2ND SEMESTER LECTURE NOTE

ECONOMICS FOR BUSINESS

FOR LEVEL 100 DEGREE STUDENTS

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 PRINCIPLES OF ECONOMICS (I)
LECTURE 1 – NATURE & SCOPE OF
ECONOMICS
By
Miss Gloria Afful-Mensah

A. The way Economists Think

B. Nature of Economic Resources
C. The Central Problem of Economics
D. Economic System
 A. The way Economists Think
1. Meaning and Definition of Economics
– Just like any other subject, an adequate definition of economics is vital even
though it is quite difficult to arrive at a working definition.

• The definition is based on limited means (resources) but

unlimited wants – the issue of scarcity.

• Wants – likes/desire for something

– No human being or nature can satisfy or have his/her wants
– At anytime you would desire to have something – one thing leads to
another and so on.
– Thus a complete satisfaction of our wants is impossible (insatiable/desire
to want more)

• Note that scarcity does not mean unavailability but with

regard to our wants, the resources to satisfy them are
limited
 Conti...
• Hence economics helps to optimise resources/make the best
out of our limited resources given our unlimited wants.

• Economics does not aim to eliminate scarcity but rather built

on the 2nd best theory (if the 1st option is not available)

• Some earlier definitions of economics:

– Adam Smith (father of modern economics) – Economics is “an
inquiry into the nature and causes of wealth of nations”.

– J. S. Mills – Economics is “the practical science of the

production and distribution of wealth”.

– A. C. Pigou (related his definition to human aspects of life) –

Economics is “a means of studying how total production could
be increased so that the standard of living of people might be
improved”.
 Conti...
– Lionel Robbins – Economics is “the science which
studies human behaviour as a relationship between
ends and scarce means which have alternatives uses”.

– Paul Samuelson – Economics is “the study of how

people and society (with or without the use of
money) choose to employ scarce productive
resources that could have alternative uses in order to
produce various commodities and to distribute them
for consumption, now or in the future among various
persons and groups in society”.
 Conti...
• Basically, there is no one definition – economics can be
viewed as a scientific discipline that answers the following
questions:

– What to produce and how much to produce

– How to distribute
– When and where to produce
– How to distribute/for whom to produce

• Note that the questions do not mean economics is just

about production and consumption – thus can be applied
to our every day life situations. Examples are:
– Some fixed amount of money (say GHC 1000) and all the things
you have to buy for a year.
– 24 hours in a day and all the things you should do.
 conti...
2. The Scope of Economics
• Economics is mainly about human behaviour with regard
to economic activities like
– Production
– Distribution
– Consumption

• Production and consumption are related to businesses,

governments, etc.

• Distribution is related to price mechanism

• The subject is concerned with the behaviour (actions and

reactions) of firms, governments and market
 Conti...
(I) Economics as a Social Science
• It applies scientific methods study human
behaviour and not objects, plants, etc.

– Unlike the physical sciences that study object (plants,

animal, etc), economics applies scientific methods to
study human behaviour.

– Unlike the physical sciences which study in a controlled

environment, economics makes assumptions to
artificially control the environment. Examples

• Ceteris paribus or other things being equal

• rationality
 Conti...
• Scientific Methods
– Statement of the problem
– Statement of hypothesis
– Collection of data
– Organisation and processing the data collected
– Draw conclusions to become theories/laws/principles
– Testing the robustness of the conclusion with new
data to come out with generalisation
– Predicting on the basis of the theory
 Conti...
(II) Positive and Normative Economics
• Positive Economics
– deals with facts, causes and effects relationships
– Uses scientific method to arrive at conclusions
– Either true/false
– Generally about “what is”
• Normative Economics
– Deals with opinions, value judgement, subjective
feelings
– Generally about “what ought to be”
 Conti...
(III) Branches of Economics
• There are 2 branches – micro economics and macroeconomics

• Microeconomics
– Deals with behaviour of individual economic units such as
– Consumers – how they allocate scarce resources, opportunity cost,
etc
– firms – what to produce and how much, how to produce, etc, pricing
of goods and services etc.

• Macroeconomics
– Deals with economic aggregates at the national level such as:
– Changes in inflation, GDP, exchange rates, interest rates, etc

• Note that microeconomics and macroeconomics are

interdependent – tools used in the micro case can be applied
to the macro.
 B. Nature of Economic Resources
• Economic resources are tools/equipment/input that
are used in undertaking any economic activity.

• Limiting ourselves to only production means

economic resources are simply factors of production
• Economic resources can be natural or man-made

• Types of Economic Resources/Factors of Production

– Land
– Labour
– Capital
– entrepreneurship
 Conti...
• Land
– All resources that man did nothing in bringing them
into existence
– Examples are land, air, mineral deposits, sunshine,
sea, oil deposit, etc
– The reward for land/the price of land is rent
• Characteristics of land
– Free gift from nature – man is endowed with land
– Scarce/limited in quantity but varies in quality
– Geographically mobile but occupationally immobile

• Students must find out the importance of land

 Conti...
• Labour
– All human efforts (physical, mental, etc) used in the
production of goods and services
– Can be skilled or unskilled
– The reward or price of labour is wage
• Characteristics of labour
– Supplied by human beings
– Scarce or limited
– Both geographically and occupationally mobile

• Students must find out the importance of labour

 Conti...
Capital (a form of wealth)
• These are man-made goods that serve as factors of production for other firms
• Unlike capital in Accounting which is regarded as only money capital, in
economics, capital is producer goods
• Capital can be created/accumulated when people/firms spend less than the
earn – the act of increasing capital through unspent income is called
investment.
• Reward/price of capital is interest

• Characteristics of capital
• There are 2 types of capital – fixed and circulating capital

• Fixed capital – maintain their form after a production process but depreciate
with time

• Circulating capital – used in the daily running of the business and their form
keep on changing from time to time

• Scarce/limited

• Students must find out the importance of capital

 Conti...
Entrepreneurship
• Makes the production decisions (what, how,
when, where etc)
• Combines the other factors of production
• The reward/price is profit

• Note:
• Generally, all the economic resources/factors of
production are scarce, have alternative uses and
can be combined in varying proportions to
produce a given good or service.
 C. The Central Problem of Economics - Scarcity
• Given that every individual or nation faces the
problem of scarcity because resources are limited
but our wants are unlimited, the is always the need
to put them into the right uses

• Economists cannot solve the problem of scarcity but

can only help to manage them

• Obviously, the problem of scarcity requires that we

make rational choices by satisfying our pressing
needs.

• To make rational choices, we must consider the costs

and benefits by drawing our scale of preference
 Conti...
• In making choices, we incur opportunity costs.
• Opportunity cost
– Thus once you make a choice, you sacrifice
something.

– Opportunity cost which is also known as true cost is

the next best alternative item(s) forgone when you
make a choice

– Note that opportunity cost is not measured in

monetary terms but in terms of real quantities of the
alternatives forgone.
 Conti...
Production Possibility Frontier (PPF) and the Concepts
Scarcity, Choice and Opportunity Cost
• Scarce resource (but alternative uses) means resources
must be used rationally – we must aim at achieving full
employment and full production

– Full employment – there should not be idle resources in the

economy

– Full production – employed resources should produce their

maximum possible output. Full production requires productive
and allocative efficiency.
• Productive efficiency means resources are used in the least-cost way

• Allocative efficiency means resources are used to produce goods

and/or services that are most wanted or yield the highest satisfaction
 Conti...
• The production possibility frontier/curve
(PPF/PPC) can be used to further explain scarcity,
choice and opportunity cost.

• PPF/PPC – a line/curve that that shows all the

maximum combinations of output that an
economy can produce using all its available
resources.

• Can be illustrated using tables or diagrams or

equations
 Conti...
• Assumptions
• There are fixed resources in the economy (land,
labour, capital and entrepreneur)
• Technology (method of production) is fixed
• The economy produces only 2 goods
• There is full employment and productive
efficiency in the use of resources
• The law of diminishing marginal returns (DMR)
holds

• Consider the example on Table 1

– Assume both labour is fixed at 5 units
 Conti...
Labour for X Output of X Labour for Y Output of Y

A 5 43 0 0

B 4 38 1 6

C 3 30 2 17

D 2 18 3 26

E 1 8 4 33

F 0 0 5 38
 Conti...
• Observations from the table:
• The sum of labour at any point is fixed at 5

• To increase the production of one good (say X), some resources

must be shifted to that particular good – full employment of
resources

• To increase the production one good (say Y), there would be

fall in output/production of the other good

• Point A – full employment of labour in good X

• Point F – full employment of labour in good Y

• However, every individual/economy will go for a combination

of the 2 goods.
 Conti...
• The data contained in the table can be plotted on
a graph (refer to what was done in class)

• Points inside the PPF/PPC

– are attainable but not desirable because they are
inefficient.
– Thus the economy can produce more of at least one
good without any trade-off.
– Such points are less than the full employment output
or they are underemployment.
 Conti...
• Points on the PPF/PPC
– Are attainable and efficient – full employment and productive
efficient

• Points outside the PPF/PPC

– Are unattainable within the given technology

The Slope of PPF and Opportunity Cost

• the slope shows the trade-off between the production of
the 2 goods

• Slope = change in vertical distance divided by change in

horizontal distance.

• For examples, refer to what was done in class

 Conti...
• The opportunity cost of a good is the quantity of
the other good which must be sacrificed
(forgone) in order to get another unit of that
good.

• PPF/PPC and Technological Growth

• Refer to the diagrams that were drawn in class
 D. Economic Systems
• This depends on the way societies deal with the
basic economic problem – Scarcity

• An economic system refers to the way in which

economic activities take place in an economy.

• These economic activities depend on the

level/degree of participation of the following
players:
– Consumers/Individuals
– Firms/Businesses
– Government
 Conti...
• Types of Economic Resources
• 3 types
– Market Economy/Free Enterprise/Capitalist/Laissez Faire
– Command Economy/Socialist/Communist
– Mixed Economy

Market Economy/Free Enterprise/Capitalist/Laissez Faire

• Productive resources are owned by private individuals

• Decisions regarding how to use resources are freely determined by these

individuals

• Their main motive is profit maximisation

• Prices are determined by the market forces (forces of demand and supply)

• There is very little or no government intervention

• Close examples are USA, UK, France

 Conti...
Command Economy/Socialist/Communist
• This is a direct opposite to the market economy

• Productive/economic resources are owned by the

government and economic decisions are made by
the government through the Central Planning
Committee.

• Prices of goods and services are also determined by

the government through the Central Planning
Committee – no competition.

• Close examples are North Korea, Cuba, etc.

 Conti...
Mixed Economy
• Combines features of both market and command
economies.

• Most capital goods are owned by private individuals

but government also owns and control some key
resources and sectors of the economy especially
where they think producers or investors may exploit
consumers (e.g. energy sector).

• In reality, most countries practice this kind of

economic system.

• Examples are Ghana, Nigeria, South Africa, etc.

PRINCIPLES OF ECONOMICS
LECTURES 2 AND 3
PRESENTATIONS

BY
MISS GLORIA AFFUL-MENSAH

18/09/2012
 DEMAND AND SUPPLY
ISSUES
1. Concept of demand
2. Concept of supply
3. Market Equilibrium & Price determination
4. Equilibrium Analysis
5. Applications of demand and supply
 The concept of Market
• Important, in order to understand and appreciate the concept of
demand and supply.

• Market generally is a set of arrangements that bring buyers and sellers

into contact in order to exchange goods and/or services.

• Alternatively, market means a mechanism that brings buyers and sellers

of a good together in order to determine the price and quantity to be
bought and sold.

– Some markets bring sellers and buyers into physical contact.

– Others do not deal with physical contact but operate through
intermediaries.

• Players in a market
– Individuals
– Firms
– Dealers
– Agents, etc
 Conti...
• Sides of a market
– Demand side – deals with the behaviour of buyers
– Supply side – deals with the behaviour of sellers
• Note that market do not necessarily mean a physical structure. Can be
done on
– Phones
– Internet
– Fax etc

• Classification of markets
1. Based on the nature of the goods and/or services
– Factor market
– Financial market
– Goods market
2. Based on the number of sellers and buyers
– Perfect competition market
– Monopoly market
– Monopolistic competition market
– Oligopoly market
 THE CONCEPT OF DEMAND
• Not a particular quantity but a complete
description of the various quantities of a good
that a buyer would purchase at each and every
price that might be charge in the market.
• Example – Table 1 gives a price-quantity relationship of say “a
phone”
Price (GHC) Quantity demand

100 20

90 25

80 33

70 50
 Conti...
• The Table expresses the demand for phone as a
function of price and have held all other factors
fixed.
• Law of Demand
• Shows the relationship between price and quantity
demand of a particular good or service
– “all things being equal, the lower the price of a good
which is being offered for sale, the higher the quantity
demand for that particular good and vice versa”.
• From the law,
– There is an inverse/negative relationship between price
and quantity demand of a particular good
– The demand for a good is not dependent on only the
price.
 Conti...
• Students should be reminded that the law of
demand can be explained in terms of:
– Price-quantity relationship and
– Satisfaction or utility that one derives from consuming
a good (remember the examples that were given in
class).
• In summary,
– As Price falls, quantity demand increases and vice
versa.
– As marginal utility falls, price must also fall and vice
versa.
 Conti...
Representation of demand
– Tabular/Schedule approach
– Graphical approach
– Equation/Mathematical approach

(I) & (II)Tabular and Graphical method

– Refer to examples done in class
– They all buttress the negative/inverse relationship
between price and quantity demanded
– Also, for each price, there exists a definite or specific
amount of the good demanded.
 Conti...
NB
• The nature of the demand curve (steepness and
the kind of slope) describes the exact relationship
between price and quantity demand.

• Slope of the demand curve

• Slope (gradient) = change in vertical distance
divided change in horizontal distance. In other
words:

• Slope = change in Price / change in Quantity

demanded
 Conti...
(III) Mathematical/Equation form
• Demand is expressed in terms of its
determinants/factors.
• Assume those factors are w, x, y, z, etc
• We write the equation in its functional form as
• Demand = F(w, x, y, z)
• Usually, we find the equation of demand written as:
• Qd = a + bP
– Where “Qd” is quantity demanded,
– “P” is the price of the good in question,
– “a” is made up of all the other factors except for the price
of the good in question.
– “b” is the slope of the curve and b<0 or negative
 Conti...
Why the demand curve slopes downwards
• When price falls,
• You will see the good as relatively cheaper compared to
other goods and would buy more
• Those who could not afford before too can now afford
– Therefore, quantity demand will increase
• When price increases,
• You will see the good as relatively more expensive
compared to other goods and would buy less
• Those who now cannot afford the good will move away
– Therefore, quantity demand will fall
 Conti...
Distinction between demand and quantity demand
• Demand looks the entire behaviour of buyers at each and every
price that is charged on the market but at every specific price,
there is a specific quantity demanded – hence the quantity
demand makes sense when we talk about a particular price.

• Types of Demand
– Derived demand
– Joint demand
– Composite demand
– Competitive demand

• Individual & Market demand

– The market demand is the horizontal summation of the individual
demand curves.
– Horizontal summation because we are interested in adding all the
quantity demanded by each consumer/buyer.
– Remember the quantity demand is measured on the horizontal axis
 Conti...
Determinants/Factors of demand
• Remember we defined demand as a relationship between price and
quantity, holding all other factors constant
• This means that there are other factors that determine the demand for a
particular good/commodity.

• The factors/determinants are:

– The price of the good in question
– The price of related goods
• Substitutes – goods that serve almost the same purpose
• Complements – goods that are consumed together
– Income of the consumer
• Normal goods
• Inferior goods
– Expectations of the consumer
– Tastes and Preferences
– Population of the country
– Advertisement
– Weather etc
 Conti...
Changes in demand Vrs. Changes in quantity demand
• Group the determinants of demand into 2;
– Price of the good in question
– All other factors/determinants

• Change in quantity demand is movement along the same demand

curve. Thus the effect of the good’s own price on the amount or
quantity demanded.

• Change in demand looks at the bodily shift/movement of the demand

curve. Thus the effect of the other factors on the amount or quantity
demand.
– The conditions under which the demand curve was drawn have changed.
– Any factor that causes demand to increase shifts the demand curve
outwards
– Any factor that causes the demand curve to decrease shifts the demand
curve inwards.

• Students should refer to the diagrams that were drawn in class

 THE CONCEPT OF SUPPLY
• Not a particular quantity but a complete description of the
various quantities that sellers/producers/suppliers of a good
are willing and able to offer for sale at each and every price.

• We are looking at effective supply, i.e.

– Willingness and
– Ability

Law of Supply
• The law shows a relationship between price and quantity
supplied of a good.
– “all other things being equal, the higher the price of a good, the
higher the quantity that would be offered for sale and vice versa”

• From the law,

– There is a positive/direct relationship between price and quantity
supply of a good because sellers are motivated by profits
 Conti...
Representation of Supply
• Tabular/Schedule approach
• Graphical approach
• Mathematical/Equation approach
(I) Supply Schedule
• This shows the relationship between price and quantity
supplied. Consider the Table below.
Price Quantity supply
2.00 5
2.50 10
3.00 15
3.50 20
4.00 30
 Conti...
• From the Table,
– For each price, there exists a definite or specific
amount of the good supplied.
– As price increases, quantity supply also increases and
vice versa.
(II) Supply curve
• This is a graphical representation of what is on
the table (refer to your notes).
• Slope = change in vertical distance divided by
change in horizontal distance
 Conti...
(III) Supply function/Mathematical Approach
• The equation is written in terms of the determinants of supply.
• Assume the determinants are q, r, s, t etc
• In its function form, supply can be written as
• Qs = F(q, r, s, t)

• Now, assume that the determinants of supply are grouped into 2;

– The price of the good in question
– All other factors that influence supply

• Typically, the equation of a supply curve is written as

• Qs = c + dP
Where;
“Qs” is quantity supply,
“P” is price of the good in question
“c” is made of all other factors of supply except the price of the good in
question
“d” is the slope of the supply curve and d>0 or positve
 Conti...
Why the supply curve slopes downwards
• When price increases, it becomes an incentive
for producers to make more profit. Therefore;
• Existing suppliers may increase their quantity offered for
sale
• Other producers will now see the good in question as a
lucrative business and would join in producing that good
– Hence there would be an overall increase in the
quantity supplied
• Students should try for a reduction in price
(remember what we did in class!)
 Conti...
Individual Vrs. Market Supply
• This is the horizontal summation of the individual supply curves (refer to
what was done in class)

Determinants of supply
• Price of the good in question
• Price of all other goods
• Prices of inputs (land, labour, capital)
• Technological advancement
• Changes in nature
– Weather
– Outbreak of diseases
– Disasters
– Fire, etc
• Government regulation
• Number of sellers/producers
• Expectation of sellers etc
 Conti...
Change in supply and change in quantity supply
• Recall that along any given supply curve, we hold all other determinants
except the price of the good in question fixed.

• Change in quantity supplied looks at movement along the same supply

curve. Thus changes in quantity supplied as a result of changes in the
price of the good in question.

• Change in supply is a bodily shift/movement of the supply as a result of

changes in the other factors of supply except the price of the good in
question.
– A shift to the right means an increase in supply
– A shift to the left means a decrease in supply

• Thus the conditions under which the supply curve was drawn have now
changed

• Refer to your notes for the graphs

 MARKET EQUILIBRIUM
• Analyse the demand and supply concepts together.

• Equilibrium occurs when opposing forces exactly offset each

other such that there is no inherent tendency for change.

• Recall the law of demand and supply and you will see that they
are examples of 2 opposing forces
– Note that if one force offsets the other, there would be
disequilibrium in the market.

Equilibrium price
• This is basically the price at which Qd = Qs
• This is also known as the market clearing price because at this
price, there is no
– Shortage or surplus on the market
– At this equilibrium price, there would be stability in the market.
 Conti...
Equilibrium Price determination

(I) Supposing there is a fall in price

– All things being equal, a fall in price serves as an incentive for buyers to
demand more (from the law of demand). At the same time, it serves as a
disincentive for sellers (from the law of supply). Here, Qd increases but Qs
declines. This leads to shortage on the market because Qd > Qs.

(II) Assume there is an increase in price

– All things being equal, an increase in price serves as an incentive for sellers
but a disincentive for buyers. Hence Qs increases but Qd falls. This leads to
surplus on the market because Qs > Qd.

• Now, in between these two instances (low price and high price), there
will be an intermediate price whereby Qd = Qs. That price is termed
equilibrium price.

• The equilibrium price is also known as the market-clearing price

because at this price, there is no shortage or surplus on the market.
 Conti...
• Note that the equilibrium price and quantity are unique
because this is the only point that clears the market.
• Example:
– Assume there is a market for phone and the price is below the
equilibrium price such that this price is fixed at GHC 100.
Suppose this gives the Qd = 200 and Qs = 70.

– Here, Qd > Qs which gives excess demand of 130. These

consumers would be frustrated and would try to buy on the
black market. There would be an upward pressure on price
(price will increase) and serve as an incentive for sellers to
increase their quantity supplied onto the market (Qs will
increase). At the same time, some consumers would leave the
market (Qd will fall) because they would see the phone as too
expensive. This adjustment will continue to take place until
Qd = Qs for an equilibrium to be established.
 Conti...
Notes
• Equilibrium is jointly determined by the forces of demand
and supply.

• At the equilibrium price, Qd = Qs

• The price will always move to the equilibrium, so far as

there is no interference in the market

• The equilibrium price is unique and it clears the market.

Representation of Equilibrium
• Table
• Graph
• Algebra/math
 Tabular Representation
Recall that
– The law of demand gives an inverse relationship between price of a good
and the quantity demand, holding all other things constant.
– The law of supply gives a direct relationship between the price of a good and
the quantity supply, holding all other things constant.

• Points Price of phone Qd Qs Shortage/Surplus

A 75 200 10 -190
B 100 180 30 -150
C 125 160 55 -105
D 150 140 70 -70
E 175 120 80 -40
F 200 100 100 0
G 225 80 150 70
H 250 60 190 130
I 275 40 220 180
J 300 20 245 225
 Conti...
• Given the equilibrium condition (Qd = Qs), from
the table, equilibrium occurs at point F where
Qd =Qs = 100
• At that point, the surplus/shortage is zero.

Graphical Representation
• Graphically, the equilibrium occurs at where the
demand curve intersects the supply curve
• Refer to what was done in class
 Algebraic Representation of Equilibrium
• Let the demand and supply functions be of the following
forms respectively:

• DD: P = a + bQ.........(1), b<0

• SS: P = c + dQ...........(2), d>0

• In equilibrium, DD = SS
• Equate the two equations, group like-terms and solve the
variable involved (refer to what was done in class).
• Then substitute the value you get into either equation (1)
or (2) for the other variable.

Note
• In equilibrium, equate the two equations but make sure
that they are all measured in terms of one variable.
 Equilibrium Analysis
• Recall that the market for any commodity
involves sellers and buyers with some conditions
that enable them to determine price and quantity
that would prevail in the market.

• This aspect of the lecture is to look at the effects

of changes in either demand or supply or both on
equilibrium price and quantity.

• Remember that in equilibrium, Qd = Qs.

 Cases of Disequilibrium
• In equilibrium, there is no tendency for sellers or
buyers to change their position but there can be
some external forces that can interfere in the
operation of the market which may cause either the
demand or supply to change. This leads to
disequilibrium in the market.

• That is Qd would not be equal to Qs. In other words,

– Qd < Qs which also implies excess supply/surplus
– Qd > Qs which also implies excess demand/shortage

• Such situations will definitely cause price to change

 Conti...
Recall that
(I) When P > Pequil., sellers would be willing to supply more (Qs
will increase) but consumers will demand less (Qd will fall)
and there would be surplus on the market.

(I) When P < Pequil., sellers would be willing to supply less (Qs will
fall) but consumers will demand more (Qd will increase) and
there would be shortage on the market.

• Anytime (I) or (II) occurs, the market would go through the

adjustment process and a new equilibrium would be
established.

(III) Remember that anytime any of the factors of demand changes

except the price of the good in question, the demand curve
shifts to the left or to the right. Likewise the supply curve.
 Changes in demand with constant supply curve
(a) Increase in demand with constant supply (e.g. increase in consumer’s
income)

• An increase in income (all things being equal) will lead to increase in

demand for goods and services. Demand curve shifts to the right.
Here, even though demand has changed, nothing has happened to the
supply curve because price has not changed. There would be excess
demand (shortage) which will put upward pressure on price. As price
increases (from the law of demand), consumers start demanding less
because they find the good to be relatively more expensive but at the
same time, high prices will attract sellers to supply more (Qs will
increase). Refer to the diagram drawn in class

• Price will continue to increase once Qd > Qs. The market adjustment
will stop when Qd = Qs.

• The end result is increase in both quantity and price

 Conti...
(b) Decrease in demand with constant supply (e.g. a fall in consumer’s
income).

• A fall in consumer’s income (all things being equal) will lead to a fall in
demand for goods and services and the demand curve will shift to the
left. Here too, even though demand has changed the price of the good
has not which means that nothing has happened to the supply curve.
There would be excess supply (surplus) and this will put downward
pressure on the price. As price falls, consumers will increase their
demand (from the law of demand) because the good is now relatively
cheaper but the same time, sellers will supply less (from the law of
supply) because there is no incentive (profits are falling). Refer to the
diagram drawn in class.

• So long as Qs > Qd, price will continue to fall until Qd = Qs for there to
be a new equilibrium.

• The end result is decrease in both quantity and price.

 Changes in supply with constant demand curve
(a) Increase in supply with constant demand curve (e.g.
improvement in technology)

• All things being equal, an improvement in technology

means a decline in the per unit cost of production. The
supply curve shifts to the right. Qs increases but demand
has not changed because the price of the good has not
changed. This means Qs > Qd which implies surplus. This
puts downward pressure on price and consumers will now
increase their demand but sellers will reduce their quantity
supply because of the lower price. Eventually, Qd = Qs.
Refer to the diagram drawn in class.

• The end result is a fall in price but an increase in quantity.

 Conti...
(b) Decrease in supply with constant demand curve (e.g.
increase in the price of inputs)

• As supply decreases, the curve shifts to the left (Qs

falls) but nothing happens to the demand curve
because price of the good itself has not changed.
This leads to Qs < Qd and hence a shortage in the
market. There would be an upward pressure on price
(price increases) which will serve as an incentive for
sellers (Qs increases) but at the same disincentive for
buyers (Qd falls). Eventually a new equilibrium is
attained where Qd = Qs.

• The end result is increase in price but a fall in

quantity.
 Simultaneous changes in demand and supply
• In reality, both demand and supply change at the same time.
Examples are:
– increase in consumer’s income and decrease in input prices.
– Government subsidy to producers and increase in minimum wage
etc.

• Cases to look at in this section

(a) Increase in both demand and supply
(b) Decrease in both demand and supply
(c) Increase in demand but a decrease in supply
(d) Decrease in demand but an increase in supply

• Note that the change in demand and supply can occur in 3

ways:
– Change in demand > change in supply
– Change in demand < change in supply
– Change in demand = change in supply
 Lecture 3

Elasticity of Demand and Supply

Michael Insaidoo
 Lecture 3
After completing this lecture, you will understands:

 How to define and measure the price

elasticity of demand and supply
 Cross-price elasticity of demand
 Income elasticity of demand
 Lecture 3
 The law or theory of demand and supply aid a decision-
maker in predicting the direction of change in quantity
demanded or supplied if there is rise or fall in price
 But you will not be able to tell by how much the quantity
demanded or supplied will change if there is a price
change
 Some measure of the responsiveness or reactions of
consumers and producers to changes in price is necessary
in order to estimates the effects of changes in price.
 Thus price elasticity comes in to measure this price
responsiveness.
 Lecture 3
 Elasticity measures the degree of responsiveness of one
dependent variable to changes in one or more
independent variables.
 It shows the extent to which the dependent variable
would react to changes in the independent variable.
 Lets say there are two variables say X (dependent
variable) and Y (independent variable). If X is dependent
on Y, then it implies that should Y change, X will be
affected.
 Thus elasticity measures the degree of responsiveness
of X to changes in Y. In other words the extent to which
X reacts to changes in Y.
 Lecture 3
 Elasticity can be defined mathematically as the
percentage change in the dependent variable divided by
the percentage change in the independent variable.
 It can also be defined mathematically as the
proportionate change in the dependent variable divided
by a proportionate change in the independent variable.
Lecture 3
 Lecture 3
A classical example
 When price of a good falls, we expect
consumers to purchase more of that good all
things being equal
 Thus quantity demanded is respondent to a fall
in price but the magnitude of the response is
undetermined
 It is this magnitude of response that elasticity
seeks to measure
 Lecture 3
 Elasticity of Demand – the degree of responsiveness
of quantity demand to changes in the price of the
good itself, income of consumers and the price of
related goods.
 Mathematically it is defined as the percentage
change in quantity demanded divided by the
percentage change in either the price of the good,
income of consumers or price of related good
 From the definition, we can get three types of
elasticity of demand namely (own price elasticity of
demand, income elasticity of demand and cross-price
elasticity of demand)
 Lecture 3
 Elasticity of Supply- the degree of responsiveness of
quantity supplied to change in the price of the good
 Mathematically it is defined as the percentage
change in the quantity supplied divided by the
percentage change in the good’s price
 Lecture 3
 Relatively Elastic- when a change in the independent
variable cause a more than relative change in dependent
variable
 Relatively Inelastic- when a change in the independent
variable cause a less than relative change in dependent
variable
 Perfectly Elastic- when a change in the independent
variable do not cause any change in the dependent
variable
 Perfectly Inelastic- when a change in the independent
variable cause an infinite change in the dependent
variable
 Lecture 3
 Unitary Elastic- when a change in the independent
variable results in exactly the same change in the
dependent variable
 Lecture 3
 Elasticity of demand measures the degree of
responsiveness of quantity demanded of a commodity to
changes in the factors that influence demand
The typical demand function for a commodity X recall was:
Qˣ = f(Pᵪ, Pᵧ, M, T, E)
Where, Qˣ is quantity demanded of commodity X
Pᵪ is the price of commodity X
Pᵧ is the price of a related commodity Y
M is income of the consumer
T is taste and preferences of the consumer
E is expectations of future prices
 Lecture 3
 Specifically elasticity of demand is defined as the degree
of responsiveness of quantity demanded to changes in
the price of the commodity itself, the income of the
consumer or the price of a related commodity
 Lecture 3
 (Price, income and cross-price elasticity of demand)
 Price Elasticity of Demand- the degree of responsiveness
of quantity demanded to changes in price of that
commodity. Specifically the price elasticity of demand is
defined as the percentage change in quantity demanded
as a result of a percentage change in the price of the
commodity
 Mathematically, it is defined as the percentage change in
quantity demanded divided by the percentage change in
price of the commodity
 Mathematical presentation; refer to what was done in
class
 Lecture 3
 Refer to what was done in class
 Lecture 3
 Fairly or Relatively Elastic-
Price elasticity of demand
is said to be fairly elastic
if a percentage change in
price causes a more than
proportionate change in
quantity demanded.
 A one percent change in
price will result in a more
than one percent change
in quantity demanded
 Lecture 3
 Fairly or Relatively Inelastic-
Price elasticity of demand is
said to be fairly inelastic if a
percentage change in price
causes a less than
proportionate change in
quantity demanded.
 A one percent change in
price will result in a less than
one percent change in
quantity demanded
 Lecture 3
 Unitary Price Elasticity-Price
elasticity of demand is said
to be unitary elastic if a
percentage change in price
causes exactly the same
change in quantity
demanded.
 A one percent change in
price will result in a one
percent change in quantity
demanded
 Lecture 3
 Perfectly Inelastic-Price
elasticity of demand is said
to be perfectly inelastic if a
percentage change in price
causes no change in quantity
demanded.
 A one percent change in
price will lead to no change
in quantity demanded
 Lecture 3
 Perfectly Elastic-Price
elasticity of demand is said
to be perfectly elastic if a
percentage change in price
causes an infinite change in
quantity demanded.
 A price fall will lead to an
infinite increase in quantity
demanded but a slight rise in
price will lead to consumers
buying none of the
commodity in question.
 Lecture 3
 Availability of Substitutes: The more substitute a
product has, the larger the price elasticity of
demand
 Luxuries vs Necessities: Luxuries has a great
elasticity cuz they can easily be dispensed with
whilst necessities tend to be inelastic cuz they
cannot be dispensed with
 Proportion of Income spent on the product:
Products that tend to consume larger proportion
of consumers income are more elastic
 Lecture 3
 Number of Possible Uses: If a product has many
uses, demand is likely to be elastic than a product
that has few uses
 Periods of Time: in the short run, demand tend to
be less elastic than in the long run when
consumers would have adjusted to the price
change.
 Habits: When one is used to a particular product,
the demand for the product will be less elastic
and vice versa eg. Cigarette smoker.
 Lecture 3
 Income elasticity of demand measures the
degree of responsiveness of demand for a
commodity to changes in income of the
consumer
 It is the measure of how demand responds to
change in the consumer’s income
 Income Elasticity is the percentage change in
quantity demanded divided by the percentage
change in income of the consumer
 Lecture 3
 Refer to what was done in class
 Lecture 3
 Cross-price elasticity is a measure of the
responsiveness of demand to changes in the
price of a related commodity
 It measures the degree of responsiveness of
quantity demanded of a good (say X) to
changes in the price of a related good (say Y).
 Cross-price Elasticity is the percentage change
in quantity demanded divided by the
percentage change in the price of a related
good.
 Lecture 3
 Refer to what was done in class
 Lecture 3
 Elasticity of supply measures the degree of
responsiveness of quantity supplied of a commodity to
changes in the factors that determine the supply of good.
The typical supply function for a commodity X recall was:
Qˣ = f(Pᵪ, Pᵣ, Pᵢ, T, F)
Where, Qˣ is quantity supplied of commodity X
Pᵪ is the price of commodity X
Pᵣ is the price of all other commodities
Pᵢ is the prices of inputs
T represents taxes and subsidies
F is the number of producers
 Lecture 3
 Economists are just concerned with the change in the
price of the good when estimating the elasticity of
supply; we would just concern ourselves to the price
elasticity of supply.
 Price elasticity of supply is defined as the measure of the
degree of responsiveness of quantity supply to changes in
the price of a commodity.
 Mathematically, the price elasticity of supply is defined as
the percentage change in the quantity supplied of a
commodity divided by the corresponding percentage
change in the price of the commodity.
Lecture 3
 Lecture 3
• For mathematical presentation, refer to what
was done in class
 Lecture 3
 Fairly or Relatively Elastic-
Price elasticity of supply
is said to be fairly elastic
if a percentage change in
price causes a more than
proportionate change in
quantity supplied.
 A one percent change in
price will result in a more
than one percent change
in quantity supplied
 Lecture 3
 Fairly or Relatively Inelastic-
Price elasticity of supply is
said to be fairly inelastic if a
percentage change in price
causes a less than
proportionate change in
quantity supplied.
 A one percent change in
price will result in a less than
one percent change in
quantity supplied
 Lecture 3
 Unitary Price Elasticity-Price
elasticity of supply is said to
be unitary elastic if a
percentage change in price
causes exactly the same
change in quantity supplied.
 A one percent change in
price will result in a one
percent change in quantity
supplied
 Lecture 3
 Perfectly Inelastic-Price
elasticity of supply is said to
be perfectly inelastic if a
percentage change in price
causes no change in quantity
supplied.
 A one percent change in
price will lead to no change
in quantity supplied.
 Lecture 3
 Perfectly Elastic-Price
elasticity of supply is said to
be perfectly elastic if a
percentage change in price
causes an infinite change in
quantity supplied.
 A rise in price will lead to an
infinite increase in quantity
supplied and a slight fall in
price will lead to producers
supplying none of the
commodity in question.
 Lecture 3
 Feasibility and cost of storage
 Characteristics of the production process
 Existence or Absence of excess capacity
 The Time Period
 LECTURE FOUR

BY

MISS GLORIA AFFUL-MENSAH

24/09/2012
Simultaneous changes in demand and supply
• In reality, both demand and supply change at the same time.
• Examples:
• Increase in minimum wage and decrease in taxes
• Fall in the price of a substitute and increase input prices, e.t.c

• The objective of this section is to look at the following:

– Increase in both demand and supply
– Decrease in both demand and supply
– Increase in demand but a decrease in supply
– Decrease in demand but an increase in supply

• Note that the change in demand and supply can occur in the
following ways:
– Change in demand > change in supply
– Change in demand < change in supply
– Change in demand = change in supply
 Case 1. Increase in both demand and supply
• E.g. Increase in consumer’s income and a fall in input
prices outward shift of both demand and
supply.

• An increase in demand with constant supply leads to

increase in both equilibrium price and quantity.

• An increase in supply with constant demand leads to

a fall in equilibrium price but an increase in
equilibrium quantity.

• This means that the equilibrium quantity will

definitely increase but the we need more
information to tell the effect on equilibrium quantity
because of the opposing forces.
 Conti...
• Deductions (refer to diagrams drawn in class):
(I) If increase in dd > increase in ss, the upward pressure
(from the demand side)on price will outweigh the
downward pressure (from the supply side) the new
equilibrium price and quantity will both increase.

(II) If increase in dd < increase in ss, the downward pressure

on price (from the supply side) will outweigh the upward
pressure on price (from the demand side) fall in
new equilibrium price but an increase in new equilibrium
quantity.

(III) If increase in dd = increase in ss no change in new

equilibrium price but an increase in new equilibrium
quantity.
Case 2. Decrease in both demand and supply
• Both curves shift to the left
• Recall that
– When dd falls (constant ss), both equilibrium price and
quantity fall.
– When ss falls (constant dd), equilibrium price increases
but that of quantity falls.

• This means that the direction of equilibrium quantity

is obvious (fall in Qequil) but that of price depend on
the following:
– If fall in dd > fall in ss Pequil falls.
– If fall in dd < fall in ss Pequil increases.
– If fall in dd = fall in ss Pequil does not change.
Case 3. Increase in demand but a decrease in supply
• Demand curve shifts to the right but supply curve shifts to the
left.

• Recall that:
– When dd increases (with constant ss) both Pequil and Qequil
increase.
– When ss decreases (with constant dd) Pequil increases but
Qequil falls.

• This means the direction of price is obvious (an increase) but

that of quantity depends on the following:

– If increase in dd > fall in ss Qequil will increase.

– If increase in dd > fall in ss Qequil will fall.
– If increase in dd = fall in ss no change in Qequil.
• Students must know the various mechanisms that go on in the
market before there is a new equilibrium.
Case 4. Decrease in demand but an increase in supply
• Demand curve shifts to the left but supply curve
shifts to the right.

• Recall that:
– When dd increases (with constant ss) both Pequil
and Qequil fall.
– When ss increases (with constant dd) Pequil falls but
Qequil increases.

• This means that the direction of the new equilibrium

price is obvious (a fall) but that of quantity depends
on the ff:
– If fall in dd > increase in ss Qequil falls
– If fall in dd < increase in ss Qequil increases
– If fall in dd = increase in ss no change in Qequil
 Applications of Demand and Supply
Taxation
• Compulsory payments by economic agents imposed by government.

Types considered here:

– Specific tax/unit per output
– Ad-Valorem/ sales tax
• These taxes affect consumers indirectly through supply

Effects of Specific tax (T) - Levied as a fixed sum per unit of the good regardless of
the price, trademark, advertisement, etc.

• Net price to sellers is (P-T)

• Shifts the supply curve to the left.

• If the old ss function is of the form S = a + bP,

• New supply function becomes: St = a – bt + bP. This is obtained after

substituting the net price into the old supply function.
 Conti...
Deductions:
• After tax ss curve moves inward because the X-axis intercept
reduces by bt.

• The slope of the curve is not affected.

• Demand curve is not affected because current demand curve

depends on the current price.

• Post-tax Pequil > Pre-tax Pequil. However, the extent of change

depends on the elasticity of dd and ss.

• Post-tax Qequil < Pre-tax Qequil because tax increases cost of

production which becomes a disincentive to produce.

• Total tax yield = per unit tax * Qequil

 Effects of a Ad-valorem Tax
• This is levied as a percentage on the value of the product.

– Example is sales tax.

• Let P and v be the price and the ad-valorem tax rate of the
good respectively.

• If old ss function is of the form: S = a + bP,

• Then, net price to the seller would be

P – vP = P(1 –v).

• After ss function is of the form: S = a + b(1-v)P

 Conti...
Deductions:
• Slope of the ss curve changes.

• X-axis intercept is not affected so the curve rotates

inwards.

• Post-tax Pequil > Pre-tax Pequil. However, the extent of

change depends on the elasticity of dd and ss.

• Post-tax Qequil < Pre-tax Qequil because tax increases

cost of production which becomes a disincentive to
produce.

• Total tax yield = per unit tax * Qequil

 Effects of subsidies
• Subsidies are negative taxation.
• Focus on:
– Specific subsidy and
– Ad-Valorem subsidy

Effects of Specific subsidy - A subsidy per unit of the

product.

• Let s be the per unit subsidy and P the price

• Amount to the seller becomes (P+S)

• New ss function would be: Ss = a + b(P+S)

 Conti...
Deductions:
• Supply curve shifts outwards

• Slope does not change but intercept changes.

• Post-subsidy Pequil < Pre-subsidy Pequil. However,

the extent of change depends on the elasticity of
dd and ss.

• Post-subsidy Qequil > Pre-subsidy Qequil because tax

increases cost of production which becomes a
disincentive to produce.
 Conti...
Effects of Ad-Valorem subsidy - A certain percentage of the price of the
good is paid to the seller on each unit sold.

• Let v be that percentage and P be the price

• Amount to the seller becomes P + vP = (1+v)P

• New ss function would be Ss = a + b(1+v)P

Deductions
• The slope changes and the curve rotates outwards
• The X-axis intercept is unchanged

• Post-subsidy Pequil < Pre-subsidy Pequil. However, the extent of change

depends on the elasticity of dd and ss.

• Post-subsidy Qequil > Pre-subsidy Qequil because tax increases cost of

production which becomes a disincentive to produce.
 ELASTICITY OF DEMAND & SUPPLY
Issues to look at:
• Concept of Elasticity
• Elasticity of demand
• Elasticity of supply
• Applications of elasticity of demand and supply
 Concept of Elasticity
• Elasticity measures the extent/degree to which the
dependent variable responds to changes in the
independent or explanatory variables.

• Mathematically, it can be defined as the percentage or

proportionate change in the dependent variable divided
by the percentage or proportionate change in the
independent variable.

Types
• Elasticity of dd – the degree of responsiveness of Qd to
changes in the price of the good itself, price of a related
good and income of the consumer.

• Elasticity of ss – the degree of responsiveness of Qs to

changes in the price of the commodity.
 Forms of Elasticities
• There 5 different forms:
(I) Relatively elastic
(II) Relatively inelastic
(III) Perfectly elastic
(IV) Perfectively inelastic
(V) Unitary elastic
 Elasticity of Demand (Ed)
• This measures the extent of responsiveness of Qd of a good to
changes in the factors of demand.

• Recall Qd = (Px, Py, M, T, A, E)

• But elasticity of demand is often defined in terms of Px, Py and

M.

Types of elasticity of demand

• Price Ed or Own price Ed = % change of Qd divided by % change
in the price of the good in question.
• Income Ed = % change of Qd divided by % change in consumer’s
income.
• Cross-price Ed = % change of Qd divided by % change in the
price of the related good.
 LECTURE FIVE

BY

MISS GLORIA AFFUL-MENSAH

02/10/2012
 Elasticity of Demand (Ed)
• Measures the extent/degree of responsiveness or sensitivity of Qd to changes in the
determinants of demand. Given that it is difficult to measure the changes in some of
them (taste and preference, advertisement, expectations, etc), there are basically three
types of Ed.
– Price Ed/Own price Ed
– Income Ed
– Cross-price Ed

Price Ed
• Measures the responsiveness of quantity demand of a good to changes in the
price of the good itself, holding all other things constant. Mathematically, it is;

Q d P

P Qd

• This is the inverse of the slope of the demand curve multiplied by the price-
quantity combination at the point where the elasticity is to be measured.

• This formula gives the point price Ed because it measures the Ed at a particular
point on the demand curve.
 Conti...
• The value of Ed is negative because of the downward sloping of
the demand curve.
• Given that at each particular price, there is a corresponding Qd,
price Ed changes along any demand curve.

• In absolute terms, Price Ed can be:

– <1
– > 1 or
– =1
• Since the point price Ed changes along any demand curve, it is
not the best when estimating Ed at two different points on the
demand curve. Hence the arc price Ed is the most appropriate.

• the arc price Ed gives the average of the changes in the point
estimates or it gives the price elasticity of demand at the
midpoint on the demand curve.
 Conti...
• Mathematically, arc Price Ed is defined as:
inQ d averagePr ice

inP averageQd

• The arc price Ed is basically used to represent the elasticity

between two points on the demand curve.

NB:
• Price Ed varies at every point on the demand curve.

• At the midpoint of the demand curve, the price Ed is 1.

• Price Ed ranges from zero to infinity as one moves along

any demand curve.
 Types of Price Ed
• There are 5 types:
– Relatively or fairly elastic demand
– Relatively or fairly inelastic demand
– Unitary elastic demand
– Perfectly or completely elastic demand
– Perfectly or completely inelastic demand

Price Ed and the Demand Curve

• From the diagram drawn in class, price Ed
decreases as one moves downwards along any
demand curve in absolute terms and vice versa.
 Determinants of Price Ed
• Why is the demand for some goods more elastic than
others???

The following may be some of the reasons:

(I) Availability of substitutes or the number of substitutes
• Recall that if a good has a substitute, then the consumer can
easily switch to the substitute when price of the good
increases. Hence the higher the number of substitutes, the
greater the price Ed and the demand curve becomes
relatively elastic. The opposite holds.

(II) Luxuries and Necessities

• Luxury goods generally have higher value of price Ed
(relatively elastic) because the consumer can easily do away
with them. On the other hand, necessities have lower price
Ed (fairly inelastic) because you need them to survive.
 Conti...
(III) Proportion of income spent on the good
• Generally, consumers tend to very sensitive to changes in the
price of goods that take a greater proportion on their incomes
making such goods have fairly elastic demand curve. On the
other hand, they are less responsive to goods that take only a
small proportion of their income making those goods have
relatively inelastic demand curves (e.g. salt, matches, etc).

(IV) Number of possible uses

• All things being equal, demand becomes very responsive (fairly
elastic) to price changes for goods that can be used for many
purposes and less responsive (fairly inelastic) to goods that
have limited number of uses.

(V) Period of Time

• All things being equal, in the short run, demand is less elastic
but in the long run, demand is more elastic.
 Conti...
(VI) Habits
• Once you develop a habit, demand becomes less
elastic and vice versa.

Importance of elasticity of demand

• Pricing policy
• Gives vital information about the impact of price
changes
• Taxation purposes
• Revenue or profit maximisation
 Income Elasticity of Demand
• Measures the degree or extent of responsiveness or
sensitivity of quantity demand of a good to changes in the
income of the consumer, holding all other things constant.

• Recall that, when income changes, the demand also

changes, all things being equal. The income elasticity of
demand helps us to estimate the magnitude of change.

• Mathematically, it is defined as:

inQ d
Y
 d
inY Q

• Where Y is income.
 Conti...
Note
• The first part of the formula gives the relationship between income and
the quantity demand of that good.

• This relationship can be negative or positive depending on the nature of

the good and may differ in terms of the magnitude.

• The coefficient of the income Ed can be:

– >1
– < 1 or
– Negative
• If the coefficient of the income Ed is positive, then the good is normal
and if it’s negative, the good is inferior.

• Luxuries and necessities have positive income Ed but the distinction lies
in the magnitude.

– If 0< income Ed < 1, then the good is a necessity

– If income Ed > 1, then the good is a luxury.
 Cross-Price Elasticity of Demand
• Measures the responsiveness of quantity demand of a good to
changes in the price of a related good, holding all other things
constant.

• Given that “X” and “Y” are the goods, mathematically, it is

defined as:
Q x
d
Py

Py Q x
• The coefficient of the cross-price Ed can be negative, positive
or zero.
– If it is positive, then the goods are substitutes
– If it is negative, then the goods are complements
– If it is zero, then the goods are not related.

• The greater the magnitude of the coefficient of the cross-price

Ed, the closer the relationship between the goods.
 Conti...
Try and find out some uses of the cross-price
elasticity of demand.
 Elasticity of Supply
• Measures the extent of sensitivity of quantity supply of a good
to changes in the factors of supply. However, here we will
consider only the price of the good in question.

• Mathematically, it is defined as: Q s P


P Qs
• The first part of the formula is the inverse of the slope of the
supply curve.

• The 2nd part gives the price-quantity relationship at the point

where the elasticity is measured. This changes along the supply
curve because at each price, there is a particular quantity
supplied. This formula is the point price elasticity of supply.

• The coefficient of the Es can be >, < or = 1.

 Conti...
• Given that the point price Es changes along any supply
curve, the best method for measuring price Es between 2
different points on a supply curve is the arc price Es.

• The arc price Es is defined mathematically as:

Q s averagePr ice

P averageQ s

Types of Es
• Fairly or relatively elastic supply
• Fairly or relatively inelastic supply
• Unitary elastic supply
• Completely or perfectly elastic supply
• Completely or relatively inelastic supply
 Determinants of Es
• Why is the supply of some goods more elastic than
others???

The following are some of the reasons:

(I) Feasibility and cost of storage
• Perishable goods will have relatively inelastic supply while
durable goods, or goods with relatively low cost of storage
will have relatively elastic supply.

(II) Characteristics of the production process

• If the factors of production are very mobile, supply will be
relatively elastic and vice versa
• If the goods are joint products in production, supply of the
by-product will be relatively inelastic (e.g. beef and hide)
• If the good requires a special or some scare input, supply
will be relatively inelastic and vice versa.
 Conti...
(III) Existence or absence of excess capacity
• If there is excess capacity (idle resource), supply becomes
relatively elastic and vice versa.

(IV) The Time Period

• This is basically the period it takes the supplier to make
effective decisions. In the very short run, supply is perfectly
inelastic. In the short run, supply is relatively inelastic. In the
long run, supply is relatively elastic.

Uses of elasticity of supply

• To estimate the effects of tax on equilibrium price and quantity
• Price controls and regulation
• Evaluate the incidence and burden of taxation
• Income stabilisation policies
 LECTURE 6

BY

MISS GLORIA AFFUL-MENSAH

12/10/2012
 Applications of Elasticity of Demand
• Recall that changes in demand or supply or both may
cause changes in the equilibrium price and quantity but
the extent of changes depend on the elasticity of demand
and/or supply.

(I) Relationship between Ed and Total Revenue (TR)

• TR = P * Q, where P & Q represent price per unit and
quantity respectively.

– For a firm, to maximise profit also means revenue

maximisation.
– All things being equal, changes in price will affect quantity
demand and subsequently affect the TR of a firm.
– However, the extent of the effect on TR depends on the Ed
and Es.
 Conti...
Case 1: Assume an increase in price with relatively elastic demand
• A % increase in price here will lead to a greater % decrease in Qd and TR
will fall by a bigger margin.

Case 2: Assume an increase in price with relatively inelastic demand

• A % fall in price will lead to less than proportionate fall in the Qd and TR
will fall by only a smaller margin.

Case 3: Assume an increase in price with unitary elastic demand

• A % increase in price will lead to an equal % fall in Qd and there would
be no effect on TR.

Case 4: Assume a fall in Price with relatively inelastic demand

• A % fall in price will lead to a less than % increase in Qd and TR will fall

Case 5: Assume a fall in price with relatively elastic demand

• A % fall in price will lead to more than proportionate increase in Qd and
TR will increase.
 Pricing Policy of the Firm
The cases considered means that:
• When demand is elastic,
– Price and TR move in opposite direction if the firm wants
to increase revenue and maximise profit. Hence, the firm
should rather decrease price in order to increase revenue
and profit.
• When demand is inelastic,
– Price and TR move in the same direction so the firm must
increase price in order to increase revenue and profit
• When demand is unitary elastic,
– Changes in price are the same as changes in Qd and no
effect on TR so the firm does not need to vary price but
rather produce more at the prevailing price
 Price Ed and Devaluation
• Devaluation is deliberate policy by the government to
reduce the value of a currency in terms of other currencies
but depreciation is the loss of value of a currency to other
currencies as a result of the forces of demand and supply
of foreign exchange

• Devaluation can be used to solve balance of payment

deficits (i.e. when imports exceed exports).

• Thus devaluation makes import expensive (imports will fall)

and exports relatively cheaper (exports will increase).

• However, the extent of success of any devaluation policy

depends on the Ed for the good in question.
 Conti...
Case 1: Reducing Import Expenditures
• Supposing imports are greater than exports (recall the example
done in class);

• Devaluation causes the domestic price of the good to increase

even though the price in the international market may be the
same.

• Now;
– if the demand for the imported good is elastic, Qd will fall by a
bigger margin and expenditure on imports will fall.

– On the other hand, if the demand for the imported good is relatively
inelastic, Qd will fall by only a smaller margin and expenditure on
imports may still be high.

• This means that, for devaluation be effective, price Ed should

be elastic.
 Conti...
Case 2: Increasing Export Earnings
• Devaluation makes our exports relatively cheaper on the
international market (recall the example done in class).

• Therefore, if demand is:

– relatively elastic, the fall in price will lead to more than

proportionate increase in the Qd and revenue from exports
will increase.

– relatively inelastic, the fall in price will lead to less that

proportionate increase in Qd and revenue from exports will be
low.

• This also means that for devaluation to be effective,

foreign demand for exports should be elastic.
THE THEORY OF CONSUMER BEHAVIOUR/CHOICE
Sub-topics to be discussed

• Principles of Consumer Behaviour/Choice

• Concept of Marginal Utility (MU)

• MU (Cardinalist) Approach to Consumer Behaviour

• Indifference Curve (Ordinalist) Approach to Consumer Behaviour

• Budget Constraint

• Consumer’s Equilibrium

The purpose of the topic is to help us understand why the demand curve is
downward sloping.
 Principles of Consumer Behaviour
Assumptions of Consumer Behaviour
(I) Axiom of Rationality
(II) Axiom of Consistency
(III) Axiom of Transitivity
(IV)Axiom of Perfect Knowledge
 The Concept of Utility
Definitions
• Total Utility (TU)
– this is the overall satisfaction derived from consuming
different goods.
– TU is directly related to the quantity of a good consumed up
to a point, then it falls after. In other words, TU increases, gets
to a maximum and falls with quantity.

• Marginal Utility (MU)

– This is the change in TU as a result of a unit change in
quantity.
– There is an inverse relationship between MU and quantity
(this explains the law of diminishing marginal utility)

• When TU is at its maximum, MU is zero.

• When TU is falling, MU is negative.
 Conti...
The Law of Diminishing Marginal Utility (DMU)
• The law states that as a consumer consumes more of a commodity, the
satisfaction derived from consuming additional unit of the commodity (MU)
diminishes.
• Consider the Table below:
Quantity Total Utility (TU) Marginal Utility (MU)

1 12 12

2 22 10

3 28 6

4 32 4

5 34 2

6 34 0

7 30 -4
 Conti...
From the Table;
– TU increases at a decreasing rate
– If you plot MU against quantity, the MU curve will be
downward sloping.
– The shape of the TU curve (after plotting TU against quantity)
is as a result of the law of DMU.

• There are 2 approaches in explaining why the demand

curve slopes downward from left to right.

• MU Approach – assumes that utility can be measured.

• Indifference Curve Approach – utility cannot be

measured but the individual can rank commodity based
on the satisfaction derived from it.
 MU (Cardinalist) Approach to Consumer Behaviour
Equilibrium of the consumer
• The consumer is in equilibrium if the marginal
benefit (MU) from consuming an additional unit of
the good is equal to the marginal cost (price) of the
extra unit consumed.

• That is, MB = MC

• According to the Cardinalists, the MC of the extra

unit consumed is the same as the price. Hence, the
consumer is in equilibrium when;

• MU = Price.
 Conti...
(I) One commodity case
Assumptions
– Let the good be X
– Let the price be Px
– The price of the good is fixed and therefore the
consumer cannot influence it.
• Here, the consumer will be in equilibrium when
MUx = Px
 Conti...
Quantity MUx
1 20
2 15
3 10
4 8
5 7

From the Table,

• If Px = 15, equlibrium will be at consuming Q=2
• If Px = 8, equilibrium will be at consuming Q=4
• Assume an initial price of 10. This means
equilibrium will be at Q=3
 Conti...
Let Px increases to 15
– If the consumer remains at consuming Q=3, he/she will not be in
equilibrium because
Px > MUx (since 15 > 10). This therefore calls for adjustments.

– The consumer can do 2 things:

• Decrease Px or
• Increase MUx

• Recall that from the assumptions, the consumer cannot influence

price so he/she would be left with increasing MUx

• From the law of DMU or from the MU curve, the only way MU will
increase is to consume less.

• The new equilibrium will be at consuming Q=2.

• From the above, as price increases, the consumer consumes less.

 Conti...
Now, assume price falls to 8
– If the consumer remains at consuming Q=3, he/she will not be in
equilibrium because
Px < MUx (since 8 < 10). This therefore calls for adjustments.

– The consumer can do 2 things:

• Increase Px or
• Reduce MUx

• Recall that from the assumptions, the consumer cannot influence price
so he/she would be left with decreasing MUx.

• From the law of DMU or from the MU curve, the only way MU will
decrease is to consume more.

• The new equilibrium will be at consuming Q=4.

• From the above, as price falls, the consumer consumes more.

 Conti...
• Putting the analysis in a tabular form,
Price Quantity

15 2

10 3

8 4

• Plotting the price-quantity relationship above

gives a downward sloping demand curve.
 Conti...
Two commodity case
• In reality, consumers consume more than one commodity even at
a time.

• Here, in equilibrium, the ratio of the MUs of the goods

consumed should be equal to the ratio of the prices.

• Let the goods be X and Y and their respective prices be Px and Py,
then the equilibrium condition is:
MU x P
 x
MU y Py
or
MU x MU y

Px Py
 Conti...
• Consider the Table below
Qty MUx MUx/Px Qt2y MUy MUy/Py MUy/PY1 MUy/Py2

1 50 5 1 75 3.75 7.5 3

2 40 4 2 60 3 6 2.5

3 30 3 3 45 2.25 4.5 1.8

4 20 2 4 30 1.5 3 1.2

5 10 1 5 15 0.75 1.5 0.6

 Conti...
Assume Px = 10 and Py = 20;

• Equilibrium is at consuming 3 units of X and 2 units of Y

because that is where the equilibrium condition is fulfilled.
(I) If Py falls to 10 (nothing has happened to Px),

MU x Px

MU y Py
• This calls for adjusting the right-hand-side (RHS) because
the consumer cannot influence price.

• Given that it was the price of Y that changes, we adjust

MUy. Hence the consumer must consumer more Y in
order for MUy to fall.
 Conti...
• From the Table, new equilibrium would be at
consuming X=3 and Y=4.

(II) Assume Py increases to 25 (nothing has happened

to Px)
MU x Px

MU y Py

• This calls for adjusting the right-hand-side (RHS)

because the consumer cannot influence price.

• Given that it was the price of Y that changes, we

adjust MUy. Hence the consumer must consumer
less units of Y in order for MUy to increase.
 Conti...
• From the Table, new equilibrium would be at
consuming X=3 and Y=1.
• The price-quantity relationship for commodity Y
can be represented as:
Price Quantity

25 1

20 2

10 4

• Plotting the price-quantity relationship above

on a graph gives a downward sloping demand
curve.
The Indifference Curve (Ordinalist) Approach to Consumer
Behaviour
• An indifference curve is the locus of combination of commodity bundles
that yield the same level of satisfaction to the consumer.

Properties of Indifference Curves

• They are downward sloping

• They are everywhere dense

• They do not intersect each other

• The farther away the indifference curve from the origin, the higher the
satisfaction derived. In other words, higher indifference curves give
higher level of satisfaction.

• They are convex to the origin as a result of diminishing marginal rate of

substitution
 Slope of indifference curve
• Slope (gradient) is given as:

• Change in vertical distance divided by change in

horizontal distance. That is,

Y X 1

X X 2

• The slope is always negative.

• Note that the formula for the slope depends on
how the axis are labelled.
 LECTURE 7

BY

MISS GLORIA AFFUL-MENSAH

19/10/2012
Marginal Rate of Commodity Substitution (MRCS or MRS)
• Any movement along the indifference curve means the consumer is
substituting one good for another so that he/she remains on the same
indifference curve.

• Hence, more of one good means the consumer must sacrifice some amount of
the other good.

• Therefore, the MRCS or MRS is simply the rate at which the consumer
substitutes one good for the other.
– Because we are looking at a curve, the MRCS varies along the IC curve
– Can be calculated for each good (MRCSxy or MRCSyx).

• For example;
– MRCSxy is the number of units of good Y that must be forgone in order to obtain a
unit of good X.

– MRCSyx would be the number of units of good X that must be forgone in order to
obtain a unit of good Y

• Recall that the slope of the indifference curve is negative and it measures the
rate at which the consumer will substitute one good for the other. This means
that the MRCS is the negative of the slope of the indifference curve.
 The Law of Diminishing Marginal Rate of Commodity
Substitution
• The law states that as the consumer substitutes one
good for the other, the rate at which he/she does
that diminishes or falls.

• This is the reason behind the convex nature of the

indifference curve.

• Literally, as the consumer substitutes one good for

the other, he/she gains more of that good and loses
some amount of the other good. As time goes on,
he/she begins to cherish or value the one he/she is
losing and will be reluctant to trade-off that good for
the other.
 The Budget Constraint
• In an attempt to maximise satisfaction as a rational consumer,
he/she is constrained by the income and the prices of the
commodities consumed.

– Let M rep income,

– Px and Py be prices of X and Y respectively

• The Budget constraint is given by:

M  Px X  Py Y
• Assuming the consumer spends all his/her income on the two
commodities which means that he/she does not save, then the
budget constraint becomes:
M  Px X  Py Y
• This can be shown graphically. Refer to what was done in class
 Properties of the Budget Line (BL)
These mainly result from changes in the consumer’s income and
prices of the good.

(I) When income changes with prices of X and Y constant, there

would be parallel shift of the budget line either to the left or to
the right.
– An increase in income (with prices of the goods constant) shifts the
budget line inwards.
– A decrease in income (with prices of the goods constant) shifts the
budget line outwards.

(II) Changes in the price of one good with the price of the other good
and income constant will rotate the budget line inwards or
outwards depending on the direction of change in that price.

(III) A proportional change in income and the prices of the two goods
in the same direction will not change the position of the budget
line.
 Slope of the Budget Line
• The slope of the budget line measures the rate of change
in one of the goods as a result of a unit change in the
other good.

• Slope of BL = change in the vertical distance divided by

change in the horizontal distance.

• The slope of BL is simply the ratio of the prices of the

goods. That is,
Px
slope  
Py
• Proof ? (refer to what was done in class)

• The value of the slope of the BL is constant along any given

BL.
 Equilibrium of the Consumer
• This simply combines the knowledge of the indifference curve and that
of the budget line.

• The consumer is in equilibrium if the rate at which he/she is willing to

substitute one good for the other is the same as the rate at which
he/she can substitute one good for the other.
– In other words, in equilibrium, the slope of the indifference curve is equal
to the slope of the BL.
– Or the indifference curve is tangential to the BL in equilibrium.
• Mathematically, the consumer is in equilibrium if
Px
 MRCS  
Py
• Note that the slope of the indifference curve is the negative of the
MRCS.

• Also note that the negative sign on both sides will cancel out so in
equilibrium,
• P
MRCS  x

Py
 Conti...
• Given that MRCS is equal to the ratio of the
marginal utilities of the goods consumed, i.e.
MU x
MRCS xy 
MU y

• Then the equilibrium of the consumer is given by

MU x Px

MU y Py

DERIVATION OF THE DEMAND CURVE

• Refer to what was done in class.
 LECTURE 8

BY

MISS GLORIA AFFUL-MENSAH

24/10/2012
 THEORY OF THE FIRM
(I) Definitions and Objectives of the firm
(II) Theory of Production in the Short Run
(III)Theory of Cost in the Short Run
(IV) Theory of Cost in the Long Run
(V) Theory of Profit Maximisation
 Definition and the Concept of the Firm
• Firms are obviously run by human beings who attempt to
answer the economic questions.

• A firm in economics is an economic agent which transforms

inputs (factors of production) into outputs (can be finished
or semi-finished goods or services).

Objectives of the Firm

• Profit maximisation (main objective)
• Growth maximisation
• Sales maximisation
• Revenue maximisation
• Survival of the firm, etc.
 Types of Firms
• There are 3 main types and these depend on the nature of ownership and
organisation.
– Sole Proprietorship
– Partnership
– Companies
Sole Proprietorship
• Owned, managed and controlled by one person (sole proprietor)
• May employ people or assisted by friends, family members in the daily
activities of the firm
• He/she answers all the economic questions
• Responsible for all the risk of the firm
• There is no distinction between him/her and the firm
• Very simple business
• Easy to set up
• Mostly does not require legal formalities except for those that are required by
law
• Easy to fold up
• All the profits go the owner
• The size of the business is limited by the amount of capital that can be raised
by the owner, etc.
 Conti...
Partnership
• Involves 2 or more people with objective of making profits
• Partners provide capital, manage daily activities of the firm
• Owners are called partners and they share responsibilities
• Guided by the partnership agreement known as the
“partnership deed”
• There are 2 main forms
– Ordinary/general partnership – partners are solely responsible for
planning, controlling and liabilities of the business. Partners may be
inactive in daily management of the business but still bear the risk
and debt of the firm
– Limited partnership – partners have limited responsibilities and
liabilities to the firm. The owner’s liabilities are limited up to the
amount of capital they invested in the business

• The law requires that every limited partnership should have at

least 1 ordinary partner who is responsible for the risk and
debts of the firm.
 Conti...
Companies
• Also known as joint stock companies
• Involves voluntary association of individuals or
groups of individuals who contribute to set up a
business with the objective of making profits
• The company is established by law
• Owners are called shareholders
• The company is a legal entity and is distinct from the
owners which means that when the owners are no
more the company remain in existence
• Has the right to sue and to be sued
• Owners hire workers who may not necessarily be
shareholders
 Theory of Production in the Short Run
• Production is the process in which inputs (factors of
production) are combined, transformed and turned
into outputs

• The inputs are combined in varying proportions

• The process can be expressed functionally known as
the production function

• The production function gives the maximum quantity

of outputs that a firm can produce by combining all its
inputs in varying proportions

• For example:
Y  f a, b, c,..., z 
 Conti...
• Where;
– Y is the output
– a, b, c,..., z are the inputs

• Even though firms can change the output by

changing the inputs, some inputs cannot be easily
changed in given time frame

Time Frames in Economics

• There 3 major decision time frames
– Short Run
– Long Run
– Very Long Run
 Short Run (SR)
• This is a time frame whereby the firm cannot vary all factors of
production
– Thus some factors are fixed and others are variable

• The period may differ across firms

• The SR of a firm depends on the nature of products produced

• Having fixed inputs means the firm can produce only up to a

certain level of output and cannot exceed that level without
incurring costs higher than the optimum.
– This means that output can be increase only when the firm is
operating below capacity

• Hence in the SR, the firm’s scale of operation is restricted and

can increase output only by increasing the variable inputs.
 Conti...
Long Run
• This is a time frame whereby the firm can vary all
inputs except technology
– Technology is fixed because it may take a very long time
to undertake research and development to come out with
a new technology
• This means that the firm can decide to expand its
scale of operation by producing new products or
replacing outdated machinery or may even close
down in order to reduce its operation

Very Long Run

• All inputs including technology are variable
 Conti...
• Now assume the firm uses 2 inputs which are Capital (K)
and Labour (L). The production function is of the form:

Q  f ( K , L)
• Where K and L can be combined in varying proportions to
produce a given output level

• Assume K is fixed and L is variable. This means that:

– K’s level is held constant in the SR and does not change with
changes in output produced
– Examples may be building, equipment, etc
– L being variable means the level can be changed in the SR. L
will have a direct/positive relationship with the out of the firm
up to a point. Another example of a variable input is raw
material.
 Conti...
• The SR production is a first step in uderstanding the law of
supply.
• The 2nd step is the theory of cost.
Assuming;
– The firm uses 2 factors of production (labour and capital.
– Capital is fixed and labour is variable
• The production function will be of the form;
Q  f ( K , L)
• Consider the following definitions:

(I) Total Product/Output (TP)

• This is the total volume of a good that is produced by
combining K and L
• Can be shown graphically or in a tabular form
 Conti...
(II) Average Product (TP)
• This is the TP per unit of the variable input
• It measures the productivity of the variable input by giving the average amount of the good
each variable input produces.
TP
AP 
L
• Can be measures as the slope of s line from the origin to any point on the TP curve.
• Can be shown graphically or in a tabular form

(III) Marginal Product (MP)

• This is the change in TP as a result of a unit change in labour (variable input).
TP
MP 
L

• This measures the changes in TP

• Can be shown graphically or in a tabular form
• MP measures the slope of TP because with every additional variable input employed, there
is an MP which is added to the existing output in order to get the TP of the firm at the new
level.
 Conti...
Capital Labour TP AP MP

10 0 0 - -

10 1 1 1 1

10 2 4 2 3

10 3 9 3 5

10 4 16 4 7

10 5 25 5 9

10 6 32 5.3 7

10 7 35 5 3

10 8 35 4.4 0

10 9 32 3.6 -3
 Conti...
From the Table,
• TP, AP and MP increase, reach a maximum point and fall as labour
increases against a fixed factor (capital)

• The maximum point of the AP is called diminishing average return

• The nature of the slope of the curves is explained by the law of

diminishing marginal returns.

Law of Diminishing Marginal Return (DMR)

• States that “as successive amount of a variable input is added to a fixed
input, the MP of the variable input increases, reaches a maximum and
eventually falls”

• This means that successive increase in the variable input to a fixed input
causes TP to increase at an increasing rate (from the 1st labour to the 5th
labour), then TP increases at a decreasing rate (from the 6th labour to the
7th labour), reaches a maximum (at the 8th labour) an eventually falls.
 Conti...
• DMR is fundamental in explaining the law of supply

Relationship between TP, AP and MP of the variable input

(I) MP and AP
• Both increase, reach a maximum and fall
• When rising, MP rises faster than AP and AP continues rising
so long as MP > AP. This means that the last worker’s
contribution is > than the average of all the existing workers

• When falling, MP falls faster than AP (here, AP will be

greater than MP). This means that the last worker’s
contribution < the average of all existing workers.

• MP=AP when AP is at its maximum. This means that the last

unit of the variable input employed contributes an output
level equal to the average product of the all existing variable
inputs
 Conti...
(II) MP and TP
• Both increase, reach a maximum and fall
• If MP is the additions to TP, then when MP is
positive, TP will be rising and when MP is negative,
TP will be decreasing.
• When MP is rising, TP increases at an increasing rate
• When MP is falling, TP increases at a decreasing rate
• When MP=0, TP will be at its maximum
• When MP is negative, TP will fall

Note that in our analysis, we assumed there was only

one variable input.
 Stages of Production
• The 3 stages of production in the SR and these depend on the slope and
shape of TP, AP and MP

Stage 1
• Characterised by increasing positive slope
• Starts from the origin to where AP is at its maximum (AP=MP)
• Also known as increasing average returns

• Stage 2
• Characterised by decreasing or negative slope
• Starts from APmax to where MP=0
• Also known as decreasing average and marginal returns

Stage 3
• Characterised by negative slope
• Starts from where MP=0 and beyond. TP begins to fall because there is
negative marginal returns
 Economic Importance of the Stages of Production
Stage 1 (irrational stage)
• Here, the average returns of the variable factor is increasing as the firm
employs additional unit of labour which means an increasing returns to
the variable input

• Also, the fixed input is > the variable input or the ratio of the fixed input
to the variable input is high

• This means that the variable input should be increased in order to take
advantage of the market

• The firm must not stop producing at this stage.

Stage 3 (irrational stage)

• TP is falling because MP is negative
• This means that the ratio of the fixed input to the variable input is low or
the fixed input is < the variable input. That is, the is congestion or
overcrowding of the variable input.
 Conti...
• This means the firm should reduce the variable input
so that the ratio of the fixed input to the variable
input will rise for TP to increase.
• The firm should not produce at this stage.

Stage 2 (rational stage)

• AP of labour reaches its maximum and begins to fall
but still positive.
• MP is also falling but still positive
• Here, there is a fair amount of the variable input
added to the fixed input
• The firm should rather produce here.
 LECTURE 9

BY

MISS GLORIA AFFUL-MENSAH

29/10/2012
 THEORY OF COST IN THE SHORT RUN
• Since in the SR, there are fixed inputs and variable inputs, it means in
the SR, there are fixed costs and variable costs.

• The cost of production is the cost of the factors used in the production
– These may include cost of raw material, capital consumption, cost for hiring
labour, etc

• First recall the reward to the factors of production:

– Land – rent
– Labour – wage
– Capital – interest
– Entrepreneur – profit

Economists' and Accountants’ View of Cost

For the economists, total cost is made up of implicit and explicit costs but
for the accountants, total cost consist of only explicit cost.

– This makes the accounting profit usually greater than economic profit.
 Theory of Cost in the Short Run
Assumptions
– The firm employs or uses 2 factors of production
– These factors are labour (L) and capital (K). Capital is fixed and labour is
variable.
– This means that the firm incurs costs in using labour and capital.

• Functionally, the cost can be written as C = f(K, L)

• The cost function shows the minimum cost the firm incurs when it uses
K and L to produce goods and services.
• If the prices of K and L are Pk and PL respectively,
• Then the cost function can be specified as:

C = PkK +PLL

Where;
PkK is the expenditure on capital
PLL is the expenditure on labour
 Some definitions
Total fixed cost (TFC)
• Overall costs incurred on the using fixed inputs for production
• Also known as unavoidable/overhead cost because it is
incurred whether or not the firm produces
• Does not vary with output.
• When output is zero, TFC = total cost

Total variable cost (TVC)

• Overall cost incurred on using variable inputs for production
• At output zero, there is no variable cost
• Also known as avoidable or direct cost

Total cost (TC)

• The summation of all rewards of factors of production Or the
expenditure incurred in production of a given level of output.
• TC = TFC + TVC
 Conti...
Average fixed cost (AFC)
• TFC per unit of output
TFC
AFC 
Q
• Where Q is the output
• AFC curve is rectangular hyperbola. Thus it approaches infinity when
output is very low and zero (0) when output is very high
• AFC curve is also asymptotic to the output axis

Average variable cost (AVC)

• TVC per unit of output
TVC
AVC 
Q
• AVC curve is “u” shaped. As output increase, AVC begins to fall because
of increasing returns of the variable input. AVC begins to increase when
decreasing returns of the variable input sets in due to the law of DMR.
 Conti...
Average total cost (AVC)
• Cost per unit of production of the firm in producing a specific amount of
a good TC
ATC ( AC ) 
Q
or
ATC ( AC )  AFC  AVC
• The ATC or AC curve is also “u” shaped.
• The nature of the slope is as a result of the law of DMR

Marginal cost (MC)

• The changes in TC as a result of a unit change in output
TVC
MC 
Q
• The MC measures the slope of the TC
• The MC is also sometimes called the marginal variable cost because, it
can be specified as:
TVC
• MC
Q
 Representation of the cost curves
Output TFC TVC TC AFC AVC ATC MC
0 100 - 100 - - - -
1 100 20 120 100 20 120 20
2 100 36 136 50 18 68 16
3 100 48 148 33.33 16 49.33 12
4 100 56 156 25 14 39 8
5 100 60 160 20 12 32 4
6 100 78 178 16.67 13 29.67 18
7 100 105 205 14.29 15 29.29 27
8 100 136 236 12.25 17 29.5 31
9 100 180 280 11.11 20 31.1 44
10 100 226 326 10 22.6 32 46
 Conti...
Relationship among the cost curves
From the Table,
• As output increases, TFC remains unchanged

• As output increases, TVC also increases because the firm must increase
the variable input in order to increase output; hence an increase in the
TVC

• When output is zero, TVC = 0

• TC increases as TVC increases

• AVC, AC and MC decrease, reach a minimum and begin to rise. The fall
in the curves is due to increasing marginal returns to the variable input.

• They rise when DMR sets in.

• When MC is rising, it cuts both AC and AVC at their minimum.

 Conti...
• As AC and AVC are falling, AVC falls faster and so gets to its
minimum before AC

• When AC and AVC are increasing, AC rises faster because of

AFC.

Relationship between the product and cost curves

• One is the inverse of the other. The cost curves are “u”
shaped but the product curves are inverted “u” shaped

• For instance;
– MC is inversely related to MP (refer to your notes for the proof)
– AC is inversely related to AP
 Theory of cost in the Long Run
• In the LR, all inputs (except technology) are variable
• This means that all costs are variable – no fixed cost.
• In the LR,
– firms can enter or leave a particular industry
– Expand or contract scale of operation, etc

Suppose we consider the way marginal and average

labour cost of a sachet water producing
manufacturer vary with (a) 10, (b) 20 and (c) 30
machines.
• Let;
• (a) 10 machines – plant 1
• (b) 20 machines – plant 2
• (c) 30 machines – plant 3
 Conti...
Refer to diagrams drawn in class
• For plant 1, the efficient output is Q1 and any increase in output using that
plant size will lead to an increase in cost.

• If the firm wants to expand production to Q2, then the firm can enjoy lower
per unit cost on plant 2 and even produce more at Q3.

• Generally, in the LR, firms are concerned with determining the best scale of
operation and this motivates management to choose bigger plant size.

• Given that firms can change their plant size in the LR, the LRAC curve is an
envelope curve which reflects the plant sizes associated with the minimum AC
of producing each level of output.

• The point of tangency of the LRAC with the various SRACs is the optimal point
of production for each plant

• The optimum output level is reached at the minimum point of LRAC and this is
unique given that LRAC is tangential to only one SRAC.
 Conti...
• The LRAC is also “u” shaped

• Thus, increase in inputs (factors of production) lead

to a fall in LRAC up to the optimum output and plant
size, after which, LRAC begin to increase.

• Economies of scale is the falling portion of the LRAC

and this is also known as increasing returns to scale

• Diseconomies of scale is the rising portion of the

LRAC and is also known as decreasing returns to
scale
 LECTURE 10

BY

MISS GLORIA AFFUL-MENSAH

05/11/2012
 MARKET STRUCTURES
ISSUES TO LOOK AT!
• Alternative market structures and profit
maximisation

• Perfect/Pure Competition Market

• Pure Monopoly Market

 Alternative market structures and profit maximisation
Recall that
• market in economics refers to the interaction of buyers and
sellers and not necessarily the physical structure

• In defining market structures, we look at the components of

the market.

• The main components are:

– Sellers
– Buyers
– Products

• Other components are:

– Flow of information and knowledge about the market by the
participants
– The difficulty or ease of joining or leaving the market by buyers and
sellers
 Conti...
• Therefore, economists define market structures in terms of:
– Number of sellers and buyers
– Type of the product
– Entry and exit conditions
– Knowledge of the market

• Based on the above criteria, there are 4 types of market structures;

– Perfectly competitive/Pure Competition
– Pure Monopoly
– Monopolistic Competition
– Oligopoly

• Perfectly competitive market is a market characterised by many sellers

producing a homogenous good and competing equally among themselves.
Here, each firm is very small compared to the industry and there is free entry
and exit into the market. Close example is the market for agricultural products

• Pure Monopoly is a market structure characterised by only one seller producing

a good which has no close substitute.
 Conti...
• Here, there are barriers to entry and there is no competition in the
market because the monopolist firm is the same as the industry.
Examples are the utility companies

• Monopolistic competition is a market structure with a relatively large

number of sellers and buyers producing differentiated products with
widespread non-price competition among sellers. Entry or exit are quite
easy and each firm has a limited ability to influence its output price.
Examples are the restaurants, clothing companies, shoe companies, etc

• Oligopoly is a market structure with few sellers of an identical product

with each recognising their interdependence. Entry is relatively
restricted. Examples are the automobiles, electrical appliances,
telecommunication, airlines, etc.

• Note that the market structure determines the conduct (behaviour) of

firms and the conduct influences their performance (e.g. price, output,
profit, efficiency, etc)
 Profit Maximisation
• This is important in order to generalise and compare the different types of
market structures.

• Profit = TR – TC
• But TR = P * Q
• TC = TFC + TVC, where applicable

• This means that profit can be positive or negative depending on the values of
TR and TC.

• Note that profit maximisation also means loss minimisation

• There are 2 approaches to determine the level of output that maximise profit
or minimise loss
– TR-TC approach
– MR-MC approach

• E.g. suppose a fixed price of 25 and fixed cost of 20. Given the values of the
variable cost and output, find the profit maximising output and the
corresponding profit level.
 TR-TC Approach
Output TFC TVC TC TR Profit MR MC
0 20 0 20 0 -20 - -
1 20 18 38 25 -13 25 18
2 20 34 54 50 -4 25 16
3 20 48 68 75 7 25 14
4 20 60 80 100 20 25 12
5 20 74 94 125 31 25 14
6 20 89 109 150 41 25 15
7 20 106 126 175 49 25 17
8 20 130 150 200 50 25 24
9 20 156 176 225 49 25 26
10 20 186 206 250 44 25 30
11 20 241 261 275 14 25 55
12 20 300 320 300 -20 25 59
 Conti...
• From the Table, the highest profit is 50 and the corresponding output level is
8.

MR-MC Approach
• The decision rule is that the firm should produce any output that adds more to
revenue than to cost and vice versa

• i.e.
– When MR > MC, the firm should increase production
– When MR < MC, the firm should decrease production

• When MR = MC, there is no incentive or disincentive to change production.

This becomes the first and necessary condition for profit maximisation.

• The sufficient condition is that, at that point, MC should be rising or the slope
of MC should be greater than that of MR.

• From the Table, using the MR-MC approach, the profit maximisation output is
also around output 8.
 Perfect Competition (PC) Market
Characteristics/Assumptions
• Many sellers and buyers
– Makes sellers price takers and quantity adjusters because they are faced
with horizontal demand curve

• Product homogeneity
– Hence firms in this market do not engage in any non-price competition

• Free entry and exit

– No significant barriers (technical, financial, legal, etc)
– There exist perfect mobility of resources (geographically and
occupationally)

• Perfect information and knowledge

• Given these assumptions, the PC market in the SR can earn:

– Abnormal/supernormal/excess/economic profit
– Break even/normal/zero economic profit
– Losses/subnormal profit
 Demand and MR for PC Market
• Each firm is insignificant compared to the industry.
Therefore price is determined by the forces of demand and
supply from the industry.

• The demand curve for PC firm is horizontal or

perfectly/completely elastic.

• However, the industry’s demand curve is downward

sloping.

• Given that the firm can sell any additional output without
lowering the price, both AR and MR are constant.

• Therefore, for PC firm, P = AR = MR.

 Profit Maximisation by a PC firm
• Profit is maximised when MR = MC

• But for a PC firm, MR = P

• Therefore, profit maximising condition is MC = P

• This condition gives the output that will maximise profit and depends on the
time frame (SR or LR).

Profit maximising output in the SR

• Refer to the diagram in your notes

• When a firm is maximising profit, it does not necessarily mean it is making

positive profit. The nature of profit depends on the level of ATC (AC) at the
equilibrium level of output.

• In the SR there are 3 cases (refer to your notes for the diagrams):
– AC below the AR or the price line
– AC at the same level as AR or the price line
– AC above the AR or the price line
 Maximum losses a PC firm can make
• In the SR, the firm has 2 options if it is making losses:
– Either to continue producing in expectation of future improvements
(so long as SR loss is not more than TFC) or
– Shut down

• Note that in the SR, the maximum loss a firm will make if it
decides not to produce is equal to TFC. Therefore, if a firm can
pay all its variable cost and even part of TFC, then it will be
profitable for the firm to continue to produce even if it is
making losses.

• Refer to the diagram from your notes

Shut Down Point

• When Price < AVCminimum, the firm should shut down because
the revenue from production is not enough to cover its variable
cost.
 LECTURE 11

BY

MISS GLORIA AFFUL-MENSAH

12/11/2012
 Shut Down Point
• When the Price = AVCminimum, the firm has the
option to either continue to produce in
anticipation for future profits or shut down (if it
thinks the future is not bright.

• However, when Price < AVCminimum, the firm

should shut down because the revenue from
production is not enough to cover its variable
cost.

• Refer to diagram drawn in class.

 Supply curve in the Short Run for P.C Firm and the
Industry

For the Firm,

• This is derived from the intersections of the marginal cost with
successive demand curves (refer to diagram drawn in class).

• In other words, for positive output, the firm’s supply curve is

the portion of the marginal cost curve that lies above the
AVCminimum.

• It is positively sloped

• Note that the industry supply curve is the horizontal summation

of the individual firms’ supply curves and is also positively
sloped.
Profit maximising output in the Long Run
• In the LR, all inputs are variable.

• The profit maximising condition states that:

• LRMC = LRMR = LRAC or LRMC = LRAC = P

• In the LR all firms earn normal profit because of

the free entry and free exit condition

• Refer to the diagram drawn in class.

 Long Run supply curve of a P.C Industry
• Cannot do the SR analysis here because of the free entry and exit
condition.

• However, the supply curve can be drawn if the effects of free entry and
exit (expansion and contraction of the industry) on the prices of inputs
are known.

• All things being equal, if the expansion or contraction of the industry

causes input prices to:

– Increase, the supply curve will be upward sloping and this is known as
increasing-cost industry

– Decrease, the supply curve will be downward sloping and this is known as
decreasing-cost industry

– Remain unchanged, the supply curve will be horizontal and this is known as
constant-cost industry
 Perfect Competition and Efficiency
• Recall that the LR equilibrium condition states
that LRMC = LRAC = P. This means that P =
LRACminimum.

• With this condition, economists believe that

there would be productive and allocative
efficiency.
– Productive efficiency because they produce at the
minimum of their AC.

– Allocative efficiency because by equating MC to MR,

each item is being produced to the value of the
alternative good sacrificed.
 MONOPOLY
Characteristics
• Single seller

• Unique product

• Control over price

– Can determine price either directly or directly
– May determine the price and allow the market to
determine the quantity or vice versa but cannot
control both.

• No entry (barriers to entry)

 Barrier to entry as conditions giving rise to monopoly
situation
• These are factors that prevent or prohibit potential firms
into the industry.

• Can be natural or artificial.

– When it is artificial, it is also known as entry barriers

Examples of such barriers include:

• Economies of scale
• Economies of scope
• Ownership or control over key production inputs
• Legal barriers (patent, license, copyright, etc)
• Technical barriers
• Pricing and other barriers
Demand, Average Revenue and Marginal Revenue curves
• Both demand and average revenue curves are
downward sloping. The monopolist’s demand
curve is the same as the industry’s demand
curve.

• Marginal revenue is less than his price because to

increase quantity sold, he must decrease price.

• Since the monopolist’s AR = Price, MR < P or AR

 Conti...
• Consider Q = 100 – 20P
Price Quantity TR AR MR
5 0 0 - -
4 20 80 4 4
3 40 120 3 2
2 60 120 2 0
1 80 80 1 -2
0 100 0 0 -4
From the Table,
• Demand curve is the same as the AR curve and are all downward sloping.

• Except for the first row, MR was constantly < AR or P

• MR falls throughout which means TR increases at a decreasing rate up to a

point (where MR=0) and then falls (where MR is negative)
 Conti...
• When you plot AR, MR and TR (as done in class),

In terms of elasticity,
• When demand is relatively elastic, TR increases with an
increase in output and

• When demand is relatively inelastic, TR decreases with an

increase in output

In terms of the profit maximisation condition,

• MC = MR means that MR should not be negative.

• This means that the profit maximising monopolist will

never produce at the inelastic region of its demand curve
because at that region MR is negative and cannot equate
the positive MC.
Short run profit maximising level of output and price of the
monopolist
• Analysis is similar to that of the P.C market
• If producing is preferred to shutting down, the profit maximising
conditions are:
• MC = MR and
• MC should be rising
• refer to diagram drawn in class

• In SR, the monopolist can earn

• Abnormal/supernormal/economic profits
• Normal/break even/ zero economic profits
• Subnormal profits or losses

• Refer to diagrams drawn in class

• Note that, from the diagrams, the total profit or loss is equal to the
vertical distance (ab) multiplied by the quantity produced
• For mathematical example, refer to the question solved in class
 Short run supply curve of a monopolist
• The monopolist has no unique supply curve because there
is no exact relationship between his price and the quantity.

• He can sell the same quantity at different prices (price-

discrimination) or

• Sell different quantities at the same price depending on its

demand curve

• Also, because the monopolist does not equate MC to price,

it is possible for different demand curves to bring about
different prices even for the same quantity.

• Refer to the diagram drawn in class

 Long run profit maximising output level and price
• Same conditions as in the SR

• However, in the LR, the monopolist can vary all its inputs (except
technology) in order to maximise profit

• He can still make abnormal profits because of barriers to entry

• He can also make losses in the LR since he cannot prevent:

– Demand from falling and
– Cost curves from increasing due to increases in input prices.

• Even though losses may be inevitable in the SR, in the LR, a monopolist
making losses will leave or exit the business. Therefore, in the LR, the
monopolist usually earns
– Abnormal profits or
– Normal profits

• The diagrams are the same as the SR cases.

 2ND SEMESTER LECTURE NOTE

ECONOMICS FOR BUSINESS

FOR LEVEL 100 DEGREE STUDENTS

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