JOMO KENYA UNIVERSITY OF AGRIC.

AND TECHNOLOGY
DEPARTMENT : STACS
UNIT : STA 2103: BUSINESS ECONOMICS
PRE-REQUISITES : NONE
_____________________
Instructor: Zackayo O. Omolo

Meets: Monday
Contacts: E-mail: zackomolo@yahoo.com
0722697380

Purpose of the course

By the end of the course the student should have a good understanding of individual, market
and firm behaviour so as to be able to effectively and profitability work in a given
environment.

Course Outcomes

 To help the student think as an economist or business person using various

economic concepts and principles.
 To develop the ability to identify the principles of microeconomics, their contribution
and limitations.
 To understand consumer and producer behaviour by focusing on the
decision-making process of firms and individuals.
 To identify and understand the different types of market structures and their
implication on consumer welfare.

Course Content
Nature and scope of economics; Central economic concepts, scarcity, choice, opportunity
cost. Economic systems; Concepts of demand and supply; Elasticity of Demand and Supply;
Consumer theory: Cardinalist and Ordinalist approaches; Theory of the firm: law of variable
proportions, law of increasing and decreasing returns to scale, theory of costs, optimum
size of the firm, theory of the firm, profit maximisation; Intermediate theory of the firm and
application of the mathematical approach; Market structures, perfect competition, imperfect
competition, monopoly. Theory of general equilibrium and welfare economics. Public goods
and externalities; An intermediate theory of factor markets; Theories of distribution, rent,
interest and profit.

Teaching Methodology
Lecture, problem-based learning, instructor-facilitated discussions, class presentations by
students, guest speakers, video/CD-ROM presentations

Assessment
Assessment of the student’s progress shall assume the following dimensions:
1. Assignments 10%
2. CAT 10 %
3. Group Project Presentation 10 %
4. End of Semester Exam 70 %
Total 100 %

Academic Policies
1. Attendance & Class Participation: students are expected to attend all classes to be eligible
for
an “A” grade pass in this course. Student must make sure they read the required texts
and
articles before the class to meaningfully participate during class.
1
2. Assignments: All assignments must be turned in at the beginning of the class period on
the date stipulated. Late submissions will be penalized 10% for each day late up to 3 days.

3. Group Project Presentation: An addendum that stipulates the nature of this project will be
presented during the course of the semester.

4. Plagiarism: or any other form of academic misconduct will result in a failed grade. Make
sure
any idea or material that you quote or use in your work is appropriately acknowledged.
Please familiarize yourself with American Psychological Association style for citation and
referencing materials (This information will be found in your resource material. Feel free to
discuss this with me if you have a problem).

COURSE TEXTS
Hardwick P. et al: An Introduction to Modern Economics, 4th Ed. (London: ELBS1990)

SUPPLEMENTARY READINGS
1. Lipsey, R. G.: An Introduction to Positive Economics, 6th and 7th Ed.(London:ELBS1983)
2. Samuelson, P. A. (1989), Economics, 11th Edition, MCgraw and Hill, London
3. Shapiro, E. (1982), Macroeconomic Analysis, Harcourt Brace Javanovich Inc, N/York
4. Todaro, M. P. (1982), Economic Development in the Third World, Longman, N/York

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 MICROECONOMICS NOTES
NATURE AND SCOPE OF ECONOMICS
What is economics?
 Economics is a social science, which seeks to explain the economic basis of human
society. Its the study of how society makes choices about what output is to be produced,
by what means and for whom, i.e. it is the study of how the society allocates its scare
resources among competing alternatives.
 The economic resources referred to in this definition are usually classified as land, labor,
capital and enterprise. The problem of allocating these resources to achieve give ends is
fundamental in the study of economics.

Importance of economics:
 Economics covers topics that are highly relevant to many of the most pressing issues
facing today’s world, e.g. free market versus government-controlled markets, resource
exhaustion, pollution, the population explosion, government, inflation, the EU, their,
changing living standards in advance nations, growth and stagnation among the worlds
poorer nations¬¬¬¬
 Economics provides the skills for analyzing, explaining and where appropriate offering
solutions to economic problems.
 Economics has a core of useful theory that explains how markets work and that
evaluates their performance.

Microeconomics versus Macroeconomics:

 Microeconomics is concerned with the behavior of individual firms industries and
customers or households and deals with the effects of individual taxes and specific
public spending programmes.
 Microeconomics deals with the problems of resources allocation, considers the
problems of income distribution, and is chiefly interested in the determination of the
relative prices of goods and services.
 Macroeconomics, however, concerns itself with large aggregates, particularly for the
economy as a whole. It deals with the factors which determine national output and
employment, the general price level, total spending and saving in the economy, total
imports and exports, and the demand for and supply of money and other financial
assets.
N.B
If from aggregate data¬¬¬¬ - data which may blur or hide quite different behavior patterns of
individual nits comprising our whole (e.g. statistics of annual agricultural output for a
particular country tells us nothing about the performance of say, groundnut growers), then
we have “a macro economic function”; if the function has been built up from a careful study
of the individual units of which it is comprised (e.g. estimating the supply schedule of cotton
producers), then we have “a micro-economic function”.

Economic methodology
Economics is often called a social science since the subject matter is a human being. This
means that controlled experiments of the natural science are impossible. It is therefore
difficult to link cause to effect. Human beings react differently to external economic events
making prediction more difficult that in the natural science. Fortunately, reaction of groups of
individuals to events is more stable, with extremes canceling each other.

The term methodology refers to the way in which economists go about the study of their
subject matter. Broadly, economists have followed positive and normative economics.
Positive economics is concerned with propositions that can be tested by reference to
empirical evidence. It relates to statements of what is, was or will be. The accuracy of
positive statements can be checked against facts and proved correct or incorrect Thus to
say that, “the rate of inflation in Kenya over the last 12 months has been 6%”, is a positive
statement. By reference to the facts, it can be proved correct or incorrect.
3
Normative economics is concerned with propositions, which are based on value judgements,
i.e., statements that are expressions of opinions. Normative statements, therefore relates to
statements of what should or ought to be the case. Normative statements are matters of
opinion which cannot be proved or disapproved by reference to the facts, since they are
based on value judgements e.g., to say that: “the govt.’s main aim should be the control of
inflation”, is a normative statement since its validity cannot be checked against any facts. It
is a statement, which we may either agree or disagree, but there is no way of providing that it
is correct.
Deduction and Empirical Testing.
The process of deduction and empirical testing is the most important approach followed by
modern economists. In this case, a theory is proposed, logical deduction applied to develop
predictions, and a test made of these predictions against the facts. For instance, one theory
is that the amount of a commodity consumers wish to purchase will usually vary with its
price. This prediction can be tested against how consumers actually behave. If the facts do
not support the theory it must be rejected in favor of other theories which better explain
actual observation.
Induction.
This is an alternative methodological approach in economics. The facts themselves are
starting point for this approach, with any observed pattern or regularity in the facts giving the
economist some guidance. It involves, first, the collection, presentation and analysis of
economic data and then the derivation of relationship among observed variables, i.e., the
available statistical closely examined in the search, for the general economic principles.

The economizing problem

 The economizing problem stems from two related facts. Economic wants are unlimited
because they can not be completely satisfied with the existing limited supply of
resources available for production.
 Resources are said to be scarce relative to these unlimited economic wants. For this
reason, people must make choices and economize on resource use.

The Economic problem/Questions:

 The basic economic problem confronting all societies is how to allocate scarce
resources between alternative uses. Resources are scarce because the collective desires
of society for consumption at any moment in time exceed the ability to satisfy those
desires.
 The economic problem thus arises because individuals’ wants are virtually unlimited,
whilst the resources available to satisfy those wants are scarce.
Because there are insufficient resources to produce all that is desired, society is forced to
make a choice. These choices are:
(a) What output will be produced? The society must choose which goods and services to
be produced from the available resources.
(b) How shall the goods be produced? There are various ways of producing given output
e.g., labor intensive or capital-intensive techniques. The technique chosen must be cost
effective.
(c) For whom shall the output be produced? Clearly, if an output is produced there must be
some means of allocating it to consumers and of deciding who receives what.
In choosing which goods will be produced from scarce resources society is forced to do
without those goods that might otherwise have been produced. This is very important to the
economists, and in choosing what to produced, the new best alternative forgone or
sacrificed is referred to as opportunity cost (or real cost) of what is produced. Opportunity
cost of a decision to produce or to consume more of one good is the next best-forgone
alternative. A decision to buy a T.V set, for example, might mean giving up the purchase of a
sofa set. In taking decision about production, the concept of opportunity cost is vital.

Types of Economic Systems

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Economic systems are concerned with the ownership and control of resources. The main
types of economic systems are:
a) Traditional economy,
b) Market economy,
c) Command economy,
d) Mixed economy.
(a) Traditional Economy.
 A traditional economy is one in which behavior is based primarily on tradition, custom
and habit. Young men follow their fathers’ occupation, typically, hunting, fishing and tool
making. Women do what their mothers did, typically, cooking and fieldwork.
 Traditional economy is characterized by few changes in the pattern of goods produced
from year to year; production techniques follow traditional patterns, except when the
effects of occasional new inventions are felt. Property is often held in common and the
concept of private property not well defined.
 The answers to economic questions of what to produce, how to produce, and for who to
produce or how to distribute are determined by traditions.
b) Market Economy.
 In this case, resources are allocated through price mechanism. This simply means that
individuals, as consumers freely choose which goods and services they will purchase,
and producers freely choose which goods and services they will provide. Because of this,
market economies are often referred to as free enterprise or laissez-faire economies.
Characteristics of Market Economies
 Individuals pursue their own self-interest buying and selling what seems best for
themselves and their families.
 People respond to incentives. Other things being equal, sellers seek high prices while
buyers seek low prices.
 There is reliance on price mechanism to allocate resources. Prices are set in open
markets in which would be sellers compete to sell their wares to would be buyers.
 There is limited role of state. Indeed, in a strictly free enterprise economy, the only major
role performed by the govt. would be that of creating a framework of rules (i.e. laws)
within which both private individuals and firms could conduct their affairs.
 There is the existence of the right to own and dispose of private property. Any individual
is free to own and dispose off factors of production.
(b) Command Economy.
 This is an economy in which resources are allocated by central planning authority
appointed by the state. In this case, key industries and resources are controlled and
owned by the state. The government issues directives (i.e. instructions) to firms
indicating what they should produce the quantities that should be produced, and so on.
The following are some of the advantages of command economy.
 Because production is not undertaken for profit, there is greater likelihood that both
public goods and merit goods are produced. The government simply has to issue
directive to ensure production.
 The production and consumption of demerit goods, which impose, relatively large social
costs on the society can be prevented or limited through taxes or subsidies.
 Greater equality in the distribution of wealth and income can be guaranteed in centrally
planned economies. In a fully command economy, there are no private entrepreneurs
who derive profits from combing the factors of production.
Disadvantages:
 With command economy, there is greater reduction of consumer sovereignty. I.e., the
state decides what to produce and the consumers have much less influence over
production than in market economies. This culminates into shortages of certain
commodities and surfaces of others.
 Moreover, there may be tendency towards bureaucratic structures. It is the govt.
planning departments, which govern resource allocation. The opportunity cost of
employing people to gather information, process it formulates plans is the alternative
output these people could otherwise have produced.
5
 There is also less incentive to increase efficiency because profit motive is absent.
(d) The Mixed Economy.
 Fully traditional, fully centrally controlled and fully free market economies are useful
concepts for studying the basic principles of resource allocation. However, there is
always some mixture of central control and market determination, with a certain amount
of traditional behavior as well.
 Mixed economy refers to an economy in which both free markets and governments have
significant effects on the allocation of resources and the distribution of income.
 The degree of mixture varies from economy to economy and over time.

6
THE THEORY OF DEMAND AND ELASTICITY
Definition of market.
 A market can be defined as any arrangement, which brings buyers and sellers of
particular products into contact. The collective actions of buyers for a particular product
establish the market demand for that product, and the collective actions of sellers
establish the market supply for that product.
 The interaction of these forces of demand and supply, i.e., market forces, establishes the
market price for any given product.

The nature of Demand and it’s Determinants

 The amount of a product that consumers wish to purchase is called the quantity
demanded. Demand does not simply mean the desire to possess. Effective demand is
therefore the desire to possess something backed up by the cash to pay for it. Demand
thus means the willingness and the ability to purchase articles.
 However, it is not enough to know the quantity demanded at particular prices. The time
period is also relevant. To say that demand is 1000 units at a price of Kshs100 is an
incomplete statement. We need to know whether this quantity will be demanded per day,
per week or per month.
 At any one moment in time, demand is expressed as a function of price. In other words,
any other factors, which might affect demand, are assured to be constant.

Determinants of Quality Demanded.

The following variables influence the quantity of each product that is demanded by each
individual consumer.
1) Changes in disposable income: An increase in disposable income will lead to an increase
in demand for most goods and services, i.e., for normal goods.
2) Changes in the price of substitutes: A rise in the price of one good will lead to a
contraction in the demanded of that good and an increase in the demand for substitutes.
The relationship between substitute goods is referred to as competitive demand.
3) Changes in the price of complements: Certain goods are jointly demanded. Fish and
chips, bread and butter, sugar and tea, etc are examples of complements. A rise in the
price of one good will lead to a contraction in the quantity of that good demanded and a
decrease in the demand for the complement.
4) The price of the product: An increase in the price of the product will lead to a decrease in
the quantity demanded of that product ‘ceteris paribus’.
5) Various sociological factors: E.g. changes in fashions, population, etc.
6) Changes in weather conditions: Some goods are demanded seasonally an at certain
times of the year demand for these goods will increase e.g. Christmas cards, exams
cards, etc.
7) Changes in consumer tastes.

Individual Demand Function

 An individual’s demand for a good, says good X, is the quantity of the good (good X) that
the individual is willing and able to buy during some time period.
Suppose we list some of the factors, which may be expected to influence this
consumer’s demand for good X over a given period (dx) as below:
 The prices of good X (Px)
 The price of substitutes of good X (Ps)
 The consumer’s income (y)
 Consumer’s taste for good X (T)
 Consumer’s expectation about future prices (E)
 Advertising (A)
 Other relevant factors (Z)
 Using functional notation, we write the following demand function:
dx = f(Px, Ps, y, T, E, A, Z). This states simply that the individual’s demand for
7
 Quantity demanded of X is a function of all the factors listed in the brackets
 However, economists analyze the relationship between a consumer’s demand for X and
the price of X by assuming that all the other factors influencing demand remain
unchanged. This is the important “ceteris paribus” assumption which is used so widely in
all branches of economics. We can now write the factions:
dx = f(Px), 'ceteris paribus.'
 An individual demand curve for a good show the relationship between the quantity
demanded by the individual and the price of the good ‘ceteris paribus’.

Price
An individual’s demand schedule for good X
40
Price of X Demand for X
10 3
20 2
30 1
40 0
0
4 Quantity of X
(Units per week)
Market Demand Function.
Market demand for a product is the sum of the demands of the individual customers in relevant
markets. The market demand for good X for instance is the sum of individuals’ demand in the
economy. The assumption here is that the market for good X is restricted to the home economy.
Suppose market demand for good X (Dx) is being influenced by the following factors:
 The prices of good X (Px)
 The price of substitutes of good X (Ps)
 Income of the economy as a whole (Y)
 Society’s taste for good X (T)
 Advertising (A)
 Other relevant factors (Z), we write the following market demand function for
good X:
Dx = f(Px, Ps, Y, T, A, Z).
This states simply that the market demand for good X is a function of all the factors
listed in the brackets
 Making ceteris paribus assumption and holding all the influencing factors constant
except for the price of X, we can write:
Dx = f(Px), “Ceteris Paribus”.
 Representing this on a graph and assuming that a fall in the price of X will cause an
increase in the total quantity demanded, we have a downward sloping market demand
curve as shown on the diagram below.
DD
Price As p[rice falls from OP1 to OP2, the total
quantity demanded in the market falls from X1
P1 to X2. If the price rise back to 0P1, the quantity
demanded would fall back to X1.

P2
DD

0
X1 X2 Quantity of

 This inverse relationship between the price of a commodity and the quantity demanded
8
 is called the Law of demand. According to this law, a rise in the price of a good leads to a
fall in the total quantity demanded and vise versa

Exceptions to law Demand.

It should be noted that the law of demand does not always apply, i.e., it is not an unassailable
truth. There are exceptions to it. The following examples explain this:
1) Giffen goods: A Giffen goods (named after the 19th century economist Sir Robert Giffen)
is a very inferior good for which quantity demanded increases as price rises and quantity
decreases as price falls. The demand curve therefore has positive slope.
2) Veblen goods: Veblen goods (named after the 19th century American
economist-sociologist Thorsein Veblen) are luxury goods like jewelry, designer perfumes
and clothing, etc. If they are put up for sale, they will lack ‘snob-appeal’ when their prices
are low, and as a consequence, may not be much in demand. The reverse also applies.
 The market demand curve for a Giffen good or for a Veblen good will be upward sloping
from left to right (i.e., positively sloped). The diagram below illustrates this

DD
Price
The demand curve for a Giffen
good or vebblen good

DD

Quantity demanded per time

period
3) Inferior goods: these goods are characterized by the fact that as incomes rise above a
certain level, less of the good is actually purchased. Stapple foods such as cassava
sweat potatoes and rice may be examples of African inferior goods.

Movement along versus a shift on the market demand curve

 Movement along demand curve refers to increase or decrease in quantity demanded
following a price change. The increase NB:in demand also being
Other things referred to as
equal, theextensions of
demand is prompted by decrease in price ‘ceteris paribus’. The decrease in demand also
effects aabout
referred to as contractions of demand is brought change in the price
by increase of of the item in
in price
question ’ceteris paribus’ The diagram below
good shows
X can the
be effects
seen byof moving
change in the prices
of goods X, ‘ceteris paribus’. These effects can be traced moving along the market
demand curve for good X. along the demand curve.

Price of
X

10
8
6 D
4
2
10 20 30 40 50 Quantity per time period
 When we say that there is increase in the demand for a good, as opposed to an increase
in the amount demand, we are talking about a shift in the entire demand curve.
 It is caused by changes in tastes, money income, or prices of other goods. The effect of
such changes would alter the position of the whole curve as illustrated on the curve
below:

d0 d1
9
 NB: the shift of the demand
Price
d2 curve can either be to the left or
to the right.

Quantity per time

period

Elasticity of Demand.
 The elasticity of demand is a measure of the extent to which the quantity demanded of a
good responds to changes in the influencing factors.
The various demand elasticities are very important in both theoretical and empirical level.
The following are the various types of elasticities of demand.
1. Price elasticity of demand:
This is a measure of the responsiveness of the quantity demanded to a change in price. It is
the proportionate change in quantity demanded over proportionate change in price.

Pr oportionat e change inquantity demanded

Price elasticity of demand ( Ed ) 
proportion ate change in price

 If price of good X for instance, rises by 10% (or 0.1) and the quantity demanded falls as a
consequence by 5% (0.05), then the price elasticity of demand would be:

0 . 05
 0 .5
0 .1

 In this case, the demand for X is inelastic because its elasticity is less than 1. Demand is
said to be inelastic if the quantity demanded changes less than proportionally in
response to a given hang in price.
 Suppose that when the price of X increases by 10%the quantity demanded falls by 20%
,the price elasticity will now be:
 Since the price elasticity is greater than 1, we say that demand for X is elastic. Demand is
0 .2
2
0 .1
said to be elastic if the quantity demanded changes more than proportionately in
response to a given change in price.
 If the demand for good X has unitary elasticity, the total sales value will be unchanged.
This is because if the price falls, quantity demanded rises by exactly the same
proportion.
 NB: perfect inelasticity and perfect elasticity.
 It is only possible to calculate price elasticity with complete accuracy at a point on a
demand curve. This is called point elasticity of demand. Point price elasticity of demand
refers to a measurement of price elasticity at a particular point on the demand curve.
Point elasticity can be found using the following formula for straight line demand curve:

q p q p
Po int Elasticity of Demand   
q p p q
 Because quantity demanded and price vary inversely, a positive change in price will be

10
 accompanied by a negative change in quantity demanded. Thus, in order to make the
coefficient of price elasticity positive, a ‘minus’ sign is introduced in the formula as
above. Point price elasticity of demand means that the coefficient computed is valid for
small movements only.
Point elasticity of a non-linear
Price demand

A
P1 d

0 q1 Point Elasticity of a non-linear

 The point elasticity at point A is measured as the negative of the reciprocal of the slope
target at point A, multiplied by the ratio of price to quantity demanded at that point. Arc
elasticity can be calculated for the following formula:
 An estimate of the elasticity along range of a demand curve is called the arc elasticity of
demand. Arc price elasticity of demand is a measurement of price elasticity between two
points on a demand curve. Arc elasticity can be calculated for both linear and non-linear
demand curves using the following formula:
q  p1  p 2  / 2
Arc elasticity of demand 
p  q1  q 2  / 2
P1 and P2 = initial quantity and price.
P2 and q2 = new price and quantity
Therefore (P1 + P2)/2 is a measure of the average price in the range along the demand curve
and (q1 + q2)/2 is the average quantity in that range.

1) Determinants of price Elasticity:

a) Initial price of a good. Price elasticity of demand changes as we move along a demand
curve.
b) Availability of substitutes. The more substitutes a good has the more elastic the demand
for it is likely to be.
c) The proportion of consumer’s incomes spent on the goods. Goods that take a large
proportion of consumer’s income e.g. cars tend to have move elastic demand than
goods like salt which only take a small proportion of consumer’s income.
d) Time. The demand for many goods may be inelastic in the short-run but move elastic in
the longer-run.
e) Whether the good is a necessity (less elastic) or luxury (elastic).
f) Whether the good is habit forming e.g. cigarettes – less elastic.
NB:
a) Perfectly inelastic demand (Ed = 0) i.e. changes in price cause no changes in quantity
demanded.
b) Perfectly elastic demand (Ed = , i.e. infinity), i.e. any quantity bought at the prevailing
price but a rise in price causes quantity demanded to fall to zero.
c) Unitary elasticity of demand (Ed = 1), i.e. changes in price causes equi-proportionate
change in quantity demanded. Total sales revenue therefore remains unchanged.\

2) Price cross elasticity of Demand.

 This measure the relative responsiveness of quantity demanded of a given commodity to
changes in the price of related commodity. In other words, it is the proportional change
of good X divided by the proportional change in the price of good Y.

 This will be positive if the related good is a substitute good and negative if the related
goods a complement.
11

Pr oportionat e change inquantity demanded
Cross e D 
proportion ate change in price of a related good

q x P y q x Py
i .e., Cross Elasticity of Demand   
q x Py P y qx

3) Income elasticity of Demand:

This measure the relative responsiveness of quantity demanded of a given commodity to
changes in money income.
 An income elasticity of demand greater than 1 means that a given proportionate increase

Pr oportionat e change inquantity of X demanded

Income eD 
proportion ate change in money income

D x M
i .e., Income eD  
D x
M
in national income will cause a bigger proportionate in quantity demanded. It follows that
producers of such goods may need to plan extra capacity in times of rising income.
Uses of elasticity of Demand.
 The empirical measurements of demand elasticity help to provide the theory of price
with empirical content.
 The government though appropriate revenue body considers elasticity of demand of the
various products before tax increments are implemented. It is used when it comes to
shifting tax burden.
 Organizations consider elasticity of demand for their products before they resort to
increasing their price.
 Elasticity of demand is used in determining exchange rates.

Consumers’ surplus
 The difference between total value consumers’ place on all units consumed of a
commodity and the payment they must make to purchase that amount of the
commodity.

THE THEORY OF SUPPLY AND ELASTICITY

Definition:
Supply refers to the amount of goods/ services that individual firm/firms are willing and
able to offer for sale over a given time period.
 The primary function of the firms is to hire and organize factors of production in order to
produce goods and services, which are then offered for sale. Firms, then, whether sole
traders, partnership, limited companies or public corporations, are the economic agents
responsible for the supply of goods and services?
 Every firm needs to earn sufficient revenues to cover its costs if it is to remain in
business in the long run. In striving to achieve their objectives of profit maximization,
firms estimate their current and future sales revenues and their current and future
production costs with a reasonable degree of accuracy. Firms must therefore know the
profitability of employing additional labor, more capital and also the profitability of
acquiring more land. All these would have an effect on the amount supplied in the
market. Before deciding to supply more in the market, firms also consider the future
demand for its products. The higher the price, the higher the supply.

Determinants of supply
12
1. Objectives of firm (O): A firm, which aims to maximize its sales, will generally supply a
greater quantity than a firm aiming to maximize profits.
2. Price of good x (Px): As the price of good x rises, with all costs and the prices of all other
goods unchanged, production of x becomes more profitable. Existing firms are likely to
expand their output and eventually new firms will be attracted into the industry.
3. Prices of certain other goods (Pg): If the prices of some other goods, say y, rises, with the
price of x unchanged, some of the firms now producing x may be tempted to move into y
production, motivated by the search for profits, e.g. wheat and barley.
4. Prices of factors of production (Pf): A rise in the prices of fop for a particular product
causes the cost of production also to rise. This causes a fall in supply since some firms
reduce output while others make losses and eventually leave the industry.
5. The state of technology (T): Technological improvements such as inventions of new
machines or development of more efficient technique of production may reduce cost
and increase profit margin on each unit sold. This increase supply.
6. Expectations (E): If the price of an item is expected to rise at a future date, firms may
reduce the amount they supplying the current period to enable them build up stock to be
offered for sale when price is high.

Individual –Vs- market supply Function

The individual’s supply function for good x can be written as; Sx= f(O, Px, Pf, Pg, T, E, Z) where
Z represents all other relevant factors e.g. natural events, levels of taxes and subsidies, etc.
Market supply is the sum of quantities of a good that individual firms are willing and able to
offer for sale over a given time period. The market supply for good x for instance is the sum
of the individual firm’s supply in the economy. Suppose the market supply for good x is being
influences by objectives of the firms, (O) price of good x (Px), prices of certain other goods
(Pg.), prices of fop (Pf), T, and Expectation (E), we can write the following market supply
function for good x:
Sx = f(Px, Pg, O, Pf , T, E, Z), where Z = all other relevant factors.

The slope of the supply curve and its economic interpretation:

 Supply curves describe the seller’s desire to make the good available. Generally, the
more someone is willing to pay for a good, the more interested is a seller in
supplying it. Thus the higher the prices, the more willing a seller is to supply. Supply
curves are merely a graphical way to describe his willingness to respond with
additional goods to an increase in the selling prices.
 The supply curve for the price of good x shows the relationship between the prices
of x and the quantities that firms are willing and able to sell at those prices, ceteris
paribus, i.e., Sx = f(Px), ‘ceteris paribus’.
 The supply will slope upwards from left to right so that as the price of the goods
increases, so does the quantity that the firms are willing to supply. The diagram
below illustrates this:

S At 20% firms are willing to supply

Price 100 units while at 10% they are
(Shs) willing to supply none.

0
Quantity per time
period

Movement along –Vs- Shifts of the supply curve

 An increase in the supply of a good refers to a shift in the entire schedule of supply,
that is, a shift in the supply curve.
 An increase in the amount supplied corresponds to movement that occurs as the
price of the good in question increases. As such, it is a movement up the supply
13
 curve without any shifts implied.
 Shift of the supply curve is caused by changes in the prices of factors of production
and technological changes. The supply curve can shift to the right or to the left.
Technological advancement for instance causes the supply curve to shift to the right
and vise versa. S2

S0 Shift of the supply curve due to changes in

Price S1 technology or prices of the factors of
production.
Other causes of shift of the s curve;
-changes in the price of substitutes in product.
-change in objective from profit to sales
0 maximization
-expected rise in price of a substitute in
Quantity
Movement along the supply curve
Price S of x due to variation in the price
of x
P1
P2

Q1 Q2
Quantity
ELASTICITY OF SUPPLY
 This is a measure of the extent to which the quantity supplied of good responds to
changes in one of the influencing factors. It describes the responsiveness of sellers
to a change in one of the influencing factors.
 Elasticity of supply can either be elastic or in elastic. Inelastic supply, for instance, is
a condition which occurs if the quantity supplied changes less than proportionately
in response to a given change in price, price being the influencing factor. However,
elastic supply occurs if the quantity supplied changes more than proportionately in
response to a given change in the influencing factor e.g. price.

Determinants of Elasticity supply

a) Time: The supply of a good is likely to be more elastic the longer the period of time
under consideration. In the momentary period, supply is limited to the quantities
already available in the market and it can not be increases even if a substantial rise
in price occurs. In such a period supply curve could be therefore, perfectly inelastic
as shown below.

S1 The quantity supplied is

unchanged despite changes in
the price. It is fixed at 0q.

In the short-run, supply can be increased by employing more variable ‘factors e.g.
laborers. The supply curve in this case will slope upwards from left to right, exhibiting
some degree of elasticity as shown below.
Price
S1
S2 As a result increase in price, supply rises as
P well and quantity availed for sale is oq2 due to
increase of variable factors. The supply curve
SS2 represent the elastic supply in the
0 short-run. 14
 q1 q2

In the long run, the quantities of all factors of production can be increased. Existing
firms can expand their operations by increasing fixed factors of production, improving
on technology and also making other adjustments. New firms can also enter the industry
if the prices are high. Supply curve in the long run is likely to be much more elastic as
shown below.
S2
Price S1

S3 S3 S3 is the supply curve in the long run. Its

P much more elastic than the short-run supply
curve (S2S2). Quantity supplied is 0q3.

q1 q2
b) Excess capacity and unsold stock: In the short-run it may be possible to increase supplies
considerably if there is a pool of unemployed labor and unused machinery (known as
excess capacity) in the industry. If the producer has accumulated a large stock of unsold
goods, supplies can quickly be increased. Supply therefore will be more elastic the greater
the excess capacity in the industry and the higher the level of unsold stocks.
c) The ease with which resources can be shifted from one industry to another: In the
absence of excess capacity and unsold stocks, an increase in supply requires the shifting
of factors of production from one use to another.

Price elasticity of supply

 This is a measure of the responsiveness of quantity supplied to a change in the goods
‘own price’, ceteris paribus’. It can be calculated using the formula below:

proportion ate change in quantity sup plied

Pr ice elasticity of sup ply 
proportion ate change in price

q p q p
ie , e s   
q p p q

Supply is said to be inelastic (es < 1) when a given percentage change in price causes a
smaller percentage change in quantity supplied. It is said to be elastic (es>1) when a small
percentage change in price causes a bigger percentage change in quantity supplied. Supply
is said to be perfectly inelastic (es = 0) when any change in price does not cause change in
the quantity supplied. It will be supplied even at a zero price. It is perfectly elastic (es = ) if
at one price, the quantity supplied is at infinity. Nothing will be supplied at the price below the
one set price. Supply is said to be unitary elastic (es = 1) when a given percentage change in
quantity supplied is exactly equal percentage change in price.
a) Perfectly inelastic supply curve b) perfectly elastic supply curve
S

Q1 Quantity Quantity per time

15
period
c) Unitary elastic S
Moving from point A to point B
along the supply curve, a 100%
10 rise in price causesa100% rise in
quantity supplied.
5

0
8 16 Quantity
Point elasticity –vs- arc elasticity of supply
 Point elasticity of supply measures elasticity at a particular point on the supply curve.
 Arc elasticity of supply is a measurement of elasticity between two points on the supply
curve.

Application of elasticity of supply

 When firms are making critical decision on the wage rate, they consider the elasticity of
supply of individual factors of production.
 Elasticity of supply is a vital tool for economic analysis. The government when deciding
on either supply-side or demand-management policies uses elasticity of demand and
supply to make an appropriate move.

Supply side policies - policies designed to influence aggregate supply by improving the
productivity of the free market economy.

Producer surplus – This is the difference between the total amount that the producers
receive for any quantity of a good and the minimum amount they would have been willing to
accept for it.

NB: Consumer surplus – (ref).

16
 EQUILIBRIUM AND ITS APPLICATION
Equilibrium in the market
 Equilibrium is the situation that results as supply and demand interact in the market
place to determine a quantity bought and sold at a stable price.
 Market equilibrium therefore is a price-quantity combination that results from the
interaction of the supply curve and the demand such that at the indicated price, the
quantity demanded equals the quantity supplied.
 The equilibrium has the property that once the market settles on that point it stays there
unless either supply or demand shifts. Additionally, a market that is not at equilibrium
price-quantity combination moves towards that point.
 Equilibrium price is the point at which the quantity demanded is equal to the quantity
supplied. It is also known as the market-clearing price. The diagram below represents
the equilibrium price-quantity.

d S
Price 0P1 is the equilibrium price while
P2 0q1 is the equilibrium quantity
(Shs) supplied and demanded
P1
P3

q1 Quantity

 At 0P2 less will be demanded while more will be supplied. At 0P3 less will be supplied
while more will be demanded.
 Comparative static equilibrium analysis is a method of analysis that compares different
equilibrium situations when the initial equilibrium is disturbed by a change in a variable.

Stable vs unstable equilibrium

 Equilibrium is said to be a stable equilibrium when economic forces tend to push the
market towards it. That is, any divergence from the equilibrium position sets up forces,
which tend to restore the equilibrium.

S The equilibrium price at 0Pe is

Price stable because the establishment
P1 of any disequilibrium like op1 or
op2 sets up economic forces
Pe (excess supply in the case of op1
and excess demand in the case
P2 of 0P2) which, given the
D
competition among buyers and
q3 q1 qe q2
q4
 An equilibrium is said to be an unstable equilibrium when economic forces tend to push
the market away from it. That is, any divergence from the equilibrium sets up forces
which push the price further away from the equilibrium price e.g., in the case of giffen or
veblen goods. The diagram below illustrates this.

S The abnormal demand curve means that at

D
prices above 0Pe, there is excess demand,
which pushes the price upwards and away
from
17 the equilibrium. Similarly, at prices below
0Pe, there is excess supply, which pushes the
price further done.
 NB: Market disequilibrium exists when the price and quantity of a commodity fail to match
consumers’ and producers’ expectation. It sets in motion a chain of adjustments and
re-adjustment processes.

Excess Demand and Excess Supply

 Excess demand of a commodity implies a shift of the demand curve to the right. This
exerts upward pressure on price until it rises to the new equilibrium. The diagram below
illustrates this: S

P1 The supply of x is assumed to be

fixed and only demand for x has
D1 increased causing a shift in the
P0
demand curve for good x.
D0
q0 q1
 With excess demand for good x, if price were to remain at P0 then a shortage equal to
q0-q1 would exist. This shortage implies that consumers compete for scarce goods and
drive the price up. This process continues until the price rises to P1, the new equilibrium
price and quantity is q1. Notice that q1, is smaller than q1. Some of the increase in
demand is discouraged by price increase that occurs.
 Price and quantity change in this case would be affected by the size of demand shift and
the elasticity of supply curve.
S
The price increase is higher
because supply is perfectly
P0
inelastic.
P1
D0
D1

 Excess supply implies a shift in the supply curve to the right. This exerts downward
pressure on price until it lowers the equilibrium as illustrated below:
D S0
S1
P0
P1

The demand for good x is assumed to be fixed and only supply has increased thereby
causing a shift of the supply curve. The new equilibrium price is at P1, price and quantity
change depend on the size of supply shift and elasticity of demand.

Application of Algebra in determining equilibrium

 Equilibrium price is attained at a point where force of demand and supply are equal.
That is to say, demand price equals the supply price.
 Suppose the quantity demanded of commodity (Qd) x equals a - bP and quantity
supplied (Qs) is -c + dP, what is the equilibrium price of commodity x?
A= qty demand when price is zero
Qs = -c + dP
B =change in qty demand due to
a c change in price
C = qty supplied at zero price
d b D = change in supplied due to
18in price.
change
 Qd = a - bP

ad  bc
b d

At equilibrium, Pd = Ps
Qd = a - bP, Qs = -c + dP

Qd = Qs  a – bP = -c + dP

a + c = dP + bP = P(d +b)
a c
 p equilibriu m price 
d b
a a c
Qd  a  bP  b
1 d b
a d  b   b a  c 
Qd 
d b
ad  ab  ba  bc
Qd 
d b
ad  bc
Qd 
d b

Example 1:
Qd  3550  266 P
Qs  1800  240 P
Qs Qd
Therefore , 3550  266 P  1800  240 P
 3550  1800  240 P  266 P
1750 506
  P
506 506
 P  3 . 46
Q s  1800  240  3 . 46  1800  830 . 4  2630 .4

Example 2

Qs  1
5
P

1
Qd  40  P
3
1 1
Qd Qs  P  40  P
5 3
1 1
 P  P  40
5 3
3P  5P
  40
15
8P 8P 600
  40  
15 8 8
 P  75
19
1
Qs   75  15
5
An Application of price mechanisms (theory)
 This is the most fundamental feature of market economic. Decisions about consumption
are undertaken by millions of different people, each freely expressing their preferences
for different goods and services. Decisions about production, on the other hand, are
undertaken by tens of thousands of producers who freely decide which goods and
services they are going to provide. There is little or no direct communication 1.1 each of
these groups, and yet any change in the preferences of consumers is accurately and
quickly transmitted to producers via ts effects on the prices of goods and services which
producers provide. These price changes ensure that the decisions of consumers and
producers, although taken independently are usually compatible with one another.
 For example, if a good suddenly becomes more popular so that there is a market
shortage at the existing price, price will rise so as to ration the available supply. However,
a rise in price will make the production of such a commodity more profitable. Output will
therefore increase as producers are now able to attract resources away from the
alternative uses by the offer of higher rewards. The process will operate in reverse when
the product becomes less popular. It is important to changes in the allocation of
resources. This is why the consumer is said to be sovereign in market economies. The
following are some of the advantages of the price mechanism;
1. Economic efficiency- Consumers are best judges of their interests and no one is better
off without making the other worse off.
2. Greater freedom of choice- Competition between firms gives rise to many goods and
services and so consumers are able to choose from a much wider range.
3. Greater responsiveness to the world economic environment- Market economy responds
more quickly to changing economic conditions in the world markets than does a
command economy.
4. Greater incentives to bear risks- Free markets encourage competition and thus stimulate
the incentive to take business risks. This leads to faster rate of technological
advancement hence economic growth.
Weakness of price mechanisms
1. Inequalities of income and wealth-As goods and services are produced in response to
money ‘votes’ cast in their favor, scarce resources are diverted in the production of
luxuries for the rich who have more 'money votes' before an adequate output of goods
for the poor is producers. The pricing system therefore ignores the equity objective of
resource allocation.
2. Unemployment-At times, total demand can fall short of total supply of goods, as a result
of which unsold stocks of goods accumulate, forcing producers to cut back on
production plans and lay off workers.
3. Inflation- The price system is prone to severe inflation most of the industrialized and less
developed countries have experienced persistently rapid rises in prices in their
economies. This has lead to social and political tensions in many countries
4. Contrived demand-Because firms compete for markets there is extensive advertising and
sales promotion activities and this have actually created new wants. Thus, consumers
demand is contrived by advertising and this have resulted in substantial loss consumer
sovereignty.
5. Market imperfections-Market imperfections such as information costs, monopoly power,
externalities and public goods are inherent in price mechanisms. With such
imperfections, price and output levels are unlikely to satisfy the condition for economic
efficiency.

20
CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION
Consumers are assumed to be rational. Given his money income and the market
prices of various commodities, he plans the spending of his income so as to
attain the highest possible satisfaction. It is possible to measure the amount or
level of satisfaction that individuals get from consuming a commodity or a
bundle of goods using the concept of utility. Two approaches to the concept of
utility (Cardinalists and Ordinalists approach) describe how utility can be gauged.
The analysis of how consumers make choices can be done using the budget
constraint and indifference curves. An indifference curve shows various bundles
of commodities that make the consumer equally happy or give him the same
level of satisfaction.

Utility Defined
Utility is a measure of the satisfaction that a consumer gets from consuming a
commodity or a bundle of goods. The marginal utility of a good is the increase in
utility that the consumer gets from consuming an additional unit of the good.
Most goods are assumed to exhibit diminishing marginal utility ie. the more of a
good a consumer already has, the lower the marginal utility derived from the
consumption of an additional unit of the commodity.
The table below illustrates diminishing marginal utility.
Quantity of x Total utility Marginal
Consumed per week (units per week) (utility units)
0 0 0
1 20 20
2 50 30
3 60 10
4 62 2
5 60 -2

The Cardinalist vs Ordinalists’ Approach

The cardinalist approach considers utility as being measurable in monetary
terms by the amount of money the consumer is willing to sacrifice for another
unit of the commodity or in subjective units called utils and can be assigned a
value eg. 10, 20, 30. The ordinalists say that utility is not measurable but is an
ordinal magnitude. The consumer need not know in specific units the utility of
various commodities to make his choice. It is enough for him to be able to rank
the various ‘baskets of goods’ according to the satisfaction that each bundle
gives him. He must be able to determine his order of preference among the
different bundles of goods. The main ordinal theories are the indifference curves
approach and the revealed preference hypothesis.

Assumptions of the Cardinal Utility Theory

1. Rationality: The consumer is rational and aims at maximizing his utility
subject to the constraint imposed by his given income.
2. Cardinal utility: The utility of each commodity is measurable. The most
convenient measure is money-the utility is measured by the monetary
units that the consumer is willing to pay for another unit of the
commodity.
3. Constant marginal utility of money: This assumption is necessary if the
monetary unit is to be used as a measure of utility.
4. Diminishing marginal utility: The utility gained from successive units of a
21
 commodity diminishes as a consumer acquires more of it.
5. The total utility of a ‘basket of goods’ depends on the quantities of the
individual commodities in the basket. The more the goods, the higher the
utility.

Assumptions of the Ordinalist Utility Theory (Indifference Curves Approach)

1. Rationality: The consumer is assumed to be rational - he aims at the
maximization of his utility, given his income and market prices and has full
knowledge of market conditions.
2. Utility is ordinal: Consumers can rank their preferences according to the
satisfaction of each basket. He need not know precisely the amount of
satisfaction.
3. Diminishing marginal rate of substitution: Preferences are ranked in terms
of indifference curves, which are assumed to be convex to the origin.
4. The total utility of the consumer depends on the quantities consumed.
5. Consistency and transitivity of choice: It is assumed that the consumer is
consistent in his choice. If at one period he chooses bundle A over B, he
will not choose B over A in another period if bathe bundles are available to
him. It is also assumed that the consumer’s choices are characterized by
transitivity. If bundle A is preferred to B, and B is preferred to C, then
bundle A is preferred to C.

Indifference curves
A consumer’s preferences allow him, to choose among various bundles of
goods. If two bundles suit his taste equally, we say that he is indifferent between
the two. Indifference curves show the bundles of consumption that make the
consumer equally happy.

Properties of Indifference Curves

As indifference curves represent consumer preferences, they have certain
properties that reflect these preferences:
1. Higher indifference curves are preferred to lower ones as consumers
usually prefer more of something to less of it.
2. Indifference curves are downward slopping. The slope reflects the rate at
which the consumer is willing to substitute one good for the other. If the
quantity of one good is reduced, the quantity of the other good must be
increased for the consumer to remain equally happy.
3. Indifference curves do not cross/ intersect.

22
 Y

B A

C I2
I1

Since both A and C are on the same indifference curve, the two points
make the consumer equally happy. Point B is on the same curve as point C
hence both make the consumer equally happy. This implies that points A
and B would make the consumer equally happy which is not true as point
A has more of both goods. The satisfaction derived from consumption at
point A is superior to that at point B.
4. Indifference curves are convex to the origin. The slope of the indifference
curve is the marginal rate of substitution (the rate at which a consumer is
willing to trade off one good for the other). The marginal rate of
substitution depends on the amount of each good the consumer is
currently consuming. People are more willing to trade away goods that
they have in abundance and less willing to trade away goods that they
have little of.

Consumer Equilibrium (Optimum choice)

The consumer will be at equilibrium when he cannot increase his total utility by
reallocating his expenditure. Suppose the consumer was consuming only one
commodity x. He can either buy X or retain his money income. The consumer will
be at equilibrium when the marginal utility of X is equal to it’s market price (MU X
= P X ). If the marginal utility of X is greater than its price, the consumer will
increase his welfare by consuming more of X. If marginal utility of X is less than
its price, the consumer can increase his total satisfaction by cutting down on the
amount of X consumed and leaving his income unspent. He maximizes his utility
when (MU X = P X )
If there are more commodities, consumer equilibrium occurs at the point where
the ratios of the marginal utilities (MRS) of the individual commodities equals
their relative prices.
MU PX
X

MU Y
PY
When you cross multiply, the consumer will be at equilibrium when
MU MU MU
X
 Y
 n

PX PY Pn
i.e. when the ratios of marginal utility and price are equal for all goods
consumed. The marginal utility per penny of X is equal to the marginal utility per
penny of Y. Suppose the price of commodity X falls then it follows that:
23
 MU MU
X
 Y

PX PY
The consumer will increase his total consumption of commodity X. This will have
the effect of decreasing the marginal utility of X due to the hypothesis of
diminishing marginal utility. The consumer will continue to increase his
consumption of X until equilibrium is achieved. Suppose initially that MUx= 20
utils, MUy = 25 utils, Px= Shs4 and Py = Shs5, the condition is satisfied as below:

MU MU
 5
x y
utils per penny
Px Py

Indifference Curves - Consumer Optimum

The above condition can also be graphically presented using the budget
constraint and indifference curves. The consumer would like to end up with the
best bundle of goods but must also end up on or below his budget constraint.
The consumer chooses the point on his budget constraint that lies on the highest
indifference curve. At this optimum point, the marginal rate of substitution equals
the relative price of the two goods. The consumer would prefer point A but he
cannot afford it as it is above his budget constraint. He can afford point B, but
this point is on a lower indifference curve, therefore provides less satisfaction.

Quantity
of Pepsi

A
Optimum

0
Quantity of Pizza

How Changes in Income Affect the Consumer’s Choice (Income Consumption

Curve)
Suppose the consumer’s income increases. He is able to afford more of both
goods. The increase in income shifts the budget constraint outwards. Because
the relative price of the two goods has not changed, the slope of the budget line
is the same as that of the initial budget constraint. An increase in income leads
to a parallel shift in the budget constraint. This allows the consumer to choose a
better combination of goods. He can now reach a higher indifference curve. The
consumer’s optimum moves from the initial position to a new optimum.

24
 Quantity
of Pepsi

Income-consumption

0
Quantity of Pizza
When the consumer’s income rises, the budget constraint shifts outward. The consumer
moves to a higher indifference curve. The two points give us the income-consumption curve.
This shows how consumption varies with changes in income. At the new optimum position,
more of both pepsi and pizza are purchased. The two goods are normal goods. Should the
amount of pepsi purchased reduce while that of pizza increases, then pepsi will be an
inferior good and pizza a normal good. This is illustrated in the following diagram.

Quantity
of Pepsi
NB: Pizza is the normal
good and pepsi the inferior
good.

I2

I1
0
Quantity of Pizza
How Changes in Price Affect then Consumer’s Choices (Price Consumption
Curve)
Suppose the price of pizza falls, and the price of pepsi and income remain the same. With
the same income the consumer is now able to buy more pizza with the same amount of
pepsi. The budget line shifts outwards to the right. The graph below illustrates this:

25
 Quantity
of Pepsi

Price consumption
I2

I1
0
Quantity of Pizza
Price of

Demand
curve for
pizza

Quantity of Pizza

The consumer’s equilibrium changes from point A to point B where he consumes more of
pizza and less of pepsi. The line A-B gives us the price-consumption curve. It shows how
changes in the price of pizza affect the quantity consumed. By extending the above graph we
can obtain the demand curve for pizza. The consumer’s demand curve is a summary of the
optimal decisions that arise from his budget constraint and indifference curves.

Quantity Substitution effect: Z1- Z2 and P1- P2.

of Pepsi Income effect: Z2- Z3 and P2- P3.

P1 Price consumption
P2 I2
P3
I1
0
Z1 Z2 Z3 Quantity of Pizza

 The total effect of a price change is the sum of the substitution and income effects. The
total effect of the decline in the price of pizza is the increase in quantity demanded from
0Z 1 to 0Z 3 . The movement from 0Z1 to 0Z2 is attributable to the substitution effect while
the movement from 0Z2 to 0Z3 is the income effect.

26
27
 PRODUCTION THEORY
Production.
 Production is defined as any economic activity which satisfies human wants. It is thus
the creation of utility (where utility means the ability of a good or service to satisfy a
human want). Indeed, to the economist, the chain of production is only complete when a
good or services is sold to the consumer.
 For any community, the volume of production depends on many factors, including the
quantity and quality of available resources, the extent to which they are utilized and the
efficiency with which they are combined. The volume of production can therefore be
increased when existing inputs yield a higher output. The latter is referred to as an
increase in productivity and is usually measured as average production per worker.
 The theory of production consists of an analysis of how the entrepreneur, given the state
of art or technology, combines the various inputs to produce a stipulated output in an
economically efficient manner. Production takes place within various forms of business
organizations.

Forms of Business Organizations.

1. Sole proprietorship.
 A sole proprietorship (or one-person business) is a business under the ownership and
control of a single individual. It is not only easier to start but it also does not involve a lot
of formalities and capital.
 In Kenya, such businesses are very common and are run on family grounds and
members of a specific family manage them for profit.
 Sources of fund for sole proprietorship are owners saving, loans from relatives, friends,
trade credit and to a lesser extent short term loans from financial institutions.
 Such businesses are usually short term in that the death of the owner leads to its
dissolution or closure. In legal circles, there is no difference between the business and
its owner. The two are the same from the legal point of view.
 Furthermore, the sole trader has no limited liability, i.e., his assets and liabilities and
those of his business are one and the same thing. In the event of its dissolution, should
the business assets fail to meet the claims of the creditors, then the personal assets to
the sole proprietor can be attached to meet the creditor’s claims.
Advantages of sole proprietorships
- It is simple to start and dissolve this type of business.
- The sole trader enjoys top secret of his business success/failures.
- Profit motives usually motivate the sole trader to work harder.
- Close supervision by sole trader enables him to boost sales.
- The owner can give personal attention to customers because the business is small in
size.
- It’s the most highly adoptable and flexible form of business when it comes to changes.
- Sole decision-making guarantees swift abrupt decision making.
Disadvantages
- The economic life of a sole trader business is usually equal to the life of the sole
proprietor. It can therefore not attract long term financing to finance long term plans due
to lack of continuity.
- The sole proprietor has unlimited liability.
- The success of the business depends upon the judgment and management abilities of
its owners.’ Laymen’ find it very hard at times.
- Relies on traditional sources of finance.
- Lack of proper accounting knowledge hence the difficulty of distinguishing between their
own cash and business capital.
 One-person businesses are common in retailing, farming, building and personal services
such as hairdressing.

28
2. Partnerships
 A partnership business is a business under the ownership and control of two or more
individuals with a view of profit.
 Usually, most partnerships are of unlimited status, meaning that in the event of the
partnership business failing to meet its obligations, then the personal assets of
individual partners may be attached to settle such obligations.
 A partnership is ideal where the amount of capital requirement is reasonably large and
so calls for contributions from various persons
 Its also ideal where pooling of effort is necessary for best performance and thus
efficiency e.g. in legal or audit professions. Ownership of any one partner can not be
transferred without the consent of other partner or partners.
 Admission or dismissal of any one partner must have full consent of the other partners.
 By law, its account does not have to be audited,
Advantages:
- The business can benefit from talents of individuals partners.
- More capital can be raised from individual partners.
- Unanimous stand on decision making guarantees sound decisions
- Partnerships have high growth due to adequate managerial talents.
Disadvantages:
- Partners may not pool their talents equally and this may lead to apathy among partners
who put more efforts in running of the businesses.
- There may be lack of mutual trust among partners therefore, suspicion.
- Disagreements among partners may delay the decision-making process.
- Active partners may use business assets to achieve personal interests/gain at the
expense of dormant partners.
- Partnership businesses may have a short life span.

3. Joint stock companies

 A joint stock company is a legal entity that carries out business in its own name. The
company is owned by its shareholders whose liability is limited.
 These companies are usually governed by an Act of parliament which lay down the
formation and general conduct of joint stock companies.
 Joint stock companies are distinct from their owners and its assets are owned by the
company and not its shareholders.
 A joint stock company can either be a private limited company or a public limited
company.
 The shares of a private company cannot be offered to the public for sale and thus can
not be transferred without the consent of other members. They require a minimum of
two and a maximum of 50 shareholders or members.
 The shares of a public company can be offered for sale to the public. A public company
requires a minimum of 7 shareholders, but there is no upper limit. The shares are freely
transferable and the company is required to hold an annual general meeting where
shareholders are able to question directors, to change the company’s article of
association, to elect or dismiss the board of directors, to sanction the payment of
dividends to approve the choice of auditor and to fix their remuneration.

4 Co-operatives
 A co-operative is an entity owned and controlled by its members on the basis of one-
member one-vote. The movement which comprises a familiar section of the retail trade
is based on consumer ownership and control. Producer co-operative, however, are
owned by producers.

5 Public Corporations
 These types of enterprises develop when the government decides to place production in
the hands of the state. The government appoints the chairman and board of directors
29
 which is responsible to the minister of the crown for fulfilling the statutory requirements
for the public corporation laid down by parliament. The minister is supposed not to
concern himself/herself with the day to day running of the company.
 Public utilities such as railways, gas, electricity and water supply are state owned in most
countries.

Factors of production
 The factors of production refer to the inputs used in production process. Economists
place the factors of production into one of the three categories. These are land, labour
and capital. Sometimes, enterprise is also added to the list
i) Land
- This include minerals, forest water and other natural resources as well as land itself used
in agriculture and as a site upon which economic activities take place. Land therefore
refers to all natural resources which are used in production.
ii) Labour
- This refers to all human attributes, physical and mental, that are used in production.
Labour is not a homogeneous factor of production as some jobs require little, if any,
training while others require several years to training e.g. surgeons and civil engineers.
The education that is invested or embodied in trained labour is sometimes referred to as
human capital.
iii) Capital
- Capital refers to goods which are not for current consumption but which will assist
consumer goods to be produced in the future. Capital goods are sometimes called
investment or producer goods. They are wanted because of the contribution they make
to production. Capitals include all plant machined and industrial buildings that contribute
to production.
- Capital is a stock, i.e., it exists at a point in time. Capital stock could be measured at a
particulate moment. With time as it consumed capital depreciates in value.
- Depreciation (or capital consumption) is a measure of the extent to which the capital
stock falls in value as a result of use (or wear and tear) during the relevant time period,
normally a year.
- The purchase of new plant or machinery is called investment. Investments a flow- i.e., it
can be measured as ‘so much’ per time period.
iv) Enterprise
 It is the entrepreneur who organizes the produce and what quantities of the factors of
production to use. The entrepreneur bears the risk of production because he/she incurs
the costs of production before receiving any revenue from the sale of the finished
product.
Production function
 Production involves the transformation of resources into final goods and services. The
relationship between inputs and output is a technological relationship which economist’s
summaries in a production function.
 Production function is a schedule or table or mathematical equation showing the
maximum amount of output that can be produced from any specified set of inputs, given
the existing technology or ‘‘state of the art’’. In short, the production function is like a
‘recipe book’ showing what outputs are associated with which sets of inputs. Suppose
that the production of good x requires inputs of capital, labor and land; Using functional
notation, we can write:
 Qx = f(K, L, LD), where QX is output per time period, f is the functional relationship;
and K, L and LD represent the inputs of the services of capital, labor and land
respectively into the production process. This is production function of the inputs
of the services of capital, labour and land.
 A production method is said to be technologically efficient if for a given level of factor
inputs, it is impossible to obtain a higher level of output, given existing technology. An
improvement in technology, of course, would enable more output to be produced from a
given level of inputs and this is a possible source of economic growth. Technology
30
 therefore acts as a constraint on production possibilities.
 The production function may be shown as a table, a graph or as a mathematical
equation.

Short-run variations in output.

 A manufacturing firm wishing to increase its output is unable to have a bigger factory
built overnight and so in the short-run can only produce more by employing more of its
variable factors such as labour, raw materials and fuel. Short-run is that period over
which at least one factor of production can not be varied. Those factors which can be
varied in the short run are called variable factors. Those which can not be varied in the
short-run are called fixed factors.
 The laws of returns explain the relationship between changes in the input of these and
changes in the level of production. The general relationship is summarized in two laws
which are sometimes combined into a single law known as the law of variable
proportions.

a) The law of increasing returns - This law states that in the early stages of production, as
successive units of a variable factor are combined with a fixed factor, both marginal and
average product will initially rise i.e., total output will rise more than in proportion to the
rise in inputs.

b) The law of diminishing returns - This law states that as successive units of a variable
factor are combined with a fixed factor with a given state of technology, after a certain
point both marginal product and average product will fall. In other words, total output will
rise less than in proportion to the rise in inputs. Eventually total output will even diminish
as marginal product become negative.
 The changing nature of returns to a variable factor can be seen in the table below: We
assume that an increasing amount of labour works on a fixed quantity of land that each
worker is homogeneous and that techniques of production are unchanged.

Wheat production illustrating the law of diminishing returns

No of Total Average Marginal
workers product product product
1 4 4 4
2 10 5 6
3 20 6.7 10
4 35 8.8 15
5 50 10 15
6 60 10 10
7 65 9.3 5
8 65 8.1 0
9 55 6.1 -10

 Under these circumstances, the firm’s production function for wheat can be written
as:
 _ _ _
Qw  f  L , K , L D , T  Where QW is the output of wheat in tones per time period, L is
 
_ _ _

labour and is changing, K is capital (fixed) L D is land (fixed), and T is technology

 It can be seen that upon the employment of the fourth worker, the firm experiences
increasing marginal returns because the increase in total product is proportionately
greater than the increase in the variable factor. This clearly shown by the rising marginal
product of each worker up to the employment of the 4th worker. When marginal product
is rising, the rate of increase of total product must also be rising. The main reason why
firms experience increasing returns is because there is greater scope of division of
31
 labour as the number of workers employed increase.
 Diminishing marginal returns set in after employing a fifth worker when it is clear that the
rate of increase of total product, i.e. marginal product begins to fall. Diminishing returns
set in because the proportions in which the factors of production are employed have
become progressively less favourable, reflecting the fact that there are limits to the gains
from specialization. The fixed factors of product have become over utilized.
 The average product of a factor of production is the total output per unit of factor input,
i.e., AP =TP/L.
 The marginal product of a factor of production is the change in total output as a result of
a unit change in the factor input. i.e., MP= ∆TP/∆L.
 The diagram below illustrates the relationship between total, average and marginal
products. The AP and MP curves, the relationship between them can be derived from the
total product (TP) curve.

C TP
products

AP
0 L1 L2
Unitsof variable factors
 MP
(No. of workers)
 Since AP=TP/L, then AP is given by the slope of the ray from the origin to the relevant
point on the AP is equal to the slope of 0L1 units of labour are used, the AP is equal to the
slope of the ray 0A, i.e., AL1/0L1 . AP is at maximum where the ray from the origin is target
to TP curve, i.e., at point C where 0L2 units of labour are employed, there are employed
until 0L2 units of labour are employed, there are increasing average returns to the variable
factor (labour). A t that point, the slope of TP is given by CL2/OL2 which is equal to AP,
confirming that AP = MP when AP is at maximum. MP is at maximum when TP curve is
steepest, i.e., between A and C
 TP reaches maximum when OL3 units of labour are employed. At this point MP=O,
confirmed by the slope of TP curve at point D. If additional units of labour are hired, total
product (TP) falls and MP is negative.
Short-run variations in costs
In the short-run it is possible to categorize the firm’s costs as either fixed costs or variable
costs. Fixed costs are incurred on fixed factors of production and variable costs on variable
factors of production.
Fixed costs
 Because it is impossible to vary the input of fixed factors in the short-run, fixed costs do
not change as output increases. Additionally, it is important to realize that fixed costs are
incurred ever when the firm’s output is zero. Fixed costs include mortgage or rent on
premises, hire purchase repayments, local authority rates, insurance charges,
depreciation and so on. None of these costs is directly related to output and they are all
costs which are still incurred in the short-run ever if the firm produces no output
 Because total fixed costs are constant with respect to output, average fixed costs (AFC),
i.e., total fixed costs (TFC) divided by output (TFC/Q), decline continuously as output
expands. Diagrammatically, the behaviour of total fixed costs and average fixed costs as
output expands are shown below.

32
 TFC

AFC
0
Output

Variable Costs:
Unlike fixed costs, variable costs (VC) are directly related to output. When firms produce no
output, they incur no variable costs, but as output is expanded variable costs are incurred.
Because they vary directly with output, these costs are sometimes referred to as direct costs
or supplementary costs. Examples of these costs include costs of raw materials and power
to drive machinery, wages of direct labour and so on. The diagram below shows the
behaviour of variable costs as output changes.

TVC
Total
Variable
Cost

0
Output
 Total costs: TC =TFC + TVC. TC is the sum of total fixed costs and total variable
costs
 Average variable costs is the variable costs per unit of output, i.e., AVC = TVC/Q
 Average total cost (ATC) is the total cost per unit of output, i.e., TC/Q.
 ATC = AFC+AVC = TC/Q.
 Marginal costs (MC) is the change in total cost as a result of changing the level of
output by one unit, i.e., MC = ∆TC/ ∆Q

The relationship between Marginal costs and Variable costs

 Since marginal costs is the change in total cost when one more unit is produced, it is
entirely a variable cost. Because in the short-run only the input of variable factors can
be changed, it is clear that the sum of MC of producing each unit equals the total
variable costs of production.
 Additionally, although variable costs (VC) vary directly with output, they are unlikely
to vary proportionately because of the effect of increasing and diminishing returns.
 It is clear that TVCs at first rise les than proportionately as output expands and the
firm experience increasing returns. Subsequently, as the firm experiences
diminishing returns TVCs rise more than proportionately as output expands.
 The changes in TVCs brought about increasing and diminishing returns also imply
changes in AVCs.
 When the firm experiences increasing marginal returns, marginal product rises and
marginal costs fall. Conversely, when the firm experiences diminishing marginal
returns, marginal product falls and marginal costs rises. The diagrams below
illustrate the effect of changes in marginal and average product on the marginal and
average cost.

Product

33
 AP

MP

Quantity of Variable
ctor
MC
Cost
AVC

0
OUTPU
T
 When MC is below AVC, the latter is falling. This is because in the
short-run MC is the addition to total variable cost (TVC). When the last unit
adds less to the total than the current average, then the average must fall,
just like in any average must fall. AVC rises when MC lies above it. The
implication of this is that the MCS curve cuts the AVC curve at its
minimum point.

The Behavior of Different costs of production
 We know that average fixed costs fall continuously as output expands and that
initially, because of increasing average returns, average variable costs (AVCs) fall.
 It follows that average total costs (ATCs) will initially fall. However, beyond a certain
point, average variable costs (AVCs) will begin to rise because of diminishing
average returns, and once the rise in AVCs move than offset the fall in AFCs (average
Fixed costs), ATCs will rise. This is clearly shown in the diagram below:

MC
The MC curve cuts the ATC
curve at the minimum point
AC (ATC) for exactly the same reason
that it cuts the AVC at the
AVC
minimum point.

AFC
0

Output Fixed cost TVC Total cost MC AVC AFC ATC

0 100 0 100 - 0 - -
1 100 50 150 50 50 100 150
3 100 95 195 45 47.5 50 97.5
4 100 135 235 40 45.0 33.3 78.3
4 100 165 265 30 41.3 25 66.3
5 100 180 280 15 36 20 56
6 100 190 290 10 31.7 16.7 48.3
7 100 195 295 5 27.9 14.3 42.1
8 100 205 305 10 25.7 12.5 38.1
9 100 225 325 20 25 11.1 36.1
34
 10 100 265 365 40 26.5 10.0 36.5
11 100 325 425 60 29.5 9.1 38.6
12 100 410 570 85 34.2 8.3 42.5

NB: Because of rounding AFC and AVC may not always exactly equal ATC.

Long- run variations in costs

 Long- run is that period of time over which the input of all factors of production can be
varied. The long run is a planning horizon. The long run refers to the fact that economic
agents (consumers and managers) can plan ahead and choose many aspects of’
short-run in which they will operate in the future. Thus, in a sense, the long-run consists
of all possible short-run situations among which an economic agent may choose.
 LAC curve-A firm is normally faced with a choice among quite a variety of plants. The
curves below illustrate six plants represented by short-run AC curves

SAC1 LMC SAC6

LAC
COST SAC2 SAC5
SAC3

0
QUANTITY
Economies of scale Diseconomies of scale

 The plant represented by SAC1 will be built because it will produce this output at the least
possible cost per unit. With the plant whose short run average cost is given by SAC1 unit
cost could be reduced by expanding output to the amount associated with point B, the
minimum point on SAC1 most efficient level. If demand conditions suddenly increase and
so larger output is desirable, the manager could easily expand and this would add to
profitability by reducing unit cost. When setting future plans, the manager would decide
to construct the plan represented by SAC2, because this would reduce unit cost even
more. The point E represented by SAC4 is the least cost point. It is the point beyond
which, diseconomies of scale is experienced.
 The Long run average cost curve is a locus of points representing the least unit cost of
producing the corresponding output. The manager determines the size of the plan by
reference to this curve, selecting that short run plant which yields the least unit cost of
producing the anticipated volume of output. Each plant is suitable for a particular range
of output.
 Each point on the LAC curve corresponds to a certain point on the SAC curve. Each point
represents a tangency between the SAC curve and the LAC curve.

Returns to scale
In the long run, there are no fixed factors and firms can vary all the inputs of factors of
production. When this happens, we say that there has been a change in the scale of
production. If a  in the scale of product leads to ‘more than proportionate’ change in output,
35
firms are subject to increasing returns to scale. E.g., if factor inputs are increased by 10%
and output grows by more than this, then firms are experiencing increasing returns to scale.
Economies of scale refers to falling average cost as the scale of output increases. The
diagram below illustrates this:
SAC3
SAC2
LAC
SAC1

C1

C2

q1 q2
Economies of scale Diseconomies of scale

 LAC curve reaches a minimum when 0q2 units are produced. Up to this level of output the
LAC curve is declining. The firm is therefore experiencing economies of scale. This is
because the firm has increasing returns to scale, assuming fixed factor prices.
 As output is increased above 0q2, the LAC curve rises indicating that the firm is facing
diseconomies of scale. With fixed factor prices, this must be because the firm is
experiencing decreasing returns to scale at these levels of output.
 It is sometimes suggested that firms might experience constant returns to scale as
output grows so that a change in all factor inputs results in an equi-proportional change
in output.

Sources of Economies of scale

1) Technical economies
These are usually common in manufacturing, since they relate to the scale of the
production unit. There are several reasons why costs might fall as the scale of product
increases, including,
a) Greater scope for division of labor - The larger the size of the production unit the
more men and machines are able to specialize.
b) Indivisibilities - Certain items of capital expenditure are relatively expensive and can
not be purchased in smaller or cheaper units, yet they may be helping raise output
substantially. E.g. the installation of automatic electronic control systems in industry,
although expensive, yield substantial increases in efficiency. This gives larger firms
considerable advantage over smaller firms because the costs of such equipment per
unit output falls dramatically as output expands.
c) Research and development - A large firm may be able to result its own research and
development programme which can result in cost reducing innovations.
d) Economies of linked processes - Most manufacturing output requires the use of
more than one machine. Large firms are able to operate more efficiently than smaller
ones, because it may be when output is large that all the machines can be used to
capacity.
e) Economies of increased dimensions - If the external dimensions of a container are
increases more than proportionately.
2) Marketing economies
These include economies from bulk purchases and economies from bulk distribution.
3) Financial economies
Large firms are frequently able to obtain finance more easily on more favourable term
36
 than smaller firms e.g. interests rates reduction.
4) Risk bearing economies
Large firms frequently engage in a range of diverse activities so that a fall in return from
any one activity does not threaten the viability of the whole firm.
5) Managerial economies -

Sources of Diseconomies:
 There is always an optimum level of capacity and increases in scale beyond this level
lead to diseconomies of scale which manifest themselves in rising average costs of
production Diseconomies of scale have several sources, including:
1) Managerial difficulties - It becomes increasingly difficult to control and coordinate the
various activities of planning, product design, sales promotion and so on as firms grow.
This is especially true where a diverse range of products is produced.
2) Low morale - This leads to high rates of absenteeism and lack of punctuality. It may also
lead to a lack of interest in the job which inhibits the growth of productivity and leads to
high incidence of spoiled work.
3) High input prices - As the scale of production increases, firms require more inputs, and
increasing demand for these might bid up factor prices. Additionally, when firms
produce on a large scale, the power of trade unions to negotiate wage awards in excess
of the growth of productivity thus increasing average labor costs.

ISOQUANTS
An isoquant is a contour line which joins together the different combinations of two factors
of production that are just physically able to produce a given quantity of a particular good. It
is sometimes called an iso-product curve. Iso stands for constant and quant for quantity

CAPITAL
(K) Each isoquant shows
different combination of
labour and capital which
300
K1 when used efficiently can
produce a given level of
K2 200 output
100
0
L1 L2 LABOUR

 The isoquant labeled Q1 combination capital and labour i.e., K1 and L1 which can produce P1
units of output.
 An output of Q2 units is bigger than Q1 and can be produced using any of the
combinations of capital and labour represented by point along the isoquant labeled Q2 ,
such as point C and D.
 An isoquant map is a family of isoquant labeled graphically illustrating the production
function for a good.
 Mathematically, isoquants can be represented as:
Q = f(K, L) = Q0 i.e., any combination gives an output of Q0.
 The slope of the isoquants gives the rate of technical substitution between labour and
capital when Q is held constant (i.e. Q). The slope shows the rate at which a unit of
capital can be traded for a unit of labour without reducing or increasing output, i.e., it tells
us the technical possibility of substituting labour for capital.

37
 k
RTS  Q≡Q
l
LK

Properties of isoquants
1) Isoquants cannot intersect.

Point H is a combination of capital and

Capital labour which used efficiently can
produce two different quantities Q1 and
Q2, which is absurd. The intersection
implies that the two factor inputs are
not efficiently used.
Q2
Q1
0
Labour

2) Isoquants are negatively sloped

Because both capital and labour have positive marginal products (so that the
employment of extra units increases total output), then it follows that to maintain a given
output, when the quantity of one factor is reduced, the quantity of the other factor must
be increased.

Capital

Q
0
Labour

3) Isoquants are convex to the origin:

If labor and capital are substitutes for each other though not perfect substitutes, then
isoquant curves will be convex to the origin. As bigger quantities of labor and smaller
quantities of capital are employed to produce a given level of output, labour becomes
less and less capable of substituting for capital. The reverse also applies ‘mutatis
mutandis’ (taking into consideration differences in details. This is illustrated below;

K
As the units of capital are given up
successively bigger quantities of labor must
be employed to keep the output level
Q unchanged. This makes the isoquant convex
to the origin as shown.
0
L
 As the qty of capital employed is reduced by one unit from OA to OB units, the quantity of
38
 labour employed must increase from OD to OE for output to remain unchanged at Q1
units. This slope is called the marginal rate of technical substitution of capital for labor.
It measures the rate at which capital can be substituted for labour keeping output
constant.

Long- run variations in costs

 Long- run is that period of time over which the input of all factors of production can be
varied. The long run is a planning horizon. The long run refers to the fact that economic
agents (consumers and managers) can plan ahead and choose many aspects of’
short-run in which they will operate in the future. Thus, in a sense, the long-run consists
of all possible short-run situations among which an economic agent may choose.
 LAC curve-A firm is normally faced with a choice among quite a variety of plants. The
curves below illustrate six plants represented by short-run AC curves

SAC1 LMC SAC6

LAC
COST SAC2 SAC5
SAC3

0
QUANTITY
Economies of scale Diseconomies of scale

 The plant represented by SAC1 will be built because it will produce this output at the least
possible cost per unit. With the plant whose short run average cost is given by SAC1 unit
cost could be reduced by expanding output to the amount associated with point B, the
minimum point on SAC1 most efficient level. If demand conditions suddenly increase and
so larger output is desirable, the manager could easily expand and this would add to
profitability by reducing unit cost. When setting future plans, the manager would decide
to construct the plan represented by SAC2, because this would reduce unit cost even
more. The point E represented by SAC4 is the least cost point. It is the point beyond
which, diseconomies of scale is experienced.
 The Long run average cost curve is a locus of points representing the least unit cost of
producing the corresponding output. The manager determines the size of the plan by
reference to this curve, selecting that short run plant which yields the least unit cost of
producing the anticipated volume of output. Each plant is suitable for a particular range
of output.
 Each point on the LAC curve corresponds to a certain point on the SAC curve. Each point
represents a tangency between the SAC curve and the LAC curve.

Returns to scale
In the long run, there are no fixed factors and firms can vary all the inputs of factors of
production. When this happens, we say that there has been a change in the scale of
production. If a  in the scale of product leads to ‘more than proportionate’ change in output,
firms are subject to increasing returns to scale. E.g. , if factor inputs are increased by 10%
39
and output grows by more than this, then firms are experiencing increasing returns to scale
.Economies of scale refers to falling average cost as the scale of output increases. The
diagram below illustrates this:

SAC3
SAC2
LAC
SAC1

C1

C2

q1 q2
Economies of scale Diseconomies of scale

 LAC curve reaches a minimum when 0q2 units are produced. Up to this level of output the
LAC curve is declining. The firm is therefore experiencing economies of scale. This is
because the firm has increasing returns to scale, assuming fixed factor prices.
 As output is increased above 0q2, the LAC curve rises indicating that the firm is facing
diseconomies of scale. With fixed factor prices, this must be because the firm is
experiencing decreasing returns to scale at these levels of output.
 It is sometimes suggested that firms might experience constant returns to scale as
output grows so that a change in all factor inputs results in an equi-proportional change
in output.

Sources of Economies of scale

1) Technical economies
These are usually common in manufacturing, since they relate to the scale of the
production unit. There are several reasons why costs might fall as the scale of product
increases, including,
f) Greater scope for division of labor - The larger the size of the production unit the
more men and machines are able to specialize.
g) Indivisibilities - Certain items of capital expenditure are relatively expensive and
cannot be purchased in smaller or cheaper units, yet they may be helping raise
output substantially. E.g. the installation of automatic electronic control systems in
industry, although expensive, yield substantial increases in efficiency. This gives
larger firms considerable advantage over smaller firms because the costs of such
equipment per unit output falls dramatically as output expands.
h) Research and development - A large firm may be able to result its own research and
development programme which can result in cost reducing innovations.
i) Economies of linked processes - Most manufacturing output requires the use of
more than one machine. Large firms are able to operate more efficiently than smaller
ones, because it may be when output is large that all the machines can be used to
40
 capacity.
j) Economies of increased dimensions - If the external dimensions of a container are
increases more than proportionately.
6) Marketing economies
These include economies from bulk purchases and economies from bulk distribution.
7) Financial economies
Large firms are frequently able to obtain finance more easily on more favourable term
than smaller firms e.g. interests rates reduction.
8) Risk bearing economies
Large firms frequently engage in a range of diverse activities so that a fall in return from
any one activity does not threaten the viability of the whole firm.
9) Managerial economies -

Sources of Diseconomies:
 There is always an optimum level of capacity and increases in scale beyond this level
lead to diseconomies of scale which manifest themselves in rising average costs of
production Diseconomies of scale have several sources, including:
4) Managerial difficulties - It becomes increasingly difficult to control and coordinate the
various activities of planning, product design, sales promotion and so on as firms grow.
This is especially true where a diverse range of products is produced.
5) Low morale - This leads to high rates of absenteeism and lack of punctuality. It may also
lead to a lack of interest in the job which inhibits the growth of productivity and leads to
high incidence of spoiled work.
6) High input prices - As the scale of production increases, firms require more inputs, and
increasing demand for these might bid up factor prices. Additionally, when firms
produce on a large scale, the power of trade unions to negotiate wage awards in excess
of the growth of productivity thus increasing average labor costs.

ISOCOST LINES
 The decision about the optimal output can be explained by (1) cost outlay or (2) by the
given level of output.
 The firm can have a given amount of money to spend in hiring a given input. The firm will
maximize output subject to given cost outlay. Maximizing output implies maximizing
profit. The firm will try to minimize input to incur little cost n producing a given output.
 The firm’s total cost (TC) can be presented diagrammatically by an isocost line. This
isocost is the counterpart of the budget line in the case of consumer choice.
 Isocost line illustrates all the combinations of capital and labour that can be bought for a
given monetary outlay
 It gives a locus combination of inputs that cost a given level money.
K

0
L
 Each isocost line shows combination of capital and labor that can be bought for a given
outlay (or cost).
 A change in the relative factor price ratio will change the slope of the isocost lines e.g., if
the price of K rises in terms of labor, the isocost lines above would become less steep.
 The firm has a choice of various combinations along any one isocost line. Any

41
 combination cost him the same amount of money.
_ _
_
c w c w
 The isocost can be expressed as K   L , i.e., c  wL  rK  K   L
r r r r
c = total cost outlay
r = interest rate for capital
w = wage rate (the cost of labour)
L = Labour
_

c
= vertical intercept (Y-intercept)
r
_

c
= horizontal intercept (X- intercept)
w
_

c
 The slope of the isocost = i.e., the rate of exchange between labour and capital.
r

The Least Cost Factor Combination

Expansion Path
 The firm chooses optimal level of input by combining isoquant and isocost, i.e., at
minimum cost, a firm will produce at a point where isoquant curve is just tangent or
touching an isocost line

CAPITAL

At point A, we have the slope

of isocost given as –w/r
which is equal to the slope of
isoquant given by MPL/MPK,
i.e., MPL/MPK =-w/r

A
K1
Q

C
L1
LABOUR

Thus at the optimal point, the slope of the isoquant equals the isocost.

Expansion Path:
This is a locus of cost minimizing points. It is a long the curve where costs are minimized for
various levels of output. The diagram below illustrates this

42
 EP2
K

The locus of points e0e1e2 is

EP1 referred to as the firms long run
expansion path

EP3

Labour

EP2 will imply that the price of labour is higher and capital is low. This therefore, is capital
intensive
EP3 will imply that the price of capital is higher and that of labour is low. Therefore, it is labour
intensive.

43
 PURE /PERFECT COMPETITION

Behavioral rules for profit maximization – short run equilibrium

These rules apply to all profit maximizing firms, whether or not they operate in perfectly
competitive markets
The rules include:
2. A firm should not produce at all if, for all levels of output exceeds the total revenue
derived from selling it or, equivalently if the average variable cost of the output exceeds
the price at which it can be sold.

MC P = TR/Q = AR

P4 P4 = MR4 =
D4 ATC
P3 P3 = MR3 = D3

AVC

P2 P2 = MR2 = D2
P1 = MR1 = D1
P1

0 Q1 Q2 Q3 Q4 QUANTITY

 At Q4, the firm is making profit.

 At Q3 price is the same as ATC and MC. There are no profits made.
 At Q2, the revenue made simply covers variable cost but does not cover fixed cost. P2 is
therefore the shutdown.
 At any price below it, the firm will shutdown. The firm cannot operate at price P1 because
it is incurring losses.
3. Whenever it is worthwhile for the firm to produce some output, it should produce the
output at which marginal cost.

MC
Price  The demand curve for
per a perfectly
unit
competitive firm is a
AR = MR = P
3 horizontal straight
line.

10 OUTPUT
0
 The firm should leave its output unaltered when the last unit produced adds the same
amount to costs as it does to revenue. This is short-run equilibrium of the firm.
4. An output where marginal cost equals marginal revenue may either be profit maximizing
or profit minimizing.

44
 Price per
unit
MC

P MR

0
q0 q1
The figure shows two outputs where marginal cost equals marginal revenue. However, the
equality of MR and MC is necessary but not sufficient.
 MC = MR at output q0and q1 output q0 is a minimum profit position because a change of
output in either direction would increase profit all for outputs below q0 MC exceeds MR
and profits can be increased by reducing output, while for outputs above q0 MR exceeds
MC and profits can be increased by increasing output. Output q1 is a maximum-profit
position, since at outputs just below it MR exceeds MC and profits can be increased by
increasing output towards q1 is a maximum-profit position, since at outputs just above it
MC exceeds MR and profit can be increased by reducing output towards q1.
 A firm that is operating in a perfectly competitive market will produce the output that
equates its MC of production with the market price (AR=MR) of its products (as long as
price exceeds average variable cost).

Assumptions of perfect competition.

 Perfect competition is a market structure characterized by complete absence of rivalry
among the individual firms. This is a market said to be perfectly competitive when buyers
and sellers believe that individually their own behaviour have no influence on the market
price. The following are the assumptions of perfect competition.
1) There are a large number of sellers and buyers in each buying or selling such a small
amount of product that individually they are powerless to influence market demand or
market supply. Each firm is a price-taker.
2) Consumers are indifferent from whom they make purchases because all units of the
commodity are homogeneous, i.e., they regard the product that an individual firm
supplies as a perfect substitute for the product that any other firm in the same market
supplies.
3) There is perfect knowledge of market condition among buyers and sellers so that each is
fully informed about the price producers in different parts of the market are charging for
their product.
4) There are no long-run barriers to the entry of firms into the market, or their exit from the
market.
5) There is perfect mobility of factors of production. It is assumed that land, labor and
capital can switch immediately from one line of production to another.
6) Buyers are able to act on the information available to them and will always purchase the
commodity from the seller offering the lowest price.
7) No government regulations.
These conditions ensure that in perfectly competitive markets all firms charge an identical
price for their product. Any firm attempting to charge a price above its competitors will face
a total loss of sales. This is because of product homogeneity and perfect knowledge by the
buyers. Perfectly competitive firms also have no incentive to change lower price since they
can sell their output at the existing market price.
The firm in perfect competition is therefore a price taker, i.e., it accepts the market price
perceive their own demand curves and demand curves of their competitors to be perfectly
elastic at the ruling market price. The diagram below shows the determination of market
price in a perfectly competitive market and individuals demand curve at this price.
45
 Price S Revenu
e

p AR = MR

QUANTITY QUANTITY
(MILLIONS) (HUNDREDS)

 Market supply and market demand are represented by supply and demand respectively.
Given these supply and demand conditions, the ruling market price is 0P, and the firm
perceives its own demand curve to be perfectly elastic at this price.

The short-run Equilibrium of a firm in perfect competition.

MC
AVC

E
P = MR = AR

q2 qE q1
 The firm chooses the output for which p=MC above the level of AVC. When the price
equals MC as at output qE, the firm loses profits if it either increases or decreases its
output.
 At any price left of qE, say q2 price is greater than the MC and it pays to increase output
(as indicated by the left-hand arrow). At any point to the right of qE, say q1, price is less
than the marginal cost and it pays to reduce output (as indicated by the right-hand
arrow).
 In a perfectly competitive market each firm is a price-taker and quantity adjuster. It
pursues its goal of profit maximization by producing the output that equates its short-run
MC with the price of its product that is given to it by the market.

Average and marginal Revenue

Because the firm sells its entire output at the prevailing or ruling market price, each
additional unit of output sold adds exactly the same amount to total revenue as each
preceding unit sold. Therefore, for the firm in perfect competition, marginal revenue is
constant at all levels of output and equals to market price (AR). Price (AR) =TR/q.

Short-run Equilibrium - Supernormal profits

 Since the firm is powerless to change the price of its product, it maximizes profit by
adjusting output to the point where MC=MR. The diagram below shows the market
equilibrium and the short-run equilibrium position of the individual firm perfect
competition.

46
 PRICE
Revenu
e & Cost MC
AC

P P AR = MR

0 0
Quantity (Millions) Q Quantity (Hundreds)

 Given the price and costs shown above, the firms equilibrium (i.e. profit maximizing)
output is 0Q, because this is the output level equates MC with MR. A t all levels of output
below 0Q, MR>MC, so that an extension of output adds more to total revenue than it
does to total cost. In these circumstances, total profit can be expanded by increasing
output. Conversely at output levels greater than 0Q, MR<MC and reduction on output will
reduce total costs by more than it reduces total revenue so that total profit will rise. It
follows therefore the profit can be maximized when MR=MC, and this simple rule applies
to all market structures.
 Details of MR and MC enable us to determine the firm’s profit maximizing output, but it is
total cost and total revenue maximizing output, but it is total cost and total revenue
which tell us the actual level of profit earned. With details shown on the above diagram,
total revenue (TR)=0P x 0Q=0PRQ while total cost
(TC) =0T x 0Q = 0TSQ .TR-TC =PRST (total cost), alternatively, average revenue (0P) -
average cost (0T) = average profit (RS) and this when multiplied by output (0Q), gives total
profit PRST.
 It this case therefore, it is clear that the firm is earning supernormal profit because
AR>AC.
 Above normal/ supernormal profit is the level of profit in excess of normal profit.
 Normal profit is the level of profit necessary to keep factors of production in their
present use in long-run.

Long-run Equilibrium- normal profits.

Earning supernormal profits will in the long-run attract other new firms into the industry.
Perfect knowledge of market conditions will ensure that firms outside the industry are aware
of the level of profits earned, and in the absence of long-run barriers to entry will ensure that
they are able to enter the industry and undertake production.
S
D MC
SI
AC
P P AR = MR

PI PI ARI = MRI

0 0
Quantity (Millions) QI Quantity
Quantity (Hundreds)
 While changes in the output of an individual firm will have no perceptible effect on
market supply, the influx of many new producers into the industry will clearly have a
47
 marked impact. If market demand for the industry’s product is constant, the increased
market supply will pull down price. Nevertheless, firms will still be attracted into the
industry so long as supernormal profits exist. Only when these have been completed
away, with all firms earning only normal profit, will the industry be in equilibrium. The
adjustment from short-run to long-run equilibriums is shown in the diagram below: ref.
 Market demand and market supply is represented by demand and supply respectively,
and the initial market price is 0P. Given this price, the firm produces its equilibrium
output OQ. The existence of supernormal profits attracts other firms into the industry so
that in the long run market supply shifts to supply and market price falls to OP. The
individual firm is powerless to resist the reduction in market price and is forced to adjust
its output so as to preserve equality between marginal cost and marginal revenue.
 The industry is in long-run equilibrium when price has fallen to the extent that all firms in
the industry earn only normal profits, or at least potential entrants to the industry see no
prospects of earning anything other than normal profit.
 Normal profits are insufficient to dissuade those firms already in the industry from
leaving.
 In the above diagram, long-run equilibrium is established when market price has fallen to
OP1 and the firm produces OQ1units. Given this output and price combination, the firm’s
total revenue (OP1x OQ1) exactly equals its total cost (OP1 x OQ1) including normal profit
and since the firm equals to MR with MC this is the maximum attainable profit given the
ruling market price OP1.

48
PURE MONOPOLY
Pure monopoly exists when supply of a particular good or services is in the hands of a single
firm or small group of firms who jointly coordinate their marketing policies. The latter
situation is referred to as a cartel.
 Because market supply is in the hand of a single supplier, a monopoly has great power to
influence the price of its product. However, this does not imply that it has total power to
fix price, since it cannot control consumer demand. In effect, the monopolist has two
choices:
1. To fix price and allow demand to determine supply (output)
2. To fix supply (output) and allow demand to determine price.
 The inability to control market demand makes it impossible for a monopolist to
simultaneously fix both price and output.
Average and marginal Revenues
 Unlike the firm in perfect competition, the monopolist’s average and marginal revenues
will be different. This is because the monopolist faces a downward sloping demand
curve and is forced to reduce prices in order to expand sales. The table below is used as
a basic for illustration.
Output/sales average revenues (shs) total revenue (shs) marginal
revenue (shs)
0 - - -
1 10 10 10
2 9 18 8
3 8 24 6

 In order to expand sales from 1 unit to 2 units, it is necessary to reduce the price of both
units. Hence price falls from shs 10 per unit to shs 9 per unit, and the marginal revenue is
shs 8. Similarly, when price is reduced from shs 9 per unit to shs 8 per unit, marginal
revenue falls to shs 6. Hence, marginal revenue will always be less than average revenue
under monopoly.

Barriers to Entry
Barriers to the entry of firms into a market might take a variety of forms and indeed entry
into any particular market might be restricted by the existence of several barriers. These
might include any of the following:
1. Technical barriers: Because of indivisibilities, some organizations have relatively high
fixed costs so that average total costs continue to fall as output expands over relatively
large ranges. This is true in the case of public utilities supplying water, electricity and so
on. Such industries are referred to as natural monopolies because distribution is most
efficiently undertaken by a single supplier.
2. Legal barriers: In certain markets, legal regulations might prevent the emergence of
competition. Patent rights might ensure a monopoly position by preventing other firms
from producing identical products. However, this barrier is only temporary and lasts only
as long as the life of the patent (usually16 years). In any case, it is often possible to
circumvent this safeguard by producing similar products.
3. Control of factor inputs or retail outlet: Where a firm has complete control over the
supply of a factor of production, it might be able to exercise monopoly power over the
products produced by that factor e.g. the ownership of land containing the only known
deposits of a specific mineral. An equally effective monopoly might result from a single
firm owning the key retail outlets for a product.
4. Agreements between suppliers: An effective monopoly can exist when firms in an
industry agree to cooperate rather than complete. The most formal type of agreement
between suppliers is known as cartel and this exists when a single agency organizes the
marketing of a product supplied by several firms. The aim of the cartel is often to restrict
market supply of the product, thereby forcing up price and increasing profits for the
members of the cartel. Cartels present a formidable barrier to entry into the market.

49
 The monopolist’s equilibrium output in the short-run.
 We have already seen that for all producers, profits are maximized when MC=MR. Based
on this, the figure below illustrates a monopolist’s equilibrium output in the short-run.

Revenue
and Cost MC

P R
AC

T
AR
MR

0 Q QUANTITY
 The monopolist maximizes profit when price is 0P and output 0Q. Here, total revenue
0PRQ minus total cost 0TSQ gives a profit equal to PRST. It can be noted that the
monopolist is earning supernormal profit and one of the characteristic features of
monopoly is that it is possible to earn this level of profit even in the long-run. If
supernormal profits continue in the long-run, this implies the existence of barriers which
restrict the entry of additional firms into the industry. These barriers are therefore the
very essence of monopoly power.

The monopolist Demand Curve

 Since the monopolist is the sole supplier of a good, the firm is in effect, the industry. The
monopolist therefore faces the market demand curve which is normally downward
sloping from left to right. The demand curve tells us the prices at which the producer can
sell different levels of output. AR=TR/Q =P. The demand curve is therefore also called
the AR curve. Faced with the downward sloping AR the monopolist has to reduce the
price of all units in order to sell extra units of output. This means that MR, which is the
revenue earned by selling an extra unit, must be less than AR (or price).
The figure below illustrates this: -
TP
Revenue

AR

MR Quantity

 From the diagram we can see that as the monopolist sells move, total revenue increases
and reaches a maximum. Beyond a certain point, TR begins to fall and MR becomes
negative. However, a profit maximizing monopolist would never produce where MR is
negative.
50
 Monopoly Equilibrium in the long-run
In a pure monopoly, entrance into the market by potential competitors is not possible. Thus,
whether or not a monopolist earns a profit in the short-run, no other producer can enter the
market in the hope profit is not eliminated in the long-run. Ref. Ferguson pg 307.

Discriminating Monopolist
A monopolist may charge different prices less different markets and, in this way, increase
total profits. This is called price discrimination.
 Price discrimination, therefore, is a situation in which a supplier charges different price to
different consumers for the same or similar product and where the price differences do
not reflect differences in the costs of supply. Price discrimination implies that
differences in price are the result of deliberate policy by the monopolist.
 Price discrimination can only be successful when the following conditions are fulfilled:
1. There must be at least two distinct markets for the good or services and there must be
no see page between these markets. They may be separated geographically, by type of
demand e.g., h/hold and industrial demand for milk, by time e.g., changing differently
during the peak and off-peak periods and finally by the nature of product e.g. medical
treatment cannot be resold.
2. Supply must be in the hands of a monopolist so that competing firms are unable to enter
production and undercut the monopolist in the higher priced markets.
3. Elasticity of demand must be different in at least two of the markets.

Price discrimination is illustrated below:

MARKET A MARKET B AGGREGATE

MARKET

P1 Revenue and cost Revenue and cost

P2 P
Revenue
and cost
AR
AR AR
Q2 Q Quantity
Q1 MR Quantity Quantity
MR MR

Note: 0Q = 0Q1+ 0Q2

 Market A and B are separated in some way so that seepage between them is impossible.
Combining the average and marginal revenues from each market yields the monopolist
applies the profit maximizing rule and equates aggregate MR and aggregate MC. This
gives the profit maximizing output 0Q, but no the profit maximizing price. To obtain this,
the monopolist must equate aggregate MC with MR in each individual market A of 0P1
and of 0P2 in market B, i.e., a higher price in the market with less elastic demand. The
sum of the sales in both markets is equal to the total amount produced. There are no
other distribution of output 0Q between the two markets (and therefore no other prices)
which could increase total profit.

Forms of price discrimination.

1. First degree price discrimination: -This is also known as perfect price discrimination
which occurs when a producer charges a consumer the highest price he/she is willing to
pay for each unit sold. The monopolist has to have knowledge of each individual
consumer’s willingness to pay or demand curve. It’s also essential that the producer is
51
 able to prevent resale of the product by individual consumers. The producer is able to
extract the whole of consumers’ surplus.
2. Second- degree price discrimination: - In this case, the monopolist charges different price
for different blocks of consumption. The aim is to charge a relatively high price for the
first block of consumption, a lower price for the next and so on. This is illustrated below.

DD
The monopolist charges different prices
A
for different prices for different blocks
P1 B
P2
C of consumption.
D E
P3
DD
0
Q1 Q2 Q3 Quantity
TR=OP1AQ1+Q1BCQ2+Q2DEQ3 for selling without the use of second degree price
discrimination, the revenue earned would be given by the area OP3 EQ3
3. Third-degree price discrimination: -The monopolist is able to separate two or more
markets with differing elasticities of demand and charge different price the separate
markets.

MONOPOLISTIC COMPETITION
Features:
 This market structure has features of both perfect competition and monopoly.
 There are no barriers to entry into the industry. Each firm produces a product which is
differentiated in some way from the products of its rivals. Such product differentiation is
often achieved or reinforced by branding and advertising.
 Because each product is differentiated, each firm has a monopoly over the supply of its
own product. It faces a downward sloping demand curve for its product with respect to
price. This implies that the MR curve lies below its AR curve. It is called competition
among the many.
 The market is characterized by non-price competition. This refers to strategies adopted
by producers to give their products a competitive advantage, other than a price cut.
 There is free entry and free exit of firms into and form the industry. Products
differentiation refers to a set of marketing strategies designed to capture and to retain
particular market segments by producing a range of related products.
 Product differentiation implies that while each firm is likely to face a relatively elastic
demand curve, it will not face a perfectly elastic demand curve. This is because if a
single firm should raise its price, it would not lose its sales, as would be the case in
perfect competition. Some customers would continue to buy the product because of the
quantities that differentiate it from the company products, i.e., brand loyalties exist.

Price and output determination in the short-run

 As with other market structures we assume that the firm aims to maximize profit.
Itproduces that level of output at which MC=MR. This illustrated below

Revenu The firm is in equilibrium when it

e and MC AC
produces 0Q units and charges a price
Cost R
of OP per unit. At this price and output
P S combination, it earns supernormal profit
AR of52
PRST.
T

0
 Q
MR
However, this cannot represent a long-run equilibrium position because the existence of
supernormal profit will attract more firms into the industry.

Long-run output and price determination

 The existence of supernormal profits in the long-run will attracts more firms into the
industry. Indeed, firms will continue to enter the industry until supernormal profits have
been completed away and each firm earns only normal profit. The firm’s long-run
equilibrium position is shown below.

LMC The extra firms attract some, but not all

Revenue
of the firms’ customers. This can be
and cost
LAC shown as a leftward shift of the firm’s
R
P demand curve until it just touches its AC
curve.
AR1
0 Q
MR1
 In the long run, total revenue=total cost=OPRQ. Each firm, although maximizing profit
(MC=MR) earns only normal profit and there is no tendency for firms to enter or leave the
industry.
 The firm maximizes profit by equating MR and LMC. It earns normal profit in the long run
as the entry of new firms competes away any short run above normal profit.

OLIGOPOLY AND DUOPOLY MODELS

 Oligopoly is a market structure characterized by few producers of either homogenous or
differentiated products. Each firm has a considerable portion of the market.
 Duopoly, however, is a special case of oligopoly whereby only two firms dominate the
market for the product.
 Oligopoly, which is sometimes referred to as competition among the few is
characterized by the unawareness of each firm in the industry of the actions or reactions
of other firms.
 Firms supply competing brands of a product and any action in terms of price and
non-price strategies by one firm may well be matched by the firm’s rivals.
 The policies of every firm affect other firms. Whatever one firm does affect the others.
 There is high degree of oligopolistic interdependence which implies that if an oligopolist
changes its price or non-price strategies, its rivals will react.
 The behaviour of oligopolists is strategic which means that they take explicit account of
the impact of their decisions on competing firms and of the reactions they expect from
competing firms
 The products have a high cross elasticity of demand.
 Moreover, oligopolistic market structure is characterized by uncertainty. When one firm
decides to reduce its price, that actual firm is unaware or uncertain of reactions of other
firms. The possible ranges of reactions could be:
a) Price undercutting
b) Reducing the price by the same magnitude
c) Advertising
d) Improving the quality
53
e) Changing design of the product
f) Improve the services associated with the product.
 All these reactions and others are not known to firm.

Price and output determination:

Under oligopoly, there are two groups/categories of models. These are:
1) Non-collusive models
2) Collusive models
Non-collusive models
This is when the firms act independently without consulting. Under this we have the
following models

a) COURNOT DOUPOLY MODEL

Here, there are two firms; The model is based on the following assumptions:
i) There are two independent firms producing and selling homogenous products.
ii) Each firm knows the demand curve for the product.
iii) The cost of production is assumed to be zero.
iv) Each firm decides about the quantity it is going to produce and sell in each period.
v) Each firm is uncertain of other firms plan regarding the quality to be produced.
vi) Each firm takes supply of the rival firm to be constant.
vii) The demand curve is assumed to be a straight line downward sloping.

ep>1
Assume that firm A initially enters the
P market. How much will it produce to
ep=1
maximize profit? Firm A will produce
where demand curve is elastic, i.e.,
ep<1
mc = where ep=1 for monopolist.

MR D=AR

 Firm A produces where MC=MR=0.

C1 e=1  To supply half of the market, output
P1
C3 C2 0Q, at price of 0P1, the profits are
P2 equal to 0Q1C1P1
mc
0 Q2 Q
Q1
MR
 When firm B enters the market, it finds when half of the market has been taken. When
will be the best position for firm B? What remains is Q1Q. Firm B is therefore facing C1Q
demand curve.

 Firms B enters the market and supply half of C1Q demand curve, i.e., the remaining
54
 market which is a ¼ of the total market. The price reduces to 0P2 . The profits are
reduced to 0Q2C2P2. Therefore, profits for firm A = 0Q1C3P2; profits for firm B = Q1Q2C2C3.
 The process continues until equilibrium is reached. Equilibrium would mean that the two
firms A and B will eventually supply the same amount. The output of firm A is declining
gradually.

Oligopolistic market there are few sellers of a product and any single seller will therefore
occupy a position of sufficient importance in the market for changes in his production
activities to induce reactions from the others.
Pricing and output decisions of oligopolistic sellers are highly interdependent. The sellers are
always aware of this interdependence and consequently each will way carefully the possible
reactions that might be forthcoming from his competitors when he makes price-output
decision.
Thus, the fundamental problem in oligopoly is that the outcome of any individual decision
will depend on the reactions of rival producers and so long as the initiator of the action
cannot predict with certainly what his rivals will do, then output and the long of oligopoly will
become highly indeterminate.
Limitations
1) The model is based on naïve assumption that each firm believes that its rival will never
change its volume of output even though it repeatedly observes such changes. That the
producer does not learn from past behaviour.
2) The assumption of cost less production is unrealistic.
3) The Cournot model is a closed one. There are no new entrants.
4) The model does not tell us how long the adjustment period will take.

Sweezy or Kinked Demand model.

 The existence of interdependence provides possible explanation for the relative price
stability that sometimes characterize oligopolistic markets.
 Despite the changes in costs or demand conditions, firms under oligopoly are not willing
to change prices. This model explains why prices tend to be stable under oligopoly
market. The following are some of the reasons why prices tend to be stable under
oligopoly:
1) Individuals firms might have learnt through experience the bad effects of price war and
therefore prefer price stability.
2) Firms may prefer to stick to the current price level in order to prevent new firms from
entering the industry.
3) Firms may be satisfied with the current prices output and profit and therefore there is no
need to change the price.
4) A stable price might have been set through agreement and therefore no firm would like
to disturb it.
 The price stability can be explained or illustrated by the kinked demand curve which is
based on the following assumptions: -
a) There is an established price at which all firms in the industry are satisfied.
b) Each firm’s attitude depends on the attitude of the rival firm.
c) If one firm reduces price, other firms will follow, and therefore, in elastic demand.
d) If one firm increases the price other firms do not follow, and therefore elastic demand.
 The MC pass through a vertical position of the MR.
 The figure below illustrates the kinked demand curve: -
D1
Revenue D
and cost
MR
P A
MC1
MC

B
D
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 C
D1

Q
MR1
 Because the firm perceives demand to be relatively elastic if it raises price, and relatively
inelastic if it reduces price, it perceives its demand (DAD1) to be kinked at the ruling price
(0P). It therefore has little incentive to alter price from 0PL. The figure shows that
because the firm perceives its demand curve to be kinked, it has discontinuous marginal
revenue curve. In fact, when price is 0P, MR is common point (A) on what is effectively
two separate demand curves (DD and D1D1), with associated MR curves. The region BC
therefore referred to as the region of indeterminacy. It implies that even when costs are
changing, so long as MC remains within the region of indeterminacy, changes in cost will
have no effect on the profit maximizing price and output combination, because the firm
will still be producing where MC=MR. For example, in the above figure when MC rises
from MC to MC1 this has no effect on the price changes or the output it produces.

Price leadership.
 There might be an accepted price leader in oligopolistic markets. Price changes are
initiated by the leader and other firms in the industry simply follow suit. The role of the
price leader might be acquired because a firm is referring to dominant firm leadership.
Alternatively perceives changes in market demand for the product. This is referred to as
“barometric price leadership”.
 Whatever, basis of leadership, its existence would explain price stability because price
changes would only be initiated by a single firm. This firm would not be confronted with
price cutting by other firms and therefore price would tend to be relatively stable.

COLLUSIVE MODELS.
This is where firms come together to make joint decisions in order to avoid uncertainty in the
oligopoly market.
There are two main types of collusion.
1) Price leadership.
2) Cartels.

Cartels
 A cartel is an organization formed by firms within the same industry for the purpose of
reducing competition and uncertainty in the market with a view of increasing profits. A
cartel is formed in order to: -
1) Determine the price.
2) Determine the amount to be produced by all firms i.e., industry supply.
3) Determine the amount to be produced and sold by each firm.
4) Determine the profits.
5) Determine the area of operation of each firm.
 There are two types of cartels: -
a) Cartels aiming at joint profit maximization
b) Cartels aiming at sharing of the market.

Non-price competition
The existence of price wars is evidence of competition in oligopolistic markets. However,
even when prices are stable, on- price competition between rival producers is often intense.
This can take a variety of forms:
1) Competitive advertising:
This is common in oligopolistic markets. Advertising is used to reinforce product
differentiation and harden brand loyalty.
2) Promotional offers:

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 These are common in some oligopolistic markets such as household detergents and
toothpaste. Such offers frequently take the form of veiled price reductions such as “two
for price of one or 25% extra free”.
3) Extended guarantees:
This is an increasingly common technique in many of the markets for consumer
durables. By offering free parts and labour guarantees for longer periods than their
competitors, firms aim to increase the attractiveness of their products.

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