Economics: What is it?

If someone asks you to define economics, what are you going to tell them? Without running to
your book, let‟s look at the word eco-nomics itself. The prefix „eco‟ from the Latin word „oeco‟
refers to household and „omics‟ is a general term for a broad discipline of science which analyses
certain variables. So the word economics can be defined as:

„...A social science that studies how individuals, governments, firms and nations make choices on
allocating scarce resources to satisfy their unlimited wants‟ (Investopedia)

„...The social science that deals with the production, distribution, and consumption of goods and services
and the theory and management of economies or economic systems.‟ (American Heritage Dictionary)

„... The study of how society uses its scarce resources.‟(The Economist)

„...the branch of knowledge concerned with the production, consumption and transfer of wealth.‟ (Oxford
Dictionary)

How is economics going to help me?

Scenario 1:

As a high school or college student, you about doing a number of different career options but why
do you end up with one or two major interests?... Yes, you make a choice whether or not you want
to be a Doctor, Lawyer, Entrepreneur, Accountant, Economist, among other professions. And
economics has to do with making effective choices and how they impact you as an individual.

This leads us to the first branch of economics. A group of concepts and explanations have been
developed to explain the choices that individuals and firms make and how they react to certain
conditions that may occur. This branch of Economics is called „Microeconomics‟ or narrow
economics.
Individuals and firms from the previous definitions are not the only ones who have to make
economic choices. Governments around the world have to make choices which affect their
population. For larger countries such as the United States, United Kingdom, China, among
others, their decisions affect the entire world. This branch of Economics is referred to as
„Macroeconomics’ or wide economics.

Throughout this course you will tested on many areas, the most popular type of questions relate
to food and other consumer choices in microeconomics and the most popular questions in
macroeconomics are in relation to national economic effects and outcomes. You are also
required to construct and use diagrams to explain economic principles in both areas. Students are
also required to have comprehensive knowledge of Mathematics up to the CSEC level.

You can use this text a as guide to completing the CAPE Economics programme. Unit 1 of
CAPE Economics requires students to attain mastery of Microeconomic concepts and principles
and apply them to real life models. In Unit 2 on the other hand students are required to attain
mastery and apply Macroeconomic principles to real life principles. The basic modules of each
unit are:

Unit 1: Microeconomics

1. Methodology: Demand and Supply

2. Market Structure, Market Failure and Market Intervention
3. Distribution Theory

Unit 2: Macroeconomics

1. Models of the Macro-economy

2. Macroeconomic problems and policies
3. Growth, Sustainable Development and Global Relations

Note: Each Unit is independent of the other so can be taken in any order.
Even though Economics is in no way English language students are urged to write their
responses in a logical format, so as to make an impression on CAPE examiners. It is also
important for students to be abreast with current economic affairs in your territory as knowledge
of such will aid in your discussions in classes, lectures, tutorials and in exams.

The CAPE economics assessment

Just like CSEC Economics the final exam is comprised of three papers. Paper 1 comprises of a
multiple choice paper of 45 questions representing 15 questions from each module. This paper is
1 ½ hrs in duration. Paper 2 comprises of six questions two from each module of which you‟ll
choose one. So in total you should complete three questions in 2 ½ hrs, Papers 1 and 2 represent
(80%) of the total assessment. Paper 3 represents the internal assessment which is a project
report. Candidates should determine a topic with their teacher‟s consultation. Further details will
be provided later on in this text. Private candidates take an alternate mini case study paper taken
on the same days as paper on a topic that is pre circulated by the Caribbean Examination Council
(CXC); further information may be sourced in the syllabus.
Unit 1
Microeconomics
Module 1
Methodology: Demand and Supply

 Central Problem of Economics

 Theory of Consumer Demand
 Theory of Supply
 Market Equilibrium
Central Problem of Economics
Now that we understand what economics is many economists, (who are professionals who use
economic theory in order to do their jobs), will tell you that they always have varying problems
to consider as they make predictions and are doing research. So it begs the question is there a
problem with economics. They answer to that is solely based on personal interpretation. Many of
my peers while doing this course expressed that it had some difficulty and they regret, the choice
they made while doing this course. Many of them also stated which course they could have done
and how much it cost them to give it up. Many individuals , I am sure you and your parents
involved want to purchase a certain volume of item (unlimited wants) but only have a certain
amount of money to purchase those wants (limited resources).

If you were reading carefully above a few clues were given on the central problems involved in
economics. Firstly we have choice, opportunity cost and scarcity. All other principles in
economics are based on one or more of these terms.

Because societies constantly face the three problems aforementioned, the societies need to be
able to three interrelated questions:

1. What to produce- because an economy cannot possibly produce everything choices

have to be made to decide in what quantities certain goods should be produced.
2. How to produce- because resources are scarce , we need to consider how to efficiently
use our resources to maximise production.
3. For whom to produce-because all persons wants cannot be satisfied , so decisions have
to be concerning how much of a person’s wants will be satisfied

Scarcity
The concept of scarcity is simply defined as unlimited wants match my limited resources. For
example; As a consumer you wish purchase a plot of farmland across 5 acres in one location. But
when you go to buy you find that you can only purchase 2.4 acres as the other areas are
developed. This shows that you wanted 5 acres of land but you were limited to the 2.4 acres
which was available.
Limited resources
In economics limited resources are characterized under four broad areas, known as Factors of
Production. These areas comprise of all major branches of resources and are characterized as:

1. Land
2. Labour
3. Capital goods
4. Enterprise(Entrepreneurship)

When considering the theory of scarcity two main goods come into play, free goods and
economic goods.

Free goods- In economics, free goods refer to items of consumption (such as air and fresh water)
that are useful to people, are naturally in abundant supply, and needs no conscious effort
to obtain.

Economics goods- These are consumable items which are useful to people but scarce in relation
to demand, so that human effort is required to obtain them.

In an exam most timse you can be asked to define scarcity and another word, but always
remember that while you define you must give examples.

Opportunity costs
Opportunity cost can be defined as:

“...the cost of an alternative that must be forgone in order to pursue a certain action. Put another
way, the benefits you could have received by taking an alternative action.”(Investopedia)

“... the value of the next-highest-valued alternative use of that resource.”(econlib)

“...The difference in return between an investment one makes and another that one chose not to
make.”(Financial dictionary)

The concept of opportunity cost as outlined by the definitions, indicate that a choice has to be
made in regards to which good or service should be bought or produced. The general task of
making these decisions is left to individuals, householder, firms and the government.
As a student of economics one must be constantly aware of the choice you have to make
and what you give up for that choice to follow through. Future questions may ask you to
identify how opportunity cost is applied to various situations and what are the
implications of it.
Production Possibility Frontier (PPF)
The production possibility frontier is a curve depicting all maximum output possibilities for two
or more goods given a set of inputs (resources, labour, etc.). The PPF assumes that all inputs
are used efficiently (Investopedia).

The PPF is a graphical representation of the total potential output of two or more goods
considering the resources available (Mortley, 2012).

To understand the PPF you must realise its two major assumptions:

For this level the market only produces two (2) goods and all resources are specialised for the
production of those goods.

To understand how the frontier works you have to understand construct the frontier.

1. Draw a pair of axes labelled with each good. (for e.g. sugar and bauxite)

2. Calculate the maximum productive capacity for each good(for e.g. 1000 units)

3. Construct a schedule of the distribution between goods(this shows opportunity cost and

accounts for the shape of the PPF)

4. Plot the points on the pair of axes

5. Construct the curve

6. Always give comments on the curve(and every other curve you draw throughout your life

studying economics)
 A diagram showing the Production Possibility Frontier (PPF) for Sugar and Bauxite

Sugar

1000
A
800 .D
B
500

.C .E

700 900 1000 Bauxite

Notes:
1. Any point outlined that is on or below the PPF (ie A, B, C, E) are considered to be
attainable.
2. Any point outside of the curve(i.e. D) is considered to be unattainable
3. Points that are located on the PPF are as a result of the full utilization of the resources
available. They are also regarded as efficient levels of production
4. Inefficient levels of production are production points either above or below the PPF
being either attainable or unattainable based on the resources available.

Analysis:
At „A‟, 800 units of sugar and 700 units of bauxite are being produced. Increasing bauxite
production to 900 units requires a reduction of sugar by 300 units. That is, the additional 200
units of bauxite required that the producer give up 300 units of sugar. This mode of analysis can
be used for all movements along the PPF.

Any increase in technology or economic growth may push the PPF outwards. That is, an increase
in the amount of resources available or an improvement in technology will cause the PPF to shift
to right so that combinations that were unattainable [„D‟] can now be produced.
NB: Movements along the PPF are caused by an adjustment to the special resources from one
good to the other and Shifts in the PPF generally outwards are caused by increases in the
resources available.

Method of Economics
Positive Economics – An approach to economics that seeks to understand behaviour and the
operations of systems without making judgements. It describes what exists and how it works.
What determines the price in a market? The answer to this question would be the subject of
Positive economics.

Normative Economics- An approach to economics that analyzes outcomes of economic

behaviour, evaluates them as good or bad, and may prescribe courses of action (policy
economics). Should theGovernment subsidize Tertiary education? The answer to this question
would be the subject of Normative economics.

Economic Theory –A Statement or set of related statements about the cause and effect, action
and reaction.

Model: A formal statement of a theory, usually a mathematical statement of a presumed

relationship between two or more variables.

Variable: A measure that can change from time to time or from observation to observation.

Rational choice

A rational choice is one that uses the available resources to most effectively satisfy the wants of
the person making the choice. {Only the wants and preferences of the person making a choice
are relevant to determine its rationality.}

Types of Economic Systems

Your instructor may ask you to do a research on this portion of the syllabus but the most
important points to note are the differences between the systems.

There are four types of systems:

1. Traditional
2. Planned
3. Mixed
4. Market
Theory of Consumer Demand

Utility
No is does not refer to utility bills like your electricity or water charges, but it solely based on the
concept of consumer satisfaction. So in economics , instead of saying the consumer was fully satisfied
with his purchase. We use the word Utility.

There are two main approaches to the utility concept:

1. The Cardinal Approach- This method assumes that a consumers utility can be quantified into
units which are measured as UTILS.
2. The Ordinal Approach – This method assumes that consumer’s satisfaction cannot be measure
but consumers will rank their consumption into bundles that represent the same level of
satisfaction or utility. This level of satisfaction bundle is represented on an indifference
curve(We will address Indifference Curve Analysis further on in the book)

Total Utility – Simply Defined as the total level of satisfaction that a consumer receives from consuming
a good or service

Marginal Utility- this refers to the difference in the level of total utility based on a single unit change in
the unit of a good i.e. the satisfaction from each additional unit of good or service consumed.

Pay keen attention to this concept as further analysis will have to be done on this area

The formula to calculate Marginal Utility (MU) = ∆TU/∆ Consumption (since it is a one unit change)

The revised formula for MU=∆TU

Law of Diminishing Marginal Returns

If you are thirsty and you buy 10 bottles of Pepsi, after the first one you feel very satisfied, after the
second you still feel satisfied but not as much as the first and the trend continues all the way to the
tenth Pepsi. The law of diminishing returns states that the more of a good or service is consumed the
marginal Utility increases at a decreasing rate. This implies that even though the total utility increases
after a certain amount of goods the rate at which the consumers thirst is quench is far less than in the
beginning.

The table below shows the results up to the 7th Pepsi. You can observe that even though the total utility
is increasing the marginal utility starts decreasing after the second Pepsi.
 Quantity of Pepsi’s Total Utility (TU) Marginal utility (MU)
0 0 -
1 100 100
2 290 190
3 350 170
4 420 150
5 500 80
6 550 50
7 570 20

Indifference Curve Analysis

This is an approach to the study of consumer behaviour without the use of quantitative means. An
indifference curve is a curve that shows all the combinations of goods that provide the consumer with
the same level or satisfaction (utility).

Good a

Y
IC2
W
Z
IC 1
X

Good B

Notes:

 The consumer will be indifferent between W and X since they are on the same indifference
curve
 The consumer will prefer either Y or Z as they fall on a higher indifference curve and thus
maximise utility
 The indifference curves never meet
  Each pair of axes can have thousands of indifference curves as consumer utilities and
preference are so variegated.
The Budget Constraint
We are going to assume that:
 There are only two goods
 Prices are given….the consumers cannot affect the price of the good.
 The consumer spends all his/her income on the two goods

The budget line shows the boundary between what is affordable and what is not. It describes
the limits to consumption choices and depends on the consumer’s income and prices.
The household’s consumption choice is constrained by the household’s income and by the price
of the goods and services.

Graphical representation of the household budget line for goods A and B:

Good A Al- upper limit for good A

Al Bl- Upper limit for good B

Bl Good B
If the price of good B decreases budget line will pivot as is become more affordable to purchase good B

Good A

Al

Good B

Bl0 Bl1
If the level of household income increases the entire Budget line can shift outwards as it is now more
affordable to purchases increased quantities of both goods.

Good A

Bl0 Bl2

Good B

Consumer Equilibrium
The objective of each consumer is to maximise his or her utility subject to their budgetary constraint.
This means that a consumer will decide to choose a bundle of products that he/she can afford.

The consumer will choose to maximise

their utility at the point where the
Good A
budget line is tangent to the
Ic indifference curve i.e. at point Y
Y 2
IC 0
IC1

Bl
Good B
Equi-Marginal Principle
This equality says that the consumer maximises utility at the point where the last dollar spent on each
good yields the same Marginal Utility(MU).

MUa/Pa=MUb/Pb

If MUb/Pb>MUa/Pa then consumers will increase their consumption of good b and this would reduce
the MU of good B according to the law of diminishing marginal utility.

Income - Consumption curve and Engel Curve

How does a change in the consumer’s income affect the optimal choice?

Cars

Income consumption curve

Food

Income
Engel curve

The Income consumption curve is the locus of consumer optimum points resulting when only the
consumer’s income varies

The Engel curve shows the amount of a good that the consumer would purchase per unit of time at
various income levels
Price consumption curve and demand curve
This curve is derived by changing the price of one good (B) and holding all others constant (ceteris
Paribus). The PCC for good B is the focus of consumer optimum points resulting when only the price of
good B varies. The demand curve of for the good shows the quantity of good B that the consumer would
purchase per unit of time at varying prices.

Cars

Food

Price

Demand Curve

Food

The demand curve is plot of the demand function, X 1 ( P1 , P2 , M ) holding P2 , M constant

X1
0 P1 X1
P1
Income and Substitution Effects
Whenever the price of a good change there are two effects:

1) Substitution effect
2) Income effect
Substitution effect: this is the change in consumption due to the change in relative prices. When the
price of good changes one of the goods become relatively cheaper. Rational consumers will substitute
towards the cheaper good. To separate the substitution effect we hold utility constant; consequently
the substitution effect is measured along the IC. The substitution effect is always negative; opposite the
price change.

Income Effect: Results from a change in purchasing power. It can either be negative or positive;
depending on whether the good is normal of inferior.

Income and Substitution Effect for a Normal good

1) Substitution effect Negative

Cars
- P Food

2) Income effect Positive

- M Food
Substitution Effect
3) Income effect reinforces the sub
Income Effect effect.

Foods

Income and Substitution Effect for an Inferior good

1) Sub effect Negative

Cars - same as above

Substitution Effect 2) Income effect Negative

M Food

Income Effect 3) Inc. effect < Sub. Effect

4) Inc. effect opposite Sub. effect

Food
Income and Substitution Effect for a Giffen good
1) Sub. effect negative

Cars - same as above

Substitution Effect 2) Inc. effect Negative

- same as above

Income Effect 3) Inc. effect > Sub effect

4) Inc. effect opposite Sub. effect

Food

ENSURE THAT GRAPHS ARE COMPLETELY,CAREFULLY LABELLED AND

THAT A DESCRIPTIVE ANALYSIS IS ALWAYS GIVEN.
Demand: Theory, Application and Elasticity

The quantity demandedof any good or service is the amount that people are willing and able to
buy during a specified period at a specified price.

Quantity demanded is measured as an amount per unit of time – e.g. 2 socks per day

The law of demandstates that there is a negative relationship between price and quantity
demanded; ceteris paribus, as the price of a good increases the quantity demanded must fall.

Demandis the relationship between the quantity demanded and the price of a good when all
other factors remain constant. The quantity demanded refers to a specific quantity at a specific
price while demand is a list of quantities at different prices illustrated by a demand schedule and
demand curve.

Demand scheduleis a table showing how much of a good an individual would be willing to buy
at different prices.

Demand Schedule for Patty

Qty Demanded [Patties

Price [$/Patty]
per day]

A 20 0

B 15 1

C 10 2

D 5 3
Demand Curve is graphical representation of how much of a good an individual would be
willing to buy at different prices.

Demand Curve for Patties

Price

Qty/day
A change in the quantity demanded [movement along the demand curve] of a good is caused
solely by a change in the price of the good.

Price

 When the price of a good

increase from P1 to P2 then the
P2 A
effective change is that the level
P1 of quantity demanded will move
B
from B to A showing the
negative relationship between
quantity demanded and price.
 When the price decreases from
Q2 Q1 P2 to P1 then the quantity
Qty/day demanded will move from A to
B. Showing the reverse of the
previous
A change in demand [shift the entire demand curve] is brought about by condition.
a change in the original
conditions; any factor other than price.
Price
If the overall level of demand increases the
demand curve shifts to the right or from D1
to d3

If the overall level of demand decreases the

demand curve will contract, or move to the
left represented by a shift from D1 to D2

D2 D1 D3
Qty/day

Factors that affect demand:

 Price of related goods: A change in the price of one good can affect the demand of a
related good. The nature of this change depends on the nature of the relationship between
the two goods; related goods can either be substitutes or compliments.

Substitutes are goods that can be consumed in place of each other, e.g. butter and Margarine.The demand
for a good will increase/ (decrease) if there is an increase/ (decrease) in the price of one of its substitutes.
This means that the demand for a good and the price of its substitute moves in the same direction.

Complementsare goods that are consumed together, e.g. bun and cheese.The demand for a good
increases/decreases if the price of its compliment decreases/increases. This means that the demand for a
good and the price of its compliment move in opposite directions.

 Income: The demand for a good is also affected by changes in the consumer‟s income.
Where the increase in income leads to an increase in demand the good is classified as a
normal good. If, however, the increase in income results in a decrease in demand then the
good is classified as an inferior good.
  Expectations: Expectations of future prices and income will affect the demand for goods and
services.

 Number of buyers: The greater the Number of buyers in a market the larger is the demand.

 Preferences: A consumer‟s demand for a particular good will depend on that consumer‟s
tastes and preferences. Whenever there is a change in preferences, the demand for one
good will increase and the demand for another will decrease.

Elasticity of Demand

Price elasticity of demand is a measure of the extent to which the quantity demanded of particular goods
change when there is a change in the price of the good, (ceteris paribus).Price elasticity of demand is
calculated by dividing the percentage change in quantity demanded by the percentage change in price:

% in quantity dem anded

% in price

Calculating the percentage changes: The Mid-Point Method

new Q ty old Q ty
% in Q ty *100
new Q ty old Q ty / 2

new price old price

% in price *100
new price old price / 2

Note: Due to the law of demand, the sign of the % change in demand will be opposite the sign of the %
change in price. Therefore, the price elasticity of demand will always be negative. However, it is
customary to express elasticity as a positive number.

Elasticity and the shape of Demand curves

The size of the elasticity measure is used to classify demand curves as either: Elastic, Inelastic or Unitary
elasticity.Demand is considered elastic if the percentage change in the qty demanded exceeds the
percentage change in price. In this case we say that demand is very responsive to price changes. There is
one particular case where demand is so responsive to price changes that changes in price do not affect the
demand. In this case we say that demand is perfectly elastic.When demand is perfectly elastic any change
in price will lead to an infinite change in quantity demanded.

Perfectly elastic Demand Curve

Price

Demand curve

Qty

Demand is considered inelastic if the percentage change in the qty demanded is less than the percentage
change in price. In this case we say that demand is not responsive to price changes. There is one particular
case where demand is very unresponsive to price changes. In this case we say that demand is perfectly
inelastic.When demand is perfectly inelastic price changes will not affect the quantity demand.

Perfectly inelastic Demand Curve

Price

Demand curve

Qty
When the percentage change in demand equals the percentage change in price we say that demand is unit
elastic.

Unit elastic Demand Curve

Price

Demand curve

Qty

Factors that affect the Price Elasticity of Demand (PED)

Availability of substitutes: The more close substitutes a good has the more elastic its demand
will be since consumers can easily switch to cheaper goods if its price should rise.

The nature of the goods (luxury vs. necessity)the price elasticity of luxury goods is usually
more elastic than that of necessities.

The definition of the good (narrow or broad): The broader the definition of a good the less
elastic is its demand. The narrower is its definition the more elastic is its demand. For example,
the demand for vegetables is very inelastic compared to the demand for canned carrots, which is
more elastic.

Passage of time: the demand for some products is more elastic in the long run than in the short
run and vice-versa.

Fraction of income spent on the good: goods that consume a large proportion of income tend
to have more price elastic than goods that don‟t. for example, a 10% increase in the price of salt
would barely affect its demand, while a 10% increase in the price of cars would have a
significant effect on the demand for cars.
Total Revenue and Price Elasticity of Demand
A major concern to the producer is the effect that a price change will have on total revenues.
Total revenue is equal to price times quantity. Therefore, a price increase, will have two
opposing effects;

 Revenues will increase, since each unit sold goes for a higher price
 Revenues will decrease, since fewer units will be sold at the higher price.

Price

A - Increase in revenues due

to price increase

B - Decrease in revenues
A
due to reduced quantity

Qty

If area A is larger than area B, then the increase in price will increase revenues. Demand is
inelastic. If area A is smaller than area B, then the increase in price will decrease revenues.
Demand is elastic. If area A is equal to area B, then the increase in price will not affect revenues.
Demand is unit elastic.

The total effect will therefore depend on which change is greater. Now, if demand is elastic, then
the increase in price will lead to a greater than proportional decrease in quantity demanded. This
suggests that where demand is elastic, a price increase will lead to a fall in revenues.

When demand is inelastic, the increase in price will lead to a less than proportional decrease in
quantity demanded. This suggests that a price increase where demand is inelastic will increase
revenues. For example, if price increases by 10% and quantity demanded falls by 5%, then
revenues will increase and we say that demand is inelastic.

Where demand is unit elastic the increase in price will lead to an equal proportional reduction in
demand suggesting that revenues will not change. For example, if price increases by 10% and
quantity demanded falls by 10%, then revenues will remain unchanged and we say that demand
is unit elastic.

Cross Elasticity of Demand

Cross elasticity of demand is a measure of the extent to which the demand for a good changes
when the price of another good changes, ceteris paribus. Cross elasticity of demand is calculated
by dividing the percentage change in quantity demanded of good A by the percentage change in
price of good B:

% in quantity dem anded good A

% in price of good B

Now, this measure of elasticity falls into three ranges:

 [CED< 0]; implies that good A and good B are Complements. For example, an increase in
the price of bun may reduce the demand for cheese
 [CED> 0]; implies that good A and good B are Substitutes. For example, an increase in
the price of tea may increase the demand for coffee
 [CED= 0]; implies that good A and good B are unrelated.

Income Elasticity of Demand

Income elasticity of demand is a measure of the extent to which the demand for a good changes
when income changes, ceteris paribus. Income elasticity of demand is calculated by dividing the
percentage change in quantity demanded by the percentage change in income:

% in q u a n tity d em a n d ed
% in in co m e

Now, this measure of elasticity falls into three ranges:

 income elastic [YED<1]; implies normal good

 income inelastic [0 < YED< 1]; implies normal good
 [YED< 0]; inferior good
Theory of Supply

Production
Production can be defined as the creation of value; or the design of articles
having exchange value. We generally start out by looking at production in the short run.

Short run: - this is a time frame in which the quantities of some resources are fixed. Examples
are technology and capital.

Long run: - this is a time frame in which all the factors of production are variable.

Fixed factors: - factors that cannot be varied in the short run

Variable factors: - factors that can be varied in the short run to increase or decrease the level of
production.

Production function - The production function relates the output of a firm to the amount of
inputs, typically capital and labour.

Assume the following:

 Production is in the short run

 Only one factor of production is variable

We have three fundamental questions to answer.

 What is the relationship between the quantity of inputs used and the quantity of
production?
 What is the relationship between the input decisions of the firm and its cost
structure?
 How do firms select the optimal quantity of a particular resource?
Total product: - is the total quantity of a good produced in a given period. TP is an output rate –
the number of units produced per unit of time. Example, the TP schedule lists the max quantities
of bottled water per hr that a firm can produce with its existing plant at each quantity of labour.

Labour (TP) (MP) (AP)

Gallons/hr gallons/L

0 0 0

1 1 1 1

2 3 2 1.5

3 6 3 2

4 8 2 2

5 9 1 1.8

6 9 0 1.5

7 8 -1 1.1

Graph of Total Product

9
8
7
6
5
4 (TP)gallons/Hr
3
2
1
0
0 1 2 3 4 5 6 7

Marginal Product: - is the change in total product that results from a one unit change in the
quantity of labour employed holding all other inputs constant.

TP
MP
L
 Graph of Marginal Product

3
2.5
2
1.5
1
Marginal Product
0.5
0
-0.5
-1
0 1 2 3 4 5 6 7

Graph of Average Product

2
1.8
1.6
1.4
1.2
1
Average Product
0.8
0.6
0.4
0.2
0
0 1 2 3 4 5 6 7

Graph of TP, MP and AP

10

tp
product

4
mp
ap

0
0 1 2 3 4 5 6 7

-2

labour
The Theory of Costs

What is the relationship between the input decisions of the firm and its cost structure?(Assume
short term conditions)

Total Cost (TC):- this is the cost of all the factors of production used by the firm. It can be
divided into two categories: total fixed cost and total variable cost.

Total Fixed Cost (TFC):- this is the cost of a firm‟s fixed factors such as land, capital and
entrepreneurship. Since, in the short run, these factors do not vary with output, TFC does not
change as output changes.

Total Variable Cost (TVC):- this is the cost of a firm‟s variable factors of production – labour.
Since the variable factor must change for output to change in the short run, TVC changes as
output changes.

Worker/Hr Gallons/Hr TFC TVC TC MC AC AFC AVC

0 0 10 0.00 10.00 0.00 0.00 0.00

1 1 10 6.00 16.00 6.00 16.00 10.00 6.00

1.6 2 10 9.60 19.60 3.60 9.80 5.00 4.80

2 3 10 12.00 22.00 2.40 7.33 3.33 4.00

2.35 4 10 14.10 24.10 2.10 6.03 2.50 3.53

2.7 5 10 16.20 26.20 2.10 5.24 2.00 3.24

3 6 10 18.00 28.00 1.80 4.67 1.67 3.00

3.4 7 10 20.40 30.40 2.40 4.34 1.43 2.91

4 8 10 24.00 34.00 3.60 4.25 1.25 3.00

5 9 10 30.00 40.00 6.00 4.44 1.11 3.33

 Graph of TVC, TFC and TC

45
40
35
30
TFC
Costs

25
TVC
20
TC
15
10
5
0
1 2 3 4 5 6 7 8 9 10
Gallons/Hr

TVC and TC increase at a decreasing rate at low levels of output and then starts to increase at an
increasing rate at higher levels of output. However, to fully understand the pattern of TVC and
TC we need to examine the Marginal and Average costs.

Marginal Costs: - is the change in TC that results from a one unit change in output.

TC
MC
Q

Average Cost: - is the total cost per unit of output. It can be expressed as average fixed cost plus
average variable cost.

TC
AC ( AFC AVC )
Q

TFC
Average Fixed Cost: - is TFC per unit of output. AFC
Q

Average Variable Cost: - is TVC per unit of output.

TVC
AVC
Q

Graph of MC, AVC, AFC and AC

 18.00
16.00
14.00
12.00 MC
10.00 AC
Costs

8.00 AFC
6.00 AVC
4.00
2.00
0.00
0 1 2 3 4 5 6 7 8 9
Gallons/Hr

The AVC and AC curves are u-shaped.

The vertical distance between the two is the AFC, which shrinks as output increases because
AFC shanks as output increases.

The MC curve is also U-shaped and intersects the AVC & AC at their Minimum points.

When MC < AC, AC decreases. When MC > AC, AC increases.

Why the AVC and AC are curves U-shaped?

The shape of the AVC and AC arises from two opposing forces.

 Spreading TFC over a larger output

 Decreasing marginal returns

When output increases TFC is spread over a larger output, thus AFC decreases (slopes
downward). However, as output increases VC increase at a faster rate than output, thus AVC will
increase (slope upward).Initial increases in output will cause both AFC and AVC to fall;
however, as output continues to increase AVC will begin to rise while AFC continues to fall.
Since AFC approaches zero as output increases, AC will eventually take the shape of the AVC
curve.
 Relationship between Cost and Product Curves

Graph of MP and AP

3.5
3
2.5
2
AP and MP

1.5
MP
1
AP
0.5
0
-0.5 0 1 2 3 4 5 6 7
-1
-1.5
Workers

Graph of MC and AVC

 7.00

6.00

5.00

4.00
Costs

MC

3.00 AVC

2.00

1.00

0.00
0 1 2 3 4 5 6 7 8 9
Gallons/Hr

At low levels of employment and output:

 As the firm hires more labour, MP & AP rise and output thus rises faster than costs so
that AVC & MC falls.
 At the Maximum of MP, MC is at its minimum. As still more labour is employed MP
falls MC rises.
 AP will continue to rise up to the point where MP = AP (at this point AP is at its
maximum). If the firm continues to hire labour after this point then MP < AP and this will
cause AP to fall.
 When AP is at its max AVC will be at its min. The subsequent fall in AP will cause AVC
to rise.

Shifts in the Cost Curves

The discussion so far has revealed that the position of the firms short run cost curves is
dependent on the technology used by the firm as well as the price of the factors of production.

Long Run Analysis

We now relax the short run assumption.

Recall that in the long run a firm can vary all the factors of production.

The question that must be answered is, how does this variation affects the cost structure of the
firm?
For example, suppose the firm is able to vary its plant size, how would this affect its AVC?

Would AVC increase, decrease or remain the same?

All three possibilities exist. When a firm increases its plant size it may experience:

 Economies of Scale
 Diseconomies of Scale
 Constant returns to scale
Economies of Scale: - this occurs when an equal percentage increase in both plant size and
labour is matched by a larger percentage increase in output thus leading to a reduction in AC.

Diseconomies of Scale: - this occurs when an equal percentage increase in both plant size and
labour is matched by a smaller percentage increase in output thus leading to an increase in AC.

Constant returns to scale: - this occurs when an equal percentage increase in both plant size
and labour is matched by a similar percentage increase in output thus leading to constant AC.

The Long Run AC Curve:-shows the lowest AC at which it is possible to produce each output
when the firm has had sufficient time to change both its labour force and its plant size.

Increasing Marginal Returns: - this occurs when the marginal product of an additional worker
exceeds the MP of the previous worker. IMR usually occurs when a small # of workers are
employed and arise from increased specialization and division of labour in the production
process.

Decreasing Marginal Returns: - this occurs when the MP of an additional worker is less than
the MP of the previous worker. DMR arise from the fact that more and more of the variable
factor (labour) is added to the fixed factors.

The law of Diminishing Marginal Returns: - this law states that as additional quantities of the
variable resources are combined with a given amount of fixed resources, a point is eventually
reached where each additional unit of the variable resource yields a smaller MP.

Average Product: - is the total product per worker employed.

TP
AP
L

AP is largest when it is equal to MP. That is, MP cuts AP at the max of AP.

When MP > AP, AP will increase

When MP < AP, AP will decrease

Supply: Theory, Application and Elasticity
The quantity supplied of a good or service is the amount that producers are willing to and able to
sell during a specified period at a specified price.It is measured in quantity supplied per unit of
time.

The law of supply states that there is a positive relationship between price and quantity supplied.

 an increase in price is usually followed by an increase in qty supplied

 a decrease in price is usually followed by a decrease in qty supplied

Supply is the relationship between the quantity supplied and the price of a good when all other
factors remain constant. The quantity supplied refers to a specific quantity at a specific price
while supply is a list of quantities at different prices illustrated by a supply schedule and supply
curve.

A Supply schedule is a table showing how much of a good an individual would be willing to
supply at different prices.

Supply Schedule for Patty

Qty Supplied [Patties

Price [$/Patty]
per day]

A 20 3

B 15 2

C 10 1

D 5 0
A supply Curve is graphical representation of how much of a good an individual would be
willing to supply at different prices.

Supply Curve for Patty

Price

Qty/day

A change in the quantity [movement along the supply curve] supplied of a good is caused solely by a
change in the price of the good.

A change in supply [shift the entire supply curve] is brought about by a change in the original conditions;
any factor other than price.

Price

S1
Key
S0
- Green: decrease in supply
S2
- Purple: increase in supply
- Red: increase in quantity supplied
- Blue: decrease in quantity supplied

Qty
Factors that affect Supply:
Prices of related goods: A change in the price of one good can affect the supply of a related
good. The nature of this change depends on the nature of the relationship between the two goods;
related goods can either be substitutes in production or compliments in production.

Substitutes in Production are goods that can be produced in place of each other, eg., butter and
Milk. The supply of a good will increase/ (decrease) if there is a decrease/ (increase) in the price
of one of its substitutes in production. This means that the supply for a good and the price of its
substitute in production moves in opposite direction.

Complements in productionare goods that can be produced together, e.g., beef and cow hide
[used to make leather]. The supply of a good will increase/decrease if the price of its compliment
in production increases/decreases. This means that the supply of a good and the price of its
complement in production move in the same direction.

Prices of resources and other inputs: The supply of a good will change if there is a change in
the price of one of its inputs [input prices affect the cost of production]. The more it costs to
produce a good the less will be supplied at each price and vice-versa {ceteris paribus.}
Productivity: This is defined as output per unit of input. An increase in productivity leads to a
reduction in costs and thus leads to an increase in supply. A decrease has the opposite effect. The
main source of productivity changes is technological change; however, some natural events also
affect productivity.
Expectations: Expectations about future prices have a big influence on supply.

Number of sellers: The greater the number of sellers in a market, the larger is the supply.
The Price Elasticity of Supply(PES)
Price elasticity of supply is a measure of the extent to which the quantity supplied of a particular
good changes when there is change in the price of the good, ceteris paribus. Price elasticity of
supply is calculated by dividing the percentage change in quantity supplied by the percentage
change in price:

% in quantity supplied
% in price

Elasticity and the shapes of Supply curves

The size of the elasticity measure is used to classify supply curves as either: Elastic, Inelastic or
Unitary elasticity.

Supply is considered elastic if the percentage change in the qty supplied exceeds the percentage
change in price. In this case we say that supply is very responsive to price changes. There is one
particular case where supply is very responsive to price changes. In this case we say that supply
is perfectly elastic. When supply is perfectly elastic any change in price will cause quantity
supplied to fall to zero.

Perfectly elastic Supply Curve

Price

Supply curve

Qty

Supply is considered inelastic if the percentage change in the qty supplied is less than the
percentage change in price. In this case we say that supply is not responsive to price changes.
There is one particular case where supply is very unresponsive to price changes in this case we
say that supply is perfectly inelastic .When supply is perfectly inelastic any change in price will
not affect quantity supplied.
Perfectly inelastic supply Curve

Price

Supply curve

Qty

When the percentage change in supply equals the percentage change in price we say that supply is unit
elastic.

Unit elastic supply Curve

Price Supply curve

Qty
Consumer Surplus

Only the marginal consumer is willing to pay just the market price in typical supply and demand
equilibrium. Consumers would be willing to pay more than the market prices which is what
makes the demand curve slope downward. The amount that these consumers would be willing to
pay, but do not have to pay is known as the consumer surplus.The diagram below is borrowed
from Who Pays a Sales Tax?, which applies this concept (Econmodel.com).

Producer Surplus

The supply curve slopes upward because, given a market price, there are producers who can
produce profitably at a price below that market price. The revenues to producers that exceed the
minimum amount that they would have to receive is known as the producer surplus.
 MARKET EQUILIBRIUM
Market equilibrium occurs when the quantity demanded equals the quantity supplied.

- The equilibrium price is the price at which the quantity demanded equals the quantity
supplied.
- The equilibrium quantity is the quantity bought and sold at the equilibrium price.

Graphical Representation of Equilibrium

Price
Supply
$

5 Market
Equilibrium

Demand

50 Qty/day

Note that at equilibrium, quantity supplied is equal to quantity demanded. Whenever this
equilibrium is disturbed, market forces will restore it.

Price is the regulator that pulls the market toward its equilibrium.

- If the price is above the equilibrium price, then there is a surplus or excess supply;
quantity supplied exceeds quantity demanded. In this case the price will fall to restore
equilibrium
- If the price is below the equilibrium, then there is a shortage or excess demand; the
quantity demanded exceeds the quantity supplied. In this case the price will increase to
restore equilibrium.

The law of market forces states that, when there is a shortage the price rises and when there is a
surplus the price falls; in both cases the move is such that equilibrium is restored.
Illustration of Surplus and Shortage

Price Surplus
Supply Quantity demanded = 40
$
8 Quantity supplied = 65
Market
5 Equilibrium Surplus = (65 – 40) = 25

Price will fall to $5, where qty

demanded = qty supplied.

Demand

40 65 Qty/day
50

Price Shortage
Supply Quantity demanded = 65
$
Quantity supplied = 40
Market Shortage = (65 – 40) = 25
5 Equilibrium
3 Price will increase to $5, where qty
demanded = qty supplied.

Demand

40 65
50 Qty/day
The Effects of Changes in Demand

So
An increase in Demand

- shifts the demand curve to

D1
- raises price
D1 - raises qty supplied
- increases equilibrium qty
D0

A decrease in Demand
So
- shifts the demand curve to D2
- lowers price
- lowers qty supplied
- decreases equilibrium qty

D0
D2

The effects of changes in supply

S0
S1
An increase in Supply

- shifts the supply curve to S1

- lowers price
- raises qty demanded
- increases equilibrium qty
D0

S2

So A decrease in supply

- shifts the supply curve to S2

- raises price
- lowers qty demanded
- decreases equilibrium qty

D0
The effects of simultaneous changes in supply and demand

Increase in supply and demand

S0 S1
Effect of an increase in:

Variables Demand Supply Total Effect

Price Raise Falls Ambiguous

Quantity Raise Raise Increases

D1

Decrease in supply and demand Effect of A Decrease in:

Variables Demand Supply Total effect

Price Falls Raise Ambiguous

Quantity Falls Falls Decrease

Increase in demand and decrease in supply

Variables Increased Decreased Total

Demand Supply Effect
Price Raises Raises Increase

Quantity Raises Lowers Ambiguous

Decrease in Demand and Increase in Supply

Decrease Increased
Variables Total Effect
Demand Supply
Price Lowers Lowers Decrease

Variables Lowers Raises Ambiguous

Module 2
Market Structure, Market Failure and Intervention

 Market Structure

 Market Failure

 Intervention
Market Structure

The Firm
The objective for this portion of the course is basically to examine the market system, which is
the process by which scarce resources are allocated. We have shown thus far that resources are
allocated through the market via a pricing mechanism. Therefore, we want to find out how are
prices determined. So far we have discovered that prices are determined by the interaction of
demand and supply.

The objective of any firm is to maximize profits, which is the difference between total revenue
(from the sale of output) and the opportunity cost of attracting resources to the firm. But the
other goals of the firm are growth, satisficing, sales and revenue maximization and market
dominance.

Profits:
1. Accounting Profit: - total revenue minus explicit costs. Accounting profit ignores the
opportunity costs of using one‟s resources.
2. Economic profit: - total revenue minus all costs (both explicit and implicit). Economic
profit accounts for opportunity cost.
3. Normal profit: - the accounting profit earned when all resources used by the firm earn
their opportunity cost.

Accounting profit above normal profit is economic profit.

Howdo firms select the optimal quantity of a particular resource?

Assume: Perfect competition (

Variable input (labour) wage rate (w)

Fixed factor (capital) interest rate (r)

Definitions

Production Function: - identifies the maximum quantities of a particular good or service that can

Be produced per period of time with various combinations of resources,

for a given level of technology.

Output

Input

Isocost Lines: - gives all the combinations of factors that yield the same cost.

TC w*L r *C

TC
With labour alone: TC w*L L
w

TC
With capital alone: TC r *C C
r

Graph of Isocost Line

Capital

Labour
 rise TC / r w
Slope Ratio of the factor prices
run TC / w r

Isoquant Line: - gives all the combinations of inputs that yield the same level of output.

Graph of Isoquant Line

Capital

Labour

Properties:

1. Convex to the origin 3. Negatively sloped

2. Do not intersect 4. Further from origin yields higher level of

output

Slope: the slope of the isoquant is called the Marginal Rate of Technical Substitution (MRTS).

MP L
MRTS
MP C

The MRTS is the rate at which the labour can be substituted for capital without affecting
output.The objective of the firm is to maximize profits. There are circumstances under which
maximizing profits is the same as minimizing costs. Therefore, the firm will choose its inputs
such that profit is maximized or cost is minimized.Now, how does the firm goes about achieving
these objectives?
Minimizing costs

1. For a given level of output, the firm will choose the lowest isocost curve that is tangent to the
given isoquant in order to minimize costs.

Maximizing profits

2. For a given cost, the firm will choose the highest isoquant that is tangent to the given isocost in order to
maximize profits.

Capital

Labour

Therefore, the input decision is determined by the slopes of the isocost and isoquant curves, i.e.,
the firm will choose its inputs such that the slope of the isocost curve is equal to the slope of the
isoquant curve.

w MP L
r MP C

This point is characterized as a point of tangency.

Profit Maximization under Perfect Competition
The firm‟s objective is to maximize economic profit, this is achieved by: Deciding how much
to produce [in the short run] and deciding whether or not to enter or exit a market [in the long
run]

Note that firms in a perfectly competitive market are price takers; they can sell as much as they
can at the prevailing market price.

Revenue Concepts

Total Revenue [TR]: is equal to price multiplied by quantity. It is the revenue earned from the
sale of the firm‟s output.

TR

TR

Qty

Marginal Revenue [MR]: is the change in total revenue that results from a one unit increase in
the quantity sold. Note that under perfect competition MR is equal to price. This is due to the fact
that the firm can sell any amount at the market price, therefore, if the firm sells an additional unit
of output it does so at the market price and thus TR increases by that amount. But the increase in
TR is the MR, which also happens to be the price.

Price

MR

Qty
Profit Maximizing Output

Recall that as output increases, TR increases. But TC also increases; and because of decreasing
marginal returns, TC eventually increases faster than TR.

The firm‟s objective then is to find the output level at which the difference between TR and TC
is maximized. This occurs when the vertical distance between TR and TC is greatest.

TC TR

TC & TR

Qty

Marginal Analysis

Another way to identify the profit maximizing level of output is to use marginal analysis; that is,
consider the MR and the MC at each output level. Recall that as output increases MR remains
constant but MC eventually increases.

1. If MR exceeds MC, then the extra revenue from selling one more unit exceeds the extra
cost incurred to produce it. This implies that economic profit will increase if output
increases.
2. If MR is less than MC, then the extra revenue from selling one more unit is less than the
extra cost incurred to produce it. This implies that economic profit will decrease if output
increases.
3. Therefore economic profit is maximized at the output level where MR is equal to MC.
MR &MC

MC

MR
 Output

The profit maximizing qty is the qty supplied at the specified price. If the price were higher the
qty supplied would increase; if the price were lower the qty supplied would decrease hence the
“law of supply”. Illustrate by shifting the MR curve up and down and show that the
maximizing qty would increase and decrease respectively.

Exit and Temporary shutdown conditions [Short Run]

In the short run firms may be making an economic loss which they believe is temporary. If this is
so they may decide to stay in operation or shut down temporarily. To make this decision, the
firm will compare the loss it would make in the two situations. If the firm decided to shut down it
would make a profit equal to the negative of the fixed costs of operation. If the firm decided to
produce some output it would make a profit equal to TR minus (TFC + TVC).

First Possibility

The firm will shut down if the profit it makes from shutting down is greater than the profit it
makes from staying in operation.

TFC TR TFC TVC

TFC TFC TVC TR Show that in this case P<AVC [TR=P*Q]
TVC TR

That is, if TR is less than TVC then the loss would be greater than TFC. As such it would suite
the firm to shut down since the loss incurred would be less than if it continued operation.

Price

MC ATC AVC

MR=P
 Output

Second Possibility

The firm will stay in operation if the profit it makes from staying in operation is greater than the
profit it makes from shutting down.

TFC TR TFC TVC

TFC TFC TVC TR Show that in this case P>AVC [TR=P*Q]
TVC TR

That is, if TR is greater than TVC then the loss would be less than TFC. As such it would suite
the firm to continue operating since the loss incurred would be less than if it shut down.

Price MC ATC AVC

MR=P

Output

Therefore, as long as the firm can cover its variable costs it will stay in business in the short run. That is,
as long as the price is greater than the minimum AVC the firm can maximize profit by producing where
MC=MR=P. If price is below AVC the firm shuts down. This implies that the firm‟s supply curve is the
portion of the MC curve above the minimum of the AVC curve.
 Price shutdown point Supply curve

AVC

MR=P

Output

The market supply curve is the horizontal summation of the individual firm‟s supply curves.

Price

Qty
Market Equilibrium and SR profit maximization

Price

MC

S ATC

MR=P

Qty

Price is determined by the market demand and supply……each firm is then able to sell all they
can at that price…….thus the demand curve facing each firm is flat [perfectly elastic].

Perfect competition in the long run

In the long run firm‟s make zero economic profit; i.e., they only make normal profit.

If economic profit existed in the short run it will act as an incentive for

1. new firms to enter the market OR

2. for existing firms to expand production
In either case market supply will increase…..this will cause a reduction in the market price and
hence profits.

This process of entry and or expansion will continue until economic profit has been completely
eroded and all that is left s normal profit. That is firms will continue to enter until the market
price is equal to ATC.

If economic loss existed in the short run it will act as an incentive for

1. firms to exit the market OR

2. for existing firms to cut production
In either case market supply will decrease…..this will cause an increase in the market price and
hence profits.

This process of exit and or contraction will continue until economic losses have been completely
eroded and all that is left s normal profit. That is firms will continue to exit until the market price
is equal to ATC.
Market structures:
There are four types of market Structures:

- Perfect Competition
- Monopoly/Monopsony
- Monopolistic Competition
- Oligopoly
- The Cob Web Model

Perfect Competition
This type of market structure exists when:

- there are many buyers and sellers in the market

- all the sellers sell homogeneous products
- there exists perfect information among the buyers and sellers about prices and availability
of resources
- no barriers to entry

When these conditions exists in a market no one individual [buyer/seller], has any control over
prices. Prices are determined by the market demand and supply and so the participants are
considered price takers.

Monopoly

This type of market structure exists when:

- one firm sells a good/service that has no close substitutes

- Barriers to entry exists
TR is the same for the monopolist, however, since the firm is the only supplier in the market the
demand curve facing the monopolist is also the market demand curve. Therefore, unlike for the
perfectly competitive firm, the demand curve facing the monopolist is downward sloping. This is
due to the fact that if the monopolist wants to increase quantity sold he must reduce the price of
Monopoly
TR is the same for the monopolist, however, since the firm is the only supplier in the market the
demand curve facing the monopolist is also the market demand curve. Therefore, unlike for the
perfectly competitive firm, the demand curve facing the monopolist is downward sloping. This is
due to the fact that if the monopolist wants to increase quantity sold he must reduce the price of
the good.

Price

Loss

Gain D = AR

Qty

Average Revenue [AR] is to revenue per unit sold.

TR
AR
Q

Since TR P *Q
TR
P AR P
Q

Note that this is the same for the perfectly competitive firm. The AR curve is the same as the
demand curve.

The relationship between P and MR is different in monopoly than in Perfect competition.

Specifically, for the monopolist the MR is less than P. As the firm increase output MR falls. This
occurs for two reasons:

1. the amount received from selling another unit declines [since price drops]
2. the revenue forgone by selling all units at this lower price increases [since all units
must now be sold at the lower price]
These two effects causes the MR to fall as the price falls along a given demand curve.

Price

Qty

MR

Marginal Revenue and Elasticity

Where demand is elastic, MR is positive; so TR increases as price falls. Where demand is
inelastic, MR is negative; so TR decreases as price falls. Where demand is unit elastic, MR zero;
TR is maximized

The profit maximizing Level of output

The rule for identifying the Profit maximizing level of output is the same for the monopolist as
for the perfectly competitive firm. The monopolist will increase output as long as the additional
output adds more to TR than to TC. That is, output will be increased as long as MR is greater
than MC. Therefore, profit is maximized at the output level where the rising MC curve intersects
the MR curve. Since MC is never negative, it will never intersect MR where MR is negative.
Thus the monopolist will only produce where the demand curve is elastic.

Price MC

ATC

Profit

MR Qty
Short Run shut down condition
The monopolist will continue to operate in the short run as long as price is greater than AVC.

Price Loss ATC

AVC

MC

D=AR
MR

Qty

Long Run Profit Maximization

Since by definition, monopoly means one seller monopoly profits can persist in the long run.

- Barriers to entry

Monopoly and PC
A monopoly will produce less and charge a higher price than under perfect competition.

Price

Pm MC

Pc

MR D=AR

Am QC Qty

MR
The Inefficiency of the monopoly

Perfect Monopoly

Price S=MC Price

S=MC

Pm dead weight loss to society

Pc

Qty Qty

Qc D=MB Qm Qc D=MB

MR

Resources are efficiently allocated when the Marginal Benefit [MB] = Marginal Cost
[MC]…that is, the society achieves allocative efficiency when the amount consumers are willing
to pay for an extra unit of output is equal to the cost of producing the extra unit output.

Recall that the marginal willingness of consumers to pay is given by the MB or demand curve
[that is, the marginal willingness to pay is P]…..therefore, the condition for allocative efficiency
can be written as MC=P.

- Under the competitive equilibrium, firms produce where MR=MC. Since

MR=P…..it implies that MB=P=MC….so that resources are being used
efficiently.
- Under the monopoly equilibrium, the firm produces where MR=MC. Since
MR<P…..it implies that MB=P>MC…. so that resources are being used
inefficiently. A dead weight loss occurs due to the underproduction that takes
place, which causes total surplus to be less than its maximum value.
Monopolistic Competition
This type of market structure exists when:

- Many buyers and sellers

- Few barriers to entry
- compete on product quality, price and marketing
- consumers face wide choice of differentiated products
- Each firms seeks to maximise profits

Oligopoly
- small number of firms
- products may be similar or differentiated
- barriers to entry

Alternative types of Oligopolistic behaviour

- Cartels
- Price Leadership
- Quantity Leadership
- Bertrand
- Cournot

Cartels

This refers to a group of firms that agree to coordinate their pricing and production decisions so
as to act as a single monopolist and earn monopoly profits. Eg., OPEC. There is always the
temptation to cheat on the cartel agreement

Price Leadership

This refers to a situation where a dominant firm in the market set the price and the others follow
the lead and try to avoid a price war.

Assumptions:

- the industry is made up of one or few large firms and a number of smaller ones
- the dominant firm maximizes profits subject to the constraint of the market demand and
the behaviour of the smaller firms
 - The dominant firm allows the smaller firms to sell all they want at the price set and then
supply the difference.
- There is no price fixing.
Quantity Leadership

Cournot: Exists where there are two firms in the market; both firms choose their production level
simultaneously.

Bertrand: Exists where there are two firms in the market; both firms choose their price level
simultaneously
The Cob Web Model

Comparative Static: - comparing the new equilibrium with the original

Dynamic Analysis:- the study of the behaviour of systems in states of disequilibrium

Supply lag: - delay between the decision to change quantity supplied and it actually being
changed.

The Cob Web model can only hold if certain conditions are met.

- production is completely determined by the producers‟ response to price under perfect

competition
- the time needed to adjust production is at least one period
- price is set by the supply available

Stable adjustment: - one which will take the market to its equilibrium; the actual price and
quantity will tend towards their equilibrium values. In this case the demand curve will be flatter
than the supply curve.

Unstable Adjustment: - one which will not take the market to its equilibrium; the actual price and
quantity will tend away from their equilibrium values In this case the demand curve will be
steeper than the supply curve

Nb: You may not need this for your CAPE course but it is good to note
Industrial concentration
Industrial concentration occurs when a small number of companies sell a large percentage of an
industry's product. There are two methods

1. Concentration Ratio- This refers to the percentage of the market by each large firm.

CRn = S1 + S2 + S3+ S4 +...+Sn

The model typically has 4 firms which possess the market share. If one firm takes up 75-90% of
the market it can be classified as a natural monopoly

2. Herfindahl-Hirschman Index - the percentage of an industry‟s output produced by its four

largest firms. This method specifically deals with 4 firms.

2
i

Apply the industrial concentration methods to the market structures mainly in relation to the
number and power of firms.
Market Failure
Pareto Efficiency
Pareto efficiency is an economic state where resources are allocated in the most efficient manner.
Pareto efficiency is obtained when a distribution strategy exists where one party's situation
cannot be improved without making another party's situation worse. Pareto efficiency does not
imply equality or fairness. (Investopedia)

Market failure: This occurs when the interaction of demand and supply in a market does not
lead to *Productive or *Allocative Efficiency

*Productive efficiency: This refers to using the least possible amount of scarce resources to
produce a particular amount of produce

*Allocative Efficiency: This refers to producing those products that are most wanted by
consumers given the costs of production

Reasons for market failure:

1. Public goods
2. Merit and Demerit Goods
3. Externalities
4. Asymmetric Information: Adverse selection and moral hazard
5. Imperfect market

Types of goods
Public goods: these are goods that bar no one from consumption (non-exclusive) and the
consumption of the good by one consumer does not impede another consumer from consumption
(Non-rivalrous). E.g. National Defence, Lighthouses, Roadways (*Quasi-public Goods)

*Quasi-public goods: These are goods that are intermediate between public and private goods.

Private goods: These are goods that bar some consumers from consumption mainly through
price and there is a limited quantity to be consumed. Therefore private goods are exclusive and
rivalrous.

Merit and Demerit goods: Merit Goods are those which offer benefit to the society for e.g.
Education , Healthcare and Affordable Housing, which if the market was left on its own it would
under-produce these goods. Demerit Goods are those goods which are more harmful to society
than not, for e.g. Tobacco and Alcohol. If the market was left on its own it would over produce
these goods.

Externalities
Externalities represent the external costs and benefits of any productive activity. These can be
classified as:

A. Production Externalities(positive and negative) -This exists when an external cost or

benefit arising from production must be borne by someone other than the producer of the
good
B. Consumption Externalities(positive and negative) –This exists when an external cost or
benefit arising from the consumption of a good must be borne by someone other than the
consumer of the good

Costs and Benefits

Marginal Social Cost: the sum of the marginal private costs and the marginal external costs

MES= MC+MEC

Marginal external cost: The cost of producing additional units of output borne by individuals
other than the product of the good or service

Marginal social benefit: The sum of the marginal private benefit and the marginal external
benefit.

MSB=MB+MEB

Marginal Benefit: The benefit of producing an additional unit of output that is borne by the
producer.

Marginal External Benefit: The benefit of producing an additional unit of output that is borne
by individuals other than the producer of the good or service.
Asymmetric Information
When individuals do not have the correct information when making transactions, distorted or
wavered decision will be made: there are two types market failures due to asymmetric
information:

1. Moral Hazard- Hidden actions or morally hazardous behaviour by one party in a

transaction, very popular in the insurance industry.
2. Adverse Selection- This occurs when asymmetric information arises from a hidden
attribute of a good or service. Applies to sales where the sellers or the buyers know more
than the other about the good.

Intervention
When the market does fail, the task is left up to the government to intervene. The government can use
many methods to stimulate the market from a point of failure to recovery.

The government can implement measures to control market failure such as:

- Regulations
- Anti-trust policies
- Taxation
- Privatisation and deregulation in some industries to offset cost and other factors
- State ownership of resources
- Subsides to firms to spur on production
- Legislation
- Market creation(tradable permits)

Government intervention according to many economic theorists can be detrimental if the government
does not allow the natural market to settle problems on its own. Many times as governments intervene
some consumers may suffer. But there are benefits to government interventions as many consumers
and producers who have been affected my market intervention do reap the benefits from some of the
actions of government aforementioned.

In the Caribbean our smaller economies are heavily reliant on government intervention but the private
sectors should be given leverage and support where needed.
Private Sector Intervention
When the private sector is allowed a hand in market failure intervention, they have many methods they
can use. According to this course they can use:

- Corporate Code of Conduct

- Corporate Social Security
- Voluntary Agreements
- Corporate Ethics
Module 3
Distribution Theory

 Demand for and Supply of Factors

 Wage differentials
 Income inequality, Poverty: Theory and Alleviation
The Demand for and Supply of Factors

Do you remember the factors of production Land, labour Capital and Enterprise? These factors
of production also had rewards that are related to them.

Factors of Production Factor rewards

Land Rent: Income earned for the usage of the land

Labour Wages: Income earned for productive activity

Capital *Interest:

Enterprise Profit: the returns to owners of resources

Derived Demand:
A term used in economic analysis that describes the demand placed on one good or service as a
result of changes in the price for some other related good or service. It is a demand for some
physical or intangible thing where a market exists for both related goods and services in
question. The derived demand can have a significant impact on the derived good's market price
(Investopedia).

Labour market
Labour is treated like any other good in the market, except demand comes from the firm instead
of the consumer. The price a firm pays for labour is known as the wage. In addition to a wage,
workers also commonly receive fringe benefits such as insurance and vacation time.

Real wage: Wage adjusted for inflation.

Perfectly competitive labour market
1. Everyone is a wage taker-neither employers nor employees set wage rates
2. Freedom of Entry- No restrictions on the movement of labour
3. There is Perfect Knowledge- workers are fully aware of what jobs are available and the wages
and employers know what labour is available and how productive it is.
4. Homogenous Labour-workers are categorized in accordance with their productivity

y=wage rate

A: Labour Market B: Employee C:Firm

SL SL

Sl
W* Dl W*

L* L* L*
x=Labour

Diagram C shows how

Diagram A shows the
interaction between the
market demand and supply
of labour which determines
the going wage rate (W*)
and the employment level
(L*)
Diagram B shows how
individual workers have to
accept the going wage
rate. In this case the
demand is perfectly elastic.
individual firms hace to
accept the going wage rate.
the supply of labour to the
employers is infinitely
elastic
Supply of Labour
The supply curve for the labour market shows how much labour workers or households will
provide at each wage.There are two alternatives for each household‟s time: leisure andworking
at home.As the market wage changes, decisions concerning work will also change. There are
two effects of a wage change, which work in opposite directions:

Substitution effect: If the marginal benefit of leisure or working at home is higher than the
market wage, the household should choose either leisure or working at home. This means that as
the wage rises (falls), households are more (less) likely to choose the labor market.

Income effect: As the wage rises (falls), households are less (more) likely to spend more time in
labour market. With a higher (lower) wage, they can work less (more) to make the same income.

The relative strengths of the income and substitution effects will determine the shape of the
household‟s labour supply curve.

 If the substitution effect is stronger, the curve will be upward sloping.

 If the income effect is stronger, the curve will be downward sloping.
 If the substitution and income effects are equal, the curve will be vertical.

Most people have a backward-bending labour supply curve, which is upward sloping for low
wages, vertical or nearly vertical at higher wages, and bends backward with a downward slope
for the highest wages.

Market labour supply, on the other hand, is a straight, upward sloping line. It is not backward-
bending because, as a whole, more workers will be attracted to higher-paying jobs.

Backward-Bending Labour Supply

Demand of Labour
The demand curve for the labour market shows how much labour firms will buy at each wage.

Firms must determine how much labour is needed for a profit-maximizing level of production.

Marginal revenue product (MRP): Revenue increase resulting from the purchase of an
additional unit of labour.

The firm maximizes profits by purchasing additional labour until the MRP is equal to
the market wage.

If the costs of any factors necessary to produce a good change, the MRP will be affected and the
amount of labour demanded by the firm will also change.

Adding up all the firms‟ labour demand curves will equal the market labour demand curve.

If demand increases (decreases) for a good that a particular type of labour produces, the demand
for that type of labour will also increase (decrease).

Wage Rate

MC

AC=W(Supply)

MRP=D

Employment level

The profit maximising firm will hire labour until MRP=AC

Labour Equilibrium
As with other goods, the supply and demand for labour create anequilibrium wage rate and
quantity in the market when they are equal.There are several possible inefficiencies, which may
cause the wage to differ from equilibrium:

Income tax: Workers pay a tax on their income, and it affects the amount of time they are
willing to work.

Minimum wage: The government sets in the market a minimum wage, which firms are forced to
pay.

 If the minimum wage is lower than the market equilibrium wage, then there is no impact
because firms will pay the equilibrium wage.
 If the minimum wage is higher than the market equilibrium wage, labour supplied will be
higher than labour demanded, and some workers will be unable to find jobs.

Discrimination: Firms may choose to hire or set wages based on factors that are not related to
productivity, such as race, age, or gender. Non-profit maximizing decisions are inefficient.

Unions By bargaining with firms for higher wages, unions decrease demand for labor. Some
workers will then move to non-union firms, which can compete with lower costs because they
pay lower wages. However, union firms often have other benefits that offset the higher cost of
labour, such as lower turnover.
Transfer Earnings and Economic Rent
Transfer earnings are the minimum payment to the Factors of Production which is just adequate to
compensate the owner

Economic Rent refers to the payment made to any Factor of Production in excess of the minimum
(Transfer Earnings)
Capital Market
The supply of capital expenditure comes from all sources from which it can be borrowed usually
from savings. Savings represent the amount available from a pool of borrowers. The cost of
capital is usually expressed as interest rates. The Marginal Efficiency of Capital (MEC) is the
marginal revenue product relating to capital.

Interest (R)

Sk

r1

Dk(MEC)

K1 Capital (k)

*Interest rates are determined through the market interaction between the supply of capital and
the MEC.

Determinants of the Supply of capital

1. Interest rates- as interest rates increase savings also increase so there is a positive
relationship
2. Price Level- As price increases the amount of goods and services which can be affected
by saved funds decreasing. As a result individual uses forgo buying to stock up on
wealth
3. Size of Income- If income increases savings increase so there is a positive relationship.

Wage Differentials
Wage differentials can be defined as the difference in the wage rate between the different types
or classifications of workers. Wages may differ based on four main discriminating factors;
Qualifications (Human capital –Education), Race, Gender and Mobility

Imperfections in the Labour Market

In the real world labour markets are rarely perfectly competitive. This is because workers or
firms usually have the power to set and influence wages and therefore wages may be set to levels
different than anticipated by MRP theory.
Different Imperfections in the Labour Market
1. Monopsony:
This occurs when there is just one buyer of labour in a market.
Even if there is more than one employer, firms may still have the ability to set wages. Therefore
they have Monopsony power

The marginal cost of employing one more worker will be higher than the average cost because to
employ one extra worker the firm has to increase the wages of all workers.

To maximise the level of profit the firm employs Q2 of workers where

MC = MRP

Therefore the firm only has to pay a wage of W2. This is less than the competitive wage.

2. Trades Unions:
Under certain conditions Trades unions can bargain for wages above the competitive equilibrium

This can be achieved by restricting the supply of labour (e.g. Closed shops) or threatening to go
on strike.
Trades Unions can cause higher wages, however in competitive markets this can have the effect
of causing unemployment of Q1 – Q2

However Trades Unions can be beneficial if

They operate in an industry with a Monopsonistic employer

They help to increased productivity by bringing in new working practices
3. Discrimination
Firms may not be rational but pay some workers different wages on the grounds of age, race, or
gender

4. Difficult to measure productivity

The theory of MRP assumes firms can measure the MPP of a worker however in practice this is
difficult because in many jobs, especially in the service sector productivity cannot be measured
precisely
e.g. How do we measure productivity of nurses and teachers?

Therefore wages may be set due to different reasons other than MRP

5. Firms may be Non Profit Maximizers

If demand for a product falls, MRP theory suggest wages are likely to fall. However firms may
be reluctant to cut wages or make people redundant therefore they may keep paying high wages
despite this.
6. Wages will vary due to geographical differences:
In the North, wages tend to be lower because there is less demand and higher unemployment. In
the South, wages tend to be higher for the opposite reason.

In theory, workers from the north could move to the south to take advantage of better
employment opportunities. However there are likely to be geographical immobilities - e.g. It is
difficult for workers to move)

This is because:

I) They are attached to their local communities

ii) Difficult to find housing in the south
iii) Ignorance of Jobs elsewhere

7. Poor information
Workers or firms may suffer from poor information. E.g. Workers may be unaware of better paid
jobs elsewhere. This enables firms to have monopsony power.
Income inequality, Poverty: Theory and Alleviation

Income inequality

The concept of income inequality refers to the extent to which income is distributed in an uneven
manner among a population. It can also be seen as the gap between the rich and everyone else.
The ultimate result is that income distribution has never or will never be totally equal.

Size and functional distribution of income

The size distribution of income is one of two ways to measure inequality in income, under this
method, individual and household income is collected and arranged in ascending order. The data
is, then, divided among groups. Most common method is to divide data into "quintiles" (i.e. in
five groups, each representing 20% of data) and/or “deciles" (i.e. in ten groups, each representing
10% of data) in percentage form. Then, it is determined that what percentage of total income is
received by each income group.

The other method is functional distribution of income, which is the method where the income
within the economy is divided among the owners of the factors of production (FOP), namely
interest, wages, rent and profit.
Lorenz Curve and Gini Coefficient
Lorenz curve: A Lorenz curve shows the degree of inequality that exists in the distributions of
two variables, and is often used to illustrate the extent that income or wealth are distributed
unequally in a particular society.

This Lorenz curve illustrates the degree of inequality in the distribution of income. A Gini
coefficient can be calculated using areas on this Lorenz curve. The 45 degree line would reflect
absolutely even distribution of income. The pink shaded area A between the line of perfect
equality and Lorenz curve reflects inequality. The blue area underneath the Lorenz curve is B,
and the Gini coefficient can now be calculated as A/(A+B). Gini coefficients are often expressed
as percentages

Gini coefficient: A Gini coefficient is a summary numerical measure of how unequally one
variable is related to another. The Gini coefficient is a number between 0 and 1, where perfect
equality has a Gini coefficient of zero, and absolute inequality yields a Gini coefficient of 1.
Although Gini coefficients are used primarily to summarize distributions of income, they are also
used to summarize inequalities in market shares by firms in an industry, or in the distribution of
wealth (unc.edu)
Income inequality Alleviation
Income inequality on the other hand can be alleviated through government intervention. as the
areas of income inequality are assessed, a government would have to make a choice to find the
most suitable method of alleviation for persons who are being either over compensated or
undercompensated but more so the latter. The CAPE syllabus emphasises three methods the
government can use to alleviate income inequality, namely; taxes, subsidies and transfers.

Taxes
Taxes are mandatory payments made to the government either on income or consumption. In this
case we will deal with income taxes. Many governments use a standard rate tax system, where
everyone pays the same percentage of their individual income over to the government, e.g. 25%
(Jamaica) once they earn a certain amount of income (Income Tax Threshold). The government
can take two actions to alleviate income inequality to some extent. The first could be to
implement a progressive tax system where persons who earn a higher income

Subsidies
Subsidies are allowance by governments to firms or individuals to either promote production or
consumption. The government can provide subsidies to firms in an attempt to get them to
increase their supply of goods at services at lower cost so that everyone will be able to afford
them. Also the government may subsidies certain services like education and healthcare to allow
for lower income earners to have access to these services.
Poverty

Absolute Poverty
This measures the actual number of people within an economy who are unable to afford certain
basic goods and services such as food and shelter. This occurs because their level of income falls
below the poverty line or threshold. According to the UNDP the worldwide poverty line is
$2.00USD / person/day.

Relative Poverty
This measures the extent to which an individual‟s financial resources fall below the average level
of income within the economy. For e.g. If the average level of income $3,000 USD /month then
an individual who earns $1,700USD / month would be classified as relatively poor where they
may not be classified as absolutely poor.

Factors that contribute to poverty:

 Unemployment
 Non-ownership of resources- whether or not a person is employed, ownership of the
Factors of production may provide sufficient income to afford a higher standard of living.
Persons who do not own any of the factors are disadvantaged and may be lead into
poverty.
 Uneven distribution of income- the size distribution of income has major bearing on the
poverty rate
 Inflation- As the price of goods increase, persons whose income is constant will be able
to afford less.
 Large number of dependents- Large families with low increase generally tend towards
poverty overtime
 Single parent/female –headed households- With only one4 income or no constant income
these household structures may suffer.
 Discrimination- Persons who are too old, too young , disabled or of a different gender
may be overlooked for the jobs available thus leading to little or no income to them or
their families which can lead to poverty
 Social and Physical environment-Drought, Inner City or tent city communities may lead
to persons being out of work thus having little or no income which can lead to poverty.
Persons who are most susceptible to poverty
A. Persons with special needs :
I. Physically challenged
II. Elderly
III. Youth
IV. Single Parent Families
V. Indigenous People

B. Reasons- Limited access to employment, level of training, Legislation, Availability of

Income to share among family

Ways to measure poverty

1. Basic needs- What is it that the general population needs as basic items and what
percentage is able to comfortably afford them
2. Poverty Line (threshold)- Persons who earn income below this line or do not earn any
income at all and are not on benefits will be classified as poor or impoverished
3. Head count- areas that have households with many members and a small income may be
classifies as impoverished
4. UNDP Human development index- The Human Development Index (HDI) is a composite
statistic used to rank countries by level of "human development" (the standard of
living and/or quality of life).

Strategies to alleviate poverty

Transfer payments-A redistribution of Income within the income by government

Free education and healthcare

Housing

Minimum wage legislation

Equal employment opportunities

Government employment creation(special works programme

Cost of poverty
Unemployed human resources

Lower potential output

Inefficient allocation of government expenditure

Social and Environmental costs

Economic benefits of poverty

Provision of Education and Health leading to development of human Capital

Improvement of well-being as measured by the UNDP HDI

More equitable distribution of income