MICROECONOMICS READING MATERIAL

Course Instructor: Saungweme Talknice

E-mail: [email protected]
Mobile: +263 772 685 837 / 715 109 838

INTRODUCTION TO ECONOMICS

The Economic Problem

▪ Economics is the study of the use of scarce resources to satisfy unlimited human wants.
▪ Human wants refer to various goods and services that we desire to have that give us some
satisfaction.
▪ Luxuries or ‘wants’ are all those commodities that we can do without e.g. perfumes.
▪ Necessities or needs are those that we cannot do without e.g. food, water shelter and
clothing.

NB: The classification differs from individual to individual, from time to time and from
society to society.

Economics as a Science

•It involves a systematic attempt to discover regular patterns of behaviour.

•It helps in explaining certain phenomena, predict the future and assist in policy formulation.
•Economics is a social science as it studies human behaviour.
•It utilises the scientific methods in analysing human behaviour.

Methodology of Economics

•The first step in the study of economics is to gather facts i.e. descriptive economics.
•The second step is the derivation of principles from facts i.e. economic theory or analysis.
This involves the systematic arrangement, interpretation and generalisation of facts.
•Finally, the theory is used formulating policies i.e. applied economics.
•To achieve this, economists make use of models which is a simplified picture of reality.

Assumptions

•In order to abstract from reality, we make use of simplifying assumptions.

•Ceteris paribus a Latin term meaning ‘all things being equal’.
•We assume that all other variables are held constant except the one under consideration.

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Induction Vs Deduction

•Induction involves the distillation of principles from facts. It begins with an accumulation of
facts which are then arranged systematically and analysed so as to permit the derivation of
principles.
•Induction moves from facts to the theory, from particular to general.
•Deduction begins at the level of theory and proceeds to the verification or rejection of theory
by appealing to facts.
•Deduction goes from the general to the particular, from theory to facts.

Positive vs Normative Economics

•A positive statement is an objective statement of fact i.e. what is. These can be proved by
looking at facts
•A normative statement involves an opinion or value judgement i.e. what ought to be. These
can be debated but they can never be settled by appealing to facts.

Microeconomics vs Macroeconomics

•Microeconomics focuses on individual parts of the economy e.g. individual consumers,

households, firms or other organisation.
•Macroeconomics is concerned with the economy as a whole. It involves the study of the
overall, total or aggregate economic behaviour e.g. total production, income and expenditure,
economic growth etc.

Scarcity, Opportunity Cost and the Inevitability of Choice

•Goods are tangible while services are intangible.

•Human wants are insatiable or unlimited. They can’t be fulfilled using the available resources.
•Resources can be natural endowments (land), human (labour) or manufactured aids to
production (capital) i.e. the factors of production.
•Scarcity implies that the available resources can’t meet ALL of our wants; hence a choice has
to be made.
•Making choices entail some costs as something else has to be sacrificed.

Opportunity Cost

•The cost of using resources for certain purpose, measured by the benefit given up by not using
them in their best alternative use.
•The cost of a good in terms of the next best alternative foregone.
•Economists consider both explicit costs (accounting costs) and implicit costs (opportunity
cost).

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The Production Possibilities Curve

•The production possibilities frontier (PPF) illustrates scarcity, choice and opportunity cost.
•Consider and economy with fixed resources, fixed technology, efficient and producing only
two goods e.g. fish and potatoes.
•Employing all of its resources towards fishing, the society can have 5 baskets (per day), or if
gardening will produce 100kg of potatoes.
•Resources can be shifted from one production possibility to produce the other (as shown in
the table below).

Production Possibilities Table

Possibility Fish (baskets/day) Potatoes

A 0 100

B 1 95

C 2 85

D 3 70

E 4 40

F 5 0

•The combinations represent the maximum amounts that can be produced with all the available
resources.

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The Production Possibilities Curve

•The PPC indicates the combinations of any two goods or services that are attainable when the
community’s resources are fully and efficiently used/ employed.
•It is a boundary between the attainable and the unattainable output combinations.
•Combinations along the PPC are efficient.
•Combinations to the right of the PPC are desirable but unattainable.
•Combinations inside the PPC are attainable but inefficient.

Scarcity, Choice and Opportunity Cost (once more)

•Scarcity is indicated by the unattainable combinations above the boundary.

•Choice by the need to choose among alternative attainable points on/inside the PPC
•Opportunity cost by the negative slope of the PPC i.e. when we move along the PPC, we trade
a unit of one good for unit(s) of the other good.
•The opportunity cost of a good increase as we move along the PPC i.e. the PPC is concave to
the origin.

Economic Growth

•With changes in the quantity and quality of resources, the production possibilities curve will
shift position i.e. the potential total output will change.
•Expanding resource supplies: the PPC will shift outwards and to the right.

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•Technological advance: results in new and better goods and improved ways of producing these
goods. It allows society to produce more goods with a fixed amount of resources through
improvements in productive efficiency.
•Economic growth: the ability to produce a larger total output.

Economic Growth and the PPC

Economising: The Five Fundamental Questions

•What to produce?
•How to produce?
•For whom?
•How much to produce?
•How should the system be adapted to change?

•Three central questions are What, How and For Whom to produce?

What to Produce?
•This deals with which goods and services to produce given scarce resources.
•Goods can be consumer goods or capital goods.
•Consumer goods are goods that are used by individuals or households to satisfy wants e.g.
food, clothing, furniture etc.

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•Capital goods are goods that are used in the production of other goods e.g. plant and
machinery, roads, dams etc.

Categories of Consumer Goods

•Non-durable- goods that are used once only e.g. food items, medicine, tobacco etc.
•Semi-durable- goods that can be used more than once but have a short life span e.g. shoes,
clothing, tyres etc.
•Durable- goods which normally last for a number of years e.g. furniture items, motorcars,
washing machines etc.

Further Distinctions
•Final goods vs. intermediate goods
•Private goods vs. public goods
•Economic goods vs. free goods
•Homogenous vs. heterogeneous

How to Produce?
•Method of production i.e. labour intensive or capital intensive.
•How to combine the four factors of production to produce the required goods?
•Four factors are land (natural resources), labour, capital and entrepreneurship or organisation.
•Choice of the best methods of production.
•This will depend on the relative costs of the factors of production among other things.

Natural Resources (Land)

•All gifts of nature including mineral deposits, water, arable land, forests and vegetation etc.
•These are fixed in supply.
•Exploitation of natural resources is of major concern globally.

Labour

•The exercise of human mental and physical effort in the production of goods and services.
•The quantity of labour available will be affected by such factors as size of the population,
gender distribution, demographic features and the proportion of the population that is able and
willing to work.
•Human capital refers to skills, knowledge and workers’ health

Capital
•Manufactured resources such as machines, tools, buildings which are used in the production
process.
•The sacrifice of current consumption in favour of future consumption.
•Capital goods have a limited life span due to depreciation.
•Some capital equipment may become obsolete because of technological progress.

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Entrepreneurship
•The combination and organisation of the other three factors of production.
•Business involves risks and they are borne by the entrepreneurs.

Technology

•Knowledge on the ways of production.

•Inventions and innovations lead to new ways of production.

For Whom to Produce?

•How to distribute the final output?
•Who will get the goods?
•The distribution of goods and services depend on the distribution of income.

THE ECONOMIC SYSTEMS

•Economic system refers to a pattern of organisation which is aimed at solving the three central
questions of what, how and for whom?
•Different countries have different methods of tackling the economic problem.
•There are three main types of economic systems.

a) The Command System

•The solutions to the economic problems are provided by a central authority.

•Also called centrally planned as everything is governed and coordinated by a central authority.
•Planners determine what to produce, how to produce and how to distribute.
•Command economies are characterised by state ownership of all goods, services and the
factors of production (save for labour).
•Resources are publicly owned and business firms are governmentally owned and produce
according to state directives.
•The USSR and North Korea are examples of command economies. The government sets
output targets for each district and factory and allocates the necessary resources. Incomes are
often more evenly spread out than in other types of economy.

b) The Market System

•There is private ownership of resources.

•Freedom of enterprise and choice.
•The markets and prices coordinate and direct economic activity i.e. reliance on the price
system.

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•There is self-interest as the dominant motive-: each economic unit seeks to maximise its
income through individual decision making.
•There is competition or economic rivalry.
•There is limited or no government intervention.
•The USA and Hong Kong are examples of market economies where firms decide the type and
quantity of goods to be made in response to consumers’ needs.

c) Mixed Economies

•In a mixed economy, privately owned firms generally produce goods while the government
organises the manufacture of essential goods and services such as education, health care,
energy and communication.
•The Zimbabwean economy is a good example of a mixed economy because it has both
privately owned firms and parastatals (that produce goods and services that are perceived to be
of strategic importance to the economy).

MARKET INTERACTION

THE PRICE SYSTEM

The Price Mechanism

•“The invisible hand”, A. Smith (1776)
•The price act as an allocative, rationing and signalling device.
•It answers the three central questions.
•The act of buying is indeed placing a ‘dollar vote’ for the production of a commodity.
•There is consumer sovereignty or the consumer in king.

Demand, Supply and Market Equilibrium

Demand for Commodities
•The amount of a commodity that consumers are willing and able to purchase at a given price
over a specific period of time.
•Demand has to be effective i.e. willingness backed by ability to pay.
•Demand can be expressed in words, schedules (or numbers), curves (graphs) and equations.
•It is a microeconomic concept.

Individual Demand

Determinants of Demand
a) The price of the product-: The lower the price of a commodity, the higher the quantity that
a consumer is willing and able to buy, ceteris paribus.
b) Prices of related goods-: The direction of change will depend on the type of good in question.
i. Complements-: goods that are jointly demanded e.g. bread and margarine or jam.
ii. Substitutes-: competing goods e.g. butter and margarine; white and brown bread etc.

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c) The Income of the consumer-: Income determines the consumer’s purchasing power.
•For most commodities, a rise in income will cause an increase in demand.
•Goods can either be superior (normal), inferior or “Giffen”.
d) Tastes or Preferences-: A change in consumer tastes or preferences may result in a change
in demand. A favourable will mean more will be demanded at each price while an unfavourable
will cause a decrease in demand.
•The effect can hence be negative or positive.
•Advertising and technological change may change tastes.
e) Expectations-: Expected changes in future prices may prompt consumers to change their
demand.
•Expectations about increase in future prices may cause consumers to ‘hoard’ i.e. to buy now
in order to beat the anticipated price rise.
•Expectations of falling prices or incomes will tend to decrease current demand.
f) Size of the Household-: there is a positive relationship i.e. the bigger the size of the
household, the higher the demand, ceteris paribus.
All in all the quantity demanded depends on the price of the good, the prices of related goods,
the income of the household, tastes, expectations and the size of the household

•Mathematically;
Qd = f ( Px , Pg , Y , T , N ...)
Qd = f ( Px , P1, P2 ,.....Pn , Y , T , N ...)

where Qd = quantity demanded of good x

Px = price of good x
Pg = price of related goods
Y = household income
T = Tastes of the consumer(s)
N = Household size
… = allowance for other factors.

The law of Demand

•All else being equal, as the price falls, the corresponding quantity demanded goes up.
•Alternatively, as the price increases, the corresponding quantity demanded falls.
•There is an inverse relationship between price and quantity demanded.
•Ceteris paribus, the higher the price of a good, the lower is the quantity demanded.

The Demand Schedule

•A table showing quantities demanded at different prices, ceteris paribus.
•Consider the following hypothetical table:

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 Possibility Price (R/kg) Quantity demanded
(kgs/week)
A 1 6
B 2 5
C 3 4
D 4 3
E 5 2

The Demand Curve

•Graphical illustration of the demand schedule.

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Price
(R/kg) 5
4
3
2
1
0
0 2 4 6 8
Quantity Demanded
(kgs/week)
The Market Demand
•Horizontal summation of individual demands of different consumers.

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The Market Demand curve
•Horizontal summation of individual demand curves
•Add the quantities demanded at each and every price level.
•The market is the sum of individual demand curves.
•Fallacy of composition

Quantity demanded

Movements along the Demand Curve

•This result in a change in quantity demanded
•Changes in quantity demanded are caused by changes in the price of the good.
•We compare points on a relevant demand curve.
•Price is the only factor that is changing i.e. all other variables are held constant.

A movement along a demand curve

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Shift in the Demand Curve
•Referred to as a change in demand.
•A change in any of the determinants of demand other than the price of the product will shift
the demand curve.
•The demand curve shifts wholly parallel to itself either to the right or to the left.
•The slope does not change but only the position of the demand curve.

Change in Income
•For normal or superior goods, an increase in income leads to an increase in demand.
•There is positive relationship.
•For inferior goods, an increase in income leads to a decrease in quantity demanded.
•There is an inverse relationship between income and demand for an inferior good.

The Supply of Commodities

•The amount of a commodity or product which producer is willing and able to produce or make
available for sale in the market at each specific price over a given period of time.
•It is what producers plan to sell at each possible price during a given period.
•Supply, like demand, is a flow.
•Can be expressed in words, schedules (numbers), curves (graphs) or equations.
Individual Supply

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Determinants of Supply
•The Price of the commodity-: The higher the price, the greater the quantity supplied, ceteris
paribus.
•As the price rises, the quantity supplied rises; as the price falls, the quantity supplied also falls.
•There is a positive relationship between the price and quantity supplied i.e. the law of supply

Other Determinants of Supply

a)Prices of other goods-: A change in the price of related goods will cause a change in the
supply of a commodity.
•The direction of change depends on the type of good in question.
•Complements-: Goods in joint supply i.e. the supply of one good entails the supply of the other
e.g. beef and hides, cell phones and cell phone battery chargers etc. Positive relationship
•Substitutes-: Goods that compete for the same factors of production e.g. corn and wheat.
•There is a negative relationship e.g. if the price of wheat increases, farmers will offer more
wheat at the market.
b) Prices of factors of production and technology-: These will affect directly the costs of
production. Increases in the price(s) of the factor(s) of production increases the costs and hence
reduce supply.
•A reduction in the costs of production maybe through technological advancement will increase
supply.

Number of Sellers
•The larger the number of suppliers, the greater will be the market supply.
•As firms enter the market, supply will increase and the curve will shift to the right.
•The smaller the number of suppliers, the less the market supplies.
•As firms leave an industry, the supply curve will shift inwards and to the left.

Expected future prices

•Expectations concerning future prices of the product also affect the current supply.
•The direction cannot be easily generalised.
•Mainly witnessed in the supply of non-perishable agricultural produce e.g. corn. An
expectation of higher prices will affect current supply as farmers will with hold some of their
produce in anticipation of higher prices.
•Expected price increases may induce firms to expand production immediately, causing supply
to increase.

Market Supply
•Derived from the horizontal summation of individual supply curves.
•Sum across at each and every price level.

•Mathematically:
Qs = f ( Px , Pg , Pf , Pe , Ty , N ...)
where Qs = quantity supplied in the market

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Px = price of the product
Pg = price of alternative products
Pf = price of factors of production
Pe= price expectations
Ty = technology
N = number of firms supplying the product.

Diagrammatically

Movements along the Supply Curve

•Caused by changes in the price of the commodity ceteris paribus.
•If the price increases from say R2 to R3 (i.e. from point b to point c), quantity supplied
increases from 2kgs to 3kgs per week.
•Contrarily, if the price falls from R3 to R2, then quantity supplied falls from 3kgs to 2kgs per
week.
•Any price change will result in change in quantity supplied

Shifts in Supply
•If one of the determinants of supply changes, the whole supply curve will shift.
•This is referred to as a change in supply.
•The supply curve shifts either to the right or to the left maintaining its slope.
•It will shift parallel to itself.
•Any factor that will lead to more being supplied at each and every price will shift the supply
curve to the right.
•Any factor that leads to less being supplied at each and every price level will shift the supply
curve to the left.

Market Equilibrium

•Quantity demanded is equal to quantity supplied i.e. buyers’ plans coincide with the plans of
the sellers.
•The price is called the equilibrium price and the quantity is equilibrium quantity.
•At any other price there will be disequilibrium i.e. either excess demand or excess supply.
•When Qd > Qs, there will be a shortage or excess demand.
•When Qd < Qs, there will be a surplus or excess supply.
•Market forces will drive the price to its equilibrium position.
Market Demand and Supply Schedules

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Demand, supply and market equilibrium

Changes in Demand
•An increase in demand will result in an increase in the price of the product and an increase in
quantity sold, ceteris paribus.
•The increase will be as a result in a change in one of the determinants of demand other than
the price of the product.
•Supply remains unchanged, but the quantity supplied will increase as the price increases.
•The demand curve shifts upwards and to the right

Factors for an increase in Demand

•An increase in the price of a substitute good.
•A decrease in the price of a complementary product.

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•An increase in the consumers’ income (normal goods) or a decrease in consumers’ income
(inferior goods).
•A greater consumer preference for the product.
•An expected increase in the price of the product.
•A decrease in demand will result in a decrease in the price of the product and a decrease in the
quantity sold, ceteris paribus.
•Supply again remains unchanged but quantity supplied will contract.
•The demand curve shifts inwards and to the left.

Factors for a decrease in Demand

•A fall in the price of a substitute product.
•An increase in the price of a complementary product.
•A fall in consumers’ incomes (normal goods) or a rise in consumers’ incomes (inferior goods).
•A reduced preference for the product.
•An expected fall in the price of the product.
Changes in Supply
•An increase in supply will result in a fall in the price of the product and an increase in quantity
exchanged, ceteris paribus.
•The supply curve shifts downwards and to the right.
•The shift could be as a result of a change in any of the determinants of supply other than the
price of the product.
•Demand remains the same, but quantity demanded increases.

Factors for an increase In Supply

•A fall in the price of an alternative product or a rise in the product of a joint product.
•A reduction in the price of any of the factors of production or other inputs (i.e. a decrease in
the cost of production.
•An improvement in productivity of the factors of production.

A Decrease in Supply
•Will result in an increase in the price of the product and a decrease in the equilibrium quantity,
ceteris paribus.
•The supply curve will shift upwards and to the left i.e. fewer goods are supplied at each price.
•Demand will remain the same, but equilibrium quantity will decrease.
•The shift could be as a result of a change in any one of the determinants of supply other than
the price of the product.

Factors for a Decrease in Supply

•An increase in the price of an alternative product or a fall in the price of a joint product.
•An increase in the price of any one of the factors of production or other inputs (i.e. an increase
in the cost of production).
•A deterioration of the productivity of the factors of production (which raises the cost of
production).

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Simultaneous Changes
•Both demand and supply change at the same time.
•The outcome is not straight forward as this depends on the relative magnitudes of the changes
in demand and supply.
•Analyse the following situations:
–An increase in demand associated with a decrease in supply.
–An increase in demand associated with an increase in supply.
–A decrease in demand associated with an increase in supply.
–A decrease in demand associated with a decrease in supply

ELASTICITY OF DEMAND AND SUPPLY

Elasticity

•A measure of the responsiveness of one variable to changes in another variable.

•The most encountered measures of elasticity in economics are:
a) Price elasticity of demand.
b) Income elasticity of demand.
c) Cross price elasticity of demand.
d) Price elasticity of supply.

Price elasticity of demand (PED)

•Measures the responsiveness of quantity demanded to change in the price of the product.
•It is the percentage change in quantity demanded if the price of the product changes by one
percent, ceteris paribus.
•It is equal to percentage change in quantity demanded over percentage change in the price of
the product.
•Elasticity is a relative concept free of units.

Calculating Elasticity

•Recall that price elasticity is equal to percentage change in quantity demanded over the
percentage change in the price.

•=> Q Q
x100
Q Q Q P
ep = = = x
P P P Q
x100
P P
•Due to the inverse relationship between price and quantity, elasticity is negative.

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Example:
Suppose that at a price of $100 monthly sales of bicycles in a city are 2000. Next month the
price of a bicycle goes up to $101. As a result of a price increase the quantity of bicycles
demanded per month falls to 1990. Calculate PED

ΔQ 1990− 2000
× 100= × 100= − 0 . 5
The percentage change in quantity demanded is Q 2000 .

ΔP 101− 100
× 100= × 100= 1
The percentage change in price is therefore P 100

PED=0 . 5÷ 1= 0 .5

Categories of Price Elasticity

•Perfectly inelastic demand (ep = 0)
–Represented by a vertical demand curve parallel to the price axis.
•Inelastic demand (0 < ep < 1)
–Quantity changes in response to changes in the price but by a less than proportionate change
in the price.
–Represented by a steep but downward sloping demand curve.

Perfectly Inelastic and an Inelastic

•Unit Elastic demand (ep = 1)

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–A change in price will bring about a proportionate change in quantity demanded.
–Represented by a rectangular hyperbola

•Elastic demand (1 < ep < ∞)

–A change in the price will lead to a more than proportionate change in quantity demanded.
–Represented by a flat demand curve.

Unitary and Elastic Demand

•Perfectly elastic demand (ep > ∞)

–Represented by a horizontal demand curve i.e. a percent change in the price will lead to an
infinity change in quantity demanded.
–Perfectly competitive firms face such demand curves.

Determinants of price Elasticity of Demand

a) Substitutability-: The larger the number of close substitutes, the greater the price elasticity
of demand, ceteris paribus.

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–This also depends on how narrowly the good is defined for example the demand for lux is
more elastic than the demand for the overall demand for bath soap.
–The broadly defined a good is, the less elastic it is.
b)The degree of Complementarity of the product-: Highly complementary goods tend to have
a low price elasticity of demand as their demand heavily depends on the demand of the other
good.
c)Type of want satisfied by the product-: The price elasticity for necessities like basic
foodstuffs, medical care tends to be lower than that for the luxury goods like recreation,
entertainment, jewellery items etc.
d)The Proportion of income-: Ceteris paribus, the greater the proportion of income spent on a
product, the greater the elasticity of demand.
–Expenditure on products such as matches, paper clips, chewing gum etc. constitutes a small
share of consumer’s budget so a change in the price will have a negligible effect on quantity
demanded.
–An increase in the price of cars will have a significant effect on the quantity of cars demanded
as it takes up a bigger chunk of the consumer’s income.
e) Time Period under Consideration-: Demand tend to be elastic in the long run than in the
short run e.g. the price elasticity of airline tickets.
f) Advertising and brand loyalty-: heavily advertised products with strong brand loyalty tend
to be inelastic.
g) Durability-: The more durable a product is the more elastic the demand will tend to be,
ceteris paribus.
h) Number of uses of the product-: The greater the number of uses of the product, the greater
elasticity of demand will tend to be.
i) Addiction or Habit formation-: Products that are habit forming tend to be relatively less
elastic.

NB. The factors may act and reinforce each other e.g. the elasticity of demand for salt is partly
affected by the fact that salt is a necessity with few substitutes and also uses a small fraction of
the consumer’s income.

Income Elasticity of Demand (YED)

Income elasticity of demand is the degree of responsiveness of quantity demanded to changes
in income.

ΔQ ΔY ΔQ Y
YED= ÷ = ×
Q Y ΔY Q
If YED>0 normal good
If YED<0 inferior good
If YED=0 income elasticity for goods whose consumption is completely unresponsive to
changes in income e.g. necessities like salt.
If YED>1 luxury goods, because as income increases the share of those goods also
increases. (e.g. foreign travel)

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Example.
Suppose the consumer is consuming apples and oranges. Price of an apple is $5 and the price
of an orange is $40. The demand for apples is 56 units while the demand for oranges is 87
units. The consumer has an income of $200. Suppose the consumer's income increased to
$300 while the demand for oranges has decreases to 70 units and the price of apple has
decreased to $2.
(a) Calculate the income elasticity of demand for oranges.

ΔQ ΔY 70− 87 300− 200 − 0 . 2

YED= ÷ = ÷ = = − 0.4
Q Y 87 200 0.5

Cross elasticity of demand (ec).

•Measures the responsiveness of quantity demanded of a particular good to changes in the
price of a related good.
•It is the percentage change in quantity demanded of a good (say x) over percentage change in
the price of another commodity (say y).
•It is the degree to which quantity demanded of one good responds to changes in the price of
another good. It may be therefore expressed as follows:
% Qx
ec =
% Py
•For unrelated goods, ec = 0
•For substitutes (e.g. Butter and margarine), the cross price elasticity of demand is positive.
•A change in the price of one product will lead to a change in the same direction in the quantity
of the substitute product.
•For compliments, the cross price elasticity of demand is negative. A change in the price of one
product will lead to a change in the opposite direction in the quantity of the complement.

•Significance of elasticity
If the demand curve is inelastic then a decrease in price will lead to a fall in revenue and vice
versa. A decrease in price will increase revenue if the product’s demand is elastic and an
increase in price will reduce revenue.

•E.g. Government will always wish to tax inelastic goods e.g. cigarettes and alcohol because a
tax on this type of goods does not reduce demand very much.

The Price Elasticity of Supply

•Measures the responsiveness of the quantity supplied of a product to changes in the price of
the product.
•It is equal to percentage change in quantity supplied over the percentage change in the price
of the product.
•Price elasticity is positive as the quantity supplied usually increases as the price of the product
increases.

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•The tomato farmer can buy more land; buy new tractors and so on. This will increase the
production capacity.

CONSUMER BEHAVIOUR
CONSUMER AND MARKET BEHAVIOR
The concept of utility can help us understand two related aspects of consumer behavior.
a) It enables us to predict how an individual will allocate his expenditure, given a fixed income
between goods and services available for consumption.
b) It enables us to predict the effect of a price change on the quantity demanded of a good and
so confirms the law of demand.

TOTAL AND MARGINAL UTILITY

UTILITY is the satisfaction people get from consuming (using) a good or a service. Utility
varies from person to person. Some people get more satisfaction from eating chips than others.
Even the same person can gain greater satisfaction by eating chips when hungry than when he
has lost his appetite.

We must assume that it is possible to quantify and measure changes in satisfaction or utility.
For this purpose a “util” will be used as a measure for utility. In reality, utility is a
psychological concept and its subjective nature makes it unmeasurable. Nevertheless, we shall
ignore this and proceed as if utility can be measured in utils just like distance can be measured
in meters or temperature in degrees. The standard util is totally imaginary.
TOTAL UTILITY represents the satisfaction gained by a consumer as a result of his overall
consumption of goods.
MARGINAL UTILITY represents the change in satisfaction resulting from the consumption
of a further unit of a good.
Assuming that utility can be measured, we can say, for instance, that a given individual enjoys
37 units of satisfaction (utils) from drinking 3 pints of beer during an evening. This is a
measure of total utility. If one more pint increases his total utility to 42 utils the marginal utility
of his fourth pint would be equal to 5 units of satisfaction. The marginal utility of the fourth
pint equals the total utility derived from 4 pints minus total utility derived from 3 pints.
Marginal utility is the increase in total utility that results from the consumption of one more
unit.

An individual’s utility schedule

22
The figures clearly display a crucial element of utility theory: the law of Diminishing Marginal
Utility. The law states that the satisfaction derived from the consumption of an additional unit
of a good will decrease as more of the good is consumed, assuming that the consumption of all
other goods is held constant. Table above satisfies this law in that although each pint consumed
until the ninth pint adds to total satisfaction, it does so by decreasing amounts. While the third
pint adds 8 units of satisfaction, the 4th pint only adds 5 units. Neither of these can compare
with the first pint that resulted in 17 units of satisfaction. Its also interesting to note that MU
can be negative. If the individual were forced to drink the ninth pint, his total utility would
actually be reduced. This is sometimes called disutility.

It is important to appreciate fully the implications of the distinction between total and marginal
utility. If you were given the choice of giving up totally your consumption of either water or

23
petrol, you would choose to give up petrol. The implication is that water provides you with
more total utility than petrol.

A man dying of thirst in the desert is faced with different conditions and therefore different
marginal utilities. He would definitely place more value on an extra gallon of water. From
these examples we can see that when a consumer makes a decision, he is concerned with the
relative utilities of different goods. But given the availability of resources, economic behavior
will be determined by relative marginal utilities rather than total utilities: shall I consume a few
extra units of good A at the expense of good B.

THE INDIFFERENCE CURVE

An indifference curve represents all combinations of market baskets that provide the same
level of satisfaction or utility to a person or consumer.
Assume that you have a basket of goods containing 16 eggs and 6 bags of crisps. If someone
comes along with a basket containing 20 eggs and 5 bags of crisps and offer to change baskets,
would you accept, refuse or find it impossible to decide, as you would be indifferent between
the two baskets?
Alternatively, what would be the minimum number of eggs you would require in order to
compensate exactly for the loss of your 6 bags of crisps? If your answer to this second question
is 3 eggs, you are in effect saying that you are indifferent between a basket containing 16 eggs
and 6 bags of crisps and one containing 19 eggs and 5 bags of crisps: each would give you the
same total utility. This being the case, the original offer would certainly have been accepted
as 20 eggs and 5 bags of crisps clearly represent a more attractive combination.
In this way it is possible to build up a set of combination of any two goods between which the
consumer is indifferent. Each combination will provide the same total utility. This whole
operation can be carried out without ever having to put a precise figure on the amount of utility
involved.

AN INDIFFERENCE SCHEDULE
Basket Eggs Bags of crisps
A 22 4
B 16 6
D 13 7
E 10 8
F 7 9
AN INDIFFERENCE CURVE

Eggs
25 -
20 -
15 - Indifference curve
10 -
5 -

24
 0 2 4 6 8 10 12 14
Bags of crisps

This curve is called the indifference curve and each point on the curve represents a combination
of eggs and bags of crisps between which this particular individual is indifferent. The nature
of the curve reveals various aspects of consumer behavior. Consider the following indifference
curve.

Some basic assumptions.

Preferences are complete, which means that a consumer can rank all market baskets.
• E.g. For any two market baskets A and B, the consumer can prefer A to B or B to A,
or can be indifferent.
Preferences are transitive. It means, that if a consumer prefers basket A to B and
•
prefers B to C, then he should also prefer A to C.
Preferences are reflexive (desirable). So that leaving costs aside, consumer always
• prefers more of any good to less. (this applies to economical goods, and not applies
to bad goods such as pollution)

Marginal Rate of Substitution

AB = PQ
BC < QR.
The slope of the curve between A and C is given by the ratio AB/BC represents the amount of
good X necessary to make up for the loss of AB of good Y that would result if the individual
moved from combination A to combination C. The rate at which one good can be substituted
for another without any change in total utility is called the Marginal Rate of Substitution
(MRS). The MRS between P & R is less than the MRS between A & C. The fact that this
ratio decreases as one moves down the curve from left to right is known as the DIMINISHING
MARGINAL RATE OF SUBSTITUTION.

25
Another point to notice is that an IC slopes downwards from left to right. Assuming that both
goods are desirable, the rational consumer could not be indifferent to a basket containing more
of both goods. Therefore, as we move from one point to the other on the IC, while the quantity
of one good increase, the quantity of the goods has to decrease if total utility is to remain
unchanged. This is why the slope of the IC is normally negative.

THE INDIFFERENCE MAP

It is a set of indifference curves that describes the person's preferences. A set of indifference
curves represents an ordinal ranking. An ordinal ranking arrays market baskets in a certain
order, such as most preferred, second most preferred… 3d most preferred.

Market basket A is in the highest of three indifference curves. It is preferred to B and C, B is

preferred to C.

The assumptions made about the consumer preferences for economic goods imply that
indifference maps have the followings:
Market baskets on indifference curves further from the origin are preferred.
•

26
 • Marginal rate of substitution (MRS). MRSXY is rate of substitution of X for Y. It is
the amount of good Y that the consumer would give up to obtain one more unit of
good X while holding utility constant. The slope of an indifference curve measures
the consumer MRS between two goods.

A single IC represents but one possible level of total utility. In fig below A, B, C & D all
represent identical levels of total utility (IC). If point E were taken at random, then together
with all other points which provide an identical utility it would form a second IC (IC2). Clearly,
all the combinations given by points on IC2 would provide a higher level of total utility than
given by IC1.

Point F would represent a lower level of total utility than any point on IC1 and IC2, but an
equal level of utility when compared to any other point on IC3 e.g. G and H.
There is an infinity number of ICs; each represents a different level of total utility. A
representative sample of a consumer’s many ICs over a given time period is called an
indifference map.

THE BUDGET LINE

Consumers face budget constraints such that;

P X X+PY Y=B
Where PX and PY are the prices for goods X and Y respectively.
X and Y are goods X and Y respectively, and
B is the consumer’s budget.

They have limited income to allocate among consumption items.

While an IC describes a consumer’s preferences, a budget line shows the various combinations
of the two goods that can be bought at current prices with a fixed budget or income. Assume
an individual has 3 dollars a week to spend on eggs and bags of crisps, and that eggs cost 10c

27
each while crisps cost 15c a bag. If the individual spends his entire budget on eggs he can
afford 30. If he can spend it all on crisps, he can afford 20 bags.
Between these two extremes there is a variety of other possibilities e.g. 15 eggs +10 bags of
crisps. Each point on the budget line represents one of the several possible combinations that
will cost exactly 3 dollars.
If X represents the number of bags of crisps and Y the number of eggs consumed per time
period, we can write the equation of the budget line as:
• 15Y +10X = 300
X bags of crisps at 15c each and Y eggs at 10c each must come to a total of 300c or 3 dollars.
In the light of market prices, the slope of the budget line is the amount of one good that has to
be sacrificed in order to buy an additional unit of the other good. This will be the same for any
point on the budget line. If this consumer reduces his consumption of eggs by AB he will save
enough to buy BC bags of crisps. While the IC slope tells us of the rate at which the consumer
is willing to trade one good for the other, given his preferences the budget line tells us the
current market rates of exchange given existing prices.

A BUDGET LINE

CONSUMER EQUILIBRIUM
Having explained both indifference curves and budget lines, we are now in a position to
represent consumer equilibrium graphically. By drawing an individual’s budget line and

28
indifference map on the same graph, consumption possibilities and preference can be
compared.
Given the constraint of his budget line the individual’s aim is to maximize his total utility.
Each point on the budget line represents a combination of eggs and bags of crisps that he can
afford. He is looking for the point that lies on the IC that is as far as possible from the origin.
The further the IC is from origin, the higher is the level of total utility it represents. In this way
point B is preferable to point A, as it lies on IC2, which is further from the origin IC1. The
consumer will be indifferent between point B and C as they both lie on IC2. Out of all the
points on the budget line point E will bring the greatest satisfaction as all other points on the
budget line lie on ICs which are nearer to the origin.

CONSUMER EQUILIBRIUM

In the diagram above the consumer is in equilibrium i.e. (maximising his total utility, given his
fixed budget) when he is consuming 15 eggs & 10 bags of crisps per time period. This is given
by point E on the budget line, the point where the budget line is just tangential to one of the IC.
Point F is clearly preferably to point E, but given the current market prices and a fixed budget,
the combination lies outside the consumer’s range of consumption possibilities. CONSUMER
EQUILIBRIUM is represented graphically by the point of tangency of the budget line with an
IC. At such a point of tangency, the slope of the budget line is equal to the slope of the IC. It

29
follows that consumer equilibrium is reached when the ratio of the prices of the two goods is
equal to the consumer’s MRS ( P X /P Y =MRS XY ).

• At the point of tangency, the slope of the budget line (Px/Py) is equal to the slope of the
indifference curve (MUx/MUy).
MU x P
= x
MU y Py

Rearranging:
MU x MU y
=
Px Py
• The weighted marginal utilities should be equal at equilibrium.
• The consumer should derive the same marginal utility from the last unit (rand/ dollar)
spent on X as from the last rand/dollar spent on Y.

The Demand Curve

•If the price of one of the commodities changes, ceteris paribus, the budget line becomes flatter.
•The consumer moves to a higher indifference curve and equilibrium will be established at a
point such as B.
•Tracing these equilibrium points, we get the price-consumption line.
•Tracing the price-quantity relationship at equilibria points, we get a demand curve for X.

The impact of a price change and the derivation of a demand curve

30
INCOME AND SUBSTITUTION EFFECTS

A fall in the price of a good has two effects:

1. Consumers will tend to buy more of the good that has become cheaper and less of those
goods that are now relatively more expensive. This is the SUBSTITUTION EFFECT. It is a
change in consumption of a good associated with a change in its price, with the level of utility
held constant.

2. Because one of the goods is now cheaper, consumers enjoy an increase in real income/
purchasing power. This is the INCOME EFFECT. It is a change in consumption of a good
resulting from an increase in purchasing power, with relative prices held constant.

Income and Substitution Effects: Normal Good

31
A decrease in the price of food has both an income effect and a substitution effect. The
consumer is initially at A, on budget line RS. When the price of food falls, consumption
increases by F1F2 as the consumer moves to B. The substitution effect F1E (associated with a
move from A to D) changes the relative prices of food and clothing but keeps real income
(satisfaction) constant. The income effect EF2 (associated with a move from D to B) keeps
relative prices constant but increases purchasing power. Food is a normal good because the
income effect EF2 is positive.

Income and Substitution Effects: Inferior Good

The consumer is initially at A on budget line RS. With a decrease in the price of food, the
consumer moves to B. The resulting change in food purchased can be broken down into a
substitution effect, F1E (associated with a move from A to D), and an income effect, EF2
(associated with a move from D to B). In this case, food is an inferior good because the income
effect is negative. However, because the substitution effect exceeds the income effect, the
decrease in the price of food leads to an increase in the quantity of food demanded.

32
GOVERNMENT INTERVENTION

Applications of Price Theory

•Government can interfere in the market via:
–Setting maximum prices (price ceilings)
–Setting minimum prices (price floors)
–Subsidising certain products or activities
–Taxing certain products or activities.

Price Ceilings
•Government set maximum prices:
–To keep the prices of basic foodstuffs low to assist the poor.
–To avoid unfair prices or the exploitation of the consumers.
–To combat inflation.
–To limit the production of certain goods and services in wartime.

Effects
•If the price ceiling is above the equilibrium price, it will have no effect on the market price or
the quantity exchanged.
•Prices will still be determined by demand and supply.
•If the ceiling is set below the equilibrium price, it will have significant effects.
•The immediate effect is to create a shortage of the product in the market.

33
•Consumers may be served on a ‘first come – first served’ basis, resulting in queues or waiting
lists.
•Suppliers may set up informal rationing systems (by say limiting the amount per customer).
•Government may introduce an official rationing system by issuing ration tickets or coupons
which have to be submitted when purchasing the product.

Maximum prices

•Price controls result in inefficient allocation.

•Queues and informal rationing systems all entail costs. Consumers have to wait (spend a lot
of time queuing) and suppliers have to use resources to administer the rationing system.
•Illegal black markets (underground economy) will emerge wherein the products are bought
and sold at prices above the legal limits.
•Official rationing require additional government intervention and stimulate corruption.

Price Floors
•Minimum price for a product e.g. min. wages
•If the floor is below the equilibrium price, it won’t have any effect. The market forces are not
disturbed.
•If it is above the equilibrium price, there will be a persistent surplus (excess supply).
•Government has to intervene and purchase the surplus or issue production quotas (limits).
•Minimum prices are usually imposed to protect producers from unstable economic conditions

34
A minimum price

Criticisms
•All consumers (including the poor) pay an artificially high price;
•The bulk of the benefit accrues to large firms;
•Protects inefficient producers;
•Entails costs to society in form of taxpayers’ money and welfare losses.

Indirect Taxes and Subsidies

In the figure below an indirect tax has been added to SS. This has the effect of shifting the
supply curve up vertically by the amount of the tax. Note in the diagram below that price does
not increase by the full amount of the tax. This suggests that the firm pays part of the tax.

35
In this figure a subsidy has been given to the firm. This has the effect of making firms willing
to supply more at each price and so shifts the supply curve downwards. The shift is equivalent
to the value of the subsidy. Note that price falls by less than the full amount of the subsidy.
This suggests that the firm keeps part of the subsidy.

THEORY OF THE FIRM

Production and Cost

The Goal of the Firm

•A firm is an institution that hires factors of production and organises them to produce goods
and services.

36
•Rational firm aim at maximising profits.
•Other objectives are maximisation of sales revenue, maximisation of market share,
maximisation of shareholder’s wealth.
•Separation of ownership from control leads to the principal-agent problem.
•Other objectives can be easily met if the goal of profit maximisation is attained first.

Profit, Revenue and Cost

•Profit is equal to total revenue less total costs i.e.
p = TR - TC.
•The goal of profit maximisation can be attained by maximising total revenues or minimising
total costs.
•Total revenues (TR) is the total value of firm sales i.e. P x Q.
•Average revenue is equal to total revenues divided by the quantity (P.Q/Q).
•Marginal revenue (MR) is the additional revenue from selling an additional unit of the product.

Short run and Long run

•The short run is that period during which at least one factor of production is fixed.
•The long run is that period where all factors of production can be varied. The period is long
enough for the firm to either expand or contract its business operations.
•The variability of the factors depends on the industry with some industries having long short-
runs.

Production in the Short Run

•Production is the physical transformation of inputs into output.
•Inputs consist of factors of production and some other intermediate inputs i.e. other goods
which are used to produce other goods.
•The short run consists of fixed inputs and variable inputs.

Assumptions
•The firm produces only one product.
•All units of a given input are identical or homogeneous.
•The inputs can be used in infinitely divisible amounts.
•The production function is given and fixed i.e. the technical relationship between inputs and
output is known.
•The prices of the product and inputs are given.
•The firm uses fixed inputs and one variable input.
•Consider a farmer with a fixed quantity of land on which to produce maize and a fixed amount
of the other inputs such as seed, picks, shovels, hoes etc.
•The variable factor is labour.
•All workers are assumed to be equally intelligent, strong and diligent and work equally hard
i.e. equally efficient.
•In the short run, the firm can expand output only by increasing the quantity of its variable
inputs.

37
Short Run Production Function

•The relationship between quantity of inputs and maximum output that can be produced.
•The production function depends on the state of technology.
•Consider a farmer with only 20ha of land (fixed input) to produce maize.
•The amount of maximum output is referred to as total product (TP).

Production Schedule for Maize

The Law of Diminishing Returns

•When more units of the variable factor are added to production, output will start increasing at
an increasing rate and then at a decreasing rate.
•This could be due to specialisation and division of labour.
•The total product increases from zero at an increasing rate, then starts increasing at a
decreasing rate until a maximum point is reached
•As more units of labour are applied to a fixed amount of land, the initial benefits of
specialisation are gradually exhausted.
Average Product (AP) and Marginal Product (MP)
•Average Product is the average number of units of output produced per unit of the variable
factor.
•Average product (AP) = TP/N
•The marginal product (MP) is the number of additional output produced by one additional unit
(the marginal unit) of the variable input.
•MPn = TPn –TPn-1

38
Production Schedule for Maize

39
Total, average and marginal product of labour

40
Total, Average and Marginal Product
•TP is S-shaped i.e. it starts increasing at an increasing rate, then at a decreasing rate, reaches
a maximum and then decreases.
•AP and MP are cap shaped i.e. as the variable input is increased, they rise at a decreasing rate,
reach a maximum and the decrease at increasing rates.
•MP reaches a maximum before AP.
•MP intersects the AP curve from above and at its maximum point.
•When the MP is below the AP, the AP starts to decline.
•When the MP equals zero (0), the TP will be at its maximum.

Costs in the Short Run

•Fixed costs-: costs that do not vary with output.
•Fixed costs are called overhead costs, indirect costs or unavoidable costs.
•Total Fixed Costs (TFC)-: consist of such costs as contractual payments for buildings, rent for
land equipment and interest payments on debt, depreciation allowances, insurance premiums
etc
•The costs have to be paid even if the firm does not produce anything.
•The graph is therefore a horizontal straight line.

Total Variable Costs (TVC)

•The costs increase with the level of output.
•Variable costs are associated with changes in the use/employment of the variable input e.g.
labour.
•Sometimes called direct costs, prime costs or avoidable costs.
•When nothing is being produced, variable costs are equal to zero.
•The costs may be of the materials used in the production process, fuel, electricity fees etc.
•Total costs = TFC + TVC

Three total cost curves

41
Average and Marginal Costs
•The firm is concerned with per unit costs.
•Three measures of average costs exist:
a) Average fixed costs (AFC)-: AFC = TFC/Q. The AFC curve declines as long as output
increases. As output increases, overheads are spread over the units.
b) Average Variable costs (AVC)-: AVC = TVC/Q. AVC initially declines, reaches a
minimum, and then increases. It is U-shaped due to the law of diminishing marginal returns.
c) Average Total costs (ATC or AC)-: TC/Q or AFC + AVC

Marginal Cost
•Marginal cost (MC) is the cost of producing one more unit of output.
•It is the increase in total cost when one additional unit of output is produced.
•Marginal cost is always equal to marginal variable cost.
•MC = .TC/.Q i.e. TCn – TCn-1
•MC can be calculated from TVC as fixed costs are always constant.

Properties of Cost Curves

• AFC is L-shaped
•AVC, AC and MC are all U-shaped. As total product increases, the costs start at high values,
decline at decreasing rates, reach a minimum and then increase at an increasing rate.

42
•MC cuts or intersects the AVC and the AC at their respective minimum points.
•The shapes are explained by the law of diminishing marginal returns.

Production and Costs in the Long Run

•All factors of production are variable hence no fixed costs.
•The firm can build new factories, install new machines, and to use new techniques
of production.
•The firm can vary its scale of operation.
•The long run is an amount of time sufficient for new firms to enter or existing firms to leave
an industry.

Economies of Scale
•Cost advantages of operating on large scale.
•Unit costs decreases as the scale of production increases.
•Economies of scale look at unit costs and are not the same as returns to scale.
•Economies of scale can be achieved by increasing the quantity or productivity of only one or
a few inputs (not necessarily in the same proportions)

Long Run Average Costs (LRAC)

Assumptions

43
•The prices of factors of production are given.
•The state of technology and the quality (or productivity) of the factors of production are given.
•Firms are profit maximisers i.e. always select the least cost combination of the factors of
production to produce each level of output.
•The LRAC is U- shaped due to economies and diseconomies of scale.
•When the firm expands, it will initially experience economies of scale.
•If it continues to expand, all economies will be exhausted and diseconomies of scale will set
in.
•Managerial problems will offset the financial and technical economies.

A typical long-run average cost curve

44
MARKET STRUCTURES
Below we are going to discuss four market structures, namely perfect competition, monopoly,
monopolistic competition and oligopoly.

PERFECT COMPETITION.
Business firm - an organization set up and managed for the purpose of earning profits for its
owner by producing goods and services for sale in markets.
Assumptions for Perfect Competition
• Firms are price takers. There are so many firms in the industry that each one produces
an insignificantly small portion of total industry supply, and therefore has no power
whatsoever to affect the price of the product. If a firm increases its price just slightly,
then the quantity demanded of its product would drop to zero. It faces a horizontal
demand curve at the market price: the price is determined by the interaction of demand
and supply in the whole market.

The market price of eggs is P1. A competitive firm can sell all the eggs it wishes at that price.
The output of any firm is a perfect substitute for that of any other firms. The market demand
curve is downward sloping because consumers will buy more eggs at a lower price. The curve
facing the firm is horizontal, because the firm’s sales will have no effect on the price.
• There is complete freedom of entry of new firms into the industry. Existing firms are
unable to stop new firms from setting business. Setting up a business takes time
however. Freedom of entry, therefore applies in the long run. An extension of this
assumption is that there is complete factor mobility in the long run. If profits are higher
than elsewhere, capital will be freely attracted into that industry. Likewise if wages are
higher than for equivalent work elsewhere, workers will freely move into that industry
and will meet no barriers.
• All firms produce an identical product (the product is homogeneous). There is therefore
no branding or advertising.
• No government intervention

45
 • Producers and consumers have perfect knowledge of the market. That is the producers
are fully aware of prices, costs and market opportunities. Consumers are fully aware of
the price, quality and the availability of the product.
• Perfect mobility of the factors of production
• No entry/ exit barriers
The assumptions are very strict. Few if any industries in the real world meet these conditions.
Certain agricultural markets are perhaps closest to perfect competition. The markets for fresh
vegetables and grains (e.g. rapoko, maize, wheat. and mhunga) and also the market for bread.
Nevertheless despite lack of real world cases the model of perfect competition plays a very
important role in economic analysis and policy. Its major relevance is its use as an ideal model.

The Short Run and the Long Run

In the short run the number of firms is fixed. Depending on its costs and revenue, a firm might
be making large profits, small profits, no profits or loss and in the short run it may continue to
do so.
In the long run, however, the level of profits will affect entry and exit from the industry. If the
profits are high, new firms will be attracted into the industry, whereas if losses are being made
firms will leave.
This leads to the distinction between normal and supernormal profits.

Normal Profit
This is the profit that is just enough to persuade firms to stay in the industry in the long run,
but not high enough to attract new firms. If less than normal profits are made, firms will leave
the industry in the LR.

Supernormal Profit
This is any above normal profit. If supernormal profits are made, new firms will be attracted
into the industry in the long run. On the other hand if a firm makes losses in the long run some
firms will leave the industry: and they will continue to do so until only normal profits are being
made. Thus whether the industry expands or contracts in the long run will depend on the rate
of profit.

The Short Run Equilibrium of the Firm

The determination of P, Q and Profit in the short run under perfect competition can best be
shown in a diagram. Figure below shows SR equilibrium for both industry and a firm under
perfect competition. Both parts of the diagram have the same scale for the vertical axis. The
horizontal axes have totally different scales, however. For example if the horizontal axis for
the firm were measured in say, thousands of tons, the horizontal axis for the whole industry
might be measured in millions of tons.
Let us examine the determination of P, Q and profits in turn.
Price
The price is determined in the industry by the intersection of demand and supply. The firm
faces a horizontal demand (AR) curve at this price. It can sell all it can produce at the market
price (Pe), but nothing at a price above Pe.

46
Output
The firms maximize profit where MC=MR, at output Qe. Note that, since the price is not
affected by the firm’s output MR will equal the price.

TR=PQ
ΔTR
=P
ΔQ
TR PQ
AR= = =P
Q Q

Total supernormal profit is given by area ARabAC.

What happens if the firm cannot make a profit at any level of output? This situation would
occur if the AC curve were above the AR curve at all points. This is illustrated in figure below
where the market price is P1. In this case, the point where MC=MR represents the loss-
minimizing point (where loss is defined as anything less than normal profit).

A COMPETITIVE FIRM BREAKING EVEN.

Normal Profit

47
Firm is producing an output Q2, where MC = MR at price (P2). Its total cost
AC× Q

equals its total revenue

P× Q . In this case the firm breaks even (or makes normal profit).

Shut Down Point.

Point at which the firm would be better off if it shuts down than it will be if it stays in business.
If a price is above minimum (AVC) the firm will continue to produce in the
• shot run.
If a price is below minimum (AVC) the firm will shut
•
down

The decision to shut down operations in the short run.

AFC=AC− AVC

48
When price is falling to a level that just allows the firm its minimum possible average
variable cost of input the firm is at shut down point. At a market price of $35 per unit of that
specific commodity P = AVC at the output for which price is equal marginal cost (P = MC),
the firm produces 150 units and a loss per unit is equal to the distance DC, which also
represents the average fixed cost. Therefore at that output (P - AC) and (AC - AVC) are both
equal to the distance DC. The economic losses incurred by continuing to operate are equal to
fixed costs. If the price were to fall below $35 per unit, the firm would close operations in the
short run. Therefore the shut down point is at C, where the AVC curve is at minimum.

THE COMPETITIVE FIRM SHORT RUN SUPPLY - CURVE.

The competitive firm short-run supply curve is the portion of a competitive firm's marginal
cost curve that lies above the minimum possible point of its AVC curve. Therefore, the MC
curve gives the relationship between price and quantity supplied by the competitive firm. Short
run supply curve slopes upwards because the firm MC tends to increase as output is increased.
At any price below minimum possible AVC quantity supplied in the short run is zero. To
determine the quantity supplied at any price greater than the minimum possible AVC, draw a
horizontal line from that price to marginal cost curve. Dropping a vertical line to the horizontal
axis gives the quantity supplied at that price.

At a price P1 quantity supplied is Q1. At a higher price P2 quantity supplied is Q2.

To induce the profit maximising firm to supply more output, market price should rise. When
the market price increases, MR would exceed MC at current output. Therefore, the firm finds
it profitable to increase quantity supplied at the new higher price and as a result increases MC
to the point at which it equals that price.

The determinants of market supply.

49
 The number of firms in the
• industry
The average size of firms in the industry measured by quantity of fixed inputs
• employed (for example average of factories for production capacity).
• The price of variable inputs used by firms in the
industry.
The technology employed in the
• industry.

Long term equilibrium under perfect competition.

If firms are perfectly competitive and industry is making short-term surplus (profits), more
firms will enter the industry. In the long run this will increase 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). If on the other hand the firms are making losses firms will leave
the industry and this will reduce supply and bid up the prices until only normal profits are
made.

Imperfect Competition

Monopoly

•A market structure in which there is only one seller of a product that has no close substitutes.
•The firm has considerable control over the price of the product.
•Under monopoly, the firm is also the industry and hence faces a downward sloping demand
curve.
•The firm’s demand curve is also the market demand curve

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•There are barriers to entry i.e. economic, legal, technological, or other obstacles keep new
competitors from entering the industry.

Equilibrium
•Assume that the firm is profit maximising.
•The firm should produce at a point where MR is equal to MC.
•The firm should shut down if AR< AVC in the short run or AR < AC in the long run.
•The firm faces the same cost structures like any other firm e.g. perfectly competitive firm.

Short run Equilibrium

•The firm maximises profit where MR = MC.
•The market price will be determined by demand.
•The monopolist can make economic profits or economic losses or even just earn normal profit
in the short run.
•Due to the presence of barriers to entry, the firm’s short run position is similar to its long run
as no new firms can enter the industry.

Monopolistic Competition
•Imperfect competition amongst the many
•Combines features of perfect competition and monopoly.
•Large number of firms produces differentiated products i.e. heterogeneous products.

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•Product differentiation occurs when products are made to appear similar enough to be perfect
substitutes but dissimilar enough to command a different price.
•Product differentiation can be achieved through advertising, packaging and branding among
other sale activities.

Features/Assumptions
•There are many sellers or a large number of firms in the industry.
•Each firm produces a distinctive, differentiated product.
•There are no barriers to entry or exit.
•Each firm faces a downward sloping demand curve for its particular product.
•Each firm has some degree of monopoly over its brand.

Equilibrium of the Firm

•In the short run, the equilibrium condition is the same as that of a monopolist.
•The firm produces at a point where MR = MC.
•The demand curve, however, is more elastic due to the presence of close substitutes.
•In the long run, monopolistically competitive firms earn normal profits only.
•In the long run, P = AR = AC but P > MC

The equilibrium of the firm under monopolistic competition

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Oligopoly
•Competition amongst the few as a few large firms dominate the market.
•If there are only two firms, it is called duopoly.
•The product maybe homogeneous or heterogeneous.
•There is high degree of interdependence between the firms.
•The firm does not only consider its own actions but also considers the actions of the
competitors and the likely reactions from its actions.
•There is uncertainty on the likely actions and/or reactions.
•There are barriers to entry
•Oligopolies can enter into price competition or non-price competition.

The Kinked Demand Theory

•The theory does not explain how the price is determined but rather explains why, once
established, the price tends to be relatively stable.
•It illustrates the importance of interdependence and uncertainty.
•Above the established price, P1, the demand curve facing the firm is relatively elastic than
below P1.
•If the firm raises its price above P1, it expects to lose parts of its custom to competitors.

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•Above P1, the competitors are likely to react by keeping their prices at P1 and hence the firm
might lose some customers.
•A price increase will therefore lead to a large fall in quantity demanded of the firm’s product.
•The firm will lose its market share.
•Below P1, the firm assumes that its competitors will react to a price decrease by lowering their
prices as well.
•The firm may not be able to increase its market share by lowering the price.
•The quantity demanded of the firm’s product will increase but not by a bigger proportion due
to brand loyalty.
•The asymmetrical reaction of competitors to price changes give rise to a kinked demand curve.
•The kink will be established at the ruling price.
•The demand curve is the same as the AR curve.
•The MR curve falls at a rate twice as steep as that of the AR and is discontinuous at the point
of the kink.

The kinked demand curve

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