Alevel Economics Notes Brian K

BRIAN ROPI A LEVEL ECONOMICS
AN INTRODUCTION TO A LEVEL ECONOMICS
Human needs and wants are unlimited meaning people will never reach a point of maximum satisfaction
even if they are to be given all the resources of the world. People by nature always demand more to less.
Resources of the world are not enough to satisfy human needs and wants. Economics is therefore
available to device different ways of allocating scarce resources to try to satisfy people needs and wants.
Economics is defined in different ways by different authors’ but they all agree on the fact that economics
is all about finding ways of allocating scarce resources.
Economics is a social or human science that deals with the allocation of scarce resources among the
competing ends to satisfy human needs and wants.
Important elements in the definition
Scarcity-resources are scarce on the sense that they are not enough to fulfill everyone’s needs and wants
to the point of satiety. The economists’ job is to evaluate the choices that exist from the use of these
resources.
Microeconomics and Macroeconomics
Microeconomics
Economists develop economic principles and models at two levels. Micro economics is the part of
economics concerned with individual units such as a person, a household, a firm, or an industry. At this
level of analysis, the economist observes the details of an economic unit, or very small segment of the
economy, under a figurative micro-scope. In micro economics we look at decision making by individual
customers, workers, households, and business firms. We measure the price of a specific product, the
number of workers employed by a single firm, the revenue or income of a particular firm or household, or
the expenditures of a specific firm, government entity, or family. In microeconomics, we examine the
sand, rock, and shells, not the beach.
Macroeconomics
Macro economics examines either the economy as a whole or its basic subdivisions or aggregates, such as
the government, household, and business sectors. An aggregate is a collection of specific economic units
treated as if they were one unit. Therefore, we might lump together the millions of consumers in the
economy and treat them as if they were one huge unit called “consumers.”In using aggregates,
macroeconomics seeks to obtain an overview, or general outline, of the structure of the economy and the
relationships of its major aggregates. Macroeconomics speaks of such economic measures as total output,
total employment, total income, aggregate expenditures, and the general level of prices in analyzing
various economic problems. No or very little attention is given to specific units making up the various
aggregates. Figuratively, macroeconomics looks at the beach, not the pieces of sand, the rocks, and the
shells. The micro–macro distinction does not mean that economics is so highly compartmentalized that
THINK LIKE AN ECONOMIST 1

every topic can be readily labeled as either micro or macro; many topics and subdivisions of economics
are rooted in both. Example: While the problem of unemployment is usually treated as a macroeconomic
topic (because unemployment relates to aggregate production), economists recognize that the decisions
made by individual workers on how long to search for jobs and the way specific labor markets
encourage or impede hiring are also critical in determining the unemployment rate.
Pitfalls to Sound Economic Reasoning
Here are some common pitfalls to avoid in successfully applying the economic perspective.
Biases- Most people bring a bundle of biases and preconceptions to the field of economics. For example,
some might think that corporate profits are excessive or that lending money is always superior to
borrowing money. Others might believe that government is necessarily less efficient than businesses or
that more government regulation is always better than less. Biases cloud thinking and interfere with
objective analysis. All of us must be willing to shed biases and preconceptions that are not supported by
facts.
Loaded Terminology- The economic terminology used in newspapers and broadcast media is
sometimes emotionally biased, or loaded. The writer or spokesperson may have a cause to promote or an
ax to grind and may slant comments accordingly. High profits may be labeled “obscene,” low wages may
be called “exploitive,” or self-interested behavior may be “greed.” Government workers may be referred
to as “mindless bureaucrats” and those favoring stronger government regulations may be called
“socialists.”
To objectively analyze economic issues, you must be prepared to reject or discount such terminology.
Fallacy of Composition- Another pitfall in economic thinking is the assumption that what is true for one
individual or part of a whole is necessarily true for a group of individuals or the whole. This is a logical
fallacy called the fallacy of composition; the assumption is not correct. A statement that is valid for an
individual or part is not necessarily valid for the larger group or whole. You may see the action better if
you leap to your feet to see an outstanding play at a
Football game. But if all the spectators leap to their feet at the same time, nobody—including you—will
have a better view than when all remained seated. Here are two economic examples: An individual
stockholder can sell shares of, say, Econet stock without affecting the price of the stock. The individual’s
sale will not noticeably reduce the share price because the sale is a negligible fraction of the total shares
of Econet being bought and sold. But if all the Econet shareholders decide to sell their shares the same
day, the market will be flooded with shares and the stock price will fall precipitously. Similarly, a single
cattle ranch can increase its revenue by expanding the size of its livestock herd. The extra cattle will not
affect the price of cattle when they are brought to market. But if all ranchers as a group expand their
herds, the total output of cattle will increase so much that the price of cattle will decline when the cattle
are sold. If the price reduction is relatively large, ranchers as a group might find that their income has
fallen despite their having sold a greater number of cattle because the fall in price overwhelms the
increase in quantity.
Post Hoc Fallacy- You must think very carefully before concluding that because event A precedes event
B, A is the cause of B. This kind of faulty reasoning is known as the post hoc, ergo propter hoc, or “after
this, therefore because of this,” fallacy. Noneconomic example: A professional football team hires a new
coach and the team’s record improves. Is the new coach the cause? Maybe. Perhaps the presence of more
experienced and talented players or an easier schedule is the true cause. The rooster crows before dawn
but does not cause the sunrise. Economic example: Many people blamed the Great Depression of the
1930s on the stock market crash of 1929. But the crash did not cause the Great Depression. The same
severe weaknesses in the economy that caused the crash caused the Great Depression. The depression
would have occurred even without the preceding stock market crash. Correlation but Not Causation Do
not confuse correlation, or connection, with causation. Correlation between two events or two sets of data
indicates only that they are associated in some systematic and dependable way. For example, we may find
that when variable X increases, Y also increases. But this correlation does not necessarily mean that there
is causation—that increases in X cause increases in Y. The relationship could be purely coincidental or
dependent on some other factor, Z, not included in the analysis. Here is an example: Economists have
found a positive correlation between education and income. In general, people with more education earn
higher incomes than those with less education. Common sense suggests education is the cause and higher
incomes are the effect; more education implies a more knowledgeable and productive worker, and such
workers receive larger salaries. But might the relationship be explainable in other ways? Are education
and income correlated because the characteristics required
for succeeding in education—ability and motivation—are the same ones required to be a productive and
highly paid worker? If so, then people with those traits will probably both obtain more education and earn
higher incomes. But greater education will not be the sole cause of the higher income.
The Central Problem of Economics
Needs and Wants
Needs are the things we can’t survive without. They are necessities of life e.g. food, clothing, shelter,
water, basic wealth and basic education.
Wants are the things we desire to have or own but we can survive without them e.g. cell phones, TVs,
radios, entertainment etc.
Our wants are unlimited and we never seem to be satisfied with what we have. It is people’s wants rather
than their needs which provide the motive for economic activity. The economic resources that are
available to satisfy our wants are limited. These resources are called factors of production which are :
Land (Natural Resources)
Land refer to natural resources over which people have power of disposal and of which may be used to
yield income/money e.g. farming and building land, forests, mineral deposits, air, seas, oceans,
vegetation, fisheries. The reward for land is rent.
Labour
Labour is human effort – physical or mental which is directed to the product of goods and services.
Reward for labour is wages/salary.
Capital

Is money and all man-made assets used in the production of goods and services e.g. money, machinery,
factories, delivery vans etc. Reward for capital is interest.
Enterprise
Land, labour and capital on their own will not produce anything. There must be a person or people who
will organise the 3 factors of production so that production can take place. Whoever takes these decisions
and consequent risks is known as the entrepreneur. Reward for enterprise is profit.
The basic economic problem
It is about unlimited wants versus limited resources. Our wants seem to be never ending because if we
satisfy one another develops. The resources are limited in supply – scarce. The basic economic problem is
of scarcity. Scarcity is said to be the basic economic problem as all other economic problems are as a
result of scarce resources, economic problems such as Inflation, Unemployment, Inequalities in income
distribution. Economists try to explain how this basic economic problem is solved by different economic
systems. Economics is sometimes referred to as a social science of scarcity. The 3 basic economic
problems faced by all societies are: -
What to produce and in what quantities? (What to produce)
How should the various goods and supplies be produced? (How to produce?) How? Capital intensive
labour intensive or equal proportions of labour and capital?
How should the goods and supplies be distributed? (For whom to produce?) For whom? Ability to pay,
willing buyer willing seller, distributed equally, goods given freely?
Scarcity, choice and opportunity cost
Scarcity means limited in supply. From our definition of economics, we can easily see why economists
view the world through the lens of scarcity. Scarce economic resources mean limited goods and services.
Scarcity restricts options and demands choices because we “can’t have it all,” we must decide what we
will have and what we must forgo. At the core of economics is the idea that “there is no free lunch.” You
may be treated to lunch, making it “free” from your perspective, but someone bears a cost. Because all
resources are either privately or collectively owned by members of society, ultimately society bears the
cost. Scarce inputs of land, equipment, farm labor, the labor of cooks and waiters, and managerial talent
are required. Because society could have used these resources to produce something else, it sacrifices
those other goods and services in making the lunch available. Economists call such sacrifices
opportunity costs: To obtain more of one thing, society forgoes the opportunity of getting the next best
thing. That sacrifice is the opportunity cost of the choice.
Purposeful Behavior
Economics assumes that human behavior reflects “rational self-interest.” Individuals look for and pursue
opportunities to increase their utility— the pleasure, happiness, or satisfaction obtained from consuming

a good or service. They allocate their time, energy, and money to maximize their satisfaction. Because
they weigh costs and benefits, their economic decisions are “purposeful” or “rational,” not “random” or
“chaotic.” Consumers are purposeful in deciding what goods and services to buy. Business firms are
purposeful in deciding what products to produce and how to produce them. Government entities are
purposeful in deciding what public services to provide and how to finance them. “Purposeful behavior”
does not assume that people and institutions are immune from faulty logic and therefore are perfect
decision makers. They sometimes make mistakes. Nor does it mean that people’s decisions are unaffected
by emotion or the decisions of those around them. “Purposeful behavior” simply means that people make
decisions with some desired outcome in mind. Rational self-interest is not the same as selfishness. In the
economy, increasing one’s own wage, rent, interest, or profit normally requires identifying and satisfying
somebody else’s wants! Also, people make personal sacrifices to others.
They contribute time and money to charities because they derive pleasure from doing so. Parents help pay
for their children’s education for the same reason. These self interested, but unselfish, acts help maximize
the givers satisfaction as much as any personal purchase of goods or services. Self-interested behavior is
simply behavior designed to increase personal satisfaction, however it may be derived.
Choice is the decision one makes because we can’t have all the goods and supplies we desire to have –
we have to choose since our resources are limited in supply. We can’t have more of one product/good
without having less of another. When we choose to buy one good, we do this at the expense of another.
Marginal Analysis:
Benefits and Costs
The economic perspective focuses largely on marginal analysis—comparisons of marginal benefits and
marginal costs, usually for decision making. To economists, “marginal” means “extra,” “additional,” or “a
change in.” Most choices or decisions involve changes in the status quo, meaning the existing state of
affairs. Should you attend school for another year? Should you study an extra hour for an exam? Should
you supersize your fries? Similarly, should a business expand or reduce its output? Should government
increase or decrease its funding for a missile defense system? Each option involves marginal benefits and,
because of scarce resources, marginal costs. In making choices rationally, the decision maker must
compare those two amounts. Example: You and your fiancée are shopping for an engagement ring.
Should you buy a half carat diamond, five eights carat diamond, a three quarters carat diamond, a one
carat diamond, or something even larger? The marginal cost of a larger-size diamond is the added
expense beyond the cost of the smaller-size diamond. The marginal benefit is the perceived lifetime
pleasure (utility) from the larger-size stone. If the marginal benefit of the larger diamond exceeds its
marginal cost (and you can afford it), buy the larger stone. But if the marginal cost is more than the
marginal benefit, buy the smaller diamond instead, even if you can afford the larger stone. In a world of
scarcity, the decision to obtain the marginal benefit associated with some specific option always includes
the marginal cost of forgoing something else. The money spent on the larger-size diamond means
forgoing some other product. An opportunity cost—the value of the next best thing forgone—is always
present whenever a choice is made.
Opportunity cost is the value of the next best alternative foregone when one makes an economic choice
e.g. opportunity cost of coming to A Level is going to work and earning a salary. The foregone alternative
is also an illustration of the basic economic problem. We live in a world of scarcity, in the sense that we
can never have everything that we might like. As a result we must make choices, for instance whether to
buy this or that, whether to eat this or that, whether to walk in the park or go to a movie, or whether to

produce this or that. Every time we make a choice to do something we automatically exclude something
else that we did not do we have given it up. We call this the “opportunity cost”.
“Opportunity cost is the best forgone alternative” i.e. it is what we gave up to get what we did. The
opportunity cost of buying new pair of shoes might be a lunch forgone.
· The opportunity cost of buying a new shirt might be not going to the cinema.
· The opportunity cost of taking a part-time job might be not being able to hang out in the mall with
your friends.
For a producer
The opportunity cost of buying plastic packaging material might be the cardboard he did not buy.
NB there can be many alternatives foregone, but only one will be the opportunity cost you cannot add
them up and say they are all the opportunity cost, because it must be a choice between them.
Opportunity cost can be thought of as:

1. The cost in dollars (represents a real thing given up); or
2. The cost in time.
Opportunity cost is important
1. We use it whenever we are deciding what to do, for example shall we hire a couple of videos or buy a
pizza instead.
2. It always arises with budget allocations. At some point in your life you may have to draw up a budget
and allocate money for different purposes. You will be forced to weigh up what is really needed in your
tennis club, computer society, your country or whatever.
3. It lies behind the cost curves that we draw. How does this work?
Consider two producers, A and B. Producer A might have to pay $20 a ton to get the iron ore to make into
motor cars. Producer A sees the cost as $20, but we see it as the way of making sure he gets the resources,
rather than letting B get them! So the opportunity cost really does stand behind the cost curves we draw.
Similarly in consumption: if something costs $10, you have to pay $10 to buy it. That $10 is not only the
price of the object, it is also the amount you have to pay to get the resources, raw materials, labour etc.
that went into making it. This prevented these resources from going into making something else. After
you buy the item it will be reordered by the shopkeeper and replaced on the shelf. S/he orders from a
wholesaler who in turn orders more from the producer. The producer then buys the raw materials etc. to
make another of whatever you bought! In this way, resources keep on going into making whatever people
demand.
4. This is how the price mechanism really works – that is, how it allocates resources to wherever the
demand is the greatest.
THE PRODUCTION POSSIBILITY CURVE (PPC)
The ppc is also called the Production Possibility Frontier (ppf) Curve or Opportunity Cost Curve or
Transformation Curve or Production Possibility Boundary.
Assumptions of the ppc
• Full employment The economy is employing all its available resources.

• Fixed resources The quantity and quality of the factors of production are fixed.
• Fixed technology The state of technology (the methods used to produce output) is constant.
• Two goods The economy is producing only two goods: manufactured goods and agricultural products.
ppc and opportunity cost
A PPC shows combinations of goods and supplies a country/society can produce with its existing supplies
of factors of production which are limited. A society has a wide variety of options as to the quantities and
varieties of goods and services it can produce.
Ceteris paribus, a country producing only two kinds of goods i.e. manufactured products and agricultural
products:-
Diagrammatically
Points inside the ppc e.g X mean some resources are unemployed (under utilization of resources).
Points A, B, and C show the maximum possible combinations of outputs of the 2 goods. There is
maximum use of factors of production available.
Points outside the ppc e.g Y are not attainable given the present country’s productive potential.
A ppc illustrates the following economic ideas:-
• Scarcity
• Choice
• Opportunity cost
• Efficiency
• The law of increasing costs
Using information on the ppc it is not possible for this economy to produce 4,5 units of
Agricultural products and 40, 5 units of manufactured goods (point Y).Again it cannot produce 6
units of agricultural products and 30 units of manufactured goods. If this economy is producing 6
units of Agricultural produce it means zero units of manufactured goods will be produced. If 30
units of manufactured goods is to be produced, a choice should be made. The choice to be made
will be of reducing production of agricultural goods by one unit. The opportunity cost of
producing 30 units of manufactured goods will be one unit of agricultural goods (forgone output).
Shifts in the ppc
a) Parallel shifts
A country’s production potential is constantly changing. If the capacity to produce goods and services
increases, the ppc will shift outwards to the right as shown i.e. parallel shift.

A ppc can shift outwards due to the following reasons
• Increase in labour force
• Increase in the stock of capital goods
• Increase in technical knowledge
• Economic growth
• Discovery of new resources
• Improvement in technology.
The ppc can also shift inwards to the left if the country’s production potential declines as shown below:-

A ppc can shift inwards due to the following reasons:-
• Wars
• Natural disasters which reduce the country’s productive potential e.g floods, droughts, cyclones,
hurricanes
• Brain drain
• Decrease in stock of capital goods
• Outbreak of diseases e.g. HIV-AIDS, TB, malaria, typhoid, dysentery, cholera, swine flu, bird flu
• Technological decay
• Depletion of natural resources eg minerals.
Pivotal shifting of the ppc
A ppc pivot after a change in the level of resources which affect only one product,for example an
increase or decrease in the labour force which only affects one good for example manufactured goods
only.
agric goods

The slope of the ppc/Types of ppc
a) Concave to the origin ppc - A common PPF: increasing opportunity cost and decreasing returns.
b) A straight line PPF: constant opportunity cost and constant returns.
c) Convex to the origin ppc - An inverted PPF: decreasing opportunity cost and increasing returns.
The Law of Increasing Costs
• The law of increasing costs is a principle that states that once all factors of production (land,
labor, capital) are at maximum output and efficiency, producing more will cost more than
average.
• As production increases, the opportunity cost does as well. The best way to look at this is to
review an example of an economy that only produces two things - cars and oranges.
• If all the resources of the economy are put into producing only oranges, there will not be any
factors of production available to produce cars. So the result is an output of X number of oranges
but 0 cars.
• The reverse is also true - if all the factors of production are used for the production of cars, 0
oranges will be produced. In between these two extremes are situations where some oranges and
some cars are produced. There are three assumptions that are made in this possibility.
• The economy is experiencing full employment (everyone who wants to work has a job), the best
technology is being used and production efficiency is being maximized. So the question becomes,
what is the cost of producing more oranges or cars?
• If the economy is at the maximum for all inputs, then the cost of each unit will be more
expensive. The economy will have to incur more variable costs, such as overtime, to produce the
unit.
Resource Allocation
The ppc can be used to illustrate the idea of efficient resource allocation.
Economic efficiency requires that it must not be feasible to change the existing resource allocation in such
a way that someone is made better off and no one worse off, since, if this is possible, the existing resource
allocation must involve a “welfare waste”. Economic efficiency is also called pareto efficiency/pareto
optimality
The PPF and Economic Efficiency
An efficient production point represents the maximum combination of outputs given resources and
technology – clearly the PPF is a useful way of illustrating this idea
Allocative efficiency
An economy achieves allocative efficiency if it manages to produce the combination of goods and
services that people actually want. For allocative efficiency to be achieved we need to be on the PPF -
because at points which lie within the frontier, it is possible to raise output of both goods and improve
total economic welfare. The definition of Pareto Efficiency is an allocation of output where it is
impossible to make one group of consumers better off without making another group at least as worse off.
Points A, B and C are allocatively efficient
Productive efficiency

Productive efficiency is defined as the absence of waste in the production process. When the production
of the two goods lies on the frontier, anywhere on the frontier is deemed to be production efficient eg A,
B & C and production inside frontier is inefficient e.g. X. Productive efficiency requires minimizing the
opportunity cost for a given value of output. When there is an outward shift of the PPF perhaps due to
improvements in productivity or advances in the state of technology, then the opportunity cost of
production falls and society can now produce more from given resources.
Distributive efficiency
We achieve distributive efficiency if we get the goods and services produced to those who actually want
or need them. Where we are on the production possibility frontier has little real bearing on distributive
efficiency, we tend to use the concept to make comment on allocative and productive efficiency. But
when an economy achieves economic growth leading to an outward shift in the PPF, economists have
concerns over the distribution of gains in output and whether or not an improvement in average living
standards has benefited the majority of consumers or whether there has been an increase in inequality and
relative poverty.
Economic efficiency
Is achieved when each good is produced at minimum cost and people and firms get the maximum
satisfaction from their resources. Economic efficiency is also called pareto efficiency.
Movement from point X towards the boundary i.e the ppc is called pareto improvement because this
results in more agricultural products and manufactured products. The welfare of the society improves.
Economic Systems
These are different ways or means in which we try to answer the 3 fundamental economic questions: i.e.
“What?”, “How?” and “For whom?”. To look at 3 means of resource allocation
1. The market mechanism
2. The planned economy
3. The mixed economy
Market Economies
It’s also called free enterprise or laissez faire or capitalist system. The framework of a market or
capitalist system contains 6 essential features which are:
1. Private Property

Private ownership of means of production or factors of production. This means individuals are
free to own factors of production. Income from these factors of production goes to the owners.
2. Freedom of choice and enterprise by individuals – free to buy/hire economic resources.

Consumers are sovereign i.e. free to spend their income as they wish. Producers respond to
consumer preferences and produce what they did.
3. Self Interest as the dominating motive. Each unit in the economy will do what is best for itself.
Firms aim to maximize profits. Owners of land aim to obtain highest possible rewards. Workers
move to occupations/jobs with the highest wages. Consumers spend incomes on goods and
supplies which yield maximum satisfaction/utility.
4. Competition - There are many sellers and buyers. Market forces of did and supplies determine
price as given and can’t influence the price. There is survival of the fittest.
5. A reliance on the price system - Decisions of producers determine supply of a good. Decisions
of customers or buyers determine demand of a good. The interactions of demand and supply
determine prices. Changes in demand and supply cause changes in market prices and it is these
changes/movements in market prices which bring about changes in the ways in which society
allocates or uses economic resources. Prices act as a rationing device; prices give the value f
goods and supplies. Prices act as an allocation/ distribution device of goods and supplies.
6. A very limited role of government-government only intervenes to correct market failure.
Advantages of market economy
Efficiency-free market economies are very competitive, most of their industries are assumed to be
perfectly competitive and so productive and allocative efficiency will occur. It makes sense that
this economy allocates its resources more efficiently. Decisions about what to produce are made
by people who will actually consume the goods.
Choice-Firms will produce whatever consumers are prepared to buy. Due to the free enterprise
factor, there are no restrictions on what the firm can produce
It allocates resources where people want them; we get maximum consumer satisfaction.
It works automatically, is essentially costless, and requires no bureaucracy to run it.
This means no wasted resources in providing a huge civil service, so that people are left with
more to spend rather than pay tax, which means a higher standard of living.
It allows the maximum economic freedom to the people to spend their own money in their own
way.
People have the freedom to choose for whom they will work and in what industry or service.
People have the freedom to set up their own businesses.
There is a strong incentive effect. People are encouraged to work hard and get on in life as they
have the freedom to try anything they want.
Competition forces out the inefficient firms, which means lower prices for consumers, and it also
releases resources needed by the more efficient firms.

Forcing out the inefficient and releasing resources for better uses encourages faster economic
growth.
There is a constant striving to improve production methods and distribution chains which is a
stimulus to technical progress. Technical progress is a major source of growth, and the major
source in developed countries.
With a totally free market there is less for the government to do. This might help to prevent the
emergence of a powerful national government that spends money and behaves in ways that the
people do not want. Totally free markets also tend to go hand in hand with some form of
democracy. A free market cannot prevent but perhaps does lessen the danger of a dictatorship.
THE DISADVANTAGES OF A TOTALLY FREE MARKET

There is no guarantee that growth will be maximised under perfect resource allocation; the
macro-economic side, and aggregate supply and demand, are most important.
The allocation of resources is determined by the distribution of income and incomes are usually
distributed unequally. The rich get more “economic votes” than the poor so the economy
produces a lot of luxury goods. One result can be that the poor and needy might suffer and at the
same time the dogs in rich areas, like Borrowdale, probably eat better than some babies in the
ghetto.
The physically or mentally challenged people would suffer greatly and unless they have a caring
family or private charity help their life, in the words of the political philosopher Thomas Hobbes,
would be poor, nasty, brutish, and short.
In similar fashion, the elderly would not do well. There would be no state pensions if the market
does everything. Not everyone can, or chooses to, accumulate enough wealth to take care of their
own old age. Those without families would be especially vulnerable and the extended family has
broken down and largely disappeared. The extended family used to take care of its own
vulnerable members.
Economic growth may be slower, rather than faster, if the people choose to spend more, save less,
and investment levels are lower as a result.
Public goods, such as defense, a police force, and a justice system will not be provided unless the
state does it. The safety of the nation and individuals cannot be guaranteed. Street lighting would
not exist, as whichever individuals paid for it could not prevent others from using or benefiting
from the free light. Similarly, a state education system or national health system would not exist,
only more limited private ones.
Some economic endeavors, such as a nation-wide transport system or postal system, may not be
established by private enterprise, and where they are, they may favor only the rich, well-
populated areas.
Abilities and resources are not equally distributed, so that rather than a host of perfectly
competitive firms we see a small number of firms in imperfect competition or monopolies who
cartels or raise prices and make monopoly profits. This distorts consumer choice, resource
allocation, and the distribution of income.
Advertising wastes may occur, where virtually identical products are heavily advertised as being
different and better than rival products. The rival firms compete with their own advertising and
the total increases. Much advertising is “percussive” repeatedly hitting consumers with statements
to influence their purchases, rather than “informative” or telling people the product exists and
what it does.
The rise of a few rich and powerful companies, and monopolies, results in the emergence of a
small number of very rich and powerful people. Power tends to corrupt and they get the ear of the

government, influencing what laws will be passed; these often help such people, generally to the
disadvantage of society as a whole.
Lack of knowledge of what is available in other areas is common for decisions by workers on
what job to pursue, by producers on the actions of their rivals, and by consumers or what good
and services are available to buy.
Factors of production (land, labour and capital) are not fully mobile, especially of workers, who
often will not move to where the jobs are for social or other reasons.
Many of the “better” jobs in the professions, such as lawyers, doctors, or dentists may require
lengthy training during which time the young trainee is out of the workplace. Socially, this
frequently means the rich and middle class parents can support their children through the training
period. The children of the poor, and of the working classes, while not excluded make up a
smaller proportion of such professions than their innate abilities suggest they should.
Only private costs are considered when decisions are made to maximise profits; public costs and
benefits are totally ignored. As a result, there is too little production of “merit goods” and too
much of “demerit goods”.
Externalities are ignored: when there are external benefits, too little is produced; when there are
external costs too much is produced.
Economies of scale can result in one or a few large companies that develop monopoly power and
can misuse it.
Economic cycles naturally occur, with booms and slumps or recessions. In a boom there can be
inflation and shortages of various goods and services. In a slump, people can be suddenly laid off
and become unemployed, with severe consequences, such as difficulty in paying the rent or
mortgage, feeding themselves and their family, and paying off things bought on credit. These
social problems are created but none of this is their fault.
Functions of the Price Mechanism
The invisible hand – the workings of the price mechanism

The price mechanism is simply the means by which the millions of decisions taken each day by
consumers and businesses interact to determine the allocation of scarce resources between competing
uses. This is the essence of economics; the price mechanism plays three important functions in any
market-based economy
The signaling function

Prices have a signaling function. Prices adjust to demonstrate where resources are required, and where
they are not. Prices rise and fall to reflect scarcities and surpluses. If market prices are rising because of
stronger demand from consumers, this is a signal to suppliers to expand output to meet the higher
demand. Consider the left hand diagram below. The demand for computer games increases. Producers
stand to earn higher revenues and profits from selling more games at a higher average price. So an
outward shift of demand leads to an expansion along the market supply curve (ceteris paribus)
In the second example on the right, an increase in supply causes a fall in the relative prices of digital
cameras and prompts an expansion along the market demand curve

Higher demand signals to producers to

step up production – if they are driven
by the profit motive An increase in supply leads to lower
market prices – a signal to consumers
that their real income has increased –
they can afford to buy more
price of computer S1 price of digital S1 S2

games cameras
P2
P1 P1
P2
D2
D1 D
0 q1 q2 qty 0 q1 q2 qty
The transmission of preferences

Through the signaling function, consumers are able through their expression of preferences to send
information to producers about the changing nature of our needs and wants. When demand is strong,
higher market prices act as an incentive to raise output (production) because the supplier stands to make a
higher profit. When demand is weak market supply contracts.
The rationing function

Prices serve to ration scarce resources in situations when demand in a market outstrips supply. When
there is a shortage of a product, the price is bid up – leaving only those with sufficient willingness and
ability to buy with the effective demand necessary to purchase the product. Be it the demand for cup final
tickets or the demand for a rare antique the market price acts a rationing device to equate demand with
supply.The growing popularity of auctions as a means of allocating resources is worth considering as a
means of allocating resources and clearing a market.
Adam Smith and the Invisible Hand

The 18th Century economist Adam Smith – one of the founding fathers of modern economics, described
how the invisible or hidden hand of the market operated in a competitive market through the pursuit of
self-interest to allocate resources in society’s best interest. This remains the central view of all free-
market economists, i.e. those who believe in the virtues of a free-market economy with minimal
government intervention.

The price mechanism is the only allocative mechanism solving the economic problem in a free market
economy. However, most modern economies are mixed economies, comprising not only a market sector,
but also a non-market sector, where the government uses the planning mechanism to provide goods and
services such as police, roads and health.
In a command economy, the price mechanism plays little or no active role in the allocation of resources.
Instead the main mechanism is state planning – directing resources to where the state thinks there is
greatest need. The reality is that state planning has more or less failed as a means of deciding what to
produce, how much to produce, how to produce and for whom. The market economy is now the dominant
economic system – even though we are increasingly aware of imperfections in the operation of the
market – i.e. the causes and consequences of market failure.
Prices and incentives

Incentives matter enormously in our study of microeconomics, markets and market failure. For
competitive markets to work efficiently all economic agents (i.e. consumers and producers) must respond
to appropriate price signals in the market.
Market failure occurs when the signaling and incentive function of the price mechanism fails to operate
optimally leading to a loss of economic and social welfare. For example, the market may fail to take into
account the external costs and benefits arising from production and consumption. Consumer preferences
for goods and services may be based on imperfect information on the costs and benefits of a particular
decision to buy and consume a product. Our preferences may also be distorted by the effects of persuasive
advertising and marketing to create artificial wants and needs.
Government intervention in the market

Often the incentives that consumers and producers have can be changed by government intervention in
markets. For example a change in relative prices brought about by the introduction of government
subsidies and taxation.
Suppose for example that the government decides to introduce a new tax on aviation fuel in a bid to
reduce some of the externalities created by the air transport industry.
1. How will airlines respond?
a. Will they pass on the tax to consumers?
b. Can they absorb the tax and seek cost-savings elsewhere in their operations?
2. If the tax raises price for air travellers, will they change their behavior in the market?
3. Is an aviation tax the most effective way of controlling pollution? Or could incentives for producers
and behavior by consumers wanting to travel by air be changed through other more effective and efficient
means?

An indirect tax increases the relative price of a A government subsidy to consumers to cover
product and should cause a contraction of some of the costs of buying child care or
demand. The government is intervening in the employing nannies is designed to reduce the
market because it wants to changes the price relative cost of this and therefore increase
signals and incentives of producers and demand. The justification could be to encourage
consumers. In this case the justification may be a more young mothers to actively seek work,
desire to correct for negative externalities expand the labour supply and contribute to the
country’s productive potential
price s + tax s1 price supply
p2
p2
p1 p1
D1
D2
D1
0 q2 q1 qty 0 q1 q2 qty
Agents may not always respond to incentives in the manner in which textbook economics suggests.
The “law of unintended consequences” encapsulates the idea that government policy interventions can
often be misguided of have unintended consequences! See the revision focus article on government
failure.
The Planned Economies
• Also called the command economy or collectivism.
• Collectivism is the system whereby economic decisions are taken collectively by planning
committees and implemented through the direction of collectively owned resources, either
centrally or at local level.
• In a command economy planning committees are appointed and they provide the answers to the
3 fundamental economic questions.
• What? problem- committees decide on whether more cars or tractors should be produced.
• They solve the “How?” problem by directing labour and other resources into certain areas of
production.
• “For whom?” problem not by pricing but by allotting goods and supplies on the grounds of
social and political priorities.
• All means of production is publicly owned. Logic for public ownership is the desire for a more
equitable distribution of income and wealth.
• There is no private property.
• Production is for use rather than for profit.
Advantages of planned economy
• Can ensure stability because it does not coincide with business cycles
• Serves people collectively instead of individuals; focus on equality
• Distributes wealth among all of society
• Products produces fulfill needs
Problems of planned economies
1. Bureaucracy and apathy
2. Corruption because planners get/are paid relatively small salaries compared to the huge amount
of planning, they find it easy to accept bribes.
3. There is no incentive to save, invest/ to be innovative because of no profits.
4. Encourages laziness
5. Workers get same salaries despite your experience, educational qualifications etc
Examples of Planned Economies
Russia in 1917 after the 1st World War till 1989
Cuba
China
Mixed Economies
• Mixed Economies come in to being as a result of increasing government intervention and control
in capitalist societies.
• Mixed economies are those where there is a significant component of both collectivism and free
enterprise.
• In mixed economies there is private property because it provides an important incentive for
people to work, save and invest.
• Despite the wave of private property significant economic decisions are still taken collectively.
The reasons for increasing government intervention are because of the unacceptable features of
laissez faire/market failure.

Sometimes market economies do not lead to economic efficiency. Market failure arise when the free
market forces of demand and supply fail to produce the quantities of goods and services people want at
prices which reflect their marginal utilities. Market failure is as a result of:
1. Instability
i.e. booms and slumps in economic activity and this results in dissatisfaction to the society as a
whole.
2. Lack of competition
Lack of competition can be caused by markets where there are few large sellers/single seller and
many buyers. Firms which dominate the market will attempt to change high/exorbitant prices leading
to consumer exploitation for e.g monopolies, duopolies and oligopoly. There is also allocative and
productive inefficiency – justifying government intervention.
3. Inequalities
The ability of some individuals and firms to acquire excessive market power leading to great
inequalities in the distribution of income and wealth. The rich become richer and the poor get poorer
– government has to intervene e.g. through taxation (progressive) or welfare transfer payments or
grants or unemployment benefits.
4. Economic Change
The market economy does not provide an equitable basis for sharing the burdens of economic change
e.g. technological advancement can lead to unemployment – workers suffer and employers gain.
Demand for older goods declines and demand for new goods in fashion increases. Some firms
benefit and others suffer e.g. black and white TV, brick cell phones etc. The burdens of change full
entirely on the unlucky ones.
5. Externalities (Spill Over Effects)
Externalities in consumption exits when the level of consumption of some goods or service by one
consumer has a direct effect on the welfare of another consumer, an effect which is not transmitted
through the price mechanism consumption externalities exist when consumption activities of an
individual directly affect consumption of another person. Production externalities exist when the
production activities of one firm directly affect production activities of another firm. Individual or
firms affected are called third parties e.g. good perfume sprayed by someone, good music played by
someone next door, smoking.
a) Positive Externalities are external benefits/advantages
b) Negative Externalities are external costs or disadvantages or economic bads e.g.

secondary smoking
c) Social Costs are the costs to the society as a whole. Consist of private costs plus negative
externalities (external costs).
d) Social Benefits are total benefits or advantages to the society as a whole. Consists of
private benefits plus positive externalities (external benefits)
6. Missing Markets
A free market economy fails to provide:
a) Public goods- these are goods which when made available to one person, they are
equally available to everyone else e.g. street lights, defence. Public goods have 4 major
characteristics:
i) non rivalry in consumption
ii) non excludability
iii) non rejectable
iv) non exhaustible
Public goods are not provided at all in a free market system and if provided, they have the problem of free
riders.
b) Merit Goods will be under provided. Merit goods are those goods which the state wants
to maximize and increase their consumption because it considers them to be highly
desirable for the welfare of citizens e.g. education, health services, insurance, training
Public goods and merit goods involve positive externalities. The government provides these goods either
for free or highly subsidized.
7. Demerit Goods
Demerit goods are goods which the state wants to discourage their consumption because it considers them
to be undesirable for the welfare of citizens. These goods are dangerous, hazardous to health e.g.
cigarettes, certain forms of drugs, beer.
Demerit goods involve negative externalities. The government discourages their consumption through
regulation, complete bans or taxation
8. Information asymmetries/ lack of Information/ Information Failure/ Imperfect information
This results in wrong choices being made

9. Factor Immobility
This means that it is difficult to transfer factors of production from one use to another e.g. workers are
immobile i.e. a teacher can’t start working as a doctor unless he/she undergoes fresh training.
10. Inequality in the distribution of wealth and income
The rich get richer and the poor poorer.
11. Short Termism
Private sector entrepreneurs often have short term objectives at the expense of long term planning. Short
Termism can result in the overproduction of consumer goods and the underproduction of capital goods
and the failure to develop new methods of production and new products.
Policy options that the government may use to correct market failure
1. Creating a framework of rules
2. Supplementing and modifying the price system i.e. price controls (maximum price,
minimum price, buffer stock)
3. Redistribution of income e.g. unemployment benefits, grants, transfer payments
4. Stabilising the economy
5. Provision of public goods and merit goods
6. Taxation
7. Fixing prices. Price floor. Price ceiling. Buffer stock.
8. Subsidising the production or sale of various goods and supplies.
9. Competition policy
10. Nationalisation of firms
11. Privatisation of firms
12. Providing information
13. Subsidies
14. Encouraging long term planning – companies or businesses and a mission statement.

Note - If the government fails to correct market failure, this results in government failure.

The Theory of Demand
Demand is the quantity of a commodity/ good which people are willing and able to buy at any given
price over some given period of time. This is effective demand. Demand is not the same as desire or
wish. Demand must be backed by an ability to pay.
Ex-ante demand is the quantity which buyers wish or intend to buy at the going price – ex-ante means
intended, desired or planned, expected before the event.
Ex-post demand is the quantity which buyers finally buy i.e. the quantity which they actually succeed in
buying.
Price and Value
Price is the quantity of money which must be exchanged for a unit of good or service or price is the cost
of a good.
Value is the worthiness of a good or service. Price is not the same thing as value.
Markets
A market is any effective arrangement of bringing buyers and sellers into contact with one another.
Sub-market is a small market within an umbrella market of a good e.g. in the market for computers,
there are keyboards, mice, screens, CPUs.
The price of any economic good under market conditions such as we find in the capitalist world is
determined by forces of supply and demand. The forces of demand acting through buyers and the forces
of supply acting through sellers determine the market price.
For the great majority of goods and services, experience shows that the quantity demanded will increase
as the price falls. This particular characteristic of demand is illustrated by a table described as a demand
schedule.
Price ($) Quantity demanded (per week)
50 50
40 80
30 130
20 190

10 300
The law of demand states that more of a good is demanded when its price falls
Hence there is an inverse relationship between the quantity of a good demanded and its price since as
price goes down the quantity demanded goes up.
Market Demand
The demand curves of all consumers in the market can be aggregated to obtain the market demand curve
showing the total amount of a good which consumers wish to buy at each price e.g.
Price ($) Individual A Individual B Individual C Total Market

Demand
1 100 120 50 270
2 90 110 40 240
3 70 90 35 195
4 50 80 30 160
5 45 70 15 120
The market demand curve is the horizontal summation of individual demand arrives at given prices.
Why does the demand curve slope downwards form left to right?

1) Income Effect – when the price of a food falls consumers buy more because the purchasing
power of their money income has increased and vice versa. E.g if a consumer has an income of
$100.00 and the price of the good falls,
Price Quantity Demanded
$100 1
$50 2
$25 4
$20 5
$10 10
$5 20
$4 25
$2 50
$1 100
If price is plotted against quantity demanded, we get a downward sloping demand curve.
1. The substitution effect – A fall in the price of a good makes it relatively cheaper when compared
with competing goods. There will probably be some switching goods of purchases away from the
now relatively dearer substitute towards the good which has fallen in price.
2. The law of diminishing marginal utility - Utility is satisfaction derived from consumption of good
or service. A person buys a good because it yields him satisfaction. As he buys more of any good, the
total utility derived increases but the increase in total utility is not proportionate to the increase in his
consumption. The additional utility derived from the last unit purchased is called marginal utility of a
good and it is generally accepted that marginal utility diminishes as consumption increases. A person
only buys more of a good as price falls. e.g
Diminishing marginal utility

a) Total Utility b) Marginal Utility
The Demand Curve
The demand curve tells us what happens to quantity demanded when price changes and there is no change
to any of the factors affecting demand.

At price OP quantity demanded is OQ. If price falls to OP1 quantity demanded would be OQ1 and vice
versa. The area of rectangles under the demand curve represents total revenue (TR) forthcoming. TR is
the amount of money a firm gets from its sales – TR = P x Q
Movements along the demand curve are referred to as extensions or expansions and contractions of
demand.
Movements down along the demand curve to the right – extension/ expansions of demand,
Movement along the demand curve to the left – contraction of demand.
Exceptional Demand Curves
1. The stock exchange market – speculative demand
2. Ostentatious snob appeal goods / Veblen goods
3. Giffen goods or staple foods
1-3 the demand curve will be upward sloping
4. Demand curve which is horizontal
5. Demand curve which is vertical
Shifts in Demand
A change in demand means that one or more of the factors which determine demand (other than the price
of product/good) has changed. It means the whole demand curve shifts/moves to the left or right. An
increase in demand means that more is now demanded at each and every price. A fall in demand means
that less is demanded at each and every price.
Increase in demand
An increase in demand would mean that the demand curve has shifted from DD to D1D1 – at price level
OP quantity demanded increases from OQ to OQ1. At price level OP1 quantity demanded increases from
OQ2 to OQ3.
Decrease in demand

A fall decrease in demand would shift the demand curve from DD to D1D1 – at price level OP quantity
demanded would decrease from OQ to OQ1. At price level OP1 quantity demanded would decrease from
OQ2 to OQ3.
Determinants of demand or Factors affecting demand
1. Changes in the price level cause the demand curve to expand or contract. The demand
curve does not shift.
2. Changes in disposable real income – If income increases, the demand for most goods
increases. These are called normal goods. Increasing incomes may cause the demand for
some goods to fall. These goods are called inferior goods e.g. second hand clothing, public
transport. Disposable income is the amount of money which an individual has available for
spending after taxes have been deducted. Real income is the purchasing power of money
i.e. what money can actually buy.
3. Changes in the price of other goods
Substitutes are goods which can be used in place of another e.g. butter and margarine, beef
and pork, tea and coffee, OMO washing powder and sunlight washing powder, colgate
toothpaste and close-up toothpaste. An increase in price of butter results in an increase in the
demand for margarine.
Complements are goods which the use of one requires the use of another. Jointly demanded
or complementary demand e.g. car and petrol, tennis ball and tennis racquet, tea and sugar,
cell phone and airtime, toothbrush and tooth paste, trousers and belt, shoes and socks, shoes
and polish, nail polish and nail polish remover. An increase in the price of sugar reduces the
demand for tea.
4. Changes in tastes and fashion
When a good is in fashion demand increases. When out of fashion demand decreases e.g.
clothing, furniture, plasma TVs are in demand.
5. Advertising
Businesses become big because they advertise. They become small or close down because
they don’t advertise. A successful advertising campaign will move the product’s demand
curve to the right and at the same time move demand curves for competing goods to the left
e.g. coca cola bottling company advertises a lot – always keeps products in front of customer
eyes – demand increases.
6. The availability of hire purchase finance
The demand for many durable consumer goods e.g. cars, furniture, houses etc depend on the
provision of hire purchase facilities. Availability of hire purchase finance increases the
demand for goods because few people can purchase these goods for cash since they require
large sums of money.
7. Changes in population
Changes in population and changes in age distribution will affect both the total demand for
goods and supplies and the composition of that demand.
8. Expectations of future price changes
If people think that prices are going to rise in the future, they are likely to buy/demand more
now before the price goes up.
9. Changes in weather conditions
Demand for some goods is affected by changes in weather conditions e.g. winter clothing,
summer clothing, sun hats and ice cream e.g. for ice cream, demand increases in summer and
decreases during winter season.
10. Exogenous shocks e.g. natural disasters e.g. cyclones, floods, earthquakes affect demand
11. Outbreaks of wars
Factor number 1 i.e. the change in the price of the good will cause the demand curve to either expand/
extend or contract.
Factors 2 - 11 will cause the whole demand curve to shift. They are called conditions of demand.
Simple Demand Curve Functions/Equations
A demand function is an equation which shows the mathematical relationship between the quantity
demanded of a good and the values of the various determinants of demand.
Demand equations are often used to relate quantity demanded to just one determinant. Thus an equation
relating quantity demanded to price could be in the form:
Qd = a – bP
Where: Qd = quantity demanded; a = price axes intercept; b = slope of the demand curve which is
negative in this case
For example the actual equation might be Qd = 10 000 -200P
From this can be calculated a complete demand schedule or demand curve.
e.g. Demand Schedule for the equation
Qd = 10 000 – 200P
Price Quantity demanded per week
5 9000
10 8000
15 7000
20 6000
25 5000
Diagrammatically
Price
30
25
20
15
10 Price
5
0
0 2000 4000 6000 8000 10000
Theory of Supply
• The supply schedule and supply curve show the relationship between market prices and
quantities which producer/suppliers/manufacturers are prepared to offer for sale at a given price
over a given period of time.

• The basic law of supply says “more will be supplied at a higher price than at a lower price”. The
supply curve will slope upwards form left to right.
• Supply Schedule is a table showing the different quantities of a good that producers are willing
and able to supply at various prices over a given period of time.
• Supply Curve – A graph showing the relationship between the price of a good and the quantity
of the good supplied over a given period of time.
Price ($) Quantity Supplied (per week)
50 250
40 220
30 180
20 120
10 50
Diagrammatically

An increase in price usually means that production will become more profitable and existing producers
are expected to expand their outputs in response to rising prices and hence more profits.
In the longer run an increase in price (and hence profits) would tend to encourage new firms to enter the
industry.
Exceptional Supply Curves
• Regressive Supply Curve
Supply curves usually slope upwards from left to right, sometimes however they change direction and are
said to become regressive e.g. an individual supply curve for labour where there may be a high leisure
preference.
As wage rates increase workers have opted to work for shorter hours. This is because instead of taking the
increased wage rate in money workers
take increased leisure and

offer less hour of labour.
A perfectly inelastic supply curve and a perfectly elastic supply curve

Market Supply
The supply curves of all producers in the market can be aggregated to obtain the market supply curve
showing the amount of a good which producers are willing to supply at each price e.g.
Price ($) Firm A Firm B Firm C Total Market

Supply
1 10 15 0 25
2 20 25 30 75
3 30 40 50 120
4 40 60 90 190
5 50 80 130 260

Movements along the supply curve
As was the case with the demand curve the supply curve is drawn on the assumption that when the price
of a good changes no other thing changes (ceteris paribus). Movements along the supply curve are
referred to as changes in quantity supplied. They are as a result of price of the good change. They either
cause an extension/expansion in supply or a contraction of supply.
The term change in supply means the whole supply curve has moved/shifted either to the left or right. A
rise in price from OP to OP1 causes an increase in quantity supplied from OQ to OQ1. This is referred to
as an extension/ expansion in supply as shown by the diagram below.
A fall in price from OP to OP1 causes a decrease in quantity supplied from OQ to OQ1. This is referred to
as a contraction in supply as shown by the diagram below.
Changes in supply
An increase in supply means that more is supplied at each and every price e.g SS to S1S1 from the
diagram below.

At price level OP quantity supplied has increased from OQ to OQ1.
A decrease in supply means that less is supplied at each and every price e.g SS toS1S1 from the diagram
below.
At price level OP1 quantity supplied has decreased from OQ to OQ1.
The determinants of supply / factors affecting supply
• Changes in the price of the good – supply curve does not shift. It only expands or contracts.
• Changes in prices of factors of Production
• Changes in prices of other commodities e.g. if the price of barley increases but not of wheat, this
will tend to reduce the supply of wheat and increase the supply of barley.

• Changes in technology/ technical knowledge. Improvements in technology tend to increase

supply.
• Tastes of producers
• Organizational changes
• Nature, random shocks and other unpredictable events
• Government policy changes
• Taxes and subsidies
• Number of suppliers in the market e.g if new firms enter the industry, supply increases
• Aims of producers
• Exogenous Factors
• Expectations about future price changes
Price & Output Determination in Competitive Markets
The Market Price
For each economic good there is a supply schedule and a demand schedule. If the 2 are brought together,
we find that quantity demanded and quantity supplied will be equal at one and only one market price.
This is called equilibrium price or the market price. The equilibrium price may be determined from the
demand and the supply schedules or as is more usually the case form the point at which the demand curve
and supply curve intersect e.g.
Price ($) Quantity Demanded Quantity Supplied

(per week) (per week)
50 50 250
40 90 200
30 150 150
20 220 80
10 350 0

Equilibrium Price = $30
Equilibrium Quantity = $150
At prices higher than the market price e.g. $40 quantity supplied is greater than quantity demanded and
there is excess supply which would oblige sellers to lower their prices in order to dispose of their output.
This situation is called or described as buyer’s market. At prices lower than the market price e.g. $20
quantity demanded exceed quantity supplied giving rise to a shortage competition between buyers will
force, push up the price giving rise to conditions known as the seller’s market. The equilibrium or
market price is $30 because at any other price there are market forces at work which tend to change the
price.
The Rationing Function of Price
The rationing function of price means that price has the potential of eliminating excess supplies or excess
demand which might exist. This will continue until equilibrium is restored at point e where equilibrium
price is P* and equilibrium quantity traded is Q*. If demand is not equal to supply it’s a situation of
disequilibrium. Its either there is excess supplies pr excess demand.
Changes in Market Price
Market prices are determined by the interaction of demand and supply and in competitive market changes
in market prices must be due to changes in demand and supply or both.
Effects of Changes in Demand
The effects of changes in demand may be stated in terms of economic laws
1. Other things being equal, an increase in demand will raise the price and increase the quantity
supplied.

2. Other things being equal, a decrease in demand will lower the price and reduce the quantity
supplied.
Assuming that DD is the original demand curve and supply is the original supply curve, the equilibrium
price is OP and the quantity OQ is demanded and supplied. Assume that demand now increases from DD
to D1D1. The immediate effect is to cause a shortage (shown by the dotted line) at the ruling price OP.
This shortage will cause the price to bid upwards and quantity supplied will increase until a new
equilibrium price is established at OP1. The quantity demanded and supplied is now OQ1.
***Question: Use the same diagram to explain the effects of a fall in demand. ***
Effects of a shift in supply
The effects of changes in supply may also be summarized in the form of 2 economic laws:-
1. Other things being equal, an increase in supply will lower the price and increase the quantity
demanded.
2. Other things being equal, a decrease in supply will raise the price and reduce the quantity
demanded.

Assuming SS is the original supply curve and DD is the original demand curve – OP is the equilibrium
price and OQ is the equilibrium quantity demanded and supplied. An increase in supply moves the supply
curve from SS to S1S1. The immediate effect is as surplus (shown by the dotted line) at the ruling priced
OP. This surplus will force the price downwards, quantity demanded will increase and eventually a new
equilibrium price OP1 will be established. The quantity demanded and supplied will be OQ1.
***Question: Use the same diagram above to explain the effects of a fall in supply.***
Complex Shifts in Demand and Supply
This is because of the different magnitude of shifts in demand and supply.
Effects of Taxes
Taxation is the transfer of money from individuals, companies , institutions or groups to the government.
Taxes may be levied upon wealth, income or capital gains. Taxation is one of the principal means by
which government finances its expenditure. When a tax is imposed on a good, this has the effect of
shifting the supply curve upwards by the amount of the tax. The tax may be regarded as an increase in the
cost of production.

XY = burden of tax borne by consumer
YZ = burden of tax borne by producer
P1P2XZ is the total tax revenue collected by the government
The amount of the tax is the vertical distance between the 2 supply curves i.e. XZ
The effect of the tax is to raise price and reduce quantity. The original equilibrium is at the point is X
where price is P and quantity Q is traded. After the imposition of a tax, the new equilibrium is where price
is P1 and quantity is Q1. Taxes can be specific (i.e. unit tax) or ad valorem (i.e. % tax/ by value). The
effect of tax depends on the elasticities of demand and supply of the product.
Effects of Subsidies
A subsidy is a negative tax. For e.g. the government sometimes subsidises a product by giving an amount
of money to the producer for each unit they sell. Subsidies normally take the form of payments by
government producers and are particularly important in the case of agriculture products (e.g. wheat, milk,
meat etc). The effect of a subsidy is to increase supply – it will reduce price and increase the quantity
supplied.

YZ = subsidy benefit to consumers
XY = subsidy benefit to producers
XZ = the amount of the subsidy which is the vertical distance between the 2 supply curves
P1 P2 XZ = total amount of subsidy paid by the government
Initially the equilibrium price is OP and quantity OQ is demanded and supplied. A subsidy, to producers
has moved the supply curve from SS to S1S1, price has fallen to OP1 and quantity demanded has increased
to OQ1. The amount of the subsidy is XZ. Consumers have benefited by a price fall equal to YZ. They
consume more at a lower price. Producers have benefited from an increase in the supply price YQ1 to
XQ1. They now supply more and receive higher supply price. The effect of a subsidy depends on the
elasticities of demand and supply for the good.
Effects of Import Tariffs
Tariffs (import duty) are taxes imposed on commodity imports. They may be levied on an advalorem
basis i.e. as a certain % of value or on a specific basis i.e. as an amount per unit. Their purpose may be
solely for raising government revenue. A tariff acts in exactly the same way as a tax by artificially raising
the price of the foreign product as it enters the country.

Effects of export subsidies
An export subsidy is a payment to a firm or individual that ships or exports a good abroad. A nation may
decide to subsidize certain domestic industries as a means of protecting them from the competition of
lower priced foreign goods. Like a tariff a export subsidy can either be specific (a fixed sum per unit) or
advalorem (a proportion of the value exported). When the government offers an export subsidy shippers
will export the good up to the point where domestic price exceeds the foreign price by the amount of the
subsidy. The effects of an export subsidy on prices are exactly the reverse of those of a tariff.
The subsidy will reduce the price of the domestic product and hence make it more difficult for the foreign
producer to sell a similar product in the home market. There will be a redistribution of income towards
producers and consumers of the subsidized good because the cost of the subsidy will fall on the taxpayers.
Effects of Price and Wages Control
Maximum Price (Price Ceiling)
A government or another body may set a maximum price. This will only affect the market pric if the
maximum price is set below the equilibrium price. A government may introduce a maximum price in
order to :-
• Promote equity or equitable distribution of Y and wealth
• Enable poorer members of the society to purchase necessities like food, housing and public
transport.
Initial market equilibrium price is OP and the quantity bought and sold is OQ. When a maximum is
imposed at OPX quantity demanded expands to OQD and quantity supplied contracts to OQs. A shortage
QS-QD arises. The problem of maximum price is that queues may emerge, there could be rationing and
the black market may develop. Maximum prices increase the welfare of those who are able to purchase
the product at that stipulated maximum price.
Minimum Price (Price Floor)

A minimum price will only affect a market if it is set above the equilibrium price. A government or other
body may impose a minimum price if it considers that the market price is too low. This is because the
government may wish to raise worker’s wages in the case of minimum wage legislation or to increase and
protect producer’s incomes.
Pushing the price up to OPM causes supply to extend, demand to contract and creates a surplus QDQS. To
maintain the minimum price, the government or some other official body will have to buy up the surplus.
Buffer Stocks
A buffer stock makes use of both minimum and maximum prices. It is a scheme operated by a central
authority and its main aim is usually to stabilize prices and protect producers from sudden shifts in
demand and supply.
The diagram shows the effect of setting up a buffer stock for oil seed. If the boundaries set by the central
authority no action is taken. However if the market price starts to move outside the buffer stock operators
will intervene.

The diagram below shows the effect of a good harvest of oil seed rape. The supply curve shifts to the
right. This puts downward pressure on the price and to prevent the price falling below the lower boundary
the operators step in to increase demand.
If there was no intervention new equilibrium would have been point e (i.e the price outside boundary) but
because of intervention its now e1 – price is now oscillating within the boundary.
Consumer surplus and Producer Surplus
Consumer Surplus
Occurs when people pay less for a product than they were willing to pay (i.e. less than the value they
place on a product based on their marginal utilities) = the area of the consumer surplus is the area under
the demand curve and above the price line.

The consumer is willing to buy the good for £7 but he finally pays £4.
Producer Surplus – occurs when the producer receives a price for a product he sells which is more than
what he was willing to sell the good for. The producer surplus is equal to the area above the supply curve
and below the price line. s
price
P2
P1
qty
The producer is willing to sell the good at price P1 but he finally sells it at price level P2.
Elasticities of Demand
• Elasticity is concerned with the extent to which one variable, for example, demand, responds to a
change in another variable for example price
• There are 3 types of elasticity of demand which measure how the quantity demanded responds to
changes in the key influences on demand i.e price, price of related products and income and
therefore we have:-

1) Price elasticity of demand
2) Cross elasticity of demand
3) Income elasticity of demand
• With elasticity of demand we will be concerned not only with the direction of change in demand
but also the size of the change (i.e the magnitude of the change)
Price Elasticity of Demand
• Price elasticity of demand (PED) refers to the responsiveness of quantity demanded of a good to a
change in price.
• PED is the relationship between the proportionate changes in quantity demanded of a good due to
a proportionate change in price.
• PED is the relationship between % ∆ in quantity demanded of a good due to a % change in the
price of that good.
%
PED = ED = ƐD = -
%
%∆
= -
%∆
PED =
Normally price and quantity move in opposite directions – the negative sign in front of the formula will
offset.
Using the formula above, it is possible to derive the following relationships.
1. If demand is elastic, it means quantity demanded is very responsive to price changes – e.g. for
luxuries a small change in price leading to a relatively large change in quantity added - % ∆
Qdemanded > % ∆ P
- 1< PED < ∞
- The demand curve is gentle or almost flat in shape.

a) An increase in price will reduce total revenue
b) A fall in price will increase TR
2. If demand is inelastic it means quantity demanded is relatively unresponsive to price changes

e.g. for necessities
% ∆ Qdemanded < % ∆ P
O < PED < 1
The demand curve is steep in shape.
a) An increase in price will increase TR
b) A fall in price will reduce TR
3. If elasticity of demand is unity it means a change in price will cause the quantity demanded to
change by exactly the same magnitude.
% ∆ Qdemanded = % ∆P
PED = 1

The demand curve is a rectangular hyperbola. A change in price will leave TR unchanged.
4. If elasticity of demand is perfectly elastic
i.e PED = ∞
The amount demanded at the ruling price is infinite e.g. price controls. The demand curve is
horizontal in shape. Demand falls to zero if price changes.
PED = % ∆QD / % ∆ P = number / 0

If it’s a calculator, it will show ϵ or error or undefined
5. If elasticity of demand is perfectly inelastic
The quantity demanded does not change as price changes. The demand curve is vertical
PED = 0 e.g a hospital signing a contract with a manufacturer of theatre gloves to bring 10 000 pairs
of gloves every week. The quantity demanded will be fixed at 10 000 and its only the price of theatre
gloves which will change.
PED = % ∆ QD / % ∆ P = 0 / number = 0
Elasticity of demand and the gradient of the demand curve
• Elasticity of demand is not measured by the slope or gradient of the demand curve.
• Normally on any downward sloping demand curve, elasticity will be different at different prices.
There are only 3 exceptions which are:-
a) A perfectly elastic demand curve
b) A perfectly inelastic demand curve
c) A demand curve with unitary elasticity

As you move down along the demand curve from left to right, the value of elasticity decreases from
infinity at point A through unity at point B and zero at point C.
Factors affecting price elasticity of demand
1) Availability of close substitutes – when a close substitute is available in the relevant price range,
demand will be elastic and if no available close substitute, demand will be inelastic.
2) The proportion of consumer’s income spent the good. Where the proportion is very small
demand tends to be inelastic and when the proportion is big the demand tends to be elastic.
3) Necessities and luxuries - The demand for necessities will be inelastic and the demand for
luxuries will be elastic
4) Habit forming goods - Some goods are habit forming and the demand for such goods tend to be
inelastic e.g. cigarettes to a chain smoker or beer to an alcoholic.
5) The durability of goods - Goods which can be used more than once are called durable goods.
They are likely to have more elastic demand. Non durable goods are likely to have inelastic
demand.
PED and Total Revenue
• A firm’s total revenue (TR) is the amount of money it makes from selling its goods – TR = P x Q
e.g. a firm that sells 100 units of a good at $10 each will have a TR = 100 x $10 = $1000

• The effects of a change in good price on the total revenue of a firm depends on whether the
demand for the good is elastic or inelastic.
• When demand is elastic a decrease in the price of a good will increase TR and an increase in price
will decrease TR.
• When demand is inelastic e.g. necessities a decrease in the price of a good will decrease TR and
an increase in price will increase TR.
• When a good has elasticity of demand which is unity, a decrease or increase in price of good
leaves TR unchanged.
Arc Elasticity of Demand
The percentage method of calculating elasticity is given by the formula

%∆ ∆ /
ЄD = %
=∆ /
This can be rearranged as follows:

∆
ED =
∆
∆
=
∆
• This formula gives an answer for straight line demand curves. It does not work for curved
demand curves.
• Arc elasticity is the average value of PED over a segment of the curve. Arc elasticity is the
measurement of elasticity between two points on a curve.
Point Elasticity of Demand
• Point elasticity of demand is the value of price elasticity at any one point on the curve
ED =
• The ratio dQ/dP is the derivative of quantity w.r.t price, while P and Q are price and quantity at
the point where we wish to measure elasticity.

• is the first derivative of Q with respect to P. This is in fact the inverse of the shape of the
demand curve.
• Point elasticity normally is used when you are given a demand equation and you are asked to
calculate elasticity at a given point e.g. 3P2 – 8P + 10 at point (15, 4)
Income Elasticity of Demand (YED or Ey)
• YED is the relationship between the % ∆ in quantity demanded of a good due to a % ∆ in income.
• YED measures the degree of responsiveness of the quantity demanded of good to changes in
income.
%∆
Ey = YED = %
∆ /
=
∆ /
∆
= x
∆
• For most goods, income and quantity demanded will move in the same direction i.e. an increase
in Y will lead to an increase in quantity demanded and vice versa. These goods are called normal
goods – YED is positive.
• For some goods, income and quantity demanded will move in opposite directions. An increase in
income will lead to a decrease in quantity demanded and vice versa. YED is negative. These
goods are called inferior goods e.g. public transport, second hand clothing, cheap food stuffs etc.
• When quantity demanded does not change as income changes YED = 0.
Factors Affecting YED
1. Current standard of living
2. Type of good (normal, inferior)
3. Level of consumer’s income
Cross Elasticity of Demand (CED or EX)

• CED measures the degree of responsiveness of the quantity demanded of one good (B) to changes
in the price of another (A)
%
CED = %
∆ /
CED =
∆ /
∆
=∆ x
• In the case of substitute goods (i.e. goods which can be used in place of another), CED will be
positive i.e. an increase in the price of good A will lead to an increase in the quantity demanded
of good B (and vice versa) e.g. tea and coffee or beef and pork.
• In the case of complementary goods ( i.e. goods which the use of one will require the use of
another). CED will be negative i.e. an increase in the price of good A will lead to a fall in the
quantity demanded of good B (and vice versa) e.g. cell phone and airtime, tea and sugar.
• If 2 goods are very close substitutes CED will have a very high positive value.
• If CED is equal to zero – the goods are not related at all. They are independent goods e.g.
televisions and toilet paper & blankets and sweets.
Usefulness of PED to a firm/business
• To calculate a firm’s revenue.
• For a firm to know pricing strategies to use/ embark on.
• For a firm to plan carefully its production levels or level of output to produce.
• For a firm to plan on which products to produce i.e. those which give maximum profits.
• For resource allocation.
Usefulness of YED
• For resource allocation.
• For production levels or level of output to produce.
Usefulness of CED
• For production levels or levels of output to produce.
• For planning on which products to produce i.e. those which yield maximum profits.
NOTE
Take note of the following terms:-
• Joint demand/ Complementary demand i.e demand for complements
• Competitive demand i.e demand for substitutes
• Composite demand - A good is said to be in composite demand if it is demanded for several

uses/different uses e.g. wool would be demanded by the textile industry, blanket manufacturers
etc. The demand for such goods are the aggregates of the demands of the various users.
• Joint supply – this means the production of one good automatically leads to the output of another
e.g. peanut butter and oil, beef and hides, mutton and wool, lead and zinc.
Elasticity of Supply
• Price elasticity of supply (PES) is the relationship between the proportionate change in quantity
supplied due to a proportionate change in price.
• PES is the responsiveness of quantity supplied to a change in price.

%
PES =
%
∆ /
=
∆ /
∆
=
∆
• PES is positive since the supply curve slopes upwards from left to right
Where PES is >1 → supply is elastic
Where PES is <1 →supply is inelastic
Where PES is = 1 → supply has unitary elasticity
Where PES is = 0 → supply is perfectly inelastic
Where PES is = ∞ → supply is perfectly elastic

Diagrammatically
1) Supply is elastic
% ∆ Quantity supplied > %∆P, the supply curve is gentle or almost flat.
2) Supply is inelastic
% ∆ in quantity supplied < % ∆P. The supply curve is steep.

3) Elasticity of supply is unity
% ∆ in Quantity supplied = % ∆ P. The supply curve passes through the origin
4) A perfectly inelastic supply curve.
PES = 0. A change in price has no effect on quantity supplied. The supply curve is vertical in
shape.
5) A perfectly elastic supply curve.

Producers will supply any amount at the ruling price. PES = ∞. The supply curve is horizontal.
Time Period and Elasticity of Supply
PES increases with time as producers have a longer period to adjust to changes in demand. Alfred
Marshal maintained that there are 3 periods of supply.
1) The Momentary Period
This is a period of time during which supply is restricted to the quantities actually available to the market.
Supply is fixed (i.e. perfectly inelastic). Normally this period will be a very short one. In the case of
perishable goods e.g. fruits, vegetables, fish, supply for the day in local markets is limited to quantities
delivered in the morning.
2) The Short Run Period
This is the interval which must elapse before more can be supplied with the existing capacity. The SR
period is the period of time which allows for changes to take place in the quantities of the variable factors
employed e.g. labour. Other factors of production are fixed. Changes in supply in this period are shown as
movements along the normal supply curve.
3) The Long Run Period
In the LR all factors of production are variable and firms may enter or leave the industry. This is a period
long enough for fundamental changes to take place in the scale of industry.
Diagrammatically

a) Momentary period
b) Short run period
c) Long run period
Determinants of Price Elasticity of Supply
1) Time period– PES increases with time i.e. from momentary to short run and finally long run
period of time. Supply changes from being perfectly inelastic to inelastic, then elastic and finally
perfectly elastic.
2) Factor immobility – i.e. the easiness with which factors of production can be moved from one
use to another will affect PES. The high factor mobility, the greater will be elasticity.
3) Natural constraints restrict supply e.g. droughts, earthquakes, floods, cyclones. Supply becomes
inelastic.
4) Risk Taking – The more willing entrepreneurs are to take risks, the greater will be the PES
(supply becomes elastic)
5) Where an industry is operating below capacity and there are unemployed resources supply will be
elastic.
6) Where suppliers are holding large stocks supply will be elastic. An increase in demand can be
met by running down stocks.
7) In a situation of full employment the supply of most goods and services will be inelastic.
Application of Elasticity Concepts

Tax Incidence
The incidence of a tax refers to who finally bears the bears the burden of the tax. Tax incidence depends
on elasticities of demand and supply conditions prevailing in the market. When the government imposes a
tax on a supplier of a good or service, the supplier can pass the burden of the tax to the consumer. This is
called tax shifting.
Examples
a) If demand is elastic (i.e demand is sensitive to changes in prices). Suppliers will experience a
fall in the supply price greater than the increase in the market price experienced by buyers.
YZ (i.e the tax burden borne by consumers is less than XY (tax burden borne by producers)
b) If demand is inelastic (demand is not sensitive to price changes). Consumers will experience a
price increase which is greater than the fall in price which suppliers will experience.
The tax burden borne by consumers (XY) is greater than the tax burden borne by producers (YZ)
***QUESTION: Do the same for i) elastic supply and ii) inelastic supply
Production Subsidy

• Subsidies may be regarded as a negative tax. They normally take the form of payments by
governments to producers and are particularly important in the case of say agricultural products
e.g. wheat, milk etc or basic necessities e.g. salt, bread, cooking oil, mealie-meal etc.
• The effect of a subsidy is to reduce the costs of supplying the commodity to the market.
• Like for a tax, the effect of a production subsidy depends on elasticities of demand and supply of
the product.
The effect of the subsidy is to shift the supply curve to the right i.e. from SS to S1S1. The amount of the
subsidy is XZ. Consumers benefit more i.e. YZ – lower price P1 instead of P and consume more Q1
instead of Q. Producers receive a higher price i.e. P2 and supplies more output i.e. Q
Benefit to consumers (YZ) < Benefit to producers (XY)
*** Experiment for a) Elastic supply and b) inelastic supply ***
THEORY OF CONSUMER BEHAVIOUR
Utility is the level of happiness or satisfaction that a person receives from consumption of a good or
service
Total utility is the overall satisfaction that an individual get from the consumption of all units of a good
or service over a given period of time.
Marginal utility is the additional satisfaction derived from the consumption of one more unit of a
particular good or service.
Consumers are rational because they want to maximize satisfaction. Rational consumers would not
consume a product when the marginal utility falls to zero.
The law of diminishing marginal utility

The law states that “other things being equal, as more and more units of a commodity are consumed, the
additional satisfaction or utility derived from the consumption of each successive unit will fall or
decrease” e.g
Number of cups of tea Total utility Marginal Utility
1 80 80
2 150 70
3 210 60
4 250 40
5 275 25
6 280 5
7 280 0
8 278 -2
The figure for marginal utility decline as each successive unit is consumed. If a consumer goes on
consuming more and more units, eventually that should the seventh unit be consumed, total utility
actually decreases so that marginal utility becomes negative. Negative utility is referred to as disutility or
dissatisfaction.
Diagrammatically
Total Utility
utils
TU

0 qty
Marginal Utility
utils
0 qty
MU
• Logical consumers would not consume a product when marginal utility falls to zero, the marginal
utility curve in practice would be downward sloping from left to right like the one above.
• This curve may look familiar. It is the basis of the demand curve. Indeed people’s demand curve
for a product is the same as their marginal utility curve for that product measured in money terms.
• Whilst utility is a subjective matter, and is so difficult to measure, it can be estimated. One way of
doing this is to look at what a person is prepared to sacrifice in order to obtain a commodity. Price
measures the sacrifice in the sense that it indicates what other things might have been obtained
with the money. Sine marginal utility diminishes; consumers will be tempted to buy more of a
good only if its price is lowered.
• By assuming that the sacrifices a person is prepared to make in order to obtain something gives
an indication of the utility derived from that good, it is possible to obtain the demand curve.
• Different individuals will derive different levels of satisfaction, and so will have different demand
curves.

• Therefore the market demand curve is the horizontal summation of the individual demand curves
at different prices.
Factors affecting the Law of Diminishing Marginal Utility
1) The time period over which decisions are made e.g a person who has not had a meal/ food for
several hours will place a high value on food than a person who has just had a meal or is full
(therefore he will not place any value or will place very low value on food).
2) Addiction e.g. smokers may find that the more they smoke the more they want to smoke – they
will always place very high value on cigarettes
3) The level of consumer’s income.
4) The price level of goods or services.
5) The type of good e.g. inferior goods versus normal goods.
6) Trends in fashion i.e. if in fashion consumers derive more additional utility.
7) Advertising i.e. informative, persuasive and generic
Ordinal Utility
• It is the concept of utility which is based on the idea of preference ordering and ranking rather
than the concept of measurable utility.
• It is assumed that a consumer is capable of comparing any 2 alternative bundles of goods and
deciding whether he prefers one bundle to the other or is indifferent between them.
• Several assumptions are made about the nature of this preference ordering which lead to the
conclusion that all possible bundles of goods can be grouped into sets in such a way that the
consumer is indifferent between all bundles in one set and not indifferent between sets.
• These indifferent sets can be arranged in increasing order of preference. It is often convenient
though not necessary to assign numbers to these sets adopting the convention that the higher a set
is in order of preference the higher its number should be.
Cardinal Utility
• It is the concept of utility which is based on the idea of a consumer quantifying the utility he
derives from consuming a particular commodity.

• In the 19th Century, many economists among them Alfred Marshal believed that it was possible
for utility to be quantified/measured in cardinal numbers as opposed to ordinal numbers – these
economists are termed cardinalists.
• A cardinal measure of utility implies that we can quantify how much more utility one unit of a
good gives to a person than the next.
Assumptions of the cardinalists approach
1. Rationality
• Consumers are assumed to be rational/sensible decision makers which mean they weigh the
costs and benefits of each decision they make.
• Rational decision involves the consumer choosing those items that give him the best value for
his money i.e. the greatest benefit relative to cost or where they derive maximum utility.
2. Cardinal Utility
• Cardinal utility refers to the fact that the utility can be measured in monetary units. The monetary
unit is conceptualized in terms of the amount a consumer is prepared to pay for another unit of the
commodity.
3. Constant Marginal Utility of money
• The measurement rod is a monetary unit and the marginal utility of money must not change as
income changes, otherwise the measurement will be useless.
• This implies that for a rational consumer to purchase an extra unit of a commodity, his expected
satisfaction from the consumption of thus extra unit must be greater than the utility of money
which he must spend in order to obtain it.
• The maximum sum of money that a consumer is willing to spend in order to acquire an extra unit
of a good can – serve as an indication of the amount of utility that he expects to realize from the
consumption of that until.
• Therefore, whether there is an increase or a decrease in the income of a consumer, the marginal
utility of money must remain the same.
4. Diminishing Marginal Utility
• The marginal utility derived from a commodity diminishes as its consumption increases.
• This means that the more a particular good is consumed, the less the additional satisfaction
derived.

Criticisms of the Cardinalist approach
Even though the multi-commodity version of marginal utility theory is useful in helping/demonstrating
the underlying logic of consumer choice, it still has major weaknesses.
• Utility can’t be measured in any absolute sense. We can’t really say therefore how much marginal
utility of one good exceeds another.
• Theories based on utility place a great emphasis upon rationality and search for utility
maximization but many decisions made by people lack rational behavior.
• These who work in advertising i.e. persuasive and informative advertising are well aware that it is
often the emotional content of a product that is more important that the rational.
• Utility can also be measured by the ordering or ranking of bundles i.e. the ordinalist approach.
The whole satisfaction derived from a basket of goods is a function of how many goods there are
in the basket e.g. if there are unknown (n) goods in a basket i.e. X1, X2, X3, X4, X5 ..., XN. The
total utility derived would be:
TU = f(X1, X2, X3, X4, X5 ..., XN)
With the above assumption, if a consumer consumes the above set of goods, then total
utility/satisfaction derived will be:-
TU = TU1(X1) + TU2(X2) + TU3(X3) + TU4(X4) + TU5(X5) + … + TUN(XN) OR
U = U1(X1) + U2(X2) + U3(X3) + … UN(XN)
Equilibrium of the consumer under the cardinalist approach/method
A consumer is in equilibrium when the marginal utility of the commodity purchased is equal to its market
price when only one commodity is consumed i.e.
MUx = Px
If MUx > Px the consumer should buy more of X to derive additional satisfaction.
If MUx < Px, the consumer should reduce the consumption of X to increase satisfaction.

→ MUx = Px is the point of consumer equilibrium, though it is very difficult to attain but at this point the
consumer achieves maximum utility.
The above analysis is basically for only one commodity. When a consumer consumes more than one good
e.g good X and good Y, the consumer will obtain his equilibrium when there is equality between the
ratios of the marginal utility of each good to its price.
→ MUX/ PX = MUY/ PY = …. = MUN/ PN
This is referred to as the equi-marginal principle.
A change in the price of any of the goods will cause a change in a person’s spending patterns.
From the above principle, the value of the expression MUX/ PX will now fall as the price of x is increased
so the MUx per $ spent will now be less than any other good. The consumer will therefore increase TU by
spending less on good x and more on all other goods. In other words the consumer only maximizes TU by
buying less of good x. The conclusion is that the demand curve is downward sloping.
The indifference curves (ordinal) Approach
• An indifference curve is a curve that describes a combination of two goods that yield the same
level of satisfaction or utility to the consumer.
• The indifference curve shows the various sets of goods that make a consumer indifferent to the
satisfaction derived from consuming them.
• Based on the same utility derived from various baskets of goods, it becomes uneasy for a
consumer to choose a particular basket of goods because utilities derived from a series of
combinations to another are indifferent.

GOOD X
X2
X1 A
0 y2 y1 GOOD Y
• From the diagram, the consumer is indifferent to combinations A(X1,Y1) and B(X2,Y2).
• Thus is because the satisfaction a consumer will derive for consuming either of the two
combinations is the same. Therefore the consumer can consume any of the combinations on the
curve because any of the combinations makes the consumer just happy as the other, be it A or B.
• One will discover that by moving downward along the curve or graph, the consumer prefers more
of x in exchange for fewer y, and moving downwards along the same curve, the consumer prefers
more of y in exchange of x.
Indifference Map
• The characteristics of indifference curves is that the farther away from the curve is to the origin,
the more the quantity of commodities, hence the higher the level of satisfaction it yields.
• The indifference map is a conglomeration of indifference curves. A higher curve than another
one signifies a higher level of satisfaction. The indifference map shows various indifference
curves that stand for different levels of satisfaction.
• It should be noted that bundles or basket of goods found on the same indifference curve produce
the same level of satisfaction.

• An indifference map ranks the preferences of the consumer. The higher the indifference curve or
the farther away from the origin it is, the more preferable it is to a rational consumer. On the other
hand, the lower the indifference curve, or the closer the curve is to the origin, the less preferable it
is.
GOOD X
I3
I2
I1
0 GOOD Y
• From the diagram I3 > I2 and I2 > I1.
• Though the level of satisfaction might not be determined the utility associated with I1 is less than
that attached to I2 and satisfaction attached to I2 is less than that of I3.
• Given that consumers are rational most purchases of goods and services will like to consume
along the highest indifference curve i.e. I3.
Assumptions of Indifference Curves
1. Rationality – the consumer always aims to maximize satisfaction from goods consumed.
2. Ordinal Utility- It is axiomatically believed that the consumer can rank his preferences in
accordance with the utility derived from various baskets of goods, utility measurements can only

be handled using the ordinal method and not the cardinal method. The total satisfaction derived
by a consumer is a function of the total quantity of commodities consumed i.e.
TU = f(q1, q2, q3, …, qx, qy, …, qn)
3. Consistency and transitivity of choice- Since we assume that a consumer is rational, his choice
of goods has to be consistent. When he chooses a particular point in time, he is not expected to
choose B over A in another time A>B, then A must be preferred to B. Similarly if A>B>C –
A>C. Meaning that if a consumer preferred bundle A to bundle B and bundle B to C, then bundle
A must be preferred to bundle C.
4. There must be two baskets of goods for the analysis to be complete. The indifference curve
analysis will not be complete if the bundles are used in isolation of the other basket.
Characteristics of Indifference Curves
1. Negative Slope
An indifference curve slopes down from left to right. This means that the consumption of the 2
goods along the indifference curve is negatively related to each other i.e. if the quantity of one
commodity (Y) consumed decreases the quantity of the other (X) must increase in order to
maintain the same level of satisfaction.
2. Non Intersection
Indifference curves must not intersect. If the 2 curves intersect, the point at which the intersection
occurs will represent 2 different levels of satisfaction, thereby violating the consistency
assumption.
3. Convexity
The indifference curve is convex to the origin. This means that the curve is inwardly curved from
left downwards to the right signifying diminishing marginal rate of substitution (DMRS)
4. An Indifference Map
An indifference map shows various indifference curve that stand for different levels of
satisfaction. An indifference map is a conglomeration of indifference curves.
Diminishing Marginal Rate of Substitution (DMRS)
• The technical term for the negative slope of an indifference curve is marginal rate of substitution.
• The MRS is the amount of one good a consumer is ready to sacrifice in order to obtain an
additional unit of another good.
Good y
0 Good x
• From the curve above, from right to left the amount of commodity y increases while that of X
decreases and vice versa.
• The increase and decrease between the two goods are as a result of compensating the changes
caused by the consumer’s preferences.
• The act of increasing and decreasing the commodities X and Y i.e. the willingness to give up one
good for the other along the indifference curve is called DMRS.
• The slope of the indifference curve = MRS = MUx/ MUy
The Budget Constraint/Budget Line
• A budget line shows combinations of two products which can be purchased with a given level of
income.
• The budget line slope shows the relative prices of the two goods i.e. Px/ Py
• A consumer’s ability to purchase goods and services is limited by his level of Y and the prices of
goods and services.
• A budget constraint/budget line or consumption possibilities curve measures the relative scarcity
between two goods.
• The line shows the combination of goods a consumer can purchase given his/her income at
market prices.
• It also classifies attainable and unattainable regions.
• The budget constraint in the case of two goods x and y is formulated as follows
I = PxQx + PyQy
Where: I is the consumer’s income
Px is the price of the good x
Qx is the quantity of the good x
Py is the price of the good y
Qy is the quantity of the good y
e.g. A budget of $100 and prices for y of $2 per unit and for x of $5 per unit.
0ption Good y($2) Good x($5)

1 50 0
2 0 20
Good y
50
.U .C .W
20
0 good x
• The consumer can attain or consume any combination along the budget line e.g. C i.e. consumers
all income or inside the budget line e.g. u i.e. doesn’t exhaust all the income – points along the
budget line are attainable and points outside the budget line e.g. W are not attainable i.e. they are
beyond the consumer’s income.
• A budget line measures marginal rate of transformation (MRT).
Shifts in the Budget Line

These are a result of:
1. An increase or decrease in the level of the consumer’s income.

Changes in prices affect the level of real income, if prices decreases real income increases and the
budget line shifts outwards. The reverse is true for increase in prices.eg if prices decrease by
50%, the effect will be as follows.
Good y 100
50
0 20 40 good x
2. Changes in prices of one good

If price of good x decrease by 50% the effect will be as follows
Good y
50
0 20 40 good x
• If the price of the good increases or decreases the budget line will not shift. It will pivot inwards
or outwards depending on the circumstances.

The Consumer Equilibrium under Indifference Curves Analysis
Given the consumer income and the prices of goods or supplies in the market, the consumer maximizes
satisfaction at the point of equilibrium.
Graphically it is the point where the budget line is tangential to the highest possible indifference curve.
Good y
Y* e
0 x* good x
Point e is the equilibrium point. The equilibrium quantities are x* and y*. The slope of the budget line =
Px/ Py
And the slope of the indifference curve = MUx/ MUY are equal at their point of tangency .Consumer
equilibrium exist at a point where marginal rate of substitution is equal to marginal rate of transformation.
At this point satisfaction will be equal to income.
Applications of Indifference Curves Analysis/Changes in Consumer Equilibrium
1. Effects of Changes in Income
A rise in the level of the consumer’s income shifts from C to C1 to C2 as more of both x and y are
consumed. The line C, C1, C2 is income consumption line/ curve.
Good y

C2 Income consumption line
C1
0 goodx
• An income consumption curve is the line that traces the different equilibrium points of the
consumer arising from changes in his income.
• If the increase in income leads to an increase in the quantity demanded of a good then this is a
normal good.
• If the increament in income results in a reduction in quantity purchased, the good is inferior.
2. Effects of changes in prices
• Changes in Px, while that of good y remains fixed.
• As the price of good x falls, the budget line shifts/pivots outwards and the consumer equilibrium
shifts from C to C1 to C2.
• CC1C2 is the price consumption curve/line (ppc) .

Good y
Price consumption line or curve
C C1 C2
0 good x

• A price consumption curve (ppc) is a line that traces or joins the new equilibrium points as a
result of continuous falling or increasing of the price of a commodity.
3. Derivation of the demand curve using the indifference curves approach
Indifference curves can be used to show how an individual demand curve is derived.
Good y
OL OM ON good x
Price x
P1 x
p2 x
p3 x
• The upper portion of the diagram shows the effect of a price change and we can see that the price
consumption line shows how the demand for x grows as the price of x falls relative to y.
• The lower portion plots the price of x against the demand for it.
• If we correct quantities of x demanded along the price on the demand curve with the various
prices on the demand curve, we can see that we derive a normal downward sloping demand
curve.
• Thus, as price falls from Op1 to Op2 to Op3, demand has expanded from OL to OM to ON.

• As we concluded with marginal utility analysis, we may also conclude here, if we can derive an
individual’s demand curve, we can also derive a market demand curve by aggregating all
individual demand curves.
Distinguishing between income and substitution effects
Total Effect
• Total price effect measures the impact on quantity of good as a result of changes in the price of
that commodity.
• The effect can be divided into two different components of substitution and income effects.
• The steeper budget line QaQm is tangential to the original indifference U1 at A, being the initial
equilibrium of the consumer.
• When the price of meat falls, the budget line tilted or pivoted outwards to AA2 and became
tangential to the higher indifference curve U2 at B establishing a new equilibrium position.

• Therefore the increase in quantity of meat purchased (m1 to m2) represents the total effect of a
price change.
• To differentiate substitute and income effects a compensated budget line is created and it is
tangential to u1 at C
• At e3 the compensated budget line divides the total effect into substitution effect and income
effect.
• The compensated budget line is parallel to the new budget line AA2. The purpose of the
compensated budget line is to disallow variation in the original utility enjoyed by the consumer
and the resultant satisfaction when the price of x changes.
The Substitution Effect(X1 to X2)
• When the price falls the consumer tends to buy more of the good and vice versa.
• From the diagram as the price of good y increases, the consumer buys less of it, meaning good y
is substituted for good x. The price of good y is relatively higher.
• The substitution effect is the increase in the quantity purchased of a good x as the price of another
good y which is a substitute increase.
Good y
0 x1 x2 good x
The Income Effect (e1 to e2)
Good y C

E2
E1 I2
I1
0 x1 x2 B D good x
• When the income of a consumer increases, he tends to buy more of normal goods. As the price of
good x falls, the real income of the consumer increases signifying an increase in purchasing
power of the consumer. The additional good x purchased due to the increase in real income
resulting from a fall in price (increase in quantity of good x from x1 to x2) is called the income
effect.
Income and substitution effect for a normal good
• A normal good is a good such that when the constraints income increases people buy more of the
good.
A decrease in price of good x causes the budget line to pivot outwards from AA to AA2 since good x is
now relatively cheaper compared to good y.

More of good x is purchased e1 to e3 = substitution effect
• As the price of good X decreases, real income of the consumer increases signifying an increase in
purchasing power of the consumer. Additional good X is purchased due to the increase in real
income
• The increase in quantity of good X from x3 to x2 which is the income effect. In the case of a
normal good, the income effect and the substitution effect reinforce each other. They are both
positive due to a reduction in the price of good X and vice versa
Income and substitution effect for an inferior good
• When people’s incomes increase, they will buy less of inferior goods e.g. public transport,
second hand clothing, poor foodstuffs etc since they will now be able to afford better quality
goods (and vice versa).
• As price of good x falls, more of good x should be bought. The consumer’s real income and
purchasing power increases.
• e1 to e3 is the substitute effect.
• Since good x is an inferior good, the consumer will buy less of good x.
• e3 to e2 is the income effect (which is negative)
Income and Substitution Effects for a Giffen good

• Giffen goods are those where an increase in price causes an increase in quantity demanded and
vice versa e.g. staple food stuffs.
• A decrease in price causes decrease in quantity demanded.
• As the price of good x falls, demand for good x does not expand but falls. This has come about
because as Giffen goods are inferior. There is a negative income effect as their price falls and
because they are such an important part of the household budget, the negative income effect has
been sufficient to outweigh / swamp/ offset the substitution effect.
Critique of the Indifference Curves Approach
1) In practice, it is virtually impossible to derive indifference curves since it would involve the
consumer having to imagine a whole series of different combinations of goods and deciding in
each case whether a given combination gave more, equal or less satisfaction than other
combinations.
2) Consumers may not behave “rationally” and hence may not give careful consideration to the
satisfaction they believe they will gain from consuming goods. They may behave impertuously
(i.e rashing or acting without considering) e.g impulsive buying.
3) Consumers are not perfectly knowledgeable. Therefore the “optimum consumption” point may
not in practice give consumers maximum satisfaction for their money.
4) The belief that consumers are rational may be influenced by advertising.
5) Indifference curves are based on the assumption that marginal increases in one good can be
traded off against marginal decreases in another. This will not be the case with consumer durables
e,g cars, TVs, sofas. Houses etc since they are purchased only now and again and then only one at
a time.
Usefulness of Indifference Curves
1. To demonstrate the logic of rational consumer choice.

2. Derivation of individual’s demand curve

3. Income and substitution effects of a price change.

4. Price consumption curve (PCC) and income consumption curve (ICC).

THEORY OF PRODUCTION AND COSTS
• A plant/establishment is a unit of production in an industry. It can be a factory, a shop, a farm, a

hotel or any economic unit that carries its own business at one geographical location.
• A firm is a unit of ownership and control. A firm may consist of just one pant in which case it is
referred to as single plant. However many large firms are likely to comprise a number of plants –
they are multiplant.
• An industry is all firms concerned with a particular line of production or all firms producing
similar products e.g. automobile industry, tourist industry, mining industry and agricultural
industry etc
• Going beyond the supply curve, we need to find how the rational producer (or firm) will behave.
• We will be looking at the benefits and costs to the firm of producing various quantities of goods
or services and using various alternative methods of production.
Questions to answer:-
How much will be produced?
What combinations of inputs will be used?
How much profit will be made?
• The traditional theory of supply or theory of the firm assumes that firms aim to maximize profits.
• Rational Producer behavior is when a firm weighs up the costs and the benefits of alternative
courses of action and then seeks to maximize its net benefit
The Short Run (SR) Period of Production
• It is the period of production when at least one factor of production is variable e.g. labour
and the rest are fixed (i.e. land, capital and entrepreneurship)
The Law of Diminishing Returns/The Law of variable proportions/The Law of Diminishing Marginal
Productivity
The law states that “as we add successive units of the variable factor of production to fixed amounts of
other factors of production, the increments to total output or total product (TP) or total physical product
(TPP) will first increase and then decline.”

e.g. assume some particular crop is to be grown on a fixed price of land e.g. 2 acres. We shall assume also
that the amount of capital to be used is also fixed. Labour will be the only variable factor of production.
Number of Workers Total Product (T.P) Average Product (AP) Marginal Product
(MP)
1 8 8 8
2 24 12 16
3 54 18 30
4 82 20.5 28
5 95 19 13
6 100 16.7 5
7 100 14.3 0
8 96 12 4
Assumptions
1. Labour is the only variable factor of production.
2. All units of the variable factor of production are equally efficient.
3. There are no changes in the techniques of production.
Total Product (TP) or Total Physical Product (TPP)
It is the total output of a product per period of time that is obtained from a given amount of inputs
Average Product (AP) / Average Physical Product (APP)
It is output per worker

( )
AP= # $ % &
AP is also called efficiency / productivity
Marginal Product (MP) / Marginal Physical Product (MPP)

It describes changes in total output brought about by varying employment by one person.
∆
MP = TP of n workers – TP of … (n-1) workers = ∆
Returns to the variable factor
Since labour is the only variable factor of production, changes in output are related directly to changes in
employment – we speak of changes in the productivity of labour i.e. returns to the variable factor of
production which is labour. Diagrammatically:
TP
TP
0 3 4 7 QTY
The LDMR sets in MP/AP
AP
0 3 4 7 MP 8 QTY
1. Increasing Returns(0 to 3 units)

TP is increasing at an increasing rate. MP is increasing
2. Constant returns (not illustrated)

TP is increasing at a constant rate. MP is constant.
3. Diminishing Returns / Decreasing Returns(3 to 7 units)

TP is increasing at a decreasing rate. MP is falling.
4. Zero Returns(7 units)

Total product is constant. MP is zero.
5. Negative Returns(7 to 8 units)
NB Total product is falling. MP is negative.
Diminishing returns set in because too many cooks spoil the meal.
The law of diminishing returns deals essentially with SR Period situations. It is assumed that some of the
resources (factors of production) used in the production process are fixed in supply.
LONG RUN PRODUCTION PERIOD
Returns to Scale
• The law of diminishing returns deals with essentially SR situations. It is assumed that some of the
resources used in production process are fixed in supply.
• In the LR period it is possible for a firm to vary all factors of production employed.
• In the LR period it is possible for a firm to change the scale of its activities.
Units of Labour Units of Land Total Output Increase in size Increase in TP
(acres) (tons) of firm
4 20 100 100% 150%
8 40 250 50% 68%
12 60 420 33.3% 33.3%
16 80 560 25% 20%
20 100 672 22% 16%
24 120 780
• It is a feature of production that when the scale of production is changed, output changes are
usually proportionate.
• When a firm doubles its size, output will change by more than 100% or less than 100%. The
relationship changes of production and changes in output are described as returns to scale.

Increasing Returns to Scale
Output increase more than proportionality e.g. as the firm increases its size from 4 people /
workers and 20 acres to 12 workers and 60 acres of land.
Constant Returns to Scale
Size of firm and output changes by the same % e.g. a change of scale from 12 people / workers
and 60 acres to 16 workers and 80 acres.
Decreasing Returns to scale
Output increases less than proportionality e.g. a change of scale from 20 workers and 100 acres to
24 workers and 120 acres.
Those features of increasing size which account for increasing returns to scale are generally
described as economies of scale.
The causes of falling efficiency as the size of the firm increase are described s diseconomies of
scale.
In the LR period it is possible for a firm to change the scale of its activities. When an increase in
the scale of production results in a more than a proportionate increase in output, the firm is said to
be experiencing economies of scale (INCREASING RETURNS TO SCALE). Economies of
Scale are the benefits which accrue to a firm as it grows in size or they are the advantages of
expansion. They are seen as the LRAC decrease / fall. Diseconomies of scale are the
disadvantages of expansion (DECREASING RETURNS TO SCALE). They are seen as the
LRAC start to increase. Minimum Efficient Scale (MES) (CONSTANT RETURNS TO SCALE)
is seen by the constant part of the LRAC.MES exist if the proportionate change in scale of
production is the same as the change in output.This can be illustrated by an envelope curve as
follows;
AC SRAC1 SRAC5 LRAC
SRAC2
B SRAC3 SRAC4 SRAC5
ECONOMIES OF SCALE DISECONOMIES OF SCALE

INCREASING RETURNS TO DECREASING RETURNS TO
SCALE SCALE
0 Q1 Q2 Q3 MES QTY
The diagram illustrates the long run production of a firm. Firms always operate at the least part of the
average cost curve. This firm was currently operating at Q1at the least point of SRAC1.Assuming that
demand of the firm’s products increases and output Q2 is now demanded. If this firm decides to continue
operating in the short run (SRAC1) its costs increases from A to B. To avoid this increase in cost this firm
should alter all its factors of production and starts operating on SRAC2, producing the same output of
Q2.This firm can increase output until it reaches Q3.
Economies of Scale
Economies of Scale can be classified into 2 groups:-
1. Internal Economies of Scale
2. External Economies of Scale
Internal Economies of Scale
These are the benefits which accrue to a firm independent of what is happening to other firms /
the industry. They arise simply from the increase in the scale of production in the firm itself.
External Economies of Scale
These are the advantages in the form of lower C which a firm gains from the growth of the
industry. These economies are available to all firms in the industry independent of changes in the
scales of their individual outputs.
Internal Economies of Scale can be divided into plant economies and firm Economies of Scale.
Plant Economies of scale include:-
Increased specialization – concentration of firms in producing a good or service
Indivisibility – full utilization of massive machinery or highly qualified personnel.

Increase in output doubling or trebling employment.
Increased dimensions – of factors of production – output increases

Principle of multiples – full use of multiple machinery unlike for small firms where some
machinery lie idle.
By product economies – waste products being recycled e.g fabric cuttings to make rags or
manure from chicken
Stock economies – e.g. joint supply, banc assurance, banking services and estate agent
Economies of Tinked processes
Firm Economies of Scale include :-
Technical Economies
Marketing Economies –bulk buying – huge discounts
- Employment of specialist buyers
- lower packaging costs
- massive advertising
Financial economies –creditworthy borrower
–special interest rates huge
–collateral or security of finance
–access to more sources of finance
Risk bearing – diversification eggs not put into one basket
Research and development economies
Managerial economies – specialist mergers
Staff facilities economies – staff canteens
–sports grounds
–medical care
Plant specialization economies –a firm may be large enough for individual plants to specialize –
advantage of specialization.
Internal Diseconomies of Scale

• These are the disadvantages experienced by a firm due to expansion. They are normally
seen as the AC of production begins to rise.
• The main problems which rise when a firm grows too large are thought to be mainly
attributable to management difficulties.
1. Management Problems
• As the size of the firm increases management becomes more complex. It becomes
increasingly difficult to carry out the management functions of
• Coordination – coordinating various debts becomes more and more difficult.
• Control – taking decisions and seeing to it that these decisions are carried out becomes
difficult workers don’t do what they are supposed to be doing.
• Communication – keeping everyone informed through vertical and lateral combination

becomes more difficult.
• Morale / industrial relations – latitude of workers to management is of critical importance

to the efficient operation of the organization. Workers end up not cooperating.
2. Increases in prices of inputs e.g. raw materials, rentals, labour, energy, transport etc
External Economies of Scale
• External economies of scale are the advantages which accrue to a firm from the growth in
the size of the industry.
• These advantages are gained by firms of any size.
• External economies of scale are especially significant when industries are heavily
localized / concentrated in industries clusters.
• In this particular case they are referred to as economies of concentration e.g.
1. Labour
2. Ancillary Services Disintegration
3. Cooperation
4. Commercial Services
5. Specialized Markets
External Diseconomies of Scale

• A firm may also experience disadvantages as a result of the industry to which it belongs becomes
too large. These are referred to as external diseconomies of scale.
• This can be due to the following reasons:-
1. Shortage of Labour
2. Increasing demand for raw materials may also bid up prices and cause costs to
rise
3. If the industry is heavily localized land for expansion will become scarce and
hence more expensive to purchase or rent.
Costs of Production
Opportunity Cost
• Opportunity cost is the next best alternative forgone when one makes economic choice.
Opportunity cost is what we have to “sacrifice or give up” in order to gain something
we value / something of economic value.
• We are forced to make a choice since economic goods are not free i.e. they are limited
in supply
Sunk Costs
• Sunk costs are costs which cannot be recouped or recovered once a firm leaves
an industry (e.g. by transforming assets to other businesses, marketing costs like
advertising).
• Sunk costs act as barriers to exit for incumbents given the large capital outlays
involved.
• They also represent barriers to entry for now firms, which may be reluctant to
enter an industry if faced with the prospect of substantial sunk costs should they
not be successful.
User Costs
• The economies term for the reduction in the value of a machine or capital
asset from its use.
• User cost is not incurred if the item is idle or cannot be used.
Shadow cost or implicit cost / imputed price / shadow price is a price which is
imputed.
• As the true marginal value of a good or opportunity cost of a resource

and which may differ from the market price.
• External costs and benefits (negative and positive externalities) are not
easy to measure since by definition they do not have a price attached to
them.
• E.g. the possible external costs arising from an overhead railway may
include visual pollution, congestion near the stations and some noise
pollution.
• The external benefits are likely to be greater and may include less air
pollution, less overall road congestion, fewer road accidents (thereby
reducing the burden on the police, health services etc), and savings in
travel time.
• Shadow costs / imputed prices are used to estimate these. Shadow

prices / costs are imputed prices based on opportunity cost.
Private Costs
• Private costs are also called internal costs.
• They are costs incurred by those who buy products and by those
who produce products e.g. if a person buys a bottle of whisky, the
cost (in the form of price charged) may be $15, and if a firm
produces a car the cost (in terms of wages, parts, overheads etc)
may be $4 000.
Costs in the SR period
1. Fixed Costs
• These are costs of production which do not vary with the level of output.
• Production or no production they have to be borne e.g. rent, interest payments on loans,
stock (depreciation).
• Fixed costs are also called overhead costs or indirect costs.
Diagrammatically :
cost

0 QTY
FC are only found in the SR period of production and not in the LR.
2. Variable Costs (VC)
• These are costs directly related to the level of output e.g. wages / salaries, costs of raw
materials, fuel, power, water bills etc. Variable costs are also called direct costs or prime
costs .
COST VC
3. Total Costs
• Total costs are the sum total of FC and VC i.e. TC = FC + VC.
• When output is zero total costs are equal to FC since VC are equal to zero.
• When production commences TC will begin to rise as VC increases.
COST TC
VC

Output Total Fixed Variable Average Average Average Marginal
units per Costs TC Costs FC Costs VC Fixed Variable Total Costs MC
week Q Costs AFC Costs Costs ATC
FC
0 QTY
AVERAGE COSTS OF PRODUCTION
• AC are costs per unit of production.
• As production or output of the firm increases average costs first decrease and there will
come a point when they will start to increase – the AC curve is U-shaped.
• When a firm is producing at the minimum point of production.

'
• ATC = = /AFC+AVC
(' () '
AFC = = /ATC-AVC
* $ +'
AVC = = /ATC-AFC
4. Marginal Cost (MC)
• Marginal cost tells us what happens to total costs when we vary / change output by some
small amount.
• MC is the extent to which TC changes when output is changed by one unit.
• MC = TC of n units – TC of (n -1) units
• The MC curve is also u – shaped because of diminishing returns experienced as output

rises.

AVC
0 116 116 0 00 - 00 24
1 140 116 24 116 24 140 20
2 160 116 44 58 22 80 16
3 170 116 60 38.6 20 58.6 24
4 200 116 84 29 21 50 40
5 240 116 124 23.2 24.8 48 56
6 296 116 180 19.3 30 49.3 72
7 368 116 252 16.6 36 52.6 88
8 465 116 340 14.5 42.5 57
• As output increases both MC and AC and AVC begin to fall, reach minimum and then begin to
rise.
• When plotted graphically AC = MC when AC is at its minimum value AVC = MC when AVC is
at its minimum value.
• The ATC curve is elongated U-shape. This is always so in the SR period.
• ATC always start at infinity and then fall rapidly as FC are spread over more and more units. It
continues to fall until the point of optimum efficiency or optimum capacity is reached.
• AC then begins to rise as diminishing returns set in and the increase in AVC outweighs the fall in
AFC.
• The best output is 5 because this output is produced at lowest unit costs (i.e. there is productive
efficiency)
Shut down conditions during the SR period
• The firm will / should continue to produce in the SR as long as price of the product is
above the AVC because the price of the AFC of production are being covered.
• As long as price > AVC, the firm should shut or stop production.

Average Costs in the LR Period
• Every plant size or level of fixed input is represented by a SRAC curve, each SRAC
curve is tangent to the LRAC curve.
• The LRAC curve is always referred to as the envelope curve of all SRAC curves.
• It shows the minimum attainable unit cost for each and every level of output
• The LRAC curve therefore consists of a series of points of different SRAC curves.
These points represent the lowest costs attainable for the production of any given
output.
• If it is assumed that there are many such SRAC curves, the LRAC curve will be an
“envelope curve”.
• It is U-shaped because of economies of scale and diseconomies of scale.
Note
In practice, evidence suggest that in these industries investigated economies of scale

exist but diseconomies of scale either do not or are outweighed by economies of
scale. In other words the LRAC curve is more “L-shaped” than “U-shaped”
Total Revenue
• Total revenue is the amount of money which a firm gets from selling its
units of output.
• TR = P x Q
Average Revenue
• Average Revenue is the other name for price if the good.
• AR is the amount a firm gets from each unit sold.

, )
• AR = = =P
• AR = P (NB : only exception is when a firm sells its output at different

price) – AR will be the weighted average price.
Marginal Revenue
• Marginal Revenue is the extra / additional revenue obtained when sales

are increased by one unit.
Output AR = P TR MR
1 8 8 6
2 7 14 4
3 6 18 2
4 5 20 0
5 4 20 -2
6 3 18 -4
7 2 14
• MR of the nth unit = TR of n units = TR from sale of (n-1) units

∆ ,
• MR =
∆

Market Structures
• Market structures are the various market conditions under which firms operate in order to
determine prices and output to be produced.
• Going to look at 4 types of market structures which are :-
Perfect competition
Monopoly/monopolist
Monopolistic competition
Oligopoly
1. Perfect Competition
• Perfect competition is a market structure where there are many sellers and buyers selling
homogeneous / identical products.
Assumptions / Features
1. All units of the commodity are identical / homogeneous (i.e. one unit is exactly like
the other)
2. There are many sellers and many buyers and their behavior has no influence on the
price.
3. Buyers and sellers have perfect knowledge of the market conditions and market
activities.
4. There are no barriers to movement of buyers form one seller to another.
5. There are no restrictions on entry or exit of firms from the market.
6. There will be one and only one market price and this price is beyond the influence of
any one buyer / seller.
7. There is no advertising.

8. There is perfect mobility of resources that firms wishing to expand their output can
attract resources.
• Firms can’t change different prices because they are selling identical / homogeneous
products.
• Each of them is responsible for a tiny part of the total supply and the buyers are fully
aware of what is happening in the market.
The Individual Firm under Perfect Competition
• The individual firm under perfect competition is powerless to exert any influence
on price. It sees the price as “given” i.e. established by market forces of demand
and supply beyond its control.
• e.g. in most countries the individual farmer has no influence on the price he sells
his wheat, beef, milk or vegetables. Any changes in the amounts of the products
which he brings to the market will have negligible effects on price.
• The firm under perfect competition is a “price taker”
• The demand curve for the product of the single firm must be a horizontal line at
the ruling price, in other words a perfectly elastic demand curve. No matter
how many units the firm sells, it can’t change the price. It can sell its entire
output at the ruling price. If it tries to sell at a higher price, its demand will drop
to zero and obviously there will be no incentive to sell at lower prices.
PRICE D S PRICE
P*
S D
0 Q*
a) The industry b) The Firm

• The diagrams above show the determination of the market price OP* by market forces of demand
and supply.
• DD is the demand curve facing the industry and supply SS is the total market supply provided by
all firms in that industry – equilibrium market price is OP* and quantity OQ*.
• The market price OP* is externally determined and the firm sees the demand curve for its product
as being perfectly elastic. The firm can now supply any quantity it wishes at the ruling price OP*.
If it rises to reduce or increase price, demand for its product falls to zero.
Average Revenue and Marginal Revenue
• The firm under perfect competition will determine output by looking at the shape of its
MR and AR curves as well as cost curves.
• A firm will continue to expand its output as long as the revenue it receives form
additional output exceeds the cost of producing that additional output.
a) Total Revenue (TR) is the total amount of money a firm receives from output sold.
TR = P x Q
b) Average revenue (AR) is revenue per unit sold. AR is another name for price.
, )
AR = = =P
c) Marginal Revenue (MR) is the additional revenue obtained when sales are
increased by one unit or more precisely it is the change in TR when quantity sold is
varied by one unit.
MR of the nth unit = TR from the sale of n units – TR from the sale of (n-1) units
The output of the firm under perfect competition in the SR period
• It is assumed that firms producing under conditions of perfect competition any business are profit
maximisers. As long as the price (AR) it receives for each unit exceeds the AC of production, a
firm will be making abnormal profits / supernormal profits or economic rent.
• The diagram below shows that when price is P, the firm will be making supernormal -s in the
range of output Q to Q3 because at all the outputs in this range AR is greater than AC of
production.

• From the diagram, at price OP the firm will be making -s in the range of output OQ to OQ3
because at all outputs AR > AC.
• We have to determine which output level between OQ to OQ3 yields maximum total -s. Output
level OQ1 will yield the maximum - per unit but firms seek to maximum total -s not profit per
unit.
• As output increases form from OQ to OQ2 the firm’s total profits will be increasing because for
each additional unit produced, the increase in TR (i.e. MR) is greater than the increase in TC (i.e.
MC)
• As output is expanded beyond OQ2 total -s will be decreasing because for each additional unit
produced MR < MC.
• Therefore since total -s are increasing up to OQ2 and falling beyond OQ2, -s must be maximized
when output is at OQ2 i.e. when MC=MR.
• This relationship which says that -s are maximized when output is at a point where MC=MR
applies to all firms whether they are operating under perfect competition or monopolies etc.
• In the case of a perfectly competitive firm, TTs are maximized at the point where
MC=MR=AR=P=demand only during the SR period of production.
Normal profit
If firms in the short run are making profits, there are incentives for new firms to enter the market. This
will increase market supply, causing market price to drop and the profit of incumbent firms to be eroded.
This can occur because there are no barriers to entry. The price will drop to the point where productive
efficiency is achieved.

The shutdown point
In the short run, a firm operating at a loss [R < TC (revenue less than total cost) or P < ATC (price less
than unit cost)] must decide whether to continue to operate or temporarily shutdown. The shutdown rule
states "in the short run a firm should continue to operate if price exceeds average variable costs."
Restated, the rule is that for a firm to continue producing in the short run it must earn sufficient revenue to
cover its variable costs. The rationale for the rule is straightforward. By shutting down a firm avoids all
variable costs. However, the firm must still pay fixed costs. Because fixed cost must be paid regardless of
whether a firm operates they should not be considered in deciding whether to produce or shutdown. Thus
in determining whether to shut down a firm should compare total revenue to total variable costs (VC)
rather than total costs (FC + VC). If the revenue the firm is receiving is greater than its total variable cost
(R > VC) then the firm is covering all variable cost plus there is additional revenue ("contribution"),
which can be applied to fixed costs. (The size of the fixed costs is irrelevant as it is a sunk cost. The same
consideration is used whether fixed costs are one dollar or one million dollars.) On the other hand if VC >
R then the firm is not even covering its production costs and it should immediately shut down. The rule is
conventionally stated in terms of price (average revenue) and average variable costs. The rules are
equivalent (If you divide both sides of inequality TR > TVC by Q gives P > AVC). If the firm decides to
operate, the firm will continue to produce where marginal revenue equals marginal costs because these
conditions insure not only profit maximization (loss minimization) but also maximum contribution.
Another way to state the rule is that a firm should compare the profits from operating to those realized if it
shutdown and select the option that produces the greater profit. A firm that is shutdown is generating zero
revenue and incurring no variable costs. However, the firm still has to pay fixed cost. So the firm's profit
equals fixed costs or −FC. An operating firm is generating revenue, incurring variable costs and paying
fixed costs. The operating firm's profit is R − VC − FC. The firm should continue to operate if R − VC −
FC ≥ −FC, which simplified is R ≥ VC. The difference between revenue, R, and variable costs, VC, is the
contribution to fixed costs and any contribution is better than none. Thus, if R ≥ VC then firm should
operate. If R < VC the firm should shut down.

A decision to shut down means that the firm is temporarily suspending production. It does not mean that
the firm is going out of business (exiting the industry).] If market conditions improve, and prices increase,
the firm can resume production. Shutting down is a short-run decision. A firm that has shut down is not
producing. The firm still retains its capital assets; however, the firm cannot leave the industry or avoid its
fixed costs in the short run. Exit is a long-term decision. A firm that has exited an industry has avoided all
commitments and freed all capital for use in more profitable enterprises.
However, a firm cannot continue to incur losses indefinitely. In the long run, the firm will have to earn
sufficient revenue to cover all its expenses and must decide whether to continue in business or to leave the
industry and pursue profits elsewhere. The long-run decision is based on the relationship of the price and
long-run average costs. If P ≥ AC then the firm will not exit the industry. If P < AC, then the firm will
exit the industry. These comparisons will be made after the firm has made the necessary and feasible
long-term adjustments. In the long run a firm operates where marginal revenue equals long-run marginal
costs.The shutdown position can be illustrated as follows;
Efficiency in perfect competition
5 reasons why Perfect Competition is efficient:
1. Allocative Efficient: This is because P = MC.
2. Productive Efficient: Firms produce where MC=ATC.
3. X Efficient: Competition between firms will act as a spur to increase efficiency.
4. Resources will not be wasted through advertising because products are homogenous.
5. Normal profit means consumers are getting the lowest price. This also leads to greater equality in
society.
Evaluation
The benefits
It can be argued that perfect competition will yield the following benefits:
1. Because there is perfect knowledge, there is no information failure and knowledge is shared
evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive any monopoly power.
3. Only normal profits made, so producers just cover their opportunity cost.
4. There is no need to spend money on advertising, because there is perfect knowledge and firms
can sell all they can produce. In addition, selling unbranded goods makes it hard to construct an
effective advertising campaign.
5. There is maximum possible:
• Consumer surplus
• Economic welfare
6. There is maximum allocative and productive efficiency:
• Equilibrium will occur where P = MC, hence allocative efficiency.
• In the long run equilibrium will occur at output where MC = ATC, which is productive
efficiency.
7. There is also maximum choice for consumers
The disadvantage of perfect (or pure) competition
It produces what is demanded under the given distribution of income. We can imagine a scenario
with a very few rich people with pet dogs or cats which dine extremely well on chicken and the
like, while the masses starve.
Spillovers and externalities can exist. These are costs caused to others, e.g. the disposal of nuclear
waste or toxic chemicals by dumping them in streams.
No economies of scale possible - all the firms are too small.
Perfect competition is consistent with a limited choice of range of goods; monopolistic
competition may have a much wider range. An example is motorcars – there are an awful lot of
different models and competition is much less than perfect.
Little or no research and development is possible because there are no funds for it. Under perfect
competition there are no surplus profits (in the long run they are whittled away!) R&D is possible under
monopoly because of the surplus profits available
MONOPOLY
Definition: Technically it is a sole supplier, i.e., there is one firm in the industry. It is
the industry.
But there are degrees of monopoly - if one firm supplies, say, 80 per cent, it is close to a monopoly and
will usually act like one.
Types of Monopoly/causes of monopolies
Economies of scale. One firm grows large, its cost curves are lower than the others, so it is able
to sell more; in the end it grows to become the sole firm. This is the so-called natural monopoly.
An example of a natural monopoly is the distribution of water. To provide waterto residents of a
town, a firm must build a network of pipes throughout the town. If two or more firms were to
compete in the provision of this service, each firm would have to pay the fixed cost of building a
network. Thus, the average total cost of water is lowest if a single firm serves the entire market.
The law. The government may restrict the industry to one nationalised firm.
Regulations. A trade union may have a monopoly over the supply of one kind of labour
Agreement between firms, so that they all act together and behave as one monopolist. This is
often illegal but it happen
Exclusive ownership of a unique resource- if there is only one well in town and it is impossible
to get water from anywhere else, then the owner of the well has a monopoly on water. Not
surprisingly, the monopolist has much greater market power than any single firm in a competitive
market. In the case of a necessity like water, the monopolist could command quite a high price,
even if the marginal cost is low. Although exclusive ownership of a key resource is a potential
cause of monopoly, in practice monopolies rarely arise for this reason. Actual economies are
large, and resources are owned by many people. Indeed, because many goods are traded
internationally, the natural scope of their markets is often worldwide. There are, therefore, few
examples of firms that own a resource for which there are no close substitutes.
Copyrights, patents and licences are particular forms of this exclusive ownership. The patent
and copyright laws are two important examples of how the government creates a monopoly to
serve the public interest. When a pharmaceutical company discovers a new drug, it can apply to
the government for a patent. If the government deems the drug to be truly original, it approves the
patent, which gives the company the exclusive right to manufacture and sell the drug for 20 years.
Similarly, when a novelist finishes a book, she can copyright it. The copyright is a government
guarantee that no one can print and sell the work without the author’s permission. The copyright
makes the novelist a monopolist in the sale of her novel. The effects of patent and copyright laws
are easy to see. Because these laws give one producer a monopoly, they lead to higher prices than
would occur under competition. But by allowing these monopoly producers to charge higher
prices and earn higher profits, the laws also encourage some desirable behavior. Drug companies
are allowed to be monopolists in the drugs they discover in order to encourage pharmaceutical
research. Authors are allowed to be monopolists in the sale of their books to encourage them to
write more and better books. Thus, the laws governing patents and copyrights have benefits and
costs. The benefits of the patent and copyright laws are the increased incentive for creative
activity.
Marginal revenue and monopoly
Marginal revenue is the addition to total revenue from the last unit sold.
A perfectly competitive firm can sell as much as it wants at an unchanged price. Its MR curve is equal to
the price – every time it sells one more item it receives, say, an additional 50 pence, which adds 50 pence
to TR.
A monopolist is the industry, so it faces a normal downward sloping demand curve.
So if wants to sell more of the good or service it must lower the price.
And of course it must sell all its products at that lower price. This means it loses by selling the items it
used to sell earlier at a higher price at the new lower price.
So the price of the marginal product is not the MR – the firm’s total revenue increases by less than this
sale, because of the bit it lost on the price on all the other products.
See the example in the table below.
AS INCREASE MUST LOWER TOTAL REVENUE MARGINAL

QUANTITY PRICE (£) ALTERS (PxQ) (£) REVENUE (£)

1 7 7 7
2 6 12 5 (12-7)
3 5 15 3 (15 -12)
4 4 16 1 (etc)
5 3 15 -1
6 2 12 -3
7 1 7 -5
Note that marginal revenue is less than price for all quantities after the first one.
PROFIT MAXIMIZATION FOR A MONOPOLY.

A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost
(point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity
(point B).
Cost and revenue MC
P B
ATC
A
AR=D
MR
0 q1 qmax q2 qty
Suppose, first, that the firm is producing at a low level of output, such as Q1. In this case, marginal cost is
less than marginal revenue. If the firm increased production by 1 unit, the additional revenue would
exceed the additional costs, and profit would rise. Thus, when marginal cost is less than marginal revenue,
the firm can increase profit by producing more units. A similar argument applies at high levels of output,
such as Q2. In this case, marginal cost is greater than marginal revenue. If the firm reduced production by
1 unit, the costs saved would exceed the revenue lost. Thus, if marginal cost is greater than marginal
revenue, the firm can raise profit by reducing production. In the end, the firm adjusts its level of
production until the quantity reaches QMAX, at which marginal revenue equals marginal cost. Thus, the
monopolist’s profit maximizing quantity of output is determined by the intersection of the marginal-
revenue curve and the marginal-cost curve.
A MONOPOLY’S PROFIT
How much profit does the monopoly make? To see the monopoly’s profit, recall that profit equals total
revenue (TR) minus total costs (TC): Profit = TR - TC.
We can rewrite this as Profit = (TR/Q -TC/Q) X Q.

TR/Q is average revenue, which equals the price P, and TC/Q is average total cost ATC. Therefore, Profit
= (P - ATC) X Q.
This equation for profit (which is the same as the profit equation for competitive firms) allows us to
measure the monopolist’s profit in our graph.
Consider the shaded box in diagram below The height of the box (the segment P1C1) is price minus
average total cost, P – ATC, which is the profit on the typical unit sold. The width of the box (the segment
C1K1) is the quantity sold Q1. Therefore, the area of this box is the monopoly firm’s total profit.
Monopoly equilibrium
Equilibrium is where MC = MR, as usual. When you are drawing the diagram and answering questions
you should locate that point first and draw it in.
Seeing monopoly profits in the diagram below
Profits = total revenue minus total cost. Total revenue = price times quantity. Total cost = average cost
times quantity.
Problems with monopoly, “what is wrong with monopoly” or "the welfare effects of monopoly"
A monopoly limits output and keeps price high.

A monopoly redistributes income from all the consumers to this one firm or person (an equity
issue).

Monopolists may develop political and social power over others, which reduces the efficiency of
democracy and is inequitable. There are political dangers of a few very rich and powerful people
(Marx called them “monopoly capitalists” who misuse their position and exploit people).
A monopoly may behave badly in an anti-social way. For instance it may force out a rival firm by
selling its product at give-away prices, well below cost and taking the short term loss. After it has
forced out the competitor, it will then put the price back up again. This behaviour may or may not
be legal. It depends on the country involved and its legislation but it is always reprehensible.
The lack of competition tends to promote inefficiency, there is no need to try hard, and it lacks
dynamism. This is probably the main criticism .
The result is lazy managers and owners. This means that technical progress is reduced, leading to
slow economic growth of the country and a lower standard of living than we could have.
Resources are misallocated. Too many go to the monopolist and they are not fully used by him.
This is a waste for society and in addition, the price mechanism is prevented from working
properly.
A monopoly reduces consumer choice. There is no one else to buy from and no other producer’s
product.
A monopolist may ignore small market demands as he cannot be bothered to meet them.
The long run effect from the existence of monopolies is slightly slower growth;
a lower standard of living; higher unemployment (because the monopolist restricts output and so
requires fewer people); higher prices (which monopolies charge); a slightly poorer balance of
payments as a result of this; a less equal income distribution; and poorer resource allocation.
Benefits of monopoly
A monopolist can use monopoly profits for research and development, leading to product
improvement, faster growth, and lower costs, despite the argument above that they are inherently
lazy. Joseph Schumpeter argued that they are important for innovation; he felt that big firms are
the only ones that are able to afford the necessary laboratories, equipment and research staff.
Against this, research exists that shows many of the breakthroughs come from small firms, for
example Apple began making those computers in a garage.
Monopolists may be able to reap economies of scale. Economies of scale mean lower costs.
A state monopoly may be safer than a private one. A private monopoly may be more tempted to
cut corners and reduces necessary maintenance to lower costs, and this could be particularly
serious in some areas like the railways or air traffic control.
Monopolies creates employmet
Monopolistic competition
The theory of monopolistic competition was developed by xdward
Chamberlin (1899-1967), an Americal economist. He was dissatislied
with the two extreme theodes that existed at the time, perfect
competition and monopoly, so wanted to devise someth.ing more

realistic that would sit between the two existing theories. In simple
terms, a monopolistically competitive market is one with many
competing firms where each firm has a little bit of market power. This
is why we have the term "monopolistic", as firms have some ability to
set their o\ry'n prices.
The assumptions of monoPolistic comPetition
The assumptions for monopolistic competition are as follows.
o The industry is made up of a fairly large number oI firms.
. The firms are small, relative to the size of the industry. This means
that the actions of one firm are unlikely to have a great effect on
any of its competitors. The lirms assume that they are able to act
independendy of each other.
r The firms all produce slightly differentiated products. This means
that it is possible for a consumer to tell one firm's product from
another.
o Firms are completely free to enter or leave the industry. That is,
there are no barriers to entry or exit.
The only difference lrom perfect competition is that in monopolistic
competition there is product differentiation. Product dilferentiation
exists when a good or service is perceived to be dil{erent from other
goods or services in some way. Products may be dilferentiated bybrand name, colour, appearance,
packaging, design, quality of service,
skill levels, and many other methods. Examples of monopolistically
competitive industdes are nail (manicure) salons, car mechanics,
plumbers, and jewellers.
Although it may appear to be a small difference from the assumptions
of perfect competition, this leads to a markedly different market
structure. As the products are differentiated there will be some extent
of brand loyalty. This means that some of the consumers will be loyal
to the product and continue to buy it if the price goes up a little. For
example, it may be that the customers of a certain plumber will stay
with that plumber when she raises her prices above local rivals,
because they believe that she is slightly more skilled than her
competitors.
This brand loyalty means that producers have some element of
independence when they are deciding on price. They are, to an
extent, price-makers, and so they face a downward sloping demand
curve. However, demand will be relatively elastic since there are
many, only slightly different, substitutes.
Have you ever walked down a street in a tourist area and seen a lot of restaurants
with similar menus? Explain why they might be considered to be in monopolistic
competition.
The demand curve facing a monopolistically competitive firm is
shown in Figure 9.1.
The firm faces a downward sloping demand curve with a marginal

revenue curve that is below it and produces so that it is maximizing

profits where MC : MR. This means that the firrn in Figure 9.I will
produce an output of q and sell that output at rhe pdce of P
Possible short-run profit and loss situations in

monopolistic competition
Just as in perlect competition, it is possible for firms in monopolistic
competition to make abnormal profits in the short run. This is shown
in Fig]jJe 9.2.
.9
Eo
o
I
.9
Student workpoint 9.1
Be a thinker-considel
and explain
Try to think of an example of a
market in your area that is in
monopolistic competition. \A,4th
reference to the assumptions of
the model, explain your choice.
lVtR Output
F Bure 9.1 lhe demand curve for a firm
in monopolistic competition
Figure 9.2 Short-run abnormal profits in
monopolistic competition
o-c
Output
122
In this case, the firm is maximizing profits by producing at the level
of output where MC = MR, and the cost per unit (AC) of C is less
than the selling price of P. There is an abnormal profi.t that is shown
by the shaded area.
It is also possible that a firm in monopolistic competition may be
making losses in the short run and this is shown in Figure 9.3. Once
again, the firm is producing where MC : MR, but this time the cost
per unit, C, is above the price, P, and the amount of losses is shown
by the shaded area.
The long-run equilibrium of the fitm in monopolistic
competition
whether fims are making abnormal profits or losses in the short run,
because of the freedom of entry and exit in the industry there will be
a long-run equilibrium, where all of the firms in the industry are
making normal profits.
II the fims are making short-run abnormal profits, then other
firms will be attracted to the industry. Since there are no barriers
to entry it is possible for these other firms to join the industry. As
they enter, they will take business away from the exisdng firms,
whose demand curves will start to shift to rhe left. If firms are making
short-run losses, then some of the firms in the industry will start to
leave. The firms that remain will Iind that their demand curves start
to shift to the right as they pick up trade from the leaving firms.
This analysis explains why it is not uncommon to see similar shops or
services spring up in an area. Imagine that a new sushi restaurant
opens up in a district. Soon it is so popular that there is a line outside
the door every evening. Other catering entrepreneurs will be attracted to the possibility of doing so
we11, and so it is likely that another sushi restaurant will open up in the area. It may not happen
immediately, but eventually this is likely to result in a fall in demand for the original sushi restaurant as
some of its customers will switch.
If demand continues to be strong, then even more restaurants will open. Each restaurant will try to
distinguish itself from the othersperhaps
by staying open longer, oflering a "Happy Hour", special theme nights, or free children's meals to name
just a few possibilities.
This product differentiation is also known as non-price competition.
Whatever the short-run situation, in the long run the firms will end up in the position shown in Figure
9.4, with all making normal profits.
T?re firms are maximizing profits by producing at the level of output where MC : MR and, at that output,
the cost per unit, C, is equal to the pdce per unit, P Each firm is exactly covering its costs, including its
opportunity costs, and so there is no incentive for firms to leave the industry. Fims outside the industry
will not enter, since they will be aware that their entrance would lead to losses for everyone.
PERFECT COMPETITION, MONOPOLY, MONOPOLISTIC COMPETITION, AND

OLIGOPOLY: GRAPHING TIPS
For all firms, the MC curve must intersect the ATC at the minimum of the ATC curve.
When a firm is making positive profits, the ATC curve must lie at least partially below the
demand curve.
When a firm is making negative profits (losses), the ATC curve must lie entirely above the
demand curve.
When a firm is making zero profits (breaking even), the ATC curve must be tangent to the
demand curve.
For perfect competition, the firm’s demand curve must be horizontal and the same as the MR
curve.
For monopolistic and monopolistically competitive firms, the firm’s demand curve slopes down
to the right. Theoretically, the monopolistic firm has a steeper demand curve than the
monopolistically competitive firm. For both the monopolistic and monopolistically competitive
firms, the MR curve is twice as steep as the demand curve (if the demand curve is a straight line).
When a perfectly competitive firm is making zero profits, the ATC curve is tangent to the
demand curve at the minimum of the ATC curve. When the monopolistic or monopolistically
competitive firm is making zero profits, the ATC curve is tangent to the demand curve at an

output level that is lower than the output at the minimum of the ATC curve. The tangency must
be directly above the intersection of the MR and MC curves.
When the oligopolist (in the kinked demand curve model) is making zero profits, the ATC curve
is tangent to the demand curve at the kink in the demand curve. This occurs at an output level that
is lower than the output at the minimum of the ATC curve. The tangency must be directly above
the intersection of the MR and MC curves.
For the oligopolist (in the kinked demand curve model), the MC cost curve intersects the MR
curve in the vertical segment of the MR curve. Each of the downward-sloping segments of the
MR curve is twice as steep as the corresponding section of the demand curve (if the demand
curve segments are straight lines).
Market failure
Market failure is a concept within economic theory describing when the allocation of goods and services
by free market is not efficient, that is there exist another conceivable outcome where a market participant
may be made better off without making someone worse off. Market failures can be viewed as scenarios
where individuals’ pursuit of pure self interest leads to results that are not efficient. The existence of
market failure is often used s a justification for government intervention in a particular market.
What does market failure mean?-It means that we do not have full efficiency; we could produce more
with the resources we have; and we could satisfy consumer demands better with the resources we have.
There is waste in the system.
Types of efficiency in economics:
A.) Allocative efficiency. This means good resource allocation, when we cannot make any consumer
better off without making some other consumer worse off. This approach looks at the given resources and
tries to get the most output from them and it also means that firms sell at a fair price to consumers that
reflects the real resource use.(p=mc)
B.) Productive efficiency. This means that production is done at the lowest possible cost.
• We are at the bottom of the average cost curve (which is always U-shaped). In that position we have
what is called “X-efficiency”.
• And this means we are also on the production frontier, not somewhere inside it.
A.) Allocative efficiency
Allocative efficiency occurs when the value the consumer puts on a good or services is the same as the
cost of the resources used in producing it. This occurs when price= marginal cost. In this position, total
economic welfare is maximized. In the perfect competition diagram below, where MC = MR for the firm,
we have allocative efficiency because the firm’s price is the marginal revenue (it can sell any amount at
the unchanged price - each extra unit sold at that price provides the marginal revenue), so MC = P. In fact,
at that point we have more equalities MC = P= MR = AR. “AR” is merely another word for price – it is
“average revenue” which we get by dividing total revenue by quantity. We know that quantity multiplied
by price gives us total revenue, so it follows that price actually is average revenue.
B.) Productive efficiency
This exists when we are actually on the production frontier. That means we are using the least resources
we can. In turn, it says that we are at minimum average costs = the bottom of the AC curve. Perfect
competition is like this – so economists prefer this position and you will recall that it is known as “X-
efficiency” – it is where we are totally efficient.
Where market equilibrium is totally efficient, we cannot make someone better off without making
someone else worse off (this is sometimes called “the Pareto optimum position”).
The production possibility curve:
When we are below the production possibility curve (e.g., at “X” in the diagram below), we can move
north-east and get onto the curve, thus making everyone better off; only when we are on it do we have
proper productive efficiency.And only when we are on it does the concept of opportunity cost arise. If we
are below it, we do not have to give anything up to get more of the other thing; we can have more of both
simply by moving out to the curve.

Note: we can have allocative efficiency and productive efficiency but still have inequity in the country,
which can also stop us reaching “perfection”.
Example 1. If you personally have all the income in your suburb, the other residents will be poor and
might even starve, which does not sound at all like perfect! The market system is amoral i.e., it is not
concerned with good or bad. Economics is not about ethics.
Example 2. Drug dealers could wait at the gates of primary schools, give away drugs for free to six year
old children and in this way build up a market as they become addicted. This would create a demand,
which the drug dealers could then supply later at a price. Most people would regard this situation as
totally wrong, exploitative, and immoral – but the market would be working - and possibly very
“efficiently” too.
Social efficiency matter not just private
We might produce too much or too little as a society, for our own good, even if have perfect competition
and an acceptable distribution of income and nothing illegal or immoral is occurring. This can happen
because of externalities. We move on to consider these next.
Sources of market failures
Monopoly elements or market dominance.

Externalities.
Public goods.
Merit goods.
De-merit goods.
Information failures.
Factor immobility.
Undesirable income and wealth distribution
EXTERNALITIES
Externalities, social cost and private costs

Externalities are said to exist when the actions of producers or consumers affect themselves as well as
third parties who are offered no compensation to the loss generated. Externalities can be known as
external diseconomies and economies as well as third party spill over effects. They exist because the
market cannot deal properly with the side effects of many economic activities. Externalities involve an
interdependence on utility and production functions. An external benefit or a positive externality refers to
the benefit from production or consumption experienced by people other than the producers or
consumers. This occurs when an externality-generating activity raises the production or the utility of the
externality-affected party. Hence, the economic activity provides incidental benefits to others for whom
they are not specifically intended.
A negative externality or external cost refers to the cost of production or consumption borne by people
other than the consumers or producers. The undesirable effects on the allocation of resources by an
externality can be explained by the Marginal Social Cost (MSC). The Marginal Social Cost is a sum of
the Marginal Private Cost (MPC) and the Marginal External Cost (MEC). MPC is a share of marginal
cost caused by an activity that is paid by the people who carry out the activity and MEC is the share borne
by others. When the firm’s activities generate negative externalities, its MSC will be greater than MPC.
Since, in equilibrium, the market will yield an output at which consumers marginal benefit is equal to a
firm’s MPC. Thus, as shown in Figure 1, MPB is less than MPC, hence the costs that is incurred to
society outweighs the benefit derived from the good. Consider the soap industry which, in a free market
would discharge waste products into the air and into rivers. The owners of soap factories being profit
maximisers will only consider their private costs and ignore the wider social costs of their activities. Thus,
MSC is more than MPC.
An example of an activity which generates an external benefit in consumption is vaccination. If an

individual makes a decision to be inoculated against a particular disease, then he will receive the private
benefit of not being infected by that particular disease. However, there are also other possible benefits to
all others with whom he comes into contact as they will not contract the disease from him. The
vaccination protects not only the person who is vaccinated but also the entire community that person lives
in, by preventing the spread of contagious diseases. Thus, MSB is greater than MPB. The individuals
consider only private benefits and costs in their consumption decisions. Hence, they will consume OQ1
units where MPB=MPC. However, the socially efficient output occurs at OQ2, where MSB=MSC. There
is thus an under consumption of Q1Q2 of the good which results in a deadweight loss equal to the area of
E2BE1. Insufficient scarce resources are being devoted to the production of this product. The market has
failed to allocate resources efficiently.

Private costs are the costs incurred when producing something. Social costs are greater than private costs.
Social costs include things like pollution and congestion that are suffered by society in general, not by any
one producer.
These problems are called “externalities” i.e., they are external to the firm producing them. They can be
negative externalities (which harm society) or positive externalities (which help).
Social cost = private cost + externality (if any)
Cost-benefit analysis tries to measure all the costs to society of a project.
We have a diagram for social costs:
Equilibrium will be where private costs cut the demand curve at Qa, as firms try to maximise profits and
charge price OPa for quantity OQa. But because of negative externalities (pollution maybe), the socially
optimum position should be where social costs cut the demand curve. These would mean producing at
Qb, reading from the social costs curve, and selling at the higher price OPb to cover these costs.
NEGATIVE EXTERNALITIES
Common types of negative externalities by producers:
• Air pollution, e.g., smoky factory chimneys.
• Soil pollution, especially by farm chemicals (closely related to the next type).
• Water pollution, e.g., rainwater run-off containing farming pesticides and fertilisers.
• Noise pollution. Do you live near an airport or by a building site?
Some types of negative externalities by consumers:
• Pollution of air and water.
• Soil pollution, e.g., lead pollution in soils from motorcar exhaust emissions.

• Litter on streets; decomposing rubbish in land-fill sites.
• Noise pollution, e.g., motorcycle noise in urban areas, especially when the baffles have been
deliberately removed from the silencer.
• Vandalism; graffiti on walls.
• Smoking and alcohol abuse, causing NHS expenditures to rise.
We are unsure why the urban sparrow population has plummeted in recent decades but it would seem to
be the result of some externality.
POSITIVE EXTERNALITIES
When these exist, society would gain more than the producer – who therefore is producing less than the
optimal social amount.
Examples include:
• Labour training in firms; one firm may do little, as it knows that when a trained worker leaves, someone
else benefits - but the first firm paid for all the training!
• Education generally.
• Health generally, especially in poor Third World countries.
• The provision of playing fields at or near schools so that the health and sporting skills of the children
improves.
• Free museums and art galleries that can encourage the poor and uneducated to widen their horizons,
educate themselves, and generally improve.
To draw the diagram for positive externalities: just reverse the labeling of the curves of social cost and
private costs above. This is done in the diagram below where you can see that we produce too little for
society if firms profit maximize for them (as they do). They choose to produce at OQa and sell for a price
of OPa, but for the
greatest good of society they should be at OQb and selling at the lower price of OPb.

Government intervention may be necessary to correct or offset market failure caused by negative
externalities – usually the government chooses to tax those producing too much, or they may use the law
to prosecute for water pollution or whatever externality the government is tackling.
There are probably fewer cases of external benefits, but if we find any (such as private firms training
labour well) we can encourage this by tax breaks or subsidies.
Government action with external diseconomies
Government might try (and does):
1. Taxation.
2. Regulation.
3. Perhaps extending property rights.
Let’s think about polluters – what can the government do using the three points above?
a) Taxing polluters
The need is to try to stop the problem being “external” and try to “internalise” it, i.e., to make the polluter
pay for it via a tax. As economists, what we are really doing is trying to get the firm to stop looking only
at the private costs and benefits. In the diagram below, we do this by putting a tax on, which shifts the
supply curve up from “S Private costs” to “Private costs + tax”. If we get it right, this moves the
equilibrium quantity produced from Qa to the smaller output Qb.

But there are problems with taxing polluters:
• When it works, output is reduced and prices are higher – but this can reduce the consumer surplus,
which some feel is not a good thing (Unit 4 looks at this concept).
• It is often hard to identify the particular firms that are causing the pollution, and then determine how
much each is responsible for the total pollution.
• Poor legislation can hurt the innocent, e.g. households who wish to get rid of large items of waste may
not be allowed to take them to the dump.
• It is not easy to put a monetary figure on the damage pollution is causing.
• Producers can pass on much of the tax to consumers if demand is inelastic and not pay it themselves.
• Taxes on demerit goods (to limit their consumption) can be regressive, i.e., hit poor households the
hardest. The tax on cigarettes does this because the poor are statistically more likely to smoke than the
wealthier.
b) Regulating polluters approach (a second way that can be used in addition to tax)
• Banning cigarette advertising at sporting events, or in places like cinemas.
• Making workplaces no-smoking areas.
• Increasing the penalties for firms that break the regulations.
c) Extending property rights (a third way that can be used)
If a lorry crashes into your garden and destroys the wall and all your trees you can get compensation – but
if a polluting factory puts out acid smoke and destroys the same trees you cannot.

If we extend property rights so you could sue for compensation, it would make the polluter think again
and perhaps install anti-smoke devices on factory chimneys!
Benefits
• The property owner knows the value of the property better than the government does, so the figures will
probably be more accurate (but owners can, and perhaps would, lie!).
• The polluter is forced to pay those suffering from his or her activities.
Disadvantages
• The damage may occur abroad.
• Global interests and national interests may conflict. The Zimbabwe cannot make Zambia extend
property rights over Zambians trees which are being killed off at a rapid rate.
Trading permits to pollute
Many believe that it is so difficult and expensive to stop companies polluting (identifying who did it can
be impossible e.g., with one stream and dozens of factories discharging into it) that instead we should
auction off the right to pollute. Only those firms that pay a high price for the limited number of licences
would be allowed to pollute. The government could then use the large sum of money raised to tackle the
pollution itself. The end result could be much better than we currently have.
If we allow a firm to sell its right to pollute (it may have used only 80 per cent of what it is permitted, for
example) then those with the greatest demand for their product, and hence the most profitable, can buy
the remaining 20 per cent. It means the things we most desire still get produced but the government has
the resources to tackle the resulting pollution.
Coase’s Theorem
Ronald Coase established that there is no need to tax or regulate polluters at all! He saw that if polluters
compensated those suffering, the market would solve it properly, with just enough “acceptable” pollution
occurring and still no one suffers without being compensated.
Monopoly elements or market dominance.
MONOPOLY
What is a monopoly?
Definition: Technically a monopolist is a sole supplier, that is to say, one firm is the industry.

But there are degrees of monopoly - if one firm supplies, say, eighty per cent of the market, it is close to
being a monopolist and will usually act like one.
If two (or more) firms supply most of the output, it pays them to work together, to act like a monopoly,
and to keep prices high (if there are two firms we call it “a duopoly”).
Types of monopoly, (sometimes called “causes of monopoly”; "sources of monopoly"; or "conditions for
monopoly"
• Economies of scale, i.e. one firm grow large, its costs fall as a result and become lower than the others,
so it can reduce its price and sell more produce. The others cannot compete because they are small and
higher cost. The firm grows to become the sole one, which then supplies the entire market.
• The result of law – the government may restrict an industry to one huge nationalized firm.
• An agreement between firms, so that all act together as one monopolist - often it is illegal but it happens.
We call this a cartel. This can happen under oligopoly conditions.
• Exclusive ownership of a unique resource: perhaps there is only one source of supply of a raw material.
• Copyrights, patents and licenses are particular forms of this exclusive ownership.
• So-called natural monopoly. This is often the result of economies of scale - e.g., electricity supply.
Problems with monopoly (what is wrong with monopoly or "the welfare effects of monopoly")
• It limits output and keeps price high - as just said. Really this means that a monopolist misallocates (and
misuses) resources.
• This behavior of the monopolist redistributes income from all the consumers of the product (they are
paying more than they need) to one firm or person (the monopolist). This is an equity issue.
• A monopolist may develop political and social power over others which reduces the efficiency of
democracy and the amount of equity.
• A monopolist may behave badly in an anti-social way. For instance, he or she may force out a potential
rival firm by selling at give-away prices (well below cost). After they have forced out the honest
competitor, they will put the price back up again.
• Lack of competition tends to encourage inefficiency in the firm. The monopolist tends to rest on his
laurels, has no need to try hard, and lacks dynamism – this is probably the main criticism .
• As a result, we can get the emergence of lazy managers and owners.

• And it may mean that technical progress is slow, leading to slow growth of the country as a whole, and a
lower standard of living than we could enjoy.
• A monopoly breeds inefficiency which means that the cost curves will be higher than they need be; this
means that the intersection of MC and MR may be higher.
• Resources are misallocated - too many are going to the monopolist who does not fully use them. This is
a waste for society. It really means that the price mechanism is prevented from working efficiently.
• A monopoly may reduce consumer choice. He may ignore small market demands as he cannot be
bothered to meet them. As Henry Ford is reputed to have said about his motor cars “You can have any
colour you want, as long as it’s black”.
Benefits of Monopoly
There are few benefits really - economists are almost united in opposition to monopolies, and many are
against both public and private ones – those on the political left wing tend to prefer public ones more than
those on the right wing.
Economists usually favour reducing or ending monopolies and increasing competition.
BUT some defence is possible!
• The monopoly profits can be used for research and development, leading to product improvement, faster
growth, and lower costs.
Joseph Schumpeter's argument on innovation - that big firms are the only ones able to afford the
necessary laboratories and research staff – may apply.
Against this, research shows that many breakthroughs come from smaller firms, not the large ones. For
instance, Apple computers began in a garage.
• A monopolist may reap economies of scale.
• A redistribution of income is not too bad perhaps:
It is always happening in a dynamic economy anyway. If necessary, it can be corrected by government

action.
Monopolies can lead to underproduction and higher prices than would exist under conditions of
competition. In a free market economy, there is nothing to prevent the emergence of oligopolies and a
monopoly in various industries. The more successful firm acquires other firms or puts them out of
business. When these imperfect market structures occur, there will be allocative inefficiency because they
generate shortages in order to hike up prices and increase profits.
Public goods
Economic goods can further be subdivided into public and private goods. A public good is one that has
two characteristics that private goods do not. Firstly, public goods are non-exclusive. This means that a
producer or seller cannot separate non payers from benefitting from the good. As a result, the payer too,
eventually does not want to pay. As a consequence, the market will not produce a public good. This is
market failure.
Using the concept of externality for public goods, there are no private benefits or revenue for the producer
at all but more benefit for the society. Examples of public goods are street lighting, defence and radio
broadcasts. The second characteristic is that public goods are non-exhaustible. This means that the use by
one person does not reduce the amount available to another. As a result, there is no rivalry in
consumption. As a result, there is no additional opportunity cost for the second and third person to use.
Public goods are collectively consumed and the market may simply not supply them; e.g., defence of the
country (a police force and army), a fire brigade, street lighting, or lighthouses. The market system does
not work well in this area.
Some goods are “semi-public goods”, “quasi public goods” or “collective consumption goods”, for
instance roads. These are often supplied by the state, but in principle they can be privately supplied, and
sometimes are.
Public goods require
• The lack of ability to exclude (if I am defended, so are you, even if you do not pay)
• The consumption by one does not reduce the consumption available to the others (if you walk down the
street after dark you do not use up any of the street lighting.)
These two requirements may be called the “non-rivalry” and “non-excludability” features.
One of the jobs of government, both central and local, is to supply public goods or services that are
needed but otherwise would not be made available by the market.
Merit Goods
These are goods with extensive external benefits. These are provided by the market - but in smaller
amounts than are needed for the good of the state. Health and education are the most obvious ones – there
will be some privately-supplied health and education but the state as a whole benefits if everyone has
access to them, not just a few. For instance, in the health area, the National Health Service tends to reduce
mass epidemics; the health service also means that fewer people will be off work sick. In the case of
education, society would not function as well if half the population could not read the instructions on the
label.
Private consumers individually value merit goods less than the state does. The market system fails to
provide enough merit goods which is why the state steps in to make them more widely available. It does
this by subsidizing the production of some merit goods or services.
Merit goods may be targeted at certain groups and rationed; for instance, we might limit access to higher
education to those passing A levels well.It is assumed that such people are the most intelligent in society.
In the diagram below, a subsidy equal to AB is applied by the government – this shifts the supply curve
downward and to the right. The equilibrium position then moves from P1Q1 to P2Q2. The result is that
more is then consumed at the lower price i.e., the demand for merit goods has extended.
Demerit goods
Demerit goods are exactly the opposite of merit goods in that they are over-consumed by individual
people and this causes problems for the nation as a whole.
Cigarettes are a clear example: they cause unpleasant smoke which is dangerous to people in the area who
are forced to become passive smokers. They also cause cancer and a whole range of nasty diseases,
including emphysema. They inflate the national health bill because both the smokers and the passive
smokers get sick and visit the doctor. But smokers will not stop, perhaps are unable to stop, because they
are addicted.
Too many demerit goods are demanded, so the government steps in and taxes cigarettes highly in order to
reduce consumption and to raise revenue which is needed anyway to spend on treating smokers. The

government also advertises heavily to try to persuade people to stop smoking and the young not to start
and is seriously considering banning smoking in all public work places, as Ireland did in 2004. Some
individual doctors are also refusing to treat smokers for smoke-related diseases unless they stop smoking
which adds to the pressure.
The effect of the government taxation is in the diagram below. The indirect tax EB is added vertically to
the supply curve, which shifts upward and to the left from S1 to S2.
This reduces the consumption from OQ1 down to OQ2, (a move from the equilibrium point A to B) as
price rises from P1 to P2 and consumers contract up the unchanged demand curve.
Rather than simply relying on tax to decrease the supply curve and force up the price, the government
may also try to tackle the demand side. It can do this in the ways mentioned above and the diagram is
reproduced below.
You will observe that, if successful, the quantity smoked falls.
The government uses both methods, reducing demand and taxing heavily, to deal with smoking as a
demerit activity.

Information failures
Consumers lack information on things like:
• What goods are available and what new goods have recently come onto the market.
• What the quality of the different models or makes available is like.
• How long an item will last before breaking down.
Information lack is particularly common in both the health service and in education where consumers do
not know much - although we now know more than a few years ago.
This lack of perfect knowledge means that we may choose badly through ignorance. The demand curves
would be different, and better, if we did know everything. This means of course that the existing demand
curves do not give us a perfect market solution.
Producers lack information on:
• What new demands are arising and how old ones are starting to change, so the producers may produce
more (or less) than they should.
• What their existing rivals, and any new ones about to emerge, are doing or might do.
Which means that the producers may produce the wrong type of goods or the wrong quantity of goods?
We know that in the world in which we live, new firms start up and many die away within the first two
years – they usually got it wrong on the demand for their service or goods in that particular place,
although sometimes they simply were not good enough at the job. In the process of being born and dying,
the firms used up resources (including the labour of the would-be entrepreneur) in a less than fruitful way.
Workers lack information on:
• All the jobs available now. Many of these will be local but more particularly they are usually ignorant of
opportunities elsewhere in the country or in the EU for that matter. So the workers may not move to
where they are needed though simple lack of knowledge.
• Which industries will grow and which will wither away in the future. This means that workers may join
a firm that will disappear in a few years time, throwing them out of work but not for any fault of their
own. Technical change can render whole jobs out of date.
- A real problem is that those leaving school or college may join an industry and train in skills that will
shortly be no longer needed.
So here again the market does not reach the “correct” or optimal solution.
The response to information failures
Private firms gather information and try to sell it. For instance:
• Private job centres may open up to try to find a job for people. These are mostly in large cities and for
service workers, rather than for manufacturing. Such firms are trying to improve the flow of information
for profit.
• Magazines like “Which?” exist. They test and investigate the quality of goods and services and publish
the results.
• Specialist magazines are produced for things like hi-fi, TV, motorcars, or computers – such magazines
also test and report the results.
• In order to help producers, various trade associations and chambers of commerce gather information and
inform their members about what is happening. They also organise conferences and set up fact-finding
trips abroad and the like.
The state tries to provide information by:
• Establishing job centres.
• Providing advice to careers advisers in schools.
• Issuing pamphlets and working papers to try to improve peoples’ knowledge. The newspapers pick up
this information and may publicise it.
Overall, as information improves, consumers adjust their demand patterns to favour what fits their needs
best. Producers chose the most suitable and cheapest sources for their inputs. This of course means the
market mechanism then works better to supply what people want and are willing to pay for.
Factor immobility
The factors of production that we have are land, labour and capital plus a remainder term (L, N, K, + R) –
most economists and textbooks focus on labour immobility, but this is not guaranteed for the exam
We can also have land immobility
• Some land is good for growing one or two particular crops and not very good at some other crops. It is
not easy to change rice (which needs wet soils) to wheat (which needs drier conditions).
• It is not possible to move land from where it is to somewhere else.

• Climate change may be occurring and farmers are often traditional, growing what they or their family
have done for years or even generations. They may be unaware of, or refuse to try growing, a now more
suitable crop.
• Economic Union subsidies keep many farmers’ attention on producing the crops that are highly
subsidised (as it gains them a higher income) rather than what might be more suitable for their land or sell
better. Quite often the EU gets it wrong, so
we ending up with a lot of produce that is hard to sell. Dumping it on international markets annoys other
countries that produce such goods efficiently as it reduces their market. Dumping it into the sea causes
criticisms of waste in a world of poverty.
And capital immobility
• Some capital is specific e.g., it makes light bulbs, and it cannot be transferred to another use, like
producing ball point pens.
• Some capital is very big and heavy, e.g., a steel mill, and it is difficult or impossible to move it to
another geographic areas.
• Some old decaying industries may be subsidised by government and continue to exist for years, well
beyond their shelf life. This keeps the capital (and the associated land and labour) where it is so that it is
not released for use where it is more wanted by society. That is to say, government subsidises prevent
factors of production moving to turn out what people now demand. The fact that the industry is decaying
shows that demand has changed and people no longer want that good or service as much as they once did.
• Some (usually small) firms stay in business despite making poor profits because the owner does not
want to move or to cease production; or perhaps the owner is too old to bother to make any major change.
Labour immobility (the really interesting one – we ourselves are people)
Geographic immobility of labour
• People are usually happy where they are: they have got relatives and friends, they know the town and
area, and they are members of various clubs and other social groupings. They do not wish to move.
• They may not know about the money they could get if they were to move (“information failure”).
Information failure actually costs money to overcome: people must pay to use the Internet, or have to buy
newspapers and magazines.
• Moving house costs money: there are estate agents’ fees, lawyers’ fees, a government stamp duty and
the cost of transporting furniture and all the other household effects.
• Inertia: people often do not like a big move as they have a sort of fear about it, so they just stay where
they are.

Institutional immobility of labour
• Trade unions and government pass rules or laws that prevent people from entering a new job easily.
• Pension schemes may tie people into a particular company – if a worker moves, he or she will probably
lose the amount paid in by the employer on their behalf (this can amount to several thousand dollars).
• Council houses (state subsidised housing) are let below market rents and can prevent people moving; if
they move it means they must give up their cheap house unless they are able to arrange for a house-
exchange with another council tenant.
• Foreign-trained doctors may not be allowed to work in the Zimbabwe unless they spend several years
retraining - and not always even then.
Sociological and economic differences causing immobility of labour
• Minority groups often get paid less. For instance, it may be harder for migrants who do not naturally
speak English to find work and to receive the same pay. If they are not selected for a vacancy, it renders
them less mobile. Even women, hardly a minority, find it hard to get the same pay as men, despite the
existence of long-standing legislation.
• We can think of this as a lower demand curve for them, because employers do not like hiring them as
much.
• Married or very close couples: one may not be able to take a better paid job offered elsewhere because it
would render the other partner unemployed, so total family income would fall if they moved.
• The skills a person has may not fit the new demand for workers, so he or she would find it hard to get
another job. As demands in society change (taste + higher incomes + new goods + new technology +
fashion and trends…) it means new skills are needed and old ones become redundant. How many chariot
wheel makers do we now need?
• Age: once past fifty years, or even forty years of age, it is difficult to get a new job.
Employers often prefer younger people. If an applicant is old, the employer fears that they will not learn
new skills quickly; and if the applicant is older than the employer, he or she may feel uncomfortable
giving them orders and so simply refuse to hire them in the first place; and old workers who join the firm
will only pay into pension scheme for, say, ten years until they retire, but will take out for perhaps another
thirty years until they die. An ageing population makes this scenario more common.
Such factors mean that wage differences (and unemployment) can permanently exist between industries
and between regions. The market does not work well enough to equalise wages and long term wage
differences persist.
Diagram: the wage of labourers in London and Cornwall: London has a greater supply but a much greater
demand so the curves are further to the right. And of course in London, the level of wages and the
quantity of workers are higher.
What can be done? Government intervention may help produce a better market solution.
Government training and retraining for the new skills that society needs.
The government may improve or alter the educational system and encourage academic courses to be more
geared to the needs of a modern economy (although some intellectuals disagree and think education
should not do this).
We can retrain workers at government expense. The state can pay for retraining courses and give
generous tax breaks to those choosing to receive new skills.
The government may tackle the geographic problem
It may pay workers to move; or pay the costs of buying or selling the house; or end (or reduce) the stamp
duty for such people; or pay the unemployed to travel to look at job opportunities in a new area.
It may subsidise firms to move to old decaying areas. This approach is generally inefficient, as it means
costs will be higher than they need be, as it is probably not a good location for the firm (which we can
assume or the firm would be there already or willing to go without a subsidy). This would make the
Zimbabwe less competitive with other countries.
The government may allow pension mobility, i.e. when a person leaves a firm he or she can take their
pension rights with them – the new stakeholder pensions do this. The push for people to take out their
own private pensions means that workers are more mobile than they once were. There is a slight problem
in that the rich who are usually already mobile are taking out stakeholder pensions, but the poor, less
mobile, are tending to avoid them.
The government could change the laws as needed
Example 1. The government could make all company pension schemes pay out the employer’s
contribution when worker leaves.

Example 2. The government could make the Zimbabwe Medical Association (ZMA) allow foreign
doctors in to work more easily. The ZMA is rather restrictive and keeps some well-trained foreign doctors
from working in the Zimbabwe unless they requalify or take special tests. This reduction in supply means
there is a permanent shortage of doctors which helps the ZMA to pressure the government for pay
increases, better conditions, or whatever it wants.
Example 3. The government could pass “non ageist” legislation to try to stop older but good being
refused jobs or even fired (government is planning to do this - eventually).
Other areas of law no doubt could be similarly changed – watch the newspapers for articles and examples
that you could quote in the exam room.
COST BENEFIT ANALYSIS (CBA)
Cost-budget analysis (CBA) is a framework for evaluating the social costs and benefits of an investment
project. This involves identifying, measuring and comparing the private costs and negative externalities of
a scheme with its private benefits and positive externalities, using money as a measure of value.
Step 1: identify all costs and benefits using the principle of opportunity cost
Step 2: measure the benefits and costs using money as a unit of account
Step 3: consider the likelihood of the cost or benefit occurring (i.e. sensitivity analysis)
Step 4: take account of the timing of the cost and benefit (i.e. discounting). A £1,000 benefit now is
worth more than £1,000 benefit in 10 years time
IDENTIFY ALL COSTS AND BENEFITS

A firm deciding on an investment project will only take account of its own private costs and benefits e.g.
total cost and total revenue. Firms ignore externalities. CBA will take account of both private and external
costs and benefits.
Consider a project to build a bridge over a river:

• Private Costs e.g. construction costs, operating costs and maintenance costs
• External Costs i.e. costs incurred by non owners (a) monetary e.g. loss of profits to competitors e.g. to
ferry owner and (b) non monetary e.g. noise, loss of countryside, inconvenience
• Private benefits direct the amount consumers are prepared to pay e.g. the tolls paid
• External benefits i.e. benefits to non owners e.g. consumer surplus of users; time savings for travellers
and fewer accidents.
MEASURE THE BENEFITS AND COSTS

Benefits and costs can be valued using money. Private costs and benefits are relatively easy to measure in
monetary terms
Total costs and total revenue.
Private costs Build the bridge: £5,000, 000 to operate it £200,000 a year, to repair and maintain £ 50,000
Private benefits 1,000,000 users each paying £1 each = £1,000,000 a year
Externalities are more difficult to measure:
• Noise or loss of countryside. What value do people place on these? By how much do those who suffer
need to be compensated Ask them using a questionnaire! If 50,000 affected people value the annual loss
of countryside at
£5 then cost = £250,000
• Time savings. What value do we place on work time saved or leisure time saved? Is the time saved
worth the same to everyone? If 100,000 hours re saved and valued at £4 per hour, benefit = £400,000
• Fewer accidents. Economists value human life using money. One life = £750,000. If the bridge saves
on life a year, annual benefit is £750,000
LIKELIHOOD OF THE COST OR BENEFIT

If there is a 50% chance that a life will be saved then the benefit is
£750,000 x 0.5 = £375,000
THE TIMING OF THE COST AND BENEFIT

The major cost of the project occurs straight away. The benefits occur over the life of the project. The
bridge may cost £5m to build but consumers benefit by £1m a year. If the expected life of the bridge is 25
years then economists use discounting to value now the £1m of benefit in 25 years time. Commonly the
rate of interest or inflation is used to discount the future earnings as the £1m in 25 years time will be
worth substantially less today.
IS A PROJECT WORTH UNDERTAKING?

Yes if discounted benefits outweigh discounted costs. If the government has to choose between
competing projects then the ones with the highest positive net present.
GENERAL POINTS REGARDING CBA

Here are some common examples that can be applied to many CBAs they will hopefully assist you in
answering any question.
The most common external costs arising from production are:
• Noise.
• Pollution of atmosphere, rivers etc..
• Danger to workers and public.
• Congestion.
The most common external costs arising from consumption are:
• Pollution from motor vehicles.
• Litter.
• Noise pollution.
• Externalities from smoking and drinking alcohol.
External benefits from production and consumption are often grouped together, the
Following are the most commonly used examples:
• Industrial training by firms.
• Education which leads to an increase in human capital.
• Healthcare.
• Knowledge.
• Employment created.
• Arts and sports.
• Neighborhood watch schemes.
A range of different projects often attract cost-benefit analysis, e.g.,

• The building of a new road.

• The building of new airport/runway.

• The expansion of a factory.
• The building of a supermarket.
• The provision of a public or merit good.
There are a number of problems with cost-benefit analysis:
• If the project leads to a time saving, it can often be difficult to place a value on the time saved.
• Lives maybe saved, again what value do we place on a life?
• How do we place a monetary value on an eyesore, pollution or illness? These require a level of
judgment that may vary from person to person.
• Over time the value of the benefits will fall as inflation erodes the value of the pound.
Any future benefits would have to be discounted.
It is accepted that cost-benefit analysis can be an imprecise; however it is deemed to be better than
making no attempt to recognise the externalities at all. Due to the amount of judgment involved when
coming to the figures and discount rate the results should be viewed with caution. All of the assumptions
made in the cost-benefit analysis should be explicitly stated.
It is important to note who is carrying out the cost-benefit analysis and do they have a particular agenda,
i.e., do they want the project in question to be approved/turned down.
Depending upon their stance will affect what data they choose to include and their methods of interpreting
it.

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BRIAN ROPI A LEVEL ECONOMICS

AN INTRODUCTION TO A LEVEL ECONOMICS

Important elements in the definition

Microeconomics and Macroeconomics

THINK LIKE AN ECONOMIST 1

Pitfalls to Sound Economic Reasoning

The Central Problem of Economics

Needs and Wants

Land (Natural Resources)

THINK LIKE AN ECONOMIST 3

The basic economic problem

What to produce and in what quantities? (What to produce)

Scarcity, choice and opportunity cost

THINK LIKE AN ECONOMIST 4

THINK LIKE AN ECONOMIST 5

Opportunity cost can be thought of as:

THE PRODUCTION POSSIBILITY CURVE (PPC)

Assumptions of the ppc

• Full employment The economy is employing all its available resources.

A ppc illustrates the following economic ideas:-

• The law of increasing costs

Shifts in the ppc

THINK LIKE AN ECONOMIST 8

A ppc can shift outwards due to the following reasons

• Increase in labour force

• Increase in the stock of capital goods

• Increase in technical knowledge

• Discovery of new resources

THINK LIKE AN ECONOMIST 9

A ppc can shift inwards due to the following reasons:-

• Decrease in stock of capital goods

• Depletion of natural resources eg minerals.

Pivotal shifting of the ppc

THINK LIKE AN ECONOMIST 10

The slope of the ppc/Types of ppc

The Law of Increasing Costs

The PPF and Economic Efficiency

THINK LIKE AN ECONOMIST 12

1. The market mechanism

2. The planned economy

3. The mixed economy

THINK LIKE AN ECONOMIST 13

2. Freedom of choice and enterprise by individuals – free to buy/hire economic resources.

6. A very limited role of government-government only intervenes to correct market failure.

Advantages of market economy

THINK LIKE AN ECONOMIST 14

THE DISADVANTAGES OF A TOTALLY FREE MARKET

THINK LIKE AN ECONOMIST 15

Functions of the Price Mechanism

The invisible hand – the workings of the price mechanism

The signaling function

THINK LIKE AN ECONOMIST 16

Higher demand signals to producers to

price of computer S1 price of digital S1 S2

The transmission of preferences

The rationing function

Adam Smith and the Invisible Hand

THINK LIKE AN ECONOMIST 17

Prices and incentives

Government intervention in the market

THINK LIKE AN ECONOMIST 18

The Planned Economies

• Also called the command economy or collectivism.