ECO231 Micro Economic Theory One
ECO231 Micro Economic Theory One
ECO231 Micro Economic Theory One
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ECO 231 MICRO-ECONOMIC THEORY I
COURSE
GUIDE
ECO 231
MICRO-ECONOMIC THEORY I
Abuja Office
5 Dar es Salaam Street
Off Aminu Kano Crescent
Wuse II, Abuja
e-mail: [email protected]
URL: www.nou.edu.ng
Published by
National Open University of Nigeria
Printed 2014
ISBN: 978-058-333-8
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ECO 231 MICRO-ECONOMIC THEORY I
CONTENTS PAGE
Introduction………………………………………………… iv
Course Aim………………………………….……..…....…. iv
Course Objectives………………………………………..… iv
Working through this Course……………………………… v
Course Materials…………………………………………… v
Study Units………………………………………………… v
Textbooks and References………………………………… vii
Assessment…………………………………………………. vii
Tutor-Marked Assignment………………………………… viii
Final Examination and Grading ……………………….….. ix
Course Marking Scheme……………………………….….. ix
Course Overview/Presentation………………………….… ix
What you will Learn in this Course……………………..… x
Facilitators/Tutors and Tutorials…………………………... xi
Conclusion…………………………………………………. xi
Summary…………………………………………………… xi
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ECO 231 MODULE 4
INTRODUCTION
This course guide tells you what microeconomics entails, what course
materials you will be using and how you can work your way through
these materials. It suggests some general guidelines for time required of
you on each unit in order to complete the course. It also guides on your
tutor marked assignments (TMAs) as contained herein.
COURSE AIMS
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ECO 231 MICRO-ECONOMIC THEORY I
to give you the detailed concept of factor pricing and the practical
way of understanding the contemporary business world.
COURSE OBJECTIVES
There are 18 study units in this course and each unit has its objectives.
You should read the objectives of each unit and bear them in mind as
you go through the unit. Each unit of this course has its objectives unit.
In addition to these, the course has its overall objectives. At the
completion of this course, you should be able to:
To successfully complete this course, you are required to read the study
units, referenced books and other materials on the course.
COURSE MATERIALS
1. Course guide
2. Study units
3. Text books
4. Assignment file
5. Presentation schedule
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STUDY UNITS
Every unit contains a list of references and further reading. Try to get as
many as possible of those textbooks and materials listed. The textbooks
and materials are meant to deepen your knowledge of the course.
ASSIGNMENT FILE
In this file, you will find all the details of the work you must submit to
your tutor for marking. The marks you obtain from these assignments
will count towards the final mark you obtain for this course. Further
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ECO 231 MICRO-ECONOMIC THEORY I
PRESENTATION SCHEDULE
ASSESSMENT
TUTOR-MARKED ASSIGNMENT
Assignment questions for the units in this course are contained in the
Assignment File. You will be able to complete your assignments from
the information and materials contained in your set books, reading and
study units. However, it is desirable that you demonstrate that you have
read and researched more widely than the required minimum. You
should use other references to have a broad viewpoint of the subject and
also to give you a deeper understanding of the subject.
When you have completed each assignment, send it, together with a
TMA form, to your tutor. Make sure that each assignment reaches your
tutor on or before the deadline given in the Presentation File. If for any
reason, you cannot complete your work on time, contact your tutor
before the assignment is due to discuss the possibility of an extension.
Extensions will not be granted after the due date unless there are
exceptional circumstances.
The final examination will be of three hours' duration and have a value
of 70% of the total course grade. The examination will consist of
questions which reflect the types of self-assessment practice exercises
and tutor-marked problems you have previously encountered. All areas
of the course will be assessed.
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You are advised to use the time between finishing the last unit and
sitting for the examination to revise the entire course material. You
might find it useful to review your self-assessment exercises, tutor-
marked assignments and comments on them before the examination.
The final examination covers information from all parts of the course.
The table presented below indicate the total marks (100%) allocation.
ASSESSMENT MARKS
Total 100%
COURSE OVERVIEW
The table presented below indicate the units, number of weeks and
assignments to be taken by you in this course.
In distance learning the study units replace the university lecturer. This
is one of the great advantages of distance learning; you can read and
work through specially designed study materials at your own pace and at
a time and place that suit you best.
Each of the study units follows a common format. The first item is an
introduction to the subject matter of the unit and how a particular unit is
integrated with the other units and the course as a whole. Next is a set of
learning objectives. These objectives let you know what you should be
able to do by the time you have completed the unit.
You should use these objectives to guide your study. When you have
finished the unit you must go back and check whether you have
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ECO 231 MICRO-ECONOMIC THEORY I
achieved the objectives. If you make a habit of doing this you will
significantly improve your chances of passing the course and getting the
best grade.
The main body of the unit guides you through the required reading from
other sources. This will usually be either from your set books or from a
readings section. Some units require you to undertake practical
overview of historical events. You will be directed when you need to
embark on discussion and guided through the tasks you must do.
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4. Turn to Unit 1 and read the introduction and the objectives for the
unit.
5. Assemble the study materials. Information about what you need
for a unit is given in the `Overview' at the beginning of each unit.
You will also need both the study unit you are working on and
one of your set books on your desk at the same time.
6. Work through the unit. The content of the unit itself has been
arranged to provide a sequence for you to follow. As you work
through the unit you will be instructed to read sections from your
set books or other articles. Use the unit to guide your reading.
7. Up-to-date course information will be continuously delivered to
you at the study centre.
8. Work before the relevant due date (about 4 weeks before due
dates), get the Assignment File for the next required assignment.
Keep in mind that you will learn a lot by doing the assignments
carefully. They have been designed to help you meet the
objectives of the course and, therefore, will help you pass the
exam. Submit all assignments no later than the due date.
9. Review the objectives for each study unit to confirm that you
have achieved them. If you feel unsure about any of the
objectives, review the study material or consult your tutor.
10. When you are confident that you have achieved a unit's
objectives, you can then start on the next unit. Proceed unit by
unit through the course and try to pace your study so that you
keep yourself on schedule.
11. When you have submitted an assignment to your tutor for
marking, do not wait for its return `before starting on the next
units. Keep to your schedule. When the assignment is returned,
pay particular attention to your tutor's comments, both on the
tutor-marked assignment form and also written on the
assignment. Consult your tutor as soon as possible if you have
any questions or problems.
12. After completing the last unit, review the course and prepare
yourself for the final examination. Check that you have achieved
the unit objectives (listed at the beginning of each unit) and the
course objectives (listed in this Course Guide).
Your tutor will mark and comment on your assignments, keep a close
watch on your progress and on any difficulties you might encounter, and
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ECO 231 MICRO-ECONOMIC THEORY I
provide assistance to you during the course. You must mail your tutor-
marked assignments to your tutor well before the due date (at least two
working days are required). They will be marked by your tutor and
returned to you as soon as possible.
• You do not understand any part of the study units or the assigned
readings
• You have difficulty with the self-assessment exercises
• You have a question or problem with an assignment, with your
tutor's comments on an assignment or with the grading of an
assignment.
You should try your best to attend the tutorials. This is the only chance
to have face to face contact with your tutor and to ask questions which
are answered instantly. You can raise any problem encountered in the
course of your study. To gain the maximum benefit from course
tutorials, prepare a question list before attending them. You will learn a
lot from participating in discussions actively.
SUMMARY
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MAIN
COURSE
CONTENTS PAGE
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Theory of Consumer Behaviour
3.2 Consumer Preferences
3.2.1 Decisiveness
3.2.2 Consistency
3.2.3 Non-satiation
3.2.4 Convexity
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7. 0 References /Further Reading
1.0 INTRODUCTION
2.0 OBJECTIVES
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SELF-ASSESSMENT EXERCISE
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3.2.1 Decisiveness
3.2.2 Consistency
The following two assumptions are not required to develop the theory of
the consumer, but simplify matters significantly.
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3.2.3 Non-satiation
3.2.4 Convexity
SELF-ASSESSMENT EXERCISE
4.0 CONCLUSION
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5.0 SUMMARY
In this unit, you learnt about the concept of consumer behaviour and
basic assumptions underlining the theory of consumer behaviour. It also
introduced you to law of diminishing marginal utility (LDMU).
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main content
3.1 Definition of Utility
3.2 Difference between Total Utility and Marginal Utility
3.3 Marginal Utility: Consumer Equilibrium
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
In making their choices, most people spread their income over many
different kinds of goods. One reason people prefer variety is that
consuming more of any one good reduces the marginal or extra
satisfaction they get from further consumption of the same good.
Formally, marginal utility (MU) is the additional satisfaction gained by
the consumption or use of one more unit of something.
2.0 OBJECTIVES
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In cardinal utility theory, utile, as a unit of measure for utility, was used.
Thus, a rough numerical measure of consumer satisfaction is derived -
what microeconomics call cardinal utility, which refers to the cardinal
numbers, starting with 1, 2, 3 and so on. There is a problem, however,
with this concept, convenient though it may be, consumers do not as a
rule calculate the numerical utility value of their purchases; only micro-
economists do. Ordinal utility, another term widely used in
microeconomics, may be a more useful way of determining consumer
satisfaction because it simply denotes consumer preferences without
assigning them numerical values.
how much satisfaction they get from buying and then consuming
an extra unit of a good or service
the price that they have to pay to make this purchase
the satisfaction derived from consuming alternative
products the prices of alternatives goods and services.
Consumers buy goods because they get satisfaction from them. This
satisfaction, which the consumer experiences when he consumes a good,
when measured as number of utile is called utility. It is necessary to
make a distinction between total utility and marginal utility.
Formula:
TUx = ∑MUx
Marginal utility (MU)
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Formula:
MU = ∆TU
∆Q
The table below explains the relationship that exists between total and
marginal utility related with a consumer's consumption of bread (in a
given time period).
The table above also shows what is known as the law of diminishing
marginal utility. This law states that marginal utility declines as more of
a particular good is consumed in a given time period, all things being
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equal. From the example above, the marginal utility of additional slices
of bread declines as more bread is consumed (in this period). In this
example, the marginal utility of bread consumption becomes negative
when the sixth slice of bread is consumed. Note that even though the
marginal utility from bread consumption declines, total utility still
increases as long as marginal utility is positive. Total utility will decline
only if marginal utility is negative. This law of diminishing marginal
utility is believed to occur for virtually all commodities. A bit of
reflection should confirm the general applicability of this principle.
The first of these conditions requires that the marginal utility per naira
of spending be equated for all commodities. To see why this condition
must be satisfied, suppose that the condition is violated, let us assume
that the marginal utility resulting from the last naira spent on good X
equals 10, while the marginal utility received from the last naira spent
on good Y equals 5. Since an additional naira spent on good X provides
more additional utility than the last naira spent on good Y, a utility-
maximising consumer would spend more on good X and less on good Y.
Spending N1 less on good Y lowers utility by 5 units, but an additional
naira spent on good X raises utility by 10 units in this example. Thus,
the transfer of N1 in spending from good Y to good X provides this
person with a net gain of 10 units of utility. As more is spent on good Y
and less on good X, though, the marginal utility of good Y will fall
relative to the marginal utility of good X. This person will keep
spending more on good Y and less on good X, until the marginal utility
of the last naira spent on good Y is the same as the marginal utility of
the last naira spent on good X.
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The reason for the assumption that all income is spent is because this
relatively simple model is a single-period model in which there is no
possibility of saving or borrowing. Of course, a more detailed model can
be constructed, which includes such possibilities, but that is a topic left
for more advanced microeconomics classes.
and all income is spent, what happens if the price of good X rises? An
examination of the equation above shows that the marginal utility per
naira spent on good X will fall when the price of good X rises. To have
consumer equilibrium back, the consumer will increase his or her
consumption of good Y and reduce his or her spending on good X. This
change in the mix of goods consumed is called the substitution effect.
When good X becomes relatively more expensive, the quantity of good
X demanded falls as a result of the substitution effect.
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price rose during the Irish Potato Famine - more careful later analysis
indicated that Giffen's evidence was flawed.) In practice, though, no one
has found reliable evidence of a Giffen good. Thus, it is probably fairly
safe to assume that demand curves are downward sloping.
4.0 CONCLUSION
Utility is the satisfying power goods have. If a good causes problem for
a consumer we say it has disutility effect. Marginal utility is measured
as the ratio of total utility to a change in the number of items consumed
while the law of diminishing marginal utility states that consumption of
any item yields the consumer declining utility holding taste constant.
MU = ∆TU/∆X. Consumer utility is achieved when the ratio of marginal
utility of one commodity is equal to its price is equal to the ratio of
another to its price. That is MUx/Px= MUy/Py where x and y represent
different commodity.
5.0 SUMMARY
The total and marginal utility of two types of drink items are given
below:
10 1170 2760
11 1120 2660
12 1020 2460
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Utility Theory- Indifference Curve Approach
3.2 Properties of Indifference Curves
3.3 Indifference Curve: Substitution and Income Effect
3.4 Consumer Equilibrium and Indifference Curves
3.5 Diamond-water Paradox
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
In this unit, you will learn more about consumer behaviour in another
way using indifference curve analysis. Marginal rate of substitution
explains the rate at which a consumer gains more of one goods and loses
little of the other. The underlining assumptions of indifference curve and
consumer equilibrium are to be discussed in this unit.
2.0 OBJECTIVES
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The MRS can be portrayed as the slope of the indifference curve. This
would show the amount of good Y given up per unit of X. The slope
between points A and B is ∆Y0/∆X, between B and C is ∆Y1/∆X, and
between C and D is ∆Y2/∆X. Notice that since ∆Y is declining, the
slope is getting flatter and flatter. For very small increases in good X,
the slope of the indifference curve becomes the slope of the tangent to it.
We can define MRS as the absolute slope of the tangent to an
indifference curve. In the diagram above, the tangent gets flatter and
flatter as we move from A to B, B to C and C to D.
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In other words, we can say that the combination of goods, which lies on
a higher indifference curve, will be preferred by a consumer to the
combination of goods, which lies on a lower indifference curve.
1 2
In this diagram above, there are three indifference curves, IC , IC and
3
IC , which represents different levels of satisfaction. The indifference
3
curve IC shows greater amount of satisfaction and it contains more of
2 1 3 2 1
both goods than IC and IC (IC > IC > IC ).
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In the above graph, two indifference curves are shown cutting each
other at point B. The combinations represented by points B and F given
equal satisfaction to the consumer because both lie on the same
indifference curve IC2. Similarly, the combinations shown by points B
and E on indifference curve IC1 give equal satisfaction to the consumer.
4. Indifference curves are bowed inward (in most cases). The slopes
of indifference curves represent the MRS (rate at which
consumers are willing to substitute one good for the other). This
is an important property of indifference curves. They are convex
to the origin (bowed inward). This is equivalent to saying that as
the consumer substitutes commodity X for commodity Y, the
marginal rate of substitution diminishes of X for Y along an
indifference curve. People are usually willing to trade away more
of one good when they have a lot of it, and less willing to trade
away goods, which are in scarce supply. This implies that MRS
must increase as we get less of a good.
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a b
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large volume of water is consumed) while the total utility received from
diamonds is relatively low (because few diamonds are consumed).
a. b.
SELF-ASSESSMENT EXERCISE
i. value in use
ii. value in exchange.
4.0 CONCLUSION
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5.0 SUMMARY
Here you have learnt more about utility theory using the concept of
indifference curve. You learnt basic properties of indifference curve. By
now should be able to use indifference curve to explain substitution
effect and income effect on utility. Lastly, you learnt about diamond-
water paradox using value in use and value in exchange as explained by
father of economics Adams Smith.
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Budget Constraint
3.2 Revealed Preference Theory
3.3 Consumer Surplus
4.0 Conclusion
5.0 Summary
6.0 Tutor -Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
2.0 OBJECTIVES
savings. The budget constraint would then say that income is equal to
the sum of consumer expenditure. Expenditure on a particular good is
the product of the amount of the good purchased times its price. We can
then write the budget constraint as:
I = Px*X +Py*Y.
In this equation, the consumer has expended all income, I, across both
goods X and Y, where Px and Py are the prices of X and Y respectively.
To illustrate this budget constraint graphically into commodity space
requires rewriting the budget constraint in terms of good Y, the variable
on the vertical axis. Using simple algebra, we can rearrange terms to
produce the following budget line: Y = I/Py - Px/Py * X.
1/py
1/px
The budget line divides commodity space into two. The commodity
bundles, which are affordable, are shown as being on or below the line.
Income is completely spent for those bundles on the line. We exclude
the commodity bundles below the budget line since all income is not
being spent. The commodity bundles above and to the right of the
budget line are beyond the reach of the consumer, given their income
and the prices of goods X and Y. Note the intercepts-the Y intercept
represents a commodity bundle that contains only good Y. This is the
amount of good Y that the consumer could purchase if they spent their
entire income on good Y. The same is true for good X’s intercept. I/Px
is the maximum amount of good X that this consumer can purchase,
given their income and the two goods’ prices.
The budget line plays two important roles. The first is determined by the
level of income. The more income the consumer has to spend the greater
number of the commodity bundles that are affordable. An increase in
income would be portrayed as a parallel shift outwards of the budget
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Thus the slope of the budget line shows the relative price of good X in
terms of good Y. If the price of good X increases, then the amount of
good Y that is foregone increases. There is an increase in the relative
price of good X. Since we are holding income and the price of good Y
constant, this increase in good X’s price results in a decrease of the
budget line’s X intercept. The line swivels inward.
Relative price is an important tool. It shows how much of one good that
the consumer must necessarily give up to obtain more of another. The
flatter the budget line, the less costly the good on the horizontal axis in
terms of the good on the vertical axis. The steeper the budget line, the
more costly the good. Note that relative price is shown solely as the
budget line’s slope. The distance from the origin does not reflect prices.
SELF-ASSESSMENT EXERCISE
The revealed preference theory makes two assumptions: (a) that the
consumer has a budget constraint (b) that the consumer is consistent in
the sense that if he prefers situation A to B, and B is superior to C, then
he will prefer A to C. superiority of A to B means that B affords him
more quantities of some or all the commodities and less of none in
comparison to C. The theory used the budget constraint to draw its
logical implications. Given the budget constraint AB in the graph below,
and given that the revealed preference of consumer is point Q on AB,
which corresponds to X1 units of commodity X and Y1 units of
commodity Y: if we now consider a fall in the price of X, then the
budget line pivots to AC.
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The price change has introduced a change in real income. So, we can
eliminate the change in the real income by shifting the new budget line
AC backwards in parallel manner until it cuts point Q of the revealed
preference on AB. We will maintain a constant real income while
preserving the new price ratio. The reconstructed budget line DE
presents the consumer with a new situation, consisting of segment DQ
and QE. Clearly, DQ is inferior to AQ, so that the consumer can only
choose either to remain on point Q or move to another point QE. This
implies that the fall in the price of X will make the consumer not
demand more of X rather less. The possibilities are the points on QE
will correspond to a downward –sloping demand curve with various
elasticities.
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As the graph below shows, the first unit of the good costs N5, but this
consumer would have been willing to pay a price of up to N9 for this
first unit of this good. In this case, the consumer receives a good that
s/he values at N9 by giving up onlyN5. Therefore, the first unit of the
good generates N4 in consumer surplus. In the graph below, the benefit
received from the first unit of the good is the sum of the shaded areas
(notice the height of this rectangle equals the price the person is willing
to pay -N9 - while the base equals 1, thus the area of the rectangle
equalsN9). The cost of this first unit of the good (N5) is given by the
shaded area. The lower shaded area at the top of the graph represents the
consumer surplus (N4) received from the first unit of this good.
More generally, the total benefit from consuming 10 units of this good is
the entire area under the demand curve (as illustrated by the shaded area
in the graph below).
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SELF-ASSESSMENT EXERCISE
4.0 CONCLUSION
5.0 SUMMARY
In this unit, you have learnt about budget constraint, which tells us about
how a consumer spends his/her income on the available commodities.
You also learnt about the properties of budget constraint or budget line
in relation to relative price of commodity. Concept revealed preferences
is also discussed in this unit.
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Market Structure
3.1.1 Types of Market Structures
3.2 Perfect Competitive Market
3.3 Assumptions of Perfectly Competitive Market
3.4 Concept of Total, Average, Marginal Revenues and
Demand
3.5 Demand Curve Facing a Single Firm
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
2.0 OBJECTIVES
At the end of this unit, you should be able to:
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SELF-ASSESSMENT EXERCISE
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b. monopoly market
c. monopolistic competition market
d. oligopoly
SELF-ASSESSMENT EXERCISE
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TR = P x Q
Where,
P = Price
Q = Quantity
TR = Total Revenue
Example:
Calculate the total revenue for a firm which is selling 10 television sets
at N21,000 each.
TR = P X Q
= 21,000 x 100
= N2, 10,000
AR = TR/Q
Where
AR = Average revenue
TR = Total revenue
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Q = Units sold
SELF-ASSESSMENT EXERCISE
What is the average revenue for firm JKB which is selling 35 units of
commodity X and getting the total revenue of N3000?
MR = TRn - TR n-1
Where
MR = Marginal revenue
TR = Total revenue
n = Unit sold
SELF-ASSESSMENT EXERCISE
By selling 30 units, firm JKB make N300. After selling the 31st unit,
firm’s revenue increased to 318. What is the marginal revenue in this
situation?
a b
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Where: P =price
D= demand function
AR=average revenue
MR=marginal revenue
4.0 CONCLUSION
Market structure implies a variety of ways consumers and firms interact
in the market. How firms actually act requires understanding the
competitive environment in which they operate. Perfect competition
exists in an industry where:
5.0 SUMMARY
In this unit, you learnt about the different market structures.
Specifically, you learnt about the types of market structure (perfect
market and imperfect market), which include monopoly, monopolistic
competition, oligopoly, some others. Furthermore, you learnt about the
concept of perfect competitive market and its basic features. Finally,
you learnt about demand curve and revenue structure facing perfect
competitive market.
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Profit Maximisation
3.2 Loss Minimisation and Shutdown Rule
3.3 Break-even Price
3.4 Short-run Supply Curve
3.5 Long-run Equilibrium
3.6 Long-run Equilibrium and Economic Efficiency
3.7 Consumer and Producer Surplus
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
In this unit, you will learn how to determine profit maximisation and
loss minimisation and shutdown rule under perfect competitive market.
Furthermore, the breakeven point, short run supply curve, long run
equilibrium and long-run and economic efficiency as it operates under
perfect competitive market will be discussed. Finally, you will learn
about consumer and producer surplus.
2.0 OBJECTIVES
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To maximise profit, we need to get the concept of the revenue and the
costs of the business. Profit is maximised when marginal revenue equals
marginal cost (i.e. marginal revenue = marginal cost) and marginal cost
is rising. Marginal revenue is the additional revenue from one additional
unit. Marginal cost is the additional cost from one additional unit.
Marginal revenue equals the market price for a firm facing a perfectly
elastic demand curve. The graph below illustrates this relationship.
Marginal and average total cost curves have been added to the graph
below. As this graph indicates, a profit-maximising firm will produce at
the level of output (Qo) at which MR = MC. The price, Po is determined
by the firm's demand curve.
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At an output level of Qo, the firm faces average total costs equal to
ATC. Thus, its profit per unit of output equals Po - ATC (= revenue per
unit or output - total cost per unit of output). Economic profits are equal
to profit per unit x, number of units of output. A cursory look at the
graph below should confirm that economic profits equals the area of the
shaded rectangle (notice that the height of this rectangle equals profit
per unit of output and the base equals the number of units of
output).When MR > MC, revenue is increasing faster than costs and the
firm should increase production.
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SELF-ASSESSMENT EXERCISE
2. From the above table, what is correct about marginal revenue and
marginal costs when profit is maximised?
3. What would be the profit maximising level of output if price fell
to N13?
Suppose that P < ATC at the level of output at which MR = MC, will the
firm continue operations? To determine this, we have to compare the
firm's loss if it stays in business with its loss if it shuts down. If the firm
decides to shut down, its revenue will equal zero and its costs will equal
its fixed costs. (Remember, fixed costs must be paid even if the firm
shuts down.) Thus, the firm receives an economic loss equal to its fixed
costs if it shuts down. It will stay in business in the short run even if it
receives an economic loss as long as its loss is less than its fixed costs.
This will occur if the revenue received by the firm is large enough to
cover its variable costs and some of its fixed costs. In mathematical
terms, this means that the firm will stay in business as long as:
TR = P x Q > VC
P > AVC
What this means in practice is that the firm will stay in business if the price
is greater than average variable cost. The firm will shut down if the price is
less than average variable cost. Consider the situation illustrated by the
graph below. In this case, losses are minimised at the level of output at
which MR = MC. This occurs at an output level of Q'. Since the level of
average total cost (ATC') exceeds the market price (P'), this
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firm receives economic losses. Since the price is greater than AVC,
however, this firm will choose to stay in business in the short run.
If the firm shown above were to shut down, it would lose its fixed costs.
The shaded area in the graph below equals the firm's fixed costs (to see
this, note that the height of this rectangle equals the firm's AFC and the
base equals Q -- therefore, the shaded area equals AFC x Q = TFC). A
comparison of the firm's losses if it shuts down (the shaded area in the
graph below) with its losses if it continues to operate in the short run
(the shaded area in the graph above) shows that this firm will receive
lower losses if it decides to continue in business in the short run.
Thus, this discussion should suggest that the shut down rule for a firm is
shut down if P < AVC. In the long run, of course, firms will leave the
industry if economic losses are received (remember, there are no fixed
costs in the long run.)
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SELF-ASSESSMENT EXERCISE
If the market price is just equal to the minimum point on the ATC curve,
the firm will receive a level of economic profits equal to zero. In this
case, the owners of the firm are receiving a rate of return on all of their
resources that is just equal to that which they could receive in any
alternative employment. When this occurs, there is neither an incentive
to enter or leave this market. This possibility is illustrated in the graph
below.
If the price drops below AVC, the firm will shut down. This possibility
is illustrated in the graph below. The green shaded area equals the firm's
fixed costs (its losses if it shuts down). The loss if it continues
operations, however, equals the combined blue and green shaded areas.
As this graph suggests, a firm's economic losses are lower when it shuts
down if P < AVC.
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is the portion of its marginal cost curve that lies above the AVC curve.
This is illustrated by the darker and thicker portion of the MC curve in
the graph below.
In the long-run, firms will enter the market if positive economic profits
are received and will leave the market if economic losses are realised.
Let us think about the consequences of such entry and exit. Suppose that
the current equilibrium price in a market results in economic profits for a
typical firm. In this case, firms enter the market and the market supply
curve shifts to the right. As market supply increases, the equilibrium
price falls. This process will continue until firms no longer have an
incentive to enter the market. As the graph below indicates, a typical
firm will receive zero economic profits in this long-run equilibrium
situation.
a b
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SELF-ASSESSMENT EXERCISE
P = MC, and
P = minimum ATC.
The equality between P and MC important for society because the price
reflects society's marginal benefit from the consumption of the good
while the marginal cost reflects the social marginal cost of producing the
good (in the absence of externalities). At the competitive equilibrium,
society's marginal benefit just equals society's marginal costs. Society's
net benefit from the production of each good is maximised when social
marginal benefit equals social marginal cost.
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only for the last unit produced. Up to that point, the marginal cost of
producing the good is below the price received by the firm.
In the graph below, the shaded region equals the amount of consumer
surplus, while the lower shaded region represents producer surplus. The
net benefit to society, also known as the "gains from trade," equals the
sum of these two areas.
4.0 CONCLUSION
5.0 SUMMARY
In this unit, you learnt how firms under perfect competitive market
maximise their profit, minimise their losses and even the way firms can
withdraw from the market to avoid unlimited waste of resources. The
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analysis of breakeven position, short run supply curve and long run
equilibrium were also explained to your good understanding of perfect
competitive market operations.
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Monopoly Markets
3.1.1 Salient Features of Monopoly
3.2 Sources of Monopoly Power
3.3 Monopoly: Demand, Average Revenue, Marginal
Revenue, Total Revenue and Elasticity
3.4 Profit Maximisation under Monopoly
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
In this unit, you will learn about ‘one in town seller’ as you have been
introduced to in the previous unit. More is to be learnt about monopoly
especially on its salient features, sources of its market power and also
monopolist profit maximisation strategy and its loss limits.
2.0 OBJECTIVES
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restricting supply, such that MR > MC. In other words, the ability to
influence the market, and in particular the market price, by influencing
the total quantity offered for sale.
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The demand curve facing a monopoly firm is the market demand curve
(since the firm is the only firm in the market). Since the market demand
curve is a downward sloping curve, marginal revenue will be less than
the price of the good. As noted earlier, marginal revenue is:
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A monopoly firm will shutdown in the short run if the price falls below
AVC. This possibility is illustrated in the graph below.
Those who have not studied economics often believe that a monopolist
is able to choose any price that it wishes and that it can always receive
higher profits by raising its price. As in all other market structures, the
monopolist is constrained by the demand for its product. If a monopoly
firm wishes to maximises its profit, it must select the level of output at
which MR = MC. This determines a unique price that will be charged in
this industry. An increase in the price above this level would reduce the
profits received by the firm.
4.0 CONCLUSION
The true monopoly exists where there is only one seller of a product for
which no close substitute is available. Monopoly firm faces the industry
demand curve; it can pick the most profitable point on the demand
curve. Monopolist is a price maker rather than price taker. Legal barrier
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5.0 SUMMARY
In this unit, you learnt about the concept and features of monopoly
market, and its characteristics. The sources of monopoly power and the
nature of its demand curve, marginal cost, marginal revenue, average
total cost and average revenue. You also learnt how monopolist
maximises profit and minimises losses in case it fails to manage its
fortune and market power it has.
Complete the table below. The table shows the demand for electricity
and cost condition for the PHCN.
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Price Discrimination
3.1.1 Types of Price Discrimination
3.2 Price Discrimination and Dumping
3.3 Comparison of Perfect Competition and Monopoly
3.4 Control of Monopoly
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
In the previous unit, you learnt about monopoly market- the price maker
and its sources of market power. In this unit, you will learn about price
discrimination as a strategy adopted by the monopolist to increase its
profit. Here, we shall discuss all the three degrees of price
discriminations and their implications. In addition, you will learn about
the differences that exist between perfectly competitive market and
monopoly market as well as government ways of curtailing the
monopolist power.
2.0 OBJECTIVES
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they purchased. A single price schedule for all clients but the prices vary
depending on the quantity of the good purchased. The theory of second-
degree price discrimination is a client is willing to buy only a specific
quantity of a good at a given price. Monopolists know that client’s
willingness to buy decreases as more units are purchased. The job of the
seller is to identify these price points and to reduce the price once one is
reached in the aim that a reduced price will spur additional purchases
from the consumer. For example, sell in bulk rather than units.
SELF-ASSESSMENT EXERCISE
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The graph below illustrates how price discrimination may be used in the
market for airline travel. Those flying for holiday purposes are likely to
have a more elastic demand than those who fly for business purposes.
As the graph below indicates, the optimal price is higher in for business
managers than for holidaymakers. Airlines engage in price
discrimination by offering low price "super subsidy" fares that require a
weekend stay and that tickets/permits be bought two-to-four weeks in
advance. These conditions are much more likely to be satisfied by
individuals travelling for holiday purposes. This helps to ensure that the
customers with the most elastic demand pay the lowest price for this
commodity.
a b
The left-hand side portion of the graph below illustrates the consumer
and producer surplus that is received in a perfectly competitive market.
The right-hand side portion of the graph illustrates the loss in consumer
and producer surplus that results when a perfectly competitive industry
is replaced by a monopoly. As this graph indicates, the introduction of a
monopoly firm causes the price to rise from P(pc) to P(m) while the
quantity of output falls from Q(pc) to Q(m). The higher price and
reduced quantity in the monopoly industry causes consumer surplus to
fall by the trapezoidal area ACBP (pc). This does not all represent a cost
to society, since the rectangle P(m)CEP(pc) is transferred to the
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a b
On the other hand, deadweight loss may understate the cost of monopoly as
a result of either X-inefficiency or rent-seeking behaviour on the part of
monopolies. X-inefficiency occurs if monopolies have less incentive to
produce output in a least-cost manner since they are not threatened with
competitive pressures. Rent-seeking behaviour occurs when firms expend
resources to acquire monopoly power by hiring
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SELF-ASSESSMENT EXERCISE
As noted above, a monopoly firm can produce at a lower cost per unit of
output than could any smaller firms in a natural monopoly industry. In
this case, the government generally regulates the price that a monopoly
firm can charge. The graph below illustrates alternative regulatory
strategies in such an industry. If the government leaves the monopolist
alone, it will maximise its profits by producing Q(m) units of output and
charging a price of P(m). Assuming that the government attempts to
emulate a perfectly competitive market by setting the price equal to
marginal cost, this would occur at a price of P(monopolistic competitive
firm) and a quantity of output of Q(monopolistic competitive firm).
Since this is a natural monopoly, the average cost curve declines over
the relevant range of output. If average costs are declining, marginal
costs must be less than average costs. Thus, if the price equals marginal
costs, the price will be less than average total costs and the monopoly
firm will experience economic losses. This pricing strategy could only
exist in the long run if the government subsidised the production of this
good.
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4.0 CONCLUSION
5.0 SUMMARY
In this unit, you have learnt how a monopolist manipulates its prices to
maximise his profit. The strategy adopted by government to control the
activities of monopoly and the comparison of perfect market structure
with monopoly were also discussed in the unit.
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Concept of Monopolistic Competition
3.2 Features of Monopolistic Competition Market
3.3 Profit Maximisation and Loss Minimisation in
Monopolistically Competitive Market
3.4 Comparison of Monopolistic Competition with Monopoly
3.5 Comparison of Monopolistic Competition and Perfectly
Competitive Market
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
2.0 OBJECTIVES
1. Product differentiation
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could cut prices and increase sales without anxiety that its actions will
prompt retaliatory responses from competitors.
There are numerous firms waiting to enter the market each with its own
"unique" product or in pursuit of positive profits and any firm unable to
cover its costs can leave the market without incurring liquidation costs
in the long run. This implies that there are low capital to start up, no
sunk costs and no exit costs. The cost of entering and exit is very low.
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SELF-ASSESSMENT EXERCISE
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elastic. (To see this, note that when firms leave the industry, the
remaining firms will receive some of the customers that used to
purchase the commodity at the firms that have left the industry.) Exit
from the industry will continue until economic profits again equal zero
(as illustrated in the graph below).
SELF-ASSESSMENT EXERCISE
Each firm produces a differentiated product; hence, it will not lose all of
its customers if it raises its prices. Therefore, a monopolistically
competitive firm faces a downward sloping demand curve for its
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Although the graph above seems similar to the demand and marginal
revenue curves facing a monopolist, there is a critical difference. In a
monopolistically competitive market, the number of firm changes as
firm enters or leaves the industry. As new firms enter the market, the
customers are spread over a larger number of firms and the demand for
each firm's product reduces. An increase in the number of firms also
tends to result in an increase in the elasticity of demand for each firm's
products (because demand is more elastic when more substitutes are
available). The graph below illustrates the shift in a typical firm's
demand curve that occurs when additional firms enter a
monopolistically competitive market.
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It should be noted that the larger the number of firms in the market, the
more elastic will be the demand for each firm's product. As the number
of firms increase, the demand curve facing a monopolistically
competitive firm will approach the perfectly elastic demand curve that is
faced by a perfectly competitive firm. In such a situation, the efficiency
cost of product differentiation will be relatively small.
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SELF-ASSESSMENT EXERCISE
4.0 CONCLUSION
The market does not have unique supply curve and its demand curve is
downward sloping because it s partially price maker and relatively
elastic as its goods has substitutes.
5.0 SUMMARY
In this unit, you have learnt more about another market structure
participant- monopolistic competition. The salient features of the
market, the profit maximisation strategy both in the short and long run,
relationship between demand curve, marginal cost and marginal revenue
in the determination of it profit. You also learnt about the comparison of
monopolistic competition with perfect competitive market and
monopoly market.
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1Oligopoly Market Structure
3.2 Oligopoly Behaviour
3.2.1 Interdependence
3.2.2 Non-price Competition
3.2.3 Mergers
3.2.4 Collusion
3.3Oligopoly Game Theories
3.3.1 Dominant firm/ Price Leadership model
3.3.2 The Cartel Game
3.3.3 Cournot-Nash Model
3.3.4 The Cournot Game
3.3.5 Bertrand Equilibrium Model
3.3.6 Kinked Demand Curve Model/ Rigid Prices Model
3.3.7 Stackelberg Model
3.4 Evaluating Oligopoly
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
In this unit, you will learn about one of the intermediate markets in our
market structure that is, oligopoly or competition. This kind of market is
found in many African countries including Nigeria- where the domestic
market size can only permit few firms to operate effectively in a
particular industry. This unit highlights the salient characteristics of
oligopoly and different models of oligopoly. It also explains price and
output decisions in the short and long run.
2.0 OBJECTIVES
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In an oligopoly industry, there are few firms; thus, each firm's output
represents a large share of the market. Because of this, each firm's
pricing and output decisions have a substantial effect on the profitability
of other firms. Furthermore, when making decisions concerning price or
output, each firm has to take into account the expected reaction of rival
firms. If Nokia lowers the price of their smart phones, for example, the
effect on their profits would be very different if Blackberry company
responded by lowering the price on their phone say Curve 3 by a larger
amount. Because of this mutual interdependence, oligopoly firms engage
in strategic behaviour. Strategic behaviour occurs when the best
outcome for one party is determined by the actions of other parties.
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3.2.1 Interdependence
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3.2.3 Mergers
3.2.4 Collusion
The incentive among oligopolistic firms to cooperate also takes the form
of collusion. With collusion, oligopolistic firms remain legally
independent and autonomous; however, they enjoy the benefits of
cooperation. Collusion occurs when two or more firms secretly agree to
control prices, production, or other aspects of the market.
Collusion can take one of two forms. Explicit collusion results when two or
more firms reach a formal agreement. Implicit collusion results when
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The variety and complexity of the models is because you can have two
to 10 firms competing on the basis of price, quantity, technological
innovations, marketing, advertising and reputation. Fortunately, there
are a series of simplified models that attempt to describe market
behaviour under certain circumstances. Some of the better-known
models are the dominant firm model, the Cournot-Nash model, the
Bertrand model and the kinked demand model.
Tacit collusion
Perhaps you can see that price leadership is almost as good as a cartel. If
the dominant firm knows that the other firms will definitely follow its
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price lead, then they can feel free to set a high profitable price. The other
firms will be happy to follow the lead and also set a high profitable price.
This is why price leadership is sometimes called tacit collusion.
It does not work with too many firms: If there are too many firms,
then at least one is surely not going to be satisfied with its market share,
and will hence compete with the dominant firm on price.
MR = MC1=MC2
In our particular case, both MCs are constant at 100, and MR = 300 –
2Q. So:
300 – 2Q = 100
Q = 100
Combined production of the two firms totals 100. Price per unit is found
using the demand curve:
P = 300 – Q = 300 – 100 = N200
doing, given how it believes the other firm will react to any change.”
The equilibrium is the intersection of the two firm’s reaction functions.
The reaction function shows how one firm reacts to the quantity choice
of the other firm. For example, assume that the firm 1’s demand
function is P = (M - Q2) - Q1 where Q2 is the quantity produced by the
other firm and Q1 is the amount produced by firm 1, and M=60 is the
market.
(Note: Let us use “Q1” to represent the units of output supplied by Firm
1, and “Q2” to represent the units of output supplied by Firm 2. Note
that Q1 + Q2 = Q; in other words, the sum of the output produced by the
two firms equals the quantity supplied to the market. Let us further
assume that the firms produce an identical product, so that each must
charge the same price per unit, P).
MR1 = MC1
(1) The total revenue equation: (Let “R1” represent total revenue of
Firm 1).
R1 = PQ1
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We know that Q = Q1 + Q2
2
R1 = 300Q1 - (Q1 + Q2)Q1 →R1 = 300Q1 - Q1 - Q2Q1
(2) MR1 is the derivative of R1 with respect to
Q1 MR1 = 300 – 2Q1 - Q2
Now Let us get back to our profit-maximising equation and try to figure
out the profit-maximising level of Q1:
MR1 = MC1
300 – 2Q1 - Q2 = 100
2Q1 = 200 - Q2
Q1 = 100 - .5Q2 →firm 1’s reaction curve
So how does Firm 1 figure out how much to produce, since it does not
know Q2? Well, it does know that Firm 2 is identical to it, and that Firm
2 will be doing the same types of calculations. We could do all of the
calculations for Firm 2, but by symmetry you can hopefully see that we
had got Firm 2’s reaction curve similar to Firm 1’s:
Q2 = 66.667 (rounded)
Compare our results to the cartel results. Same two firms, same demand
curve, but different results, because we imposed different rules on the
game and the players.
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Suppose we keep the same two firms, but assume that they compete
viciously based on price—to heck with profits and quantity!
In this theory, each firm faces a demand curve kinked at the existing
price. The assumptions of the model are; if the firm raises its price
above the current existing price, competitors will not follow and the
acting firm will lose market share; and second, if a firm lowers prices
below the existing price, then their competitors will follow to retain
their market share and the firm's output will increase only marginally.
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--If one firm in an oligopoly increases its prices, then none of the other
firms in the oligopoly will raise theirs.
--If one firm in an oligopoly reduces its prices, then all of the other firms
in the oligopoly will reduce theirs.
Demand curve
Above the kink, demand is relatively elastic because all other 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. Therefore, the best option for the oligopolist is to
produce at point E, which is the equilibrium point and the kink point.
This is a theoretical model proposed in 1947, which has failed to receive
conclusive evidence for support.
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Marginal revenue curve: You might think that since the demand curve
is kinked, the marginal revenue curve will also be kinked; contrarily, the
laws of maths dictate that there is a gap in the kink in the demand curve.
The gap in the marginal revenue curve means that marginal costs can
fluctuate without changing equilibrium price and quantity. Thus prices
tend to be rigid.
Assumptions
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q2=(a-c2)/2b – q1/2
From FOC:
Stackelberg equilibrium
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4.0 CONCLUSION
Oligopolies exist where relatively few firms control all or most of the
production and sale of a product. The products may be homogeneous or
barrier to entry are often very high, which makes it difficult for firms to
enter into the industry.
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Some of the game theories under this market include dominant theory,
Cournot model, Cournot – Nash model, Bertrand equilibrium model,
Stackelberg model, kinked demand curve model.
5.0 SUMMARY
In this unit, you have learnt about the oligopoly market and its
characteristics. By now, you should able to explain the various game
theories under oligopoly structure. Some these include dominant theory,
Cournot model, Cournot – Nash model, Bertrand equilibrium model,
Stackelberg model, kinked demand curve model. Lastly, you learnt
about appraisal of oligopoly market structure.
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Concept of Theory Distribution
3.2 Reason for the Study of Factor Pricing
3.3 The Differences between Factor Market and Product
Market
3.3.1 Nature of Demand
3.3.2 Nature of Supply in Relation to Price
3.3.3 Nature of Supply in Relation to Cost
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading
1.0 INTRODUCTION
2.0 OBJECTIVES
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SELF-ASSESSMENT EXERCISE
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Factors of production are never demanded for their own sake thus the
demand here is a derived demand. When workers are engaged or capital
is borrowed, it does not offer any direct satisfaction to the producer. The
employer of factors of production only uses these factors in the
production of goods and services to be finally sold in the product
market. The demand for goods and services is direct demand, as goods
demanded directly satisfy the need of consumer, for example the
demand for apple by a consumer.
The demand of factor of product can also be joint demand because for
producer to produce orange s/he has to demand for all the factors of
production; however, the demand for orange by a consumer is not a joint
demand once he can pay for it.
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The similarities that exist in both market is that in both markets are
fundamentally based on the interaction of the forces of demand and
supply. That is, buyers and sellers play important role in the
determination of price in both markets.
4.0 CONCLUSION
5.0 SUMMARY
In this unit you have learnt, the basic concept of factor market and why
is it different from product market. You also learnt that the interplay of
demand and supply in the determination of price play important role in
both market. Thereafter, the major differences were clearly stated for
your understanding.
Elucidate major differences that exist between the factor market and the
product market.
Bradley, R.S. (2003). The Micro Economic Today. New York, USA:
McGraw-Hill Irwin.
Jain T.R. & Khanna (2011). Managerial Economics. New Delhi, India:
V.K Publications.
Jain T.R. & Khanna (2011). Business Economics. New Delhi, India:
V.K Publications.
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CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Basic Concept of Factor Pricing: Productivity of the
Factor
3.2 Productivity of the Factor
3.2.1 Marginal Productivity
3.3 Marginal Revenue Productivity (MRP)
3.4 Average Physical Productivity
3.4.1 Average Physical Productivity
3.4.2 Average Revenue Productivity
3.4.3 Relationship between ARP and MRP Curves
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
In this unit, you will learn about productivity of factors and its divisions.
You will also be introduced to the concept and the calculation of
marginal productivity and average productivity and different divisions
each of them has. All the relationships that exist among these concepts
will be explained in detail.
2.0 OBJECTIVES
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The clear understanding of basic concepts in factor pricing will help you
appreciate the operations of the market participants both in perfectly
competitive market and imperfect market. These concepts relate to the
following:
a. Marginal productivity
b. Average productivity
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TPPn-1 = Total physical productivity of a factor and n-1 are the units of
the factor employed
Assuming 1000 shirts were produced in a month when 100 labourers are
engaged with 15 units of capital. When 101 labourers are employed with
the same amount capital, 1100 shirts were produced. Calculate the
marginal physical productivity (MPP).
Where,
Or:
MRP = MPP × MR
Where
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SELF-ASSESSMENT EXERCISE
SELF-ASSESSMENT EXERCISE
From the above solution of MPP, assuming the price of the shirt is N100
each and MPP of 101st labourer is 100 shirts, calculate VMPP.
Marginal revenue productivity (MRP) is, on the other hand, the multiple
of MPP and MR
MRP = MPP × MR
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Table 9.1
SELF-ASSESSMENT EXERCISE
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SELF-ASSESSMENT EXERCISE
1. When the ARP curve rises, the MRP curve is above it.
2. When the ARP curve is` at its maximum, a point M, the MRP
curve cuts it from above.
3. When the ARP curve falls, the MRP curve is below it and falls
steep.
4.0 CONCLUSION
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5.0 SUMMARY
In this unit, you learnt about productivity of factors. The average and
marginal productivity of factors were fully discussed and calculated for
you. You learnt about average revenue product and marginal revenue
product and their relationships. The equality between MRP and value of
MPP under perfectly competitive market was also explained to you.
Finally you learnt about relationship between ARP and MRP curves.
Jain, T.R. & Khana, O.P. (2009). Business Economics. New Delhi-2,
India:V.K. Publications.
Jain, T.R. & Khana, O.P. (2009). Managerial Economics. New Delhi-2,
India:V.K. Publications.
196
ECO 231 MODULE 4
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Cost of the Factor
3.1.1 Average Factor Cost (AFC)
3.1.2 Marginal Factor Cost (MFC)
3.1.3 AFC and MFC under Perfect Market Competition
3.1.4 AFC and MFC Curves under Imperfect Market
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
In the last unit, you studied the concept of productivity and all its
divisions. In this unit however, you are going to study the concept of
cost and its divisions. Attempt is made to distinguish between marginal
cost of factor and average cost of labour. The comparison is made
between average factor cost and marginal factor cost under perfectly
competitive and imperfectly competitive market. Before we continue, let
us see what you should be able to achieve after going through this unit.
2.0 OBJECTIVES
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Note: Average factor cost (AFC) and Marginal factor cost (MFC) are
considered the cost of variable factors, as it is the employment of
variable factors which the firm is concerned with.
This is obtained by dividing total factor cost TFC by the total number of
units of the factor employed N (labour)
AFC = TFC/N
Y
P AFC =MFCP
SELF-ASSESSMENT EXERCISE
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3a b
Y MFC
AFC
0 Units of factor X
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ECO 231 MICRO-ECONOMIC THEORY I
SELF-ASSESSMENT EXERCISE
4.0 CONCLUSION
In this unit, you have been able to understand that the cost to the
producer is the income to the households that possess factors of
production used to produce goods and services. The expenditure
incurred on the factors of production in the process of producing goods
and services is considered as cost of factor. You further learned that
marginal factor cost is the extra amount expended on the factor to have
extra unit of output. In this unit you are able to get the relationship
between Average Factor Cost and marginal factor cost, and how prices
of factors are determined under perfectly competitive market and
imperfectly competitive market.
5.0 SUMMARY
By now you should have learnt the difference between the productivity
of factor and cost of factor. In this unit, you learnt about the concept of
cost factor and its various divisions such as average factor cost and
marginal factor cost. You learnt the concept of these factors under
perfectly competitive market and imperfect market. Finally, you were
taught how to calculate each of them.
Critically examine the difference between the concept AFC and MFC
under the following market:
Jain, T.R. & Khana, O.P. (2009). Business Economics. New Delhi-2,
India:V.K. Publications.
Jain T.R. & Khana, O.P. (2009). Managerial Economics. New Delhi-2,
India:V.K. Publications.
200
ECO 231 MODULE 4
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 The Concept of Marginal Productivity Theory of
Distribution (Factor Pricing)
3.2 Assumptions of the Marginal Productivity Theory
3.3 Problem Inherent in the Use of Marginal Productivity
Theory
3.4 Demand for a Factor of Production
3.4.1 The Magnitude of Demand
3.4.2 Elasticity of Demand for Factors
3.5 Market Demand Curve for a Factor of Production
3.6 Supply of a Factor of Production
3.7 Equilibrium in Factor Market
3.8 Problem Inherent in the Theory of Factor Pricing
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
2.0 OBJECTIVES
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ECO 231 MICRO-ECONOMIC THEORY I
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ECO 231 MODULE 4
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ECO 231 MICRO-ECONOMIC THEORY I
SELF-ASSESSMENT EXERCISE
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ECO 231 MODULE 4
We have stated earlier that the demand curve for a factor is the marginal
revenue productivity curve of a firm. If we add up laterally individual
demand curves of all the firms, we get market demand curve for a
factor. This is illustrated below.
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ECO 231 MICRO-ECONOMIC THEORY I
1
In the diagram above, when the wage is OW the firm s in equilibrium
2
at point K and the demand for the factor is OR. When wage is OW , the
firm is in equilibrium at point M. The firm engages OS units of a factor.
If we sum up laterally the individual demand curves of all the firms, we
/
get DD market demand curve for a factor.
It is clear from this Fig. 18.3 (b) that with the fall in wages, the demand
1
for a factor increases and vice versa. For instance, at OW , market is
OK units (in thousands) of factor are demanded. When wage falls to
OW, the demand for factor increases from OK to OR. With further fall
2
in wage to OW , the market demand for factor increase from OR to OS.
The market demand curve for a factory is a negatively sloped curve
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ECO 231 MODULE 4
SELF-ASSESSMENT EXERCISE
We have stated earlier that the demand for various factors of production
is a derived demand. Just as the supply and stock of a commodity can be
different, similarly, the supply and stock of a factor of production can
also vary. If the supply price of a factor is high, other things remaining
the same, the larger will be the units of factor offered for sale. If the
supply price is low, less quantity of factors of production will be
supplied in the factor market. The supply of a factor to an industry
depends upon the transfer earnings of the various units of factor.
Another characteristic of factors of production is that they do not bear
direct relation between the prices of services offered by the factors of
production and their cost of production.
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ECO 231 MICRO-ECONOMIC THEORY I
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ECO 231 MODULE 4
/ /
In the diagram above, DD is the demand curve and SS is the supply
curve of a factor, the demand and supply curves intersect at point E. The
equilibrium factor price is OP. The price of a factor cannot be stable at
the level higher than or lower than OP. For example, the price cannot be
1 1
established at OP since at price OP , the quantity offered to supply, is
greater than the quantity demand (QM). Therefore, the competition
between the owners of the factor will force down the price to OP level.
2
Similarly, the price of factor cannot be determined at the level of OP
because at this price, the supply of a factor is less than demand by
1 1
M Q . The competition among the producers demanding the factor of
production will push the price to OP level. We thus find that the reward
of a factor of production is determined by the interaction of the forces of
demand and supply.
SELF-ASSESSMENT EXERCISE
With the use of graphical illustration explain how the forces of demand
and supply determine the price of factor in the factor market.
4.0 CONCLUSION
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ECO 231 MICRO-ECONOMIC THEORY I
5.0 SUMMARY
In this unit, you learnt about marginal productivity theory, which states
that a factor of production is paid price equal to its marginal
product.You were also taught the assumptions of marginal productivity
theory such as prevalence of perfect competition in factor as well as
product market, all factors are identical, perfect substitute for each other,
perfectly mobile, perfect divisibility of factors and so on. You also learnt
that the demand for factor is a derived demand and supply for factor is
directly related to price of offer. The equilibrium in this market is
determined by the forces of demand and supply. You also learnt about
factors that determine both the demand and supply of factor in the factor
market.
Jain, T.R. & Khana, O.P. (2009). Business Economics. New Delhi-2,
India:V.K. Publications.
Jain T.R. & Khana, O.P. (2009). Managerial Economics. New Delhi-2,
India:V.K. Publications.
210
ECO 231 MODULE 4
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 The Factor Market under Perfect Competition
3.2 The Factor Market Equilibrium under Perfect Competition
of the Firm
3.3 Firm's Equilibrium
3.4 Factor Pricing under Imperfect Competition
3.5 Factors Price Determination under Imperfect Market
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References /Further Reading
1.0 INTRODUCTION
In this unit, you will learn how the factor market under perfectly
competitive market and imperfect competition operate. Furthermore, the
firm’s equilibrium, factor pricing under imperfect competition, factors
price determination under imperfect market are also examined.
2.0 OBJECTIVES
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ECO 231 MICRO-ECONOMIC THEORY I
individual buyers and sellers of a factor take the market price of a factor
as given and adjust the quantity of a factor in the light of market factor
price. The buyers and sellers of a factor are therefore called price takers.
Each firm faces a perfectly elastic resource supply curve. The diagram
below illustrates this relationship. The market price of the resource is
determined by the interaction of market demand and supply. As you
have known that each firm is a price taker in a perfectly competitive
resource market, each firm faces a resource supply curve that is
perfectly elastic at the equilibrium resource price.
Since each firm is a price taker in a perfectly competitive resource
market, the additional cost that results from the use of an additional unit
of the resource is just equal to the resource price. Thus, the marginal
factor cost curve is horizontal at the market price of the resource in such
a market. Two possible MFC curves are illustrated in the diagram
below.
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In the figure above, we assume that labour is the only variable factor in
the factor market. KL straight line represents the marginal wage rate. All
the firms in the factor market can hire any number of workers at the
ruling wage of OK. The marginal revenue product curve of labour cuts
the wage line KL at two points P and R. The firm is not in equilibrium at
point P because by the employment of increasing number of workers,
the marginal revenue product raises higher than the marginal factor cost
(MFC) or the marginal wage OK. At point R, the marginal revenue
productivity of the labour is equal to its marginal factor cost. When the
firm employs OE number of workers, it is in equilibrium because at
point R, marginal revenue product of the variable factor is equal to
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ECO 231 MICRO-ECONOMIC THEORY I
marginal factor cost (MFC). In case a firm decides to engage more than
OE workers, the marginal factor cost (marginal wage) will exceed its
marginal revenue productivity. The firm with therefore not be in
equilibrium.
Assuming in the factor market there is only one firm to employ while
there is perfect competition in the product market. As the demand of this
firm for the labourer goes on increasing, marginal factor cost (MFC) and
average factor cost (AFC) of these labourers will also go on increasing.
Both MFC curve and AFC curve will be upward sloping and MFC curve
will rise more steeply than average factor cost curve. AFC and MFC are
referred here as supply curve while marginal revenue product is the
demand curve for labour. In the imperfect market (monopsony), a firm
will employ that number of labourers at which their marginal revenue
productivity (MRP) is equal to their MFC. This is the equilibrium
situation.
Average factor cost is the price of the factor concerned with labour.
Since marginal wage or MRP is more than average wage, the labourers
will be receiving a wage rate which will be less than their marginal
productivity. Therefore, under monopsony, labourers will suffer
exploitation. Exploitation of factor refers to a situation in which it is
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employed at a price that is less than its marginal productivity. The extent
of exploitation depends upon the difference between marginal wage or
marginal revenue productivity and AVC.
Y- Factor cost
MFC (MW)
A E
AFC (AW)
W expl
F
MRP
L X- Units of factor
4.0 CONCLUSION
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ECO 231 MICRO-ECONOMIC THEORY I
5.0 SUMMARY
In this unit, you learnt about the operations of factor market under
perfectly competitive market and under imperfect market. You also
studied how the equilibrium is established in the market by the forces of
demand and supply. Factor pricing in these two distinct markets were
also explained.
Jain, T.R. & Khana, O.P. (2009). Business Economics. New Delhi,
India: V.K. Publications.
Jain T.R. & Khana, O.P. (2009). Managerial Economics. New Delhi-2,
India:V.K. Publications.
216