Microsoft Word - ECN 111 PDF

DISTANCE LEARNING INSTITUTE
UNIVERSITY OF LAGOS
MODULE FOR ECN 111
PRINCIPLES OF MICROECONOMICS
COURSE TEAM:
DR. ISAAC CHII NWAOGWUGWU
DR. W.A. ISHOLA
DR. W.A. AYADI
DR. B.W. ADEOYE
MR. J. BALOUGA
MR. FOLUSO AKINSOLA
MR. ANTHONY OSOBASE
MR. TUNDE BAKARE
CONTENT EDITOR: DR. S.O. AKINLEYE
LANGUAGE EDITOR: DR. NTEKIM-REX
Page 1 of 245
TABLE OF CONTENTS Page
Study Session 1: Nature and Scope of Economic theory 12
1.1 The Economic Problem: Scarcity and Choice 12
1.2 The Methodology of Economics 21
1.2.1 Deductive Method 21
1.2.2 Inductive Method 22
1.2.3 Integration of the Two Methods 23
1.2.4 Economic Assumptions 24
1.2.5 The Concept of Equilibrium 25
1.2.6 Micro and Macro Analysis 27
Summary 31
Self-Assessment Questions 31
References 33
Study Session 2: Consumer Behaviour 34
2.1 The Market 36
2.2 Demand, Supply and Equilibrium 36
2.3 Shifts in the Demand Curve 41
2.4 Shifts in the Supply Curve 42
2.5 Free Markets and Price Controls 42
2.6 Utility Theory 45
2.7 The law of Diminishing Marginal Utility 47
2.8 Equilibrium and the Consumer 48
Page 2 of 245
2.9 The Ordinal Approach 48
2.9.1 Characteristics of Indifference Curve 50
2.9.2 Indifference Maps 50
2.9.3 The Marginal Rate of Substitution 50
2.9.4 The Budget Constraint 51
2.9.5 Consumers Equilibrium 52
Summary 53
References 58
Study Session 3: Elasticity of Demand and Supply 59
3.1 Elasticity of Demand 59
3.1.3 Types or Forms of point Elasticity of Demand 63
3.2 Income Elasticity of demand 68
3.2.1 Types of Income Elasticity of Demand 69
3.2.2 Illustration of Income Elasticity of Demand 70
3.2.3 Interpretation of the Income Elasticity of demand 72
3.2.4 Reason a Firm Wants ……. 72
3.3 Cross Elasticity of Demand 73
3.3.1How business can make use of the Concept of Cross Price Elasticity of Demand 75
3.4 Determinants of Elasticity of Demand 76
3.5 Measurement of Elasticity 78
3.6 Elasticity of Supply 79
Page 3 of 245
3.6.1 Illustration of Price Elasticity of Supply 80
3.6.2 Types or Forms of Elasticity of supply 81
3.6.3 Factors that Influence the Elasticity of Supply 85
3.7 Useful Application of price Elasticity of Demand and Supply 85
Summary 86
References 90
Study Session 4: Introduction to the Theory of Production 92
4.1 Definition and Types of Production 93
4.2 The Factors of Production 93
4.3 The Time Horizons (Production Periods) 94
4.4 The Concept of Product 95
4.5 The Three Stages of Production 95
4.6 Derivation of Average and Marginal Products from a Given Total Output and Labour 97
4.7 The Production Functions (Functional analysis) 98
Summary 99
References
Study Session 5: Introduction to the Economies of Scale 104
5.1 The concept of Economies of Scale 104
5.2. The Internal and External Economies of scales 105
Page 4 of 245
5.3 The Concept of diseconomies of scale 107
5.4 Law of Diminishing Returns (This is a Short-Run Concept) and Laws of Return to Scale
(This is a Long-Run Concept) 110
5.6 Derive production scale from a given Cob Douglas function 111
5.7 The Concept of Return to Scale 112
5.8 Economies of Expansion 113
Summary 114
References 117
Study Session 6: Introduction to Theory of Costs. 118
6.1 Concepts of Costs 118
6.2 Production Costs in the Short Run 122
6.3 Behind every Cost Curve is a Socioeconomic Environment 124
6.5 The Algebraic Derivation of Cost Functions 131
Summary 132
References 136
Page 5 of 245
Study Session 7: Market Structure and Equilibrium of Profit
Maximizing Firms 137
7.1 Perfect Competition 138
7.1.1 Profit Maximization under Perfectly Competitive Market 138
7.1.2 Short Run Equilibrium of Perfectly Competitive Firm 140
7.1.3 Long Run Equilibrium of Perfectly Competitive Firm 141
Page 6 of 245
7.2 Monopoly 142
7.2.2 Short Run Equilibrium under Monopoly 145
7.2.3 Constraints on Monopoly 146
7.3 Monopolistic Competition 147
7.3.1 Equilibrium Point under Monopolistic Competition 147
7.3.2 Some Other Elements in Monopolistic Competitive Market 149
7.4 Oligopoly 150
7.4.1 Equilibrium in Oligopoly Market 153
7.5 The Marginal Revenue and Marginal Cost Approach 154
Summary 157
References 161
Study Session 8: Factor Market Analysis 163
8.1 Factor Market 164
8.2 Factor Price 164
8.2.2 Big ideas about factor or resource markets. 165
Page 7 of 245
8.3 Nature of Factors and the Factor Market 167
8. 4 Factors Affecting the Shift of the Factor Demand Curve 173
8.5 Supply of Factor Inputs 175
Summary 177
References 180
Study Session 9: Theory of Distribution 182
9.1 Theory of distribution. 182
9.2 Aspects of distribution. 184
9.2.1 Personal distribution 184
9.2.2 Functional distribution 185
9.3 The Neoclassical/Marginalist Theory 186
9.4 Advantages of the neoclassical theory of distribution 188
9.4.1 Mathematical expression of the neoclassical/marginalist theory of distribution 188
9.5 Returns to the factors of production 189
9.5.1 Rent 189
9.5.2 Wages 190
9.5.3 Interest 191
9.5.4 Profit 192
9.6 Dynamic influences on distribution 192
9.6.1 Prices 193
9.6.2 Technology 193
9.7 Personal income and neoclassical theory 194

Page 8 of 245
Summary 195
References 199
Study Session 10: Introduction to Welfare Economics 200
10.1 Analysis of Welfare Economics 200
10.1.1 Marshall’s Welfare Definition of Economics 201
10.1.2 Features of Marshall’s Definition: 201
10.1.3 Robbins Criticism of Marshall’s Welfare Definition 203
10.1.4 Basic Concepts in Welfare Economics 205
10.2 The Pareto Principle 205
10.2.1 External Benefits 206
10.2.2 Public Goods 207
10.2.3 Market Failures 207
Summary 207
References 211
Appendix: Answers to Self-Assessment Questions 212
Page 9 of 245
GENERAL INTRODUCTION
This module serves as an introductory text in the study of Microeconomics at the tertiary level.
An attempt has been made here to tackle most of the topics that are usually studied in the
beginners’ class. This ranges from the Meaning and Scope of Economics to an introduction
to Welfare Economics. The approach adopted by the authors in this book is simple and this is
reflected in the language of the book.
This Module is divided into Eight Study Sessions. Each Study Session is divided into five sub-
sessions or sections namely; Introduction, Learning Objectives, Main Text, Summary and
Self Assessment Questions. A highlight of each of the Study Sessions is provided below.
Study Session One, Nature and Scope of Economic Theory; deals with the basic issues that a
student encounters in the subject which ranges from the definition of Economics to the scope,
assumptions and the methodology of Economics.
Study Session Two, Consumer Behaviour; takes the student through the fundamental theories
that explain the consumption behavior of the micro economic units. Some of these include
Cardinal and Ordinal Utility Analysis and Demand and Supply Analysis.
Study Session Three, Elasticity of Demand and Supply; examines one of the most interesting
topics in consumer behavior, that is, Elasticity of Demand. Here, the student is taught how
various economic units respond to changes in the various factors that determine demand.
Page 10 of 245
Study Session Four, Introduction to the Theory of Production; introduces the students to the
basis of the theory of production. After analyzing different types of production, factors of
production and their rewards, it highlights the basic concept of production with graphical
illustration and differentiates between Cobb Douglas production function and Leontief
production function and their derivatives.
Study Session Five, Theory of Costs; generally explains the concept of costs as it relates to
different fields of endeavour, distinguishes among various concepts of costs, relates types of
cost to time horizon and makes some algebraic derivatives from and given total cost value.
Study Session Six, Market Structure and Equilibrium of Profit Maximizing Firms; looks at
Market Structure and how price and output is determined in each type of market.
Study Session Seven, Factor Market Analysis and Theory of Distribution; describes the major
factors of production and also considers the demand for factors of production, which leads us
to a crucial insight; the marginal productivity theory of income distribution. In addition, it
discusses the supply of the most important factor, labor.
Study Session Eight, Introduction to Welfare Economics; introduces the students to welfare
economics as well as principles of welfare economics. It also exposes the students to basic
concepts such as the concepts of externalities, pareto – optimality, market efficiency, etc
which are very relevant in the field of Welfare Economics.
Page 11 of 245
Study Session 1: Nature and Scope of Economic Theory
Introduction
This section of this module introduces the student to the study of Economics. It deals with the
basic issues that a student encounters in the subject which ranges from the definition of the
subject to the scope, assumptions and the methodology of Economics. Thus, an attempt is
made to explore economic problems and how the same can be solved. An attempt is also
made to show how ‘Rationality’ in economic decisions defines the degree of economic
problem which any of the economic units tries to mitigate. Some of the sub-topics discussed
include; Scarcity and Choice, Scope of Economics, Economic Assumptions, Concept of
Equilibrium, and the division of Economics into Micro and Macro components.
Identification
Learning Outcomes for Study Session 1
At the end of this study session, you should be able to:
1.1 Define the fundamental concepts in the study of economics;
1.2 Discuss the scope of economics;
1.3 Explain the methodology of economics;
1.4 Discuss the role of assumptions in economics study.
1.1 The Economic Problem: Scarcity and Choice
Economic theory propagates the laws and principles which govern the functioning of an economy
and its various parts. This becomes necessary consequent upon two facts that are obvious in
Page 12 of 245
every economy. First, human wants for goods and services are unlimited, and secondly,
productive resources with which to produce goods and services are scarce.
Thus, in view of the scarcity of means at our disposal and the multiplicity of ends we have to
achieve, the economic problem lies in making the best use of our resources. Therefore, with
the limited amount of money at the disposal of the consumer, he has to strive to obtain the
highest possible (maximum) satisfaction from the same. Similarly, the producer must try to
maximize his profit by employing his limited resources more efficiently – that is, in his
choice of what to produce, how to produce and for whom.
Hence, economic problem lies in making decisions regarding the ends to be pursued or the wants
to be satisfied and the goods to be produced and as regards the means to be used in producing
them. It may be recalled here, that, Economics studies human behaviour as a relationship
between ends and scarce means that have alternative uses. It follows that whereas the ends
are many, and the means are scarce, the means can be subjected to alternative use; thereby
causing economic problems.
Thus economic problems arise because:
(a) ends are unlimited
(b) ends are of varying importance
(c) resources are in short supply
(d) Resources are capable of alternative uses or can be put into a number of uses.
Page 13 of 245
It is pertinent to point out that all agents of consumption and production are confronted with the
economic problem – individuals, households, firms and governments. Thus, an attempt at
solving the “economic problem” necessitates “rationality” in consumption behaviour and
production pattern as the same is the basic ingredient of “welfare” and profit maximization.
What does scarcity mean?
It means that whereas the ends are many, and the means are scarce, the means can be
subjected to alternative use; thereby causing economic problems.
The Scope of Economic Theory and Basic Economic Problems
The subject matter of economics has generated controversy over the years. This is amply borne by
the “variety” of definitions of the subject since the period of Adam Smith - who defines it as
an “enquiry into the nature and causes of the wealth of nations”. Other Economists see it as a
subject that deals with how the produce of the earth is distributed. That is, the distribution of
income and wealth form the focal point of Economics. Other scholars define the subject
either as a study of “social welfare, market, prices and market exchange or with respect to
allocation of scarce resources among competing end or uses”. Thus, there is no agreement
amongst economists with regards to the scope of the subject especially when contempt is
exhibited regarding the ‘narrowness’ or “broadness” of a particular definition.
Nevertheless, the succinct and pragmatic definition by Jacob Viner appeared to have settled the
dust. According to him, “Economics is what Economists do”. By implication, this means that
the science of economics can be better understood from what economists do or what they
Page 14 of 245
have been doing. This has strong bearing on the types of questions which economists ask and
have been asking and the solutions they have provided to those questions. Some of these
questions are ;
(a) What goods are produced by the productive resources which the economy possesses and
in what quantities?
(b) How are the different goods produced? What production techniques are used for the
production of various goods and services?
(c) How is the total output of goods and services of a society distributed amongst the people?
(d) Are the uses of productive resources economically efficient?
(e) Are all available productive resources within a society being fully utilized or are some of
them lying unemployed and unutilized?
(f) Is the economy’s productive capacity increasing, declining or remaining static over time?
These are the questions which Economists all over the world have been asking – and this is not
peculiar to a particular economic system. Thus, all economies whether capitalist, socialist or
mixed, planned or unplanned, developed or developing must take decisions about these
questions. Economic theory therefore studies how these decisions are arrived at in various
societies. It has to be pointed out, however, that economic theory has evolved and developed
mainly in the framework of capitalist institutions where free market mechanism plays a
dominant role in solving the “economic problems” highlighted above.
The Problem of Allocation of Resources
The decision as to “what to produce” to satisfy the wants of the people is the basic problem
confronting an economy. The problem as to what to produce and in what quantity arises
Page 15 of 245
directly from the scarcity of resources. Hence, the society must decide on what goods and
services to produce and what not to produce. Consequently, the wants for the goods not
produced will remain unsatisfied.
If the society produces a particular good in large quantity, it will have to withdraw resources from
the production of other goods, thus reducing the quantity of those goods. The greater the
quantity of goods to be produced the more the resources that would be allocated to that good
and vice versa. Thus, the question of what goods to produce and in what quantities is
essentially a question of the allocation of scarce resources between alternative uses.
In a capitalist economy, the decision about the allocation of resources is made through the
efficiency of the free-market forces that is the price mechanism. Thus, it is the relative prices
of goods and services determined by interplay of the forces of demand and supply that
ultimately determines the allocation of resources.
Choice of a Production Method
The problem of “how to produce” implies a choice with regards to the combination of resources
as well as the “technology” to be used in the production of desired goods and services. The
production of some goods and services might require more labour and less capital while
others may require more capital than labour. Similarly, a producer may rely on manual or
obsolete methods of production while others may use automatic or modern techniques. This
way, one notes that the agricultural sector is labour-intensive while the industrial sector is
capital-intensive. In addition, while the big players in the manufacturing and
telecommunication industries produce goods and services employing automatic and highly
Page 16 of 245
sophisticated machines and equipment, small players may rely more on manual and obsolete
technology.
It has to be emphasized, however, that the choice of an appropriate combination of factors and
technology is greatly influenced by the availability of resources, relative prices of the factors
of production, the substitutability of the factors and the adaptability of technology. This
means that the method of production influences not only the cost of production but the
surplus or profit that is generated in the process. Hence, the choice of the method of
production is a crucial problem that confronts every economy.
Distribution of National Product
The distribution of the total output of goods and services is a question concerning social justice or
equity. The distribution of income has a strong bearing with the distribution of money and
wealth. Thus, those individuals with larger income would have larger capacity to buy goods
and services. Put differently, those with larger income and wealth would have larger
entitlement for goods and services and hence will get greater share of the national output and
vice versa. Thus, the more equal the distribution of money income and wealth, the more
equal the distribution of national output will be.
Incomes can be earned either by doing some work or by lending the services of one’s property
such as land or capital. Labour, land and capital are factors of production and all of them
contribute to the production of national product. They get their respective prices for their
contribution – wages, rent and interest. How much each factor gets is dealt with under the
theory of factor pricing and is called functional distribution of income. The question as to
Page 17 of 245
how much each individual member of the society gets from the national output is fully
ascertained through the personal income distribution. It has to be pointed out, however, that
the personal distribution of income is greatly affected by the distribution of the ownership of
property.
Economic Efficiency
Since resources are scare, it is desirable that they should be used most efficiently. Hence, it is
necessary to find out whether or not the economy functions efficiently. This means that it has
to be ascertained if the production and distribution of national product is done efficiently.
The production is said to be efficient if the resources are utilized in such a way that through any
re-allocation of resources it is impossible to produce more of one good without reducing the
production of another good. If the production of any one good or service results into the
reduction in the output of any other good or service, then production is said to be inefficient.
In a similar fashion, the distribution of the national output is said to be efficient if it is
impossible to make, through any redistribution of goods and services, some individuals or
any person better off (more satisfied) without making at least one individual worse off (less
satisfied).
The other terms that require explanation are Technical Efficiency and Economic Efficiency.
Technical efficiency prevails when a firm, industry or the economy utilizes the available
resources fully and most effectively and thereby produces maximum possible output of goods
and services with the given amount of resources. That is, a firm, industry or the economy is
said to have achieved technical efficiency when it is having the greatest possible rates of
Page 18 of 245
physical output from available inputs. If technical efficiency is achieved, then it would be
impossible to increase the output of any one good or service without reducing the output of
any other good or service.
On the other hand, economic efficiency, which is also called the allocation efficiency is achieved
by an economy when it is producing a combination of goods and services that people want or
prefer and are able to pay for them, given their incomes. Thus, economic efficiency implies
that an economy’s output mix or pattern of production of goods and services is such that
corresponds to the people’s scale of preferences. When economic efficiency is achieved, it is
then impossible through any reallocation of resources between goods, to make some people
better of without making at least one person worse off.
The Problem of Full Employment
In view of the scarcity of resources, it seems strange to ask whether or not all the available
resources are utilized. This is consequent upon the fact that since the resources available to a
community are limited, the community is expected to utilize them fully so as to achieve
maximum possible satisfaction for its people. Hence, a community would not consciously
permit the existence of idle resources. In capitalist free market economy, it however happens
that during depression the available resources are not fully utilized. Thus, there may be
unemployment of labour and resources. This was typically exemplified during the great
depression of the 1930’s when 25% of the labour force in USA, Britain and other
industrialized countries was rendered unemployed, and on the other hand a number of
factories representing a lot of capital stock remained idle.
Page 19 of 245
The explanation of that phenomenon by J.M. Keynes lies basically in the fall in aggregate
effective demand of goods and services. Keynes theory of deficiency of effective demand
causing recession and resulting into involuntary unemployment of labour and under-
utilisation of capital stock has played a prominent role on the formulation of policies to deal
with economic fluctuations.
Economic Growth
Another crucial problem which economists have been trying to solve relates to economic growth.
It is important to know if the productive capacity of the economy is increasing. If the
productive capacity is growing, then the economy would be able to produce progressively
more goods and services. An enhanced welfare of the citizens will result from such increased
capacity. Conversely, if the capacity to produce is declining or static it implies that the
standard of living of the people will be declining or remains constant as the case may be. It is
here that the importance of “increased capacity” or economic growth lies. Thus, Economists
over the years have been propagating ideologies and building models with a view to
identifying a stable growth path.
Positive and Normative Science
A positive science explains the causes and effect of things, that is the ‘why’ and
‘wherefore’ of things. On the other hand a normative science discusses the
rightness or wrongness of things. Economics is a subject that deals with human
behaviouer and therefore economists hold different views on this point. Some
Page 20 of 245
feels it is a positive science whereas others believe it to be a normative science.
There are some who are however neutral on the issue.
What is the difference between positive and normative economics?
Positive Economics deals the causes and effects of economic decisions
whereas normative economics looks into the rightness or wrongness of
economic decisions.
1.2 The Methodology of Economics
Economics generalizations or laws describe the relationship between variables. On the one hand,
it does not provide any explanation of the described relation. On the other hand, a theory
provides an explanation of the stated relation between the variables. This means that it brings
out the logical basis of the generalizations. An economic theory or a model therefore derives
a generalization through a process of logical reasoning and explains the conditions under
which the stated generalization will hold.
Two methods are generally employed in the formulation of economic generalizations, viz, the
Deductive and the Inductive Methods.
1.2.1 Deductive Method
In the Deductive Method, we start with a few indisputable facts about human nature which are
general principles and draw inferences about individual or particular cases. For instance, we
Page 21 of 245
assume that self-interest alone governs human behaviour and we explain or predict the
behaviour of a particular individual on this assumption. The steps followed in the Deductive
Method of Inquiry are as follows:
(a) Perception of the problem
(b) Definition of the technical terms and making appropriate assumptions.
(c) Deducing hypotheses through logical reasoning,
(d) Testing or verifying of the hypotheses deduced.
Merits of Deductive Method
The Deductive Method has several advantages some of which are listed below:
(a) It is a simple method and helps in explaining complex economic phenomenon.
(b) It is certain if the assumptions are correct, the results flow naturally.
(c) It is easy to apply as elaborate statistical information may not be required.
(d) Since observation and experimentation are not possible where human behaviour is
concerned, we have to rely on the Deductive Method.
Limitations of Deductive Method
(a) The underlying assumptions may turn out to be untrue thus, invalidating the inference
drawn.
(b) The Deductive Method makes economics dogmatic because there is a tendency to regard
assumptions as always valid.
(c) This method is dangerous when practical policies are formulated on imperfect
assumptions.
Page 22 of 245
1.2.2 Inductive Method
In the inductive method, the relevant information are collected and analysed. On the basis of such
analyses conclusions are drawn. Thus, under the inductive method of inquiry, the tendency is
to move from “particulars” to “generals”. Thus, generalizations are based on the study of
specific crises.
Merits of Deductive Method
(a) It is highly scientific method of investigation.
(b) It is easy to apply if the instruments are well designed.
(c) The results are very reliable
Limitations of Deductive Method
(a) Poorly defined instruments may complicate the results.
(b) Statistical errors may distort the conclusions
(c) It could be cumbersome to carry out.
1.2.3 Integration of the Two Methods
We find that both the deductive and the inductive methods suffer from certain shortcomings.
Therefore, the solution lies in the application of both so that one supplements the other. It has
to be pointed out that both methods are of great use in formulating theories.
Thus, the true solution of the context about method is not to be found in the selection of deduction
or induction but in the acceptance of deduction and induction. The methods to be used in a
particular situation depend on the nature of the inquiry, the information base of the inquiry
and, of course, the stage of the inquiry
Page 23 of 245
Generally, three stages of scientific investigation have been identified:
(a) construction of theories
(b) The deduction of conclusions or prediction from theories
(c) The testing of theories.
1.2.4 Economic Assumptions
As has been pointed out earlier, every economic law and generalization of ideas in economics is
based upon some assumptions. The main issue that has confronted economists relates to the
question of whether realistic laws must be based on realistic assumptions. Two views have
emerged. One view believes that if economic laws must be realistic, then they must be based
on realistic assumptions. According to this view, an economic law that is based upon
unrealistic assumptions would simply be invalidated by those assumptions.
However, Prof. Milton Friedman holds a contrary view. According to him, a distinction must be
made between positive and normative economics. In his words, positive economics “is a
system of generalizations that can be used to make correct predictions about the
consequences of any change in circumstances”. Since the predictions of this positive
economics must be tested empirically, it is as much a science as the physical or biological
sciences even though the assumptions made may not be realistic.
In conclusion, therefore, the point to be noted is whether the predictions based on economic
generalization of positive economies are confronted by empirical evidence. As pointed out by
Friedman, assumptions need not be realistic since they are made merely to simplify the
analysis. It may be, however, pointed out that while drawing conclusions from economic
theories and laws regarding economic policies, it must be known whether the assumptions
made do not make the policy conclusions invalid if these assumptions are removed.
Page 24 of 245
1.2.5 The Concept of Equilibrium
The concept of equilibrium is central to Methodology of Economics. It is employed in every
theory of economics viz price, income and growth analysis. The word equilibrium means a
state of balance. When two opposing forces are in balance or rest so that the object is held
still, the object is said to be in equilibrium Alfred Marshall refers to equilibrium as “simple
balancing of forces which corresponds rather to the mechanical equilibrium of stone hanging
by an elastic staring or of a number of balls resting against one another in a balance. Thus,
according to Prof. J.K. Melita, equilibrium in economics denotes absence of change in
movement while in physical sciences it means absence of movement itself. The concept of
equilibrium was made clearer by Prof. Tibor Scitovosky when he said that “a person is in
equilibrium when he regards his actual behaviour as the best possible under the
circumstances and feels no urge to change his behaviour as long as circumstances remain
unchanged. The same is true of the equilibrium of the firm. A market or an economy or other
group of persons and firms is equilibrium when none of its members feels impelled to change
his behaviour”.
Whether it is price, level of income or employment, the solution always lies in equilibrium values.
Hence, in microeconomics, one of the most interesting topics is the determination of the price
(equilibrium price) at which the quantity demanded is equal to the quantity supplied. Similar
interest is aroused by the determination of income and employment in the advanced capitalist
countries, which reach their equilibrium levels by the equality of aggregate demand and
aggregate supply. It must be pointed out; however, that equilibrium in economic activities
may never be realized in actual practice. The importance of equilibrium analysis lies in the
Page 25 of 245
fact that if other things remain the same, the economy would tend towards the equilibrium
values. Equilibrium could be partial or general.
Partial Equilibrium in microeconomic analysis, explains the variation in the quantity purchased of
a particular commodity by the changes in its own price. Hence, we assume that the prices of
other commodities are constant and assume that demands of various commodities are not
interdependent. In his explanation of partial equilibrium, Alfred Marshall wrote: “The forces
to be dealt with are, however, so numerous that it is best to analyse a few at a time and to
work out a number of partial solutions as auxiliaries to our main study”. Thus, we begin by
isolating the primary relations of supply, demand and price in regard to a particular
commodity. We reduce to inaction all other forces by the phrase ‘all things being equal. We
do not suppose that they are inert, but for the time being we ignore their activity.
Thus, all partial equilibrium analysis are based on “ceteris paribus” all things being equal.
The General Equilibrium analysis on the other hand explains the mutual and simultaneous
determination of prices of all the goods and factors in the market. Hence, it looks into
multiple market equilibria. This general equilibrium deals with inter-relationship and
interdependence between equilibrium adjustment of prices and quantities of various goods
and factors with each other.
1.2.6 Micro- and Macro Analysis
Economic theory is generally studied under two broad categories – Micro and Macroeconomics,
and hence, the two approaches of economic inquiry – micro and macro analysis.
Page 26 of 245
Microeconomics
Microeconomics deals with the individual components of the national economy. Thus,
microeconomics may be defined as that branch of economics which studies the economic
behaviour of the individual unit, may be a person, a particular household or a particular firm.
It is the study of a particular unit rather than all the units combined. It suffices to say that
Microeconomics is concerned with specific economic units and a detailed consideration of
the behaviour of these individual units.
In microeconomics, we study the various units of the economy, how they function and how they
reach their equilibrium. Thus, microeconomics studies the micro quantities of macro
variables.
The various issues studied under microeconomics are stated below:
(1) The Economic Units and the Flow Model;
- Individual Consumer
- Household, and
- Firm
(2) Theory of Product Pricing
- Demand and Supply Analysis
- Consumer Behaviour
- Production theory
- Cost and Cost Concepts
(3) Factor Pricing
- Theory of wages
Page 27 of 245
- Theory of Rent
- Theory of Interest
- Theory of Profits
(4) The Welfare Theory
Some of these are examined in details below;
Theory of Product Pricing
Demand and supply analysis Definition of demand and supply, effective demand, types of
demand and supply, law of demand and supply, exceptions to the law of demand and supply,
individual versus market demand and supply, determinants of demand and supply, change in
quantity demand and supply and change in demand and supply, equilibrium analysis and
elasticity.
Consumer behavior From the law of demand, it can be deduce that the market demand curve
slopes downward from left to right without any logical reason (theory). In order to see how
the market demand curve is derived, it is vital to study the individual demand curve. To do so
requires observing the behavior of the consumer i.e. an analysis of the individual consumer.
There are three theories that try to provide logical reason why individual demand curve
slopes downward namely: cardinal, ordinal and reveal preference theory.
Product theory – Having discussed the demand side of price theory (product pricing), it is
important to discuss the supply side – this relates to the production of goods and services.
Page 28 of 245
Definition of production and production functions, types of production function – short and
long run, basic production concept, stages of production and principle of returns to scale.
Cost and cost concepts – definition, types of cost, short versus long run cost and basic cost
concept.
Factor Pricing
Unlike commodity market, factor market deals with the exchange of factor input – land, labor,
capital and entrepreneur. The prices of these factors are rent, wage, interest and profit and
each factor input can be analyzed by a separate body of theory. Theory of wage – definition,
nominal versus real wage, theory of wage, supply of labor, wage under perfect and imperfect
market and trade union and wage determination. Theory of rent – definition and
determination of rent. Theory of interest – definition, theory and determination of interest.
Profit – definition, theory of profit and its determination.
The Welfare Theory
Welfare theories are concerned with the evaluation of alternative economic situations. To do this,
we need some criteria of social well being or welfare. The measurement of social welfare
requires some ethical standard and interpersonal comparisons, both of which involve
subjective value judgments. Since objective comparison and judgments of the worth of
different individuals are virtually impossible, various criteria of welfare have been suggested
by economists at different times namely; growth of gross domestic product, Benthams
Page 29 of 245
criteria, cardinalist criteria, pareto-optimality criteria, Kaldor-Hicks compensation criteria
e.t.c.
The Economic Units and the Flow Model
The flow model shows the activities of the two major sectors of the economy namely; household
and firm. The household buys goods and services, supply factors of production and
entrepreneurship. On the other hand, a firm purchases those factors of production and supply
goods and service. The flow model also shows the two major markets in which the two
sectors interacts - product and the factor market.
Generally, economic agent’s viz individual consumer, households and firms are faced with the
problem of allocating scarce resource to competing needs. In other words, economics is the
study of how the individual consumer, household and firm face the problem of making
choices in a world of scarce resources. By so doing economic agents are face with the
fundamental problem of economics – choice, scarcity, opportunity cost and scale of
preference. Thus, the question of what to produce, how to produce, for whom to produce and
how to use resources efficiently are to be considered.
Macroeconomics
Macroeconomics deals with the overall averages of the national economy. Here, we study the
aggregates such as output, inflation, unemployment, money, aggregate investment, aggregate
consumption, external accounts and balance of payments etc. We study these macroeconomic
Page 30 of 245
variables individually to determine their structures and trends as well as collectively, to
determine the relationship among them.
Summary
In Study Session 1, you have learnt about:
The meaning of economics as a subject that teaches people how to minimize economic
problems.
The scope of economics which include, allocation of resources, choice of method of
production, distribution of national income, economic efficiency, the problem of full
employment, and economic growth.
The relevance of assumptions in economic analysis.
The methods of economic study; deductive method -- where we start with a few
indisputable facts about human nature of general principles and draw inferences about
individual or particular cases and Inductive method – the method of inquiry where the
tendency is to move from “particulars” to “generals”.
The concept of equilibrium which is employed in every theory of economics is the price,
income and growth analysis.
The Economic Units, Individual Consumer, Household and Firm
Difference between of Micro and Macro Economics.
Self-Assessment Questions
S.A.Q 1.1 Define Economics and show its relevance in solving an economic problem.
S.A.Q 1.2 Evaluate the scope of Economics
S.A.Q 1.3 What methods are relevant to economic study? How are these methods used?
Page 31 of 245
Multiple Choice Questions
1. Which of the following fundamentally describes the existence of an

Economic problem?
(A) The problem of scarcity.

(B) the problem of choice.
(C)The problem of alternative uses.
(D)The problem of means and ends.
2. which of the following options clearly identifies Microeconomic Units?

(A) Individual Consumer, Households and Firms.
(B) Households, Firms and Governments.
(C)Individual Consumer, Households, Firms and Government.
(D)Individual Consumer, Households, Trade Unions and Firms.
3. Economics is a subject that teaches how to consume and produce ….?

(A) Rationally
(B) Satisfactorily
(C)Economically
(D)Objectively
4. identify the odd option from the following

(A) Wants
(B) Efforts
(C) Satisfaction
(D) Distribution
5. Economics is traditionally divided into ……

(A) Consumption-Production-Exchange-Satisfaction
(B) Satisfaction-Production-Distribution-Stabilization
(C)Consumption-Production-Exchange-Distribution
(D)Distribution-Production-Stabilization-Allocation
6. Microeconomics deals with the study of …..?

(A) Individual Aggregates
(B) Aggregative individuals
(C)Individual Economic Units
(D)All of the above
7. Economic laws are merely statements of ……..?

(A) Consumption rules that must be obeyed
(B) tendencies
(C)Economic problems minimisation
(D)facts
Page 32 of 245
8. Economic laws are …….?
(A) Flexible
(B) Hypothetical
(C)Exact
(D)All of the above
9. Economics is a …….. science

(A) Positive
(B) Normative
(C)Objective
(D)A and B above
10. Rationality of a firm in production decisions revolves around …….?

(A) what and how to produce
(B) what, how and when to produce
(C)what, how and for whom to produce
(D)what, when and for whom to produce
References
Fashola, Mashhud A. (2000): Microeconomic Theory: Highlights and Policy Extensions for Less-
Developed Economies; Concept Publications, Lagos.
Umo, Joe U. (1995): Practical Microeconomic Analysis in African Context; Sibon Books Ltd.,
Ibadan.
Lipsey, Richard G. and Chrystal, Alec K. (1995): An Introduction to Positive Economics; ELBS
with Oxford University Press, London, 8th edition.
Samuleson, P.A. and Nordhaus, W. D (2001): Economics; 17th edition, McGraw-Hill/Irwin.
Koutsoyiannis, A. Microeconomic Theory; Macmillan Press, London.
Ekanem, O.T. and Iyoha M.A; Microeconomic Theory; Mareh Publishers, Benin City.
Should you require more explanation on this study session, please do not hesitate to contact your e-tutor
via the LMS.
Page 33 of 245
Are you in need of General Help as regards your studies? Do not hesitate to contact
the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
Page 34 of 245
Study Session 2: Consumer Behaviour
Introduction
We are concerned about theories that try to explain and predict human behavior.
However, a scientific study of human behavior is possible only if humans respond in
predictable manners to things that affect them. For instance, the proper functioning of any
economy depends on an understanding of how markets work. How does the market
mechanism decide WHAT to produce, HOW to produce, and FOR WHOM to produce? Why
does the price of electronics keep falling while house prices keep rising? This is a question
about the ways different markets work and what factors influence these outcomes. This
module therefore examines market price (a major influence on the way resources are
allocated) in a market economy and the simple analytical tools of demand and supply which
Economists use to build a theory of price. This section also elucidates on government
interference in the market place by considering two modes of interference (price ceilings and
floors) explaining their potency and how they can be maximized as a tool or wealth re-
distribution.
Consumer behavior is multidimensional and this makes it so complex to fully understand. The
numerous goods available in the marketplace make consumption decisions very complicated
while the consumers’ goal remains the same. That is getting as much satisfaction or utility as
possible from their available income. The breakdown of consumer choice – theory anchors
on the theory of the marginal utility which also has a close link with the law of demand.
Page 35 of 245
Generally therefore, the utility maximization theory anchors on the fact that a consumer will
not just buy things they best like, but aims at maximizing their satisfactions by choosing the
goods which convey the most marginal utility per income level (Say Naira).
The basic principles of consumers’ choices form the core of this course which provides the
foundation for in-depth consumer behavior analyses
Learning Outcomes
2.1 Explain how markets work;
2.2 Identify market participants;
2.3 Discuss the factors affecting how much of a product consumers wish to buy;
2.4 Describe the determinants of how much of a product producers sell;
2.5 Explain how consumers and producers interact to determine the market price;
2.6 Explain other institutional structures that affect market outcome;
2.7 The meaning of utility using the Cardinal approach
2.8 The concept of total and marginal utility and their relationship
2.9 The concept of diminishing marginal utility
2.10 The consumer’s equilibrium under the cardinal approach
2.11 The meaning of utility (Ordinal approach) and the indifference curve and maps
2.12 The marginal rate of substitution
2.13 The budget constrain
2.14 The consumer’s equilibrium under the ordinal approach
Page 36 of 245
2.1 The Market
A market is a set of arrangements where buyers and sellers conduct the act of exchanging goods
and services (usually for money). Examples of markets are shops and fruit stalls that physical
bring buyers and sellers together. The Stock Exchange is also another form of market; this
market utilizes intermediaries like stockbrokers for transacting in the market. A recent form
of market is the E-commerce which is conducted and supported over the internet.
There are three types of participants in the market of our concern. These participants are referred
to as agents. An agent is any person who makes decisions relevant to our theory. The three
agents are individuals, firms, and government. In this session therefore, you will encounter
individuals as demanders and firms as suppliers (although, in the labour market, you will find
individuals as suppliers and firms as demanders). The third agent (government) plays a role
in some markets either as producers or demanders. They also intervene in the market through
regulations or by imposing taxes (eg. sales tax, value added tax or excise tax).
2.2 Demand, Supply and Equilibrium
Demand is the quality of product that buyers wish to purchase at every possible or conceivable
price. There is a concept you must understand here, quantity demanded is a desired quantity
indicating how much consumers wish to purchase as against how much they succeed in
purchasing. The quantity purchased is captioned as quantity actually bought and sold to
distinguish it from quantity demanded.
Page 37 of 245
Supply is the quantity of a good or product the sellers wish to sell at various possible prices -per
unit of time.
Demand and supply are determined by various factors. In the case of demand, it is determined
mainly by the following factors:
(i) Price of the goods in question
(ii) The prices of other (related) goods
(iii) The consumer’s income and wealth
(iv) Some individual’s specific or environmental factors
(v) The consumer’s tastes (such as weather, time of the year etc).
Specifically, these determinants of quantity demanded can be summarized under what is called
the demand function which presents the functional relationship between quantity demanded
on the left hand and its determinants on the right. Put in another way, the form of a function
is the exact quantitative relation between the variables of the two sides of the equation.
Qd = f (P, Pr, I , T , S )
Where Qd is the quantity demanded of a product, P is the price of the product, I is the consumer’s
income level, T is consumer’s tastes, Pr is the price of other goods and S is a host of other
factors.
Page 38 of 245
We would not be able to understand the influence of each variable or quantity demanded if we
allow all variables to change at once. We can know the influence of price on quantity
demanded only if we assume all other influences remain unchangeable or constant. This we
put as ceteris paribus (all things being equal). This can also be done on other variables of
the model so as to know the impact of a small change on them
The major determinants of the quantity supplied in any market include the price of the product
itself, the cost of factors of production, and; the state of technology among others. The
functional form of a supply function is:
Qs = f (P, Pn, _ _ _, E)
Where; Qs is the quantity supplied of the product, Pn is the cost of factors of production and P is
the price of the goods.
A demand schedule is a way of showing the relationship between quantity demanded and the
price of the good. It is a numerical tabulation showing the quantity that will be demanded at
the various prices. A demand curve shows the complete relationship between quantities
demanded and price graphically. A supply schedule is similar to the demand schedule. It
shows the records of quantity all producers wish to produce and sell at alternative prices. The
supply curve however shows the quantity produced and offered for sale at each price
graphically. The table below shows the demand and supply schedule for milk
Page 39 of 245
Table 2.1: Demand and Supply Schedule for Milk
Price per tin (N) demand (no of tin) supply (no of tin)
0 200 0
10 160 0
20 120 40
30 80 80
40 40 120
50 0 160
From the schedule, the first column shows the price per tin of milk while columns 2 and 3
respectively show the quantity demanded and supplied at the various prices. The first row for
instance, shows that if tins of milk are free (zero price), a finite amount is wanted as people
get satiated drinking milk. As the price of milk rises, the quantity demanded falls. At the
price of zero, the supplier supplied nothing to the market as milk is not produced at zero cost,
nobody would supply it at zero price. At higher prices, it is more lucrative and attractive to
supply milk and there is a rise in quantity supplied. The figure below presents the demand
and supply for milk based on the schedule above.
Page 40 of 245
Price (N)
Excess Supply
50
SS
a
E
30
10 b
Excess Demand
80 200 Quantity
Figure 2.1: Demand Supply and Equilibrium
Equilibrium price is the price at which the quantity demanded equals quantity
supplied. It is also known as the market clearing condition. Equilibrium condition for the
above market is at a price of N30 in which quantity demanded is equal to the quantity
supplied. Below the equilibrium price (say at a price of N20), we have excess demand. That
is, the quantity demanded (120) exceeds the quantity supplied (40). The numerical value of
excess demand at price N20 is (N120 - N40 = N80). At a price above the equilibrium (say a
price of N40), we have excess supply. It exists when the quantity supplied exceeds the
quantity demanded at the ruling price. Numerically, we have excess supply of (N120 - N40 =
N80).
Suppose the price is originally set at N50 a tin, this is surely above the equilibrium price.
Suppliers of milk will supply 160 tins and nobody would buy. This will force the sellers to
cut their prices (say to N40). This cut in price has two effects. It raises the quantity demanded
from zero to 40 tins while it reduces the quantity producers offer to sell to 120 tins. Both
actions reduce the excess supply. The price cutting action will continue until excess supply is
eliminated and equilibrium is achieved.
Page 41 of 245
On the other hand, if the price is below the equilibrium (say N20), 120 tins of milk are demanded
while suppliers only supplied 40. At that price, sellers run out of stock and charge higher
prices to provide additional milk in as much as there is excess demand, sellers will be
motivated to increase charges until equilibrium is attained.
2.3 Shifts in the Demand Curve
Movements along a given demand curve is known as change in quantity demanded. For
instance, a movement from a to b (in figure 3.1 is the change in quantity demanded due to a
reduction of price of that commodity. Movements along the demand curve isolate the effects
of price on quantity demanded holding other things equal. Changes in any of these other
factors will change the demand for that commodity. A demand curve shifts to a new position
in response to a change in any of the variables that were held constant when the original
curve was drawn.
Figure 3.2 shows a rise in the price of a substitute for butter which leads people to demand more
of margarine and less of butter. At every margarine price, there is larger quantity of
margarine demanded when butter price is increased.
Page 42 of 245
Price (N) D’
D
E’ S
E
P
D’
S
D
Q Quantity (Tins)
Figure 2.2: Change in Demand
2.4 Shifts in the Supply Curve
A shift in the supply curve means that, at each price, a different quantity is supplied. Variables
(other than the product’s own price) that affect the amount of a product firms are willing to
produce and sell, government policy, technology the prices of inputs, and the extent of
government regulation. So, apart from the price of that commodity, if there is a change in any
other determinants of supply, this could lead to a shift in the supply curve. Suppose that
tougher environmental legislation makes it more expensive to make soap bars in mechanized
factories. Figure 2. 3 shows a shift to the left in the supply curve, from SS to SiSi and
equilibrium shifts from E to Ei. This was caused by factors other than the own price of the
commodity.
Page 43 of 245
Price (N) Si
D
E’ S
E
S’ P
S
D
Q
Q
Quantity (Tins)
Figure 2.3: Change in Supply
2.5 Free Markets and Price Controls
Free markets allow prices to be determined purely by the forces of supply and demand. If prices
are sufficiently flexible, the pressure of excess supply or excess demand will quickly beat
prices in a free market to their equilibrium level.
If market is however not free, there is what we call effective price controls or administered
prices. Price controls are put in place to correct excessively high prices of some goods and
excessively low prices of some factor inputs like labour. There are two categories of price
controls (i.e. price ceilings and price floors).
Price ceilings make it illegal for sellers to charge more than a specified maximum price. It may
be introduced when a shortage of a commodity threatens to raise its price excessively.
Example of this you see is food prices during war period. Price ceiling is usually set at a
price below the equilibrium. Figure 2.4 shows the graph of price ceiling.
Page 44 of 245
Price D
S
E
Pe
Pc A B
S D
Shortage
Qs Qe Qd Quantity
Figure 2.4: Price Ceiling Curve
From the graph, the market equilibrium price is Pe at the Qe quantity. The price ceiling is fixed at
Pc. At this ceiling price, quantity demanded Qd exceeds quantity supplied Qs leading to
market shortage of AB.
Price ceiling brings disruption to the market clearing process and to mitigate this, government
must replace the market mechanism with some other means of rationing. Rationing by
quota ensures that available supply is shared out fairly, independently of ability to pay.
In many instances where price ceilings are imposed, black markets emerge. Black markets are
markets processes in which participants buy and sell goods that are controlled by price
ceilings at prices above the legally set price.
For price system to be effective, as a way of resource re-allocation, government must be able to
supply the shortfall between market demand and supply at the ceiling price (AB in our
graph). Government can do this through importation, direct provision of goods or by granting
subsidies to manufacturers engaged in the production of the affected goods.

Page 45 of 245
Price floors are legally set minimum prices usually set at above the market equilibrium. The aim
of price floor is to raise the price for suppliers. You will recall that in Nigeria, the new
minimum wage is set at N18,000, this is an example of price floor.
Price D
Pf A Surplus B S
E
Pe
S D
QdQe Qs Quantity
Figure 2.5: Price Floor Curve
In figure 2.5, the equilibrium is set at Pe where equilibrium quantity is Qe with a price floor of Pe,
Qd quantity was demanded while Qs quantity was supplied leading to a surplus of AB.
The success of any price floors depends on the government’s measures to accommodate the
resulting surplus. In the case of commodities, government may decide to buy the surplus
good. In case of factors like labour, government must create ways to employ the surplus
labour either through policies that can expand the productive base of the economy and
capacity to employ. Alternatively, government can go into direct employment.
2.6 Utility Theory
Utility refers to the want satisfying power that any commodity has. Utility is a subjective concept
generally employed by economists as a measure of the satisfaction an individual derives from
the consumption of an economic good. There are two approaches

Page 46 of 245
Cardinal Utility
Under cardinal ranking, a specific quantity of utils (unit of measuring utility) is assigned to each
alternative. The numerical magnitude of the quantity determines its position in the ranking.
Its assumptions are:
1 Rationality: consumers behave rationally, maximizing utility subject to their budgets
2 Cardinality- utility is measurable
3 Constant marginal utility of money.
4 Diminishing marginal utility.
Marginal Utility
The word ‘marginal’ means ‘extra’ in the economic sense. Marginal utility (MU) therefore is the
extra utility derived by consuming an additional unit of any commodity. Mathematically,
marginal utility is represented by.
MU=ΔTU/ΔX
Where ΔTU is the change in total utility and ΔX is the change in commodity consumed.
Total Utility (TU)
The overall satisfaction or pleasure derived from the consumption of various quantities of an
economic good per unit of time is known as total utility.
The table and graphs below show the total utility and marginal utility curves for a commodity.
Page 47 of 245
Table 2.1: Total and Marginal Utility Schedule
Qty of Bread Total Utility Marginal utility ΔTU⁄ ΔX
1 25 -
2 29 4
3 32 3
4 34 2
5 35 1
6 35 0
Total Utility
TU
Loaves of Bread
Fig. 2.6: Total Utility curve
MU (Utils) MU
Loaves of Bread
Fig. 2.7: Marginal Utility curve
Page 48 of 245
2.7 The Law of Diminishing Marginal Utility
A consumer has diminishing marginal utility from a good if each extra unit consumed, holding
constant consumption of other goods and tastes, add successively less to total utility. As you
can see in panel 4.2, at lower quantity of loaves’ consumption, marginal utility was higher
than at greater quantities of loaves consumption. For instance, at the consumption of 2
loaves, marginal utility was 4 utills. As consumption increased to three loaves, marginal
utility declined to 3 utils. At the consumption of the fourth and fifth units, marginal utilities
declined further to 2 utils and 1 util respectively. This process continues to the point of
saturation in which MU is zero. Further consumption leads to negative utility or disutility.
2.8 Equilibrium and the Consumer
Equilibrium of consumer is a condition for maximizing their total utility. Suppose an individual
consumes two goods X and Y and also wishes to spend all his income on these goods and the
market prices of these goods are given. His allocations must be made in such a way that the
marginal utility derived from each commodity is proportional to their prices.
MUx⁄Px = MUy⁄Py
If this is not fulfilled, the consumer will keep adjusting expenditure until it is fulfilled. If MUx/Px
is 30 utils and MUy/Py is 20 utils, you will realize that if the consumer spends an extra Naira
on Y, 20 utils will be gained and if this same Naira is spent of X, 30 utils will be gained.
Clearly, the consumer will gain more by buying X than Y. the process of adjustment will
Page 49 of 245
tend to reduce MUx as the consumer buys more of it, and raise MUy as he or she gets less of
it. This adjustment process will continue until equilibrium is achieved.
Generally, the equilibrium condition of the consumer can be generally stated as:
MUa/Pa = MUb/Pb = - - - - = MUz/Pz
2.9 The ordinal approach
Francis Edgeworth (1845-1926) introduced the concept of indifference curve to the utility theory.
This is based on the understanding that utility is not measurable. He provided insights into
the determinants of demand.
The indifference curve shows the combinations of goods that can yield equal satisfaction and
among which the consumer is indifferent. The indifference concept is based on some basic
assumptions.
(1) Others things being equal, the consumer always prefers more of any one product to less of
that same product.
(2) The less of one product that is presently being used by a consumer, the smaller the amount of
it that the consumer will be willing to forgo in order to increase consumption of a second
product (diminishing marginal rate of substitution).
The table and graph below shows the indifference curve.
Page 50 of 245
Table 2.2: An indifference Schedule
Bundle Clothing Food

A 30 5
B 18 10
C 13 15
D 10 20
E 8 25
F 7 30
Clothing
IC3
IC2
IC1
Food
Fig.2.8: Indifference Maps
Characteristics of Indifference Curves
(1) An indifference curve is downward sloping. It is convex to the origin.
(2) The farther away indifference curve is to the origin, the higher the level of utility it denotes.
(3) Indifference curves do not intersect.
(4) There is transitivity in preference. If IC1< IC2 and IC2<IC3, then IC1< IC3
Page 51 of 245
Indifference maps
A set of indifference curves is called an indifference map. An indifference curve to the right of
the other represents a higher level of satisfaction. In the figure 2.8 above, the indifference
curve IC1 represents a lower combination of goods than IC2. The same way, IC2 represents a
lower combination of goods than IC3 with more combinations of goods.
2.10 The Marginal Rate of Substitution
The shape of a normal indifference curve is always convex to the origin. The slope of indifference
curve measures the trade-off ratio between the two goods in the two-commodity bundles.
This ratio is referred to as the marginal rate of substitution (MRS). In other words, the rate
of substitution tells us how much more of one product we need to compensate for successive
lost units of the other commodity, mathematically:
MRSx,y = ∆Y/∆X
Where MRSx,y is the marginal rate of substituting Y for X. Since the movement along the
indifference curve leaves the utility level the same, the amount of utility lost by giving up a
certain amount of Y is exactly compensated for by the amount of utility gained by consuming
one additional unit of X.
The diminishing marginal rate of substitution states that a consumer is willing to give up smaller
and smaller amounts of a commodity so as to increase his consumption of the other by a unit.
Page 52 of 245
Table 2.3 : Marginal Rate of Substitution
COMBINATION GOOD X GOOD Y MRSxy
A 1 12 0
B 2 8 4
C 3 5 3
D 4 3 2
D 5 2 1
In the table, a move from a to b produces MRS of 2.4. From b to c, the individual is willing to
give up 1.0 unit of Y so as to have a unit of X. This process continues through the length of
the indifference curve. This is the law of diminishing marginal rate of substitution.
2.11 The Budget Constraint
The budget describes the different bundles that the consumer can afford. In other words, the
budget constraint shows the maximum affordable quantity of one good given the quantity of
the other good being purchased. If for example, the amount of income of a consumer is I, and
the price of X is Px while price of Y is PY, the equation of the budget when a consumer
wishes to spend the entire income on the two commodities is
PxX + PYY = 1
Page 53 of 245
The line of the budget line is show below.
y
I/Py
- Budget line
Q
I/Px x
Figure 2.9: The Budget line
2.12 Consumer’s equilibrium
The budget line tells us what consumers can do; they can select any consumption bundle on, or
below the budget line, but not above it. This means that they can spend only within the limits
of a given income. On the other hand, as you have been told, consumers seek to maximize
total satisfaction, which means reaching the highest possible indifference curve.
Satisfaction is maximized at the point where an indifference curve is tangential to the budget line.
At that point, the slope of the indifference curve – which measures the consumer’s marginal
rate of substitution – is equal to the slope of the budget line-which measures the opportunity
cost of one good in terms of the other as determined by market prices.
Qty. of Y
Page 54 of 245
IC3
Qey
IC2
B IC1
Qex Qty. of X
Fig 2.10: Consumer’s equilibrium
In figure 4.5, you will see that indifference curve IC1 represents lowest level of satisfaction and it
cuts the budget line at points a and b where the budget is exhausted on the two commodities.
Combinations a and b are however not optimal because the same budget could be utilized to
achieve higher level of satisfaction (higher indifference curve). Indifference curve IC3
represents the highest level of satisfaction in comparison with IC1, and IC2. However the
budget cannot accommodate any combination along this curve (not attainable due to budget
constraint). However, at point E along IC2, the budget is tangential to IC2 establishing the
consumer’s equilibrium by consuming QEY and QEX.
Summary
In Study Session 3, you have learnt about:
• The market, its agents and how its participants interact in the market place.
• The concepts of demand, supply and their determinants as well as how their interactions
bring about equilibrium in the market and the forces sustaining equilibrium.
• Shifts in demand and supply as distinct from changes in quantity demanded and supplied.
• The concepts of administered prices and their effectiveness in influencing behaviours in the
market.
Page 55 of 245
• The concept of utility and the two approaches to them (cardinal and ordinal approaches),
• The concepts of total and marginal utility and the pattern of their graphs, the law of
diminishing marginal utility and consumer equilibrium of the cardinal approach.
• The concept of indifference curve (and their characteristics) of the ordinal approach and were
taught the basic concepts such as indifference maps and marginal rate of substitution (MRS).
SAQ 2.1: The demand and supply functions of a good are given as:
QD = 5 – P and QS = -3/2 + P
Where P is price, QD is the quantity demanded and QS is the quantity supplied.
(i) Determine the equilibrium price and quantity
(ii) What is the effect on the market equilibrium if government imposes a fixed tax of N2 on the good?
Compare your results in (i) and (ii).
SAQ 2.2: What do we mean by market equilibrium? What are the forces sustaining the
equilibrium?
SAQ 2.3: With appropriate examples, explain the law of diminishing marginal utility
Multiple-choice Questions
(1) One of the following best describes complementary goods
(a) Goods whose prices moves in opposite direction
(b) A pair of goods consumed together
(c) Goods that are not consumed in the same place
(d) None of the above
Page 56 of 245
(2) Substitutes are goods whose ---
(a) Prices move together
(b) Price of one and quantity demanded of the other move in the same direction
(c) Price of one and quantity demanded of the other move in opposite direction
(d) None of the above
(3) Goods whose prices move in the same direction are called
(a) Complements (b) Substitutes (c) Composite (d) Adjacent
(4) One of these best describes a demand function
(a) A relationship between quantity demanded and price
(b) A relationship between quantity demanded and income
(c) A relationship between quantity demanded and its various determinants
(d) All of the above
(5) A good whose demand decreases as income rises is called
(a) A necessity (b) An inferior good (c) A superior good (d) None of the above
(6) A good whose demand increases as income increases is known as
(a) A necessity (b) An inferior good (c) A superior good (d) None of the above
(7) The term ceteris Paribus used in economics means
Page 57 of 245
(a) Everything being equal (b) Other things being equal (c) Something being equal (d) None of
above
(8) Which of the following is likely going to cause a change in quantity demanded of a
commodity?
(a) Consumers’ income (b) Price of the commodity (c) Prices of related commodities (d) Taste
(9) Which of the following cannot cause a shift in demand for a commodity?
(a) Consumers’ income (b) Price of the commodity (c) Prices of related commodities (d) Taste
(10) Which of the following answers to the question of what, how and for whom to produce in an
economy?
(a) Supply (b) Demand (c) Market signals (d) None of the above
(11) The term utility refers to;
(a) Marginal utility (b) Total utility (c) The pleasure or satisfaction derived from consuming a
good or service (d) The satisfaction foregone by consuming a good or service.
(12) So long as marginal utility is positive, total utility must be ---
(a) Declining (b) Constant (c) Doubling (d) increasing
(13) Negative marginal utility represents
(a) Satisfaction (b) Distasteful (c) Maximizing of satisfaction (d) None of the above
(14) At the point where the marginal utility is zero, total utility is
Page 58 of 245
(a) At its peak (b) Increasing (c) decreasing (d) None of the above
(15) The fact that additional quantities of a good tend to yield increasingly smaller increments of
satisfaction is known as
(a) The principle of diminishing marginal utility (b) The marginal utility (c) Diminishing returns
to scale (d) consumer’s equilibrium
(16) The combinations of goods that yield equal satisfaction is shown on
(a) Budget line (b) Isocost (c) Indifference curve (d) None of the above
(17) The figure depicting all combinations of goods on equal satisfaction level and other
combinations which are more or less satisfying is called
(a) Indifference figures (b) Indifference curves (c) Budget line (d) Indifference map
(18) A line showing all combinations of goods that are affordable given the income level and
prices is known as
(a) Indifference figures (b) Indifference curves (c) Budget line (d) Indifference map
(19) The shape of an indifference curve is
(a) Convex to the origin (b) Concave to the origin (c) U – Shaped (d) A straight line
(20) The shape of the budget line is
(a) Convex to the origin (b) Concave to the origin (c) U – Shaped (d) A straight line
Page 59 of 245
References
Ibadan.
.Koutsoyiannis, A. Microeconomic Theory; Macmillan Press, London.
David, Begg; Stanley, Fischer and Rodiger, Dornbusch (2003) Economics.Mcgraw-hill, UK.
Bradley, R, Schiller (1997) The Micro Economy Today.Irwin McGraw-Hill. California.
Myrick, A. Freeman III (1983) Intermediate Microeconomic Analysis. Harper & Row Publishers. New York.
Should you require more explanation on this study session, please do not hesitate to contact your
e-tutor via the LMS.
08033366677
Page 60 of 245
Study Session 3: Elasticity of demand and supply
Introduction
In this study session, an attempt has been made to discuss the concept of elasticity of
demand at a level understandable to learners in the field of economics. Within the concept of
elasticity, the form/types of elasticity of demand will be briefly discussed. Likewise the
applicability of the concept in daily activities is also incorporated herein. This session also
examines the concepts of elasticity of supply and how they are applied to everyday economic
activities.
3.1. Define and use correctly the key words printed in bold:
3.2. Explain elasticity of demand
3.3. Discuss income elasticity of demand
3.4. Describe cross price elasticity of demand
3.5. Identify the determinants of elasticity of demand
3.6. State the tools for measuring elasticity of demand 3.7
explain elasticity of supply
3.8 Highlight the determinants of elasticity of supply
3.9. Discuss useful applications of price elasticity of demand and supply
3.1 Elasticity of Demand
We know that when the price drops the quantity demanded will rise and the quantity supplied will
fall. In many cases, the directions of these changes are all that matter. However, in other
cases, the magnitude of the change matters as well. Will a change in price have a large
Page 61 of 245
impact or only a small impact on consumer and producer behaviour? Economists use the
concept of elasticity to measure these changes. While elasticity can be calculated and used
for any two related variables, there are four basic coefficients of elasticity used in economics.
These include; the own price, income, cross elasticity of demand as well as the elasticity of
supply. This section will examine the concepts that relate to elasticity of demand.
3.1.1 The ‘Own’ Price Elasticity of Demand
The Price Elasticity of Demand (PED) which is the same as elasticity of demand is measured as
the percentage change in quantity demanded divided by the percentage change in price. Also,
it is a measure used in economics to show the responsiveness, or elasticity, of the quantity
demanded of a good or service to a change in its price. Precisely, it gives the percentage
change in quantity demanded in response to a one percent change in price (holding constant
all the other determinants of demand, such as income). The essential idea is that elasticity
measures how sensitive we are to changes in price. If prices matter very little, changes in
price only will have small impacts on our willingness to buy or sell. If the percentage change
in quantities demanded and supplied are small, the elasticity calculation will also be small
and we will get inelastic results. On the other hand, if product is very sensitive to prices,
even small changes in prices will cause large changes in our willingness to buy or sell. The
large changes in quantity will give us large elasticity’s. For instance, if a 10 percent increase
in price causes consumers to cut their willingness to buy by 12 percent then the elasticity of
demand = 12/10 = 1.2 [Purists will note that the elasticity is actually negative 1.2, but we
will worry only about the absolute value].
It can be measured by the following formula:-
Page 62 of 245
epx = Proportionate change in the quantity of X demanded
Proportionate change in the price of X
Or
∆Qx Px
e px = *
∆Px Qx
Or
epx = Dx2 - Dx1/Dx1 ÷ Px2 - Px1/Px1
Where:
∆Qx = Change in quantity demanded (taken to be Dx2 - Dx1)
∆Px = Change in price of goods demanded (taken to be Px2 - Px1)
Dx1 and Px1 = Demand for X, and price of X before price-change
Dx2 and Px2 = Demand for X, and price of X after price-change.
For example, if Dx1 = 100, Dx2 = 150, Px1 = 12, Px2 = 10.
Then epx = 150 - 100/100 ÷ 10 - 12/12 = - 3
epx = - 3
The negative sign indicates the inverse relationship between Dx and Px. Normally we ignore the
sign and consider only the absolute value. In sum, the price elasticity of demand can be
calculated at a specific price and quantity. This is called the point price elasticity and is
different at every price. To calculate the point price elasticity, we have to restate the above
formula which is given as;
∆Q P1
ep = *
∆P Q2
Page 63 of 245
Where;
= ∆Q
∆P : is the slope of the demand function.
P1 : is the original price.
Q1. : is the original quantity.
Also, the average price elasticity can be calculated between two price-quantity combinations.
This is called the average or ‘Arc’ elasticity of demand. It measures elasticity between two
points on a curve. The average or “Arc” elasticity is calculated with the following formula;
Ep =∆Q P1 + P2
∆P * Q1. +Q2
Where;
=∆Q
∆P ; is the slope of the demand function.
P1 ; is the original price. P2 ; is the new price.
Q1. ; is the original quantity. Q2. ; is the new quantity.
Example of Arc Elasticity of Demand Suppose
the price of rice increases from N10 to N12 and quantity demanded by University of Lagos
students decreases from 40 cups of rice to 20 cups, calculate the Arc Elasticity of Demand.
Here we can assume the Arc elasticity of demand to be calculated using the midpoint
between 40 and 20 which is equals to 30.
The % change in quantity is 20/ 30 = - 0.667
The % change in price is 2 / 11 = 0.18
Therefore PED = -0.667 / 0.18 = -3.7

Page 64 of 245
The term price elasticity of demand is defined as?
Price elasticity of demand can be defined as the degree of responsiveness of
change in quantity demand due to a change in price. The formula for estimating
price elasticity of demand is given as percentage change in quantity demanded/percentage
change in price.
3.1.2 Types or Forms of Point Elasticity of Demand
(a) Elastic demand
If a curve is elastic, then small changes in price will cause large changes in quantity consumed.
Consider a case in the figure below where demand is very elastic, that is, when the curve is
almost flat. You can see that if the price changes from N.74 to N75, the quantity demanded
decreases a lot from 80 units to 10 units (see figure 3.1). There are many possible reasons for
this phenomenon. Buyers might be able to easily substitute away from the good, so that when
the price increases, they have little tolerance for the price change. Maybe the buyers do not
want the good that much, so a small change in price has a large effect on their demand for the
good.
Price
75
74
Page 65 of 245
0
20 80 Quantity
0
Fig. 3.1 Elastic Demand
If the elasticity of demand is greater than or equal to 1, meaning that the percent
change in quantity is great than the percent change in price, then the curve will be relatively
flat and elastic: small price changes will have large effects on demand. Thus, when Epx >1,
we say: demand is elastic. Examples of goods are Omo, Toothpaste, Milo etc.
(b) Inelastic demand
If demand is very inelastic, then large changes in price would not do very much to the quantity
demanded. For instance, whereas a change of N.1 reduced quantity by 60 units in the elastic
curve, in the inelastic curve, a price jump let say from N.10 to N.80 reduces the quantity
demanded from 10 units to 9 units. Within the inelastic curves analysis, there is a greater
change in price than in quantity demanded as depicted in Figure 3.2. Possible explanations
for this situation could be that the good is an essential good that is not easily substituted for
by other goods. That is, for a good with an inelastic curve, customers really want or really
need the good, and they cannot get that good offer from anywhere else. This means that
consumers will need to buy the same amount of the good from week to week, regardless of
the price.
Page 66 of 245
Price
80
10
0 9 10 Quantity
Figure 3.2: Inelastic demand
If the elasticity of demand curve is less than 1, meaning the percent change in
quantity is less than the percent change in price, then the curve will be steep and inelastic: it
will take a big change in price to affect demand. In summary, when Epx < 1, we say: demand
is inelastic.
(c) Unitary demand
Unitary Elastic Demand is a proportionate change in price and quantity. This means that the
reaction of consumers to price changes is stable and not dramatic like elastic products, and
not small changes in quantity like inelastic products. It is in the middle of these two.
Page 67 of 245
Price
20
10
0
20 30 Quantity
Fig. 3.3: Unit elasticity
For instance in figure 3.3, we can see that, when price increases from N.10 to N.20, quantity
demanded decreases from 30 units to 20 units. This illustration shows that, there is a
proportionate increase or changes in price and quantity demanded. In sum, we say, when Epx
= 1, demand is unitary elastic.
(d) Perfectly elastic demand
This is experienced when the demand is extremely sensitive to the changes in price. In this case
an insignificant change in price produces tremendous change in demand. The demand curve
showing perfectly elastic demand is a horizontal straight line. Thus, perfectly elastic
demand (e = ∞). It should be noted that at a given price an infinite quantity is demanded. A
Page 68 of 245
small change in price produces infinite change in demand. A perfectly competitive firm faces
this type of demand.
Price
P1
0
Quantity
Fig. 3.4: Perfectly Elastic Demand
(e) Perfectly inelastic demand
This describes a situation in which demand shows no response to a change in price. In other
words, whatever the price, the quantity demanded remains the same. This is shown in fig 3.5.
Price
P1
0
Quantity
Fig 3.5: Perfectly Inelastic Demand Curve
The vertical straight line demand curve as shown in the graph above reveals that with
Page 69 of 245
a change in price, the demand remains same. Thus, demand does not respond to a change in
price at all. Perfectly inelastic demand (ep = 0). That is, the case of zero elasticity is
described as being perfectly inelastic.
3.2
Briefly pinpoint the difference between elastic and inelastic demand?
ITA 3.2
Demand is price elastic if a change in price causes a greater or bigger percentage
change in demand. The Price Elasticity of Demand (PED) is said to be greater than
one. While Demand is price inelastic if a greater change in price causes a smaller percentage
change in demand. It will have a PED of lesser than one.
3.2 Income Elasticity of Demand
The discussion of price elasticity of demand reveals the extent of change in demand as a result of
change in price. However, as already explained, price is not the only determinant of demand.
Demand for a commodity changes in response to a change in income of the consumer. In
fact, income effect complements the price effect. The income effect suggests the effect of
change in income on demand.
The income elasticity of demand (IED) explains the extent of change in demand as a result of
change in income. In other words, income elasticity of demand means the responsiveness of
demand to changes in income. Thus, income elasticity of demand can be expressed as:
IED = [Percentage change in demand / Percentage change in income] or

Page 70 of 245
IED = (% Change in Quantity Demanded)/(% Change in Income)…………………..(1)
This can be derived as follow:
IED =∆Q Y1…………………………………………………………………………………………………….…………..(2)
∆Y * Q1
Where:
∆Q = Change in quantity demanded (taken to be Q2 - Q1)………………………….(3)
∆Y = Change in income (taken to be Y2 - Y1)……………………………………….(4)
Q1. = is the original quantity….……………………………………………………….(5)
Y1 = is the original income level …………………………………………………….(6)
Q2 and Y2 = Demand for X, and income of the consumer after income change.
Fill in the value obtained from (3), (4), (5) and (6) into equation (2) to get;
IED = Q2 - Q1 Y1…………………………………………………………………………………….…………..(2)
Y2 - Y1 * Q1
3.2.1. Types of Income Elasticity of Demand
• Income elasticity of demand greater than one:
When the percentage change in demand is greater than the percentage change in income, a greater
portion of income is being spent on a commodity with an increase in income. Income
elasticity is said to be greater than one.
• Income elasticity is unitary
Page 71 of 245
When the proportion of income spent on a commodity remains the same or when the percentage
change in income is equal to the percentage change in demand, IED = 1 or the income
elasticity is unitary.
• Income elasticity less than one (IED< 1)
This occurs when the percentage change in demand is less than the percentage change in income.
• Zero Income Elasticity of Demand (IED=0)
This is the case when change in income of the consumer does not bring about any change in the
demand for a commodity.
• Negative Income Elasticity of Demand (IED< 0)
It is well known that income effect for most of the commodities is positive. In the case of inferior
goods, the income effect beyond a certain level of income becomes negative. This implies
that as the income increases the consumer, instead of buying more of a commodity, buys less
and switches on to a superior commodity. The income elasticity of demand in such cases will
be negative. Unlike price elasticity, we do care about negative values, so do not drop the
negative sign if you get one.
3.2.2. Illustration of Income Elasticity Of Demand
• For Normal goods
A normal good is one where demand is directly proportional to income. When the estimated value
of a given question gives positive result, the good is said to be a normal good. For instance, if
Mr. Onogiese, income increases from N40,000 to N50,000, and he decided to buys 200
loaves of bread per year instead of 180, then the IED is given as:
IED = 200 - 180 X 40000………………………………………………………………………….…………..(2)
Page 72 of 245
50000 - 40000 180
= 0.4.
The estimated value gives a positive figure, thus the product is a normal good.
• Inferior goods
When IED is negative, the good is classified as inferior. For example, following an increase in
income of Mr. Onogiese from N40,000 to N50,000, and he decided to buys 180 loaves of
bread per year instead of 200, then the IED is:
+-10 +25 = (-) 0.4
The negative sign means that the good is inferior, and, because the coefficient is less than one,
demand for the good does not respond significantly to a change in income. This indicates that
the good is not particularly inferior compared with a good which has an IED of > (-) 1.
The sign and the number provide different information about the relationship between income and
demand. Income elasticity of demand can also be illustrated by Engel Curves.
Engel Curves, named after 19th Century German statistician Ernst Engel, illustrate the
relationship between consumer demand and household income. Engel curves for normal
goods slope upwards – the flatter the slope, the more luxurious the good, and the greater the
income elasticity. In contrast, Engel curves for inferior goods have a negative slope.
Income (Y)
Normal
good
Luxury
Y1
Y2
Inferior
good
Page 73 of 245
Q1 Q Q1 Q2
Fig. 3.6: Income elasticity of demand for different types of goods
The demand for the three goods as shown in figure 3.6, respond very differently to the same
change in income from Y2 to Y1. Demand for normal good increases from Q to Q1, demand
for the luxury good rises much more, to Q2, and demand for the inferior good falls from Q to
Q3 .
3.2.3. Interpretation of the Income Elasticity of Demand
Income elasticity of demand is used to see how sensitive the demand for a good is to an income
change. The higher the income elasticity, the more sensitive demand for a good is to income
changes. Very high income elasticity suggests that when a consumer's income goes up,
consumers will buy more of that good. Very low price elasticity implies just the opposite,
that changes in a consumer’s income have little influence on demand. •
If IED > 1 then the good is a luxury good and Income elastic
• If 1 > IED > 0 then the good is a normal good and income inelastic
• If IED < 0 then the good is an inferior good and negative income inelastic.
3.2.4. Reasons why a Firm wants to Know IED

There are several reasons why a firm would want to know IED, including the following:
i) Sales forecasting
A firm can forecast the impact of a change in income on sales volume (Q), and sales revenue (P x
Q). For example, a hypothetical car manufacturer has calculated that IED with respect to its
luxury car is (+) 3.8 and it has also undertaken research to discover that consumer incomes
will rise by 2% next year. It can now predict the impact of this change. Knowing IED helps
the firm decide whether to raise or lower price following a change in consumer incomes. If
incomes are falling and IED is positive, a reduction in price might help compensate for the
reduction in demand (Pricing policy).
Page 74 of 245
ii) Diversification of Production
Firms can diversify and offer a range of goods with different IEDs to spread the risks associated
with changes in the level of national income. For example, a car manufacturer may produce
cars with a range of IED values, so that sales are stabilised as the economy grows and
declines.
iii) IED and the business cycle

Changes in real national income tend to be cyclical. The demand for normal goods increases
when the economy is expanding, but decreases when the economy is contracting.
Conversely, the demand for inferior goods is counter-cyclical.
The type of goods that have negative Income elasticity of demand is noted as?
(ii) The form of goods that possess positive Income elasticity of demand is said to
be?
(i) Inferior goods have negative Income elasticity of demand feature because as
income of consumers increases, the demand for such goods decline.
(ii) The case of normal goods is positive Income elasticity of demand, because as
the income of the consumers increases, quantity demanded of such good increases.
3.3. Cross Elasticity of Demand

This is an economic concept that measures the responsiveness in the quantity demanded of one
good when a change in price takes place in another good. It is called the Cross Elasticity of
Demand. The measure is calculated by taking the percentage change in the quantity
demanded of one good, divided by the percentage change in price of the substitute good:
P1 A + P2 A ∆ Q B
Ec = *
Q 1B + Q 2B ∆ P A
Where:
P1A = The price of good A at time period 1
Page 75 of 245
P2A = The price of good A at time period 2
Q1B = The quantity demanded of good B at time period 1
Q2B = The quantity demanded of good B at time period 2
∆Q B = The change in the quantity demanded of good B
∆P A = The change in price of good A
Here, we are mainly concerned with the effect that changes in relative prices within a market has
on the pattern of demand. With cross price elasticity we make an important distinction
between substitute products and complementary goods
3.3.1. Illustration of cross elasticity of demand for two types of goods
Substitutes: With substitute goods such as brands of cereal or washing powder, an increase in the
price of one good will lead to an increase in demand for the rival product. Cross price
elasticity for two substitutes will be positive.
Complements: With goods that are complementary, such as the demand for DVD players and
DVDs, when there is a fall in the price of DVD players we expect to see more DVD players
bought, leading to an expansion in market demand for DVD videos. The cross price elasticity
of demand for two complements is negative
The stronger the relationship between two products, the higher the co-efficient of cross elasticity
of demand. For example with two close substitutes, the cross-price elasticity will be strongly
positive. Likewise when there is a strong complementary relationship between two products,
the cross-price elasticity will be highly negative. Unrelated products have a zero cross
elasticity.
Relationship between two close Relationship between two

complements substitutes
Page 76 of 245
Price Price
D
P1 P1 D
QY
Qx D
0
PX
Fig. 3.7: Cross price elasticity of demand for different types of goods
Two goods that are independent have a zero cross elasticity of demand: as the price
of good Y rises, the demand for good X stays constant
3.3.1. How businesses can make use of the concept of cross elasticity of
demand?
i) Pricing strategies for substitutes: If a competitor cuts the price of a rival product, firms use
estimates of cross-price elasticity to predict the effect on the quantity demanded and total
revenue of their own product. For example, two or more airlines competing with each other
Page 77 of 245
on a given route will have to consider how one airline might react to its competitor’s price
change. Will many consumers switch? Will they have the capacity to meet an expected rise
in demand? Will the other firm match a price rise? Will it follow a price fall?
ii) Pricing strategies for complementary goods: For example, popcorn, soft drinks and cinema
tickets have a high negative value for cross elasticity– they are strong complements. Popcorn
has a high mark-up i.e. popcorn costs few naira to make but sells for more than N100 in
Ozone Viewing Centre Yaba. If Ozone management has a reliable estimate for cross price
elaticity, they can estimate the effect, say, of a two-for-one popcorn offer on the demand for
ticket of N1500 per viewing of a movie. The additional profit from extra ticket sales may
more than compensate for the cost of popcorn for entry into the cinema.
iii) Advertising and marketing: In highly competitive markets where brand names carry
substantial value, many businesses spend huge amounts of money every year on persuasive
advertising and marketing. There are many aims behind this, including attempting to shift out
the demand curve for a product (or product range) and also build consumer loyalty to a
brand. When consumers become habitual purchasers of a product, the cross price elasticity of
demand against rival products will decrease. This reduces the size of the substitution effect
following a price change and makes demand less sensitive to price. The result is that firms
may be able to charge a higher price, increase their total revenue and turn consumer surplus
into higher profit.
3.4 Determinants of Elasticity of Demand
i. Nature of the Commodity: Humans wants, i.e. the commodities satisfying them can be
classified broadly into necessities on the one hand and comforts and luxuries on the other
Page 78 of 245
hand. The nature of demand for a commodity depends upon this classification. The demand
for necessities is inelastic and elastic for comforts and luxuries.
ii. Number of Substitutes Available: The availability of substitutes is a major determinant of the
elasticity of demand. The greater the number of substitutes, the higher the elasticity of
demand. The demand will be elastic if a commodity has many substitutes. As against this, in
the absence of substitutes, the demand becomes relatively inelastic because the consumers
have no other alternative but to buy the product irrespective of whether the price rises or
falls.
iii. Number of Uses: If a commodity can be put to a variety of uses, the demand will be more
elastic. When the price of such commodity rises, its consumption will be restricted only to
more important uses and when the price falls the consumption may be extended to less urgent
uses, e.g. coal, electricity, water etc.
iv. Possibility of Postponement of Consumption: This factor also greatly influences the nature
of demand for a commodity. If the consumption of a commodity can be postponed, the
demand will be elastic.
v. Range of prices: The demand for very low-priced goods as well as very high-price commodity
is generally inelastic. When the price is very high, the commodity is consumed only by the
rich people. A rise or fall in the price will not have significant effect in the demand.
Similarly, when the price is so low that the commodity can be brought by all those who wish
to buy, a change, i.e., a rise or fall in the price, will hardly have any effect on the demand.
vi. Proportion of Income Spent: The income of the consumer significantly influences the nature
of demand. If only a small fraction of income is being spent on a particular commodity, say
newspaper, the demand will tend to be inelastic.
Page 79 of 245
vii. In addition, it is observed that demand for durable goods, is usually elastic.
viii. The nature of demand for a commodity is also influenced by the complementarities of goods.
From the above analysis of the determinants of elasticity of demand, it is clear that no precise
conclusion about the nature of demand for any specific commodity can be drawn. It depends
upon the range of price, and the psychology of the consumers. The conclusion regarding the
nature of demand should, therefore be restricted to small changes in prices during short
period. By doing so, the influence of changes in habits, tastes, likes customs etc., can be
ignored.
3.5 Measurement of elasticity
For practical purposes, it is essential to measure the exact elasticity of demand. By measuring the
elasticity we can know the extent to which the demand is elastic or inelastic. Different
methods are used for measuring the elasticity of demand. In this text, we shall be looking at
three methods of measuring elasticity. They are; the percentage, the total outlay and the point
or graphical methods. These methods are briefly discussed below.
i. Percentage Method: In this method, the percentage change in demand and percentage change
in price are compared. For instance; ep = [Percentage change in demand / Percentage change
in price]. In this method, three values of ‘ep’ can be obtained. Viz., ep = 1, ep > 1, ep > 1. If
5% change in price leads to exactly 5% change in demand, i.e. percentage change in demand
is equal to percentage change in price , e = 1, it is a case of unit elasticity. If percentage
change in demand is greater than percentage change in price, e > 1, it means the demand is
elastic. If percentage change in demand is less than that in price, e > 1, meaning the demand
is inelastic.
Page 80 of 245
ii. Total Outlay Method: The elasticity of demand can be measured by considering the changes
in price and the consequent changes in demand causing changes in the total amount spent on
the goods. The change in price changes the demand for a commodity which in turn changes
the total expenditure of the consumer or total revenue of the seller. If a given change in price
fails to bring about any change in the total outlay, it is the case of unit elasticity. It means if
the total revenue (price x quantity bought) remains the same in spite of a change in price, ‘ep’
is said to be equal to 1. If price and total revenue are inversely related, i.e., if total revenue
falls with rise in price or rises with fall in price, demand is said to be elastic or e > 1. When
price and total revenue are directly related, i.e. if total revenue rises with a rise in price and
falls with a fall in price, the demand is said to be inelastic or e < 1.
iii. Point or graphic method: Graphic method is otherwise known as point method or geometric
method. According to this method, elasticity of demand is measured on different points on a
straight line demand curve. The price elasticity of demand at a point on a straight line is
equal to the lower segment of the demand curve divided by upper segment of the demand
curve.
Thus at mid-point on a straight-line demand curve, elasticity will be equal to unity; at higher
points on the same demand curve, but to the left of the mid-point, elasticity will be greater
than unity, at lower points on the demand curve, but to the right of the midpoint, elasticity
will be less than unity.
Mention four determinants of elasticity of demand?
(i) Nature of the commodity

(ii) Possibility of postponement of consumption.
Page 81 of 245
(iii) Amount of income spent
(iv) Price ranges
3.6. Elasticity of Supply
The elasticity of supply measures the responsiveness of the quantity supplied to a change in the
price of a good, with all other factors remaining the same. The formula for elasticity of
supply is given as:
Elasticity of supply (epx = (% change in quantity supplied) / (% change in price). Thus,
as demand for a good or product increases, the price rises and the quantity supplied rises in
response. How fast it increases depends on the elasticity of supply. Let us
look at an example. Assuming the price of rice rises by 40% and the quantity of rice supplied
increases by 26%. Using the formula above, we can calculate the elasticity of supply as; =
(26%) / (40%) = 0.65
Elasticity of supply tells us how fast supply responds to quantity demand and price increase.
When there is a popular product that is in short supply for instance, the price may rise as a result.
The manufacturers of that product will increase output (the supply) to keep up with the
demand. The higher the elasticity of supply, the faster the supply will increase when demand
and price increase.
Therefore, the higher the elasticity, the more sensitive suppliers are to price changes. The higher
the elasticity when prices increase sellers supply less and when price goes down sellers
supply more. Some goods/services are more supply inelastic, whenever there is a supply
shortage. Limited tickets to a concert may have a very inelastic supply. The price of the
concert tickets can be raised to any amount, but because there is a fixed number of seats and
tickets, the supply (of tickets sold) may not be increased by much if at all.
Page 82 of 245
3.6.1. Illustration of Price Elasticity of Supply (PES)
Calculate the elasticity of supply when the price of cup of bean increases from N100 to N110 and
the quantity supplied by Onogiese Enterprise increases from 20,000 to 25,000.
Therefore:
Change in Price [N110 - N100] / N100 = 10%
Change in Quantity [25,000 - 20,000] / 20,000 = 25%
Price elasticity of supply is depicted as:
[% change in quantity supplied] / [% change in price]
PES = .25 / .10
PES = 2.5
This example explores a price change of N10 with a corresponding increase in quantity
supplied of 5,000 units. This information is used to calculate a single value elasticity of
supply, to relate the percent change of quantity supplied to the percent change in price. In this
particular example, elasticity of supply is equal to 2.5.
3.6.2. Types or Forms of Elasticity of Supply:
There are five types of elasticity of supply which are given below
(i) Perfectly elastic supply: It is a case where a very slight change in price causes an infinite
change in supply. A slight fall in prices brings quantity supplied to zero. In such a case the
supply curve runs parallel to the X -axis. The supply curve takes the shape of a horizontal
straight line. In the diagram given (Figure 3.8), the supply curve shows an infinitesimally
small change in price causes an infinitely large change in the quantity supplied.
Price
Page 83 of 245
P1 S
Fig. 3.8: Perfectly supply demand
Therefore, when PES = infinity, supply is perfectly elastic following a change in
demand.
(iii)Relatively elastic supply: The supply is relatively elastic when a given change in price
produces a more than proportionate change in quantity supplied. A doubling in price
will result in more than double the quantity supplied. In the diagram shown in figure
3.9, a given change in price is attended by a much more change in supply. Thus, when
PES > 1, then supply is price elastic
Price
S
P1
P2
D1
Q Q1 Quantity
Supply is price elastic
Page 84 of 245
Fig. 3.9: Relatively elastic supply
(iii) Perfectly inelastic supply: The supply of a commodity is said to be perfectly
inelastic when the supply of a commodity is completely non-responsive to changes in price.
It is a case where quantity supplied remains the same despite the change in price. A perfectly
inelastic supply curve is a vertical straight line which is parallel to OX-axis. In figure 3.10,
the perfectly inelastic supply curve runs parallel to OX-axis.
Price
S
Y
P1
P2
0 Q Q1 Quantity X
Fig. 3.10: Perfectly price inelastic of supply
When PES = 0, supply is said to be perfectly inelastic.
(iv)Relatively inelastic supply: When a certain change in price causes a smaller proportionate
change in quantity supplied of a commodity, the supply is said to be relatively inelastic. The
percentage change in price is more than the percentage change in quantity supplied. In figure
3.11, a rise in price brings about less than proportionate change in supply. When PES < 1,
then supply is price inelastic.
Price S
P1
Page 85 of 245
P2
D2
D1
Q Q1 Quantity
Fig. 3.11: Relatively price inelastic of supply
(v) Unitary elastic supply: In such a situation the proportionate change in supply
equals the proportionate change in price. In the diagram given in figure 3.12, the unitary
elastic supply curve depicted increase in price which is accompanied by a proportionate
change in quantity
supply. Price
S
P2
P1
Fig. 3.12: Unitary supply elastic
Q1 Q2 Quantity
When PES = 1, then supply is unitary elastic
Unitary elasticity
3.6.3. Factors that determine the Price Elasticity of Supply (PES)
i) Spare production capacity.
If there is spare production capacity, the business is able to increase the output without a rise in
costs and therefore supply will be elastic in response to demand. This happens mostly during
Page 86 of 245
recession because there are plenty of spare labour and capital resources available.
ii) Stocks of finished products and components
If stocks are on a high level, businesses are more able to respond to a change in demand quickly.
Therefore, the businesses with big stocks will be elastic in response to demand, and
businesses with small stocks will be inelastic in response to change in demand.
iii) The ease and cost of factor substitution
If labour and capital can easily be switched, businesses will be able to respond to a changing
demand and these businesses will be more elastic in responding to changes in demand.
iv.) Time period involved in the production process
For many agricultural products, there are time lags in the production process which means that
elasticity of supply is very low.
3.7. Useful Applications of Price Elasticity of Demand and Supply
Elasticity of demand and supply is tested in virtually every area of economic activity. The key is
to understand the various factors that determine the responsiveness of consumers and
producers to changes in price. The elasticity will affect the ways in which price and output
will change in a market. Elasticity is also significant in determining some of the effects of
changes in government policy when the state chooses to intervene in the price mechanism.
Some relevant issues that directly use elasticity of demand and supply include:
Taxation: The effects of indirect taxes and subsidies on the level of demand and output in a
market e.g. the effectiveness of the congestion charge in reducing road congestion; or the
impact of higher duties on cigarettes on the demand for tobacco.
Changes in the exchange rate: The impact of changes in the exchange rate on the demand for
exports and imports

Page 87 of 245
Exploiting monopoly power in a market: The extent to which a firm or firms with monopoly
power can raise prices in markets to extract consumer surplus and turn it into extra profit
(producer surplus)
Government intervention in the market: The effects of the government introducing a minimum
price (price floor) or maximum price (price ceiling) into a market.
Elasticity of demand and supply also affects the operation of the price mechanism as a means of
rationing scarce goods and services among competing uses and in determining how
producers respond to the incentive of a higher market price.
Summary
In Study Session 3, you have learnt about the concepts of elasticity and their
applications. You have been taught that elasticity of demand implies the degree of
responsiveness of demand to changes in the factors that affect demand. Hence, if the price of
the commodity, income of consumers or price of related commodities change and we are
interested in measuring elasticity we can talk of price elasticity of demand, income elasticity
of demand and cross elasticity of demand respectively. In the case of elasticity of supply you
have also been taught that this concept shows how producers respond to changes in price and
other factors that affect supply.
Essay Questions
SAQ 3.1: Explain the concept of price elasticity of demand
SAQ 3.2: Explain the concept of price elasticity of supply
SAQ 3.3: Under what context can we say that demand is perfectly elastic or inelastic?
Page 88 of 245
Multiple choice Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the following
questions:
i.) A perfectly price elastic supply curve i….:
(a) Vertical.
(b) Horizontal
(c) Positively sloped.
(d) Negatively sloped.
ii) Price cross-elasticity of demand measures the relative responsiveness of the quantity sold of a
given good to a change in the….
(a) Price of that good.
(b) Individual's income
(c) Sales of another good.
(d) Price of another good.
iii.) If the price of a bed space in Moremi Hall decreases from N25,000 to N7000 and the number
of bed spaces demanded by DLI female students increases from 510 to 720 , then the price
elasticity of demand for bed space is…..
(a) Perfectly elastic
(b) Perfectly inelastic
(c) Relatively elastic
(d) Relatively inelastic
iv.) A supply curve that is….
(a) Vertical is perfectly price elastic.
Page 89 of 245
(b) Horizontal is perfectly price inelastic.
(c) Linear and goes through the origin has a price elasticity of one
(d) Rectangularly hyperbolic is also unitarily elastic.
v.) Which of these factors influences the price elasticity of supply of a producer of palm oil in
Arihaha market in Aba…………….
(a) Stocks of finished products and components
(b) Spare production capacity (c) Time
period involved in the production pro
(d) All of the above.
vi.) If the prices of land in Christ the King estate and Onogiese Estate in Ikorodu area of Lagos
State rises from N500,000 to N600,000, causing annual sales to drop from 30,000 to 10,000,
then the price elasticity of demand for land is equals:
(a) 11.00.
(b) 2.75.
(c) 5.50.
(d) 13.75.
vii.) A cross price -elasticity of demand of -2 between cable TV and VCRs implies that these
goods are:
(a) Complementary goods.
Page 90 of 245
(b) Substitute goods
(c) Negatively related goods.
(d) A luxury and a necessity, respectively.
viii.) If increased demand causes the price of Cement to climb from N2750 to N3250 per Bag and
Dangote cement production consequently rises from 24,000 to 40,000 per month, this cement
has a price elasticity of supply roughly equal to:
(a) 1/3.
(b) 1.0.
(c) 2.3.
(d) 3.0.
ix.) The price elasticity of demand is the relative proportional change in the:
(a) Quantity of a good demanded yielded by a given absolute price change.
(b) Price generated by a given change in quantity demanded.
(c) Quantity of a good demanded divided by a very small price change.
(d) Percentage of income spent on a good as its price changes.
x.) If the price of ofada rice is N100 and Osamudiamen Emmanuel demanded for 50 cups of rice
in Abuja and later the price dropped to N80 per cup and the quantity demanded was 70 cups.
His price elasticity of demand for ofada rice is:
(a) 5/8.
(b) 3/2.
(c) 4/5.
Page 91 of 245
(d) 2/3.
References
Fashola, M. A. (2000): Microeconomic Theory: Highlights and Policy Extensions for Less-
Geoff Riley, Eton College, September 2006
Ibadan.
Samuleson, P.A. and Nordhaus, W.D. (2001): Economics; 17th edition, McGraw-Hill/Irwin.
http://www.investopedia.com/terms/i/incomeelasticityofdemand.asp#axzz1zTWQgZ9X
http://economicsonline.co.uk/Competitive_markets/Demand_and_income.html
http://kalyan-city.blogspot.com/2009/08/demand-price-law-of-demand-determinants.html
http://www.investinganswers.com/financial-dictionary/economics/elasticity-supply-2909
http://staffwww.fullcoll.edu/fchan/Micro/2income_elasticity_of_demand.htm
http://www.dineshbakshi.com/as-a-level-economics/price-system-theory-of-firm/119-revision-
notes/1728-price-elasticity-of-supply
Page 92 of 245
via the LMS.
08033366677
Page 93 of 245
Study Session 4: Introduction to the Theory of Production
Introduction
This session introduces the students to the basis of the theory of production. After
analyzing different types of production, factor of production and their rewards, it highlights
the basic concept of production with graphical analysis and differentiates between Cobb
Douglas production function and Leontief production function and their derivatives.
Learning Outcomes for Study Session
At the end of this study session, student should be able to:
4.1 Discuss the concept of production
4.2 Identify and explain the categories (Types) of production
4.3 Discuss factors’ input (i.e. factor of production) and their basic reward
4.4 Explain the short run and long run production period.
4.5 Differentiate between Law of Variable Proportion and Return to Scale.
4.6 Distinguish between fixed inputs and variable inputs.
4.7 List and explain basics concepts of production (i.e. total products (TP), average product (AP)
and marginal product (MP)).
4.8 Draw and explain the shape of TP, AP and, MP.
4.9 Derive Average Product and Marginal Product from Total Products
4.10 Draw Curves to represent the Three stages of production and identify the most economically
viable stage..
Page 94 of 245
4.11 Distinguish between Long-run and Short-run time horizon
4.12 Distinguish between Leontief and Cobb Douglas production functions.
4.1 Definition and Types of Production
Production can be defined as transformation of raw materials to finished or partly finished
products. It can also be said to be the creation of utility. This means that production ends
only when the products (goods or/and services) gets to the final consumer(s).
Production could be classified as follows:
• Primary production
• Secondary production
• Tertiary production
i. Primary production – This consists of extraction of raw materials from the surface of the earth. It
includes economic activities such as fishing, hunting, quarrying, farming, among others.
ii. Secondary production: This form of production involves changing the raw materials from (i)
above to finish or partly finished product, e.g. manufacturing industries and construction
industries.
iii. Tertiary production – This consists of service rendering such as transportation, distribution and
communication.
4.2 The Factors of Production
There are basically four (4) factors of production which are also referred to as factor inputs. They
include; land, labour, capital and entrepreneur and they are rewarded with rent, salaries or
Page 95 of 245
wages, interest, and profit (loss) respectively. These factors together with other productive
resources could be collectively distributed into two in the short-run, namely:
(i) Fixed inputs (ii) Variable inputs
(i) Fixed Inputs – These are productive resources that are constant, and do not change with the
level of production. They include top management positions, land, building and machinery.
However, they can be varied (increased in number) as the level of production changes in the
long-run.
(ii) Variable Inputs – These are productive resources that vary (change) with the level of output,
such as raw-materials, labour bills, e.t.c.
4.3 The Time Horizons (Production Periods)
There are two periods ever experienced in the production process. These are:
(i) The Short Run – This is productive planning period during which some factors are held
constant (e.g. land, building, plant and machinery) while others vary. This is subject to law of
variable proportions (diminishing returns)
(ii) The Long Run – This is a production period, long enough to vary all production resources.
This is however subject to the law of return to scale.
Differentiate between Short Run (SR) and Long Run (LR) period of production.
Short run is a production planning period in which some factor inputs(e.g, Land,
equipment, building) are fixed why others (labour, materials etc.) varies .on the
other hand long run period is a product period in which all factor inputs become variable.
4.4 The Concept of Product

Page 96 of 245
(i) Total Product:- This is the sum total of all output produce from specific combination of
inputs (fixed and variable in the short run) at a particular product process and period.
Algebraically TP = Q or AP X L
(ii) Average Product:- This is the output per unit of labour. It is the contribution of an individual
to work. Algebraically, AP = that is the ratio of quantity produced to number of labour
employed.
(iii) Marginal Product:- This is the change in total output as a result of additional unit of labour
employed. It is the contribution of the last labour employed to total output.
∆TP Q2 − Q1 δQ
Algebraically, MP = = or MP =
∆L L2 − L1 δL
4.5 The Three Stages of Production
The three stages of production is depicted in the diagram below. The first stage is associated with
increase in output (at an increasing rate) up to point c (point of inflexion) where output starts
to increase (at a decreasing rate). This point coincides with highest or maximum MP, which
continues until point a (where MP = AP).
The stage two begins from point A and ends at point B where MP = 0 and TP at maximum. The
last stage starts at the point B and beyond. This stage is associated with continuous decline in
total product and average product while the marginal product is negative continuously.
Page 97 of 245
Output
Output
TP
AP
PP
0 Labour 0 Labour
Total Product
Average Product
4.1. Total product curve 4.2. Average product Curve
Output
0 Labour
MP
Marginal Product
Page 98 of 245
Fig 4.3. Marginal Product Curve
Output
Stage II
A
Stage
TP
Stage I
B A
0 Labour
MP
Fig 4.4. The three stage of production
4.6 Derivation of Average and Marginal Products from a Given Total Output and
Labour
L Q AP MP
1 20 20 -
2 50 25 30
3 90 30 40
4 120 30 30
5 120 24 0
6 115 19.17 -5
4.2. State the law of variable proportion
Page 99 of 245
The law of diminishing returns states that as the amount of variable input is
increased, the amount of other inputs held constant (or fixed), a point is reached
beyond which the total product declines.
4.7 The Production Functions (Functional analysis)
TP = Q
Q= ______ short – run
The Leontief Production Function
(i) Given A Leontief Function as given below;
Q = 2L3 + 4L2 + 2L
APL =
APL =
APL = 2L2 + 4L + 2
MPL =
The Cobb Douglas Production Function
(ii) Given a Cobb Douglas production Function
Q = f (L, K)
Q=
Page 100 of 245
AP =
Recall that,
Note: similarly, the marginal product of capital (MPK) and average product of
capital (APK) can also be calculated from the given function.
Summary
This session explained the rudiments of production concepts. It also explained a
different production type that exists such as primary, secondary and tertiary and it also
discussed categories of production activities in each type of production. The concept of
production was explained. Student was also exposed to quantitative and functional
explanations of product concept through algebraic derivation of average product and
marginal product from a given level of output and vice versa. From the foregoing the popular
Cobb-Douglas production function and that of Leontief were used to derive marginal product
and average product of labour and capital.
SAQ 4.1: Explain the three stages of production
Page 101 of 245

SAQ 4.2: Evaluate the following table;
L Q AP MP
2 20 a b
5 80 c d
7 120 e 20
9 150 16.67 f
11 g h 0
12 140 i j
.
SAQ 4.3 Graphically explain the three stages of production. Which these stages are
economically viable?
1. The demand for factor inputs is
a. Derived demand
b. Complementary demand
c. Joint demand
d. Composite demand
2. Production is defined as
a. All available resources
b. Creating activities
c. Creation of utilities
Page 102 of 245
d. Organizational effort
3. When the total product is 100 unit and price is N10/unit, while wage rate is N15. If 5 labours
were employed, what is the average product? _________
a. 15 Units
b. 25 Units
c. 20 Units
d. 45 Units
4. The marginal product of the 6th labour employed is -2units, if the average product when the
5th labour joined is 12units, what is the total product when the last labour was employed.
a. 55units
b. 25 units
60 units
c. 58 units
5. If total product at 6th labour is given as 65 units, and the average product at 5th labour is
12units. What is the marginal product at 6th labour level?
a. 6 units
b. 3 units
c. 5 units
d. 2units
6. A change in total product as a result of a unit increase in labour is known as;
a. average product
Page 103 of 245

b. marginal product
c. marginal revenue
d. marginal cost
7. The ratio of total product to labour employed is known as.
a. average product
b. marginal product
c. average revenue
d. marginal output
8. Given that C-D production function Q = , the marginal product of labour is
a. APL
APK
APL
APK
9. Any human effort mentally and physically used during production activities is known as;
a. labour
b. capital
c. human capital
d. energy
10. The , in the following Cobb Douglas production function Q = represent
a. output elasticity
Page 104 of 245
b. input elasticity
c. output elasticity with respect to capital
d. output elasticity with respect to labour
References
Fashola, M. A. (2000): Microeconomic Theory: Highlights and Policy Extensions for Less-
Ibadan.
Samuleson, P.A. and Nordhaus, W.D. (2001): Economics; 17th edition, McGraw-Hill/Irwin.
http://www.investopedia.com/terms/i/incomeelasticityofdemand.asp#axzz1zTWQgZ9X
http://economicsonline.co.uk/Competitive_markets/Demand_and_income.html
http://kalyan-city.blogspot.com/2009/08/demand-price-law-of-demand-determinants.html
http://www.investinganswers.com/financial-dictionary/economics/elasticity-supply-2909
http://staffwww.fullcoll.edu/fchan/Micro/2income_elasticity_of_demand.htm
http://www.dineshbakshi.com/as-a-level-economics/price-system-theory-of-firm/119-revision-
notes/1728-price-elasticity-of-supply
via the LMS.
Page 105 of 245

08033366677
Page 106 of 245

Study Session 5: Introduction to the Economies of Scale
Introduction
This section generally explains the concept of economies of scale as regard both
economies of scale and diseconomies of scale. This concept essentially emphasized the
advantages derived from expansion of scale of production as well as danger that are
associated with large scale production. It is possible for a big firm or industry to be having
problem with its expansion . it should be noted that economies of scale concept could be
divided into three namely increasing returns (synonymous to economies of scale), decreasing
returns (synomymous to diseconomies of scale) and constant return to scale. All these would
be clearly explain in this study session.
5.1 Discuss the term economies of scales;
5.2 Explain Internal and External economies of scale
5.3 Explain the concept of Diseconomies of scale
5.4 Distinguish between economies of scale and diseconomies of scale.
5.5 Explain law of return to scale and law of diminishing returns
5.6 Derive production scale from a given Cob Douglas function..
5.7 Differentiate and explain the three types of return to scale.
5.8 Explain Economies of Expansion
5.1 The concept of Economies of Scale
Page 107 of 245

Economies of scale are advantages that arise for a firm because of its larger size, or scale of
operation(production).These advantages translate into lower unit costs (or
improved productive efficiency), although some economies of scale are not so easy to
quantify. In some markets, firms have to be of at least a certain size to be able to compete at
all, because of the minimum level of investment required; economists call this minimum
efficient scale.
These (economies of scale) are costs saved. The forces causing long run average cost (LRAC) to
fall for larger outputs and larger plant sizes are called economies of scale. Three important
sources of economies of large-scale operations are:
i. Division and specialization of labour
ii. Technological progress.
iii Bulk purchase of raw materials (through quantity discount).
It is noteworthy to differentiate Economies of scale with the theoretical economic notion of
returns to scale. Where economies of scale refer to a firm's costs, returns to scale describe the
relationship between inputs and outputs in a long-run (all inputs variable) production
function. However, the two is concept are related and complementary but not really the same.
Explain what is meant by economies of scale?
Economies of scale are advantages that arise for a firm because of its larger size, or
scale of operation(production).These advantages translate into lower unit costs (or
improved productive efficiency), although some economies of scale are not so easy to
quantify. In some markets, firms have to be of at least a certain size to be able to compete at
Page 108 of 245

all, because of the minimum level of investment required; economists call this minimum
efficient scale.
5.2. The Internal and External Economies of scales
Economies of scale can be ‘internal’ (specific to an individual firm) or external (advantages that
benefit the industry as a whole). The main kinds of internal Economies of Scale are:
Purchasing – firms producing on a larger scale should be able to bulk buy raw materials or
product for resale in larger quantities. They may be able to cut out wholesalers by buying
direct from producers, and transport costs per unit may also be reduced. The firm might also
be buying in large enough quantities to make very specific demands about product quality,
specifications, service and so on, so that supplies exactly match their needs.
Technical – it may be cost-effective to invest in more advanced production machinery, IT and
software when operating on a larger scale.
Managerial – larger firms can afford to have specialist managers for different functions within a
business – such as Marketing, Finance and Human Resources. Furthermore, they may be able
to pay the higher salaries required to attract the best people, leading to better planning and
decision making.
Specialisation – with a larger workforce, the firm may be better able to divide up the work and
recruit people whose skills very closely match the requirements of the job.
Marketing – more options are available for larger firms, such as television and other national
media, which would not be cost-effective for smaller producers. The marketing cost for
Page 109 of 245
selling 10 million items might be no greater than to sell 1 million items. Larger firms might
find it easier to gain publicity for new launches simply because of their existing reputation.
Financial – there is a wider range of finance options available to larger firms, such as the stock
market, bonds and other kinds of bank lending. Furthermore, a larger firm is likely to be
perceived by banks as a lower risk and the cost of borrowing is likely to be lower.
Risk bearing – a larger firm can be safer from the risk of failure if it has a more diversified
product range. A larger firm may have greater resilience in the case of a downturn in its
market because of larger reserves and greater scope to make cutbacks.
Social and welfare – larger firms are more likely to be able to justify additional benefits for
employees such as pension funds, healthcare, sports and social facilities, which in turn can
help attract and retain good employees.
• External economies of scale
External economies of scale arise from firms in related industries operating in a concentrated
geographical area; suppliers of services and raw materials to all these firms can do so more
efficiently. Infrastructure such as roads and sophisticated telecommunications are easier to
justify.
There is also likely to be a growing local pool of skilled labour as other local firms in the industry
also train workers. This gives a larger and more flexible labour market in the area.
Page 110 of 245

It also encourages technological spillover and human capital development which could account
for more efficient workers and creation of new jobs through training and re-train. Healthy
competition can also spring up through interaction among staffs and managements.
5.3 The Concept of diseconomies of scale
As plant gets larger and larger, management efficiency drops: supervision and control become
more a difficult, just because of its (plant) size: paper work increases, travel expenses
plummet, phone bills pile up, additional employees are engaged (which is not supposed to
be), management decisions are delegated to juniors, etc. Therefore, diseconomies of scale
are inefficiencies that can creep in when a firm operates on a larger scale (do not confuse
with high capacity utilization). The main diseconomies of scale are:
Lack of motivation – in larger firms, workers can feel that they are not appreciated or valued as
individuals - e.g. Mayo and Herzberg. It can be more difficult for managers in larger firms
to develop the right kind of relationship with workers. If motivation falls, productivity may
fall leading to inefficiencies.
Poor communication – it can be easier for smaller firms to communicate with all staff in a
personal way. In larger firms, there is likely to be greater use written of notes rather than by
explaining personally. Messages can remain unread or misunderstood and staff are not
properly informed.
Co-ordination – a very large business takes a lot of organizing, leading to an increase in
meetings and planning to ensure that all staff knows what they are supposed to be doing.
Page 111 of 245

New layers of management may be required, adding to costs and creating further links in the
chain of communication.
Evaluation – is bigger better than smaller?
Many firms strive to grow at least partly because of the economies of scale they could enjoy. The
increased efficiency from economies of scale is very compelling in many industries.
Another reason is that they may be able to enjoy market power, with more control over suppliers
and customers. Still another reason is the perceived success of the business simply because of
its growth – this can be especially important for a stock exchange listed company.
Diseconomies of scale do not have to happen as a business becomes larger. Effective management
and organisation can minimise these effects and help to ensure that the benefits of increased
size outweigh any disadvantages. In an exam question, consider what you have learned about
management approaches to organisational structure and motivation to show how a firm could
overcome diseconomies of scale.
Smaller firms are not necessarily at a disadvantage in all markets. In some markets, economies of
scale are not available or not compelling enough for large firms to dominate. This is often the
case with small local businesses, such as hairdressers and plumbers. Furthermore, small
businesses can succeed simply by identifying a niche market and by serving it really well.
Smaller firms can be more flexible and may be able to adapt quickly to changes in their
markets or in the economy.
Page 112 of 245

In the correct sense of the term, economies and diseconomies of scale relate to advantages and
disadvantages of an increase in the firm’s productive capacity – such as moving to a larger
factory or installing completely new technology. Do not confuse these terms with capacity
utilisation, which is the degree to which the current scale of operations is actually being
used.
5.4 Law of Diminishing Returns (This is a Short-Run Concept) and Laws of
Return to Scale (This is a Long-Run Concept)
Law of Diminishing Returns
The law of diminishing returns states that as the amount of variable input is increased, the amount
of other inputs held constant (or fixed), a point is reached beyond which the total product
declines.
Laws of Return to Scale
i. In case the output response to changes is inputs in by the same proportion we say that there
are constant returns to scale. For example, if we increase inputs five times, output will be
multiplied exactly five times. Thus,
5 X inputs = 5 X outputs
In other words, the ratio of inputs to outputs is 1:1.
ii. If the output response to changes in inputs increases less than proportionally with the
increase in all factors, we have what is called decreasing returns to scale. For example,
when input is increased five times, output increases only three times. Thus,
5 X inputs = 3 X outputs
In this case, the ratio of inputs to outputs is 3:5 or 0.66,

Page 113 of 245
iii. If the output response to change in input increases more than proportionally with the increase
of all factors, we then have what is called increasing returns to scale. For example, when
input is increased three times, output increases five times! Thus,
3 X Inputs = 5 X outputs.
In this case, the ratio of inputs to outputs is 5:3 or 1.67, which is greater than 1.
5.6 Derive production scale from a given Cob Douglas function
Given a Cobb Douglas production Function
Q = f (L, K)
Q=
Where;
Q = Output Level or Total Product
L = Labour Employed
K = Capital
A = Technical efficiency
= are output elasticity with respect to Labour and Capital
respectively.
Determining Production Scale from a given Cobb-Douglas function
Page 114 of 245

Deriving Average and marginal product from a given Cobb-Douglas
function
APL =
Recall that,
5.7 The Concept of Return to Scale
In economics, returns to scale describe what happens when the scale of production increases
over the long run when all input levels are variable (chosen by the firm). Returns to scale
explains how the rate of increase in production is related to the increase in inputs in the long
run. There are three stages in the returns to scale: increasing returns to scale (IRS), constant
returns to scale (CRS), and diminishing returns to scale (DRS). Returns to scale vary between
industries, but typically a firm will have increasing returns to scale at low levels of
production, decreasing returns to scale at high levels of production, and constant returns to
scale at some point in the middle.
Page 115 of 245

Increasing Returns to Scale
The first stage, increasing returns to scale (IRS) refers to a production process where an increase
in the number of units produced causes a decrease in the average cost of each unit. In other
words, a firm is experiencing IRS when the cost of producing an additional unit of output
decreases as the volume of its production increases. IRS may take place, for example, if the
cost of production of a manufactured good would decrease with the increase in quantity
produced due to the production materials being obtained at a cheaper price.
Constant Return to Scale
The second stage, constant returns to scale (CRS) refers to a production process where an increase
in the number of units produced causes no change in the average cost of each unit. If output
changes proportionally with all the inputs, then there are constant returns to scale.
Diminishing Return to Scale
The final stage, diminishing returns to scale (DRS) refers to production for which the average
costs of output increase as the level of production increases. The DRS is the opposite of the
IRS. DRS might occur if, for example, a furniture company was forced to import wood from
further and further away as its operations increased.
5.2 Briefly discuss various scales of production
5.2 Returns to scale explains how the rate of increase in production is related to the
increase in inputs in the long run. There are three stages in the returns to scale:
increasing returns to scale (IRS), constant returns to scale (CRS), and diminishing returns to
scale (DRS). Returns to scale vary between industries, but typically a firm will have
Page 116 of 245
increasing returns to scale at low levels of production, decreasing returns to scale at high
levels of production, and constant returns to scale at some point in the middle.
5.8 Economies of Expansion
These are advantages arising from growth or from diversification. Economies of expansion are
not enduring. The advantages arise simply from getting started but once the expansion is
completed, the firm will not enjoy any special advantages over competitor of equivalent size.
The advantages of expansion in this sense are strategic rather than technological.
Summary
This session explained the rudiments of production concepts. It also explained
different production types that exist such as primary, secondary and tertiary and it also
discussed categories of production activities in each type of production. The concept of
production was explained. Student was also exposed to quantitative and functional
explanations of product concept through algebraic derivation of average product and
marginal product from a given level of output and vice versa. From the foregoing the popular
Cobb-Douglas production function and that of Leontief were used to derive marginal product
and average product of labour and capital.
SAQ 5.1 List and explain internal economies factors.
SAQ 5.2 Discuss the three returns to scale of production
SAQ 5.3 Explain the concept of diseconomies
Page 117 of 245

1. Return to scale can be discuss under ----------- main headings
a. all available
b . two
c. three
d. four
2. Given a Cobb-Douglas production function Q = and = 0.8; what is the
scale of production?
a. Increasing return
b. Decreasing returns
c. Constant returns
d. No returns
a. Derived demand
b. Complementary demand
c. Joint demand
d. Composite demand
4. The success a firm achieved due to its size is known as,
a. Economies of scale
b. Diseconomies of scale
c. Re-economies of scale
d. Efficient economies of scale
5. The advantages large firms enjoy from other firms for being large is called.
Page 118 of 245
c. internal economies of scale
d. External economies of scale
6. A disadvantage accrued as a result of large scale production is known as ;
c. Re-economies of scale
d. Efficient economies of scale
7. The existence of technology spillover among large firms is part of------------- .
c. internal economies of scale
d. External economies of scale
8. Because of the existence of economies of scale, business firms may find that:
a. each additional unit of labor is less efficient than the previous unit.
b. as more labor is added to a factory, increases in output will diminish in the short run.
c. increasing the size of a factory will result in lower average costs.
d. increasing the size of a factory will result in lower total costs.
9. Diseconomies of scale occur in the long run when
a. a firm faces a high level of sunk costs.
b. a firm pays a higher price for inputs as its level of production increases.
Page 119 of 245
c. firm's long run average total cost increases with increased production.
d. the workforce demands a higher share of company profits as output increases
10. As output increases in the short run, we know that
a. total fixed costs decline
b. average fixed costs will always decline
c. average total costs will always decline
d. average variable costs will always decline
References
Ibadan.
Samuleson, P.A. and Nordhaus W.D. (2001): Economics; 17th edition, McGraw-Hill/Irwin.
via the LMS.
Page 120 of 245

08033366677
Page 121 of 245

Study Session 6: Introduction to Theory of Costs.
Introduction
This section generally explains the concept of costs as it’s relates to different field of
endeavour, distinguish among various concepts of costs, relate types of cost to time horizon
and makes some algebraic derivatives from given total cost value. In addition to these, we
introduce the students to functional analysis (viz., TC = F (Q)) and make some meaningful
derivations using simple differential calculus. Students are introduced to the basis of the
theory of costs
6.1 Discuss the costs of production for business firms;
6.2 Explain the categories of costs of production;
6.3 Distinguish between fixed costs and variable costs.
6.4 Derive average costs and marginal cost from total cost
6.5 Draw curves to represent average-costs concepts and marginal cost.
6.6 Differentiate between economies and diseconomies of scale.
6.7 Distinguish between long-run and short-run costs.
6.8 Describe the relationship between costs of production and the socioeconomic
environment.
Page 122 of 245

6.1 Concepts of Costs
Accounting cost = TC = TVC + TFC
Accounting cost = Total Variable Cost + Total Fixed Cost = Total cost
Economic cost = Accounting cost + opportunity cost
In calculating the cost of factors of production the concept of opportunity cost is applied. Every
business activity has an opportunity cost because the decision to embark on one activity
precludes the undertaking of another. The opportunity cost of using any factor is what is
currently forgone by using it. With factors currently obtained from outside the firm, this cost
is measured by the price currently paid for their services. With factors already owned by the
firm, this is measured by the amount for which the factors could be hired or sold to another
firm.
Risk-taking in itself is a form of opportunity cost. Hence, the cost of factors of production could
be the cost of providing these factors which are referred to as explicit or accounting cost. Or
it could be the cost of the alternatives forgone which are referred to as implicit or economic
cost.
Explicit Costs
These are the accounting cost of production or money outlay. They represent the basic cost of
buying and processing productive resources. They are money outlays made by the firm to
meet the direct costs of production: viz payment for raw materials, overheads, wages etc.
Page 123 of 245

Implicit Costs
These are the costs implied by the alternatives given up, that is, the opportunity cost of
production. They can be thought of as the opportunity cost of staying in business, i.e. the
amount of money needed to bid all necessary resources away from alternative uses. This
could be the salary one would earn if he has to work for someone else, the rental income he
could receive if he leases his house to someone and the fund he could raise if the fund he has
invested in his business were put into stock or bonds or savings account. The implicit costs
incurred by an entrepreneur in producing a given commodity consists of the amounts he
could in the best alterative use of his time and money. Thus, in economic terms, a profit
exists if total receipts from the sales of the product exceeds the sum of his explicit and
implicit costs.
Opportunity cost is the best alternative forgone. It is also known as alternative cost or social cost
of production. The opportunity cost of producing one unit of commodity X is the amount of
commodity Y that must be sacrificed in order to use those resources to produce X rather than
Y.
Time Horizons:They are time-factors planning concepts for the entrepreneurs. They are usually
divided into the short run and the long run. In the short run, resources such as lands,
buildings, heavy machinery and top management positions cannot be varied. They are short-
run fixed resources for the firm. Their costs are fixed. In the long run, quantities of all
resources are variable. Therefore there are no fixed costs in the long run.
Page 124 of 245

Total costs
In the accounting sense, the total cost of production will be the cost paid to the factors of
production, i.e. cost paid for the fixed factors called fixed costs and those paid for the
variable factors called variable costs. But the costs paid to the factors of production are only
explicit costs. In the economic sense therefore, both explicit and implicit costs are added to
arrive at the total cost of production. Hence, the economic cost of production can be defined
as the summation of the explicit (accounting) cost and the implicit (opportunity) cost of
production.
Marginal Costs
They are the change in total costs resulting from a unit change in output.
Profits
The profit from production consists of the difference between the value of the output and the
value of the input. The value of output is the revenue the firm gets from selling its products
while the value of the input is the cost of the inputs. This may be written thus, π= R-C (where
π is profit; R= revenue and C= cost).
Accounting profit: This is the difference between explicit (accounting) cost and total sales.
Accounting profit = total revenue – accounting cost
Economic profit: The returns to the firm in excess of both the explicit and implicit costs of
production. Economic profit = Total revenue – Accounting cost – Implicit cost.
Page 125 of 245

Normal profit: This is the opportunity cost of capital and entrepreneurship. It is the level of
profit that is necessary for a firm to remain in business in a competitive industry. In other
words, normal profit is the part of implicit cost structure of the firm.
Normal profit = zero (after taking TR and TC and implicit cost).
Negative profit occurs when the firm is not making the normal profit (i.e TC > TR) . This is
referred to as loss. Positive profit occurs when TR > TC.
The correct definition of profit is essential in order to predict the behavior of firms. For example
when economic profits are positive, it means other firms will enter the industry; when
negative, some firms might leave and when it is zero, the firms will remain in the industry.
6.1 Explain explicit cost concept.
Answer
Explicit cost is simply money cost of production.
6.2 Production Costs in the Short Run
Average Total Cost (ATC)
This is the total cost of production divided by the number of units of output. To find the average
total cost, we add total fixed cost to total variable cost for each level of production, and
Page 126 of 245

divide this sum by that level of output. This is to say that we are adding the average fixed
cost to the average variable cost for each level of output. This could be written as:
AC = TC/Q or AC = AFC +AVC
Average Fixed Cost (AFC)
It is the total fixed cost (TFC) divided by the number of units of output. However, the total fixed
cost remains the same whatever the level of production. Therefore when we divide the fixed
amount of cost by an ever-increasing denominator (i.e. the number of units produced) the
resulting average fixed cost will be smaller and smaller as more units are produced. This is
referred to as “spreading the overhead” in business. This could be written as:
AFC = TFC/Q
Average Variable Costs (AVC)
This is calculated by dividing total variable cost by the corresponding level of output. The AVC
declines initially, reaches a minimum and then increases again because total variable cost
reflects the law of diminishing returns and so must be the AVC which is derived from total
variable cost. Because of increasing returns it takes fewer and fewer additional variable
resources to produce each of the first units of output. As a result variable cost per unit will
decline. Average variable cost (AVC) then hits a minimum with the next subsequent unit of
output and beyond this point it rises as diminishing returns necessitate the use of more and
more variable resources to produce each additional unit of output. In symbols:
AVC = TVC/Q
Consider for example, the following hypothetical costs of a firm.
Page 127 of 245

Table 6.1: Short-Run Cost Schedule
Output per Total fixed Total Total Average Average Average Marginal
week (Q) cost variab cost fixe cost total cost
(TFC) le cost (TC) d (AV cost (MC
(TVC cost C) (AT )
) (AF C)
C)
0 60 0 60 0 0 0 -
1 60 40 100 60 40 100 40
2 60 76 136 30 38 68 36
3 60 108 168 20 36 56 32
4 60 140 200 15 35 40 32
5 60 175 235 12 35 47 35
6 60 216 276 10 36 46 41
7 60 262 322 8.6 37.4 46 46
8 60 312 372 7.5 39 46.5 50
9 60 369 429 6.7 41 47.7 57
10 60 430 490 6 43 49 61
Costs for a hypothetical firm
From the above the following observations can be made:
Page 128 of 245

1. Fixed costs remain constant for all levels of production
2. Variable costs represent the cost of variable inputs during production
3. (TVC) increases at a decreasing rate (i.e. moves slowly), then it increases at an increasing
rate (i.e. moves rapidly).
4. When TVC is moving slowly we have increasing returns to scale.
5. When TVC is increasing at an increasing rate we have decreasing returns to scale.
6.3 Behind every Cost Curve is a Socioeconomic Environment
Costs are culture-bound. An ATC curve for the manufacture of tennis balls, may be very different
from the ATC curve for tennis ball production in Kabul, Afghanistan. It may be
economically prohibitive to produce them in Kabul. Why?
Imagine yourself in the Northern part of Nigeria with a capital stock of =N=200 million and a
burning desire to produce tennis balls in Afghanistan. How do you begin? Where do you find
qualified labour? Where do you find the raw materials? How do you build the plant? If the
economic environment is not cooperative, all the money and ideas in the world would not
help.
Let us consider once again your decision at the beginning of this module to go into the fishing
business. One reason you were able to buy a ₦200,000 maxi-boat is that such boats were
being produced. This simple fact presupposes the not-so-simple fact that a boat-building
industry exists.
It also means that engineers, welders, steels manufacturers, electricians, accountants,
communications people, painters, dry lock operators and a ten of thousand of very productive
Page 129 of 245

people are working in thousands of firms. In addition, it assumes that you can arrange
payment through a banking system already in place.
How do you come by a fishing crew that can handle sonar and radar, repair engines, and read
navigation charts? That assumes ready availability of qualified people. How do they acquire
expertise? Through schools and a system of municipal bonds to finance them, there seems to
be a never-ending set of linkages back into every sector of our economy.
The presence of qualified people, institutions, and industries is so familiar to us that it is difficult
to realize that without our political, cultural, and social as well as our economic – system
nothing could be produced except perhaps in an economically primitive way. Blueprints and
modern technical knowledge may be available, but without a fairly advanced socioeconomic
climate, they would be totally unusable. Your maxi boat would remain nothing but a dream.
Those who are fortunate to belong to an already highly developed industrialized society take this
kind of socio-economic environment for granted. It seems reasonable to them, if they need a
skilled crew, to simply telephone the classified department of the newspaper and wait for
applicants. In fact, that is what they do.
That is what General Motors does, what Sony does, and what Westinghouse does. But if no
telephones, postal service, or newspapers existed, how do you go about organizing a modern
labour force? How could you produce automobiles, air conditioners, and fish? Can you
Page 130 of 245

imagine how different cost structures would be if any one of these factors was absent? And
how impossible it would be to produce fish or furniture if they were underdeveloped.
This is to say the social and economic environment is as important a factor of production as
entrepreneurship, capital, labour and land. It is not clear whether people in Afghanistan or
Libya can adopt technologies from the United States and Canada as readily as people in
Japan and New Zealand can. Cost structures are very much culture-bound.
6.4 Types of Costs
Total Cost (TC) is the total monetary value incurred during production processes. It consists of
the cost expended on variable inputs (variable cost) and Fixed inputs (Fixed cost) of
production. Algebraically, TC = TVC + TFC.
Note: At zero output, total cost (TC) = total fixed cost(TFC)
Cost Cost
LTC
STC
0 Outpu 0 Output
Short Run Total Cost t Long-Run Total Cost
Figure 6.1 (a): Short run total cost Figure 6.1

(b) long run total cost
Total Fixed Cost (FC) – This is the cost of fixed inputs of production (such on Land, Building,
Machinery or Plant etc.). This is money expended on fixed inputs of production at a
Page 131 of 245

particular production period, usually in the short-run. It is fixed (unchanged) throughout any
production output level.
Cost
FC FC = f(
O Cost
Figure 6.1 (c): Total Fixed Cost
Variable cost (VC) or The Total Variable Cost (TVC or VC) is the money value incurred on
variable input of production such as labour, raw materials, bills etc. variable cost changes
with level of output; VC = f(Q)
Cost
Cost
TVC
O 0
Output Output
Short Run Total Cost Total Variable Cost
Figure 6.2 : Short run Total Cost Figure 6.3:

Total Variable Cost
Page 132 of 245

Marginal Cost (MC) – This is changes in total cost as a result of a unit increase in output. That is,
the cost of additional unit of outputs. Algebraically, Marginal cost (MC) =
i.e. MC = (for numerical analysis)
MC = (for functional analysis)
Cost
MC
O
Output
Figure 6. 4 Marginal Cost Curve
Average Total Cost (ATC)
This is the total cost of production divided by the number of units of output. To find the average
total cost, we add total fixed cost to total variable cost for each level of production, and
divide this sum by that level of output. This is to say that we are adding the average fixed
cost to the average variable cost for each level of output. This could be written as:
Page 133 of 245

AC = TC/Q or AC = AFC +AVC
Cost
AVC
O
Q
Figure 6. 5: Average Cost or Average Total Cost
Average Fixed Cost (AFC)
It is the total fixed cost (TFC) divided by the number of units of output. However, the total fixed
cost remains the same whatever the level of production. Therefore, when we divide the fixed
amount of cost by an ever-increasing denominator (i.e. the number of units produced) the
resulting average fixed cost will be smaller and smaller as more units are produced. This is
referred to as “spreading the overhead” in business. This could be written as:
AFC = TFC/Q
Cost
AVC
O Page 134 of 245 Q
Figure 6.6 Average Fixed Cost Curve
Average Variable Costs (AVC)
more variable resources to produce each additional unit of output. In symbols: AVC =
TVC/Q or AVC = AC - AFC
Cost
AVC
O
Q
Average variable cost curve
Figure 6.7 Average Variable Costs (AVC)
Page 135 of 245

Note: The U shape of average total cost, average variable cost and marginal cost curves are in
response to the law of variable proportion (or diminishing returns).
6.1 Why is average fixed cost asymptotic to quantity axis?
Answer
Average fixed cost is asymptotic to the quantity axis because it falls continually as output
increases but can never equals zero.
6.5 The Algebraic Derivation of Cost Functions

The functional or mathematical derivation of FC, VC, ATC, AFC, AVC and MC from a given
total cost function are below calculated.
Given that TC = 0.01q3 + 0.3q2 + 10q + 1000
Calculate;
(i) TFC (ii) TCV (iii) ATC (iv) AFC (v) AVC (vi) MC
Solution:
TC = TFC + TVC
recall FC is constant while variable cost varies (changes) with level of output, therefore from the
above function, we derive TFC and TVC as follows;
Page 136 of 245

(i) TFC = 1000 (cost of fixed inputs)
(ii) TVC = 0.01q3 + 0.3q2 + 10q (cost of variable inputs)
(iii) ATC =
ATC = = 0.01q2 + 0.3q +10 +1000/q
AFC =
(iv) AVC =
AVC =
δTC
MC = MC = = 0.03q 2 + 0.69 + 10 (i.e First derivative of Total Cost function)
δQ
Note: that total cost (TC), Total Variable Cost, Average Fixed Cost, Average Variable Cost,
Average Total Cost and Marginal Cost could be determined quantitatively by mere
substitution of a given value(s) of quantity (q).
Summary
From the above analysis students have been exposed to different concepts within the topic under
review, specifically, student should be able to differentiate among the various cost concepts,
such as total cost, average cost, marginal cost, fixed and variable cost. Students should
Page 137 of 245
distinguish the disparities that exist between short run and long run production period as well
as express these with illustrations. They should equally be able to explain the incongruences
between accounting concept of cost and economics concept of cost as well as describe the
conceptual difference between implicit cost and explicit cost of production and discuss what
constitutes economist concept of production cost.
SAQ 6.1Determine the value corresponding to the missing spaces.

Q TC TVC TFC MC AC AVC AFC
0 350 a b ---------- c d e
1 500 f g h i j k
2 680 l m 180 n o p
3 q r s 100 t u v
4 850 500 w x 212.5 125 87.5
5 850 500 y A B 100 C
6 D 550 z E 150 F G
SAQ 6.2 (a) Differentiate between implicit and explicit cost.
b) Given that the total revenue of firm is N120000 and that its fixed and variable costs calculate
the profit;
(i) In economics and
(ii) Accounting perspectives.
SAQ .3 what is average variable cost?
1. Implicit cost is identical to

Page 138 of 245
e. All available resources
f. Explicit cost
g. Money cost
h. Opportunity cost
2. When the total variable cost of producing 10 unit is N100 and the total fixed cost of
producing 1unit is N15, the total cost of producing 10 units is _________
e. N 115
f. N125
g. N250
h. N145
e. Derived demand
f. Complementary demand
g. Joint demand
h. Composite demand
4. The total variable cost of producing 10 unit is N50 and the Average fixed cost producing 1 unit
is N50, the total cost of producing 10 units is
d. N35
e. N25
f. N100
Page 139 of 245

g. N30
5. Total cost of producing 10unit and 12 unit of output are N 230 and 260 what is marginal cost.
e. N 16
f. N30
g. N15
h. N25
6. A change in total cost as a result of a unit increase in output is known as;
a. average cost
b. marginal output
c. marginal revenue
d. marginal cost
7. The ratio of total cost to output produced is known as.
a. average cost
b. marginal product
c. average revenue
d. marginal cost
8. Given that, the average cost when 10 units was produced is N25, what is the total cost;
a. N 160
b. N300
c. N150
Page 140 of 245

d. N250
9. The total cost and total fixed cost are the same at a point where output produced is;
e. 10units
f. 5 units
g. 0 unit
h. Infinity
10. the different between an accountant's and economist's perspective of cost is that;
a. The latter consider money as priority and the former makes use of forgone alternative.
b. The former consider money as priority and the latter makes use of forgone alternative
c. they both have same view
d. None of the above
References
Fashola, Mashhud A. (2000): Microeconomic Theory: Highlights and Policy Extensions for
Less-Developed Economies; Concept Publications, Lagos .Geoff Riley, Eton College,
September 2006
Umo, Joe U. (1995): Practical Microeconomic Analysis in African Context; Sibon Books
Ltd., Ibadan.
Lipsey, Richard G. and Chrystal, Alec K. (1995): An Introduction to Positive Economics;
ELBS with Oxford University Press, London, 8th edition.
Page 141 of 245

via the LMS.
08033366677
Page 142 of 245

Study Session 7: Market Structure and Equilibrium of Profit
Maximizing Firms
Introduction
We are going to start this session by making a distinction between a market and a
market structure. Simply put, a market is an institutional arrangement facilitating the
interaction of buyers and sellers in a process that determines price and quantity sold. Some
markets, such as the Oyingbo market in Lagos or Dugbe market in Ibadan where local sellers
congregate to sell their wares, conduct their businesses at a particular location. Virtual
markets are conducted by telephone or over the internet. In essence, a market is any means
of bringing about an interaction between sellers and buyers irrespective of location. Market
structure on the other hand, refers to those characteristics such as size, number of sellers and
buyers, the nature of the product and market information which influence the behavior of
firms in the market and hence the performance of these firms. In this session we are going
to discuss Perfect Competition, Monopoly, Oligopoly and Monopolistic Competition

Page 143 of 245
Learning Outcomes for Study Session 6
7.1 Differentiate between market and market structure;
7.2 Compare and contrast perfect competition and monopoly;
7.3 Explain excess capacity as related to monopolistic competition; and
7.4 Discuss the major characteristic of oligopoly.
7.5 Determination of Profit across markets
7.1 Perfect Competition
A market structure characterized by absence of rivalry among the individual firms is otherwise
referred to as perfect competition. Some of the other features of perfectly competitive market
include many buyers and sellers, product homogeneity, free entry and exit and no
government intervention. Others are freely mobile factors of production resources in
response to price changes and information about the market is easily available and perfect.
Given the assumptions of many buyers and sellers and product homogeneity, the demand facing
the firm under perfect competition is perfectly elastic and shown below:
Price
P = AR = MR
DD
Page 144 of 245

Figure 7.1: Average and Marginal Revenue Curve
7.1.1 Profit Maximization under Perfectly Competitive Market
As highlighted above, under perfect competition, there are a large number of sellers who can
freely enter and exit the market and who offer identical products to many buyers; with perfect
information, firms will earn a normal profit. Identifying normal profit on a diagram does not
cause unhealthy anxiety because it occurs where the total revenue equates with the total cost
curve. In the diagram below, point X on the Graph 1, then mirrored in point Y on Graph 2;
at the point where MC equates with the demand curve (or price).
Firms under perfectly competitive environment maximise their profit from the competitive
conditions they find themselves in. The market price is their marginal revenue (MR = AR =
P) and they are equating this with their marginal cost to maximise their profits. The
equilibrium output that will maximise profit occurs at the point where MR = MC. In the
figure above, it is the point of X and Y and is the market clearing output Qm.
Page 145 of 245

Equilibrium point under perfectly competitive market
GRAPH 1
TR, TC TC
TR
O
GRAPH 2
P,MR,
MC
Y
MC=AC
AR = D
MR Qm Q
Figure 7.2:
7.1.2 Short Run Equilibrium of Perfectly Competitive Firm
The marginal revenue = marginal cost approach/concept is very useful in explaining the short run
equilibrium of perfectly competitive firms. Firms reach short run equilibrium at output level
that equate MR = MC = P. Note that the price of a perfectly competitive firm is the same as
marginal revenue (MR = P). In the short-run, it is possible for an individual firm to make an
economic profit because at best output, the market price exceeds the short run average total
cost (SATC).
Y SM
Revenue SAT
Page 146 of 245
Cost
SAV
MR = AR = P
L
Pm
M
K
O Qm Q
Figure 7.3: Short Run Equilibrium under Perfectly Competition
In the diagram above, output is measured along OQ axis and revenue / cost on OY
axis. It is assumed here that the market price is equal to OPm. A perfectly competitive firm
has to sell its entire output at this prevailing market price i.e. OPm. The firm is in equilibrium
at point L, where MC = MR. The inter-section of MC and MR determine the quantity of the
good the firm will produce in order to maximize profit.
Having determined the quantity, a vertical line is drawn to the horizontal axis to see what the
average total cost (ATC) is at that output level (point Qm). The competitive firm will produce
OQm quantity of output and sell at market price OPm. The total revenue of the firm at the
best level of output OQm is equal to OPmLQm. Whereas the total cost of producing OQm
quantity of output is equal to OKMQm. The firm is earning supernormal profits equal to the
shaded rectangle KPmLM. The per unit profit is indicated by the distance LM or PmK.
It may be noted that a firm would not produce more than OQm units because producing another
unit adds more to the cost than to the revenue (MC > MR). The firm would not stop short of
OQm output because producing fewer unit adds more to the revenue than to cost (MR > MC).
Page 147 of 245

Hence, OQm is the best level of output where the profit of the firm is at its maximum. Thus, it
is the short run profit maximizing output (equilibrium) of a competitive firm.
7.1.3 Long Run Equilibrium of Perfectly Competitive Firm
In the long period, supernormal profit cannot be sustained as ability to make supernormal profit in
the industry brings new entrants since there are no entry barriers. The arrival of new firms or
expansion of existing firms (if returns to scale are constant) in the market causes the
(horizontal) demand curve of each individual firm to shift downward, bringing down at the
same time the price, the average revenue and marginal revenue curve. The final outcome is
that, in the long run, the firm will make only normal profit (zero economic profit). Its
horizontal demand curve will touch its average total cost curve at its lowest point. It also
increases the market supply of the product and reduces the market price as well as the profits
until all firms in the industry make a normal profit (break-even)
MC
ATC
PRICE
Pe E D = AR = MR
Page 148 of 245

O Qe Quantity
Figure 7.4 Long Run Equilibrium under Perfect Competition
From the diagram above, the long run equilibrium price is Pe while the quantity is
Qe. The firm in long run equilibrium will operate at point E, any increase or decrease in
output from point Qe would result in the firm making a loss.
7.2 Monopoly
A firm is a monopoly if it is the only producer or supplier of a particular commodity which does
not have close substitutes. Hence a monopoly is the only firm in the market. It can then
change price at will because of the enormous power bestowed on it. It is very difficult to find
a monopolist in its purest form anywhere in the world. However, there used to be some
examples of monopolist firms out of which some of them have metamorphosed. For instance,
National Electricity Power Authority (NEPA), used to be the sole provider of electricity in
Nigeria.
Characteristics of Monopoly
1. There is heavy barrier to entry: In most monopoly, new entrants are not allowed into the
market. In other words, new firms are not allowed to produce or sell the same goods or
services which are already rendered by the monopolist. Barriers may be natural or man-
made.Natural barriers usually arise as result of economies of scale. Big firms have
Page 149 of 245

significantly lower average total cost (ATC) than smaller firms meaning that the unit cost of
production is less. Generally, technology allows largeness of firm. A firm owning a given
technology can be deemed to be a monopolist. Another type of technological deterrence is set
up cost also called first cost.
Man-made barriers include: availability of resources, technology, set-up-cost and geographical
location. Barriers also occurs in form of policies that support particular groups.This barrier
may occur in terms of patent given to a particular firm in order to enable it enjoy full benefit/
reward of her inventions or discoveries. There are also licenses induced barrier e.g. In
Nigeria, only government-licensed petroleum marketers can import finished petroleum
products into the country.
2. A monopolist is a price giver. In monopoly market arrangement, the firm dictates the price
for her commodities which consumers have no choice but pay if they want to enjoy the
commodity.
3. Goods are usually not produced at the least average cost.
7.2.1 Profit Maximization under Monopoly
For a monopolist to maximize profit under a given cost and demand conditions, output will be
produced at the point where marginal revenue equals marginal cost; which is also the point
TC
where the gap between the TR and TC is widest, as shown in the diagram below.
MR T
Page 150 of 245 C
TR
TR
MC
0 Q1 Q2
Figure 7.5 (a): Profit Maximization under Monopoly
Points Q1 and Q2 are breakeven point output levels. Also in the diagram below, the maximum
point on a TR curve is reached at precisely that rate of output and sales for which MR equal
zero, also elasticity is unitary. (MR = 0, Ed =1
TR
TP
q
MR
Q (Point of optimum output)

DD
Page 151 of 245
MR
Figure 7.5 (b) Profit maximization under Monopoly
7.2.2 Short Run Equilibrium under Monopoly
There are two things to be considered in production of goods; the cost and price. In cost analysis,
there are basically three areas, thus:
Increasing Cost. This is also called decreasing return to scale and at this point the benefit in
terms of revenue is less than the cost. Firms should not produce at this point in order to
maximize profit.
Decreasing Cost. This is also called increasing return to scale. At this point, revenue increases
faster than cost.
Constant Cost. Revenue and cost increases at the same rate and is also called constant return to
scale.
Economic analyses of profit maximization under a short run in a monopoly are based on the
following two important assumptions:
1. The firm maximizes profit.
2. The firm has no competitor.
7.2.3 Constraints on Monopoly
Despite its price-setting ability and desire to always the make highest profit possible, a
monopolist firm is constrained by the position of its demand. Hence, a monopoly cannot
charge a price which is beyond consumers paying limit. A market condition is then placed on
Page 152 of 245

firm’s condition. Assuming that the firm aims to maximize profits at the point where
M
MR=MC, a short run equilibrium
C is shown in the diagram below.
AT
D C
P1
C
Pm
B A
D (P)
qm
MR
Figure 7.6: Constraints on Monopoly
The profit-maximising output can be sold at price P1 above the average cost AC at output qm.
The firm is making abnormal, “monopoly” profit (or economic profit) which is shown by the
shaded area equal ABCD. The area underneath ATC shows the total cost of producing output
qm. Total cost equals average cost multiplied by output. There is a tendency for a monopolist
to make excess profit both in the long run and short run unlike the perfectly competitive
market.
7.3 Monopolistic Competition
This is a market structure that has both elements of monopoly and perfect competition. In other
words, it possesses both attributes of monopoly and perfect competition.
Page 153 of 245

Characteristics of Monopolistic Competition
1. There is no easy entry but new entrants are allowed. Monopolistic competitive firms do have
substantial fixed cost that automatically shut entry door to some potential entrant. For
instance in Nigeria, not all firms can compete with the likes of Unilever, Cadbury, Nestle,
etc.
2. Firms produce close substitutes. Similarity of products contributes to the competitiveness of
monopolistic competitive market structure.
3. Products are differentiated. Each good is produced by many firms that offer some degree of
differentiation. Product differentiation is the physical or perceives differences among goods
in a market that made them close but not perfect substitutes for each other.
7.3.1 Equilibrium Point under Monopolistic Competition
In the short run, monopolistic competitive firms can make abnormal profit just like the
monopolists. They do this by producing output at the point where MR = MC and charge price
that is higher than marginal revenue. Diagram A, shows the profit maximizing output of
monopolistic competitive firms in the short run.
In the long run however, positive economic profits possibilities in the short run attract new firms
unlike monopoly, there is no barrier to entry; so, as competition becomes keener, ability to
make abnormal profit fizzle out, only normal profit (economic profit) is realized. See the
diagram below
Page 154 of 245

DIAGRAM A: SHORT RUN EQUILIBRIUM OF MONOPOLISTIC COMPETITIVE
FIRM
MC
ATC
p
DD
0 Qm
Output
MR
Figure 7.7: Short Run Equilibrium of Molopolistic Competitive Firm
As entry into the market increases, the supply of differentiated products into the
market increases which make the firm’s demand curve shift inward continuously until it is
tangential to the average total cost curve at the profit maximizing level of output. At this
point, the firm’s economic profits are zero, and there is longer incentive for new firms to
enter the market.
PRICE
MC ATC
Page 155 of 245

MR = P
O Q Output
Figure 7.7 (b): Short Run Equilibrium of Molopolistic Competitive Firm
7.3.2 Some Other Elements in Monopolistic Competitive Market
Brand loyalty
It is the willingness of the consumer to continue buying a good at a price higher than the price
charged by its close substitute. This category of customers is regarded as loyal customers.
Besides, they are unyielding to any change because irrespective of the variation in one brand,
they stick to their choice.
Role of Advertising
The firms in monopolistic competition like Coca Cola in the food sector, have strong incentive to
advertise. They expect advertising to cater for the undue effects of increasing competition.
Generally, advertising has been adjudged to serve dual purposes which are provided
information that can intimate the masses about the products of firms and also drive sales.
Page 156 of 245

Increasing market share
Lowering price is one of the many ways to persuade consumers already in the market to switch
brands. Advertising however, may engineer that without lowering price. Advertising
provides consumers with selective information and sometimes mis-information which may
be the only information available to many in the market. Advertising often suggests
association with advertised goods and such highly valued activities, events or institutions as
sports, family, position in firm, etc.
Excess capacity
Unlike a perfectly competitive firm, a monopolistically competitive firm ends up choosing a level
of output that is below its minimum efficient scale point. When the firm produces below its
minimum efficient scale, it is under-utilizing its available resources. In this case, the firm is
said to have excess capacity because it can easily accommodate an increase in production.
Excess capacity is the major social cost of a monopolistically competitive market structure.
7.4 Oligopoly
Oligopoly is a market arrangement where few large firms dominate the market and control large
market share. It is an industry where there is a high level of market concentration. Oligopoly
like monopolistic competition, has elements of perfect competition and monopoly but
oligopoly has more market powers than firms under monopolistic competition. The degree of
competition in an oligopoly market arrangement is less than that of monopolistic
competition. In the market, about 6 firms control the market, say more than 60% of total
market. A typical example of oligopolistic market arrangement in Nigeria is the upstream

Page 157 of 245
segment of the oil and gas industry where the likes of Exxon Mobil, Shell, Chevron and other
firms operate; and dominate the market.
Moreover, oligopoly exists in different forms and kinds. It can be broadly divided into two forms-
collusive and non-collusive oligopolists. Collusive oligopoly takes the form of firms coming
together to agree on price and output management in order to continue to manage the price of
their commodity effectively. This type of oligopolistic arrangement is regarded as cartel.
OPEC is a good example of a cartel. Under Non collusive the firms are usually in dilemma
between the desire to collude, in order to maximize joint profits, and the desire to compete, in
order to raise market share and profits at the expense of rivals. Yet, if all firms compete,
jointt profits are low and no firm does very well.
What do we mean by equilibrium of profit maximising firms?
Equilibrium of profit maiximising firms refers to that output level that gives highest level of
profit. Basically, two approaches are used to determine equilibrium output. They are: (i)
Total Revenue-Total Cost approach; and (ii) Marginal Revenue-Marginal Cost approach.
Characteristics of an oligopoly
There is no single theory of how firms determine price and output under conditions of oligopoly.
If a price war breaks out, oligopolists will produce and price much as a perfectly competitive
Page 158 of 245

industry would; at other times they act like a pure monopoly. An oligopoly usually exhibits
the following features:
1. Uniquely Branded Products: Each firm in the market is selling a branded (differentiated)
product.
2. Barriers to Entry is Enormous: Significant entry barriers into the market prevent the thinning
of competition in the long run which maintains supernormal profits for the dominant firms. It
is perfectly possible for many smaller firms to operate on the periphery of an oligopolistic
market, but none of them is large enough to have any significant effect on market prices and
output.
3. Interdependent decision-making: Interdependence means that firms must take into account
likely reactions of their rivals to any change in price, output or forms of non-price
competition. In perfect competition and monopoly, the producers do not have to consider a
rival’s response when choosing output and price.
4. Sticky prices: Any attempt to increase or reduce price by a particular firm usually result in a
chain of reactions from other firms as such there is a particular path where prices navigate. In
this path, prices do not go outside the range.
5. Non-price competition: Non-price competition is a consistent feature of the competitive
strategies of oligopolistic firms. Examples of non-price competition include:
a. Free deliveries and installation,
b. Extended warranties for consumers and credit facilities,

Page 159 of 245
c. Longer opening hours (e.g. supermarkets and petrol stations),
d. Branding of products and heavy spending on advertising and marketing,
e. Extensive after-sales service; and
f. Expanding into new markets plus diversification of the product range
7.4.1 Equilibrium in Oligopoly Market
The determination of equilibrium in the oligopoly market is more complicated. This is because in
determining price and output, the firm has to take into account the action of its competitors.
Similarly with competitors, the decisions depend on the action of other firms. Since firms’
decisions depend on the behaviour of their competitors, how is equilibrium price and output
determined in the oligopoly market? The modern treatment of the theory of oligopoly is now
rooted in game theory. Some models have been developed to help address this issues among
which are Cornout model, Bertrand model, and Stackelberg model. These models are
however beyond the scope of this current discussion and will not be considered.
7.5 The Marginal Revenue and Marginal Cost Approach
In this approach the Necessary Condition. The sufficient condition shall be proven also.
To derive the sufficient condition, take the second derivative of the profit function.
d 2Π d 2
= 2 (TR − TC ) < 0
dq 2 dq
d 2 TR d 2 TC
− <0
dq 2 dq 2
Page 160 of 245

d 2 TR d 2 TC
<
dq 2 dq 2
d 2 TR d
If = MR
dq 2 dq
d 2 TC d
= MC
dq dq
dMR dMC
∴ <
dq dq
This implies that the rate of growth of MR is less compared to the rate of growth of MC. In other
words, the rate of growth of the MC must exceed that of the MR. This is the sufficient
condition.
At this juncture, it is worthy to note that for a firm to maximize its profit, two conditions must be
met;
1. MR = MC
2. MC must be rising at that point where MR = MC.

Price
MC3
P* E MC2
MC1
R
Page 161 of 245
0 Q/T
Q*
MR
Figure 7.8 : Equilibrium of Oligopoly Firm
From the diagram (Fig.6.8) it is shown that the MC cuts the MR curve at points R which reflects
the profit maximizing quantity (Q*).
Illustration 1:
The total revenue function of a particular product is TR = 40q – 4q2. The total cost for the product
is TC = 100 + 30q – 3q2. Determine the profit function and the value of q for which profit are
maximized. What is the price that maximizes the profit?
Solution;
TR = 40q – 4q2 TC = 100 + 30q – 3q2
Given that ∏(q) is the profit function
∏(q) = TR – TC
= 40q – 4q2 – {100 + 30q – 3q2}
∏(q) = 40q – 4q2 – 100 - 30q + 3q2
To maximize ∏(q), take its derivative of q and equate to zero.
dΠ (q ) d
dq
=
dq
[
40q − 4q 2 − 100 − 30q + 3q 2 ]
Page 162 of 245

Consider: 40 – 8Q – 30 + 6Q = 0
10 – 2Q = 0 ∴ Q=5
TR = 40(5) – 4(52)
= 200 – 100 = 100
Pric
e
MRD1
Pe E
MR2
O Qe D1 Output
Figure 7.9: The Kinked Demand Curve
From the graph above, the firm is faced with two different demand curves which
originated from the marginal revenue curves (MR1 and MR2). The kink point, E, is the
equilibrium point. At such point, equilibrium output is Qe and the price charge is Pe; above
the kink, demand is relatively elastic because all firms’ prices remain unchanged.
Below the kink, demand is relatively inelastic because all other firms will introduce a similar
price cut, eventually leading to a price war.
In a nutshell, once a Kink in the demand curve is known and given, oligopoly equilibrium
automatically follows. The point of Kink such as E is itself an equilibrium point.
Moreover, such equilibrium is rigid and stable. There is no incentive on the part of the oligopolist
firm to move away from the point of Kink. Any attempt on the part of a firm either to lower
or raise the price will not be to the advantage of the firm which initiated such move.
Page 163 of 245
What types of demand curves face different markets?
Perfect competition faces a horizontal demand curve while the other three markets face a
downward sloping demand curve. However, the demand curve for oligopoly has a kink
which makes it a little different from others.
Summary of Study Session 7
Under perfect competition, all sellers and buyers are price takers. The actions or
inactions of individuals have no effect on the market price.
When firms make identical product with free entry and exit and perfect information about the
market, competition becomes keen.
The price of a perfectly competitive firm is same as its Marginal revenue. Also, output sets price
equal to the marginal cost.
The equilibrium output that will maximise profit occurs at the point where MR = MC.
An individual firm can make abnormal profit in the short run because at optimum output level, the
market price exceeds the short run average total cost (SATC).
Page 164 of 245

In the long, abnormal profit cannot be sustained in perfectly competitive market as abnormal
profit in the industry attracts new entrants since there are no entry barriers. This expansion
will cause the (horizontal) demand curve of each individual firm to shift downward, bringing
down at the same time the price which is the average revenue and marginal revenue curve.
A monopoly is the only seller of a commodity that does not have close substitute. As such,
monopoly does not worry about new entrants even in the long run.
A monopolist can alter price or quantity supplied to the market in order to increase revenue and
consequently profit. However, it cannot change both variables at a time.
A profit-maximising monopolist will choose output level that equates MC to MR but not a supply
curve that exceptionally relate price to output. The demand curve determines the relationship
between price and MR.
Monopolistic competitive firms produce differentiated products. Each individual firm has
monopoly power in its particular brand. Entry is allowed but new entrants will have to
overcome certain barriers.
In the short run, monopolistic competitive firms can make abnormal profit just like the
monopolists. They do this by producing output at the point where MR = MC and charge price
that is higher than marginal revenue.
In the long run equilibrium, price equals average cost but greater than marginal revenue and
marginal cost.
Oligopoly is a market arrangement where few large firms dominate the market and control large
market share. It is an industry where there is a high level of market concentration.
Oligopolists can either collude in order to maximise joint profit or compete for a larger share of
smaller joint profit.
Page 165 of 245

A Kink in the demand curve automatically determines oligopolists’ equilibrium. The point of
Kink itself is an equilibrium point and such equilibrium is rigid and stable.
SAQ 7.1 A competitive market has free entry and exit. Why is free exit important?
SAQ 7.2 How do economics try to narrow down the assumptions that firms make about their
competitors concerning output decision and equilibrium?
MCQ
1. Perfect competition is
a. a market with few sellers
b. a market with high concentration
c. a market with many sellers and buyers
d. a tomato market
2. The two extreme market structures are
a. monopoly and duopoly
b. oligopoly and duopoly
c. perfect competition and monopolistic competition
d. perfect competition and monopoly
3. Which is correct under perfect competition?
a. P = MR = AR
b. P = AFC
c. AR > MR
Page 166 of 245

d. TR = TC
4. A monopolist has
a. zero market power
b. minimal market power
c. some market power
d. absolute market power
5. Under monopoly
a. P = MR = AR
b. P = AFC
c. AR > MR = MC
d. TR = TC
6. When marginal cost is less than marginal revenue profit maximising firms
a. will increase profit by producing more units.
b. increase profit by reducing output
c. maintain same output level
d. reduce profit by increasing output
7. Monopolistic competition
a. is same as monopolist
b. is a market structure with two sellers
c. does not allow entry
D. has element of monopoly and perfect competition
8. Monopolistic competitive firms
a. choose output level that is below its minimum efficient scale point
Page 167 of 245

b. choose output level that is above its minimum efficient scale point
c. collude to increase joint profit
d. form a cartel
9. Under oligopoly market structure,
a. many firms dominate the market and control large market share
b. one firm dominate the market and control large market share
c. few large firms dominate the market and control large market share
d. dominate the market and control large market share
10. Equilibrium in oligopoly market is
a. where MR = MC
b. the kink point
c. highest profit level
d. where price equal marginal cost
References
Ekanem, O.T. and Iyoha M.A (1999): Microeconomic Theory; Mareh Publishers, Benin City.
Koutsoyiannis, A. (1979): Microeconomic Theory; (2nd Edition): Macmillan Press, London.
Page 168 of 245

Umo, Joe U. (1995): Practical Microeconomic Analysis in African Context; Sibon Books Ltd., Ibadan.
Should you require more explanation on this study session, please do not hesitate to contact your
e-tutor via the LMS.
08033366677
Page 169 of 245

Study Session 8: Factor Market Analysis
Introduction
This session discusses the major factors of production. We also discuss the demand
for factors of production as well as the marginal productivity theory of income distribution.
We then consider some challenges to the marginal productivity theory. Next, we examine the
factors affecting the demand for factors .The chapter concludes with a discussion of the
supply of the most important factor, labor.
Learning Outcomes of Study Session
8.1 Distinguish between factor market and product market;
8.2 Show how factors of production—resources like land, labor, and both physical capital
and human capital—are traded in factor markets,
8.3 Determine the factor distribution of income.
8.4 Reveal how the demand for factors leads to the marginal productivity theory of income
distribution.
8.5 Describe of the sources of wage disparities and the role of discrimination;
Page 170 of 245

8.6 Discuss the way in which a worker’s decision about time allocation gives rise to labor
supply.
8.2 Factor Market
Factors of production are bought and sold in factor markets, and the prices in factor markets are
known as factor prices. What are these factors of production, and why do factor prices
matter? Economists divide resources into four principal classes (land, labour, capital and
enterprenuership) then we have the orchestra of ideas which is the entrepreneur. These
factors of productions are bought and sold in a factor market while goods and services are
bought and sold in a product market. We define capital as the value of the assets that are used
by a firm in producing its output. There are two broad types of capital. Physical capital—often
referred to simply as “capital”—consists of manufactured resources such as equipment,
buildings, tools, and machines, while the second type of capital is Circulating Capital
In the modern economy, human capital; the improvement in labor created by education and
knowledge, and embodied in the workforce, is at least equally significant.
The importance of human capital has been greatly increased by the progress of technology, which
has made a high level of technical sophistication essential to many jobs—one cause of the
increased premium paid for workers with advanced degrees.
Page 171 of 245

8.2 Factor Price
Factor markets and factor prices play a key role in one of the most important processes that must
take place in any economy: the allocation of resources among producers. For example, if
there is a natural disaster, the government of Nigeria will urgently need workers, carpenters,
plumbers, engineers and so on— to repair or replace damaged homes and businesses. What
guarantees that the needed workers will be paid? The factor market: the high demand for
workers drives up wages. In this sense factor markets are similar to goods markets, which
allocate goods among consumers. There are two features that make factor markets special.
Unlike in the goods market, demand in a factor market is what we call derived demand. That is,
demand for the factor is derived from the firms output choice. The second feature is that
factor markets are where most of us get the largest shares of our income (government
transfers being the next largest source of income in the economy). Let us now consider some
big ideas and concept in the factor markets.
8.2.2 Big ideas about factor or resource markets.
1) The economic concepts of factor markets are the same as for product markets.
2) The demand for a factor of production is derived from the demand for the good or service
produced from that resource.
3) A firm tries to hire additional units of a resource up to the point where the resource’s marginal
revenue product (MRP) is equal to its marginal resource cost (MRC).
4) In hiring labor, a firm will do best if it hires up to the point where MRP = the wage rate.
Wages are the marginal resource cost of labor.
Page 172 of 245

5) If you want a high wage: a) make something people will pay a lot for.
b) work for a highly productive firm.
6) Real wages depend on productivity.
7) Productivity depends on real capital, human capital, labor quality, and technology.
Most families in Nigeria get most of their income in the form of wages and salaries— that is, they
get their income by selling labor. Some people, however, get most of their income from
physical capital: when you own stock in a company, what you really own is a share of that
company physical capital. Some people get much of their income from rents earned on land
and houses they own.
Obviously, then, the prices of factors of production have a major impact on how the economic
“cake” is sliced among different groups. For example, a higher wage rate, other things
equal, means that a larger proportion of the total income in the economy goes to people who
derive their income from labor, and less goes to those who derive their income from capital
or land. Economists refer to how the economic cake is sliced as the “distribution of
income.” Specifically, factor prices determine the factor distribution of income—how the
total income of the economy is divided among labor, land, and capital.
All economic decisions are about comparing costs and benefits—and usually about comparing
marginal costs and marginal benefits. This goes both for a consumer, deciding whether to
buy another phone, and for a producer, deciding whether to hire an additional worker.
Although there are some important exceptions, most factor markets in the modern economy are
perfectly competitive, meaning that buyers and sellers of a given factor are price-takers. In a
Page 173 of 245

competitive labor market, it is clear how to define an employer’s marginal cost of a worker:
it is simply the workers wage rate.
8.3 Nature of Factors and the Factor Market
The demand for a factor input is a derived demand. The producers need factor inputs to produce
any goods and services so that production derives the demand for factor inputs. In a
simplified way, the factor of production - labour is used to illustrate the nature of factor
demand.
Labour Market
The firm is on the demand side and the labour ( also being the consumer ) is on the supply side.
To the producer, the wage rate is treated as the price of labour.
Assumptions:
o Workers are perfectly mobile and divisible.
o Both labour and firm are price-takers or wage-takers, i.e. they are not in a position to affect
the market wage rate.
o The product market is a price-taking market in equilibrium, i.e. equilibrium price exists.
o Labour is homogeneous, i.e. equally skillful so that there is perfect substitution of labour.
o In the short run, labour is the only variable factor of production.
Page 174 of 245

Marginal Factor Cost (MFC)
If labour is the only variable factor, then it implies that the marginal cost of a firm is in fact the
marginal cost spent on employing a unit of labour (hour), together with a certain amount of
fixed inputs in the short run, to produce a certain amount of output.
Value of Marginal Product (VMP) of Labour
A firm is always interested in how much its revenue could be increased by hiring a unit of labour
from the extra revenue earned, the firm could determine whether that unit of labour is worth
hiring or not. More labour means more outputs or a change in its marginal product. From the
view of the firm, the importance of labour is its marginal product contributed to the firm
through production. Precisely, a firm is concerned about the value of the marginal product of
any unit of labour. Here, the word value refers to the market value of the product, i.e. the
market price of the product.
Therefore,
VMP = Price of product x Marginal Product = P x MP.
The relationship between the quantity of inputs (workers) and quantity of output (candy bars) is
called the PRODUCTION FUNCTION.
MARGINAL REVENUE PRODUCT is the change in total revenue resulting from the use of
one additional unit of a resource.
MARGINAL RESOURCE COST is the change in total cost resulting from the use of one
additional unit of a resource.
The profit maximizing rule for employing resources is MRP = MRC
Page 175 of 245

8.1 What is Marginal Factor Cost?
8.1 It implies that the marginal cost of a firm is in fact the marginal cost spent on employing a
unit of labour (hour), together with a certain amount of fixed inputs in the short run, to
produce a certain amount of output
Marginal Revenue Product ( MRP )
However, in a price-searcher market, the price-searcher must take account of the fact that in order
to sell an extra unit of output, it must reduce the price on all units sold. If the monopolist
wants to find out the change in total revenue that results from an increase in the use of a
variable factor, say, L,
the monopolist must look at the change in output due to an extra unit of labour and the
marginal revenue resulting from the sale of that extra unit of output.
Thus, the increase in total revenue due to a one-unit increase in the variable input is given by :
Marginal Revenue Product = MR x MP
Where; MR = Marginal Revenue and MP = Marginal Prtoduct
What is Marginal Revenue Product?
Page 176 of 245

It is the increase in total revenue due to a one-unit increase in the variable
input.
Let us suppose Foluso and Son’s Farm are considering whether or not to employ an additional
worker. The increase in cost from employing that additional worker is the wage rate, W. The
benefit to Foluso and Son’s Farm from employing that extra worker is the value of the extra
output that worker can produce. What is this value? It is the marginal product of labor, MPL,
multiplied by the price per unit of output, P. This amount—the extra value of output that is
generated by employing one more unit of labor—is known as the value of the marginal
product of labor, or VMPL:
Value of the marginal product of labor = VMPL = P × MPL
Should Foluso and Son’s Farm hire the extra worker? The answer is yes, if the
value of the extra output is more than the cost of the worker—that is, if VMPL > W.
Otherwise, they should not hire the worker. The decision to hire labor is a marginal decision, in
which the marginal benefit to the producer from hiring an additional worker (VMPL) should
be compared with the marginal cost to the producer (W). As with any marginal decision, the
optimal choice is where marginal benefit is just equal marginal cost.
VMPL = W
This rule does not apply only to labor; it applies to any factor of production. The value of the
marginal product of any factor is its marginal product times the price of the good it produces.
The general rule is that a profit-maximizing price-taking producer employs each factor of
Page 177 of 245

production up to the point at which the value of the marginal product of the last unit of the
factor employed is equal to that factor’s price.
It is important to realize that this rule does not conflict with our analysis in the previous sessions.
There, we saw that a profit-maximizing producer of a good chooses the level of output at
which the price of that good is equal to the marginal cost of production. It is just a different
way of looking at the same rule. If the level of output is chosen so that price equals marginal
cost, then it is also true that at that output level the value of the marginal product of labor will
equal the wage rate.
Example:
TABLE 8.1: EMPLOYMENT AND OUTPUT OF FOLUSO AND SON’S FARM
Quantity of labour Quantity of Cassava Marginal Product of labour

L Q MPL
(workers) (kilogram) MPL= change in Q
change in L
0 0
1 19 19
2 36 17
3 51 15
4 64 13
5 75 11
6 84 9
7 91 7
8 96 5
Page 178 of 245

FILL IN THE VALUES FOR TABLE 8.2:
TABLE 8.2: GIVEN, PRICE OF FINAL GOODS = $20 / UNIT ; and WAGE RATE = $60 / HOUR.
Working Total Marginal MRP of Average Average Revenue
Hour Pro Produ Labour Prod Product
s duct ct uct ( ARP = AR x AP )
1 5 5 5
2 12 7
3 20 8 6.67
4 26
5 30
6 33
7 35
8 36
In the product market the firm maximizes its wealth by producing at an output level where its
MR = MC.
Similarly in the factor market, the firm maximizes by hiring any factor ( labour here ) up to the
point at which the extra revenue to be obtained from hiring one more unit of the factor ( i.e.
MRP) equals the cost of hiring ( i.e. MFC ) it. Thus, in deciding to hire a certain unit of
labour or not, a firm has to be sure that the value of the marginal product produced by
that unit of labour ( VMP or MRP ) is greater than or equal to the cost of hiring that unit
of labour ( i.e. the wage rate).
Page 179 of 245

In case of a price-taking firm with labour as the only variable factor, the MFC is the amount of
wage rate (determined by the demand and supply of the factor market) faced by the firm.
In equilibrium: M F C (Wage Rate) = M R P (of labour ) = V M P
The Labour Market An Individual Firm

Wage rate Wage rate
DL SL
w1 ARP
MRP
0 L1 L 0 L0 L
Figure 8.1 (a): Labour Market Wage Rate Figure 8.1 (b): An Individual Firm
Wage Rate
The price-taking firm, faced with an equilibrium wage rate of w1 determined in the labour market,
has to decide how much labour to hire. By equating MFC or wage rate with MRP, the firm
decides to hire L0 units of labour.
Total Revenue = Price x Quantity = P x (Q/L) x L = P x AP x L
where P = AR
Total Revenue = AR x AP x L = ARP x L = Area under the ARP curve.
Page 180 of 245

Total Variable Cost = Wage Rate x Labour Hours.
(Total Cost = TFC + TVC)
If the difference between TR and TVC is greater than the amount of TFC, the firm is enjoying a
gain in wealth in the short run.
8. 4 Factors Affecting the Shift of the Factor Demand Curve
As in the case of ordinary demand curves, it is important to distinguish between movements
along the factor demand curve and shifts of the factor demand curve. What causes factor
demand curves to shift? There are three main causes:
■ Changes in prices of goods
■ Changes in supply of other factors
■ Changes in technology
1. Changes in prices of goods
The price of a good sold in the product market affects the value of MRP as well as the final
equilibrium point between MFC and MRP. Remember that factor demand is derived demand:
if the price of the good that is produced with a factor changes, so wills the value of the
marginal product of the factor. That is, in the case of labor demand, if P changes, VMPL = P
× MPL will change at any given level of employment.
a. The change of the MP curve also depends on:
o the level of technology used in production ;
o the degree of diminishing returns which partly depends on the amount of fixed factors used ;
o other factors that affect technology and fixed capital, e.g. interest rate.
b. The elasticity of demand of the final product ;
Page 181 of 245

c.The share of the labour cost to the total cost : the greater the share, the more elastic the demand ;
d.The ease of factor substitution: the rate of technical substitution between labour and capital
matters in determining the demand for factors of product.
2. Changes in supply of other factors
Suppose Foluso and Sons’ Farms acquire more land to cultivate by clearing a woodland on their
property. Each worker now produces more because each one has more land to work with. As
a result, the marginal product of labor on the farm rises at any given level of employment.
This has the same effect as an increase in the price of wheat, the value of the marginal
product of labor curve shifts upward, and at any given wage rate the profit-maximizing level
of employment rises. Similarly, suppose Foluso and Sons’ farm cultivate less land. This leads
to a fall in the marginal product of labor at any given employment level. Each worker
produces less wheat because each has less land to work with. As a result, the value of the
marginal product of labor curve shifts downward.
3. Changes in Technology
In general, the effect of technological progress on the demand for any given factor can go either
way: Improved technology can either increase or reduce the demand for a given factor of
production. How can technological progress reduce factor demand? Consider the demand for
receptionist or secretary, which was once an important factor of production. The
development of substitutes for receptionist such as computers greatly reduced the demand for
receptionist. The usual effect of technological progress, however, is to increase the demand
for a given factor. In particular, although there have been persistent fears that machinery
Page 182 of 245

would reduce the demand for labor, on the long run the Nigerian economy has seen both
large wage increases and large increases in employment in some sectors of the economy,
suggesting that technological progress has greatly increased labor demand.
7.5 Supply of Factor Inputs
In this section we focus exclusively on the supply of labor. This is so because labor supply is the
area in which factor markets look most different from markets for goods and services.
In the labor market, the roles of firms and households are the reverse of what they are in markets
for goods and services. A good such as cassava is supplied by firms and demanded by
households; labor, though, is demanded by firms and supplied by households. How do people
decide how much labor to supply?
As a practical matter, most people have limited control over their work hours: either you take a
job that involves working a set number of hours per week, or you do not get the job at all. To
understand the logic of labor supply, however, it helps to put realism to one side for a bit and
imagine an individual who can choose to work as many or as few hours as he or she likes.
Why would such an individual not work for as many hours as possible? Workers are human
beings, too, and have other uses for their time. An hour spent on the job is an hour not spent
on other, presumably more pleasant, activities. So, the decision about how much labor to
supply involves making a decision about time allocation—how many hours to spend on
different activities.
The Individual Labor Supply Curve shows how the quantity of labor supplied by an individual
depends on that individual’s wage rate. Now , let us consider some factors that affect the
supply of factors.
Page 183 of 245

Factors Affecting the Supply of a Factor
Changes in Preferences and Social Norms: Changes in preferences and social norms can lead
workers to increase or decrease their willingness to work at any given wage. A striking
example of this phenomenon is the large increase in the number of employed women—
particularly married employed women—that has occurred in Nigeria since the 1990s. Until
that time, women who could afford not to largely avoided working outside the home.
Changes in preferences and norms in the country (helped along by the invention of labor-
saving home appliances such as washing machines, increasing urbanization of the
population, and higher female education levels) have induced large numbers of women to
join the work force— a phenomenon often repeated in other countries that experience similar
social and technological forces.
Changes in Population: Changes in the population size generally lead to shifts of the labor
supply curve. A larger population tends to shift the labor supply curve rightward as more
workers are available at any given wage; a smaller population tends to shift the labor supply
curve leftward. Currently the size of the Nigerian. labor force grows by approximately 6%
per year, As a result, many labor markets in Nigeria are experiencing rightward shifts of their
labor supply curves.
Changes in Opportunities: At one time, teaching was the only occupation considered suitable
for highly educated women. However, as opportunities in other professions opened up to
Page 184 of 245

women starting in the 1960s, many women left teaching and potential female teachers chose
other careers like banking
Summary
We have discussed the following:
• In a perfectly competitive market economy, the price of the good multiplied by the marginal
product of labor is equal to the value of the marginal product of labor: VMPL = P × MPL. A
profit-maximizing producer will employ labour up to the point at which the value of the
marginal product of labor is equal to the wage rate: VMPL = W. The value of the marginal
product of labor curve slopes downward due to diminishing labor production.
• The market demand curve for labor is the horizontal sum of all the individual demand curves
of producers in that market. It shifts for three reasons: changes in output price, changes in the
supply of other factors and technological progress.
• As in the case of labor, producers will employ land or capital until the point at which its
value of the marginal product is equal to its rental rate. According to the marginal
productivity theory of income distribution, in a perfectly competitive economy, each factor of
production is paid its equilibrium value of the marginal product
• The market labor supply curve is the horizontal sum of the individual labor supply curves of
all workers in that market. It shifts for four main reasons; changes in preferences and social
norms, changes in population and changes in opportunities.
SAQ 8.1 Explain Factor Market and Factor Prices
Page 185 of 245

SAQ 8. 2 Explain how changes in price of goods and technology affect shifting of the factor
demand curve.
1. For a firm operating in a perfectly competitive output and labor markets, an optimal level of
labor is used in the short run when:
(A). MRP = W
(B) MRP = MFC
(C) P x MP = W
(D) all of the above are correct
2.In a perfectly competitive labor market operates until

(A)MFC > W
(B) MFC < W
(C) MFC = W
(D) none of the above are correct
3. For a monopoly firm operating in labor market, an optimal quantity of labor is hired in the
short run when:
(A) MRP = W
(B) MRP= MRC
(C) P x MP= W
(D) all of the above are correct
4.In a labor market, the producer will always consider ……… as the most important factor
before hiring a worker.
(A) the wage rate.
(B) Cost of capital
(C) number of workers
(D) extra value of each worker
Page 186 of 245

5.The introduction of an effective minimum wage law in a monopsony market will cause the
optimal level of employment to:
(A) decrease
(B) change in a manner that cannot be determined without additional information
(C) remain unchanged
(D) increase.
6.There is as much, or more, price searching in factor markets as in product markets.

(A) True
(B) False
(C) Maybe
<C> None of the above
7.Labor is a unique factor of production because its price is not determined by the supply and
demand for it.
(A)True
(B) False
(C) Maybe
(D) None of the above
8.The supply curve for a factor of production typically shows that the higher the factor’s price,
the greater the quantity that will be supplied.
(A)True
(B) False
(C) Maybe
9.Foluso and Son’s company purchase factor inputs because the inputs directly yield satisfaction.
(A)True
(B) False
Page 187 of 245

(C) Maybe
10.If the demand for wine falls so that the price and marginal revenue from wine falls, then the
demand for grape pickers declines.
(A)True
(B) False
(C) Maybe
References
Ibadan.
Ekanem, O.T. and Iyoha M.A; Microeconomic Theory; Mareh Publishers, Benin City. Should you require
more explanation on this study session, please do not hesitate to contact your e-tutor via the LMS.
Page 188 of 245

08033366677
Page 189 of 245
Study Session 9: Theory of Distribution
Introduction
The entire idea of economics stands on the foundation of locating, mining and
managing the scarcely available resources in order to satisfy the human needs in the most
effective way thus avoiding waste and making provision for next the generation. i.e
sustainability.
It is important to share the available resources among the factor that operates in a particular
economy. The concept of sharing national income among the factors of production in an
economy is the concept of distribution. This distribution must be done in a way that allows
for continuity and a way that best reward each factor of production.
Learning Outcomes for Study Session 14:
When you have studied this session, you should be able to:
9.1 Distinguish between functional and personal distribution of income (SAQ
14.1).
9.2 Explain the major drawback of the neoclassical theory of distribution. (SAQ 14.2)
9.3 State the returns to the factors of production and give an analysis of their
respective share of income. (SAQ 14.3)
9.4 List and explain two dynamic influences on distribution (SAQ 14.4).
9.1 Theory of distribution.
Page 190 of 245

You will agree with me that production does not just happen; there are provisions and factors that
make production possible within an economy. These factors must be in place for production
process to be fulfilled. It is important to note that these factors must at every point be
rewarded in order to maintain their provision and ensure continuity.
The approach to sharing the available but scare resources among the factors of production must be
systemic and monitored in order that each factor of production gets return that it not in the
proportion it has contributed to the process, The level of contribution to the process must be
put into consideration when distributing the proceeds that come from such production. This
factors as popularly known are land, capital and labour. Off-course the coordinating factor
which some school of thought called entrepreneur is not relegated but emphasis of the
session will drive towards the three factors earlier mentioned.
It is important to mention that economists have studied the costs of these factors and the size of
their return i.e rent, profit and wages as the case may be and put into consideration the
possible economy diversities that may occur while planning for production.
There are three most important questions to ask when discussing distribution.
• How is national income distributed
• What determines the prices attached to each factor of production
• How then is the national income proportionally distributed among the factors of production
A further breakdown of the third question is what determines the share of labour, capital and land
and consequently the determinant of the returns that accrues to individual factor of
production. Bearing these questions in mind, we shall discuss the aspects of distribution that
call for concern.
Page 191 of 245

Question;
• Why is the need to study the theory of distribution?
Answer;
• The study of the theory of distribution is necessary because the resources available within
an economy are scarce and the needs within this same economy are enormous hence the
need to understand the position of the factors of production and how to share the
resources among the factors that make production possible.
9.2 Aspects of distribution.
Bearing in mind the population within a particular economy and the size of the national income, it
bears the question of how much individual will earn and what determines what they earn.
There is a huge level of inequality in developing nations as a bigger part of the national
income goes to a few and the remaining is shared among the greater percentage of the
populace.
9.2.1 Personal distribution
There exist numerous possible reasons for the level of inequality obtainable in various countries.
The reasons range from natural reasons which are spelt out in the differences displayed in the
level of ability and intelligence among groups of people to social reason which is explained
by the level of education and relevance to particlar economic need. This is not to relegate
factors such as political power and shear exploitation of people by the political office
holders.
Page 192 of 245

At what level will population grow for labour to earn less and at what point will capital holders
begin to earn more. Karl max indicated in one of his works that the workers (labour) would
continually be cheated as against the level of impute given and also exploited and he believed
that these harsh conditions will mean the end of capitalism (Economic system that allow for
private ownership of capital ). This is not the case yet as the share of rent decreased and the
share of labour witness an increase.
From the above, wage rate is calculated as the amount of wage level multiplied by the amount of
labour available within the economy.
Wage bill = wage level × amount of labour.
The national income therefore is written as national output multiplied by the price level
National income = national output × price level
If the wage bill and national income in the above pattern, the share of labour is constant. If the
real wage rate increases faster than the amount of labour productivity, the share of labour
goes up. The share of capital and land also follow this pattern.
9.2.2 Functional distribution
The functional approach to the theory of distribution further explain the prices of factors of
production i.e land, labour, and capital, It captures the demand for land, labour, and capital as
derived demand. (The demand for a particular product that is necessitated by the
presence/availability of another product; especially when they are used together). This is
further explained by the act of an entrepreneur demanding land, labour, and capital because
he needs them in the production of goods and services. It is to be noted that the production
process is impaired upon greatly when one or all of this factors are not available, hence the
relationship between the theory of distribution and the theory of production, this relationship
Page 193 of 245

between the theory of production and distribution theory is explained more by neoclassical
theory which we shall looking at right away.
9.3 The Neoclassical/Marginalist Theory
The underlying concept expressed in neoclassical distribution theory is the returns on all factors
of production engaged in the production process. It is further expressed in the thought that
incomes are earned in the production of goods and services they have been employed to do
and that the value that is placed on the productive factor reflects its contribution to the total
production process and consequently the product as the case may be. This fundamental
thought was basically that of a French economist J.B Say from the 19th century. The basic
difficulty/criticism face by this thought erupted from the inability to carefully separate the
contribution of basic and individual factor imput (the factors of production).
It is agreeable that without capital, total output deliverable will be minimal and without labour,
there will be no product at all. Without land of space to work from, the entire process in
greatly impaired upon. It is clear at this juncture that all these factors of production are
relevant and very important if the production process will achieve the singular goal of
meeting needs as they manifest within a particular economy.
9.1 According to the neoclassical theory of distribution, is the price attached to a
factorr of production determined by the level of contribution made in the
production process or the availability of the same?
Page 194 of 245

9.1 The level of contribution made by a factor of production determines the
value placed on the factor of production.
The difficulty expressed in the thoughts of J.B Say was addressed by the submissions of a
renowned economist J.B Clark also in the 19th century. He came up with the theory of
marginal product.
The concept of marginal product in thus explained. The marginal product of an input, e.g labour,
is captured as the extra output attained from the production process because an additional one
unit of the factor of production (labour) was added to the initial combination of productive
factors.
He further stated that the optimum condition, the wage rate accrued to labour will be equated to
the marginal labour product of the labour. i.e the excess proceeds from the production
process because an additional one unit was added to the factor combination. While this is
happening, he stated that the rate of interest be equated to the marginal product of capital.
The process of optimization begins when the entrepreneur is out for profit maximizing. At
the point, the entrepreneur will employ more labour when the wage rate is less than the
marginal product of additional labour input and will also engage more capital when the rate
of interest is lower than the marginal product of capital.
The actual value of the final output can be separated as the marginal product which is the extra
product resulting from an additional unit of labour. This extra product can now be taken as
productive contribution of individual factor input. It is important to note that the factors of
production are priced and these prices are determined by market forces. i.e the force of
demand and supply.
Page 195 of 245

9.2 of all the possible determinant of the prices of factors of production. The forces
of market are most important. True or false?
What is the major drawback of the theory of distribution as proposed by the neoclassical
9.2 True, the forces of demand and supply are best left to determine the prices of
the prices of the factors of production.
The theory of distribution as described by the neoclassical was unable to separate the individual
contribution of the factors of production
9.4 Advantages of the neoclassical theory of distribution
A distinguishing reasoning of the neoclassical/marginalist theory of distribution lies in its
unbiaseness in the treatment of the factors of production; it does not take one factor of
production as more superior to the other one, they are treated equally. This is not the case
with other distribution theories. The neoclassical/marginalist theory of distribution is also in
consonant with the theory of production.
9.4.1 Mathematical expression of the neoclassical/marginalist theory of distribution
Suppose that the production function bearing in mind all possible combination of the factors of
production is
Q = f (L,K)…… (1)
Where Q = total output,
L = Amount of labour employed,
Page 196 of 245

K = Stock of capital goods.
Land is taken as a subset of capital. This is to make the equation less cumbersome
From the above, calculating the wage rate is achieved by differentiating output with respect to
labour. That is ∆Q/∆L
From the above, the total wage bill is
The distributive share of labour is
Calculating capital follow the same exact pattern where all K capital is used in place of L labour.
Other aspect of this subject matter is not covered in this session.
9.5 Returns to the factors of production
In this and succeeding sub-sessions of study session 14, we will attempt an explanation of the
distribution of income for the factors of production from the supply side.
9.5.1 Rent
Rent is the main determinant and reward for the supply of land in the economy. Land owners will
provide their land to be used for production if the price is right, and the price is the rent. The
supply of land, however, is inelastic because land owners cannot swiftly respond to changes
in rent in the market. Hence, land is said to be fixed in supply. Also, land as a factor of
production is the last to be paid for its services after other factors of production have been
paid. In the neoclassical analysis, land’s share of the income is rather a claim to the residue
of the total income and, most times, an insignificant proportion of the income.
Page 197 of 245

While the above neoclassical view of land holds true to some extent even in today’s economy, it
falls short in explaining income distribution for some reasons. Firstly, in modern economies
there is little or no reason why land should be fixed in supply since land can be put to various
purposes, unlike in the agrarian economy. Moreover, even if land were to be fixed, that
characteristic would not be peculiar to land alone. Hence, a more relevant explanation for the
share of land in the distribution of income in today’s economy is desirable.
9.5.2 Wages
As a factor of production, the share of income of labour is the wage it earns for providing certain
quantity and quality of its service. While in the long run, the wage rate is a function of the
demand and supply of labour, in the short run it is largely determined by the marginal
productivity of labour; that is that additional value that can be created by employing an extra
input of labour in the production process. Nevertheless, it has to be admitted that there exist
market failures even in the operations of the labour market that affect the determination of
the wage rate, especially in the short run. Two of such influences are trade unionism and
socio-cultural factors. Thus, while the marginal productivity of labour may be significantly
related to the level and changes in wage rate, the former can often not totally explain the
variations in the latter, especially in the short run.
It is often agreed that trade unions do have considerable influence on the distributive share of
income of labour. They can persuade and, sometimes, even coerce organizations and
governments to raise the nominal wage rate for their members over and above market
determined wage rate. However, it has also been observed that the market often adjusts itself
Page 198 of 245

to such distortions in various ways. Firstly, the trade unions cannot coerce the government or
organization to employ and maintain certain amount of labour. Hence, downsizing is often a
natural cause to follow in the face of forced wage increment. Furthermore, forced increment
of nominal income seldom leads to increment in real income. In fact, more often than not, the
increment in nominal wage is eroded by corresponding inflationary tendencies caused by the
forced increment in wage rate itself. Moreover, there is an inherent tendency in any economy
for substitution of costlier factors of production with more affordable factors, subject of
course to consideration for their relative productivity. In fact, in some cases, certain type of
labour has been replaced by another type of labour due to cost variations and implications. A
good example is the substitution of indigenous labour with cheaper, foreign labour in certain
industries and countries.
The debate about the significance or otherwise of the influence of trade unionism and other
market failure forces in the determination of the distributive share of income of labour in the
production process is still on-going. What is, however, certain is that ultimately the marginal
productivity of labour plays the major role in the short run, just as the demand and supply of
labour are the main determinants in the long run.
9.5.3 Interest
The reward of capital as a factor of production is interest. The amount of interest earned by capital
is a function of the marginal productivity of capital, which is in turn a function of the level of
capital stock and the rate of accumulation of capital stock. While addition to capital in the
form of net investment increases the stock of capital, it also reduces the marginal
Page 199 of 245

productivity of capital and, hence, interest as reward for capital. Thus, while additional net
investment may add to capital stock and even profit, it would often lead to lower interest
income for every additional capital employed. Hence, the marginal productivity of capital is
the major determinant of the distributive share of capital in income distribution, although the
influences of government fiscal policies, saving activities of households and lending
decisions of banks cannot be discountenanced.
9.5.4 Profit
A fourth factor of production identified by later economists is the entrepreneur and its reward is
profit. This factor was neglected by the neoclassical economists in their analysis because they
assumed perfect competition and, by extension, zeros profit in the long run. However, as it
has been seen, the importance of this factor cannot be overemphasized for good reasons.
Firstly, in modern economies, profit accounts for a significant part of the distributive share of
income. Also, the entrepreneur as a factor of production is credited for taking uninsurable
risks, without which the whole production process itself may be impossible. Furthermore, as
brought to the lime light by Schumpeter, the entrepreneur is responsible for creation of
wealth and value through innovation in the production process. These new ways of
production reduce cost and create a margin taken as profit. Profit may also arise as a result of
degrees of monopolistic tendencies and unforeseen, favourable changes in demand for the
entrepreneur’s product.
9.6 Dynamic influences on distribution
Under certain assumptions, the neoclassical theory of income distribution discussed in the
proceeding sub-sessions of this study session has focused more on comparative static
Page 200 of 245

analysis of changes in income distribution. Under this sub-session, an attempt is made at not
just the explanation of the changes of share of income distribution amongst various factors of
production, but also of the processes through which such changes occur. Our focus here is on
prices and technology as two dynamic influences.
9.6.1 Prices
In the short run, business cycles, changes in general price level and quickly increasing prices can
affect the distribution of income. A rise in prices affects purchasing power negatively. Such
rise causes reduction of profit through fall in effective demand. Wages also suffer through
downsizing since reduction in wage rate is often difficult and resisted by the trade unions.
Ultimately, fixed income earners, such as wage and interest earners, suffer greater losses in
the face of rapidly rising prices because their nominal income does not increase with the
price level, while variable income earners, such as profit earners, are the gainers. The reverse
is however the case in a situation of deflationary tendency.
While the foregoing dynamic analysis may seem economically plausible, recent evidence in some
countries do not support the conclusions drawn. Contrary to expectations, it has been
observed that the share of labour in income distribution has actually increased at incremental
rate overtime, while shares of land and capital have decreased at a faster than usual rate. On
the other, the change in the share of profit in income distribution has remained fairly
insignificant. In the general picture, it has been observed that the share of the factors of
production in income distribution do not change as much as the rapidly rising or falling price
level.
Page 201 of 245

9.6.2 Technology
More often than not, economic growth occurs due to technical progress ushered in by new ways
of doing business and production. At times, it could be in the form of innovation, and in other
cases it could be a total revolution. Whatever the case may be, the bottom line is that income
is not generated or increased merely due to increase in the quantity of factor inputs. The
quality and improvements in quality of every factor input in the production process has
become as important as its quantity, and in some cases even more important than its quantity.
While the neoclassical theory of distribution assumed technological progress to be fairly
constant and, hence, it was of little or no dynamic significance in their analysis, in the real
world technical progress occurs every day, especially in today’s economies, through
improvements in factors of production.
Technological changes can be accounted for in various ways. Assume an increase in the quality of
workers, such that more skilled and better educated labour is available for production
purposes. If the labour elasticity of production rises, we can say that technical change is
“labour-using”, and this will cause the share of labour to rise in the distribution of income.
The entrepreneur as a factor of production also benefits from technological changes. In most
cases, though capital and/or labour may benefit from the increased output of production,
there is often a proportion of such increase that accrues to the entrepreneur in the form of
increased profits. According to Schumpeter, part of such increased profit is invested in
bringing about innovation, which in turn is expected to give rise to increased profits again.
Page 202 of 245

Thus, profit benefits immensely from the increased income and its share of income
distribution increases. This in turn translates into economic growth.
9.7 Personal income and neoclassical theory
The way and manner in which income is distributed amongst individual economic agents is the
concern of personal income distribution, and the neoclassical theory tells us little or nothing
about this. At the societal level, personal income distribution is a function of existing legal
and social institutional frameworks. Such arrangements determine and/or influence how
much an individual agent receives as income and pays out of its income. For instance, the
type of tax system and regime decides how much each economic agent pays out of its
income, while the social arrangement influences an economic agent’s receipts due to
institutional rules on, for instance, social security or welfare receipts, old age benefits, etc.
At the corporate level, the tax system and the corporate policy determines how much profit may
be declared, retained in the organization, paid out as wage and benefits of management and
staff, paid as company income tax etc. Thus, in as much as the power of the managers and
owners of the business to pay themselves huge remuneration is not in doubt, such powers are
limited by existed laws and conventions in the society and business world.
Summary of Study Session 9
In Study Session 14, you have learned that:
1. The concept of the theory of distribution is a major concept in the study of economics from
the angle of scarce resources and insatiable human needs.
Page 203 of 245

2. The major difference between personal and function approach to distribution lies in the
contribution individual factor of production makes to the production process which in turn
determine the returns to each of this factor.
3. The unbias expressed in the neoclassical theory of distribution is a major advantage in that
no factor of production is given less relevance
4. There are four types of returns to factors of production, name: rent for land, wages for
labour, interest for capital and profit for entrepreneurship. While profit has steadily increased over
the years, wages have risen relatively, fast, and interest and rent have lagged behind.
5. Two major dynamic influences on distribution are prices and technology. Fixed income
earners, such as labour and land, loose most during inflation and rapidly rising prices. Profit
seems to benefit most from technological progress.
6. The neoclassical theory tells us little or nothing about personal income distribution, which is
a function of existing legal and socio-economic institutional frameworks of the society.
SAQ 9.1 What is Functional Distribution of Income?
SAQ 9.2 How is capital rewarded?
1. The theory of distribution is necessary because of
(a) Economics of resources
(b) Scarcity of resources
(c) Scarcity of production
(d) All of the above

Page 204 of 245
2. The proportion of returns accrued to a factor of production as stated by the
neoclassical school of thought should be determined by
(a) The amount of national income
(b) The amount received by other factor
(c) The level of contribution by the factor
(d) The decision of the entrepreneur.
3. The purpose of production is to
(a) Share natural resource
(b) Give jobs to the people
(c) Promote factories
(d) Meet national needs
4. The form of demand that exist between factor of production is
(a) committed demand
(b) Needful demand
(c) Derived demand
(d) Amend demand
5. Marginal product is
(a) The profit margin on goods and services
(b) The extra output caused by an additional unit impute of a factor of production
(c) The margins between the factor of production
Page 205 of 245

Option: None of the above.
6. Returns to factors of production are ……..
(a) returns inwards of factors at the end of production.
(b) returns outwards of income that factors could not exhaust.
(c) rewards factors earn for engaging in the production process.
7. Neoclassical theory of distribution neglects profit in their analysis because
(a) in the short run, profit tends to be negligible.
(b) profit vanishes in the long run.
(c) they assume perfect competition, thus profits is either normal or zero.
8. In the neoclassical analysis, which of the following is the most important factor that
determines share of income of capital and labour in the short run?
(a) Demand and supply of capital and labour
(b) The rate of interest set by the bank.
(c) the pressure from trade unionism to fix minimum wage.
(d) Marginal productivity of the respective factors of production.
9. In the dynamics of income distribution, what is the effect of rapidly rising prices on
fixed income earners?
(a) Fixed income earners gain from rising purchasing power
Page 206 of 245

(b) Fixed income earners’ share of income remains the same
(c) Fixed income earners loose from falling purchasing power
(d) The effect on fixed income earners is indeterminable.
10. Aside from marginal productivity, demand and supply of factors of production, which
of the following play a role in income distribution?
(a) Trade unionism
(b) Tax system and regime
(c) Legal and socio-cultural institutions and their arrangements
Further Reading
Edward T. Dowling (1980): Introduction to Mathematical Economics; McGraw-Hill, Inc., Third
Edition
John Black (2002): Dictionary of Economics; Oxford University Press, Oxford, New York
Koutsoyiannis, A. (1979) Microeconomic Theory; Macmillan Press, London.
Ibadan.
Page 207 of 245

via the LMS.
08033366677
Page 208 of 245

Study Session 10: Introduction to Welfare Economics
Introduction
The main purpose of this study session is to introduce the students to welfare economics as well
as principles of welfare economics. Students will be exposed to different definitions as
highlighted in the literature. The possible criticisms of the different definitions would also be
discussed. Moreover, basic concepts such as the concepts of externalities, pareto –
optimality, market efficiency, etc would also be covered.
10.2.1 Define the concept of Welfare Economics;
10.2.2 Explain the concept of Welfare Economics;
10.2.3 Describe the General Equilibrium and Welfare Economics; and

Page 209 of 245
10.2.4 Describe the concept of Pareto optimality.
10.1 Analysis of Welfare Economics
Definition
Welfare economics is concerned with value judgments concerning the desirability of particular
changes or policies. The basic aim of welfare economics is to provide us with criteria
according to which various policy proposals can be ranked. For instance, policy A is superior
to policy B. This helps us in understanding the ethical presumptions on which policy
statements are based. It can be defined as the cost-benefit analysis of the allocation of
resources, economic activity, and distribution of the resulting output on a society's welfare.
10.1.1 Marshall’s Welfare Definition of Economics
Alfred Marshall, a pioneer neoclassical economist, reoriented Economics towards the study of
mankind and provided economic science with a more comprehensive definition. In his
famous book ‘Principle of Economics’ (1890) he defines economics as:
"Political economy or economics is a study of mankind in the ordinary business of life. It
examines that part of individual and social action which is most closely connected with the
attainment and the use of material requisites of well-being".
This definition clearly states that economics is, on the one hand, a study of wealth, and on the
other importantly “a part of the study of man”. Marshall’s followers like Pigou, Cannon and
Baveridge have also defined Economics in terms of material welfare.
10.1.2 Features of Marshall’s Definition:

Page 210 of 245
The Marshall’s definition of Economics has the following main features:
(1) Wealth is not the be-all and end-all of economic activities: Economics does not regard
wealth as the be-all and the end-all of economic activities. Wealth is sought for promoting
human welfare. Hence, wealth is only a means to the fulfilment of an end which is human
welfare. Therefore, wealth is relegated to a secondary place.
(2) Study of an ordinary man: Economics is not concerned with what is called in Economics
‘economic man’, i.e., a man whose only motive is to acquire wealth for its own sake and who
is not influenced by human considerations in the pursuit of wealth. Rather, Economics deals
with ordinary men and women who are swayed by love, affection and fellow-feelings and not
merely motivated by the desire to get maximum monetary advantage.
(3) Economics is a social science: Economics is a social science and not one which studies
isolated individuals or Robinson Crusoes. Economics study people living in the society
influencing other people and being influenced by them.
(4)Economics does not study all activities of man:Economics does not study all the activities of
man. It is concerned with those actions which can be bought directly or indirectly with the
measuring-rod of money. Marshall clearly explains that an economic activity is different
from other activites. For example,
If a student visits a friend who is ill, it is a social activity,
If a person gives his vote in an election, it is a political activity.
If a person goes to church/temple, it is a religious activity.
Page 211 of 245

Marshall says that economic activity is different from the above mentioned activities. A farmer
going to the field or a worker going to the factory to work, is an economic activity—they are
working to earn money. With that money they will buy things to satisfy their wants. In other
words, economics deals with wants, efforts and satisfaction.
In the words of Marshall, "man earns money to get material welfare." Marshall gives importance
to welfare and man. As such this definition came to be called the welfare definition.
(5) Study of material welfare: Economics is concerned with the ways in which man applies his
knowledge and skills to the gifts of nature for the satisfaction of his material welfare.
Economics studies only ‘material requisites of well-being’ or causes of material welfare.
For a long time, the definition of economics given by Alfred Marshall was generally accepted. It
enlarges the scope of economics by emphasizing the study of wealth and man rather than
wealth alone. However, Marshall’s definition was criticized by Lionel Robbins. In his book
“Nature and Significance of Economics Science” Robbins gives a critical review of the
welfare definitions of economics. These criticisms are discussed below.
10.1.3 Robbins Criticism of Marshall’s Welfare Definition
(1) Classificatory and Impractical: Robbins rejected Marshall’s definition as being classificatory
because it makes a distinction between material and non-material welfare and says that
Economics is concerned only with material welfare. Robbins does not think it right for the
economists to confine their attention to the study of material welfare, because in the actual
study of economic principles, both the ‘material’ and ‘immaterial’ are taken into account.
Page 212 of 245

(2) Narrow down the scope of economics: According to Robbins, the use of the word “material”
in the definition of economics considerably narrows down the scope of economics. There are
many things in the world which are not material but are very useful for promoting human
welfare. For example, “the services of doctors, lawyers, teachers, dancers, engineers,
professors etc., satisfy our wants and are scarce in supply”. If we exclude these services and
include only material goods, then the sphere of economics study will be very much restricted.
(3)Relation between economics and welfare: The second objection raised by Robbins on welfare
definition is on the establishment of the relation between economics and welfare. According
to him, there are many activities which do not promote human welfare, but they are regarded
economic activities, e.g., the manufacture and sale of alcohol or opium, etc.
(4)Welfare is a vague concept: The third criticism raised by Robbins was on the concept of
“welfare”. In his opinion, welfare is a vague concept and purely subjective. It varies from
man to man, from place to place and from age to age. Moreover, Robbins questioned the use
of a concept which cannot be quantitatively measured and on which two persons cannot
agree as to what is conductive to welfare and what is not. For example, the manufacturing
and sale of guns, tanks and other warheads, the production of opium, liquor etc. are not
conducive to welfare but these are all economics activities. Hence, these cannot be excluded
from the study of economics.
(5) It involves value judgment: Finally, the word “welfare” in Marshall’s definition involves
value judgment and brings Economics to the realm of ethics. Whereas, according to Robbins,
economics is neutral as regards ends. It is not supposed to be its function to pass moral
judgments and say what is good and what is bad
Page 213 of 245

10.1 Define the term welfare economics
ITA 10.1 Welfare economics is concerned with value judgments concerning the
desirability of particular changes or policies. The basic aim of welfare
economics is to provide us with criteria according to which various policy proposals can be
ranked
10.1.4 Basic Concepts in Welfare Economics
• Allocation of resources
It involves the analysis of how scarce resources ('factors of production') are distributed among
producers, and how scarce goods and services are apportioned among consumers. This
analysis takes into consideration the accounting cost, economic cost, opportunity cost, and
other costs of resources and goods and services. Allocation of resources is a central theme in
economics (which is essentially a study of how resources are allocated) and is associated
with economic efficiency and maximization of utility.
• Economic Activity
This is an action that involves the production, distribution and consumption of goods and services
at all levels within a society. Gross domestic product or GDP is one way of assessing
economic activity, and the degree of current economic activity and forecasts for its future
level can significantly impactbusiness activity and profits, as well as inflationand
interestrates
Page 214 of 245
• Distribution
The movement of goods and services from the source through a distribution channel, right up to
the final customer, consumer, or user, and the movement of payment in the opposite
direction, right up to the originalproducer or supplier
10.2 The Pareto Principle
In order to be able to say anything about social (overall) welfare in a multi-household economy,
some value judgments must be introduced. Whenever we say that one situation is better than
another, our assessment must be based on a certain set of value judgments. The basic value
judgment used in welfare economics is known as the Pareto principle. This principle says
that a change is desirable if it makes some individual(s) better off without making any others
worse off.
The concept of Pareto optimality has been used to draw much of the policy conclusions of
modern welfare economics.
A typical definition of Pareto efficiency would he: "A given economic arrangement is efficient if
there can be no arrangement which will leave someone better off without worsening the
position of others." Thus any exchange or reallocation of resources is only Pareto optimal if
the exchange or reallocation will not harm somebody
Define Pareto Optimality
Page 215 of 245

A given economic arrangement is efficient if there can be no arrangement
which will leave someone better off without worsening the position of others.
10.2.1 External Benefits - Modern welfare economics, following in the tradition of Pigou, has
used the existence of external benefits as a justification for government intervention on the
grounds of economic efficiency. This argument for government intervention follows directly
from the acceptance of perfect competition as a policy norm following from Pareto
optimality. The whole argument for government subsidy payments in the case of external
benefits revolves around the idea that these benefits can be objectively measured by someone
not involved in the transaction.
10.2.2 Public Goods - Related to the arguments that the government should subsidize a good
when it generates external benefits is the argument that the government should provide the
good when it has public goods properties. The major defining characteristic of a public good
is that the consumption of the good by one person does not reduce the amount available to
any other person. The second major defining characteristic of a public good is that the costs
of exclusion are high, so as to render pricing difficult.
10.2.3 Market Failures– There are a number of reasons why a market economy may fail to
achieve Pareto Optimality. One source of failure is increasing returns to scale. This is one
reason why we sometimes observe a few or even a single firm, a monopolist, operating in a
market. The most often used example is national defense. Since consumers cannot be
Page 216 of 245

excluded from consuming a pure public good, it is very difficult to provide such goods via
the market.
A similar problem occurs in the case of externalities. Perhaps the most discussed example has
been air and water pollution. There is a difference between private and social costs in such
cases; polluters do not have to pay for losses they inflict on others. This means that the
resource allocation provided by the market may not be efficient.
Summary
In this study session, we have learnt about welfare economics – the meaning, scope and
applications. We examined different ways in which welfare economics was described. The
case of Marshal’s definition was discussed. The major criticisms of his definitions were
highlighted. Some basic concepts such as the principle of Pareto optimality, externalities,
public goods, market failures were also discussed.
Page 217 of 245

SAQ 10.1 Identify and discuss Robbins criticism of Marshallian definition of
Welfare Economics
SAQ 10.2 Identify and discuss the major features of the Marshallian definition of
Welfare Economics
MCQs
1. The concept of Pareto Optimality in Economics describe
a. Fairness
b. Parity
c. Inequality
d. Efficiency
Answer: d
2. Marshallian Definition of Welfare Economics is criticized on the ground that
a. It narrows down the scope of Economics
b. It is unnecessarily wieldy
c. It is ambiguous
d. It is laborious
Answer: a
3. The Renowned Economist who Criticised Marshal is
a. Alfred
b. Adam Smith
Page 218 of 245

c. Robbins
d. David Ricardo
Answer: c
4. Welfare Economics is related to which of these concepts
a. Microeconomics
b. Public Goods
c. Macroeconomics
d. Government intervention
5. Which of the following does not belong to welfare economics
a. Non- Excludability
b. Market Failures
c. Indivisibility
d. Externalities
Answer: c
6. The book titled ‘Principle of Economics’ was published in what year
a. 1890
b. 1790
c. 1870
d. 1980
Answer: a
7. The book titled ‘Principle of Economics’ was published by

Page 219 of 245
a. Alfred
b. Adam Smith
c. Robbins
d. David Ricardo
Answer: a
8. A good example of externalities is:
a. Production
b. Distribution
c. Allocation
d. Pollution
Answer: d
9. A good example of a Public good:
a. Television
b. Refrigerator
c. Roads
d. Vehicles
Answer: c
10. ………… is one of the followers of Marshal
a. Alfred
b. Pigou
c. Robbins
d. David Ricardo
Page 220 of 245

Answer: b
References
Stieglitz, J (2000). Economics of the Public Sector.London and New York: Norton & Co. 3rd
Ed. Chapters 3, 4, 5, 11 and 19
Comes, R., and Sandier, T. (1986) The Theory of Externalities, Public Goods, and Club Goods.
Cambridge: Cambridge University Press.
Ibadan.
APPENDIX: Answers to Self-Assessment Question
S.A.Q 1.1 Define Economics and show its relevance in solving an economic problem.
Answer
Page 221 of 245
Economics help economic units to solve economic problems. This becomes necessary consequent
upon two facts that are obvious in every economy. First, human wants for goods and services
are unlimited, and secondly, productive resources with which to produce goods and services
are scarce. Thus, in view of the scarcity of means at our disposal and the multiplicity of ends
we have to achieve, the economic problem lies in making the best use of our resources.
Therefore, with the limited amount of money at the disposal of the consumer, he has to strive
to obtain the highest possible (maximum) satisfaction from the same. Similarly, the producer
must try to maximize his profit by employing his limited resources more efficiently – that is,
in his choice of what to produce, how to produce and for whom.
Economic problem lies in making decisions regarding the ends to be pursued or the wants to be
satisfied and the goods to be produced and as regards the means to be used in producing
them. It may be recalled here, that, Economics studies human behaviour as a relationship
between ends and scarce means that have alternative uses. It follows that whereas the ends
are many, and the means are scarce, the means can be subjected to alternative use; thereby
causing economic problems.
It is pertinent to point out that all agents of consumption and production are confronted with the
economic problem – individuals, households, firms and governments. Thus, an attempt at
solving the “economic problem” necessitates “rationality” in consumption behaviour and
production pattern as the same is the basic ingredient of “welfare” and profit maximization.
S.A.Q 1.2 Evaluate the scope of Economics
Answer
Page 222 of 245

Economics can be better understood from what economists do or what they have been doing. This
has strong bearing on the types of questions which economists ask and have been asking and
the solutions they have provided to those questions. Some of these questions are ;
(g) What goods are produced by the productive resources which the economy possesses and
in what quantities?
(h) How are the different goods produced? What production techniques are used for the
production of various goods and services?
(i) How is the total output of goods and services of a society distributed amongst the people?
(j) Are the uses of productive resources economically efficient?
(k) Are all available productive resources within a society being fully utilized or are some of
them lying unemployed and unutilized?
(l) Is the economy’s productive capacity increasing, declining or remaining static over time?
These are the questions which Economists all over the world have been asking – and this is not
peculiar to a particular economic system. Thus, all economies whether capitalist, socialist or
mixed, planned or unplanned, developed or developing must take decisions about these
questions. Economic theory therefore studies how these decisions are arrived at in various
societies.
S.A.Q 1.3 What methods are relevant to economic study? How are these methods used?
Answer
Two methods are generally employed in the formulation of economic generalizations, viz, the
Deductive and the Inductive Methods. In the Deductive Method, we start with a few
indisputable facts about human nature which are general principles and draw inferences
Page 223 of 245

about individual or particular cases. For instance, we assume that self-interest alone governs
human behaviour and we explain or predict the behaviour of a particular individual on this
assumption. The steps followed in the Deductive Method of Inquiry are as follows:
(e) Perception of the problem
(f) Definition of the technical terms and making appropriate assumptions.
(g) Deducing hypotheses through logical reasoning,
(h) Testing or verifying of the hypotheses deduced.
In the inductive method, the relevant information are collected and analysed. On the basis of such
analyses conclusions are drawn. Thus, under the inductive method of inquiry, the tendency is
to move from “particulars” to “generals”. Thus, generalizations are based on the study of
specific crises. Nevertheless find that both the deductive and the inductive methods suffer
from certain shortcomings. Therefore, the solution lies in the application of both so that one
supplements the other. It has to be pointed out that both methods are of great use in
formulating theories.Thus, the true solution of the context about method is not to be found in
the selection of deduction or induction but in the acceptance of deduction and induction. The
methods to be used in a particular situation depend on the nature of the inquiry, the
information base of the inquiry and, of course, the stage of the inquiry
Answers to MCQs of Sessions 1
(1) B (2) A (3) A (4) D (5) C (6) C (7) B (8) B (9) D (10) C
SAQ 2.1: The demand and supply functions of a good are given as:
Page 224 of 245

QD = 5 – P and QS = -3/2 + P
Where P is price, QD is the quantity demanded and QS is the quantity supplied.
(i) Determine the equilibrium price and quantity
(ii) What is the effect on the market equilibrium if government imposes a fixed tax of N2 on the
good? Compare your results in (i) and (ii).
Answer
QD = 5 – P
QS = -3/2 + P
At equilibrium, QD = QS = Qe
5 – P = -3/2 + P
-2P = -3/2 – 5 = - 13/2
P = 13/2 x ½ = 13/4 or 3¼
Substitute for P in either QD or QS
Qe = 5 – P = 5 – 13/4
Qe = 7/4 or 1¾
OR
Qe = -3/2 + P = -3/2 + 13/4 = 7/4 or 1¾
With a tax of N2 on the good, the seller will be charging P – 2. Substituting this into the supply
equation and solving for equilibrium we have:
QD = 5 – P and New QS = -3/2 + (P-2) = -7/2 + P
At equilibrium, QD = QS = Qe
5 – P = - 7/2 + P
Page 225 of 245

-2P = -7/2 – 5 = -17/2
P = 17/2 X ½ = 17/4 or 4¼
New Qe
Qe = 5 – p = 5 – 17/4 = ¾
OR
Qe = -7/2 + 17/4 = ¾
With a tax of N2 per product, price goes up while equilibrium quantity decline.
SAQ 2.2: What do we mean by market equilibrium? What are the forces sustaining the
equilibrium?
Answer
Equilibrium price is the price at which the quantity demanded equals quantity supplied. It is also
known as the market clearing condition.
Price (N)
Excess Supply
50
SS
a
E
30
Page 226 of 245

10 b
Excess Demand
80 200 Quantity
Demand Supply and Equilibrium
Equilibrium condition for the above market is at a price of N30 in which quantity demanded is
equal to the quantity supplied. Below the equilibrium price (say at a price of N20), we have
excess demand. That is, the quantity demanded (120) exceeds the quantity supplied (40). The
numerical value of excess demand at price N20 is (N120 - N40 = N80). At a price above the
equilibrium (say a price of N40), we have excess supply. It exists when the quantity supplied
exceeds the quantity demanded at the ruling price. Numerically, we have excess supply of
(N120 - N40 = N80).
Suppose the price is originally set at N50 a tin, this is surely above the equilibrium price.
Suppliers of milk will supply 160 tins and nobody would buy. This will force the sellers to
cut their prices (say to N40). This cut in price has two effects. It raises the quantity demanded
from zero to 40 tins while it reduces the quantity producers offer to sell to 120 tins. Both
actions reduce the excess supply. The price cutting action will continue until excess supply is
eliminated and equilibrium is achieved.
On the other hand, if the price is below the equilibrium (say N20), 120 tins of milk are demanded
while suppliers only supplied 40. At that price, sellers run out of stock and charge higher
prices to provide additional milk in as much as there is excess demand, sellers will be
motivated to increase charges until equilibrium is attained.
SAQ 2.3: With appropriate examples, explain the law of diminishing marginal utility
Page 227 of 245

Answer
A consumer has diminishing marginal utility from a good if each extra unit consumed, holding
constant consumption of other goods and tastes, add successively less to total utility.
MU
MU (Utils) 4
2 3 4 Loaves of Bread
As you can see in panel above, at lower quantity of loaves’ consumption, marginal utility was
higher than at greater quantities of loaves’ consumption. For instance, at the consumption of
2 loaves, marginal utility was 4 utills. As consumption increased to three loaves, marginal
utility declined to 3 utils. At the consumption of the fourth and fifth units, marginal utilities
declined further to 2 utils and 1 util respectively. This process continues to the point of
saturation in which MU is zero. Further consumption leads to negative utility or disutility.
Answers to MCQs of Sessions 2
(1) C (2) D (3) B (4) A (5) A (6) C (7) D (8) C (9) (10) D (11) B (12) B
(13) A (14) C (15) B (16) C (17) B (18) B (19) B (20) C
Page 228 of 245

SAQ 3.1 Explain the concept of price elasticity of demand
Answers
i) The price elasticity of demand is measured as the percentage change in quantity demanded
divided by the percentage change in price. Demand is price elastic if a change in price causes
a bigger percentage change in demand. It will have a PED of greater than one. Inelastic
demand is when the quantity demanded changes less than the price does. Unitary elastic
demand is when the quantity demanded changes the same percent that the price does.
SAQ 3.2 Explain the concept of price elasticity of supply
Answers
Price Elasticity of Supply (PES) measures the relationship between change in quantity supplied
and a change in price. If supply is elastic, producers can increase output without a rise in cost
or a time delay. If supply is inelastic, firms find it hard to change production in a given time
period. The formula for price elasticity of supply is:
Percentage change in quantity supplied divided by the percentage change in price. The
following rules apply with regard to PES:
• When Pes > 1, then supply is price elastic
• When Pes < 1, then supply is price inelastic
• When Pes = 0, supply is perfectly inelastic
• When Pes = infinity, supply is perfectly elastic following a change in demand
SAQ 3.3 Under what context can we say that demand is perfectly elastic or inelastic?
Page 229 of 245
Answer
Demand is said to be perfectly elastic when quantity demanded skyrockets to infinity as the price
dropped by any amount. While demand is said to be perfectly inelastic when any change in
price there is no change in the quantity demanded. Therefore the demand is completely
unresponsive to any change in price. In this case the demand is said to be perfectly price
inelastic (e = 0).
Answers to MCQs of Study Sessions 3
Questions 1 2 3 4 5 6 7 8 9 10
Answers B D D C D C A D C B
SAQ 4.1: Explain the three stages of production
1. The three stages of production is an extension of law of variable proportion or law of
diminishing returns, it further explain situations when two inputs are used to produce a
certain product, and that one of these production inputs is fixed(land) while the other varies
(labour). However, the result of increasing the variable factor at the initial stage is output to
increase at an increasing rate, this continues until marginal product (MP) equates average
product (AP), this is the end of stage one and begining of stage two, beyond this point output
increases at decreasing rates up to the point where MP is zero and total product(TP) is at
maximum. This point also end stage two and start stage three, which is the stage at which TP
and AP decline contonually and MP negative.
SAQ 4.2: Evaluate the following table;
L Q AP MP
Page 230 of 245

2 20 a b
5 80 c d
7 120 e 20
9 150 16.67 f
11 g h 0
12 140 i j
.
Answer
L Q AP MP
2 20 10 -
5 80 16 20
7 120 17.14 20
9 150 16.67 15
11 150 13.63 0
12 140 11.66 -10
.
Note: the AP is calculated by dividing Q by L while MP is calculated by dividing change in
output by change in number of labour employed.
SAQ 4.3 Graphically show the three stages of production. Which these stages are
economically viable?
Answer
Output
K
Stage II
Page 231 of 245
A
Stage
TP
Stage I
A
The three stage of production. Stage II is the economically viable stage.
Answers to the MCQs of Study Session 4
1.A 2.C 3.C 4.D 5.C
6.B 7.A 8.A 9.A 10. C
SAQ 5.1 List and explain internal economies factors.
Answer
Economies of scale can be ‘internal’ (specific to an individual firm) or external (advantages that
benefit the industry as a whole). The main kinds of internal Economies of Scale are:
Purchasing – firms producing on a larger scale should be able to bulk buy raw materials or
product for resale in larger quantities. They may be able to cut out wholesalers by buying
direct from producers, and transport costs per unit may also be reduced. The firm might also
be buying in large enough quantities to make very specific demands about product quality,
specifications, service and so on, so that supplies exactly match their needs.
Technical – it may be cost-effective to invest in more advanced production machinery, IT and
software when operating on a larger scale.

Page 232 of 245
Managerial – larger firms can afford to have specialist managers for different functions within a
business – such as Marketing, Finance and Human Resources. Furthermore, they may be able
to pay the higher salaries required to attract the best people, leading to better planning and
decision making.
Specialisation – with a larger workforce, the firm may be better able to divide up the work and
recruit people whose skills very closely match the requirements of the job.
Marketing – more options are available for larger firms, such as television and other national
media, which would not be cost-effective for smaller producers. The marketing cost for
selling 10 million items might be no greater than to sell 1 million items. Larger firms might
find it easier to gain publicity for new launches simply because of their existing reputation.
Financial – there is a wider range of finance options available to larger firms, such as the stock
market, bonds and other kinds of bank lending. Furthermore, a larger firm is likely to be
perceived by banks as a lower risk and the cost of borrowing is likely to be lower.
Risk bearing – a larger firm can be safer from the risk of failure if it has a more diversified
product range. A larger firm may have greater resilience in the case of a downturn in its
market because of larger reserves and greater scope to make cutbacks.
Social and welfare – larger firms are more likely to be able to justify additional benefits for
employees such as pension funds, healthcare, sports and social facilities, which in turn can
help attract and retain good employees.
SAQ 5.2 Discuss the three return to scale of production
Page 233 of 245

Answer
In economics, returns to scale describe what happens when the scale of production increases over
the long run when all input levels are variable (chosen by the firm). Returns to scale explains
how the rate of increase in production is related to the increase in inputs in the long run.
There are three stages in the returns to scale: increasing returns to scale (IRS), constant
returns to scale (CRS), and diminishing returns to scale (DRS). Returns to scale vary between
industries, but typically a firm will have increasing returns to scale at low levels of
production, decreasing returns to scale at high levels of production, and constant returns to
scale at some point in the middle .
(A) Increasing Returns to Scale
The first stage, increasing returns to scale (IRS) refers to a production process where an increase
in the number of units produced causes a decrease in the average cost of each unit. In other
words, a firm is experiencing IRS when the cost of producing an additional unit of output
decreases as the volume of its production increases. IRS may take place, for example, if the
cost of production of a manufactured good would decrease with the increase in quantity
produced due to the production materials being obtained at a cheaper price.
(B) Constant Return to Scale
The second stage, constant returns to scale (CRS) refers to a production process where an increase
in the number of units produced causes no change in the average cost of each unit. If output
changes proportionally with all the inputs, then there are constant returns to scale.
Page 234 of 245

(C) Diminishing Return to Scale
The final stage, diminishing returns to scale (DRS) refers to production for which the average
costs of output increase as the level of production increases. The DRS is the opposite of the
IRS. DRS might occur if, for example, a furniture company was forced to import wood from
further and further away as its operations increased.
SAQ 5.3 Explain the concept of diseconomies
Answer
Diseconomies of scale are inefficiencies that can creep in when a firm operates on a larger scale
(do not confuse with high capacity utilization). The main diseconomies of scale are:
Lack of motivation – in larger firms, workers can feel that they are not appreciated or valued as
individuals - e.g. Mayo and Herzberg. It can be more difficult for managers in larger firms
to develop the right kind of relationship with workers. If motivation falls, productivity may
fall leading to inefficiencies.
Poor communication – it can be easier for smaller firms to communicate with all staff in a
personal way. In larger firms, there is likely to be greater use written of notes rather than by
explaining personally. Messages can remain unread or misunderstood and staff are not
properly informed.
Co-ordination – a very large business takes a lot of organizing, leading to an increase in
meetings and planning to ensure that all staff knows what they are supposed to be doing.
Page 235 of 245

New layers of management may be required, adding to costs and creating further links in the
chain of communication.
Evaluation – is bigger better than smaller?
Many firms strive to grow at least partly because of the economies of scale they could enjoy. The
increased efficiency from economies of scale is very compelling in many industries.
Another reason is that they may be able to enjoy market power, with more control over suppliers
and customers. Still another reason is the perceived success of the business simply because of
its growth – this can be especially important for a stock exchange listed company.
Diseconomies of scale do not have to happen as a business becomes larger. Effective management
and organisation can minimise these effects and help to ensure that the benefits of increased
size outweigh any disadvantages. In an exam question, consider what you have learned about
management approaches to organisational structure and motivation to show how a firm could
overcome diseconomies of scale.
Smaller firms are not necessarily at a disadvantage in all markets. In some markets, economies of
scale are not available or not compelling enough for large firms to dominate. This is often the
case with small local businesses, such as hairdressers and plumbers. Furthermore, small
businesses can succeed simply by identifying a niche market and by serving it really well.
Smaller firms can be more flexible and may be able to adapt quickly to changes in their
markets or in the economy.
Page 236 of 245

1.C 2.A 3.A 4.A 5.B
6.D 7.C 8.C 9.C 10. B
SAQ 6.1Determine the value corresponding to the missing spaces.

0 350 a b ---------- c d e
1 500 f g h i j k
2 680 l m 180 n o p
3 q r s 100 t u v
4 850 500 w x 212.5 125 87.5
5 850 500 y A B 100 C
6 D 550 z E 150 F G
Answer

0 350 0 350 ----- ------ ------- -------
1 500 150 350 150 500 150 350
2 680 330 350 180 340 165 175
3 780 430 350 100 253.3 143.3 116.67
4 850 500 350 70 212.5 125 87.5
5 850 500 350 0 170 100 70
6 900 550 350 50 150 91.67 58.67
b) Given that the total revenue of firm is N120000 and that its fixed and variable costs calculate
the profit;
Page 237 of 245

Differentiate between accounting concept of cost and the economics concept of cost.
SAQ 6.2 (a) Differentiate between implicit and explicit cost.
Answer
Implicit cost is the opportunity cost in production concept, it refers to the cost of alternative
foregone while explicit cost is the money cost of production, that is , the cost accrued to all
factor inputs including the coordinator of other inputs (entreprenuer), in other word any
expenditure in monetary term that could be linked to production of goods or services is
referred to as explicit cost.
SAQ 6.2 (b) Given that the total revenue of firm is N120000 and that it’s fixed and variable costs
calculate the profit;
Profit is total revenue less total cost.
the revenue is given by N120,000
The Profit in economics concept
Profit = TR - TC = 120,000 - (implicit + explicit costs)
= 120,000 - (78,900 + 18,450) = 120,000 - 97,350 = 22,650
Profit = 22,650
The Profit in accounting concept
Profit = TR - TC = 120,000 - explicit costs
Profit = 120,000 - 78,900 = 41,100

Page 238 of 245
Profit = 41,100
Note
Explicit cost = Fixed cost + Variable cost
SAQ .3 what is average variable cost?
Answer
more variable resources to produce each additional unit of output. In symbols: AVC =
TVC/Q or AVC = AC - AFC
Cost
AVC
O
Q
Page 239 of 245
1.D 2.A 3.A 4.C 5.C
6.D 7.A 8.D 9.C 10. B
SAQ 7.1 A competitive market has free entry and exit. Why is free exit important?
Answer
Free entry and exit allow us think about each period separately. If exit becomes costly, a potential
firm will have to make a long run decision from the outset. Amidst the opportunity to make
abnormal profits during the period after an entrant joins the industry, the entrant has to think
about its duration in the market and whether the cumulative profit is sufficient to pay the cost
of exit if the market situation becomes bleak.
SAQ 7.2 How do economics try to narrow down the assumptions that firms make about their
competitors concerning output decision and equilibrium?
Answer
In determining price and output, the firm has to take into account the action of its competitors.
Similarly with competitors, the decisions depend on the action of other firms. Since firms’
decisions depend on the behaviour of their competitors, the only guess about rivals’
responses are ones that are profit maximising for them
Page 240 of 245

(1) C (2) D (3) A (4) D (5) C (6) A (7) D (8) A (9) C (10) B
SAQ 8.1 Explain Factor Market and Factor Prices
Answer
Factor markets and factor prices play a key role in one of the most important processes that must
take place in any economy: the allocation of resources among producers. For example, if
there is a natural disaster, the government of Nigeria will urgently need workers, carpenters,
plumbers, engineers and so on— to repair or replace damaged homes and businesses. What
guarantees that the needed workers will be paid? The factor market: the high demand for
workers drives up wages. In this sense factor markets are similar to goods markets, which
allocate goods among consumers. There are two features that make factor markets special.
Unlike in the goods market, demand in a factor market is what we call derived demand. That is,
demand for the factor is derived from the firms output choice. The second feature is that
factor markets are where most of us get the largest shares of our income (government
transfers being the next largest source of income in the economy). Let us now consider some
big ideas and concept in the factor markets.
SAQ 8. 2 Explain how changes in price of goods and technology affect shifting of the factor
demand curve.
Answer
Changes in prices of goods
The price of a good sold in the product market affects the value of MRP as well as the final
equilibrium point between MFC and MRP. Remember that factor demand is derived demand:
if the price of the good that is produced with a factor changes, so wills the value of the
Page 241 of 245

marginal product of the factor. That is, in the case of labor demand, if P changes, VMPL = P
× MPL will change at any given level of employment.
b. The change of the MP curve also depends on:
o the level of technology used in production ;
o the degree of diminishing returns which partly depends on the amount of fixed factors used ;
o other factors that affect technology and fixed capital, e.g. interest rate.
b. The elasticity of demand of the final product ;
c.The share of the labour cost to the total cost : the greater the share, the more elastic the demand ;
d.The ease of factor substitution: the rate of technical substitution between labour and capital
matters in determining the demand for factors of product.
Changes in Technology
In general, the effect of technological progress on the demand for any given factor can go either
way: Improved technology can either increase or reduce the demand for a given factor of
production. How can technological progress reduce factor demand? Consider the demand for
receptionist or secretary, which was once an important factor of production. The
development of substitutes for receptionist such as computers greatly reduced the demand for
receptionist. The usual effect of technological progress, however, is to increase the demand
for a given factor. In particular, although there have been persistent fears that machinery
would reduce the demand for labor, on the long run the Nigerian economy has seen both
large wage increases and large increases in employment in some sectors of the economy,
suggesting that technological progress has greatly increased labor demand.
Answers to MCQs of Study Sessions 8
(1) D (2) A (3) B (4) D (5) A (6) B (7) B (8) A (9) B (10) A
Page 242 of 245

SAQ 9.1 What is Functional Distribution of Income?
Answer
The functional approach to the theory of distribution further explain the prices of factors of
production i.e land, labour, and capital, It captures the demand for land, labour, and capital as
derived demand. (The demand for a particular product that is necessitated by the
presence/availability of another product; especially when they are used together). This is
further explained by the act of an entrepreneur demanding land, labour, and capital because
he needs them in the production of goods and services. It is to be noted that the production
process is impaired upon greatly when one or all of this factors are not available, hence the
relationship between the theory of distribution and the theory of production, this relationship
between the theory of production and distribution theory is explained more by neoclassical
theory which we shall looking at right away.
SAQ 9.2 How is capital rewarded?
Answer
The reward of capital as a factor of production is interest. The amount of interest earned by capital
is a function of the marginal productivity of capital, which is in turn a function of the level of
capital stock and the rate of accumulation of capital stock. While addition to capital in the
form of net investment increases the stock of capital, it also reduces the marginal
productivity of capital and, hence, interest as reward for capital. Thus, while additional net
investment may add to capital stock and even profit, it would often lead to lower interest
income for every additional capital employed. Hence, the marginal productivity of capital is
Page 243 of 245

the major determinant of the distributive share of capital in income distribution, although the
influences of government fiscal policies, saving activities of households and lending
decisions of banks cannot be discountenanced.
Answers to MCQs of Study Session 9
(1) A (2) C (3) D (4) C (5) B (6) C (7) D (8) D (9) C (10) D
SAQ 10.1 Identify and discuss Robbins criticism of Marshallian definition of
Welfare Economics
Answer: (i) Narrow down the scope of Economics (ii) Classificatory and Impractical (iii) Welfare
is a vague concept (iv) Relation between economics and welfare
SAQ 10.2 Identify and discuss the major features of the Marshallian definition of
Welfare Economics
Answer: (i) Wealth is not the be-all and end-all of economic activities (ii)Study of an ordinary
man (iii) Economics is a Social Science (iv) Economics does not study all part of man (v)
Study of material welfare
Answers to MCQs of Study Session 10
D (2) A (3) C (4) A (5) C (6) A (7) A (8) D (9) C (10) B
via the LMS.
Page 244 of 245

08033366677
Page 245 of 245

Microsoft Word - ECN 111 PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Microsoft Word - ECN 111 PDF

Uploaded by

Copyright:

Available Formats

DISTANCE LEARNING INSTITUTE

CONTENT EDITOR: DR. S.O. AKINLEYE

LANGUAGE EDITOR: DR. NTEKIM-REX

Study Session 1: Nature and Scope of Economic theory 12

1.1 The Economic Problem: Scarcity and Choice 12

1.2 The Methodology of Economics 21

1.2.1 Deductive Method 21

1.2.2 Inductive Method 22

1.2.3 Integration of the Two Methods 23

1.2.4 Economic Assumptions 24

1.2.5 The Concept of Equilibrium 25

1.2.6 Micro and Macro Analysis 27

Study Session 2: Consumer Behaviour 34

2.1 The Market 36

2.2 Demand, Supply and Equilibrium 36

2.3 Shifts in the Demand Curve 41

2.4 Shifts in the Supply Curve 42

2.5 Free Markets and Price Controls 42

2.6 Utility Theory 45

2.7 The law of Diminishing Marginal Utility 47

2.8 Equilibrium and the Consumer 48

2.9.1 Characteristics of Indifference Curve 50

2.9.2 Indifference Maps 50

2.9.3 The Marginal Rate of Substitution 50

2.9.4 The Budget Constraint 51

2.9.5 Consumers Equilibrium 52

Study Session 3: Elasticity of Demand and Supply 59

3.1 Elasticity of Demand 59

3.1.3 Types or Forms of point Elasticity of Demand 63

3.2 Income Elasticity of demand 68

3.2.1 Types of Income Elasticity of Demand 69

3.2.2 Illustration of Income Elasticity of Demand 70

3.2.3 Interpretation of the Income Elasticity of demand 72

3.2.4 Reason a Firm Wants ……. 72

3.3 Cross Elasticity of Demand 73

3.4 Determinants of Elasticity of Demand 76

3.5 Measurement of Elasticity 78

3.6 Elasticity of Supply 79

3.6.2 Types or Forms of Elasticity of supply 81

3.6.3 Factors that Influence the Elasticity of Supply 85

3.7 Useful Application of price Elasticity of Demand and Supply 85

Study Session 4: Introduction to the Theory of Production 92

4.1 Definition and Types of Production 93

4.2 The Factors of Production 93

4.3 The Time Horizons (Production Periods) 94

4.4 The Concept of Product 95

4.5 The Three Stages of Production 95

4.7 The Production Functions (Functional analysis) 98

Self-Assessment Questions 103

Study Session 5: Introduction to the Economies of Scale 104

5.1 The concept of Economies of Scale 104

5.2. The Internal and External Economies of scales 105

(This is a Long-Run Concept) 110

5.7 The Concept of Return to Scale 112

5.8 Economies of Expansion 113

Self-Assessment Questions 114

Study Session 6: Introduction to Theory of Costs. 118

6.1 Concepts of Costs 118

6.2 Production Costs in the Short Run 122

6.3 Behind every Cost Curve is a Socioeconomic Environment 124

6.5 The Algebraic Derivation of Cost Functions 131

Self-Assessment Questions 133

Maximizing Firms 137