Economics 101

Chapter 1:

Introduction to Economics

Economics deals with the problem of Scarcity. It is concerned with the how resources are distributed.
The problem of scarcity can be envisage as a two-pronged problem:

(i) At any point in time there is a limited stock of resources

(ii) At any point in time there is an unlimited wants

NB it is important to differentiate between Scarcity and Poverty.

Resources

Resources can be defined as inputs that are used in the production of the goods and services that we
desire. When resources are productive they can be referred to as factors of Production.

Factors of production can be classified into:

(i) Natural resources – example, Land and mineral deposits

(ii) Human Resources – example, Labour or Human Capital – enterprenuership
(iii) Manufactured Resources – example, Capital (Machinery used in production) - Physical
Capital

Types of Goods

Scarce resources produces Economics Goods. Economic Goods are goods derived from scares
resources.

Free Goods – These are a few things that nature can provide at zero price.

Choice

Since most of the goods fall under economic goods (are not free) we have to make a choice. Scarcity
forces us to choose

This leads to the definition of Economics ;- Economics is the study of how individuals or societies
choose between the alternative use of scarce resources to satisfy their unlimited wants.

Opportunity Cost

Every indidvidual has unlimited competing wants that cannot all be satified due to unlimited resources.
Therefore a choice has to be made. Choosing to fulfill a specific wants means other wants have to be
forgone. In a world of scarcity, for every wants that is satisfied, some other want(s) remained
unsatisfied. This brings up the concept of opportunity cost. Opportunity Cost refers to as the highest
valued alternative that had to be sacrificed or forgone for the option that was chosen.

Trade off – Opportunity cost leads us to the concept of trade-off. Choicing meaning trading off one use
of a resource to one or more other use. This leads us to the concept of Production Possibilities Curve/
Production Possibilities Frontier.
Production Possibilities Curves

PPC can be defined as all possible combinations of the maximum amount of any two goods or services
that can be produced from a fixed amount of resources at a specifc point in time all other factors held
constant. PPC can be a straight line.

Production Possibilities Curves (PPC) shows Scarcity, choice,opportunity cost, Trade-off and efficiency.
The curve or the frontier shows that one can not produce anything beyong the curve or frontier. It show
the idea of limited resources. The curves shows trade-off; to be able to produce a unit more of one
good, I have to reduce the production of the other good or services by a specific amount. Giving up x
unit of one good or sevice to produce a unit more of the other. Opportunity cost is the number of unit of
goods forgone or sacrifaced in the production of a unit more of another good. Any production/
combination inside the curve shows inefficiency- the limited resources have not been fully utilised.
Effeciency is production alone the curve. It is important to have production outside the curve due to the
limited resources available at any point in time.

NB Any point that is outside the production possibilities curves is unattainable due to the limited
available resources. Any point that is inside the curve (not along the curve) represents an ineffficient use
of available resources. PPC shows a Trade- off between the two goods and services. Trade -Off occurs
along the Production Possibilities Curves.

When any one of the factors affecting productivity changes, the production possibilities curve shifts
either inwards or outwards. For instance if there is a technological invention that greatly improves
productivity, then the Curve will shift outwards. On the other hand if the labour time reduces, the curve
will shift inwards to the left.

NB See the concept of one - to - one Trade off.

Assumptions underlying the Production Possibities Curves

1. We have a specified time period over which the production takes place.
2. There are limited resources available over this period of time.
3. We also assume that all other factors that may affect the production of the goods and services
are held constant.
4. All the available resources are effectively utilised.

Why the Production possibilities curves is bowed outwards – Shows the law of increasing relative cost.

In special cases, we might have Production possibilities curve that is straight. This means that the trade-
off ratio is fixed, that is the opportunity cost of obtaining more and more units of one good remain
constant. In more general case the Production possibilities curve bows outwards, that is, the
opportunity cost of obtaining more and more units of one good rises – Each additional unit cost more in
forgone alternatives than the previously produced unit. This concept brings us to the law of increasing
relative cost. That is as society takes more and more resources and applies them to the production of
any specific item, the opportunity cost for each additional unit produced increases at an increasing rate.

Consumer Goods and Capital Goods

Conusmer Goods are goods that we consumer direclty for instance clothes, fruits, drinks. While Capital
goods are goods that we consumer indirectly like Machinery. Capital goods are used to make consumer
goods.

Trade-Off Between Consumer Good and Capital Good

Production of Capital goods of Capital Goods helps us to produce more Consumer goods in the future.
Producing Consumer Goods only without Capital Goods curtains the production of Consumer goods in
the future. To have more consumer goods in the future, we must accept fewer consumer goods today.
With the resources that we do not use to produce consumer goods today, we invest in the production of
Capital goods in-order to have more consumer goods tomorrow. In other words, the more we give up
(as consumer goods) today the more we have in future. More Capital goods today leads to a more
production of future Consumer Goods.

Economics As a Social Science

Just like any other science subject, economics uses theories and models.

Economics As an Empirical Science

Evidence is used in testing the usefulness of economic models. Empirical meaning that real evidence
(real data) is looked at to see if the model does the right thing.

Ceteris Paribus Assumptions – means other factors held constant.

Economic Model (Between the Firm and the household)

The household sell factors of production to the firm in return the firm pays the household money
income in form of wages, interest, rents, and profits. The household receive wages for their labor
service, interest for their capital service, rent for the land they own and profits for their entrepreneurial
abilities. The firm produces finished goods and services and sell them to the household who in return
pays money.

Branches of Economics

There are two main branches of Economics, that is, Macroeconomics and Microeconomics.

Macroeconomics is the study of the entire economy. Here we look at broadly defined macroeconomics
variables for instance the overall output of a region.

Fields in Macroeconomics

1. Monetary Economics
a. Money
b. Central Banking and Policy
c. Interest rates
d. Credit market
2. International Economics
a. Trade
b. Exchange rates
c. International Investment
 d. Growth and Development
e. Foreign Aid

Microeconomics is the study of choices and behavior of individual consumers, businesses, and
governments. Or the study of individual economic actors such as firms or households.

Chapter 2

Economics Systems of the World

Economics Systems is a mechanism used by the society to determine how best to allocate scarce
resource. The various economics systems help to answer the following three economics questions.

1. What to produce?
2. How should we produce?
3. To whom should we produce?

All societies face the problem of scarcity. The difference is in how each community tackle the problem.
The difference is in the degree of government control of the economy that is, the extent of which the
government decide what, how much and to whom to produce.

At the one extreme lies the Centrally planned economy –(Command/Communism) and at the other
extreme lies the free market economy. In practical all economies are a mixture of the two economies,
the difference is in the degree of government interactions. For instance, in China, the government plays
a large role while in USA, the government plays a small role. Countries differ in the type of government
intervention as well as levels. Government can intervene through; planning, public ownership,
regulation, taxes and subsidies, partnership schemes with private industry and so on.

Three common economic systems around the world.

1. Free Market (Market Economy)

2. Centrally planned Economy (Command Economy)
3. Mixed Economy (Keynesian Economy)

Free Market Economy- Adam Smith

Free Market Economy operates on itself through competition and consumer purchasing without
government interaction. This concept is called Laiseez Faire economics. Firms produces goods and
services that consumer needs and wants the most. Consumers purchase these products to maximize
their own utility and at the same time firms needs to produce quality goods and services in-order to
remain competitive in the market (to compete for profits). Everyone (every entity) acts on their own
selfish interest and by doing so meets the needs of the society through market interaction. This is what
is referred to us the Invisible Hand. Invisible Hand are the nature forces that allow the market to
control itself. Thus the phrase a pursuit of private gain leads to a social good.

In the free market economy, consumers act to satisfy their own utility by buying goods and services that
they need and want. The answers the question, what should be produced?
Firms act to satisfy their profit motive by producing at lower cost. This answers the question, How
should goods and services be produced?

The natural forces of the economy or the Invisible hand helps to answer the question, to whom should
the goods and services be produced for?

In a free market economy, all the economic decisions are made by firms and companies without the
government’s interaction. Individuals and firms are free to make their own economic decisions.
Individuals can freely decide what to buy with their income and firms can decide what to produce,
techniques used for production. The demand and supply decisions for consumers and firms are
transmitted to each other through their effects on prices - price mechanism. Price Mechanism is the
interaction between supply and demand in the market economy.

Price Mechanism

Prices respond to shortage and surplus. Shortage results in price raising while surplus result in price
dropping. When consumers want more of a good or the producers decide to cut back on supply, the
demand will exceed the supply causing a shortage. This will lead to increase in the prices of the good.
This will act as an incentive for producers to increase production and supply since producing or supply to
satisfy their profit motive. It will discourage consumer from buying too much. Prices will continue to
raise until the shortage is eliminated.

On the other hand, if consumers want less of a specific good or producers supply more off a good, the
supply will exceed the demand causing a surplus in the market. This will cause the price of the good to
drop. This will be a disincentive for producers to supply more since producing more will be less
profitable. Consumers will be motivated to buy more. The price will continue to fall until the surplus is
eliminated.

The price where demand is equal to supply is called Equilibrium Price.

The effect of Change in Demand and Supply on Price Equilibrium

In all cases of changes in demand and supply, the resulting changes in prices act as both signals and
incentives.

A change in demand- A rise in demand is signaled by a rise in price, which then act as an incentive for
supply to rise. The higher price in these goods relative to their cost of production signals that consumers
are willing to see resources diverted from other uses. Firms use this approach; they divert resources
from goods with lower cost hence lower profits to goods with more Profits.

A fall in demand is signaled by a fall in price. Then this act as an incentive for supply to fall. The goods
become less profitable to produce.

A change in Supply – A rise in supply is signaled by a fall in price. This then acts as an incentive for
demand to rise. A fall in supply is signaled by a rise in price, which then acts as an incentive for demand
to fall.

NB Markets adjust in-order to equate demand and supply.

The Interdependence of the Markets

The interdependence of the goods and factor markets – A rise in the demand for a good will raise its
price and profitability. Firms will respond by supplying more. However, to do this more inputs (Factors of
production). Thus, the demand for inputs will rise which in turn will raise the prices of inputs. The
supplier of the Inputs will respond to this incentive by supplying more. See the summary below.

I. Good market
a. Demand for goods rises.
b. This causes a shortage.
c. This causes the price of the goods to rise.
d. This eliminates the shortage by reducing demand and encouraging the suppliers of
inputs to supply more.
II. Factor market
a. The increased supply of the good causes an increase in the demand for factor of
production used in making it.
b. This causes a shortage of those inputs.
c. This causes their price to rise.
d. This eliminates their shortage by reducing demand and encouraging the suppliers of
inputs to supply more.

Challenges associated with free market.

I. Free market does not maximize efficiency and fairness in the allocation of scarce resources.
Individual or firms with more power and property are like to make more at the expense of
people with less.
II. Presence of limited competitive firms – monopoly – supply set higher price for their goods.
III. Instead of responding to the need of the society suppliers use advertising to persuade the
consumers ‘wants.
IV. Ethical Objection – free market with rewarding self-interested behavior, it encourages
selfishness, greed, materialism, and acquisition of power. Free market may fail to meet the
various social objectives.

Centrally-Planned Economy (Command/Communist/Socialist) – Karl Marx

In a Centrally planned economy, the government or a central administrative figure owns and controls all
the resources, decide what to produce, how much to produce and who to receive the produce. All the
economic decisions are made by the government. Examples of countries who’s centrally planned
Economic system is their major system are Cuba, North Korea, former Soviet Union and China.

In Centrally planned economy, the government/ state or a central administrative figure plan the
allocation of resources in three different levels.

(i) Allocation of resources between current consumption and investment for the future.
Sacrificing present consumptions and diverting resources to investment for the future for
economic growth.
 (ii) At microeconomic level, the state plans the amount of output that firms and individuals
produce. This is done through an input -output analysis. The state considers the technique
used, the labor and other resources used in the production.
(iii) Allocation of output to consumers. This can be based on the various factors such as giving
more to those who produce more to act as incentive for production, or giving more to those
who needs more, setting lower prices to encourage consumption of goods and setting high
prices to discourage consumption.

Challenges of a Centrally Planned Economy

The bigger and the more complex the economy the greater the task of collecting and analyzing
information required for planning and the more complex the plan.

If there is no system of pricing or if pricing is done arbitrarily by the state or government, then planning
is likely to lead to inefficient use of resources.

It is difficult to set up incentives for workers and managers to increase production without reducing the
quality of goods and serves.

Right from 1980s, some communist countries have abandoned centrally planned economy and adopted
private enterprises. In the western countries, it has been because of deregulation of private industry and
privatization of government owned entities.

Mixed Economy

Due to the challenges associated with both the free market and the centrally planned economy, most
real-world economies are a mixture of the two economic systems.

In a mixed economy, economic decisions are made partly by the government or a central administrative
figure and partly through the market.

The government may control the following:

I. The relative prices of goods and inputs through taxation, subsidies, and direct price control.
II. Relative income through income taxes, welfare payment or direct control over wages, profits
and rents.
III. The patterns of production and consumption through subsidies and taxation, use of legislation
and direct provision of goods and services.
IV. The microeconomic problems of unemployment, inflation, lack of growth, balance of trade
deficits and exchange rate fluctuations, by the use of taxes and government expenditure, the
control of bank lending and interest rates, the direct control of prices and control of foreign
exchange rates.
Informal Sector

The parts of the economy that involves production and /or exchange, but where there are no money
payment. For instance, many activities done in groups such as clubs and charities, involve the provision
of goods and/or services, but no money changes hands.

Subsistence Production

This is a part of the economy where people produce goods and services for their own consumption.

Chapter 3 Supply and Demand

The price mechanism act as a transmitter of information from the producers to the consumers and from
the consumers to the producers, as well as an incentive.

Demand

The Relationship between Demand and Prices

The law of Demand – There is an inverse relationship between price and quantity demanded, when the
price of a good rises, the quantity demanded fall. There are two reasons for this:

I. People will feel poorer. They will not be able to afford to buy as much good with their money.
Their purchasing power of their income fall. This is called the Income effect of a price rise.
II. The good will now cost more than alternative or substitute good and people will switch to those
substitute goods. This is called the substitute effect of a price rise.

NB Quantity demanded refers to the amount that consumers are willing and able to purchase at a given
period.

The Demand Curves

As the price reduces the quantity demanded increases. Plotting the prices against the quantity
demanded forms the Demand Curve.

Demand curve is a downwards sloping curve, reasons:

I. The substitution effect.

II. The Income effect.
III. The Law of Diminishing marginal Utility – Marginal means additional, Utility means Satisfaction.
The law of diminishing marginal Utility states that as you continue to consume a given product,
you will eventually get less additional utility from each unit you.
A change in prices moves along the price curve but a change in anything else other than the price
changes shifts the curve either outwards (right) or inwards (left). A shift to the left show a decrease in
demand while a shift to the right show an increase in demand.

Determiners Or Shifters of Demands

I. Taste and Preference

Taste and preference are affected by advertising, Trends, fashion, Observing other Consumers,
health consideration and experience from prior consumption.
II. Income-
If the income of an individual increases, the ability for the person to purchase more Normal
goods increases, thus increase in demand for Normal Goods and decrease in the demand for
Inferior Goods.
III. Change in Expectation – If we know or expect the price of a good to increase in the coming days,
the demand for that good will increase now, because people will want to acquire it now at a
cheaper price.
IV. The Price of Relative Goods – Complementary and Substitute
If the price for an alternative or substitute good increases, the demand for the good will
increase since people will move from the substitute to the good.
V. Number of Customers
If new consumers move into a town, the demand for a good will increase.

Movement Along and Shift in the Demand Curve

A change in price is illustrated by the movement along the Demand Curve. The movement along the
demand Curve assume all other factors are held constant (Ceteris Paribus). If other determinants other
than price are at play, the curve shift either to the right (Increase in demand) or to the left (Decrease in
demand). To understand the difference between movement along the demand curve and the shift in the
curve, we need to understand the difference between Change in the Demand and Change in Quantity
Demanded.

A movement along the Demand Curve due to the change in price is referred to as the change in the
quantity demanded.

A shift in the demand curve either to the right or left is referred to as the change in demand.

Supply

Supply and Price

The law of Supply - There is a direct relationship between the price of a good and the quantity supplied.

When the price of a good rises, the quantity supply also rises. There are three reasons for this:

1. As the prices of a commodity rises, production becomes more profitable for

the manufacturers or farmers. This act as an incentive to supply more.
2. Given time, if the price of a goods remain high, new manufacturers are likely
to enter the market therefore increasing the market supply.
3. Increasing production past a certain level result into increase in the cost of
production, for manufacturers to be persuaded to increase production past
that level, the price of the good will have to increase.

Supply Curve

Supply Curve is a graph showing the relationship between the price of a good and the quantity of the
good supplied over a given period.

Supply Curves are upward sloping curves. Movement along the curve is due to the change in the price of
the good.

Shifters/ Determiners of Supply Curve

An increase in supply shifts the curve to the right and a decrease in supply shifts the curve to the left just
like the demand Curve.

Shifters:

1. The price of Resources (Factors of production)

Increase in the prices of factors of production makes production of goods to be expensive and
less profitable. Producers will opt to reduce the amount of goods produced to satisfy their profit
motive, therefore reducing the supply of goods. – The curves move to the left.
2. Increase in the number of producers:
 Increase of producers in the market will lead to the increase in supply therefore the curve shifts
to the right.
3. Technology & Technological advancement
Adaption of a new technology or advancement in technology boost production, therefore
increases supply since production of more goods is likely to be cheaper.
4. Taxes and Subsidies -Government Policy
Increase in taxes for inputs or factors of production rises the cost of production, therefore
producers will produce less, therefore shifting the curve to the left. When the government put
subsidies on input or resources production becomes cheaper, therefore producers are likely to
produce more at a cheaper cost therefore increasing the supply.
5. Expectations (Future Expectations)
If manufactures think that the prices of a goods will rise after a few months, they will horde back
supply now and sell when the prices are high for higher profits. Thus, decreasing the supply and
the curve shifts to the left.
6. Change in organizational Structure – For instance Increase in labor, increase production thus
increases supply and verse visa.
7. The price of a Substitute Good - If the production of an alternative good becomes more
profitable, producers are likely to alter their to production to produce the substitute good to
meet their profit motive, thus lowering the supply of the good.

NB A change in price moves along the supply curves and a change any other determiners apart from
prices will make the curve shift to either the right or left. This helps us understand the difference
between change in supply and Change in Quantity Supplied.

A movement along the supply curve is often referred to as a change in quantity supplied whereas a shift
in the curve refers to as a change in supply.

PRICE AND OUTPUT DETERMINATION

Equilibrium Price and Output

A sustainable price is when quantity demanded is equal to quantity supplied. At this price, the market is
said to be clear, no shortgages and no surplus. Market Clearing is when supply matches demand, there
is no shortages and no surplus.

The price at which the quantity demanded is equal to the quantity supplied is called Equilibrium Price.

Equilibrium Price is the price at the intersection of the Demand and Supply Curves. A point on the curves
where demand equals supply.

NB The Equilibrium Price remains the same as long as one or both curves – Demand and Supply curves-
do not shift. A shift in either of the two or both will lead to a New Equilibrium Price.

A Shift in the Demand Curve – A shift in the Demand Curve means the demand curve will move along
the supply curve therefore adjusting the point of intersection (Equilibrium Price).
A Shift in the Supply Curve – A shift in the Supply Curve means the supply curve will move along the
demand curve therefore adjusting the point of intersection (Equilibrium Price).

NBB A shift of the supply curve to the right increases the Equilibrium Price whereas a shift to the left
reduces the Equilibrium Price.

NB People and Firms response to incentives.

ELASTICITY

The Price Elasticity of Demand

The responsiveness in demand to a change in price is Called Price Elasticity of Demand. For example
how will demand respond /change to increase in prices for both Cabbarge and oil. A rise in the price of
oil is likely to result in a relative small fall in the quantity demanded. If peple wants to continue driving
they have to pay higher price for the oil. Some may opt to cycle or ride bicycles, some may make fewer
journeys, but for most people, a rise in the prices of diesel and petrol will make little difference in the
short term to how much they use their car.

On the other hand, a rise in the price of Cabbarge, will have a drastic fall in the quantity demanded since
most people will opt to consume alternative / substitute goods at a reasonable or cheaper prices.

One good will have a relatively small fall in quantity demanded while the other will have a relatively
drastic fall in the quantity demanded.

A good is said to be more elastic than the other if a relatively small change in price causes a large
increase in quantity demanded. Therefore Cabbarge is more elastic than oil.

Measuring Price Elasticity of Demand

Measuring Price Elasticity of Demand entails comparing change in quantity demand and the change in
price. The two entities are measured using different units, therefore we will use percentage change or
Proportion to compare th two.

Price Elasticity of Demand = Percentage (Proportionate) change in Quantity Demanded / Percentage

(Proportionate) change in price

% ∆Q D
Price Elasticity of Demand P ∈D =
%∆P
If a 40 percent rise in the price of oil causes the quantity demanded to fall by a mere 10 percent, then
the price elasticity of demand for oil will be:

% ∆Q D −10 %
P ∈D = = =−0.25
%∆P 40 %
If a 5 percent rise in the price of Cabbarge causes the quantity demanded to fall by 15 percent, then the
price elasticity of demand for oil will be:

% ∆Q D −15 %
P ∈D = = =−3
%∆P 5%
Cabbarge is more elastic then oil.

Interprating the Figures/ Answers

The Negative or Positive Sign – The Demand Curve is downward sloping. This means that the quantity
demanded and price move in the opposite direction. When the price rises (Positive) the quantity
demanded falls (Negative) whereas when the price falls (falls), the quantity demanded rises (Positive).
When calculating the Price Elasticity of demand, we either divide a positive change in quantity
demanded by a negative change in price or a negative change in quantity demanded by a positive
change in price, either way we end up with a negative figure as the answer.

Figure (Ignoring the sign)

Elastic ∈>1 Elasticity is greater than one implies that a change in price of the good will cause a
proportionate larger change in the quantity demanded.

Inelastic ∈<1 Elasticity is smaller than one implies that a change in price of the good will cause a
proportionate smaller change in the quantity demanded.

Unit ∈=1 Elasticity is equal to one implies that a change in price of the good is proportional to the
change in the quantity demanded (Unit elasticity of demand). Implies the price of good and quantity
demanded change by the same proportion.

Determinants of Price elasticity of demand

Price elasticity varies enormusly across the various products.

1. The number or /and the closeness of Substitute goods - The more substitute there are and the
more closer they are to the good, the more people will switch to these alternatives when the
price of the good rises: therefore , the greater the price elasticity of demand.
2. The proportion of income spent on the good - The higher theproportin of our income we spend
on a good the more we will be forced to cut consumption when its price rises: the bigger will be
the income effect and the more elastic will be the demand.
3. The time period – When price rises, people may take time to adjust their consumption patterns
and find alternative. The longer the time period after a price change the more elastic the
demand is likely to be. For example In the oil industries, It is estimated that the price elasticity of
demand for fuel is -0.07 in the short run, -0.13 in the medium term and -0.85 in the long run. Oil
is more inelastic in the short run than in the long run. If fuel prices rise, people will find it dificult
to reduce their consumption by a significant amount in the short run.

Price Elasticity of Demand and Consumer Expenditure

Total Consumer Expenditure = Price per item * Quantity Demanded

TE=P x Q
Total Consumer Expenditure is equal to the Total Revenue collected by the firm for the sale of products,
before taxationa and other deductions.
TR=TE
What will happen to consumer expenditure ( and hence firm’s revenue ) if there is a change in price?
The answer depends on the price elasticity of demand.

Answer

Elastic Demand

For goods with elastic demand, quantity demanded changes proportionately more than changes in
prices.

As the price rises, the quantity demanded falls and vice versa. When the demand is elastic, the quantity
demanded changes proportionately more than price. Thus a change in quantity demanded has a bigger
effect on total consumer expenditure than does the change in price. This can be summarised as follows:

P rises; Q falls proportionately more; thus TE falls.

P falls; Q rises proportionately more; thus TE rises.

NB Total Consumer Expenditure change in the same direction as the quantity demanded.

The Triangles in the middle show the Total Consumer Expenditure.

As the price increases, the Total Consumer Expenditure reduces as shown below.
Inelastic Demand

For goods with Inelastic demand, price changes proportionately more than the quantity demanded.
Therefore price has a greater impact on the Total Consumer expenditure that the quantity demanded.

To summarize this we say that:

P rises; Q falls proportionately less; thus TE rises.

P falls; Q rises proportionately less; thus TE falls.

The Total Consumer Expenditure changes in the same direction as the change in Prices.

The Triangles below show the Total Consumer Expenditures and how change in price affects Total
Consumer Expenditure.

NB Assume that demand for a product is inelastic. Will consumer expenditure go on increasing as price
rises? Would there be any limit?

Three Special Cases

The Totally Inelastic Demand

Pϵ D =0 - This is shown by a vertical straight line. No matter the changes in the price of a good, the
quantity demanded remains the same. It is clear that the Total Consumer Expenditure increases with
incraeses in the Price.

Inifinitely Elastic Demand

Pϵ D =−∞ - This is shown by a horizontal straight line. At prices above P 1 the quantity demanded is Zero
and below P1 quantity demanded is inifinitely large. The Total Consumer expenditure increases with
increase in Quantity Demanded.

The Unit Elastic Demand

Pϵ D =−1 - The price and quantity demanded change by the same proportion.Therefore, the Total
Consumer Expenditure remains the same.

The Measurement of Elasticity

NB Price Elasticity of Demand refers to the percentage or the proportionate change in quantity
demanded divided by the percentage or proportionate change in price of the good.

There are two methods of measuring elasticity: Arc elasticity and Point elasticity

Arc Elasticity

NB A mistake people make is to talk about the Elasticity of the whole curve. In most cases elasticity
various along the length of the curve. Normally we can refer to elasticity of a portion of the demand
curve not the whole curve. However, there are two exceptions to this:

i) The case of the three above special cases where the elasticity is the same all along the
curve.
NB Although we cannot talk about elasticity of a whole curve, but we can talk about elasticity between
any two point along the curve.The is known as arc elasticity.

Arc elasticity is the measurement of elasticity between two point on a curve.

Proportionate ∆ Q
Formula =
Proportionate ∆ P
∆Q
Proportionate ∆ Q=
Q
∆P
Proportionate ∆ P=
P
∆Q ∆P
Price elasticity of demand (arc elasticity) = ÷
midpoint Q midpoint P
Example

What is the elasticity of Demand between point m and n?

Answer

Proportionate ∆Q
Pϵ D =
Proportionate ∆ P
 ∆Q
Proportionate ∆ Q=
midpoint Q
∆P
Proportionate ∆ P=
midpoint P

∆Q ∆P
Price elasticity of demand (arc elasticity) = ÷
midpoint Q midpoint P
10 −2
÷
Price elasticity of demand (arc elasticity) = (10+20) (8+6)
2 2
10 −2 −7
Price elasticity of demand (arc elasticity) = ÷ = =−2.3333333
15 7 3
Ignoring the negative, since the Price Elasticity of Demand Pϵ D >1 the demand is elastic between point
n and m.

Method 2: The Point Elasticity

Rather than measuring elasticity between two points along the demand curve, we measure elasticity for
a single point along the curve for instance point r.
 ∆Q ∆P
From the arc method, elasticity of demand is given by Pϵ D = ÷
Q P
∆Q P
Rearranging the formula we get ×
∆P Q
For point method, we want to see the impact of an inifinitesimally small change in price on the quantity
demanded. Inifinitesimally small change in price is denoted as ∂ . Therefore our formula becomes

∂Q P ∂Q ∂Q
× where is the differential calculus of quantity demanded with respect to price. is
∂P Q ∂P ∂P
obtained by getting the gradient of the slope. Draw a tangent line passing the point of reference.
Calculate the slope of the tangent line.

(100−0)
Slope = =−2
(0−50)
30
Elasticity of Demand (Point Elasticity) = −2 × =−1.5
40
NB The Point Elasticity is a measurement method used to measure elasticity of demand for a single point
along the curve (Demand or supply Curve).

The Price Elasticity of Supply (Pϵ S )

The price elasticity of supply can be defined as the responsiveness of the quantity supplied to a change
in price of a good. An elastic good is that which a change in price causes a proportionately larger change
in the quantity supplied, Inelastic good is vice versa.
Any two points along the Supply Curve S2 is more elastic than any points along the supply curve S1.

%∆ QS
The price elasticity of Supply=
%∆ P
Determinants of Price Elasticity of Supply

i) The additional cost of producing additional output – The less the additional cost of
producing additional output the more firms will be encouraged to produce more for a given
prie rise, therefore increasing the elasticity of Supply and vice versa.

ii) Time

The Measurement of Price Elasticity of Supply

A straight vertical supply has a zero elasticity. The Quantity supplied is unresponsive to a change in price.
A straight horizontal supply curve has infinite elasticity. There is no limit to the amount supplied at the
price where the curve crosses the vertical axis.

For two Supply curves, the steeper one will be less elastic between any two points along the curve as
compared to the less steeper one.
NB Any straight line supply curve starting at the origin,however, will have an elastcity equal to one
throughtout its length, irrespective of its slope.

Income Elastcity of Demand

NB Elasticity is the responsiveness of one variable

We have looked at the reponsiveness of quantity demaneded and quantity supplied to changes in the
price, however, price is not the only determinants of change in demand and supply. We will look at
Income and Cross-Price.

The Income elasticity of Demand Yϵ D refers to the responsiveness of demand to change in the
Consumer income.This helps to measure how the demand curve will shift for a given change in the
consumer income (Y).

%∆D
The Income elasticity of Demand Yϵ D =
%∆Y
A major determinants of Income Elasticity of Demand Yϵ D is the Degree of “Necessity” of the good. In
developed countries, the demand for luxury goods expand rapidly as people’s income rises and the
demand for basic goods like vegetables and socks rises a little. As Income for people rises, the demand
for luxury goods like designer bags and luxurious holiday trips increases rapidly as compared to the
demand for basic goods like vegatables. Therefore luxury goods have a high income elasticity of Demand
while basic goods have a low income elasticity of demand.

If the income elasticity of demand is positive and greater than 1, it means that the consumer’s share of
income spend on the good rises as the income rises. If the income elasticity of demand is positive but
less than one, it means that the consumer’s share of income spend on the good drops as the income
rises. In both cases the demand for good (Normal goods) increases as the income rises.

However, the rise in income beyond a certain level may cause the demand for some goods (Inferior
goods such as Supermarket ‘Service line’ goods and Bus Journey reduces. Normal goods have a positive
income elasticity of demand while Inferior goods have negative income elasticity of demand.

The Cross-Price Elasticity of Demand

The Cross -price elasticity of demand ( Cϵ D ) can also be called the cross elasticity of demand. The
AB

cross elasticity of demand is the responsiveness of the demand of one good to the change in price of
another good – substitute good or a compliment good. It enables us to predict how much the demand
curve for the first product will shift as a result of change in price of the second product.

The formula for the Cross -price elasticity of demand ( Cϵ D ) is the proportionate (Percentage) change
AB

in the demand for good A divide by the proportionate (Percentage) change in the price for good B.

%∆ DA
Cϵ D =
AB
% ∆ PB
If a good B is a subsitute for good A, good A demand will rise when the price of good B rises. In this case
the cross elasticity of demand will be positive. For example the demand for Butter will rise by 2 per cent
when the price of mangarine (Substitute) rises by 8 per cent. The cross elasticity of demand for butter
2
with respect to mangarine will be =0.25
8
If a good B is a compliment of good A, however, Good A demand falls when the price of good B rises,
thus the quantity of good B demanded also falls. For instance the demand for butter will fall by 2
percent when the price for bread (Compliment) rises by 8 percent. The cross elasticity of demand will be
−2
a negative, that is , =−0.25
8
The Cross elasticity of demand is greatly affected by the closeness and the number of substitute
/Compliment goods. The closer the good to the substitute or compliment good the greater the effect on
the demand of the good by the change in price of the substitute or compliment good and the greater
the cross elasticity of demand.

Another application of International trade is in the International Trade and the balance of payments.
How does the change in price of domestic goods affects the demand for imports?If the price of domestic
goods rises due to inflation, the demand for imports will rise substantially thus worsening the balance of
trade.

NB Normal goods – Normal goods are goods whose demands increases as consumer incomes increases.
They have a positive Income elasticity of demand. Luxury goods will have a higher income elasticity of
demand than basic good.

Inferior goods – Inferior goods are goods whose demand decreases as consumer incomes increase. Such
goods have a negative income elasticity of demand.

Chapter 4: The Government and The Market

There is the free market economy, where there is no government intervention, and there is a mixed
market economy which is the case for most of the economies of the world. There are various techniques
which government can intervene in the mixed market economy:

I. Fixing prices on goods and services, either above the equilibrium price or below.
II. Taxation; Taxation on production or sale of goods and services
III. Regulations: Enacting policies that controls production of certain goods or operation of various
companies for instances setting up Regulatory bodies to oversee the activities of certain firms.
IV. Subsidizing the production or sale of goods and services.
V. Government can itself produce goods and services e.g., Health Care and Defense Sector.

The Control of Prices

At equlibrium price there is no surplus or shortage since supply equals demands. However, the
equilibrium price might not be the desirable price and so the government may decide to either keep the
price above or below the market clearing price (Equilibrium price).

If the government decide to set the minimum price above the equilibrium price (floor price),there will
be a surplus as seen by the below chart, see Curve S and D.

The Surplus produced by the two curves S and D is Q d −Q s (b−a) . Legislation prevents the price from
falling to eliminate the surplus.

The size of the surplus is dependent on:

i). the Price elasticity of demand and supply. For a lower price elasticity of demand and supply ( Curve S 1
and curve D1 as compared to Curves S and D) on the same minimum price, the surplus Q d −Qs (d −c)
1 1

will be smaller then the Surplus Q d −Q s (b−a) as shown in the above diagram.

ii). Time - With the effect of time on price elasticity of demand and supply, the surplus with expand in
the long run.

If the government set a maximum price below the equilibrium price, there will be a shortage.
Just like the surplus caused by the minimum price, the size shortage depends on the following:

a. The price elasticity of demand and supply – more elastic goods have a bigger shortage as
illustrated in the diagram above by the curves S and D. Shortage ( Qd −Q s ) ( a−b )is bigger than
( Q d −Qs1 ) (d−c)
1

b. Time: Given the impact of time on the elasticity, the size of the shortage will increase in the long
run.

NB Maximum price – Maximum price is the ceiling price set by the government or agencies. Prices
cannot go above this price. Policies are enacted to prevent prices from rising above this price level.

NB Minimum price – Minimum price is the floor price set by the government or agencies. Prices cannot
go below this price. Policies are enacted to prevent prices from falling below this price level.

Threshold – The market may fail to meet the social objectives, therefore there may be a need for
Government intervention. There are several Policy instruments that they government can use to
influence the market or replace it altogether; these are Taxation, Benefits and Subsidiaries, Laws and
regulations, License and Permits or direct provision by government departments or agency such as the
National Health Service in the UK.

Reasons why Government can set a minimum price (Above the Equilibrium Price).

1. To protect or Cushion producers’ income – This is evident for products with fluctuating supply
for instance weather affecting crops.
2. To create a surplus (especially in the time of plenty) – Which can be stored in preparation for a
future shortage e.g., grains.
3. To deter the consumption of a specific good. Some goods might have on the long term, negative
health impact on the consumers.
 4. In the case of wages (Price of labor) – minimum wages legislation prevents the wages from
falling below a certain level. This might be in- line with the government agenda on inequality
and poverty.

There are various ways in which the government can deal with the surplus associated with minimum
price: -

1. The government can buy the surplus and store it, destroy it or sell it to the international market.
2. The government can artificially manipulate the surplus by restricting the producers’ quotas.
3. The government can increase the Demand through advertisement, finding alternative use of the
good or reducing the consumption of the substitute good.

Problems associated with a minimum price (Above the equilibrium price)

1. To handle the surplus some producers will find ways of shortchanging the minimum level price
directive and sell at lower prices to reduces their surplus through the black market.
2. Producers or manufacturers might be tempted to produce inefficient goods for profit
maximization since there is an already set price floor threshold.
3. Producers or manufacturers might overlook the opportunity to producer more efficient
alternative goods.

Setting a maximum price (Low) – Below the Equilibrium Price

The Government can fix a maximum price below the equilibrium price causing a shortage. In
most cases the government do this to create fairness in the accessibility of the good or service. This
allows individual with lower income to be able to afford the good or service. This is evident during time
of war or famine.

However, setting a maximum price lower than the equilibrium price without setting strategic plans to
address the shortage that would result might lead to bigger problems. Sellers or suppliers of the good or
service might decide to allocate the good based on the following criteria:

1. First come, first served basis; this is likely to result in long queues outside stores or apps or
websites crushing due to huge traffic of people purchasing online.
2. Random ballot; - based on lucky.
3. Favored customers – this could be the seller’s relatives, friends, or regular customers.
4. Measure of merit – pick highest performing students.
5. A rule or a regulations

All the above ways are not fair since some individuals may still not be able to get the good or service.
Therefore, the government might decide to do rationing of the good or service to ensure fairness.

Problem of setting a maximum price (Below the Equilibrium Price)

1. The major problem of setting up a maximum price is the emergency of

shadow/illegal/underground markets where people willing to pay high prices will be able to
access the good or service.

INDIRECT TAXES AND SUBSIDIES

The effect of imposing taxes on goods

Another way of government intervention in the market is by Imposition of taxes on goods, sometimes
they can be referred as Indirect taxes. These include Value Added Tax (VAT) and Excise Duty.

The taxes can be either a fixed amount per unit of goods sold – called the Specific Tax, or a percentage
of the price (proportion of the estimated value of the good) or value added at each stage of production
– called an Ad valorem tax, e.g., VAT.

When taxes are levied on goods, this causes the supply curve to shift upwards by the amount of tax. For
specific tax, there will be a parallel curve since the amount of tax is the same at every price. However,
for ad valorem tax, the curve will swing outwards. At zero the tax will be zero however the gap between
the original curve and the new curve (with taxes) widens as the quantity supply increases since the
percentage tax will be a larger absolute amount the higher the price.

NB Why would a supply curve move upwards by the amount of the tax?

See the diagram below to understand how to answer the above question
To be persuaded to produce the same quantity Q 1as before the imposition of the tax, firms/producers
now have to receive price which allows them to recoup the tax they have to pay i.e., (P1 +tax).

The effect of taxes is to raise prices and reduce quantity. The price will not rise by the full amount of the
tax, however, because the demand curve is downward sloping, see above diagram. As shown in the
above diagram the price will rise to P❑2. The burden or incidence of the taxes is distributed between
the consumers and the producers. Consumers pay to the extent that that price rises. Producers pay to
the extent that this rise in price is not sufficient to cover for the tax.

NB. Indirect Tax- A tax on the expenditure of goods. Indirect taxes include Value added tax (VAT) and
excise duties on tobacco, alcoholic drinks, and petrol. These taxes are not paid directly by the consumer,
but indirectly via the sellers of the good. Indirect taxes contracts with direct taxes such as income tax
which are paid directly out of people incomes.

Specific tax – An indirect tax of a fixed amount per unit sold.

Ad valorem tax – An indirect tax of a certain percentage of the price of the good.

Incidence of tax – The distribution of burden of tax between the sellers and buyers.

Elasticity and the Incidence of taxation

The incidence of the indirect taxation depends on the elasticity of demand and supply of the commodity
in question. See the figure below.
In the diagram above the size of the tax is the same, the supply curve shift upwards by the same
amount. Prices rises to P2 and quantities fall to Q 2 in each of the case. However, as can be seen the size
of the increase in prices and decrease in quantity differs in each case depending on the price elasticity of
demand and supply.
CHAPTER 5: MICROECONOMIC THEORY – BACKGROUND TO DEMAND: THE RATIONAL CONSUMER

In a real world – typical world – with limited income and the problem on scarcity, we have to make a
choice on what to buy, for instance you can decide to save up money to buy a car or use the money for
daily spending.

We start this chapter by assumming that all the consumers are rational ( bahave rationally). Rational
choices with regards to consumption, deals with the consideration of the cost and benefit to us of the
alternative we could have spend our money on. This is done for the purpose of maximazing sartification
of the limited resources.

There are two approcahes for analysis consumer behaviour:

1. The marginal utility approach

2. The indifference approach

Rational Consumer is a term used by economists to mean a person who attempts to gets best value for
money for their purchase,especially with limited income. Thus a rational consumer tries to ensure the
benefit of the purchase are worth the expense.

Rational- Behaviour that is consistent with one particular goals- behaviour directed at getting the most
out of most out of your limited resources.

MARGINAL UTILITY APPROACH

People buy goods and services beacuase they want to obtain sartification from it. The satisfication
obtained from consuming a good or service is called “Utility”.

TOTAL AND MARGINAL UTILITY

Total Utility is the total sartification a person gained from the total units comsumed of a commodity for
a given period of time.

Marginal Utility is the additional satisfication that a perosn gains from an extra unit consumed for a
given period of time. For instance the satisfication derived from the second cup of tea as compared to
the first.

Diminishing Marginal Utility

The principle of diminishing marginal utility – Up to a point, consuming more and more units of a
commodity gives you a greater utility. However, as you become more satisfied, each extra unit of the
commodity consumed will give a less additional satisfication(utility). In other words, as more units of
goods are consumed, additional units will provide less additional satisfication than the previous unit.

At the maximum levels of total utility, the marginal utility is zero. For instance, if your desire for tea is
fully satisfied at seven cup (Maximum total utility), and extra eighth cup will not give you any extra
satisfication but it may instead give you displeasure (Negative marginal utility).

NB We assume that Utility can be measured in units called utils.

Total and Marginal Curves

The table above shows the measure of Total and Marginal Utility obtained from consuming additional
packets of crips.

From the diagram above:

The Marginal Utility is a downward slopying. This illustrate the concept of the diminishing marginal
utility.

The Total Utility is upward slopying. It starts from the origin – zero. Zero consumption unit yield zero
total utity.

The Total Utility reaches the peak when the marginal utility is Zero. At Zero marginal Utility, means there
are no additional units of satisfication to add to the maximum satisfication.
Marginal Utility can be derived using the Total Utility. The MU is the slope of the line joining two
adjecent quantities on the curve. For Instance, the marginal utility of the third pocket of crisps
consumed is the slope of the line joining points a and b .

∆ TU
=( MU )
∆Q
2
In our example, ∆ TU =2 , and ∆ Q=1. Thus MU = =2
1
The ceteris Paribus assumption

In the above example we have assumed that all other factors are held constant. However, in the real
world all other factors are change. Utility is in the mind of the consumer, therefore, factors such as
taste, Circumstances, and consumption patterns changes.

The Optimum level of consumption: The simplest case – one commodity

How much of a good should people consumed in order to make good use of their limited resources? In
order to answer this question we need to sort out the problem of measuring utility because in real life
utility can be measure ‘utils’.

One way to solve this problem is to measure utility with money. How much are people willing to spend
for an extra unit of the commodity?. Therefore, Marginal Utility becomes the amount of money
someone is willing to pay for an extra unit of a commodity. For example, if Ollie is prepared to pay 60p
to obtain an extra packet of crisps, then MU =60 p.

Marginal Consumer Surplus

Marginal consumer surplus (MCS) is the difference between what a person is willing to pay for one more
unit of a good and what he/she is actually charged. For instance, if Ollie were willing to pay 45p for
another packet of crips which in fact only cost him 40p, he would be getting a marginal consumer
surplus of 5p. MCS=MU −P

In other words, the marginal consumer surplus is the excess of utility from the consumption of one more
unit of a good (MU) over the price paid: MCS=MU −P

Total Consumer Surplus

The Total Consumer Surplus is the sum of the marginal consumer surplus that you have obtained from
all the units of a good you have consumed. It is the difference between the total utility from all the units
and your expenditure on them.

For example, if Ollie consumes four packets of crisps, and if he would have been prepared to spend
$ 2.60 on them and only had to spend $ 2.20, then his total consumer surplus is 2.60−2.20=0.4
TCS=TU −TE ; where TE is the total expenditure on a good, i.e P ×Q .
NB Therefore the rational consumer behaviour can be defined as people attempt to maximise the
consumer surplus.
Consumer Surplus is the excess of what a person would have been prepared to pay for a good over what
that person actually paid.

People will go on purchasing additional units as long as they gain additional consumer surplus: In other
words, as long as the price they are prepared to pay exceed the price that they are charged ( MU > P ¿ .

But as more is purchased they will experience a diminishing marginal utility. They will be prepared to
pay less for each additional unit. Their marginal utility will go on falling untill MU = p,.i.e untill no
further consumer surplus can be gained. At that point they will stop purchsing additional units. If they
wish continue to purchase MU will be less than P.Thus they would be paying more for the last units
than they were worth to them.

Marginal Utility and the demand curve for a good

An Individual Demand Curve

Where Utility is measured in money, individual demand curve for a good is the same as the utility curve
for that good. Just like quantity demanded increases as price of the commodity decreases, as the
quantity consumed increases the Marginal Utility decreases.MU and price on the same axis, i.e the y-
axis.

Look at the diagram below.

From the diagram above, if the price of the good was at P1 the person would consume Q 1 , where
MU =P1. If the price fell to P2, consumption would rise to Q2, since this is where MU =P2 .

Thus as long as the individual seeks to maximize consumer surplus and hence consume where P=MU ,
their demand curve will be along the same line as their marginal utility curve.

The market demand curve

The market demand curve is (horizontal) the sum of the individual demand curves and hence marginal
utility curves for a good in the market. It shows the quantity demanded of the goods by all individuals at
varying price points. It is a downward sloping because as prices increases the quantity demanded
decrease and vice versa.

The shape of the demand curve: The price elasticity of demand will reflect on the rate of Marginal
utility. If there are many close substitutes, the good will be more elastic like for the case of the Shell
petrol and others such as the Total petrol, the Marginal Utility will diminish at a slower rate as
consumption increases. This is because the increase consumption of the good is accompanied by the
decrease consumption of the other alternative goods. Since the total consumption of this good plus, it’s
alternatives will have increase slightly (if any), the Marginal Utility will fall only slowly.

For example, one petrol brand like shell petrol cut their prices, assuming the prices of the other brands
do not change, consumption of petrol from shell petrol will increase while consumption of the other
alternative brands’ petrol will reduce. Generally, the total consumption of petrol for shell petrol plus
other alternative brands will slightly increase (If any), therefore the Marginal Utility for the product,
petrol, will falls slowly.
The relationship between the demand curve and the diminishing marginal utility is a fundamental
concept in microeconomic because it helps to explain why the demand curve slopes downwards.

Marginal Utility and the Willingness to pay: According to the law of diminishing marginal utility,
consumption of the first few units of a good or service will lead to a greater satisfaction than the
subsequent units, ie. consumption of an extra unit of the good will lead to a less additional satisfaction
that the previous units. Therefore, consumers will be willing or prepared to pay less for the additional
unit of the good as consumption increases. Therefore, to increase their consumption of the goods price
of the good must reduce.

Shift in the demand curve; How does shift in the demand relate to the marginal utility? For this we,
Change in the prices of the substitute product. For example, if the prices of coffee increases, more
coffee drinkers will move to tea consumption. This will lead to increase marginal utility for tea, since
more people are drinking less coffee, their desire for tea is higher. The demand curve, hence, the
marginal curve shifts to the right (upwards).

Other Factors: A change in Income: - An increase in income will lead to more consumption, other
factors held constant. The marginal utility derived from that good will therefore reduce. The satisfaction
derived from $1 will be less than in the previous period before the income increasement. Therefore, the
marginal Utility diminishes as the income increases.

The Optimum combination of goods consumed.

The rule for rational consumer behavior is called the equi-marginal principle. This states that the
consumer will get the highest utility for a given level of income if the ratio of the marginal utilities is
equal to the ratio of the prices. Algebraically, consumption of two goods A and B can be represented as
M U A PA
=
M U B PB
For example, If the utility/ satisfaction derived from good A is three times a much as the last unit you
consumed of good B, with good A costing only twice as much as good B. The suitable option (maximizing
utility) would be increasing the consumption of good A and reducing that of good B. The marginal utility
for good A will reduce because of the diminishing marginal utility conversely that of good B will increase.
M U A PA
To maximize utility, continue increasing good A and reducing good B until the ratios = . At
M U B PB
this point no further gain can be made by switching one good for another. This is the optimum
combination of the two goods consumed.

M U A PA
If the price of good A falls, such that, > the person would buy more good A and less of good B
M U B PB
M U A PA
until the equation is once more satisfied i.e. = .
M U B PB
THE TIMING OF COSTS AND BENEFITS

The timing of the cost incurred, and the benefit earned or enjoyed vary for various goods. For some the
cost and benefits are instant or may have small delays between incurring the cost and enjoying the
benefits for instance if you purchase coffee, the cost is incurred instantly unless you are paying through
a credit card and the benefits a short while after. However, for some goods, such as cars, the cost is
incurred instantly, unless you are paying in installment and the benefit is enjoyed later throughout the
future period. The varying in the timing for incurring the cost and enjoying the benefits affects the
process of making rational choice. There maybe a significant delay between the period of incurring the
cost and enjoying the benefits. This is called the Intertemporal Choice. For instance, I pay for a brand-
new Mercedes Benz from South Africa. I will have to wait for several days to receive the car and use it in
Kenya.

Because consumers would rather have goods now than later, benefits (and costs) that occur in the
future have to be discounted to give them present value.

The higher the discount factor, the lower the present value for any given future benefits or cost.

THE INDIFFERENCE ANALYSIS

The limitation of the marginal Utility approach: - The marginal utility for a product can not be measured
in the absolute sense. We can not tell by how much the marginal utility of one good exceed the other.

The alternative approach is the Indifference approach. Indifference approach deals with ranking the
various combination of goods base on the consumer preference. We assume that the consumer is able
to choose between different combinations of products. For instance, we have two baskets of fruits, one
contains two mangos and one orange, and the other one contains two oranges and one mango. The
consume is able to make a decision which of the two baskets to choose.

Indifferent analysts use two things: Indifference curves and budget lines. The two elements of the
indifference analysis are the indifference map (various indifference curves resulting from different
levels of utility) and the budget line.

Indifferent Curves

Indifference curve is a curve that shows the various combinations of two goods that give equal
satisfaction or utility to the consumer. For instance, the table shows various combination of pears and
oranges that give the same satisfaction as 10 pears and 13 oranges.
The table above is called the indifference set. It shows the alternative combinations of two goods that
gives the same level of satisfaction. From the indifference set we can create an indifference curve. On
one axis it shows units of one good and on the other axis it shows units of the other good.

The curve shows that Ali is indifference on whether to purchase a combination of 30 pears and 6
Oranges (point a), or 24 pears and 7 oranges (point b) or other combinations of pears and oranges along
the indifference curve.

The shape of the Indifference Curve

The indifference curve is not a straight line, it is bowed towards the origin. The slope of the indifference
curve gets smaller as we get down the curve. Why is that the case?
The slope of the indifference curve shows the rate at which the consumer is willing to exchange units of
one good for units of another but still retaining the same level of satisfaction. For instance, from point a
to point b Ali is willing to exchange 6 pears for an extra orange since he will still retain the same level of
satisfaction. The slope of the indifference curve between point a and point b is thus
∆ y 30−24
= =−6.
∆x 6−7
The slope of the indifference curve (the rate at which the consumer is willing to substitute one good for
another) is called the Marginal Rate of Substitution (MRS). The MRS between point a and b along the
indifference curve is 6 , ignoring the negative sign.

As we move down the curve the marginal rate of substitution diminishes as the slope of the curve
∆ y 10−8
becomes less and less. For instance, the MRS between point e and f is = =−1. MRS is 1
∆ x 13−15
ignoring the negative sign. The MRS between point a and b is higher than the MRS between point e and
f.

The reason for the diminishing marginal utility is related to the diminishing marginal utility looked at in
the previous subtopic.

As discussed in the previous subtopic, the law of the diminishing marginal utility states that individuals
will gain less and less additional satisfaction for more of a good that they consume. This principle
assumes that the consumption of other goods is held constant. This is not case for the indifference
curve. As we move down the curve, the consumption of one good increase as that of the other good
decreases but still retaining the same level of satisfaction. As Ali consumer more pears and less
orange, his marginal utility from pears will diminish, as his marginal utility from orange increases. He
will thus be prepared to give up fewer and fewer pears for an additional orange. MRS diminishes.

The relationship between Marginal Utility and the Marginal Rate of Substitution

Consumption at point a give the same level of satisfaction as consumption at point b. Therefore, the
utility sacrificed by giving up 6 pears is equal to the utility gained by consuming an orange. In other
M UO
word, the marginal utility of an orange is six times as great as that of a pear =6, which is the
MUP
same as the Marginal Rate of Substitution. Therefore
MUX
MRS= =(Slope of the Indifference Curve); where x ⇒ x axis∧ y ⇒ y axis .
MUY
NB Not all the indifference curves are bowed towards the origin as the one showed above.
Explain the shapes of the above curves with corresponding each with the below examples?

Indifference map

More than one indifference curve can be drawn. Ali can provide us with a separate combination of pears
and oranges that give equal utility but higher utility than the origin indifference set. An indifference
curve with a higher utility is to the right of the original curve while that of a lower utility is to the left of
the original curve.

The higher the indifference curve is from the original utility curve the higher level of utility. Consumption
of the various combinations along curve l 5 gives a higher utility than consumption of the various
combinations along curve l 1.
The Budget Line

A budget line is a graph that shows all the possible combinations of goods that can be purchased at a
given price for a given budget.

It shows the all the possible combinations of two goods that can be purchased, given:

i. Your level of income available to spend on them.

ii. The prices of the goods.

We can construct a budget line from the below table.

With a budget of 30 you can spend on any combination of good X and good Y along the curve. With that
budget you cannot spend on any combination above the curve on the region painted grey. This region is
called the infeasible region for the given budget. For maximum satisfaction of that budget, spend any
combination alone the line. Spending of any combination below the line does not give a maximum
satisfaction.

Two factors that influence the number of goods people will buys:

i. The level of income available to spend on the good.

ii. The prices of the good.

A change in the Income Level

An increase in the income levels (Increase in the amount of income available to spend on the good) will
enable an individual to buy more of the good assuming the price and other factors remain constant. The
budget line will move to the right (upwards) parallel to the original budget line. For instance, if the
budget increases to $40, the amount of goods for the all the possible combinations will increase as
shown in the table below.

The Change in Price of the goods

The ratio of the price of good Y to the price of good X is the slope of the Budget line, i.e.
PY
=( Slope of the Budget line ) . A change in the price of either of or both of the goods, will affect the
PX
slope of the Budget line. Below is a graph showing the impact of change in the price of good X.
The Optimum Consumption point

The optimum consumption point is where the budget line touches (is tangential to) the highest possible
indifference curve.

Explanation

Across the various indifference curves, the highest curve provides the highest utility to the consumer
than the rest. However, it important to identify indifference curve that are in the infeasible regions.

Curves l 5 and l 4 offer higher utility over the other curves, however there are in the infeasible region. The
budget we have is not enough to buy any combination of good X and good Y in the region (Infeasible
region). Point r, s, u and v offer lower utility than point t because they are found along the two lowest
indifference curves. Therefore, the optimum consumption point is at point t where
PX MUX
=MRS= .
PY MUY
Notice that this is the equi- marginal principle that we had established in the first approach.
The effect of change In Income

As the income increases, the budget line shifts to the right. At every level of income increase we will
have different optimum consumption points as shown in the graph below. The curve connecting all the
optimum consumption points is called the Income consumption curve.

The effect of change in Price

Pages 146 -151

CHAPTER FIVE: CONSUMER BEHAVIOR IN AN UNCERTAIN WORLD

Demand under Risk and Uncertainity

In most cases, we assume that when we buy a good we know the exact cost of the good, for instance,
when we buy a bar of chocolate we know the exact price of the bar, and how much we are probabily
going to like it. However, for products like laptops, cars, mobile phones, that we will be using for a
longer period, we might not know the whole exact price since we might need to incur repair cost after a
while or for the case of a car, there are servicing costs, and repair cost. These goods are called
Consumer durables. Consumer durables are consumer goods that lasts a period of time, during which
the consumer can continue gaining utility from it.

Therefore Consumer durables have uncertainities, so as assets both physical assets such as a house or
financial assets such as shares. The share bought can gain value over a period of time, making it more
valuable or loss value.

Attitude Towards Risks and Uncertainities

Expected Value – Before understanding people attitude towards risks, it esssential to understand the
concept of Expected Value.

Expected value for instance on a gamble is the amount the person would earn on avarage if the gamble
was repeated for several occassions.

To get the Expected value of the gamble, multiple each possible outcome with their respective
probability of occurrence then add the values together.

Example.

Imagine that as a student you only have $105 to spend out of your loan money and have no other
income or savings. You are thinking of buying an instant lottery ticket/ scartch card. The instant lottery
ticket cost $5 and there is a 1 in 10 chance/ a 10 percent chance that the lottery will be a winning ticket.
A winning ticket pays a price of $50. Calculate the expected value of this gamble.

Soln

There are two possible outcomes; you either purchase a winning ticket or a lossing ticket.

There is a 10 percent chance of purchasing a winning ticket of which you will have $150 to spend. There
is a 90 percent chance of purchasing a losing ticket of which you will only remain with $100 to spend.

Therefore the Expected value of this gamble is:

E V gamble=0.1 ( 150 ) +0.9 ( 100 )

E V gamble=105

If you do not purchase the ticket you will have $105 to spend:

E V gamble=1 ( 105 )=105

There are three categories of attitude towards risk:

(i). Risk Neutral: A person who is risk neutral will always pick the option with the highest Expected
Value. In the above example, the person will be indifference about whether to buy or not to buy the
instant lottery ticket as each option has the same expected value.

(ii). Risk Averse: If a person is risk averse they will never choose a gamble if it has the same expected
value as a certain payoff. Therefore a student who is risk averse would never buy the instant lottery
ticket. However, it is not to say, that, a risk averse person cannot take risk. A risk averse person can
choose to take a gamble if the expected value of the gamble is higher than the certain pay-off.

Whether or not a risk averse person is able to take risk depends on the strength of their aversion of risk.
The greater a person’s level of risk aversion, the greater expected value of a gamble they are willing to
give up for a certain pay-off.

The certain amount of money that would give a person an equal utility to a gamble is called Gamble’s
Certainty Equivalent. The greater risk averse a person is the lower the gamble’s certainty equivalent for
them. For instance, I more risk averse person may be okay losing $2 than losing $5.

The expected value for a gamble minus the gamble’s certainty equivalent is called the Risk Premium.
The more risk averse a person is , the greater the positive risk premium.

(iii). Risk Loving: A risk loving person would chose a gamble that has the same expected value as the
pay-off from not taking a gamble. Therefore, if the student was a risk loving person, he would have
bought the instant lottery ticket.

However, it is not cast on stone that risk loving person will always take risk. Risk loving person is likely
not to take risk if the expected value of the certain pay-off is greater than the expected value of the
gamble. This depends on the extent in which the person likes taking risks. For a risk loving person the
gamble’s certainty equivalent is greater than the expected value of the gamble.

The greater the risk loving people are, the greater the expected value from a certain pay-off they are
willing to give for a gamble. Since the gamble’s certainty equivalent is greater than the expecetd value of
the gamble, the risk premium is negative.

Diminishing Marginal Utility of Income and the attitude towards risk taking

Most people are risk averse. The reason is the marginal utility gain from an extra $100 is less than the
marginal utility loss from forgoing a $100.

The risk averse behaviour accords with the principle of diminishing marginal utility.

Diminishing marginal utility of Income: The greater the income earned, the lower the utility gained
from an extra $1.If a person earning $5,000 receives an extra $1000, they will feel better off. The
marginal utility gained from the extra amount will be relatively very high. If another person earning
$500,000 receives an extra $1000, their gain in utility will be less.

Diminishing marginal utility of Income Where each additional pound earned yields a less additional
utility than the previous pound.

Why do income make us risk averse?

The slope of this curve shows the marginal utility of income. As the marginal utility diminishes, the curve
flattens. Compare the slope of point a to b with point b to c.

Insurance:- A way of removing risks

Insurance is the opposite of gambling. It removes risk. Given that most people are risk averse, they may
be willing to pay a premium for an insurance policy even though it will leave them less than the
expected value of not buying the insurance and taking the gamble.

For instance if you have a net worth of $100,000.The chances of you getting an accident are 5%. Incase
of an accident the insurance will get you $20,000 brand new car (assuming the policy is comprehensive).
The premium for the policy is $1100. Expected value of not buying the insurance policy is
0.05 ( 80,000 )+ 0.95 ( 100,000 )=99,000. Risk averse individuals will be willing to pay more than the
$1000 to get a comprehensive cover for their car. Buying the comprehensive insurance will reduce the
worth of the individual to $98,900. Risk averse individuals will take the option of buying the insurance
policy. The utility gained from buying the insurance policy is greater than the expected value of not
buying the insurance and taking the gamble.

Why is it that the insurance companies are prepared to shoulder the risk that their customers were not?
Insurance companies are able to spread the risks.

The insurance company does not insure only one driver.It insures many other drivers. As the number of
customers (Policy holders) increases, the outcome each year will beacome much closer to the expected
or average value. For instance if only 5 out 100 drivers report claims. The insurance company will pay
out $100,000 however, it will have received $110,000 in paid premiums. Therefore making a profit of
$10,000 for every 100 customers every year. This is called the Law of large numbers.

What is unpredictable for an individual becomes more predictable for the mass. The more people the
insurance company insures the more predictable the final outcome becomes. In other word the
insurance company will be able to convert your uncertainty into a risk.
Law of large number: The larger the number of events the more predictable will be the expected or
average outcome.

The independence of risks

Spreading the risk does not only means having many policy holders, it requires that the risks be
independent of each other. For instance, if a person out of the 100-policy holder gets an accident, it
means the chances or probability of other remaining policy holders getting into accidents will still remain
the same. It will not change. Like in the previous example it will remain 5%.

Another way, insurance companies can spread their risks is by diversification of their portfolio. The
more types of insurances (motor, fire, life, medical) company offers the likelihood the risks would be
independent.

Independent risks: Where two risky events are unconnected. The occurrence of one will not affect the
likelihood of the occurrence of the other.

Problems for unwary insurance companies

A major problem facing the insurance company is that they are operating in a market where there is
significant asymmetric information. Asymmetrical information exits where one party has information
that is relevent to the value of that transaction that the other party does not.

For insurance companies the policy buyers have more personal vital information about themselves that
the insurance company does not have.

Asymmetrical information can be split into two different types:

(i). Unobservable characteristics

(ii). Unobservable action

The two types generate different problems.

Unobservable characteristics generates the problem of adverse selection. Unobservable action

generates the problem of moral hazard.

The problem that is caused by the unobservable characteristics – adverse selection.

The variuous insurance consumers have different characteristics, for instance, a person can be a
cautiuous and skillful driver on the road, while the other may be thrilled by high speed. Or one might be
taking care of their health by eating healthy and doing regular exercises while the other one might be
eating plenty of fast foods every day. In the first case the two are likely to buy the same accident
insurance policy and In the second case have the same medical cover.

In each case the consumer is likely to know more about their own characteristics than the insurance
company.