget line
J
"oint B is the e-uilibrium point where the consumer is ma!imi,ing the utility sub=ect to
his budget constraint. At point A the consumer has unutili,ed income and cannot derive
ma!imum satisfaction. "oint % is an attainable since the consumers income is limited by
the marginal rate of substitution at the point B which is also the slope of budget line.
3;" Income Consumption Curve
*ncrease in consumer income leads to an upward shift in the budget line such that it
remains parallel to the original one and vice versa. *ncome consumption curve is a locus
of points of consumer e-uilibrium resulting when only the consumer income is varied or
the consumer income change. *t is also referred to as effects on an income change. The
income consumption curve can be used to derive the 1n5el curve which illustrates the
FA
amount of a good a consumer will purchase per unit of time at various leave of income
holding the price constant.
*6
*7
* >
>
> *%7
*%0
*%%
*ncrease in income
*%6
B10 B17 B16
Decrease in income
#igure A.9 %onsumer income curve
Illustr$tion o* indiAerent curve *or per*ect substitute $nd per*ect compliment$r% 5oods
The assumption that indifference curves are conve! to the original implies that the goods are
substitute but not perfect substances. *n case goods are perfect substances the
indifference curve is represented by a strait line with negative s lopes parallel to one
another. #or perfect substitutes goods the marginal rate of substitution is constant
complimentary goods have indifference curves that are 1 shape if only they are perfect
compliments as illustrated in #igures A.07 and A.00
K
A
B
>
> >
%
*A
*6
*0
#igure A.07 "erfect complimentJ
F:
y
*A
*0 *6
!
#igure A.00 "erfect substitutes
"oint A3 B and % are o the same indifference curve yet at point % it involves the same
amount of commodity K but more of commodity J than at point B. This implies that the
customer is saturated with commodity K and therefore the .R+M7 for both J and K.
+imilar case applies at point A involving same amount of J and more of commodity of K
indicating that the consumer is saturated with commodities J and therefore the .arginal
Rate of +ubstitution &.R+' of J and K M7
0pplic$tion o* IndiAerence Curves
0' *t provides an e!planation of the underlying reasons why change in price led to
change in -uality demand by distinguishing between substitution and income
effects of price change.
6' *t enables the derivation of normal and abnormal demand curve through price
consumption curve
A' *t is applied in labor economics to measure the trade off between income and
leisure
:' *t is used to e!amine the welfare affect of different 5overnment "olicy like ta!es3
subsidies for comparative welfare effects of direct and indirect ta!es.
E' *t enables assessment of the impact of change in the cost of living on welfare
.g..3 the effect of change in money income and price of the welfare can be
analy,ed.
FE
3;& -evie7 Guestions
0. (hat are indifference curves) Discuss the properties of indifference curves
6. !plain the law of diminishing marginal rate of substitution
A. (hat do you mean by price line) 2ow does it change)
:. !plain the e-uilibrium of the consumer according to indifference curve techni-ue.
E. (rite notes on
a' *ncome consumption line
b' "rice consumption line
F. Distinguish between income and substitution effects
3;' -e*erences
+aleemi ..A &6770' 1conomics 3impli4ed (-evised 1dition) +aleemi "ublishers 1td
&"ages F9-9A'
8outsoyiannis A4 &099:'3 Modern Microeconomics3 .acmillan ducation 1td
FF
L133O8 :O?-: (61 (61O-@ O: P-O#?C(IO8
Purpose: To introduce the learner to the production theory so as to be able to appreciate
the role the key factors that influence production.
3peci4c Objectives
By the end of the lesson the learner should:
&i' !plain the key factors influencing production
&ii' !plain the importance of speciali,ation
&iii' Apply the production function in determining optimal combination of resources
!;1 #e4nition
Production comprises all activities that provide goods and services which people want
and for which they are prepared to pay a price. The composition of the total output can be
classified into consumer goods and produce goods and services.
Consumer 5oods are commodities that satisfy human needs directly .They can be:
a. #ur$ble consumersI 5oods provide a steady stream of satisfaction and their
value
diminishes slowly through age and usage.
b. 8on- dur$ble consumer 5ood are consumed and destroyed in the very act of
being
used e.g. #ood3 =uice3 cigarettes.
Producer 5oods are commodities that do not directly satisfied wants but they are used
for the contribution they make to the production of other goods. !ample: factories3
buildings etc.
3ervices are intangible economic goods e.g. banking3 transport3 tourism and
administration. +ervices are non transferable i.e. they can not be purchased and then
resold at a different price.
"roduction can be categori,ed into three:
1.tr$ctive industries2 e!amples are farming3 fishing and forestry. "rimary products result
from such industries
M$nu*$cturin5 industries these include engineering3 vehicle manufacture3 chemical
and food processing.
#istribution industriesD these incorporate the activities of wholesaling and retailing.
FG
!; :$ctors o* Production
This refers to the inputs or resources from the society that are used in the process of
production .They include land3 labour3 capital and entrepreneurship
L$nd *t refers to all natural recourses over which people have power of disposal and
which may be used to yield income. *t includes farming land3 forest3 river3 lakes3 building
land3 and mineral deposit. The total supply of land in the world is limited although the
supply of land for some particular use is not fi!ed. Thus for e!ample3 more mai,e can be
planted at the e!pense of potatoes. Alternatively3 more land can be allocated to buildings
at the e!pense of farming land3 drainage3 irrigation and fertili,ers can increase the area of
agricultural land.
L$bour refers to the e!ercise of human mental and physical effort in the production of
goods and services. The supply of labour in an economy is measured by the number of
hours of work which is offered at a given wage rate at a given period of time.
C$pit$l is a manmade input. *t can be classified as working capital or circulating capital
referring to stocks or raw materials3 partly finished goods and goods held by producers.
Alternatively3 capital can be classified as fi!ed capital which consists of e-uipment used in
production such as machinery and buildings. The value of total output re-uired for
replacement of won out producer goods every year is referred to as depreciation. The
total output of producer goods is referred to as the gross investment and any addition to
capital stock is referred to as the net investment.
This implies that: 5ross investment - Depreciation M ;et investment
;ote that in economics3 the concept of depreciation is distinct from the concept of
depreciation in accounting. Depreciation is considered to be the period allocation of the
cost of a fi!ed asset
1ntrepreneurs)ip the organi,ational of the factors of production with a view to make a
profit *t involves hiring and combining other production factors making decision on what to
produce how and what and where to produce. *t in involves risk taking which arises
because most production is undertaken in e!pectation of demand and in most cases the
future is uncertain. ntrepreneurs make payments to cover their costs without any
certainty that the cost will be covered by revenue.
Mobilit% o* :$ctors o* Production has two main aspects
FH
a' /ccupational mobility refers to the ease of movement of factors of production from
one =ob or task to another.
b' 5eographical mobility refers to the movement factors of production from one
location to another.
Individu$l mobilit% o* *$ctors o* production
L$nd is not mobile geographically but has a high degree of occupation mobility i.e. land
can be put into different uses of farming building roads etc
C$pit$l is mobile in both cases e.g. a vehicle and tools are geographical and occupational
mobile. +ome capital are immobile e.g. railways. /ther form of capital has occupational
mobility e.g. a building
L$bour is mobile both geographical and occupation. 2owever there are barriers to
geographical and occupation mobility.
/$rriers to Mobilit% o* L$bour
0' Reluctance of the family to move
6' %ost involves in labour mobility
A' 1anguage barriers
:' Adverse climatic condition
E' *nsecurity and political instability
F' *gnorance of =ob opportunities
!;3 3peci$li>$tion
This refers to the concentration of activity in those lines of production where the
individual3 firm or country has natural or ac-uired an advantage. Adam +mith drew
attention to the importance of division of labour in his book3 the wealth of nations. 2e
was fundamentally concerned with division of labour of a particular industry where the
manufacture of products was broken down into many speciali,ed activities. Adam +mith
observed that the making of pins re-uired 0H distinct operations3 estimating that the
production per day in the factory was about E3777 pins per person employed. *f however
the whole operation was undertaken from first to finish by each employee3 +mith
estimated that he would have been able to make only a few do,en pins per day. Apart
F9
from speciali,ation in particular industries the following other forms of speciali,ation can be
identified:
a' Intern$tion$l speci$li>$tion - refers to the concentrating of a country of its
resources on a specific area of production for e!ample3 the concentration by
8enya in the production of coffee and tea or the production of copper by Wambia. b'
-e5ion$l speci$li>$tion within a country where factor endowments and economic
history have led industries to concentrate in certain areas because it is difficult for
competitive plants to be established elsewhere. Thus for e!ample3 in 8enya the
production of tea is concentrated in the highlands.
c' 3peci$li>$tion bet7een Industries since each economy includes many industries
an e!ample4 it is possible to speak of the motor manufacturing industry3 the steel
industry and so on.
d' 3peci$li>$tions bet7een 4rms- since industries are composed of firms that can be
regarded as units of production. Thus for e!ample different firms can speciali,e in
the manufacture of different components of a product. Thus for e!ample3 in the
car industry certain firms speciali,e in the provision of spare parts.
e' 3peci$li>$tion 7it)in *$ctories which arises because one firm will often control
a
number of factories3 and these are usually referred to as plants and are units of
production. #or e!ample3 a manufacturer might find it economical to build
engines in one plant3 a!les in another3 car bodies in a third and so on3 and
subse-uently transport all the parts of another plant for final assembly.
f' +peciali,ation within plants can be of two types:
i' A particular plant may produce more than one item and plant may thus
be regarded as two working side by side.
ii' (ithin every plant there is a considerable speciali,ation of labour. *n
a typical manufacturing firm3 some employees will be receiving and
storing raw materials and components whereas the ma=ority will be
engaged in the manufacturing process3 while others will be checking and
packing finished product.
G7
()e $dv$nt$5es o* speci$li>$tion
0. The fundamental advantage of division of labour is the increased output
arising from division of labour.
6. +peciali,ation may lead to boredom or monotony as some workers perform
the same operation hundred of times. This monotonous repetion may lead to
a greater incidence of accidents and greater absenteeism as a result of low
morale. *n addition3 labour relations between senior management and
production workers may deteriorate as communication becomes more
difficult.
A. +peciali,ation may be accompanied by decline in craftsmanship as skills
are transferred from the hands of the workers to a machine that controls the
design3 -uantity and -uality of a given product. *t should however be noted
that mechani,ation has produced many craftsmen in occupations that
re-uire a high degree of skills.
:. +peciali,ation is associated with an increased risk of unemployment as
speciali,ed workers do not have a wide industrial training that would make
them adaptable to changes in techni-ues of production. *n the short term
such workers are susceptible to unemployment although in the long run the
simplification of tasks implied by speciali,ation would mean that =obs in
different industries are fairly similar and retraining is relatively easily
achieved.
E. +peciali,ation is economically limited by the e!tend of the market in that
methods of production using e!pensive capital e-uipment are only
worthwhile if there is a potential demand for the mass produced product
that keeps the capital e-uipment fully employed. This mass market may not
always e!ist because of low income levels in a particular country.
F. +peciali,ation especially in cases involving mass production is inevitably
associated with standardi,ation of products. This is because of the heavy
development costs incurred in launching mass commodities that leave little
possibility for the accommodation of tastes and preferences of individual
G0
consumers sovereignty is3 to some e!tend3 limited by this narrow regard for
individual preferences.
!;! Production :unction
This is a technical relationship between the output of good and the input re-uired to make
these goods. The function may take the form of an e-uation3 a table or a graph. The
relationship between an input and output is a technological relationship which may be the short
run or long run.
? M f &83 1' where ?-output4 8-capital4 1 - 1abour
3)ort run refers to a period of time in which only some variables change. *t is an
economic process during which supply of certain factors of production e.g. land are fi!ed and
cannot be varied.
Lon5 run refers to a period of time in which all variables are able to settle at their
e-uilibrium and all economic processes have time to work in full.
0ver$5e product (0P) is the output per unit of the variable factors and its given
by:
A" M Total product &T"'
;umber unit of variable factors
.g. the average product of workers and capital are given by:
A" M T"4 A" M T"
1 8
M$r5in$l products it is changes in the total product brought about by varying the
employment of the variable factors by one unit e.g. increasing employment by 0 person.
." M %hange in total product
%hange in -uality of labour employment
M NT"
N1
:i.ed Costs - are costs that do not change as output varies. They are associated with
fi!ed factors of production and include4 rent rates3 insurance3 interest on loans and
depreciation. #i!ed costs remain the same whether output is one unit or output is 03777
units. #i!ed costs are also referred to as overhead costs or unavoidable costs.
G6
Depreciation3 especially in capital intensive industries usually constitute a ma=or item in
fi!ed costs since the life of capital tends to be measured in economic rather than technical
terms and machinery3 for e!ample3 depreciates even when not in use.
<ariable %osts- are costs that are related directly to output and include the wages of
labour3 the costs of raw materials3 fuel and power. <ariable costs are alternatively known as
direct or prime costs.
Total %osts represent the sum of fi!ed costs &#%' and variable costs &<%'.
T% M #%L<%
(hen output is e-ual to ,ero3 total costs will be e-ual fi!ed costs since variable costs will be
,ero. (hen production begins to increase total costs will continue to rise as variable costs
increase since output e!pands.
L$7 o* #iminis)in5 M$r5in$l -eturns9L$7 o* B$ri$ble Proportions
*t states that holding other factors constant as additional unit of a variable factor are
added to a given -uantity of a fi!ed factors3 the total product and the marginal product
will initially increase at an increasing rate but beyond a certain level of output it will
increase at a decreasing rate and eventually fall.
A"1
."1
+tage 6
+tage 0
+tage A
T"
A"1
1
."1
GA
#igure :.0 1aw of diminishing marginal returns
+tage 0
There is increasing returns to the variable factors. *n this stage the total product is
increasing at an increasing rate while the marginal product and average product are also
rising with marginal product higher than average product at any given point. This is an
indication of increasing efficiency of the proportion in which the factors are combined
since the fi!ed factors are still under utili,ed and there is greater scope of speciali,ation.
+tage 6
*t represents a decreasing return to the variable factors in that the total product is
increasing at a decreasing rate. The marginal product and the average product are positive but
they are falling at this stage. The average product is higher than the marginal product and
only national production takes place.
+tage A
This represents a stage of negative return of the variable factors. At this stage the
marginal product is negative and as a result the total output is reducing. *t represents a
stage of e!treme inefficiency when factors of production are probably getting into each
others way &conflicting'. At this stage the producer will not operate even with free
labour3 since he could also raise the total output by using less labour.
The law of diminishing marginal returns is e!plained by the use of the schedule in Table
:.0
1abour Total product Average product &A"' .arginal product &A"'
7 7 7 7
0 A A A
6 H : E
A 06 : :
: 0E A.GE A
E 0G A.: 6
F 0G 6.HA 7
G 0F 6.69 -0
H 0A 0.F6E -A
Table :.0 1aw of diminishing marginal returns
G:
The average product curve raises at first3 reaches the ma!imum and then falls. *t remains a
positive as long as the total product is positive. The marginal product rises and reaches the
ma!imum before the average product and then declines. The marginal product
becomes ,ero when the total product starts to decline. Therefore the falling portion of
marginal product curve illustrates the law of diminishing returns.
0ssumptions
0' The state of technology remains unchanged.
6' +uccessive units of the variable factors are assumed to be e-ually efficient
A' "roduction take place in the short run where at least one factor of production is
fi!ed.
:' There is one variable factor of production under consideration.
!;E Lon5 -un C)$n5es in Production
*n the long run all factors of production can be varied and thus the firm will chose the
input combination which optimi,e output and at the same time minimi,e their cost. This is
illustrated by the use iso<u$nt $nd isocost;
Iso<u$nt shows all the difference combination of labour and capital with which a firm
can produce a specific -uantity of output.
0ssumption o* Iso<u$nt
0' There are only two factors of production i.e. labour and capital
6' *t is possible to substitute labour for capital and vise versa continuously in the
production process
8
80
?A
86
?6
?0
#igure :.6 5raphical representations of iso-uants
GE
A higher iso-uant shows a greater level of output &?A' while a lower iso-uant shows
lower level of output &?0'. A series of iso-uant gives iso-uant map series
Properties o* Iso<u$nts
0' They are conve! to the origin
6' Do not intersect
A' They have a negative slope
Isocost shows all different combination of labour and capital that a firm can purchase
given the total outlay &ability' of the firm and factor prices.
0ssumptions
0' The firm takes the input prices as given by the market
6' There are two inputs4 there are the labour and the capital.
%
"R
*ncrease in cost
outlay
Decrease in
cost outlay
%
"1
#igure :.A 5raphical representations of isocosts
The slope of an isocost line is given by N"k
N"1
*f the firm spends all the total outlay on capital then he will purchase % units of capital
"8
*f the spends all the outlay in labour then would purchase %
"1
By going the two points we get the is cost of the firm and therefore the total cost for
utili,ing labour and capital will be given by
% M (1Lr8 (here w- price for labour4 r- "rice for capital
GF
Optim$l Input ?tili>$tion
#or a firm to minimi,e the cost of production which is the optimal input utili,ation point3
it must do so t
iso-uant is a tangent to the isocost line are shown in #igure :.:.
%apital
8
hat the point where the
>
>
-
>
A
B
1abour
#igure :.: /ptimal input utili,ation
At point A there will be under production since the resource are not ma!imally utili,ed. At
point - the firm achieves the optimum input utili,ation.
At point B the firm is unable to produce since the resources are limited at the point -.
()e M$r5in$l -$te o* 3ubstitution (M-(3)
The slope of an iso-uant measures the rate at which labour can be substituted for capital
keeping the output constant.
The .RT+ refers to the slope of the iso-uant
The .RT+ of labour for capital refers to the amount of capital that a firm can give up by
one unit and still remain on the same iso-uant
.RTs M ."l M N1
."k Nk
.RTsk M ."k M N8
."1 N
GG
1.p$nsion P$t)
*n the long run all the factors of production can be varied and thus there is no limitation
to the firms e!pansion on its output. The ob=ective of the is to choose the optimal way
of e!panding its output so as to minimi,e its cost and ma!imi,e the output within a given
factor prices and given the production function3 the optimal e!pansion path is determined
by the point of tangency of successive isocost line sand successive iso-uant curves as
shown in #igure :.E
%apital
!pansion path
8A
86
80
10 16 1A
1abour
#igure :.E "ath of e!pansion
!;" ()e ()eor% o* Cost
*t helps in understanding the concept of cost. The following are necessary:
Opportunit% Cost Assuming full resources allocation and employment in production
of good and services increasing the production of any one product involves the
sacrifice of an alternation product. The cost of producing a certain product is taken to refer
to the forgone value of the alternative product
Priv$te cost $nd soci$l cost (ne5$tive e.tern$lities) private cost refers to
these costs
which relates to an individual producer. They include both e!plicit and implicit.
(hile social cost refer to these costs which occur to the third party in the production
process.
GH
Implicitl% cost The e!plicit costs refer to the money paid out made by the firm. This
includes payment for resources bought or hired e.g. wages3 cost of raw materials3 rent
etc.
Implicit cost includes the resources owned and used by the firms the owner. (hen
the profits are calculated on the bases of e!plicit and implicit cost we obtain economic
pro4t. (hen calculated only on basis of e!plicit cost we obtain 4n$nci$l pro4t.
0ssumptions
&i' The firms take prices or input as determined by the market forces.
&ii' #irms aim at minimi,ing the production cost.
3)ort -un Cost :unction
*n the short run input levels will depend on output level that the firm wants to achieve. *n short
run not all factors will be varied. At least one must be fi!ed and therefore the cost incurred
on it will be fi!ed cost. The total fi!ed cost will be constant regardless of the output level
e.g. rent for factory building3 salaries of office staff etc.
B$ri$ble costs $re incurred by the firm for its variable input. A firm wishing to increase
its out put will re-uire large variable input thus higher variable cost. The variable costs of a
firm will increase as the output levels increase e.g. cost of raw materials3 cost of direct labour
and other direct running e!penses.
<% M f &?' (here <% - variable costs3 f -function3 ?- output
(ot$l cost represents the sum of the fi!ed cost and the varied cost.
T% M &<% L #%' (here T% - Total costs4 <% variable costs3 #% - fi!ed costs
0ver$5e cot is the cost per unit is the total cost of producing any given output divided by
the total number of unit produced. 5iven by:
A % M T% (here A% - average cost3 ? - total units produced
?
Average fi!ed cost3 the total fi!ed cost divided by the output. 5iven by:
A#% M T#% (here T#% - total fi!ed costs
?
0ver$5e v$ri$ble cost is given total variable cost divided by the output
A<% M T<% (here T<% - total variable costs
?
G9
M$r5in$l cost is the change in the total cost as a result of a unit change in output.
.% M NT%
N?.
5raphic representation
%ost
T.#.% &not affected
by output
/utput
#igure :.F #i!ed costs
%ost T.<.%
/utput
#igure :.G <ariable costs
()e rel$tions)ip bet7een $ver$5e cost $nd m$r5in$l cost
*n most of case the marginal cost the average cost from below. The average cost must be
failing as compared to marginal cost
a' .athematically it can be shown that3 if the slope of average cost is less than ,ero3
then the marginal cost will be less than average cost A%Q74 .%QA%
b' *f the average cost is greater than ,ero3 then marginal cost is greater than average
cost. A%P7 4.%PA%
+ince the average cost curve is @- shaped the slope of average cost becomes ,ero to its
minimum and hence marginal cost is e-ual to costs at this point.
H7
()e rel$tions)ip bet7een $ver$5e tot$l costs2 average fi!ed cost3 average
variable cost and marginal cost is shown in Table :.6.
/utput A#% A<% A% .%
0 E7 67 07 -
6 6E 0E :7 07
A 0F.G 00.G 6H.A E
: 06.E 00.A 6A.H 07
E 07 0A 6A 67
F H.A 0H.A 6F.G :.E
Table :.6 Relationship between costs variables
..%
A.%
A<%
A#%
#igure :.H 5raphical representations of cost variables
1.ercise !;1
5iven that total cost is
T% M ?
6
L A? L 6
#ind a' .arginal cost function
NT% M 6? LA
N?
b' The average total cost function
AT% M T% M ?
6
L A?L 6 M ?LAL6
? ? ?
H0
c' Average variable cost function
A< M <% M ?
6
LA? M ?LA
? ?
d' At what level of output would the firm minimi,e its average total cost and its average
variable cost in the short run
.% M AT% - 6? L A M ?LAL6$?
&6?LA'? M &?LA'?
M 6?
6
L A?M ?
6
LA?L6
6?
6
- ?
6
M 6
?
6
M 6
? M 6
M 0.:0
.% M A<%
6?LA M ?LA
-M7
1.ercise !;
+uppose that the total cost function of a firm operating in the short run is given by
T% M ?
6
L E?LF #ind
&i' The AT% function
&ii' The marginal cost function
&iii' The average variable cost function
%alculate the average fi!ed cost where ?M A
&iv' (hat will be the value of the following at the output of 077 unit
a' Average variable cost
b' A#%
c' .arginal
&v' At what level of output will the firm minimi,e its average total cost by average
variable cost)
3olution
i. AT% M T% M ? ?
6
L E?L F?M ?L ELF
? ? ? ?
H6
ii. .% M NT% M 6?LE
iii. A<% M A<% M ?LE
iv. 5ive AM A#% M F M6
A
v. 5iven ? M 07: @nit
a. A<% M <% M X&07'
6
LEJ07Y M 0E7 M0E
? 07 07
b. A#% M T% M F M7.F
? 07
c. .% M NT% M 6? LE M 6J 07 LE M 6E
N?
d. .% M T%
? &6? LE' M& ?LELF ' ?
?
6?
6
LE? M ?
6
L E? LF
6?
6
LE? - ?
6
- E? M F
?
6
M F
? M F
M 6.:E @nit Z A @nit
.% M A<%
6?LE M ?LE
? M 7
HA
1.ercise !;3
+uppose the marginal cost function of firm operating in the short run is given by .% M 6?
L9. #ind
i' the total cost function
ii' The average variables cost function
iii' %alculate the average fi!ed cost where ?MA
iv'
At what level of output will firm minimi,e its average total cost and average
variables cost in the short run.
.% M NT%
N?
6? L 9 M NT%
N?
NT% M ?
6
L9? L% 6? L 9 M NT%
i' T% M ?
6
L9? L % N?
ii' A<% M <% M ?
6
L 9? M ? L9
? ?
iii' A#% M #% M % M %
? ? A
.% M AT% AT% M ?6 L 9? L % M ? L 9 L %
6? L 9 M ? L 9L% ? ?
?
? M %
?
?
6
M %
? M E %
H:
!;& -evenue :unction
Revenue is the receipt from the sales of a good or service
Total revenue is given by the price ! -uantity sold
TR M "? (here TR- total revenue3 "?- price ! -uantity
Average Revenue is given by4
AR M TR refers to revenue per unit sold on average
?
.arginal revenue it is the increase in revenue brought about on e!tra unit sold.
.R M NTR
N?
1.ercise !;!
5iven a demand function " M E -0$: ?. %alculate total revenue marginal revenue and
average revenue.
TR M "?
M &E -
0
$: ?' ? M E? - [ ?
6
.% M NTR M E - R ?
N?
A< M TR M E? -
0
$:?
6
M [ ?
? ?
M E - [ ?
1.ercise !;E
5ive the following demand function " M A L? - E
?
%alculate total revenue marginal revenue and average revenue.
TR M "? M &
A
$?6 L ? - E' ?
M
A
$? L ?
6
- E?
A<MTRM
A
$? L ?\ - E? M A L? - E
? ? ? -6
.R M NTR M 6? -E - A
N? ?\
HE
A< M TR M
A
$? L ?\- E?
? ? ? ?
A
$?\ L ? - E
!;' Optimum 3ei>e o* $ :irm
This is the level of output at which total profit is at ma!imum. *t is the best or the most
efficient si,e of a firm when the long run average cost of a firm is at minimum. At this
point there will be no motive for further e!pansion since at any other si,e large or smaller the
firm will be less efficient. This is also attained when the firm cost of production is at its
minimum level as illustrated in #igure :.9
A
T%
TR
B"
>
A
B"
>
T%

TR
/ 1 . ; /utput
#igure :.9 /ptimum sei,e of a firm
Below /1 total cost e!ceeds total revenue and hence the firm is making loss. At the
point 1 neither profit nor loss are being made and hence its break even point &B"'
when total revenue is e-ual to the total cost. The same case applies to the point ;.
.a!imum profit lies where revenue and total cost difference total in the greater i.e. the
point where the vertical distance between the total revenue and the total cost is greatest.
*n #igure :.9 the ma!imum profit is at point . where AA is the largest vertical distance.
HF
;$B: #or profit ma!imi,ation the following two conditions must be met
i' The necessary conduction - according to this conduction profit are ma!imi,ed at
the levels of output where marginal revenues is e-ual to marginal cost. To
ma!imi,e profits profit is symboli,ed by pie & ] '
.a!imi,e profitM N "rofit M 7
N ?uantity
M K ] M 7
K?
But ] M TR - T%
N] M NTR - NT%
N? N? N?
7 M .R - .%
.R M .%
ii' The sufficient condition states that the slope of marginal revenue curve must be
less than the slope of marginal cost curve at the point where they meet. .eaning that
the marginal cost curve cuts the marginal revenue curve from below as shown in
#igure :.07
.%
A%
"
AR3 .R
#igure :.07 +ufficient conditions for revenue ma!imi,ation
;$B: Total profit function is ma!imi,ed as follows
i. Taking the first derivative and setting it e-ual to ,ero to obtain the critical values.
ii. Taking the second derivative and evaluating it at the critical values to ascertain if
the function is at the relative minimum or ma!imum.
HG
1.ercise !;"
Trusts enterprises is a medium si,ed firm which speciali,es in production of water taps
The finance department has determined the following cost structure per unit of a tap
produced.
a' <ariables cost per unit 0E$M
b' The fi!ed cost period is 67$M
c' +elling price for tap is 6 E$M
Re-uired:
i. Deriver the total cost function and re venue function
ii. Determine the break win point.
iii. The number of taps that would give a profit of :$M
iv. *f for some reason the price o f taps increase to A E$M per tap. (hat will be the
break even output)
<%M0E #%M67 "M6E
0' T% M<% L #% <% Mf &?'
M 0E?
a' T% M 0E?L 67
b' TR M "?M6 E-
ii' T% M TR
0E? L 67 M 6E?
67 M 07?
6 M ?
iii' " - ] M TR - T%
: M 6 E?-&0E?L67'
: M 0 7?-67
HH
6: M 07?
6.: M ? Z 6taps
iv' TRM T%
AE ! ? M 0E? ! 67
6 ? M 67
? M 0
1.ercise !;&
The total cost e-uation in the production of beckon at a certain factory is given as follows
%M 0777 L 0777-6E?6L ?A (here % is the cost is +hs. and ? is the -uality in 8g.
Re-uired:
i. %ompute the total and average cost at the output of 0 7kg and 00kg.
ii. (hat is the marginal cost of the 06
th
kg)
iii. !plain the slope and relationship between the average cost3 average variable
cost3 marginal cost and fi!ed cost curve using relevant diagrams
3olution
T% M 077 L 077? - 0E?
6
L?
A
AT% M T%M 077 L 077 - 0E? L ?
6
? ?
0 a' T% M 0777 L 077 ! 07 - 0E ! 07
6
L07
A
AT%M0777 L 077 - 0E ! 07 L 07
6
M0E77 07
M 0E7
b' T% M 077 L 077? ! 00 - 0E J 00
6
L 00
A
AT% M 0777 L 077 - 0E ! 00 L 006
M0F0F 00
M0:F.90
ii' .%MNT% M 077 - A7? L A?
6
At 06
th
85 M 077 - A7 ! 06 L A ! 066
N? M0G6
H9
!;+ 1conomies o* 3c$le
*n the long run3 all the input into production processes are variable so the problems
associated with diminishing returns to the variable factors do not arise. The law of
diminishing returns therefore only applies to short run costs and not on long run costs.
This implies that whereas short term decisions are concerned with diminishing returns
given fi!ed factors of production3 long run output decisions are concerned with
economies of scale which are based on assumptions that all factor inputs are variable.
conomies of scale are aspects of increasing si,e which lead to falling long run average
costs. conomies of scale assist in e!planation of trend towards large production units in
some industries. conomies of scale can be classified into internal and e!ternal
economies of scale. They are the advantages that arise due to e!pansion in scale of are
two categories:
a' *nternal economies of scale
b' !ternal economies of scale
Intern$l economic o* sc$le are factors which bring to reduction in average cost as
the
scale of production of individual firm rise. *nternal economies of scale are those factors
which bring out a reduction in average costs as the scale of production of individual firm
arises3 depending on what is happening to other firms. This is attributed to the activities
within the firm hence the economics are brought about by various source which include:
&i' M$rketin5 economies of scale consists of all the advantages a firm ac-uires as
they approach the market such as
- /u%in5 $dv$nt$5e- large firms en=oy buying advantage since they
purchase goods in bulk hence receive heavy bulk discounts that reduce
cost of production.
- P$ck$5in5 $dv$nt$5e *t is easier to package goods in bulk than in small
unit with reference to packaging costs.
- Transportation advantage due to transporting many units at the same time
which reduces transportation cost to a large scale producer compared to a
small scale producer.
97
- 3ellin5 $dv$nt$5e in terms of advertising whereby the large scale
producer will benefit more as he will sell more as compared to a small
scale producer due to mass advertisement
&ii' (ec)nic$l economic o* sc$le consists of:
- :$ctor indivisibilit% e.g.3 certain capital e-uipment must be of a specific
minimum scale or capacity of =ustify manufactures ability. A small firm will
not utili,e its e-uipments in full due to idle capacity arising from the small
production capacity. 1arge scale producer will be advantaged since he will
optimally utili,e the e-uipments.
- Incre$sed speci$li>$tion The larger the scale of production the greater the
scope of speciali,ation of both labour and machinery leading to high
productivity.
- Principle o* multiples *f the production process involves use of different
stages and type of machinery the large firms will benefit due to high
productivity while smaller ones will be disadvantaged since they produce
fewer units.
- -ese$rc) $nd developments A large firm may be able to support its
research and development programs which could result in cost reducing
innovations
&iii' :in$nci$l economies 1arge firms can easily obtain financial resources at lower
rates than small firms. 1arge firms can also produce more security for loans and
investments
&iv' -isk becomin5 economies $ large firm that has diversified into several markets is
usually better placed to withstand adverse trading conditions.
&v' M$n$5eri$l $nd $dministr$tive economies .anagers and administrators are
highly -ualified in managements of large firms. This creates division of labour
which improves efficiency.
1.tern$l economies o* sc$le
These are advantages that arise from the growth of industry resulting from simultaneous
interaction of a number of industries in the same or various industries as well as the
community at large. !ternal economies of scale are those advantages in the form of
90
lower average costs that a firm gains from the growth of the industry. !ternal economies are
available to all firms in the industry no matter their si,e.
These advantages include:
&i' 1mplo%ment Due to growth of industries employment opportunities are created to
the communities that will help to improve the standard of living.
&ii' 3peci$li>$tion Different firms within the industry will decide to speciali,e in one
area of production which will reduce cost of production and improves -uality of
the product and reduce prices. The repeated performance of the same actions
means that labour can become very skilled. The breaking of the production
process into many stages signifies that machines can be designed specifically for
each stage. An e!ample is in the motor assemble plant where many of the
different stages in the assembly are completed using computer controlled
machines.
&iii' =ro7t) o* compliment$r% service (henever a business is e!panding its output3
there are some complimentary services that arise e.g. schools medical facilities
financial institutions3 better roads3 etc. that benefit the society.
&iv' Incre$sed co-oper$tion .any firms within the industry can co-operate with one
another in terms of research and development hence improve the -uality of a
product3 new techni-ues in production which lowers the cost of production and
reduction in prices.
Intern$l diseconomies o* sc$le
*ncreasing the si,e of a firm beyond a certain scale can lead to rising average costs. This is
because of management difficulties and rising prices of inputs. .anagement problems arise
because:
a' As the si,e of departments in an organi,ation increase3 the task of coordination
becomes more difficult.
b' Despite the e!istence hierarchy of authority in large firms3 the task of control3
that is3 of ensuring implementation is e!tremely difficult in practice.
c' *n the firms of large si,ed communic$tion may be problematic in that it
is
difficult to ensure an effective vertical and lateral line of communication.
96
%ommunication network are generally more comple! in large organi,ation with
associated greater likelihood of communication breakdown.
d' The maintenance of morale is more difficult in large organi,ations because
individual workers in large organi,ations may feel unimportant the firm and often
do not identify with the firms ob=ectives.
e' An additional source of internal diseconomies of scale is increase in price of
inputs since as the scale of production increases3 the firm will increase the
demand for inputs likelihood and transport and this may lead to the bidding up of
prices of prices of certain inputs.
1.tern$l diseconomies o* sc$le
.ay arise because of a shortage of various inputs used in the industry may arise leading to an
increase in the cost of those inputs. #or e!ample3 an increased demand for raw materials
may bid up the prices of raw materials and cause their prices to rise. 2eavy locali,ations
of industry may make land for e!pansion scarce and therefore more e!pensive to rent
and purchase. *ncreased congestion could also lead to higher transport costs. /thers costs
include:
- Over production *ncrease in growth of a firm will lead to overproduction
leading to wastage due to lack of a market
- 8e5$tive e.tern$lities e;5. pollution3 poor working condition this will be
e!perienced as many firms e!pand their output.
- M$inten$nce o* mor$le *ndividual workers feel unimportant to the firm
and may not identify with the firm ob=ectives
- =overnment inter*erence (henever there is increase in output due to
increase in growth its led to increase in profit. The government then
imposes ta! which is a disadvantage to the firm
!;1, Mer5ers $nd 0c<uisitions
.ergers occur where two firms agree mutually to =oint their operations together. (hile
an ac-uisition occurs when a firm called a predator decides to take over another firm
referred to as a prey either forcefully of willings. .ergers and ac-uisitions are driven by
different motives. The following are ma=or types of mergers and ac-uisitions.
9A
&i' Bertic$l inte5r$tion occurs when merger takes place between firms engaged
in
different stages of the production process. Thus for e!ample3 a tyre manufacturer
can ac-uire rubber plantations. Backward integration is said to take place when
the movement is towards the market outlets as3 for e!ample in the case of large
oil companies taking control of petrol stations.
&ii' 6ori>ont$l inte5r$tion occurs when firms engage in the production of the same
kind
of good or service brought under unified control. An e!ample would be an
amalgamation of several motor manufacturers.
&iii' #iversi4c$tion occurs when firms that produce goods that are not directly related
to
each other combine. An e!ample would be the merger of a firm producing
fertili,ers with a manufacturer of paint. The main aim of diversification or
conglomerates is to reduce the risk of trading.
()e surviv$l o* sm$ll 4rms
+mall firms continue to survive for the following reasons:
a' Demand for variety that cannot be met by mass production especially in
industries like clothing and footwear.
b' .any owners of small firms have no ambition to grow large because they do
not want to sacrifice their independence and control.
c' A personal contact with customers is important in many industries like
accountancy and architecture.
d' The si,e of the firm may be limited by the e!tend of the market since a firm
can only grow in si,e if this is permitted by the market. The market for lu!ury
items for e!ample is limited by income and wealth.
e' #irms may want to avoid the rising costs that arise from diseconomies of
scale
f' There is a tendency for mass production industries to disintegrate into a large
number of specialist firms.
!;11 -evie7 Guestions
0. (hat are the main factors of production) Briefly describe them.
6. (hat do you understand by mobility of factors of production)
A. Discuss different forms of speciali,ation
9:
:. !plain law of diminishing marginal returns$law of variable proportions
E. (rite short notes on:
$) *socosts
b) *so-uants
F. Define total3 average and marginal product. Discuss the relationship between average
and marginal product.
G. Define total3 average and marginal product cost. Discuss the relationship between
average and marginal cost.
H. Distinguish between average total cost3 average variable cost and average fi!ed cost.
9. !plain the short run and long run cost curves of the firm.
07. Define total3 average and marginal revenue
!;1 -e*erences
+aleemi ..A &6770' 1conomics 3impli4ed (-evised 1dition) +aleemi "ublishers 1td
&"ages 00G-0:A'
8outsoyiannis A4 &099:'3 Modern Microeconomics3 .acmillan ducation 1td
9E
L133O8 :IB1: M0-L1( 3(-?C(?-13
Purpose: To introduce the learner to market structures. This will enable the learner
appreciates features of different market for various industries.
3peci4c Objectives
By the end of the lesson the learner should:
&i' !plain features perfect markets
&ii' Describe characteristics of monopoly market
&iii' !plain features of a monopolistic market
.arkets can be divided into imperfect market and perfect market.
E;1 Per*ect M$rkets
Per*ect m$rket is a market with many buyers and sellers where nobody can determine the
price of goods or services.
C)$r$cteristics
&i' 1arge number of buyer and sells where each individual firm supplies part of total
-uality supplied. Buyers are many such that no monopolistic powers can affect the
working of the markets. @nder this condition no individual firm or buyer can affect
the market
&ii' :ree entr% $nd *ree e.ist there are no barriers to entry or e!it to the industries.
ntry and e!it from the industries may take time but firms have the freedom of
movement in and out of the industry.
&iii' Product )omo5eneit% The industry is defined as group of firms producing
homogenous product i.e. the technical characteristic as well as the service
associated with product sold are identical. There is no why is which buyer can
differentiate among the products of different firms.
;$B: @nder perfect competition firms are price takers. .eaning the demand curve of an
individual firm will be perfectly elastic showing that the firm can sell any -uantity of
output at a given or prevailing market price. The concept of price taking is illustrated in
#igure E.0
9F
K
"rice
*ndustry
d s
e
#irm
K
"rice
s
d
?uality demand J ?uality demand J
#igure E.0 %oncept of price taking
&iv' Pro4t m$.imi>$tion The goal of the firm is profit ma!imi,ation both is the short
run and in the long run. ;o other goal is pursued.
&v' ;o government regulation. There is no government intervention in the operation
of this market.
&vi' Per*ect mobilit% o* *$ctors o* production; #actors are free to move from one firm
to another throughout the economy. *t is assumed that there is perfect competition on
the factor market.
&vii' Per*ect kno7led5e All sellers and buyers are assumed to have complete
knowledge about the conditions in the market. This knowledge refers not only to
prevailing condition in current but also for future periods.
()e revenue position o* $ per*ectl% competitive 4rm
*n perfect competition since each unit of out is sold at the same price both the average
and marginal revenue are constant. This is illustrated in Table E.0
"rice&ksh' ?ty demand Total demand .arginal revenue
67 0 67 67
67 6 :7 67
67 A F7 67
67 : H7 67
67 E 077 67
67 F 067 67
67 G :7 67
67 H 0F7 67
9G
TableE.0 illustrates that as the -uantity demand increases the price remains unchanged.
This implies that each additional unit sold increases the total revenue by in amount e-ual to
its price. This relationship is illustrated graphically as shown in #igure E.6
K a!is
Revenue
"
AR M .R
/utput J a!is
#igure E.0 /utput of the firm in perfect competition
()e s)ort run Recall that the short run is the conte!t the theory of the firm is the period in
which the -uality of at least one factor of production is fi!ed. The level of output during
this period of time can alter the utili,ation of variable factors. *n the short run is the
perfect competition can make normal profit3 abnormal profits or losses
8orm$l pro4t This refers to the minimum level of profit which a firm must make in order
to induce it to remain in operation. The level of normal profit varies from one industry to
the other. This because of different level of risk and nature of the production process
involved in different industries. ;ormal profits may be considered be =ust past cost of
production line since production will not continue unless at least this level of profit is
attained.
Revenue
cost price
.%
A%
ARM.R
?0
#igure E.6 ;ormal profits
9H
*n the #igure E.6 the firm is earning normal profit because price is e-ual to the average
cost. The profit ma!imi,ing level of output is ?0 where the necessary sufficient
conditions are satisfied. +ince normal profit are made where the price is e-ual to average
cost it implies that when price e!ceeds average cost the firm is said to be earning normal or
super-normal profits.
3upernorm$l pro4t (PM0C) %ategories all those firms which are earning a return which
e!ceeds the minimum necessary to induce them to remain the industry they currently
occupy. #igure E.A shows a firm making super-normal profits.
Revenue
D
"
%
.% A%
ARM.R

?6 /utput J a!is
#igure E.A #irm making super-normal profits
#rom #igure E.A when the level of output is ?6 the cost for unit is ?6 and the price
D?6 supernormal profit is e-ual to %"D which is represented by the scheduled area.
E; Monopol%
.onopolies are usually associated with economies of scale because of the large si,e of
the market controlled by the firm. conomies of scale imply lower units costs of
production. *t is likely that the consumer will benefit from this cost effectiveness through
lower prices from a monopoly supplier. A monopolist like any other firm finds profit
ma!imi,ing level of output where the marginal revenue is e-ual to marginal cost as
shown in #igure E.:. .onopoly firm ma!imi,es profit at the level of output ? where the
necessary and sufficient conditions of profit ma!imi,ation are satisfied. The super normal
profits earned by the monopolist are represented by the shaded area "%BJ. This
monopolist profit will persist in the long run since the are barriers to the entry in the
99
industry. *n the long run the monopoly can e!pand or use the e!isting plants at any level
that will ma!imi,e profit. /wing to the e!istence of barriers it is unnecessary for the
monopolist to reach the optimum scale of production which corresponds to the minimum
point of the long run average curve.
Revenue
^
cost
"
%
.%
A A%
B
A%
? .R .%
/utput
#igure E.: +upernormal profits made by a monopolistic firm
3ources o* monopol% po7er
Le5$l b$rriers This takes the form of statutory monopolies or patents i.e. monopolies
established by an Act of parliament and patent meaning that a firm is protected from
competition of new firms.
Products diAerenti$tion b$rrier This may be in form of product
uni-ueness3
advertisements and branding where an e!isting monopolist may e!ploit his position as a
supplier of an established products which the customer is persuaded to believe that it is
the best.
1conomies o* sc$le b$rriers could arise where e!isting firms are already operating
on a vast scale production and en=oying technical economies of sale.
(r$nsport cost $nd t$riA b$rriers +ome firms may en=oy local monopoly position
arising
from the ability to sell more cheaply in their own localities than other firm. +uch firms
can therefore rise prices in their local markets above the production cost by an amount
that does not e!ceed transport cost close of firm in other localities with similar production
cost
077
0dv$nt$5es o* monopolies
a' conomies scale
b' ;o wastage of resources
c' "rice stability since monopolists are price makers
d' Ability to carry out research and development to improve on their product
#is$dv$nt$5es
&i'
&ii'
&iii'
&iv'
Price
#iscrimin$tion
#iseconomies o* sc$le $rises in case the firm grows in a very
large si,e3 e!ploits the economies of scale and fails to achieve
the targeted economies of scale.
*nefficiency since there is no competition
1ack of motivation though the firm is in a better financial position to
research and develop there product the monopoly may fail to do so
since there is no competition or a challenging firm.
%onsumers e!ploitation .This is the most notorious practice of
monopoly. This is done through overpricing and price
discrimination of their products.
This e!ists where the same product is sold at different prices to different buyers. This
depends on the tastes and preferences of the consumers3 different periods of the firm3
consumers income etc. These factors will give rise to a demand curve with different
elasticities in different areas in the markets for the firms. "rice discriminates is easily
implemental by a monopolists since he controls the whole supply of a given good. There are
two necessary condition for price discrimination to take place:
0. The monopolist must effectively separate markets. *f he has not separated the
market the customers in the low price market will buy and sell the commodities
those consumers in the higher price market.
6. The price elasticity of demand for the two markets must be different so that
profitability will be reali,ed. At every price the demand in any market must be
elastic than the other where the low priced market have a more elastic demand than
the high priced market. By selling the -uality dined by the e-uation .% and .R at
different price the monopolist reali,es a higher total revenue and profits3 the
070
monopolists reali,es a higher total revenue and profits as compound to charging
uniform prices.
;$B: suppose that a monopolist has two markets .0 and .6 the profit in each market
ma!imi,ed by e-uating marginal cost to the corresponding marginal revenue i.e.
*n the first market4 .R0M.%0
*n the second market4 .R6M.%6
That mean monopolist will ma!imi,e profit by e-uating the common market cost with the
individual market revenues as .%M.R0M.R6
E;3 Monopolistic Competition
This is a form of imperfect competition which lies between the e!tremes of perfect
competition and monopoly and includes elements from both markets. !amples include:
restaurants3 hair dressers etc
C)$r$cteristics
0 There are many buyers and sellers in the market
6 The product of the sellers is differential yet very close substitute for each other
A There is freedom of entry and e!ist of firms
: The goal of the firms is profit ma!imi,ation both in the short run and in the long
run.
E The prices of factors of production and technology are given. @nder this
competition3 each producer sells a product which is to slightly different from that of
the competitor and attempts to emphasi,e on differences like packaging and
advertisements.
This process of creating the differences is called product differentiation which is aimed at
creating brand loyalty. The firm demand curve will be relatively elastic since the products
sold by the competition will be relatively close substitutes. .onopolistic firm sells
differentiated products therefore have limited control over the price. They are prices
makers since they can raise their prices without loosing their customers and have to
reduce the prices in order to sell more
3)ort run e<uilibrium in monopolistic competition
076
*n #igure E.E a firm operating under monopolistic competition makes supernormal profit in
the short run as shown by "%AB. The supernormal profit will attract new firms into the
industry and the surplus profit will be reduced to normal profit in the along-run as
shown in #igure E.F
Revenue
^
cost
.%
A%
" A
% B AR
.R
/ ?
#igure E.E +upernormal profits in short run
.%
/utput
A%
A
"
AR
M-
/
?
0 ?6
/utput
#igure E.F ;ormal profits in long run
A firm in monopolistic competition in the long run will make normal profit since average
revenue will be e-ual to average cost. The e!istence of many brands enhances the
consumer choice and ability. 2owever it is considered wasteful because of e!istence of
e!cess capacity shown by &?6-?0' which is carried &borne' by the consumer through
07A
prices. *t is also in wasteful since the resources that could have been used in e!pansions and
e!ploitation of economies of scale are used in advertising.
E;! Oli5opol%
This refers to the market structure dominates by large few firms. The number of sellers
&firms' is small enough for other sellers to take account of each other i.e. if one seller
changes his prices or uses non- price strategies his$her rivals would react. This is called
oligopolistic dependency.
C)$r$cteristics
0. %ontains few firms who produce goods that are substitute but need to be perfect
substitutes.
6 1ies somewhere between e!treme of perfect competition are monopoly.
A There are barriers to the entry.
: Decision of the firms are strictly interdependent
E +ellers agrees on the price or the market share
:orms o* oli5opol%
&i' Duopoly where market is dominated by two firms
&ii' "ure oligopoly where the products of the few sellers are identical.
&iii' Differentiated oligopoly where products are differentiated in term of -uality
packaging etc.
&iv' %ollusive oligopoly where the few sellers in the market come together and
make decisions to control the prices3 -uality and -uantity to be produced.
&v' ;on collusive oligopoly where the few sellers determine their prices3 -uality
and -uantity without colluding.
Linked #em$nd Curve
The interdependence in oligopolistic firms e!plains the price rigidity among the firms.
The theory of kinked demanded curve suggests that firms in oligopoly face two sets of
demand curves.
&i' "rice increase
&ii' "rice reduction which is slightly inelastic
07:
D
"rice
"0
d

d
D
?0 ?uantity
" d
8ink

D
?0 ?
#igure E.G 8inked demand curve
#or price increases the firm is an elastic demand curve dd. #or price decreases it is on the
inelastic demand curve DD. This means the actual demand curve for firms is represented
by dD. The demand is said to have a kink at point associated with the price "0 and
-uantity ?0. All firms in the industry are assumed to be in a similar position which
implies that if a firm raises its prices and its competitor fails to follow suits then3 it will
loss large sales of revenue. This firms is on the elastic portion of the demand curve
*f one firm reduces prices then3 its competitors will have to reduce their price by at least a
much or even more to retain the market share. (hen the price is lower each firm has the
same market share which implies that the firms are on the inelastic portion of the demand
curve. %ollusion will take the form of agreeing the prices for each market share. This is
done in order for the oligopolistic firms to ma!imi,e their =oint profits and reduce
uncertainty. A form of open collision is known as a cartel whereby firms produce
differently but act like determinants of price and output. #igure E.H shows the
-uilibrium of an oligopolistic firm facing kinked demand curve.
The marginal revenue is discontinuous at the output level where there is a kink in the
demand curve. The kink in the demand curve e!plains the nature of the marginal revenue
curve. (here at point and output ? the marginal revenue curve falls vertically since at
the higher price the marginal revenue curve correspond to less elastic demand curve. The
firm ma!imi,es its profit where the marginal cost is e-ual to marginal revenue. *ts is very
likely that the marginal cost curve will cut the marginal revenue curve between point J
and K which corresponds to the discontinuous part of marginal revenue curve.
07E
Revenue
cost
d
8ink

.%
!
D
y
.R
? /utput
#igure E.H -uilibrium with kinked demand curve
E;E -evie7 Guestions
0. (hat is meant by a perfect market)
6. (hat is meant by monopoly) (hat are the main sources of monopoly power)
A. 5ive the arguments for and against monopoly
:. 2ow can the government control monopoly)
E. Discuss the e-uilibrium of a firm under monopoly
F. %ompare the e-uilibrium under a firm under perfect competition and monopoly
G. 2ow are price and output determined under price discrimination)
H. (hat is monopolistic competition) Discuss the salient features
9. !plain the concept of kinked demand curve.
E;" -e*erences
+aleemi ..A &6770' 1conomics 3impli4ed (-evised 1dition) +aleemi "ublishers 1td
&"ages 0A6-0G7'
8outsoyiannis A4 &099:'3 Modern Microeconomics3 .acmillan ducation 1td
07F
3$mple P$per 1
0ns7er Guestion O81 7)ic) is COMP?L3O-@ $nd $n% ot)er (WO <uestions
G?13(IO8 O81
a' Define the term Cconsumer rationalityD and outline the conditions that must be
fulfilled for consumer rationality &F marks'
b' @sing indifference curves derive the demand curve for a normal good. &F marks'
c' (ith the help of a diagram distinguish between the income effect and
substitution effect of change in the price of a normal good. &H marks'
d' @sing an illustration3 e!plain the concept of market e-uilibrium in economics
&H marks'
e' Define the term Copportunity costD &6 marks'
(3, m$rks)
G?13(IO8 (WO
a' !plain the factors that influence cost beheviour in a firm &: marks'
b' *llustrate and briefly e!plain the relationship between marginal cost &.%' and
average cost &A%' curves of a firm &F marks'
c' The total cost in thousands of shillings &T%' of producing ? units of a given
product is given by the following function:
T% M 03777 L 6G-06?
Re-uired:
&i' The total fi!ed costs.
&ii' The output level that will minimi,e the marginal cost.
&iii' The marginal cost when the level of output is E777 units.
&F marks'
d' conomics is both a science and an art. !plain &: marks'
(, m$rks)
07G
G?13(IO8 (6-11
a' Distinguish between the following
&i' %onsumption curve and ngel curves &: marks'
&ii' %ardinal approach and marginal approach to measuring utility &F marks'
b' Briefly e!plain the limitations of the cardinal approach in measuring utility
&F marks'
c' Define the term Ccross elasticity of demandD &6 marks'
"rice of commodity J &+2' Demand for commodity J &@nits'
06 H7
0F 077
67 067
6: 0:7
6H 0F7
d' The following data relate to a consumer in a certain market:
-e<uired: %alculate the cross elasticity of demand of commodity K with each of the
changes in price of commodity J. comment on the relationship the two commodities.
&6 marks'
(, m$rks)
G?13(IO8 :O?-
a' Define the term Cinferior goodsD &6 marks'
b' !plain the law of supply &6 marks'
c' !plain a situation where the law of supply is violated &6 marks'
d' !plain the concept of consumer sovereignty &: marks
e' Briefly e!plain the usefulness of the concept of elasticity of demand in
decision making process &H marks'
G?13(IO8 :IB1
a' *dentify the source of monopoly power &F marks'
b' *n relation to the theory of production3 e!plain the shut point of a firm &F marks'
c' !plain with illustrations3 the long run output choice of a firm operating in a
perfectly competitive structure &H marks'
07H
3$mple P$per
0ns7er Guestion O81 7)ic) is COMP?L3O-@ $nd $n% ot)er (WO <uestions
G?13(IO8 O81
a' (rite brief notes on the following:
i' +carcity and choice
ii' Diminishing marginal utility
iii' "rice elasticity of demand
iv' +ubstitution and income effects of price change &ach E marks'
b' *llustrate and e!plain the three stages associated with the law of variable
proportions &07 marks'
(3, m$rks)
G?13(IO8 (WO
a' (hat is oligopoly) &: marks'
b' @sing a well illustrated diagram3 show that a monopolist can make losses in the
short-run even when .%M .R &H marks'
c' @sing a well illustrated diagram3 e!plain why prices are Isticky downward
under oligopolistic market &H marks'
(, m$rks)
079
G?13(IO8 (6-11
a' The demand and supply schedules for carrots in a certain market are given below.
"rice 8+hs I777 ?uantity demanded per ?uantity supplied per
per ton month &thousands of tons' month &thousands of tons'
6 007.7 E.7
: 97.7 :F.7
H FG.E 077.7
07 F6.E 00E.7
06 F7.7 066.E
Determine the e-uilibrium -uantity and price by graphical method &H marks'
b' !plain how the of elasticity guides in price discrimination by a monopolist
&6 marks'
c' By focusing on an inferior good3 use the indifference curve analysis to
demonstrate and e!plain income and substitution effects &07 marks'
(, m$rks)
G?13(IO8 :O?-
a' (hat is meant by the term Cproduction functionD &6 marks'
b' 5iving appropriate e!amples3 e!plain the term Cfi!ed factors of productionD
&A marks'
c' !plain and illustrate the resultant hypothetical total and marginal product curves
for an economy with only two factors of production3 one of which is fi!ed.
&H marks'
d' (hat is a Cproduction possibility frontierD &A marks'
e' 5iven a production possibility frontier curve3 show the impact of a new more
efficient mode of production. &: marks'
(, m$rks)
G?13(IO8 :IB1
a' Discuss the barriers to occupational mobility of labour &07 marks'
b' !plain the characteristics of free market economy &07 marks'
007