QUESTION 4 – DEMAND AND SUPPLY – UNIT 4

Demand refers to the quantities of a good or service that prospective buyers are willing and able to
purchase during a certain period. It shows the relationship of a good that consumers are willing to
buy and the price of the good.
Aspects of Demand
Demand is linked to consumers
Demand is a flow concept (quantity measured over a specific period)
Demand is not wants, needs or requests
Why?
In order for us to know how much to produce and what to charge our products we need to be able
to determine equilibrium in the market
The Law of demand
Other things being equal (ceteris paribus), the higher the price of a good the lower is the demand.
DEMAND CURVE

-Downward sloping curve shows

an inverse relationship between
price and quantity.
- Blue line – Demand line
- Arrow up – Increase Price
-Arrow left – Decrease in Quantity
Q .NB – Shows a negative relationship
between price and quantity.
THE DEMAND SCHEDULE
The demand schedule is a table which shows the quantities of goods demanded at each possible
price, ceteris paribus.

1
Maximize utility (HAPPINESS) (we will only demand more when we can have a lower price)
THE DEMAND EQUATION
Q.d.= f(Px ,Pg, Y, T, N) – Independent determinants.
FACTORS DEMAND
Px - Price of Product itself – movement along demand curve
- The lower the price of a product = the larger the quantity a consumer will be willing and able to
buy.
P.g - Price of related goods – shift
- The consumer’s decision about how much of a product to purchase will also depend on the prices
of related goods.
**Complement Goods – Are goods that are used together
**Substitute Goods – are goods which can be used instead of the good in question
Y - Household income – shift
Consumer income determines their purchase power, that is, their ability to purchase goods. The
higher the income the more goods a consumer can afford.
T - Taste and Preferences – shift
A consumer’s decision will also be influenced by their tastes and preferences. All non-measurable
influences on consumers’ decisions are usually lumped together under ‘taste’ or preferences. It can
have a positive or negative impact on the quantity demanded.
N - Size of Household - shift
A consumer in a small household will tend to buy less than a household consisting of more
individuals.
P.e. – Expected future prices
- If a price pf a good is expected to fall, ceteris paribus, consumers will tend to reduce their current
demand, preferring to wait and buy more later at a lower price.
- If expected price increases can cause an increase in demand, ceteris paribus.
CHANGES IN DEMAND
Change in Quantity vs Change in Demand
- Change in Price = movement along demand curve = change in quantity demanded
- Chang in other influence on demand = A shift of the demand curve = change in demand

2
SUPPLY
- Quantities of goods or services that producers plan to sell at each possible price during a
certain period.
- It refers to planned quantities – the quantities that producers are willing to sell and the price
of the good.
Aspects of Supply
- Linked to Producers (they want to maximize profits, will only produce more if price increase)
- Supply is a flow concept
THE SUPPLY CURVE

LAW OF SUPPLY
Other things being equal (ceteris
paribus) – the higher the price of a good
the lower the demand.
Positive relationship between
price and quantity supplied.
Upward Sloping curve

3
THE SUPPLY SCHEDULE

FACTORS - DETERMINANTS
P.x. Price of product – Change or movement Along, - The higher the price the larger the quantity
supplied.
P.g. Price of alternatives in products – Shift – Producers will always consider prices of alternative
goods and joint outputs that they can produce with the same resources
Joint Products I.e. Cream and Milk, Alternative Products – Milk and Cheese
If the price of cheese increases the farmer will produce more cheese and less milk.
P.f. Prices of Factors of Production – In order to make a profit, cost of production should be
covered. Prodution factors i.e. Labour, Capital, Entrepreneurship, Natural Resources and
Technology. NB! Consider Price changes used as factors in production.
P.e. Expected future prices – future prices of a produced good will affect the decision of a supplier.
T.y. Technology – New tech enable producers to produce at lower costs this will increase the
quantity supplied at each price. (a change in tech advancement will lead to a change in the supply)

N. Number of Suppliers – A change in the number of suppliers for a specific good will lead to a
change in the supply of the market.

4
CHANGES IN SUPPLY
Change in Price = A movement along the supply curve = change in quantity supplied
Change in other influence on supply = A shift of the supply curve = change in supply

EQUILIBRIUM
At equilibrium all factors of production is used efficiently, no overproduction or undersupplying.
Producing correct amount of product and pricing product based on consumer affordability. It is
when demand intersects with supply
Aspects of Equilibrium
- Market Equilibrium at a particular price
- This price is called equilibrium price
P

5
MARKET EQUILIBRIUM

EQUILIBRIUM CALCULATIONS
- Calculate equilibrium quantity and price if the quantity supplied can be represented by the
equation. Qs = 3600 + 0.4P and the quantity demanded can be represented by the equation
Qd = 4800 – 0.2P.

Step 1. Equilibrium
Qs = Qd
3600 + 0.4P = 4800 – 0.2P

Step 2. Solve for P

3600 + 0.4P = 4800 – 0.2P
0.4P+0.2P = 4800-3600
0.6P = 1200
P=(1200/0.6)
P= 2000

Step 3. Substitute P in either equation to solve for Q

Qd = 4800 – 0.2P
= 4800 – 0.2 (2000)
= 4400

Step 4. Test for Q value

Qs = 3600 + 0.4P
= 3600 + 0.4 (2000)
= 4400

Step 5: State your answer

P=R2000 and Q = 4400 units

6
QUESTION 5

STARTING POINT

- Demand curve (D)

- The Supply Curve (S)
- The Equilibrium (E0)
- Equilibrium Price (P0)
- Equilibrium Quantity (Q0)

Step1 – Determine whether the demand

and supply curve will shift or if there is a
movement along the curve.

Step2 – Determine in which direction the

curve will shift or the movement will be

Step3 – Show the change in the

equilibrium price and the
equilibrium quantity as per shift or
movement on curve.

- An increase in demand is represented by a rightward shift of the demand curve.

INCREASE IN DEMAND

STARTING POINT

- The demand curve (D)

- The Supply curve (S)
- The Equilibrium (E0)
- Equilibrium Price (p0)
- Equilibrium Quantity (Q0)

INCREASE IN D

- Demand D0 – D1 (increase)
- Equilibrium D0 – E1
- Quantity E0 – E1

 Quantity – Q0 – Q1 (increase)
 Price – P0 – P1 (Increase)

DEMAND DETERMINANTS

Increase in the price of a substitute product (↑P substitute)

Decrease in the price of a complement product (↓Pcomplement )
A increase in consumers’ income (↑Y)
A increase consumer preference for the product (↑T)

7
 A increase in Population (↑N)
An expected increase in price (↑Pe )

DECREASE IN DEMAND

- Represented by a leftward shift of the demand curve, demand will result in a decrease in the
price of the product and a decrease in the quantity exchanged, ceteris paribus.

STARTING POINT

The demand curve (D),

The supply curve (S),
The equilibrium @ (E0)
Equilibrium price (P0)
Equilibrium quantity (Q0)

DECREASE IN DEMAND

Demand: D0 →D1
[DECREASE]
Equilibrium = E0→E1
Quantity = Q0 →Q1
[DECREASE]
Price = P0→P1
[DECREASE]

Decrease in the price of a substitute product (↓Psubstitute )

Increase in the price of a complement product (↑P complement)
A decrease in consumers’ income (↓Y)
A decrease consumer preference for the product (↓T)
A decrease in Population (↓N)
An expected decrease in price (↓P e)
INCREASE IN SUPPLY – Represented by a rightward shift of the supply curve. The Supply will result in
a decrease in the price of the product and an increase in the quantity exchanged, ceteris paribus.

STARTING POINT The demand

curve (D),
The supply curve (S),
The equilibrium @ (E0)
Equilibrium price (P0)
Equilibrium quantity (Q0)

INCREASE IN SUPPLY An
increase in supply
(represented by a
rightward shift of the supply
curve)
Supply: S0 →S1 [INCREASE]
Equilibrium = E0→E1

8
 Quantity = Q0 →Q1
[INCREASE) Price = P0→P1
[DECREASE]

SUPPLY DETERMINANTS

A decrease in the price of an alternative product or a rise in the

price of a joint product
A decrease in the price of any of the factors of production or
other inputs (ie a decrease in the cost of production)
An improvement in the productivity of the factors of production
(eg as a result of technological progress) – this also lowers the
cost of production

DECREASE IN SUPPLY – Represented by a leftward shift of the supply cu

STARTING POING

The demand curve (D)

The supply curve (S),
The equilibrium @ (E0)
Equilibrium price (P0)
Equilibrium quantity (Q0).

DECREASE IN SUPPLY

Supply: S0 →S1 [DECREASE]

Equilibrium = E0→E1
Quantity = Q0 →Q1 [DECREASE]
Price = P0→P1 [INCREASE

9
SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY

If demand and supply change simultaneously the precise outcome cannot be predicted. Changes of
price and quantity depend on the amount by which each curve shifts and the shape of each curve.

INCREASE in S&D
An increase in demand
(represented by a
rightward shift of the demand
curve)
An increase in supply
(represented by a
rightward shift of the supply
curve)
Demand: D0 →D1 [INCREASE]
Supply: S0 →S2 [Larger
INCREASE]
Equilibrium = E0→E2
Quantity = Q0 →Q2 [INCREASE]
Price = P0 →P2 [DECREASED

REASONS FOR SIMULTANEOUS INCREASES

- War, shortage of goods decreases supply, while high employment levels and total wage
payments increase the demand too.

Fig. 1 (a) shows a scenario where the increase in demand is equal to the increase in supply. Therefore, the new
demand curve, D1D1, and the new supply curve, S1S1, meet at the new equilibrium point E1. Also, the
new equilibrium price is equal to the old equilibrium price = OP.

Fig. 1 (b) shows a scenario where the increase in demand is more than the increase in supply. Therefore, the
new demand curve, D1D1, and the new supply curve, S1S1, meet at the new equilibrium point E1. However, in
this case, the new equilibrium price, OP1, is higher than the old equilibrium price, OP. On the other hand, if
there is a fall in the demand and supply and the fall in demand is more than the fall in supply, then the new
equilibrium price will become lower than the old equilibrium price.

10
Fig. 1 (c) shows a scenario where the increase in supply is more than the increase in demand. Therefore, the
new demand curve, D1D1, and the new supply curve, S1S1, meet at the new equilibrium point E1. However, the
new equilibrium price, OP1, is less than the original equilibrium price, OP. Conversely, if there is a fall in the
demand and supply and the fall in supply is more than the fall in demand, then the new equilibrium price will
become higher than the old equilibrium price.

QUESTION 6 – GOVERNMENT INTERVENTION

MIN AND MAX PRICES – PRICE CEILINGS AND FLOORS – SURPLUS OR SHORTAGE – SU5

Quite frequently, consumers, trade unions, farmers, business people and politicians are unsatisfied
with the prices and quantities determined by market demand and supply. Their dissatisfaction
makes them pressure the government to intervene to influence prices and quantities in the market.

This intervention can take different forms, including:

Method 1: Maximum prices

Method 2: Minimum prices.
Method 3: Taxes [Self Study]
Method 4: Subsidies [Self Study]
Method 5: Quotas [Self Study]
Method 6: Tariffs [Self Study]
MAXIMUM PRICES

Governments often set maximum prices for certain goods and services.
Governments set maximum prices to:

- Keep the prices of basic foodstuffs low as part of a policy to assist the poor
- Avoid the exploitation of consumers by producers, that is, to avoid “unfair” prices
- Combat inflation
- Limit the production of certain goods and services (e.g. in wartime)

- If a maximum price is set above the equilibrium (or market-clearing) price, it will not affect
the market price or the quantity exchanged.
- Prices and quantities will still be determined by demand and supply.
- However, when a maximum price is set below the equilibrium
price (as is usually the case), it will have significant effects.

MAXIMUM PRICE SET BELOW EQUILIBRIUM

STARTING POINT

The demand curve (D),

The supply curve (S),
The equilibrium @ (E0)
Equilibrium price (Pe)
Equilibrium quantity (Qe)

11
MAXIMUM PRICE

- Suppose the government sets a maximum price (Pm)

below the equilibrium price (Pe).
- At the lower price (Pm),
- Consumers will demand a quantity Q2, which is
higher than the equilibrium quantity (Qe).
- Suppliers, however, will be willing to supply only
Q1, which is lower than Qe.
There is thus a market shortage (or excess demand)
equal to the difference between Q2 and Q1.

MINIMUM PRICES – PRICE FLOORS

- Markets for agricultural products are usually characterised by a relatively stable demand,
but also by a supply which is subject to large fluctuations.
- Prices therefore tend to fluctuate and farmers’ income is unstable and uncertain.
- To stabilise farmers’ income, governments often introduce minimum prices (or price floors)
which serve as guaranteed prices to producers

NB. If the minimum price is below the ruling equilibrium price, the operation of market forces is not
disturbed, but if the minimum price is above the ruling equilibrium price (as is often the case), there
is a surplus (or excess supply).

MINIMUM PRICE SET BELOW EQUILIBRIUM

STARTING POINT

The demand curve

(D),
The supply curve (S),
The equilibrium @

12
(E0)
Equilibrium price (Pe)
Equilibrium quantity (Qe)

MINIMUM PRICE

Suppose the
government sets
a minimum price
(Pm) above the
equilibrium price
(Pe).

At the higher
price (Pm),
- Consumers will
demand a
quantity Q1,
which is
lower than the
equilibrium
quantity (Qe).
- Suppliers,
however, will be willing to supply at
Q2, which is higher than Qe.
- There is thus a market surplus (or excess supply)
equal to the difference between Q2 and Q1

IDENTIFY AND CALCULATE MARKET SHORTAGES/ SURPLUSES

QUESTION 7/8 – PRICE ELASTICITY

CALCULATE AND INTERPRET VALUES – TWO METHODS **POINT AND ARC.

ARC ELASTICITY

- Calculate the price elasticity of demand between two points using the average of the two
quantities rather than merely changing from one point to the next. This provides the average
elasticity for the arc of the curve between two points

Formula

13
 Q2−Q1
/P 2−P 1
Ep = (Q1+Q 2) E= ARC Price Elasticity
(P 1+ P 2)
Q1 = Original Quantity Demanded

Q2 = New Quantity demanded

P1 = Original Price

P2 = New Price

POINT ELASTICITY

LINEAR DEMAND

CATEGORIES
The values of Ed imply that a 1%△ in price will lead to an (insertvalue) %△ in Quantity.
Price elasticity of demand (Ed) can be classified into five categories based on the obtained value:

14
 - Perfectly Inelastic Demand → Ep = 0
A perfect inelastic demand curve is represented by a vertical line parallel to the price axis. It shows
consumers plan to purchase a fixed amount of the product irrespective of its price.
Total Revenue
If the demand for a product is perfectly inelastic, the producers can raise their revenue by raising the
products price.
- Inelastic Demand → 0 < Ep < 1
Demand is inelastic when the quantity demanded changes in response to a change in price, but the %
change in the quantity is less than the % change in the price of the product. It has a steep diagonal
curve.
Total revenue
If producers are faced with an inelastic demand for their product they will have an incentive to raise
the price of the product since the % fall in the quantity demanded Q will be smaller than the
percentage increase in the Price of the product.
- Unitarily Elastic Demand → Ep = 1
Unitary elasticity occurs when the percentage change in the quantity demanded is exactly equal to the percentage
change in price. The elasticity coefficient is thus equal to one.
Unitary elasticity is the dividing line between
inelastic and elastic demand
Total Revenue
If producers are faced with a unitarily elastic demand curve, they cannot raise their total revenue by decreasing or
increasing the price of the product.

In both cases the percentage change in the price will be exactly offset by a corresponding percentage change in the

quantity demanded (in the opposite direction to the change in price). TR (= P ×Q) will therefore remain unchanged
- Perfectly Elastic Demand → Ep = ∞ Horizontal Curve
This curve shows that consumers are willing to purchase any quantity at a certain price (P1), but if the price is
raised only fractionally,the quantity demanded falls to zero.
* Horizontal Curve e p =∞
- Elastic Demand → Ep > 1
Demand is said to be elastic when a price change leads to a proportionally greater change in the quantity
demanded, that is when the elasticity coefficient is greater than one.
Total Revenue
If producers are faced with an elastic demand for their product, they can increase their total revenue by
lowering the price of the product. When the price of the product P decreases there will be a proportionally
greater increase in the quantity demanded Q

FACTORS INFLUENCING THE ELASTICITY OF A DEMAND

- Luxury or necessity
- Availability of substitutes
- The portion of monthly income spent on product
- Habit forming products
- Durability of products
- Time period

Other factors influencing the elasticity of demand:

- Definition of product
- Advertising
- Number of uses of the product

TOTAL REVENUE
Total Revenue = Total Expenditure by consumers on a product.
TR = PxQ
- The price elasticity of demand can be used to determine the total revenue of the firms producing a

15
product changes when the price of the product changes.
NB! LAW OF DEMAND (↑P → ↓Q)
- The effect of a △P on total revenue will depend on the size of the △P and, in turn, the △Q.
Total Revenue = Total Expenditure by consumers on a product.

CROSS-PRICE ELASTICITY OF DEMAND

- The quantity demanded of a particular good also depends on the prices of related goods.
- The cross elasticity of demand measures the responsiveness of the quantity demanded of a
particular good to changes in the price of a related good.
- The cross elasticity of demand (ec) is the ratio between the percentage change in the quantity
demanded of a product (the dependent variable) and the percentage change in the price of a
related product (the independent variable).
-

METHOD – ARC ELASTICITY

FORMULA

Where:
Ec = Arc Cross-Price elasticity
QA1 = Original quantity demanded (product A)
QA2 = New quantity demanded (product A)
PB1 = Original Price (product B)
PB2 = New Price (product B)

COEFFECIENT SIGNS

- The cross elasticity of demand can be positive, negative or zero.

POSITIVE
- SUBSTITUTE GOODS
In the case of substitutes (eg butter and margarine) the cross elasticity of demand is positive. A change in the price of
the one product (eg butter) will lead to a change in the same direction in the quantity demanded of the substitute
product.

For example, when the price of butter increases, more margarine will be demanded, ceteris paribus, as consumers
switch to the relatively cheaper margarine

NEGATIVE

- COMPLEMENT GOODS
In the case of complements, the cross elasticity of demand is negative. A change in the price of the one product (eg
motorcars) will lead to a change in the opposite direction in the quantity demanded of the complementary product (eg

16
 motorcar tyres).

For example, if the price of motorcars falls, the quantity of motorcars demanded will increase and as a result more
motorcar tyres will be demanded

ZERO

- UNRELATED GOODS
When two goods are unrelated (eg motorcar tyres and margarine) the cross elasticity of demand will be zero.

INCOME ELASTICITY OF DEMAND

-The quantity demanded of a product depends on the income of the consumers. As consumers’ incomes rise,
the quantity demanded usually increases, ceteris paribus.
- The income elasticity of demand (ey) measures the responsiveness of the quantity demanded to changes in
income.

METHOD: ARC ELASTICITY

Where:
Ey = Arc Income
elasticity
Q1 = Original
quantity
demanded
Q2 = New quantity demanded
Y1 = Original Income
Y2 = New Income

COEFFICIENT SIGNS

POSITIVE GOODS

- Normal Goods
Goods with a positive income elasticity of demand are called normal goods.

- Luxury Goods
When the income elasticity of demand is greater than one, that is, when the percentage change in the quantity demanded is

greater than the percentage change in income, the good is called a luxury good.

- Essential Goods
When the income elasticity of demand is positive but less than one, that is, when the percentage change in the quantity

demanded is smaller than the percentage change in income, the good is called an essential good

NEGATIVE GOODS – INFERIOR GOODS

Goods with a negative income elasticity of demand are called inferior goods.

A negative income elasticity of demand means that an increase in income leads to a decrease in the quantity demanded of the good

concerned (or that a decrease in income leads to an increase in the quantity demanded). Crazy Store

QUESTION 9 – CONSUMER EQUILIBRIUM (UNIT 7)

CONSUMERS = Unlimited Wants --- Need to be satisfied by limited resources

17
CONSUMER AIM

– Achieve maximum satisfaction from daily purchases.

– Gain maximum utility from consumption (given available and alternative consumption
options)

UTILITY – Satisfaction/welfare

- Literal – Measure happiness

- Functional – economists summary of what guides individual choice.

Utility can be used as a tool for the construction of an individual choice model based on the
assumptions that a rational individual will act as if decisions are made to maximise utility.

- Ordinal utility means that the satisfaction which a consumer obtains from consuming
different products or bundles of products can be ranked or ordered
- The consumer can rank different products or combinations of products in order of
preference but can say nothing about the absolute level of satisfaction that each product or
combination of products yield.
- Consumers can rank things from highest to lowest, best to worst, most satisfying to least
satisfying.

INDIFFERENCE CURVE – THEORY AND APPLICATION

The indifference curve is a curve which shows all the combinations of two products that will provide
the consumer with equal satisfaction or utility. The combinations are equally desirable and the
consumer is thus indifferent between them.

- The indifference approach to analysing the demand for goods and services is based on the
notion of ordinal utility.

The indifference approach is based on three basic assumptions

1. COMPLETENESS
Assumed that a consumer is able to rank all possible combinations of goods and services in
order of preference
2. CONSISTENCY
Consumers are assumed to act consistently.
3. NON-SATIATION
Consumers are not yet fully satisfied and prefer more to less

INDIFFERENCE CURVE

18
INDIFFERENCE CURVE PROPERTIES - INTERSECTION

INDIFFERENCE MAP

WHAT IS THE MARGINAL RATE OF SUBSTITUTION WHAT DOES IT APPLY

19
INDIFFERENCE CURVE – MARGINAL RATE OF SUBSTITUTION

MARGINAL UTILITY

Is the additional satisfaction a consumer gains from consuming one more unit of a good or service

- Utility is an ordinal concept

- This means that more of a commodity is preferred to less = if a consumer consumes more of
a commodity = increased utility.

FORMULA

MU = (change in TU)/(change in Quantity)

ΔTU
MU = ΔQ

20
THE BUDGET LINE

BUDGET LINE ILLUSTRATION

21
22
BUDGET LINE CHANGES

23
CONSUMER EQUILIBRIUM

24
Δ IN CONSUMER EQUILIBRIUM

Consumer Equilibrium changes due to;

Changes in Income

 Budget line shifts Parallel

Changes in Price

 Budget line swivels (one point remains constant)

25
PRICE CONSUMPTION CURVE

26
QUESTION 10

PRODUCTION AND COST

FIRM – A collection of resources that is transformed into products demanded by consumers

i.e. Individual proprietorships, partnerships, companies, close corporations, cooperatives, trusts and
public corporations.

GOAL – All firms seek to maximise profit

- Firms may also have other objectives, e.g. market share, dominance
- Theory of Supply of goods = theory of the firm

CALCULATING REVENUE

27
DIFFERENCIATE BETWEEN SHORT RUN AND LONG RUN PRODUCTION

28
SHORT RUN PRODUCTION

- In the short run, a firm can expand output only by increasing the quantity of its
variable inputs.
- However, the fixed inputs place an absolute limit on the quantity of output that
the firm can produce (ie at some point output cannot be increased further by
increasing the quantity of the variable inputs).
- The relationship between inputs and output is called a production function.

PRODUCTION

- Is the physical transformation of inputs into outputs?

INPUTS

- The inputs typically consist of factors of production and intermediate inputs.

- An intermediate input is any good or service other than the basic factors
of production (natural resources, labour, capital and entrepreneurship)
which is used to produce something else (eg screws, nails and hinges for
making furniture, flour for producing bread, or parts assembled into an
electric toaster or a computer)

29
ASSUMPTIONS

- The firm produces only one product.

- All units of a given input are identical or homogeneous.
- The inputs can be used in infinitely divisible amounts.
- The technical relationship between inputs and output, called
the production function, is given and therefore cannot be
changed.
- The prices of the product and of the inputs are given.
- The firm uses fixed inputs and one variable input.

TOTAL PRODUCT FORMULA

30
TOTAL PRODUCTION SCHEDULE

LAW OF DIMINISHING RETURNS

- Law of diminishing returns: as more of a variable input is

combined with one or more fixed inputs in a production process, points will be
reached where first the marginal product, then the average product & finally the total
product will decline.
- To formulate the law of diminishing returns more formally, we
need first to explain average product and marginal product
-

31
MARGINAL PRODUCTION

32
AVERAGE PRODUCT

Refers to the additional quantity of output produced by adding ONE

additional unit of input to the production process.
Remember:
In the Short-Run, only labour van be changed

FORMULA

AP of Product X

APx = Δ TP / X

While holding input Y constant (fixed)

33
34
LAW OF DIMINISHING RETURNS

SHORT RUN COST

- In the short run a firm’s costs consist of fixed costs and variable costs.
- Production refers to the products or services (output) produced by a firm.
- The raw materials, component parts, labour and other ingredients that are needed to
actually produce the goods or services (inputs) all cost money.
- The money spent on all the inputs required to produce the outputs are referred to as
the “cost of production.

TAKE NOTE

- The money spent on all the inputs required to produce the outputs
are referred to as the “cost of production.”
- The cost function is therefore merely the production function
expressed on monetary terms as follows: RQ = f(RX ,R Y)
Where
- RX and RY = the rand values of the inputs X and Y.
- RQ = total cost of producing output Q.

TOTAL FIXED COSTS

As the name implies, refers to those costs that do not change within a
certain production capacity range.
Total fixed cost (TFC) is the total cost of using the fixed input, capital (K).
A cost that does not vary with the level of output and that can be eliminated only
by shutting down
TOTAL VARIABLE COSTS
Refers to those costs in the total cost that vary as the amount of output
changes.
Total variable cost (TVC) is the total cost of using the variable input, labour (L).
Cost that varies as output varie

35
TOTAL COST

- The total economic cost of production consisting of fixed and variable

costs.
- Total cost (TC) is the total cost of using all the firm’s inputs
FORMULA:
TC= TFC+TVC
AVERAGE FIXED COST

Fixed cost divided by the level of output.

Average fixed cost (AFC) is the average per-unit cost of using the fixed input K
FORMULA:
AFC= TFC÷Q

AVERAGE VARIABLE COST

Average variable cost (AVC) is the average per-unit cost of using the variable input L
FORMULA:

AVERAGE TOTAL COST

Average total cost (AC) is the average per-unit cost of all the firm’s inputs
FORMULA:
ATC= TC÷Q (or)
ATC= AFC + AVC
MARGINAL COST

Increase in cost resulting from the production of one extra unit of output.
Marginal cost (MC) is the change in a firm’s total cost resulting from a unit
change in output
FORMULA:
MC= △TC÷△Q (or)
MC= TC0 - TC1 (or)
MC= TVC0 - TVC1

36
QUESTION 11 (SU9 AND 10)

MARKET STRUCTURES

The behaviour of a firm depends on the features of the market in

which it sells its product(s) and on its production costs.
The major organisational features of a market are called the structure of the market
(or market structure).
Economists identify 4 different market structures:
Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly

The main features / criteria of a market structure:

- The number of firms in the market
- The nature of the good or service sold
- Ease of entry for new competitors into the market
- How freely available information is within the market
- Degree of collusion
- Control that the firm has over price
- Shape of the demand curve for the product of the firm
- Whether the firm can possibly make long-run economic profits

37
THE EQUILIBRIUM CONDITION

- Firms want to maximise profit!

- Thus: look at revenue and cost.
- Then decide:
(a) Produce at all?
(b) If so, how much?
- Shut-down (start-up) rule:
Revenue:
TR = or greater than TVC;
Unit Costs: AR (p) = or greater than AVC
- Profit-maximising rule:
- Determine profit in short-term according to:
Total approach - Firm produces where profit (TR – TC) is the highest
Marginal Approach (the profit-maximising rule) NB!
MR = MC

38
TOTAL, MARGINAL AND AVERAGE REVENUE

- Under perfect competition the firm receives the same price for any
number of units of the product that it sells.
- Its marginal revenue (MR) and average revenue (AR) are thus both equal to the
market price.
MR = AR = P.
- (TR) is equal to the price of the product (P) multiplied by the quantity sold (Q),
- TR = P × Q (= PQ).
Under perfect competition the price is given, thus for each additional unit that the firm
sells, total revenue will increase by an amount equal to the price of the product.
This is simply another way of stating that MR = AR = P

39
40
SHORT RUN EQUILIBRIUM
Normal profit = Best return that a firm’s resources could earn
elsewhere and is part of the cost of production = an implicit cost
*P = min of AC
*TR = TC
*MR = MC
Economic profit = Total revenue > Total cost (Explicit and implicit
cost including normal profit)
*P > min of AC
*TR >TC
*MR > MC
Economic loss
*P < min of AC
*TR < TC
*MR < MC

41
42
THE SUPPLY CURVE

LONG RUN EQUILIBRIUM

LONG RUN EQUILIBRIUM

- In the long run, two things can change.

** First, new firms can enter the industry, and existing firms can leave.
** Second, all factors of production become variable and existing firms earning
economic profit in the short run may decide to expand their plant sizes to realise

43
 economies of scale.
- Economic profit invites the entry of new firms.
- Economic loss causes the exit of firms.
- The supply curve shifts to the left and puts upward pressure on prices, and
increases profits.

-
-
- In the long run, the price in the competitive market will settle at the point where firms
earn a normal profit.-
- The earlier the firm enters a market, the better its chances of earning above-normal
profit.
- As new firms enter the market, firms must find ways to produce at the lowest possible
cost, or at least at cost levels below those of their competitors.

44
MARKET STRUCTURES – PERFECT COMPETITION AND MONOPOLY

MONOPOLISTIC COMPETITION

- One type of market in the spectrum between the extremes of perfect competition and
monopoly is monopolistic competition.
- As the name indicates, monopolistic competition combines certain features of monopoly
and perfect competition.

45
OLIGOPOLY

- Under oligopoly a few large firms dominate the market. When there are only two firms in
the industry, it is called duopoly. It indicates, monopolistic competition combines certain
features of monopoly and perfect competition.

MONOPOLY

- The word monopoly is derived from the Greek word, monos, meaning single and polein,
meaning sell.
- In its pure form, monopoly is a market structure in which there is only one seller of a good or
service that has no close substitutes.

46
EQUILIBRIUM (PROFIT MAX)

- Monopolistic firm aims to maximise profit.

- Monopolist should produce where:
- Marginal revenue (MR) is equal to marginal cost (MC) (the profit-maximising rule),
provided that average revenue (AR) is greater than minimum average variable cost
(AVC) in the short run or average total cost AC in the long run (the shut-down rule).
- The firm has the power to set any price it wants.
- However, the firm’s ability to set prices is limited by the demand curve for its product
and in particular, the price elasticity of demand for its product.

SHORT RUN EQUILIBRIUM

47
48
PRICE DISCRIMINATION

- Firms with market power find it profitable to sell the same

product to different consumers or groups of consumers at
different prices.
- This practice is called price discrimination. Price discrimination occurs only when
price differences are based on different buyers’ valuations of the same product. If
price differences are based on cost differences, they are not discriminatory.

THREE TYPES OF PRICE DISCRIMINATION

FIRST-DEGREE PRICE DISCRIMINATION

First-degree price discrimination (sometimes also called discrimination
among units) occurs when each consumer is charged the maximum price
he or she is prepared to pay for each unit of the product.

SECOND-DEGREE PRICE DISCRIMINATION

Second-degree price discrimination (sometimes also called discrimination
among quantities) occurs when the firm charges its customers different
prices according to how much they purchase.

THIRD-DEGREE PRICE DISCRIMINATION

Third-degree price discrimination (sometimes also called discrimination
among buyers) occurs when consumers are grouped into two or more
independent markets and a separate price is charged in each market.

49