PRINCIPLE OF ECONOMICS 101

UNIT 1

• INTRODUCTION
• WHAT IS ECONOMIC
• MICRO AND MACROECONOMICS
• LOGIC OF ECONOMICS
• CENTRAL OF PROBLEM AND SOLUTION
• ECONOMIC SYSTEM
• TECHNOLOGICAL POSSIBILITIES
• PRODUCTION POSSIBILITY FRONTIER- SOCIETY’S CHOICE AND PPF
• MODERN MIXED ECONOMY
• ECONOMICS THEORIES
• ECONOMIC DATA AND GRAPHS
Introduction to economic

A traditional definition of economics, advocated by Lionel Robbins, says that, “Economics is the
science which studies human behaviour as a relationship between ends and scarce means which
have alternative uses.”

The typical questions that can be addressed within this framework are: what goods and services to
produce, how to produce them efficiently, how to allocate goods and services among consumers,
how to allocate gains from production/trade among consumers etc. These questions can be analysed
at micro or macro level.

As microeconomics studies behaviour of individuals (like consumers, producers, firms, managers

etc.), while macroeconomics studies behaviour of aggregate variables (like employment, gross
domestic product, inflation etc.).

Traditionally economic questions (or more precisely answers) are divided into positive and
normative. Positive economics explains how economy works or predicts some future trends, while
normative economics is more concerned in social welfare and policy recommendations.

To a large extend economics is an operational science, i.e. economists try to solve real life/economy
problems. This does not mean that economists do not use formal or theoretical tools. On the
contrary much of economic research is based on abstract models.

This requires a comment. Real life economic problems are typically very complicated, and it is
difficult to analyse them in their full complexity. For this reason, economists create models that are
supposed to represent the main / important trade-offs and problems of interest, but still abstract
from other (non- critical) elements. Hence, by construction models are not realistic and based on
questionable assumptions. For this reason, economists say that: All models are unreal, but some are
useful, stressing applicability of model’s results.
1 Demand and Supply Curves

1. A market is nothing more or less than the locus of exchange; it is not necessarily a place, but
simply buyers and sellers coming together for transactions.

2. The law of demand states that as price increases (decreases) consumers will purchase less (more)
of the specific commodity.

a. The demand schedule (demand curve) reflects the law of demand it is a downward sloping
function and is a schedule of the quantity demanded at each and every price.

As price falls from P1 to P2 the quantity demanded increases from Q1 to Q2. This is a negative
relation between price and quantity, hence the negative slope of the demand schedule; as predicted
by the law of demand.

1. utility (use, pleasure, jollies) from the consumption of commodities

2. The change in utility derived from the consumption of one more unit of a commodity is
called marginal utility.
3. Diminishing marginal utility is the fact that at some point further consumption of a
commodity adds smaller and smaller increments to the total utility received from the
consumption of that commodity.
a. The income effect is the fact that as a person's income increases (or the price of item
goes down [which effectively increases command over goods] more of everything
will be demanded.
 b. The substitution effect is the fact that as the price of a commodity increases,
consumers will buy less of it and more of other commodities.
Demand Curve

a. Price and quantity - again the demand curve shows the negative relation between price
and quantity.
b. Individual versus market demand - a market demand curve is simply an aggregation of all
individual demand curves for a particular commodity.
c. Nonprice determinants of demand; and a shift to the left (right) of the demand curve is
called a decrease (increase) in demand. The nonprice determinants of demand are:
1. tastes and preferences of consumers,
2. the number of consumers,
3. the money incomes of consumers,
4. the prices of related goods, and
5. consumers' expectations concerning future availability or prices of the
commodity.
d. Changes in demand versus in quantity demand

An increase in demand is shown in the first panel, notice that at each price there is a greater
quantity demanded along D2 (the dotted line) than was demanded with D1 (the solid line). The
second panel shows a decrease in demand, notice that there is a lower quantity demanded at each
price along D2 (the dotted line) than was demanded with D1 (the solid line).
Movement along a demand curve is called a change in the quantity demanded. Changes in quantities
demanded are caused by changes in price. When price decreases from P1 to P2, the quantity
demanded increases from Q1 to Q2; when price increases from P2 to P1 the quantity demanded
decreases from Q2 to Q1.
4. The law of supply is that producers will supply more the higher the price of the
commodity.
a. Supply schedule - are the quantities supplied at each and every price.
5. Supply curve - is nothing more than a schedule of the quantities at each and every price.
a. There is a positive relation between price and quantity on a supply curve.
b. Changes in one or more of the nonprice determinants of supply cause the supply curve to
shift. A shift to the left of the supply curve is called a decrease in supply; a shift to the right is
called an increase in supply. The nonprice determinants of supply are:
1. resource prices,
2. technology,
3. taxes and subsidies,
4. prices of other goods,
5. expectations concerning future prices, and
6. the number of sellers
A decrease in supply is shown in the first panel, notice that there is a lower quantity supplied at each
price with S2 (dotted line) than with S1 (solid line). The second panel shows an increase in supply,
notice that there is a larger quantity supplied at each price with S2 (dotted line) than with S1 (solid
line).

Changes in price cause changes in quantity supplied, an increase in price from P2 to P1 causes an
increase in the quantity supplied from Q2 to Q1; a decrease in price from P1.

6. Market equilibrium occurs where supply equals demand (supply curve intersects
demand curve).

a. An equilibrium implies that there is no force that will cause further changes in price,
hence quantity exchanged in the market. This is analogous to a cherry rolling down the
side of a glass; the cherry falls due to gravity and rolls past the bottom because of
momentum and continues rolling back and forth past the bottom until all of its' energy is
expended and it comes to rest at the bottom - this is equilibrium [a rotten cherry in the
bottom of a glass].

b. The following graphical analysis portrays a market in equilibrium. Where the supply and
demand curves intersect, equilibrium price is determined (Pe) and equilibrium quantity
is determined (Qe).

a. The graph of a market in equilibrium can also be expressed using a series of equations. Both the
demand and supply curve can be expressed as equations.
Demand Curve is Qd = 22 - P

Supply Curve is Qs = 10 + P

The equilibrium condition is Qd = Qs

Therefore:
22 - P = 10 + P

adding P to both sides of the equation yields:

22 = 10 + 2P

subtracting 10 from both sides of the equation yields:

12 = 2P or P = 6

To find the equilibrium quantity, we plug 6 (for P) into either the supply or the demand curve and
get:

22 - 6 = 16 (Demand side) & 10 + 6 = 16 (Supply side)

7. Changes in supply and demand in a market result in new equilibria. The following graphs
demonstrate what happens in a market when there are changes in nonprice determinants of supply
and demand.

Movement of the demand curve from D1 (solid line) to D2 (dashed line) is a decrease in demand (as
demonstrated in the above graph). Such decreases are caused by a change in a nonprice
determinant of demand (for example, the number of consumers in the market declined or the price
of a substitute declined). With a decrease in demand there is a shift of the demand curve to the left
along the supply curve, therefore both equilibrium price and quantity decline. If we move from D2 to
D1 that is called an increase in demand, possibly due to an increase in the price of a substitute good
or an increase in the number of consumers in the market. When demand increases both equilibrium
price and quantity increase as a result.

Considering the following graph, movement of the supply curve from S1 (solid line) to S2 (dashed
line) is an increase in supply. Such increases are caused by a change in a nonprice determinant (for
example, the number of suppliers in the market increased or the cost of capital decreased). With an
increase in supply there is a shift of the supply curve to the right along the demand curve, therefore
equilibrium price and quantity move in opposite directions (price decreases, quantity increases). If
we move from S2 to S1 that is called an decrease in supply, possibly due to an increase in the price
of a productive resource (capital) or the number of suppliers decreased. When supply decreases,
equilibrium price increases and the quantity decreases as a result. That is the result of the supply
curve moving up along the negatively sloped demand curve (which remains unchanged).

If both the demand curve and supply curve change at the same time the analysis becomes more
complicated.

Consider the following graphs:

Notice that the quantity remains the same in both graphs. Therefore, the change in the equilibrium
quantity is indeterminant and its direction and size depends on the relative strength of the changes
between supply and demand. In both cases, the equilibrium price changes. In the first case where
demand increases, but supply decreases the equilibrium price increases. In the second panel where
demand decreases and supply increases, the equilibrium price decreases.

In the event that demand and supply both increase then price remains the same (is indeterminant)
and quantity increases, and if both decrease then price is indeterminant and quantity decreases.
These results are illustrated in the following diagrams.
The graphs show that price remains the same (is indeterminant) but when supply and demand both
increase quantity increases to Q2. When both supply and demand decrease quantity decreases to
Q2.

8. Shortages and surpluses occur because of effective government intervention in the market.

a. Shortage is caused by an effective price ceiling (the maximum price you can charge for
the product). Consider the following diagram that demonstrates the effect of a price
ceiling in an otherwise purely competitive industry.

1. For a price ceiling to be effective it must be imposed below the competitive equilibrium
price. Note that the Qs is below the Qd, which means that there is an excess demand for this
commodity that is not being satisfied by suppliers at this artificially low price. The distance
between Qs and Qd is called a shortage.

b. Surplus is caused by an effective price floor (i.e., the minimum you can charge):
9. Supply and Demand is rudimentary and does not exist in the real world. In most respects the
supply and demand model are the beginning point for understanding markets. Monopoly,
monopolistic competition and oligopoly are, in some important respects, refinements from the
purely competitive market. Therefore, the basic supply and demand model may accurately be
thought of as the beginning point from which we will explore more realistic market structures.

Supply & Demand: Elasticities

1. Price Elasticity of Demand is how economists measure the responsiveness of
quantities demanded to changes in prices.
a. The elasticity coefficient is calculated using the midpoints formula
presented below:
1. Ed = Change in Qty ) Change in price
(Q1 + Q2)/2 (P1 + P2)/2

b. Elastic demand means that the quantities demanded respond more than
proportionately to changes in price; with elastic demand the coefficient is more than
one.
c. Inelastic demand means that the quantities demanded respond less than
proportionately to changes in price; with inelastic demand the coefficient is
less than one.
d. Unit elastic demand means that the quantity demanded respond proportionately
to change in prices; with unit elastic demand the coefficient is exactly one .

2. Perfectly Elastic and Perfectly Inelastic Demand Curves

 Notice that the perfectly elastic demand curve is horizontal, (add one more horizontal
line at the top of the price axis and it will look like an E) and the inelastic demand curve
is vertical (looks like an I).

a. Elasticity changes along the demand curve, however slope does not. Elasticity is
concerned with changes along the curve rather than the shape or position of the curve.

3. Demand Curve and Total Revenue (total revenue = P x Q) Curve

In examining the above graphs, notice that as total revenue is increasing, demand is elastic. When
the total revenue curve flattens-out at the top then demand becomes unit elastic, and when total
revenue falls demand is inelastic.
4. Total Revenue Test uses the relation between the total revenue curve and the demand curve to
determine elasticity.
Consider the following numerical example:

The total revenue test is simply the inspection of the data to see what happens to total revenue. If
the change in total revenue (marginal revenue) is positive then demand is price elastic, if the change
in total revenue is negative the demand is price inelastic. If the marginal revenue is exactly zero then
demand is unit elastic.

5. The following determinants of the price elasticity of demand will determine how responsive the
quantity demanded is to changes in price. These determinants are:
a. substitutability
b. proportion of income
c. luxuries versus necessities
d. time

6. Price Elasticity of Supply is determined by the following time frames. The more time a producer
has to adjust output the more elastic is supply.
a. market period
b. short run
c. long run
7. Cross elasticity of demand measures the responsiveness of the quantity demanded of one product
to changes in the price of another product. For example, the quantity demanded of Coca-Cola to
changes in the price of Pepsi.
8. Income elasticity of demand measures the responsiveness of the quantity demanded of a
commodity to changes in consumers' incomes.
9. Interest rate sensitivity.
CONSUMER BEHAVIOUR

1. Individual demand curves can be constructed from observing consumer purchasing behaviours as
we change price.
a. This is called REVEALED PREFERENCE
b. Market demand curves are constructed by aggregating individual demand curves for
specific commodities.
2. Individual preferences can be modelled using a model called indifference curve -budget constraint
and from this model we can derive an individual demand curve.
a. The budget constraint shows the consumer's ability to purchase goods.

The consumer is assumed to spend their resources on only beer and pizza. If all resources are spent
on beer then the intercept on the beer axis is the amount of beer the consumer can purchase; on
the other hand, if all resources are spent on pizza then the intercept on that axis is the amount of
pizza that can be had.
If the price of pizza doubles then the new budget constraint becomes the dashed
line. The slope of the budget constraint is the negative of the relative prices of beer and
pizza.
b. The indifference curve shows the consumer's preferences:
1. There are three assumptions that underpin the indifference curve,
these are:
1) Indifference curves are everyplace thick
2) Indifference curves do not intersect one another
3) Indifference curves are strictly convex to the origin
The dashed line (2) shows a higher level of total satisfaction than does the solid line (1). Along each
indifference curve is the mix of beer and pizza that gives the consumer equal total utility.
Consumer equilibrium is where the highest indifference curve they can reach is exactly tangent to
their budget constraint. Therefore if the price of pizza increases we can identify the price from the
slope of the budget constraint and the quantities purchased from the values along the pizza axis and
derive and individual demand curve for pizza:

When the price of pizza doubled the budget constraint rotated from the solid line to the dotted line
and instead of the highest indifference curve being curve 1, the best the consumer can do is the
indifference curve labelled 2.
Deriving the individual demand curve is relatively simple. The price of pizza (with respect to beer) is
given by the (-1) times slope of the budget constraint. The lower price with the solid line budget
constraint results in the level the higher level of pizza being purchased (labelled 1for the indifference
curve - not the units of pizza). When the price increased the quantity demanded of pizza fell to the
levels associated with budget constraint 2.
Notice that Q2 and P2 are associated with indifference curve 2 and budget constraint 2, and that Q1
and P1 result from indifference curve 1 and budget constraint 1. The above model shows this
individual consumer's demand for pizza.

3. Income and substitution effects combine to cause the demand curve to slope downwards.
a. the income effect results from the price of a commodity going down permitting
consumers to spend less on that commodity, hence the same as having more resources.
b. As a price increases, the consumer will purchase less of that commodity and buy more of
a substitute, this is the substitution effect.
c. The combination of the income and substitution effects is that an individual (hence a
market) demand curve will generally slope downward.
d. Giffin's Paradox is the fact that some commodities may have an upward sloping demand
curve. This happens because the income effect results in less of a quantity demanded for a
product the lower the price.
1. There is also the snob appeal possibility where the higher the price the more desired the
commodity is - Joy Perfume advertised itself as the world's most expensive.
Utility maximizing rule - consumers will balance the utility they receive against the cost of each
commodity to arrive at the level of each commodity they should consume to maximize their total
utility.
a. algebraic restatement - MUa/Pa = MUb/Pb = . . . = Mu z / P z = 1
Income and Substitution Effects

The income and substitution effects combine to cause the demand curve to slope downwards as was
discussed earlier in Chapter 4. In fact, an individual consumer's demand curve can be rigorously
derived using concepts from intermediate microeconomics called indifference curves which
illustrate, graphically, the income and substitution effects.

The income effect results from the price of a commodity going down having the effect of a
consumer having to spend less on that commodity, hence the same as having more resources.
However, as price increases, the consumer will purchase less of that commodity and buy more of a
substitute, this is the substitution effect. It is the combination of the income and substitution effects,
and their relative strength, that causes an individual (hence generally a market) demand curve to
slope downward. However, there is an interesting exception to this general rule -- Giffin's Paradox.

Giffin's Paradox is the fact that some commodities may have an upward sloping demand curve.
Such commodities are called inferior products. This happens because the income effect results in a
lesser demand for a product. (In other words, the income effect overwhelms the substitution effect).
There are at least two types of goods that often exhibit an upward sloping demand curve. One is
necessity for very poor people and the other is one for which a high price creates a snob effect.

In the diagram above notice that as price is decreased from P1 to P2 the quantity demanded
decreases, hence snob appeal may go down from the loss of a prestigiously high price – consumers
who value the product simply because it is high priced leave the market as the price falls. As price
increases from P2 to P1 poor people can’t afford other more luxurious items therefore they have to
buy more of the very commodity whose price wrecked their budgets.
In the case of poor people who experienced the price of necessity increasing, their limited resources
may result in their buying more of the commodity when its price increases. For example, if the price
of rice increases in a less developed country, people may buy more of it because of the pressure
placed on their budget prevents them from buying beans or fish to go with their rice. To maintain
their caloric intake rice will be substituted for the still more expensive beans and fish.

The other situation is where a luxury is involved. There is the snob appeal possibility where the
higher the price, the more desired the commodity it. Often people will drive expensive cars, simply
because of the image it creates. If the car is extremely expensive, i.e., Rolls Royce, the snob effect
may be the primary motivation for the purchase. This also works with less expensive commodities.
For example, Joy Perfume advertised itself as the world's most expensive to attract consumers that
their marketing surveys indicated would respond to the snob effect.

Rational behaviour was defined as economic agents acting in their self- interest. It is the idea of
rational behaviour that permits the rigorous examination of economic activity. Without rationality,
our analyses fail to conform with the basic underlying assumption upon which most of economics is
based.
Consumers (when acting in their own self- interest) will generally attempt to maximize their utility,
given some fixed level of available resources and income with which to purchase goods and services.
The utility maximizing rule is that consumers will balance the utility they receive from the
consumption of each good or service against the cost of each commodity they purchase, to arrive at
how much of each good they need to maximize their total utility.
The algebraic restatement of the rule:
MUa/Pa = MUb/Pb = . . . = MUz/Pz

When the consumer reaches equilibrium each of the ratios of marginal utility to price will be equal
to one. If any single ratio is greater than one, the marginal utility received from the consumption of
the good is greater than the price, and this means the consumer has not purchased enough of that
good. Therefore the consumer must purchase more of that good (causing price to increase and
marginal utility to go down to the point they are equal), where MU > P. If the ratio is less than one,
where MU< P, then the consumer has purchased too much of the commodity (price is larger than
the marginal utility received from the commodity) and needs to cut back.
Whether consciously or not, rationality requires each individual consumer to allocate their resources
in such a manner as to meet the restrictions of the above equation that is when the consumer is said
to be in equilibrium. In reality, a consumer is always seeking those levels, but because of changing
prices and changing preferences, it is understood that the consumer is always seeking, but never
quite at equilibrium.

Utility and Demand Curves

The material in this appendix is not subject to testing and will not be included on any of the
examinations or quizzes. It is provided simply to demonstrate how an individual demand can be
derived.

The demand curve is dependent on the individual consumer's tastes and preferences. Individual
preferences can be modelled using a model called indifference curve -budget constraint and from
this model we can derive an individual demand curve.

A consumer's budget constraint is a mapping of the ability to purchase goods and services. We
assume that there are two goods and that the budget constraint is linear. The following budget
constraint shows the consumer's ability to purchase goods, beer and pizza.
The consumer is assumed to spend their resources on only beer and pizza. If all resources are spent
on beer then the intercept on the beer axis is the amount of beer the consumer can purchase; on
the other hand, if all resources are spent on pizza then the intercept on that axis is the amount of
pizza that can be had.

If the price of pizza doubles then the new budget constraint becomes the dashed line. The slope of
the budget constraint is the negative of the relative prices of beer and pizza.
An indifference curve is a mapping of a consumer's utility derived from the consumption of two
goods, in this case beer and pizza. There are three assumptions necessary to show a consumer's
utility with an indifference mapping.
These three assumptions are:
(1) every point in the positive/positive quadrant is associated with exactly one indifference curve
(every place thick),
(2) indifference curves do not intersect (an indifference above another shows greater utility
unequivocally), and
(3) indifference curves are strictly convex toward the origin (bow toward the origin).

The following indifference curve shows the consumer's preferences:

The dashed line (2) shows a higher level of total satisfaction than does the solid line (1). Along each
indifference curve is the mix of beer and pizza that gives the consumer equal total utility.

Consumer equilibrium is where the highest indifference curve they can reach is exactly tangent to
their budget constraint. Therefore if the price of pizza increases we can identify the price from the
slope of the budget constraint and the quantities purchased from the values along the pizza axis and
derive and individual demand curve for pizza:
When the price of pizza doubled the budget constraint rotated from the solid line to the dotted line
and instead of the highest indifference curve being curve 1, the best the consumer can do is the
indifference curve labelled 2.
Deriving the individual demand curve is relatively simple. The price of pizza (with respect to beer) is
given by the (-1) times slope of the budget constraint. The lower price with the solid line budget
constraint results in the level the higher level of pizza being purchased (labelled 1for the indifference
curve - not the units of pizza). When the price increased the quantity demanded of pizza fell to the
levels associated with budget constraint 2.

Notice that Q2 and P2 are associated with indifference curve 2 and budget constraint 2, and that Q1
and P1 result from indifference curve 1 and budget constraint
1. The above model shows this individual consumer's demand for pizza.
UNIT 3

CONSUMER AND MARKET BEHAVIOR

The concept of utility can help us understand two related aspects of consumer behavior.

a) It enables us to predict how an individual will allocate his expenditure, given a fixed income between
goods and services available for consumption.
b) It enables us to predict the effect of a price change on the quantity demanded of a good and so
confirms the law of demand.

TOTAL AND MARGINAL UTILITY

UTILITY is the term used by economists to convey the pleasure and satisfaction derived from the
consumption of goods and services. Utility represents the fulfillment of a need or desire through the
activity of consumption.

We must assume that it is possible to quantify and measure changes in satisfaction or utility. For this
purpose a “util” will be used as a measure for utility. In reality, utility is a psychological concept and its
subjective nature makes it unmeasurable. Nevertheless, we shall ignore this and proceed as if utility can
be measured in utils just like distance can be measured in meters or temperature in degrees. The standard
util is totally imaginary.

TOTAL UTILITY represents the satisfaction gained by a consumer as a result of his overall consumption
of goods.

MARGINAL UTILITY represents the change in satisfaction resulting from the consumption of a further
unit of a good.

Assuming that utility can be measured, we can say, for instance, that a given individual enjoys 37 units
of satisfaction (utils) from drinking 3 pints of beer during an evening. This is a measure of total utility.
If one more pint increases his total utility to 42 utils the marginal utility of his fourth pint would be equal
to 5 units of satisfaction. The marginal utility of the fourth pint equals the total utility derived from 4
pints minus total utility derived from 3 pints. Marginal utility is the increase in total utility that results
from the consumption of one more unit.

An individual’s utility schedule

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

It is important to appreciate fully the implications of the distinction between total and marginal utility. If
you were given the choice of giving up totally your consumption of either water or petrol, you would
choose to give up petrol. The implication is that water provides you with more total utility than petrol.
A man dying of thirst in the desert is faced with different conditions and therefore different marginal
utilities. He would definitely place more value on an extra gallon of water. From these examples we can
see that when a consumer makes a decision, he is concerned with the relative utilities of different goods.
But given the availability of resources, economic behavior will be determined by relative marginal utilities
rather than total utilities: shall I consume a few extra units of good A at the expense of good B.

THE INDIFFERENCE CURVE

An indifference curve represents all combinations of market baskets that provide the same level of
satisfaction or utility to a person or consumer.
Assume that you have a basket of goods containing 16 eggs and 6 bags of crisps. If someone comes
along with a basket containing 20 eggs and 5 bags of crisps and offer to change baskets, would you
accept, refuse or find it impossible to decide, as you would be indifferent between the two baskets?

Alternatively, what would be the minimum no of eggs you would require in order to compensate exactly
for the loss of your 6 bags of crisps? If your answer to this second question is 3 eggs, you are in effect
saying that you are indifferent between a basket containing 16 eggs and 6 bags of crisps and one
containing 19 eggs and 5 bags of crisps: each would give you the same total utility. This being the case,
the original offer would certainly have been accepted as 20 eggs and 5 bags of crisps clearly represent a
more attractive combination.

In this way it is possible to build up a set of combination of any two goods between which the consumer
is indifferent. Each combination will provide the same total utility. This whole operation can be carried
out without ever having to put a precise figure on the amount of utility involved.

AN INDIFFERENCE SCHEDULE
Basket Eggs Bags of crisps

A 22 4

B 19 5

C 16 6

D 13 7

E 10 8

F 7 9

AN INDIFFERENCE CURVE
Eggs

25 -

20 -

15 - Indifference curve

10 -
 5 -

0 2 4 6 8 10 12 14

Bags of crisps

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

Some basic assumptions.

Preferences are complete, which means that a consumer can rank all market baskets. E.g. For
•  any two market baskets A and B, the consumer can prefer A to B or B to A, or can be
indifferent.

Preferences are transitive. It means, that if a consumer prefers basket A to B and prefers B to C,
•  then he should also prefer A to C.
Preferences are reflexive (desirable). So that leaving costs aside, consumer always prefers more
•  of any good to less. (this applies to economical goods, and not applies to bad goods such as
pollution)

Marginal Rate of Substitution

AB = PQ

BC < QR.

The slope of the curve between A and C is given by the ratio AB/BC represents the amount of good X
necessary to make up for the loss of AB of good Y that would result if the individual moved from
combination A to combination C. The rate at which one good can be substituted for another without any
change in total utility is called the Marginal Rate of Substitution (MRS). The MRS between P & R is less
than the MRS between A & C. The fact that this ratio decreases as one moves down the curve from left
to right is known as the DIMINISHING MARGINAL RATE OF SUBSTITUTION.
 Another point to notice is that an IC slopes downwards from left to right. Assuming that both goods
are desirable, the rational consumer could not be indifferent to a basket containing more of both goods.
Therefore, as we move from one point to the other on the IC, while the quantity of one good increase, the
quantity of the goods has to decrease if total utility is to remain unchanged. This is why the slope of the
IC is normally negative.
THE INDIFFERENCE MAP

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

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

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

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

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

Good Y

·A

·F ·B

·G ·C ·E

·H ·D IC2 IC3

IC1

Good X

Point F would represent a lower level of total utility than any point on IC1 and IC2, but an equal level of
utility when compared to any other point on IC3 e.g. G and H.

There is an infinity number of ICs; each represents a different level of total utility. A representative
sample of a consumer’s many ICs over a given time period is called an indifference map.

THE BUDGET LINE

Account for the fact that the consumers face budget

•   constraints

P X X+PY Y=B                             

Where PX and  PY are the prices for goods X and Y respectively.

X and Y are goods X and Y respectively, and

B is the consumer’s budget.            

They have limited income to allocate among consumption items.

While an IC describes a consumer’s preferences, a budget line shows the various combinations of the
two goods that can be bought at current prices with a fixed budget or income. Assume an individual has
3 dollars a week to spend on oranges and bags of crisps, and that eggs cost 10c each while crisps cost 15c
a bag. If the individual spends his entire budget on eggs he can afford 30. If he can spends it all on
crisps, he can afford 20 bags.

Between these two extremes there is a variety of other possibilities e.g. 15 eggs +10 bags of crisps. Each
point on the budget line represents one of the several possible combinations that will cost exactly 3
dollars.

If X represents the number of bags of crisps and Y the number of eggs consumed per time period, we can
write the equation of the budget line as:

 15X +10X = 300

X bags of crisps at 15c each and Y eggs at 10c each must come to a total of 300c or

3 dollars.

In the light of market prices, the slope of the budget line is the amount of one good that has to be
sacrificed in order to buy an additional unit of the other good. This will be the same for any point on the
budget line. If this consumer reduces his consumption of eggs by AB he will save enough to buy BC
bags of crisps. While the IC slope tells us of the rate at which the consumer is willing to trade one good
for the other, given his preferences the budget line tells us the current market rates of exchange given
existing prices.

BUDGET LINE

Eggs 30 R

15 T S

0 10 20

Bags of crisps
THE SLOPE OF THE BUDGET LINE

Eggs A AB=XY

C BC=YZ

B X

Y Z

Bags of crisps

The slope of the budget line = AB/BC = XY/YZ.

Shifts in the budget line

The budget line will shift its position as a result of any change in the consumer’s budget or changes in the
prices of either of the two goods under consideration.

If the consumer’s budget is doubled, he could now buy 60 eggs if no of crisps are consumed or 40 bags
of crisps if no of eggs are consumed. An increase in income will shift the budget line away from the
origin, while a fall in income will shift towards the origin. Unless the relative prices change the new
budget lines will be parallel to the original one.

a) An increase in income

Eggs 60

30

0 20 40 Bags of crisps

If income and the price of eggs remain constant while the price of crisps doubles, the new budget line
will be as shown below.
b) An increase in the price of crisps

Eggs

30

0 10 20 Bags

Changes in relative prices will alter the slopes of the budget lines.

CONSUMER EQUILIBRIUM

Having explained both indifference curves and budget lines, we are now in a position to represent
consumer equilibrium graphically. By drawing an individual’s budget line and indifference map on the
same graph, consumption possibilities and preference can be compared.

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

Eggs

C ·F

15 ·E IC4

IC1 B IC3

D IC2

0 10 Bags of crisps

In the diagram above the consumer is in equilibrium i.e. (maximising his total utility, given his fixed
budget) when he is consuming 15 eggs & 10 bags of crisps per time period. This is given by point E on
the budget line, the point where the budget line is just tangential to one of the IC.

Point F is clearly preferably to point E, but given the current market prices and a fixed budget, the
combination lies outside the consumer’s range of consumption possibilities. CONSUMER
EQUILIBRIUM is represented graphically by the point of tangency of the budget line with an IC. At
such a point of tangency, the slope of the budget line is equal to the slope of the IC. It follows that
consumer equilibrium is reached when the ratio of the prices of the two goods is equal to the consumer’s
P X / P Y =MRS XY ).
MRS (

INCOME AND SUBSTITUTION EFFECTS

- What happens if the price of bags of crisps falls from $2 to $1?

- The budget line shifts from AB to AB1. As a result of that change, the optimal combination of
eggs and bags of crisps shifts from X to Y.
The impact of a price change

Eggs

·Y

·X IC3

IC2

IC1

B Bags of crisps B1

In the example above more bags of crisps are bought when their price falls and more eggs are also
bought.

Two things happen when the price of a good falls. First the fall of price has led to an increase in the real
income/purchasing power of the consumer and this change in income will alter the goods that the
consumer chooses to purchase. This is the INCOME EFFECT. Second, the relative prices (slope of the
budget line) of eggs and bags of crisps have changed, which also alter the choices of purchases. This is
the SUBSTITUTION EFFECT.

In the diagram below the overall change induced by the increase in the price of bags of crisps (the price
effect) is indicated by the shift from X to Y.

- IC1 represents lower real income than IC2 after the price increase.

- The slope of the budget line represents relative prices.

(Y-X) = Price effect

(N-X) = Income effect

(Y-N) = Substitution effect

(Y-X) = (Y-N) + (N-X)

Total Effect = Income Effect + Substitution Effect.

The substitution effect may be defined as the change in the basket of goods that would be purchased if
relative prices change at a constant real income. This may be interpreted as the movement around the
indifference curve, IC2 from Y to N. The above analysis is for a normal good.

As for the inferior goods less of them are demanded as real income increases. Note that we have another
type of inferior good called a Giffen good. For this type of good the negative income effect offsets the
positive substitution effect to the extent that less than the initial quantity of the good is consumed.
 THEORY OF PRODUCTION AND COSTS

Production function refers to the functional relationship between the physical output and

the physical inputs. Thus it is the relationship between the quantity of output and the quantities

of inputs used in the process of production.

Example x = f ( a, b, c, d….)

Production function can be of both the fixed proportions type and the variable proportions type.

In the fixed proportions type the labour as well as the capital are used in the fixed proportions.

Example if the technical coefficient of production is 1/5, i.e. to produce 200 units of a commodity

40 labourers are employed then it continues to be the same for all the units.

Variable proportions type production function

In this type of the production function different factors of production can be used to produce a

given level of output.

One variable input

Law of increasing returns to a factor or diminishing costs: it occurs when more and more units are

employed and the marginal production goes on increasing or the average costs start diminishing.

It could be due to the indivisibility of factors or the increase in efficiency arising out of the division

of labour.

Law of Diminishing returns or the increasing returns: It occurs when as a result of increase in the

factors of production cost of production per unit of the commodity goes on increasing.

It could be due to the fixed factors of production or more than the optimum production or

imperfect factor substitutability between the factors.

Law of constant costs or the constant returns to the factor: It takes place when the additional

application of the variable factor increases the output only at a constant rate
Law of variable proportions
Returns to scale

When all the factors of production are increased in the same proportion and as a result output

increases more than proportionately then it is known as constant returns to scale. Example P = f

(L, K)

If both the labour and capital are increased in the same proportion and a result there is a

change in the output it will be termed as returns to scale.

P1 = f (mL, mK)

Two variable input

Meaning of the equal product curves:

An iso product curve shows all the combinations of the two inputs physically capable of

producing a given level of output. In the able given below we can have an estimate regarding the

equal product combinations.

Combinations Factor Z1 Factor Z2

A 1 12
B 2 8
C 3 5
D 4 3
E 5 2
 Consumer side Producer side
Indifference Curve Isoquant
IC’s are level sets of Isoquants are level sets of
consumer’s utility function. production function.
Every point on an IC Every point on an isoquant
represents a combination of represents a combination of
consumption goods that inputs that yields the same
yields the same level of output.
utility.
Iso – Product Map

Marginal Rate of Technical Substitution Marginal Rate Of

Technical Substitution (MRTS) is the increase in productivity a
company experiences when it substitutes on unit of labour input - ie,
an hour worked by a factory worker - for one unit of capital - ie, a
machine on the factory floor.

A positive MRTS indicates that it is advantageous for a

company to make this substitution, and a negative MRTS implies that
the company would drop in productivity if it did this.
 An Isocost Line
45
Capital per w eek 40
35
30
25
20
15
10
5
0
0 5 10 15 20
Labour per week

An iso cost line is that line which shows the various combinations of two factors that can be

purchased with the given amount of money.

Change in the iso cost curves

Producer’s equilibrium with the equal product curves

 Cost Minimisation
45
40
Ca p ita l p e r w e e k 35 Cost minimising
30 point
25
20
15
10
5 50
0 £1000
0 5 10 15 20

La bour pe r w e e k

The expansion path

Deriving Long Run Total Cost

45
40
Ca p ita l p e r w e e k

35
30 Expansion path
25
20
100
15
10
50 £1600
5
0 £1000
0 5 10 15 20

La bour pe r w e e k

INCREASING, CONSTANT AND DIMINISHING RETURNS TO SCALE

Decreasing returns to scale

 If an increase in all inputs in the same proportion k leads to an increase of output of a proportion less than k, we have decreasing

returns to scale.

Constant returns to scale

If an increase in all inputs in the same proportion k leads
to an increase of output in the same proportion k, we have
constant returns to scale. Example: If we increase the number
of machinists and machine tools each by 50%, and the number
of standard pieces produced increases also by 50%, then we
have constant returns in machinery production.
Increasing returns to scale
If an increase in all inputs in the same proportion k leads to an
increase of output of a proportion greater than k, we have
increasing returns to scale.

RIDGE LINES OR THE ECONOMIC REGION OF PRODUCTION

Between the shaded area the factors of production can be substituted for each other. No

producer will operate at the points outside the ridge lines, as it is an inefficient zone. The

production outside the ridgelines involves an increase in both the labour as well as capital to

produce the same amount of output. Hence this area is called the region of economic nonsense.

A rational producer will operate in the region bounded by the two ridgelines where the iso

quants are negatively sloping and marginal products of factors are diminishing but positive.

Cost analysis

Fixed costs: These are the costs that do not change with the change in the level of output. These

costs remain fixed at all the levels of output. Even if the output is zero these costs are to be borne

by the producer.

Variable costs these are the costs, which change with the change in the level of output. These

costs rise as the level of output also goes high.

Total cost: These costs are the summation of the fixed costs and the variable costs.

TC = FC + VC
Marginal cost
Marginal cost is the change in the total costs due to the production
of one more or one less unit of output.
 
Marginal cost = the change in total costs
  the change in output
 
Using mathematical notation where the Greek letter delta is used to
signify - change in.
 
MC = DTC
  DQ
Average fixed costs: these are a obtained by dividing the fixed costs with output

Average variable costs: these are obtained by dividing the variable costs with the output

Average total costs: these are obtained by dividing the total costs with the output.
 Relationship between short run variable costs.

Relationship between AC and MC

Long run average cost curve

Long run average cost curve is the summation of the short run average cost curves. Therfore it is

also called the envelope curve.

Economic Cost

Economic cost consists of two distinct types of costs: (1) explicit (accounting) costs, and (2)

opportunity (implicit) costs. Explicit costs are direct expenditures in the production process.

These are the items of cost with which accountants are concerned.

An opportunity cost is the next best alternative that must be foregone as a result of a particular

decision. Rather than a direct expenditure, an opportunity cost is the implicit loss of an

alternative because of a decision. For example, reading this chapter is costly, you have implicitly
decided not to watch T.V. or spend time doing something else by deciding to read this chapter.

Every choice is costly; that is, there is an opportunity cost.

Production Possibilities

The production possibilities frontier (or curve) is a simple model that can be used to illustrate

what a very simple economic system can produce under some restrictive assumptions. The

production possibilities model is used to illustrate the concepts of opportunity cost, productive

factors and their scarcity, economic efficiency (unemployment etc.) and the economic choices an

economy must make with respect to what will be produced.

There are four assumptions necessary to represent the production possibilities in a simple

economic system. The assumption which underpin the production possibilities curve model are:

(1) the economy is economically efficient, (2) there are a fixed number of productive resources,

(3) the technology available to this economy is fixed, and (4) in this economy we are going to

produce only two commodities. With these four assumption we can represent all the

combinations of two commodities that can be produced given the technology and resources

available are efficiently used.

Consider the following diagram:

Along the vertical axis we measure the number of units of beer we can produce and along the

horizontal axis we measure the number of units of pizza we can produce. Where the solid line

intersects the beer axis shows the amount of beer we can produce.

if all of our resources are allocated to beer production. Where the solid line intersects the pizza

axis indicates the amount of pizza we can produce if all of our resources are allocated to pizza

production. Along the solid line between the beer axis and the pizza axis are the intermediate

solutions where we have both beer and pizza being produced.

The reason the line is curved, rather than straight, is that the resources used to produce beer are

not perfectly useful in producing pizza and vice versa. The dashed line represents a second

production possibilities curve that is possible with additional resources or an advancement in

available technology.

Increasing Opportunity Costs is illustrated in the above production possibilities curve. Notice as

we obtain more pizza (move to the right along the pizza axis) we have to give up large amounts of

beer (downward move along beer axis). In other words, the slope of the production possibilities

curve is the marginal opportunity cost of the production of one additional unit of one commodity,

in terms of the other commodity.

Inefficiency, unemployment, and underemployment are illustrated by a point inside the

production possibilities curve, as shown above. A point consistent with inefficiency,

unemployment, or underemployment is identified by the symbol to the inside of the curve.

Economic growth can also be illustrated with a production possibilities curve. The dashed line in

the above model shows a shift to the right of the curve. The only way this can happen is for there

to be more resources or better technology and this is called economic growth. It is also possible

that the curve could shift to the left (back toward the origin -- the intersection of the beer axis

with the pizza axis), this could result from being forced to use less efficient technology (pollution

controls) or the loss of resources (racism or sexism).

 PRODUCTION FUNCTION

Production is the process of using the services of labor and equipment together with national resources
and materials to make goods / services available.
Technology is the knowledge of how to produce goods and services.

Production function is the relationship between inputs and the maximum attainable output under a
given technology.  
In order to understand the economics of production, we have to start by examining the purely physical
aspects; i.e. the relationship between the units of capital, land, and labor employed and the resultant
physical units of output. In making a product, a firm does not have to combine the inputs in fixed
proportions. Many farm crops can be grown by using relatively little labor and relatively large amounts
of capital (machinery, fertilizers etc) or by combining relatively large amounts of labor with very little
capital. In most cases the firm has some opportunity to vary the input mix.

The effects of varying the proportions between the factors of production is a subject of great
importance because nearly all short run changes in production involve some changes in these
proportions. When a firm wishes to increase (decrease) its output it cannot, in the short run, change its
fixed factors of production, but it can produce more (less) by changing the amounts of the variable
factors (labor, materials etc). When the farmers wish to increase their output they are usually obliged
to do so by using more labor, more seed, more fertilizer (i.e. the variable factors) on some fixed supply
of land (the fixed factor).

Manufacturers are in a similar position. In the short run they cannot extend their factories or install
more machinery but they can adjust their output by varying the quantities of labor raw materials fuel
and power.
The short run is a period of production during which some inputs cannot be varied. In the shot run for
example manufacturing firms are confined to a given size of factory.

The long run is a period of production so long that producers have adequate time to vary all their inputs
used to produce a certain commodity.
Total product of a variable input is the amount of output produced where a given amount of that input
is used along with the fixed inputs.
The average product of variable input the total product of the variable input divided by the amount of
that input used.

TP L
AP L =
L
Marginal product of variable input is the change of the TP corresponding to one unit change in the
input.

ΔTP L
MP L =
ΔL
NON-PROPORTIONAL RETURNS
 Labour hours L Total product of Average product of Marginal product
labour TP1 labour AP1=TP1/L MP1=TP1/L

1 10 10

2 26 13 16

3 56 18.6 30

4 84 21 28

5 97 19.4 13

6 102 17 5

Table above illustrates some important relationships, but before we examine them we must state the
assumptions on which the table is based.

a) Labour is the only variable factor.

b) All units of the variable factor are equally efficient.

c) There are no changes in the techniques of production.

On the basis of these assumptions we can conclude that any changes in productivity arising from

variations in the number of people employed are due entirely to the changes in the proportions in

which labour is combined with other factors.

COSTS OF PRODUCTION

Total Costs

A firm organizes the manufacture of a good or service. An industry is made up of all those firms

producing the same commodity. The amount spent on producing a given amount of a good is

called total cost, TC, and is found by adding together variable costs (VC) and fixed costs (FC).

Variable costs

Variable costs depend on how many goods are being made (output). If just one more unit is made

then the total variable costs rise. Variable costs include the following:

• Weekly wages paid to the shop floor workers.

• The cost of buying raw materials and components

 • The cost of electricity and gas.

Fixed Costs

Fixed costs are totally independent of output. Fixed costs have to be paid out even if the factory

stops production. Fixed costs include the following:

• Monthly salaries paid to managers;

• Rent paid for the use of premises;

• Rates paid to the council;

• Any interest paid on loans;

• Insurance payments in the case of accidents;

• Money put aside to replace worn-out machines and vehicles sometime in the future

(depreciation).

Average Cost

Average Cost (AC) or cost per unit is the cost of producing one item and is calculated by dividing

total costs by total output.

Marginal Cost

Marginal cost (MC) is the cost of producing one extra unit and is calculated by dividing the change

in total costs by change in output.

Revenue

 Total Revenue (TR) is the money the firm gets back from selling goods and is found by
multiplying the number sold, Q, by the selling price, P.

 Average Revenue (AR) is the amount received from selling one item and equals the selling
price of the good.

 Marginal Revenue (MR) is the additional revenue got when one more unit of the good is sold.

Equations
TC=VC+FC

VC=TC−FC

FC=TC−VC

TC
AC=
Q

TR=P×Q

TR PQ
AR= = =P
Q Q

ΔTC
MC=
ΔQ

ΔTR
MR=
ΔQ

No of Q FC VC AFC AVC AC MC
workers

0 0 500 0 500 --- --- ---

1 7 500 300 800 71.43 42.86 114.29 42.86

2 18 500 600 1100 27.78 33.33 61.11 27.27

3 33 500 900 1400 15.15 27.27 42.42 20.00

4 46 500 1200 1700 10.87 26.09 39.96 23.08

5 55 500 1500 2000 9.09 27.27 36.36 33.33

6 60 500 1800 2300 8.33 30.00 38.33 60.00

7 63 500 2100 2600 7.94 33.33 41.27 100.00

8 65 500 2400 2900 7.69 36.92 44.61 150.00

9 66 500 2700 3200 7.57 40.91 48.48 300.00

10 66 500 3000 3500

11 64 500 3300 3800

12 60 500 3600 4100

If these figures are used the following is the diagram that you will get.
 Per Unit Output Cost Curves

MC ATC

Costs per

Unit AVC

AFC

0 Q1 Q2 Q3 Q

Social Cost

The private cost to a motorist of driving from Harare to Chitungwiza is the cost of petrol and oil and the
wear and tear on his car. However, other people have to put up with the externalities of the journey, for
instance the noise, smell, pollution and traffic congestion that the motorist helps to cause along the way.

If we add on to private cost an amount of money to compensate for the inconvenience caused, the
overall figure will be the social cost of the journey:

Private costs + Externalities = Social cost

Cost to individual + Cost to other people = Cost to everyone

PRIVATE AND SOCIAL COST

Definition of Externality
An externality is a situation where the actions of one’s production or consumption activities
affects other economic agents who are not directly involved in the production or
consumption of the commodity. An externality is also referred to as a ‘spillover effect’ or
‘third party effect’ because it affects third parties. When a smoker decides to consume
cigars in public, the non-smokers nearby may be harmed by his actions, and this can be
considered as a negative externality since it is detrimental to third parties. Similarly if Collen
Bawn cement factory produces pollutants in the process of producing cement, and
eventually cause environmental damage affecting the Gwanda communities, then it is
generating a negative externality. Thus a negative externality is one which inflicts harm or
damage to third parties. When there

is a
negative externality in production, the firm’s private costs will diverge from the social costs
since the social costs would include the pollution, which is a negative externality:

Marginal social cost = marginal private cost + external cost

MSC = MPC + E

The external cost is the cost associated with pollution. The firm considers the private costs
that it directly incurs and totally disregards the external cost of pollution. The ideal output
from the firm’s perspective then is Qp. Society, however, considers both the private cost to
the firm and the external cost imposed by pollution. As such the marginal social cost is
larger than the marginal private cost as shown in the above graph. The optimal output from
society’s perspective is Qs.

PRICING UNDER PERFECT COMPETITION

Perfect competition is a market situation characterized by the following features:

Large number of buyers and sellers

Homogeneous products

No selling costs

Same AR and MR curves

Perfect mobility

Perfect knowledge

No extra transportation costs

In the pure competition the conditions of Perfect mobility and Perfect knowledge are

missing.

SHORT RUN EQUILIBRIUM IN PERFECT COMPETITION

In the short run in perfect competition the firms may get normal profits, super normal profits of it

may incur the loss. First of all the firm earning the super normal profits is shown in the diagram.
 Short-run equilibrium of industry and firm under
perfect competition

P £
S MC AC

Pe D = AR
AR
AC = MR

D
O O Qe
Q (millions) Q (thousands)

(a) Industry (b) Firm

In the diagram the firm incurring the loss is shown but the extent of loss should not exceed the

average variable costs.

Loss minimising under perfect competition

P £ AC
S MC

AC
D1 = AR1
P1 AR1
= MR1

D
O O Qe
Q (millions) Q (thousands)

(a) Industry (b) Firm

The shut down point of the firm is given below

 Short-run shut-down point

P £
S MC AC

AVC

D2 = AR2
P2 AR2
= MR2
D2
O O

Q (millions) Q (thousands)

(a) Industry (b) Firm

Long run equilibrium of the firm

Long-run equilibrium under perfect competition

Profits return
Supernormal
New firms enter to normalprofits
P £
S1
Se

LRAC
P1 AR1 D1
PL ARL DL

D
O O QL
Q (millions) Q (thousands)

(a) Industry (b) Firm

Long run equilibrium of the firm

 Long-run equilibrium of the firm under perfect competition
£ (SR)MC
(SR)AC

LRAC

DL
AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

O Q

Constant cost industry

Various long-run industry supply curves under perfect competition

P S1 S2
b

a c
Long-run S

D1 D2

O Q
(a) Constant industry costs

Increasing cost industry

 Various long-run industry supply curves under perfect competition

P S1 S2

Long-run S
c
a

D2
D1

O Q
(b) Increasing industry costs: external diseconomies of scale

Decreasing cost industry

Various long-run industry supply curves under perfect competition

P
S1
b S2

a
c
Long-run S

D2
D1

O Q
(c) Decreasing industry costs: external economies of scale

PRICE AND OUTPUT DETERMINATION UNDER MONOPOLY

A monopoly is a market situation in which there is

1. One seller
2. Large number of buyers
3. No entry or exit of firms
4. No distinction between firm and industry
5. Price discrimination
6. AR and MR curves downward sloping
7. No close substitutes

Causes of monopoly

1. Government policy
2. Entry lag
3. Unfair competition
4. Business mergers

Determination of price and equilibrium under monopoly

Losses under monopoly

 In the long run also the monopoly firm continues to earn the super normal profits.

Discriminating monopoly
When a monopolist charges different prices from different people for the same product, he is said to be

a discriminating monopolist.

Degrees of price discrimination

First-degree price discrimination: here the monopolist charges a different price for each unit of the

commodity sold. He charges what the consumer is willing and able to pay. Thus there is the

maximum exploitation of the consumers in this case.

Second degree price discrimination: here the buyers are divided into different groups and from each

group the monopolist charges a different price.

Third degree price discrimination: Here the monopolist splits the entire market into a few sub

markets and thus charge a different price in each sub market

MONOPOLY
Monopoly is the market structure in which only one producer or seller exists for a product that has no
close substitutes.
Characteristics of monopolies:

•  There is only one firm which supply the entire market and many buyers and consumers

The firm sells a unique product, which has no close substitutes.

•  

The firm has market power (that is it can control it's price)
•  

Entry into the market is restricted, e.g. due to high costs and some special barriers to entry.
•  
These barriers to entry are:

•  High cost to enter a market that can support only one business, e.g. the supply of water and
electricity etc.
A business may have exclusive control of a natural resource. Other producers cannot compete,
•  because they don't have that resource at their disposal. E.g. De Beers controls a large part of
all diamond production, and this creates a barrier to entry for other firms.
A business may have exclusive control of a natural resource. Other producers cannot compete,
•  because they don't have that resource at their disposal. E.g. De Beers controls a large part of
all diamond production, and this creates a barrier to entry for other firms.
A business may have copyright or patent right on it's product, thus making it illegal for other
•  producer to duplicate the product.

A monopoly may be created by the state making it legal.

•  

A well-known and popular trademark could ensure consumer loyalty, e.g. Pepsi.
•  
Demand and marginal revenue.
Under pure monopoly, the business is the industry and faces the negatively sloped industry demand
curve for its product. This means that if the monopolist wants to sell more of its product it must lower
its price. Thus, for a monopolist MR is less than price, and the Marginal Revenue (MR) curve lies
below the demand curve.

MONOPOLY: SHORT TERM EQUILIBRIUM.

Profit maximizing rule: Produce at an output level at which MC = MR.
Finding the monopolist price and output.
Steps to follow:
•  Find the profit maximizing output level where MC = MR.

Extend the line up to the demand curve and down to the Q – axis, to determine the output
•  Qm, the monopoly chooses.

From the point, where the line intersects with the demand curve, extend it horizontally to the
•  P-axis or vertical axis. This will determine the price the monopolist will charge.
 What is the output where the firm’s profits are maximized? - 60.
The price at that output level is - $11.
The average total cost at that output level is - $8.

The profit / loss per unit is: P− ATC=$ 11−$ 8=$ 3 .

The total revenue at this output is: TR=P×Q=$ 11×60 =$ 660 .

The total cost at that output level is: TC=TVC+TFC=ATC×Q=$ 8×60 =$ 480  

The total profit / loss at this output level is: Tπ =TR−TC=$ 660−$ 480 =$ 180 .
Where  = Profit.
MONOPOLISTIC COMPETITION
This was a theory developed in the 1930’s by the American economist Edward Chamberlain.
Monopolistic competition is nearer to the competitive end of the spectrum. It can best be understood as
a situation where there are a lot of firms competing, but each firm does nevertheless have some degree
of market power (hence the term monopolistic competition): each firm has some discretion as to what
price to charge for its products.

Assumptions of monopolistic competition

a) There are quite a number of firms. As a result, each firm has an insignificantly small share of the
market, and therefore its actions are unlikely to affect its rivals to any great extent. What this means
is that each firm in making its decisions does not have to worry how its rivals will react. It assumes
that what its rivals choose to do will not be influenced by what it does. This is known as the
assumption of independence (as we shall see later this is not the case under oligopoly). There we
assume that firms believe that their decisions do affect their rivals, and that their rivals’ decisions do
affect them. Under oligopoly we assume that firms are interdependent).
b) There is freedom of entry of new firms into the industry. If any firm wants to set up business in this
market, it is free to do so. In these two respects, therefore, monopolistic competition is like perfect
competition.
c) Unlike perfect competition, however, each firm produces a product or provides a service in some way
different from its rivals. The firm has monopoly over its brand, but faces competition in the overall
product range. As a result, it can raise its price without losing its customers. Thus the curve in
downward sloping, albeit relatively elastic given the large number of competitors to whom
customers can turn. This is known as the assumption of product differentiation.

Petrol stations, restaurants, hairdressers & builders are all examples of monopolistic competition.

SR EQUILIBRIUM OF THE FIRM

As with other market structures, profits are maximized at MC = MR. The diagram will be the same as for
the monopolist except that the AR & MR curves will be more elastic. This is illustrated in the figure
below. As with competition, it is possible for the monopolistically competitive firm to make supernormal
profit in the SR. This is shown in the diagram below. Just how much profit the firm will make in the SR
depends on the strength of demand: the position & elasticity of demand. The further to the right the
demand curve is relative to the average cost curve, and the less elastic the demand curve is, the greater
will be the firm’s profit. Thus a firm facing little competition and whose product is considerably
differentiated from its rivals may be able to earn considerable SR profits.

SR equilibrium under monopolistic competition

MC AC

P1

PROFIT BOX

AC

MR AR=D

0 Q1 Q

LONG RUN EQUILIBRIUM

If typical firms are earning supernormal profit, new firms will enter the industry in the LR. As new firms

enter, they will take some of the customers away from the existing firms. The demand for existing firms

will therefore fall. Their demand (AR) curve will shift to the left & will continue doing so as long as

supernormal profits remain and thus new firms continue entering. LR equilibrium will be reached when
only normal profits remain: when there is no further incentive for new firms to enter. This is illustrated in

figure below.

The firm’s demand curve settles at D1, where it is tangential to the firm LRAC curve. Output will be Q L:

where ARL = LRAC. At any other output, LRAC is greater than AR thus less than normal profit would be

made.LR equilibrium of the firm under monopolistic competition

The firm under monopolistic competition does not achieve allocative efficiency and productive
efficiency. Furthermore there is excess capacity, which is shown by the difference between QL and
the output it would otherwise produce, were it operating at minimum LRAC.

LIMITATIONS OF THE MODEL

There are various problems in applying the model of monopolistic competition to the real word:

a) Information may be imperfect. Firms will not enter as an industry if they are unaware of the
supernormal profits currently being made or if they underestimate the demand for the
particular product they are considering selling.
b) Given that the firms in the industry produce different products, it is difficulty if not
impossible to derive a demand curve for the industry as a whole. Thus the analysis has to be
confined to the level of the firm.
c) Firms are likely to differ from each other not only in the product they produce or the service
they offer, but also in their size and in their cost structure. What is more, entry may not be
completely unrestricted. Two petrol stations could not set up in exactly the same place – on
busy crossroads. Thus although the typical or representative firm may earn only normal
profit. They may have the cost advantage or produce a product that is impossible to
duplicate perfectly.

One of the biggest problems with the simple outlines in the previous sections is that they
concentrate on price & output decisions. In practice, the profit maximising firm under monopolistic
competition will also need to decide the exact variety of product to produce & how much to spend
on advertising it. This will lead the firm to take part in non-price competition.

OLIGOPOLY: THE THEORY OF FEW SELLERS

Monopoly is a theory of a market with one seller and many buyers. Supply and demand is the theory
of a market with many sellers and many buyers. What changes in these theories would be needed to
tell us what happens if there is oligopoly, that is, more than one seller, but fewer than many? What,
for example, happens if there are two sellers, or duopoly? Though many economists suspect that the
results of two sellers are more similar to those of one seller than to those of many sellers, economics
lacks a clear theory that can prove this suspicion.

The problem of interdependence has thwarted economists' attempts to develop a good theory of
oligopoly. When there are only a few sellers, each recognizes that his decisions affect others who
may react to what he does.

When the possession of market power is profitable, it should attract new entrants into the industry.
If entry is easy, then the existence of very few or even only one firm may not result in economic
inefficiency. The threat of potential entry may be enough competition to keep the industry operating
at or close to the competitive solution. In this case, the market is a contestable market. However, if
entry is not easy but there are significant barriers to entry, the threat of competition is less. Barriers
to entry exist when there are sunk costs--expenses that cannot be recovered once a firm has
entered the industry. Where these costs are high, the industry probably operates as the theory of
monopoly suggests it will.

Barriers to entry can take several forms. They will exist if large amounts of specialized machinery are
required to enter an industry and resale of that machinery is difficult. They will exist if a firm must
establish a reputation for the quality or reliability of a product. They will also exist if a firm must
expend resources in order to get governmental approval to enter. In all of these cases, the barriers
to entry can be viewed as sunk costs.2

Collusive oligopoly.

In contrast, there are times when great numbers of sellers are able to organize and act as a unified
seller. Sellers have the incentive to act in this way because it will increase profits. This form of
oligopoly is called collusive oligopoly and the unified organisation that results is called a cartel. The
profit maximisation under collusive oligopoly is the same as the one for monopoly, since this
effectively becomes the only seller in the market.

Conditions under which cartels are likely to Flourish

Cartel are likely to last longer in an environment with the following features:

• There should be few firms so that coordinating their decisions becomes easier.

• The firms should have similar cost structures and technology of production so that a
common, mutually acceptable price can be a reality.

• There should not be cheating by the members of the cartel, so that the firms observe or
adhere to their allocated production quotas to avoid over-production.

• The legal framework should not be too restrictive, otherwise the cartels will be outlawed.
• The macroeconomic environment should be relatively stable so the firms do not need to
regularly meet and agree on a new price, each time creating the possibility of the cartel collapsing
through lack of consensus.

Pricing under oligopoly

Kinked demand curve

Price leadership under monopoly

Under this system one firm becomes a leader and set the price which is to be followed by all the
firms. It often happens that price leadership is established as a result of price war between the firms
and as a result one firm comes out as a leader.

Price leadership is mainly of the following types

By a dominant firm (which produces a bulk of ots products)

Barometric price leadership (which can predict future well as well as custodian of other firms)

Aggressive price leadership (due to aggressive price policies)

Firm A has a lower MC. The profit maximising price of firm A is lower than the firm B. It means that
now the Firm A will dictate the terms for the firm B whose profit maximising price is higher. If B does
not follow the conditions as dictated by A then it will be ousted by A.

COURNOT MODEL OF OLIGOPOLY

In the diagram before the entrance of B, A produces the output OA which is 1/2 of OB. The price is
OC and the profits are OAPC. B produces the output AH which is 1/4 of OB. The price falls from OAPC
to OARZ total profit being OHQZ. When B produces the AH which is ¼ of the whole the total output
left for A is ½ ( 1 – ¼) = 3/8. What is now not produced by A is produced by B that is (1-1/8) = 5/16.
Now A may react by producing

½ (1 – 5/16) = 11/32.

This process will continue till equilibrium output and price are reached.