Micro-

Economics
Prepared by
Mr. Joseph B Ndawi (MSc ,BSc Economics
(Project Planning and Management)
COURSE REC 101/230-BBA 1/BAFIT 2
TOPIC 1

INTRODUCTION
 1.0 INTRODUCTION
Economics- we study the allocation of scarce resources.

1.1 What is Economics?

Economics is best described as the study of human’s behavior in
response to limited resources to fulfill unlimited wants and needs.
According to Robins, Economics as social studies behaviour of the
people and its consequences. Economics behaviour is essentially the
process of evaluating Economics opportunities open to an individual
or society and, given the resources, making choice of the best of the
opportunities
The objective behind this economics behaviour is to maximise gains
from the available resources and opportunities.
 Cont…
The basic function of economics is to observe, explain and
predict how people (Individual, households, firm and
government) as a decision makers make choices about the use of
their resources (Land, Labour, Capital, time and technology etc)
to maximise their income, total utility (as consumer).
Economics is the fundamentally the study of choice-making
behaviours of the people. This gives Economics the status of
social science. Economic behaviour of the individuals,
households, firms, government and society as whole which firm
the central theme of economics as a science. Thus economics is
fundamentally the study of how people allocate their limited
resources to produce and consume goods and service to satisfy
their endless wants with the objective of maximising their gains
 
 
 Cont…
1.2 The scope of economics/Branches
The scope of Economics as it is known in a modern economics is divided into two
branches i.e. Microeconomics and Macroeconomics

 Microeconomics is the branch of economics that studies the behavior of

individual decision- making units such as consumers, resource owner and business
firms as well as individual markets.
Microeconomics studies how consumers and producer make choices, how their
decisions and choices affect the market demand and supply condition, how
consumer and producers interact to settle the prices of goods and services in the
market, how prices are determined in different market settings and how total
output is distributed among those who contributed to production i.e., landlords,
labour, capital supplier and the entrepreneurs 
 Cont..
Macroeconomics
 is the study of the behaviour of the economy as a whole whereby
the relationship is considered between broad economic aggregates
such as national Income, employment and prices. Macroeconomics
studies the working and performance of the economy as a whole.
It analyses behaviour of the national aggregates including
National income, aggregate consumption, savings, investment,
total employment, the general price level and country balance of
payments.
Therefore “macroeconomics” is the study of the nature,
relationship and behaviour of aggregates and average of
economics quantities.
 Cont…
1.3 Normative Vs Positive Economics
i) Positive Economics
Economics as a positive science seeks to analyse
systematically and explain economic phenomena as they
actually happen; studies the common characteristics of
economics events, bring out the cause and effect relationship
between the economics variables, if any and generalize this
relationship in the form of theoretical proportion.
 Cont..
ii) Normative Economics
Economics as a normative science is concerned with ideal
economic situation, not with what actually happens. Its objective is
to examine “what actually happens” from moral and ethical points
of view and to judge whether “what happens” is socially desirable.
It examines also whether economics phenomena like production,
consumption, distribution prices, etc are socially desirable or
undesirable. Desirability or undesirability of economic happenings
are determined on basis of socially determined values. Thus
normative economics involves value judgement and values are
drawn from moral and ethical values and political aspirations of the
society.
1.4 Scarcity and choice

(Why does the problem of making choice arise?)

The concepts of scarcity and choice are central to the discipline of economics
The need for making choice arises because of some “basic facts of economic life”. The
history of human civilization bears evidence to the fact that
i) Human desire, wants and aspiration are unlimited. Human’s wants, desire and needs
are endless (unlimited) in the sense that they go on increasing with increasing in peoples’
ability to satisfy them.
 
(ii) Resources are scarce and limited. The need making choice between the various goods
that people want to produce and consume arises mainly because resources that are
available to the people at any point of time for satisfying their wants are scarce and limited.
iii) Furthermore, the problem of making choice arises also because resources have alternative uses. Where
the issues of Opportunity cost come in.
 Cont..
iv) Gain maximisation behavior is another aspect of human
behaviour that leads to the choice-making behaviour. Most
people aim at maximising their gain from the use of the limited
resources. A rational consumer wants to maximize his/her
utility or satisfaction, a producer wants to maximize their
output/profit and as factor owner wants to maximise their
earnings. If the people were not to maximise their gains, the
problem of choice making would not arise.
 Resources classification
a) Natural resource (Land, lakes, rivers, minerals, forest
b) Human resource (manpower, human, energy, talent, professional skills
etc)
c) Manmade resource/ capital (machinery, equipments, tools, technology
etc)
d) Entrepreneurship
All these resources are scarce. It is scarce in relative terms. It implies that
resources are scarce in relation to the demand for resources.
The scarcity of the resources is the mother of all economics problems. It
is the scarcity of resources in relation to human wants that forces people
to make choice
 Opportunity cost
This is the one of the most fundamental concepts in economics.
The opportunity cost of an action is the value of the best forgone
alternative action. The opportunity cost arises because many
resources are scarce and have alternative uses. The choice of one
action, therefore, often implies that an alternative action will be
foregone. Thus, for example, if a consumer has 20,000 shillings to spend
and has choice between going for a movie and buying a book, the
opportunity cost of going for the movie, if he decides to make that
decision, would be the book forgone.
The concept of opportunity cost applies to individual firms deciding
what combinations of goods and services to produce.
 
 Cont..
1.5 The Production Possibility’s Frontier (PPF)
PPF- Refers to the alternative combination of goods and
services that a society is capable of producing with its given
resources and state of technology
See table 1
The PPF show all the alternative combinations of two goods (
food and clothing ) that can be produced by making full use all
the available resources (labour and capital) given the state or
technology
 Cont..
Table alternative production possibilities

Alternative Foods(‘000 tons) Clothiong(ooo

’ooo metres)
P 8 0
A 7 40
B 6 55
C 5 64
D 4 71
E 3 76
F 0 80
 Cont…
Food P
‘000 8 A .H
tons 7
6 B
5 C

4 .G
3 D
0 E
40 55 647176 80F
clothing 000’000 tons
 Cont..
Each point in the PPF show a different combination of two goods e.g. if
a country choices point P on the PPC , it can produce 8000 tons of food
and no clothing.
Similarly, point F shows that the country can produce 80 million meters
of clothing but no food

Implications of points away from PPF

The PPF shows the alternative combination of two goods under the
conditions that all the resources (labour and capital) are fully employed.
Any point below PPF e.g. point G implies underutilization or
unemployment of resources.
 Cont..
Point ‘H’ is unattainable for lack of resources. The scarcity of resources
does not permit production of any combination of food and closing
indicated by a point outside the PPF.
PPF also indicates the opportunity cost of one commodity in terms of
the other
Along PPF/PPC the opportunity cost is not the same. From the figure
above movement from Point “A” downwards to point “B, C, D, E and
F” shows increasing opportunity cost of closing in terms of lost output
of food.
Shift in PPF is caused by
 Expansion or resources (labour and capital )
 Technology improvement
 Cont..
Shift of PPF
 Cont..
1.6 Methodology of Economics
The basic function of economist is to observe and analyse economics phenomena and
formulate economics theories
An economics theory is the statement of a general tendency. Specifically, an economic
theory is the statement of cause and effect relationship between two or more observed facts of
real economic life.
To formulate an economic theory, economists use a scientific method of study. Scientific
method of investigation involves observation of economic phenomena or events, collection
and analysis of relevant data and prediction of economic phenomena
Predictive statements give the cause-effect kind of relationship between two or more
economic variables.
When the relationship between the selected variable is established with a high degree of
confidence, it is presented in form of a theory
This process is called theorization or formulation of theory 
 Cont..
1.6.1 Model building and formulation of economics theory
A model is an abstraction from reality. It represents reality in a simplified form.
Practically, a model is a logically consistent analytical framework made for analysing facts
of life in an abstracted form. Economic models may take the form of a logical statement,
graph or mathematical equations specifying relationship between the economic variables.
Steps of model building and economic theorization
1. Specifying the problem of study
2. Formulating a testable hypothesis
3. Making assumptions and making postulates
4. Collection of related data and other relevant facts
5.Deducing the testable predictions
6. Testing the validity of prediction
Supplement notes
What is a theory?
A theory is an unproven idea or speculation. It is a set of statements or
principles devised to explain a group of facts or phenomena. Theories
enable us to predict unobserved events.
A theory consists of:
•A set of definitions describing variables to be used
•A set of assumptions outlining conditions under which the theory applies
Hypotheses/hypothesis about the behaviour of variable
Predictions deduced from assumptions of theory
Testing against data
 Cont..
A variable is a magnitude that can take on different values. There are two
types of variables; endogenous and exogenous variables. Endogenous
variables are those which are explained within the model and exogenous
variables are those which are explained outside the model.
Assumptions are significant factors/propositions that are taken into
consideration in a theory
A hypothesis is a proposed explanation about the relationship between
variables. It is a specific, testable prediction about what you expect to
happen; for example ‘there is a positive/negative relationship between
variable A and B.
Predictions are propositions that can be deduced from a theory
A theory is tested by evidence to see if the predictions are true or not
 Cont..
A good theory:
Must make predictions that match our observations
Should have a good chance of being right
Should stand the test of time
Should be backed up by other theories with proof
Is often simple to accept
A good theory is always close to the reality of a situation; for example price and
demand. The law of demand says that as price increases demand falls, this is
observable in many situations in the economy. It is easily applicable to the real
world situation in many instances.
Economic theories provide an outlet for research in many areas to refute or approve
a theory.
 Cont..
Economic Models
A model is a specific quantitative formulation of a theory.
Specific numbers are attached to mathematical relationships in a
theory. The specific form of the model can then be used to make
precise predictions.
Models can be expressed as words, diagrams, or mathematical
equations depending on the audience and the point of the model.
You cannot present to a local uneducated society models in
mathematical form.
 Cont..
Economic models are used for different purposes in economics:
Forecasting economic issues with conclusions which are
logically related to assumptions
Economic policy making and recommendations
Presenting arguments to justify economic policy in politics,
company strategy at firm level or advice to households
Planning and resource allocation
 Why studying economics
1) Economics provides the underlying principles of optimal resource allocation
and thus enables individuals and firms to make economically rational decisions.
e.g., the preparation of budgets involves knowledge of demand and elasticity
analysis. Additionally, the theory of production in economics is concerned with
the principles that facilitate the optimal combination of factors of production.
2) A study of economics enables individuals and organizations to appreciate the
constraints imposed by economic environment within which any entity
operates. The student of economics is able to analyse the effects of such
economic variables such as inflation, exchange rates, interest rates etc.
3) The area of development economics is fundamentally concerned with the
reasons why society develop and means of accelerating development
4) Economics is an analytical subject and its study can help to develop logical
reasoning
1.7 CONSUMER SOVEREIGNITY
The power of consumers to determine what goods and
services are produced.
The theory suggests that consumers ,not producers, are the
best judge of what products benefits them the most.
Due to the fact that consumer markets depend so heavily on
demand, producer must monitor the needs of these individuals
if they want their products to have any chance at success. The
authority of consumers to determine what goods and services
are produced is often referred to as consumer sovereignty.
THREE BASIC ECONOMIC QUESTIONS
Economic theory is concerned with how society answers the basic economic
questions of WHAT goods and services should be produced, and in what amounts,
HOW these goods and services should be produced (i.e., the choice of the
appropriate production technology), and FOR WHOM these goods and services
should be produced.
1.WHAT GOODS AND SERVICES SHOULD BE PRODUCED?
In market economies, what goods and services are produced by society is a matter
determined not by the producer, but rather by the consumer.
Profit-maximizing firms produce only the goods and services that their customers
demand Consumers express their preferences through their purchases of goods and
services in the market.
The authority of consumers to determine what goods and services are produced is
often referred to as CONSUMER SOVEREIGNTY
 Cont..
2. HOW ARE GOODS AND SERVICES PRODUCED?
How goods and services are produced refers to the technology of production, and this is
determined by the firm’s management.
Production technology refers to the types of input used in the production process, the
organization of those factors of production, and the proportions in which those inputs are
combined to produce goods and services that are most in demand by the consumer.

3. FOR WHOM ARE GOODS AND SERVICES PRODUCED?

Those who are willing, and able, to pay for the goods and services produced are the
direct beneficiaries of the fruits of the production process.
While the what and the how questions lend themselves to objective economic analysis,
answers to the for whom question are fraught with numerous philosophical and analytical
pitfalls.
 Cont..
In market economies, the returns to the owners of these
factors of production are largely determined through the
interaction of supply and demand.

Production is made for someone to consume somewhere. What

is the final destination of the product is the key question here.
Is a free market this is determined by who is able to afford at
the market price. If you do not know for whom you are
producing, it will be difficult for you to decide what to produce
because you might not be able to sell your products.
TOPIC 2

CONSUMER BEHAVIOUR
 Consumer Behaviour
2.1 Introduction
Consumer behavior is the study of individuals, groups, or
organizations and the processes they use to select, secure, and dispose of
products, services, experiences, or ideas to satisfy needs and the impacts
that these processes have on the consumer and society.
It attempts to understand the decision-making processes of buyers, both
individually and in groups.
According to Hamansu (2008), „the main objective of the study of
consumer behaviour is to provide marketers with the knowledge and
skills that are necessary to carry out detailed consumer analyses which
could be used for understanding markets and developing marketing
strategies‟.
 2.2 The Concept of Utility
Utility refers to satisfactions derived from all the units of that product
consumed.
It’s the satisfaction which is derived by the consumer by consuming the
goods. For example, cloth has a utility for us because we can wear it. Pen
has a utility for a person who can write with it
Therefore, Utility is subjective in .nature. It differs from person to
person. The utility of a bottle of wine is zero for a person who is non
drinker while it has a very high utility for a drinker
Total Utility is the total satisfaction that a consumer gets from
consumption of a certain product/commodity
Marginal utility is extra/additional utility derived from the consumption
of one more (additional) unit of a commodity/products, the consumption of
all other goods remaining unchanged.
 Cont…
Total utility (TU) from a single commodity may be defined as some of utility derived
from all the units consumed of the commodity. Example consumer consumes 4units of
commodity and derive U1,U2,U3 and U4 utils from successive units
TU=U1+U2+U3+U4
Marginal Utility can be defined as the utility derived from the marginal or last unit
consumed
Marginal utility is the additional of total utility derived from the consumption or
acquisition of one additional unit. More precisely Marginal utility (MU) is the change
in total utility resulting from the consumption of one additional unit
i.e. MU=ΔTU/ΔC ,where

Therefore MU=TU n – TUn-1

 Cont..
For example, one hamburger per day (or, more generally, one unit of good X
per period of time) gives the consumer a total utility (TU) of 10 utils, where
A Util is an arbitrary unit of utility. Total utility increases with each additional
hamburger consumed until the fifth one, which leaves total utility unchanged.
This is the saturation point.
Therefore consuming the sixth hamburger then leads to a decline in total utility
because of storage or disposal problems.
The extra or marginal utility resulting from the consumption of each additional
hamburger. Marginal utility is positive but declines until the fifth hamburger,
for which it is zero, and becomes negative for the sixth hamburger.
The negative slope or downward-to-the-right inclination of the MU curve
reflects the law of diminishing marginal utility.
 2.3 Approaches of
Analysing/Measuring Utility
The concept of utility discussed in the previous section was introduced in the
early 1870s, by William Stanley Jevons of Great Britain, Carl Menger of
Austria, and Léon Walras of France.
They believed that the utility an individual receives from consuming each
quantity of a good or basket of goods could be measured cardinally just like
weight, height, or temperature. An actual measure of utility, in util.
In contrast, ordinal utility only ranks the utility received from consuming
various amounts of a good or baskets of goods. Ordinal utility specifies that
consuming two hamburgers gives the individual more utility than when
consuming one hamburger, but it does not specify exactly how much additional
utility the second hamburger provide.
In short, ordinal utility only ranks various consumption bundles, whereas
cardinal utility provides an actual index or measure of satisfaction
 Cont…
(i) Cardinal approach
The cardinal’s approach assumes that the consumer’s
satisfaction can be measured in a unit known as Utils. Up to a
point, the more units of commodity the individual consumes
per unit time the greater the greater total utility received.
Consider an individual’s consumption of a particular
commodity X over a period of time. The table shows what
happens to the consumer’s total utility and marginal utility as
he/she consumes more units of the goods.
 Cont..
Table 2.1 the total and marginal utility of a consumer
Quantity of X Total utility(Units Marginal utility
consumed per per week) (Utils)
week

0 0 0
1 20 20
2 50 30
3 60 10
4 62 2
5 60 -2
 Law of Diminishing Marginal Utility
The law of diminishing marginal utility states that “as the
quantity of a good consumed by an individual increases, the
marginal utility of the good will eventually decrease”.
Its any additional consumption of commodity will lead to a
decline in total utility.
Tables 2.1 illustrate the operation of the law of diminishing
marginal utility. As the consumer initially increases his
consumption of the commodity X, the additional satisfaction
derived from consuming one more unit (marginal utility)
increases and beyond a certain level, the marginal utility
decline.
 Cont..
Utility
TU

Normal goods

Qx
MU
Assumptions of law of Diminishing of Marginal
Utility
The law of diminishing Marginal utility holds only under
certain given conditions.
1) The consumers taste and preference remain unchanged
during the period of consumption
 Cont..
(2) The ordinal approach
The underlying assumption in the ordinal approach is that utility is not
measurable but is ordinal magnitude.
This approach does not require the consumer to know in specific units the
utility of the various commodities in order to make a choice.
It is sufficient for him/her to be able to rank the various combinations
according to the satisfaction derived from each bundle.
The basic difference between the cardinal approach and the
indifference curve (ordinal) approach is that the cardinal approach rests
on the unrealistic assumption that utility is measurable in a cardinal sense,
while the indifference curve approach requires only an ordinal measure of
satisfaction.
 2.4 Indifference Curve Analysis
What do they show?

Consumers tastes can be examined with ordinal utility. An ordinal measure of utility is based on
Three assumptions.

1 First, we assume that when faced with any two baskets of goods, the consumer can determine
whether he or she prefers basket A to basket B, B to A or whether he or she is indifferent between the
two.
2. Second, we assume that the tastes of the consumer are consistent or transitive. That is, if the
consumer states that he or she prefers basket A to basket B and also that he or she prefers basket B to
basket C, then that consumer will prefer A to C
3. Third, we assume that more of a commodity is preferred to less; that is, we assume that the
commodity is a good rather than a bad, and the consumer is never satiated with the commodity. E.g.
pollution


The three assumptions can be used to represent an individuals tastes with indifference curves. In
order to conduct the analysis by plane geometry, we will assume throughout that there are only two
goods, X and Y
 What is Indifference curve
An indifference curve may be defined as the locus of points each
representing a different combination of the two goods but yielding
the same level of utility/satisfaction, or
An indifference curve is a graph showing a combination of
different commodities that yield the same level of satisfaction or
utility to the consumer.
Since each combination of two goods yield the same level of
utility, the consumer is indifferent between any two combinations of
goods when it comes to making a choice between them.
Indifference curve is also called Iso- utility curve or equal utility
curve.
 Cont..
A higher indifference curve refers to a higher level of
satisfaction, and a lower indifference curve refers to less
satisfaction.
However, we have no indication as to how much additional
satisfaction or utility a higher indifference curve indicates. That
is, different indifference curves simply provide an ordering or
ranking of the individuals preference.
The entire set of indifference curves is called an indifference
map and reflects the entire set of tastes and preferences of the
consumer.
 Cont..
The following figure 2.2 illustrate indifference curve

Commodity Y

I3

I2

I1

X1 X2 Commodity X
 Cont…
Assignment 1:
I. Find out the limitation of the Cardinal approach.
II. What is Consumer surplus, justify your explanation with
the use of graph
III. What are the distinction between ordinal and cardinal
approaches of utility
 Properties of indifference curves
Indifference curve have the following 4 basic properties
1. Indifference curve are convex to the origin
As more and more units of one good, say Y, are given, it is reasonable to suppose that successively
bigger quantities of X must be obtained to compensate the consumer for his loss of satisfaction and
leave him/her at the same level of utility.
The assumption that indifference curves are convex to the origin implies that the two commodities
under consideration can substitute one another, but they are not perfect substitute
Indifference curves are usually convex to the origin; that is, they lie above any tangent to the curve.
Convexity results from or is a reflection of a decreasing Marginal Rate of Substitution (MRS)

2. Indifference curves never intersect

Consider the figure 2.3 below which shows two intersecting curves. Since both combinations D and
E are on the same indifference curve, the consumer must be indifferent between them. Combinations
E and F also lie on the same indifference, so the consumer must be indifferent between them as well.
 Cont..
If however, the consumer is indifferent between D and E, and
between E and F, he/she must (by rule of transitivity) be
indifferent between D and E. This, however, would be absurd
since D contains more Y and the same amount of X as F and so
must preferred to it. We therefore, conclude that indifference
curves never intersect.
 Cont…
Commodity Y
D

Fir
Fig.2.3
F

Commodity X
 Cont..
3.Indifference curves slope downwards towards from left to
right
If both X and Y are goods, and if the consumer is not satisfied
with either X or Y, then as some of one good is given up, more
units of other good must be obtained if the consumer is to
remain at the same level of utility or satisfaction. This implies
that movement on same indifference curve. See figure 2.4
 Cont..
Commodity Y

Commodity X
 Cont..
The slope of indifference curve is called Marginal rate of substitution.
The Marginal Rate of Substitution (MRS) of X for Y refers to the
amount of Y that a consumer is willing to given up in order to gain one
additional unit of X (and still remain on the same indifference
curve/satisfaction).
MRS=Δqi
Δq2
As the individual moves down an indifference curve, the marginal rate of
substitution of X for Y diminishes.
4. Upper indifference curve indicates a higher level of satisfaction than the
lower ones.
Marginal Rate of Substitution (MRS)
The amount of a good that a consumer is willing to give up
for an additional unit of another good while remaining on the
same indifference curve.
For example, the marginal rate of substitution of good X for
good Y (MRS) XY refers to the amount of Y that the individual
is willing to exchange per unit of X and maintain the same
level of satisfaction.
Note that: MRSxy measures the downward vertical distance
(the amount of Y that the individual is willing to give up) per
unit of horizontal distance (i.e., per additional unit of X
required) to remain on the same indifference curve.
That is, MRS XY=−∆Y/∆X
Because of the reduction in Y, MRS XY is negative. However,
we multiply by −1 and express MRSXY as a positive value
 Cont..
Is the rate at which an individual must give up "good A" in order to obtain one
more unit of "good B", while keeping their overall utility (satisfaction) constant
MRS is given by the slope of the IC curve. The marginal rate of substitution is
calculated between two goods placed on an indifference curve, which displays a
frontier of equal utility for each combination of "good A" and "good B".
As such, the marginal rate of substitution is always changing for a given point
on the indifference curve, and mathematically represents the slope of the curve
at that point.
NOTE;
Upper indifference curve indicates a higher level of satisfaction than the lower
ones
 Cont…
For example, consider an indifference curve between coca and
safari at a picnic. If the marginal rate of substitution coca for
safari is 2, then the individual would be willing to give up 2 coca
in order to obtain 1 extra safari.
The Law of Diminishing Marginal Rates of Substitution
states that MRS decreases as one moves down on the standard
convex-shaped curve, which is the indifference curve.
The marginal rate of substitution is another way of
mathematically expressing the opportunity cost for one more unit
of something; in this case the opportunity cost is the giving up of
some other specific good.
 Cont…
Suppose a consumer consumes two goods X and Y and that
utility function of the consumer is given as;
U = f (X,Y)
where X and Y are substitute
As a consumer can substitute X for Y Such that his total
utility remains the same. When consumer sacrifices some units
of Y, his stock of Y decreases by ∆Y and he looses a part of his
total utility. His loss of utility may be expressed as
 Cont..
- ∆Y . MUy
On the other hand, as a result of substitution, his stock of O
Increases by ∆X. His gain of utility from ∆X equals

+∆X. Mux
The total utility remains the same, only when
- ∆Y . MUy = +∆X. MUx

Rearranging; -∆Y/ ∆X = MUx/MUy

 Cont…
Here , -∆Y/∆X is simply the slope of the indifference curve,
which gives the MRSx,y ,when X is substituted for Y.
Similarly, -∆X/∆Y gives MRSx,y when Y is substituted for X.
MATHEMATICALLY
MRSx,y = -∆X/ ∆Y = MUy/Mux and }
MRS y,x = -∆Y/ ∆X = MUx/Muy } Slope 0f indifference
curve
Note: The diminishing marginal rate of substitution
causes the indifference curve to be convex to the origin.
 Quiz
1. Why does MRS diminish?
 2. 5 The Budget Line
We now introduce the constraints or limitations that a consumer faces in attempting
to satisfy his or her wants. The amount of goods that a consumer can purchase over a
given period of time is limited by the consumer’s income and by the prices of the
goods that he or she must pay.
In what follows we assume (realistically) that the consumer cannot affect the price of
the goods he or she purchases. In economics jargon, we say that the consumer faces a
budget constraint due to his or her limited income and the given prices of goods.

A budget line is a graphical description of the basket a consumer can buy, given a
certain budget.
A utility maximizing consumer would like to reach the highest possibilities
indifference curve on his/her indifference map. But the consumer is assumed to have
a limited income, which set limits to which a consumer can maximize his/her utility.
The limitedness acts as a constraint (Budgetary constraints).
The indifference curves only do not tell us which combination a consumer would
prefer between two goods.
 Cont..
Budget constraint is the limitation on the amount of goods
that a consumer can purchase imposed by his or her limited
income and the prices of the goods
Budget line is a line showing the various combinations of two
goods that a consumer can purchase by spending all income
 Cont…
In addition, consumer’s preference is limited by income and
prices of the two goods. Given this information and assuming
that the consumer will choose the combination of the two
goods which will yield him greatest utility (i.e., put him/her in
the highest attainable indifference curve). One can determine
the combination of X and Y that a consumer will choose.  
e.g., suppose the price of commodity X is Tsh. 200, the price of
commodity Y is 100 and suppose a consumer’s income is
Tsh.1000, 000.
 Cont..
Table 2.2

Quantity of X Quantity of Y
(prices= Tsh. 200) (Prices= Tsh 100)
0 1000
1000 8000
2000 6000
3000 4000
4000 2000
5000 0
 Cont..
If these points are plotted on the same graph as the
indifference map, we obtain what is called a budget line.

Commodity Y

10000

5000 Commodity X
 Cont..
Assume there are only two possible types of object
that our consumer wants to buy. We will call them
goods 1 and 2, known as guns and butter. We therefore
have the first part of the optimization problem:
The objects of choice are the amount of these two
good that the consumer wants to buy. We will call
these x1 and x2. We can illustrate the commodity
space graphically with good 1 on the horizontal axis
and good 2 on the vertical axis ( figure 1).
 Cont…
The world we are thinking of has three parameters or things
that the consumer cannot control the price of the two goods
(which we call P1 and P2) and the amount of money that the
consumer has to spend (which we will call M).The constraints
that consumer is operating under should now be obvious. They
can only choose bundles of goods that they can afford. This is
called the budget constraint, and can be written as follows;

P1X1 +P2X2 ≤ M
 Cont…
We can now illustrate the budget constraint in the graph of commodity
space.
In order to do so we want to graph the line for which the budget
constraint holds with equality, which is called the budget line.

P1X1 +P2X2 = M

Rearranging this equation gives

P2X2 = M −P1X1
X2 = M/P2 – P1/P2*X1.
 Cont…
The budget line is therefore a straight line in the
commodity space, with the slope –P1/P2. This is the
rate at which the consumer can exchange one good for
another Marginal Rate of Transformation(MRT): If
they give up 1 unit of good 2 they will get P1/P2 units
of good 2. The budget set, or set of objects that the
consumer can afford, are the objects on the ‘inside’ of
the budget line.
 Cont..
Y

M/Py
Qy=M/Px-Px/Py(Qx) .B
NON FEASIABLE AREA

.A
FEASIBLE AREA
Budget line

M/Px X
 Cont…
How do changes in the parameters (prices and income) change
the budget set? First, think about an increase in price 2. This is
going to flatten the slope of the budget line (the rate at which
good 1 can be traded for good 2). However, it is not going to
change the amount of good 1 that can be bought if all income is
spent on that good. Thus, the budget line pivots round the point
where it touches the horizontal axis (figure ). Similarly, an
increase in price 2 causes the budget line to steepen, and pivot
round the point where it touches the vertical axis

An elementary of price and income substitution.

 Cont..
 The budget line shows the various combinations of two goods (say, X and Y)
that a consumer can purchase by spending all income (I) on the two goods at the
given prices (PX and PY). The vertical or Y-intercept of the budget line is given
by I/PY and −PX/PY is the slope. The budget line shifts up if I increases and
down if I decreases, but the slope remains unchanged. The budget line rotates
upward if PX falls and downward if PX rises.
A rational consumer maximizes utility when reaching the highest indifference
curve possible with the budget line. This occurs where an indifference curve is
tangent to the budget line so that their slopes are equal (i.e., MRS XY = PX/PY).
Government warnings or new information may change the shape and location
of a consumer’s indifference curves and the consumption pattern. If indifference
curves are everywhere either flatter or steeper than the budget line o
 Cont…
By assuming that a consumer spends all of his or her income on good X(hamburgers) and on
good Y(soft drinks), we can express the budget constraint as

PXQX +PYQY=I

Where, PX is the price of good

QX is the quantity of good
PY is the price of good
QY is the quantity of good
and I is the consumers money income.
Equation postulates that the price of X times the quantity of X plus the price of Y times the
quantity of Y equals the consumers money income.
That is, the amount of money spent on X plus the amount spent on Y equals the consumers
income
 Cont..
With an income of I=$10, and PY= $1 and PX=$2, we get budget line JK. This shows that the
consumer can purchase 10 Y and 0X(endpoint J), 8Y and 1 X (point L ), 6 Y and 2X (point
B ),or...0Y and 5X (endpoint K).I/PY=$10/$1=10 is the vertical or Y-intercept of the budget
line and−PX/PY=−$2/$1=−2 is the slope
TOPIC 3

Price Mechanism:
Demand, Supply, Equilibrium Price
and Elasticity)
 
 Introduction
The market mechanism plays crucial role in solving the basic
economic problems in free market economy and the entire
market system functions.
The market system work orderly because its governed by the
law certain fundamental laws of markets known as demand and
supply.
The laws of demand and supply interact to determine the price
of goods and services brought to the market.
 3.1 DEMAND

3.1 DEMAND
Definition of Demand
Demand refers to the quantity of a commodity that consumers are willing and
able to purchase at any given price over a given period of time.
It is important to realize that demand is not the same thing as want, need or
desire. Only when want is supported by the ability and willingness to pay the
price does it become an Effective demand and have influence on the market
price.
A desire with resources but without willingness to spend is only a potential
demand.
A desire accompanied by ability and willingness to pay makes a real or
Effective Demand
 LAW OF DEMAND
The law of Demand:
The law of demand states the relationship between the quantity demanded and
price of commodity depends also on many factors e.g. consumer’s income, price
of related goods, consumers taste and preferences, advertisement .
Price is the most important and the only determinant of demand in short run
The law of demand states that, “Ceteris paribus (other things remain Constant)
the lower the price of a commodity, the greater the quantity demanded by
the individual and vice versa”.
This inversely relationship between price and quantity is reflected in the
negative slope of the demand curve
Marshall states that the law of demand as ‘the amount demanded increases
with fall in price and diminishes with a rise in price.”
 Cont…
Price of commodity

P2

P1

Q1 Q2 Quantity demanded
 Cont..
The figure above shows the law of demand. There fore the law of
demand can be illustrated through a demand schedule and demand
curve;
A decrease in the price from P2 to P1, leads to an increase in the
quantity demanded from Q1 to Q2.
The individual’s demand schedule is a tabular presentation shows the
alternative quantities of a given commodity that a consumer is willing
and able to purchase at various alternative prices for that commodity.
The individual demand defined as the quantity of a commodity that a
person is willing to buy at a given price over specified period of time,
say per day, per week, per month etc.
 Cont..
Example of A demand schedule for potatoes
Price of potatoes Quantity of potatoes
Tshs per kg (kg per week)
34 190
36 180
38 170
40 160
42 150
44 140
46 130
 Cont..
Price DD

DD

Quantity
 Cont..
The demand curve is graphical representation of demand
schedule.
The market demand curve is the horizontal summation of
individual demand curve. Its obtained by plotting demand a
demand schedule
In fact , market demand is the sum of is the sum of individual
demands
Assumption of the law of Demand
The law of demand assumes the following;
Income of consumers do not change. If consumer’s income
increases/decreases, the law will not hold good.
Peoples taste and preferences remain the same/unchanged and
Prices of substitutes and complimentary goods do not change
 Determinant of demand
3.1.3 The determinants of demand
The market demand for a product is determined by a number of factors. These factors affecting
demand for a product includes; price of the product, price and availability of the substitutes,
consumer’s income, taste and preference etc
1. The price of the product
The nature of relationship between price of the commodity and it quantity demanded as discussed
earlier on the law of demand; this shows the movement along the same demand curve. i.e., if the
prices of the commodity increases the quantity demanded decrease and vice versa.

2. The price of related goods:

The price of Substitutes or complementary goods may cause demand of such goods to increase
or decrease. Two goods X and Y are said to substitutes if a rise in the price of one commodity, say
Y, leads to rise in the demand of the other commodity X. e.g., Meat Vs Bean, a mango Vs an
orange. The relationship of substitutes can be shown graphical by the diagram below:
 Cont…
Concept of substitute goods
P2
Price of

Meat

P1

Q1 Q2

Quantity of Beans
 Cont…
Complementary goods are usually jointly demanded in the
sense that the use of one requires or enhanced by the use of the
other.
Two goods A and B are said to be Complementary if a rise in
one of the goods, say A (Petrol), leads a fall in the demand of
another goods Say B (Car). E.g., Cars and petrol, computers
and software, bread and margarine.
The relationship of complementary can be shown graphical by
the diagram
 Cont…
The concept of complementary
Price of Petrol
goods.

P2

P1

Q1 Q2 Demand of Car
 Cont..
3. Change in Real Income
An individual’s level of income can be said to have an important effect on his/her level
of demand for most products. If income increases the demand for most goods and
services will increase especially the demand of better quality goods and services.
However, a rise in income may cause the demand for some goods to fall. e.g., Inferior
goods
 4. Taste and fashion:
Change in taste and fashion may play an important role in governing a consumer’s
demand a certain commodity. For example preferring to consume imported
commodities despite their being much expensive than local commodity.
5. Level of advertisement
Advertisement is very important determinants of demand. In highly competitive
markets, a successful advertisement campaign will increase the demand of a particular
product while at the same time decreasing the demand for competing products.
 6. The availability of credit to consumers
This factor especially affects the demand for durable consumer goods which are often
purchased on credit. Change in the terms on which credit can be obtained will have a
marked effect on the demand for a certain products like furniture and home appliance.
Take example of TUNAKOPESHA Ldt
 Cont..
7. Government policy:
The government may influence the demand of a given commodity through
legislation. e.g., making it mandatory to wear seat belts. The consumer will
then buy more seat belts as a result
8. Population size of a country
The total domestic demand for a product depends also on the size of
population. Given the price, per capita income, taste and preferences etc.,
the larger the population, the larger, the larger the demand for a product of
common use.
9. Distribution of National Income ,the distribution pattern of national
income also affects the demand for commodity. If national income is evenly
distributed, market demand for normal goods will be the largest
Why Demand Curve slopes Downward to the
Right
Why does it happen? The reasons behind the law of
demand are following:
i.Income Effect
Among the cause behind the operation of law of demand is
income effect.
As the price of a commodity falls, the consumer has to buy
the same amount of the commodity at less amount of money.
After buying his required quantity he is left with some
amount of money.
This constitutes his rise in his real income. This rise in real
income is known as income effect. This increase in real
income induces the consumer to buy more of that
commodity. Thus income effect is one of the reasons why a
consumer buys more at falling prices.
However, Income effect is negative in case of inferior
 Cont…
ii. Substitution Effect, When the price of a commodity falls, it
becomes relatively cheaper than other commodities. The
consumer substitutes the commodity whose price has fallen for
other commodities which becomes relatively dearer.
For example with the fall in price of tea, coffees. Price being
constant, tea will be substituted for coffee. Therefore the demand
for tea will go up.
Consequently a rational consumers tends to substitute cheaper
goods for costlier one within a range o normal goods-goods
whose demand increases with increase consumer ‘s income-
other things remain the same.
 Cont…
iii. Diminishing Marginal Utility
Marginal utility is the utility derived from the marginal unit
consumed of commodity.
Consumer always equalises marginal utility with price.
(Muc=Pc) The law states that a consumer derives less and less
satisfaction (utility) from the every additional increase in the
stock of a commodity. When price of a commodity falls the
consumer's price utility equilibrium is disturbed i.e. price
becomes smaller than utility.
Cont…
The consumer in order to restore the new
equilibrium between price and utility buys more of it
so that the marginal utility falls with the rise in the
amount demanded. So long the price of a commodity
falls, the consumer will go on buying more amount of
it so as to reduce the marginal utility and make it
equal with new price.
Thus the shape and slope of a demand curve is
derived from the slope of marginal utility curve.
Exception of Law of demand
There are some demand curves that slope upwards from left to
right showing that as prices of a product rises more is demanded and
vice versa. This type of demand curves are known as regressive,
exceptional or abnormal demand curves and occur in the
following situations.
However, the law of demand doesn’t apply in the following cases;
 1.Fear of a more drastic price changes in future(Expectation
regarding future price):
When a consumers expect that in the future price is expected to
increase drastically than it is now, s/he tends to purchase more now
even if the price is higher.
 Cont..
2. In the case of Giffen goods
In economics and consumer theory, a Giffen good is a product that people
consume more of as the price rises—violating the law of demand. For any good, as
the price of the good rises

 3. Seasonality:
The demand for a commodity such as an umbrella is higher during the rain season.
Even if the price is higher during rainy season, the consumer tends to buy it.
4.Goods of ostentation (prestigious goods):
These are commodities whose prices fall in the upper prices ranges and that have a
snob appeal. These goods are demanded more when the price is higher than when
price is lower. e.g., jeweler
3.1.4 Shift in the demand curve
A demand curve either shift to the right or left, due to changes
taking place in other factor and not price of commodity
When demand curve changes its position retaining its shape
(though not necessarily), the change is known as shift in demand
curve.
The change in the position of demand curve due to these changes
can be termed as the increase and decrease in demand.
When the demand curve shifts upwards or to the right, its called
Increase in demand
 Cont..
Similarly, when less is demanded at the same price due to
changes in other factors, it is called decrease in demand. Here,
the demand curve gets shifted left ward
 Cont…

D1

D
Price

Q1 Q2 Quantity
 Cont..
The above figure shows, a rightward shift in the demand
curve from DD to D1D1. An increase in demand is therefore
caused by a factor other than the commodity’s own price.
The commodity’s price remains constant at P while the amount
purchased has been increased from Q1 to Q2.

A change in any of the determinants factors of demand apart

from own price causes the demand curve to shift either to the
left or to the right with more or less being demanded at each
of the original prices.
 REASONS FOR SHIFT IN DEMAND
CURVE
Shifts in a demand curve may take place owing to the change in one or more
of the determinants of demand.
1. Income effect – If consumer's income falls, it implies that consumer
purchasing power is reduced. Thus demand curve shift downward from it
origin holding the price constant.
2. Substitution effect-arise due to change in the relative price of substitute say
Coke and Pepsi. When price of Coke commodity decreases (or increases), it
become relative cheaper (costlier) than the demand for Pepsi . The consumer
have an inherent tendency to substitute cheaper goods for relative costlier
ones.
3. Change in taste and preferences – due to change may be to fashion,
religious values etc, consider the advertisement made by the producer of a
substitute good, changes consumer’s taste and preferences
 Cont…
4. Price of complementary goods-These are goods that that are
consumed together, therefore Increase in the price of complimentary
good of X say car will lead to the fall in demand for a petrol
5. Change in population size (number of consumers)
The increase in population leads to increase in demand while
decline in population leads to a fall in demand in a market.
6. Change in consumer expectations, if consumers expects the
price of certain goods to increase in the future, they will purchase
more of those goods now. As the result demand in the current period
will increase, shifting the demand curve to the right and vice versa
is true.
 A MOVEMENT ALONG THE DEMAND
CURVE
 A movement along the demand curve occurs when a change in
amount purchased results from change in the commodity’s own prices.
In the case of normal goods, an increase in the commodity’s price
leads to a contraction along the demand curve or a decrease in the
quantity demanded and vice versa.
Movement along the demand curve is simply termed as change in
quantity demanded i.e. change in demand due to change to a change in
the price of commodity other things being equal
Therefore movement along the demand curve takes place when there is
a change in price of a good, other things remain constant. This is called
extension and contraction in demand.
 Cont…
When quantity demanded of good rises due to the decrease in
price alone, its said that the extension of demand have taken
place
And when quantity demanded falls due to rise in price; it is
called contraction in demand
Therefore, the extension and contraction of demand takes
place only due to changes in the prices of a commodity, other
factors remaining constant. This shows that people are
normally willing to buy less of a product at a high prices and
more at a low price.
 Cont..
Price

Quantity
 3.5.1 The demand function
Demand function states the relationship between demand for a product
(dependant variable) and its determinants (the independent variables).
Assume that the quantity demanded of commodity X depends only on its
price (Px), other factors remaining constant.
A simple mathematically demand function is
 
 Dx=ƒ(Px).
Dx is a dependant and Px is independent variable.
It implies that a change in price Px will cause change in demand Dx. When
a quantitative relationship between Dx and Px is known, the demand
function is expressed in the form of an equation, as
 Cont..
Dx=a – bPx
 Linear demand function-A demand function is said to be linear when the
slope of demand curve remain constant throughout its length
Given this demand function, if value of parameters a- intercept and b-
slope are known, the total demand (Dx) for any given price (Px) can easily
be obtained and if a series of alternative price is given, a demand schedule
can be easily prepared.
Let assume that a=10 and b= 5, now the demand function can be written as
Dx=10 – 5Px therefore the value of Dx can be easily obtained for any value
of Px. Thus, a demand schedule can be prepared assigning different values
for P
 SUPPLY
In a market economy, while buyers of a product constitute the
demand side of a market, sellers of that products make the
supply side of the market.
 3.2 SUPPLY
3.2 Supply
The nature of supply
The amount of a product that firms are able and willing to offer for sale is called
the quantity supplied.
Alternatively, Supply refers to the quantity of a given commodity that a producer
is willing and able to offer for sale at a given price over a specific time period.

3.2.1 The Supply Schedule

The supply schedule is a tabular presentation of the supply function/law of supply.
 It shows alternative prices of a commodity and the corresponding quantity that
suppliers are willing to offer for sale.
 Cont..
Supply schedule for paddy

Price per bag Tshs. Quantity per week (Bag)

20,000 10
25,000 12
30,000 15
35,000 20
40,000 25
45,000 30
 The supply curve
A supply curve is a graphical depiction of the supply
schedule. If the price – quantity relationship shown in the table
above is plotted in graphing, this is called supply curve.
The supply curve depicts the law of supply. The upward
slope of the supply curve indicates the rise in the supply of
paddy with the rise in its price and fall in the supply with fall in
its price.
A supply curve has a positive slope. In fact, supply curve is
derived from the marginal cost curve
 Cont..

PRICE
45,000
40,000
35,000
30,000
25,000
20,000
10 12 15 20 25 30 Qty
 LAW OF SUPPLY
3.2.2 The law of Supply
The supply of commodity depend on its price and cost of production.
In other words , supply is the function of price and production cost.

The law of supply can be stated as the supply of a product increases

with the increase in its prices and decreases with decrease in its
prices, other things remaining constant.

It implies the positive relationship between quantity of commodity

supplied and its corresponding price.
3.2.3 The Determinant of quantity supplied;

1. The price of the product

As the price of a given commodity say X rises, with all costs and prices of all
other goods remaining unchanged, the production of commodity X becomes
more profitable. The existing firms are therefore likely to expend their output
while new firms are likely to be attracted into the industry. Also expectations
concerning future prices may motivate the producers in question.

2. . The price of inputs of production

If price of inputs of production is low, producers are likely to produces more
and the supply curve will shift rightward. For example in agricultural sector, if
price of fertilizer, insecticides, herbicides, pesticides etc. is some how low may
be due to government subsidies, supply of agricultural produce will be higher. 
 Cont..
3. Prices of factors of production
As the prices of factors of production used intensively by the producers
of a certain commodity rise, so do the firm’s costs. This will cause the
supply to fall since some firms will reduce output while other less
efficient firms will make losses and eventually leave the industry.
4. The state of Technology
Technological improvements or progress such as improvement in
machine performance, management and organization or an improvement
in the quality of raw materials leads to a lowering of costs through
increased productivity and increases the profit margin on every unit
sold. This should lead to an increase in supply. E.g. Power tiller, tractors
 Cont…
5. Weather
The supply of agricultural produces is considerably affected by change in
weather conditions. Output in agriculture is subject to variations from one
year to the next, which are independent of the acreage planted and weather
condition. An excellent growing season associated with favourable weather
conditions will result in a bumper harvest leading to an increase in supply.

6. Indirect Taxes and subsidies

A tax on a commodity can be regarded as an increased in the costs of supply
that commodity and supply curve will shift to the left as a result. Subsidies
usually take the form of payments by the governments to the producers and
will have the effect of the lowering the cost of production and hence
increasing the supply. e.g. subsidies in agricultural inputs
 Cont..
7. Natural hazards or political disruption
The occurrence of natural hazards (i.e. droughts, floods, earth
quakes etc) and political disruption (i.e. war and political
crisis) lead to stoppage of production activities leading the
production to the less production hence decrease in supply and
vice versa.
8. Number of producers/ sellers
The number of producers that exists in a market has great
influence in the supply of the commodity. The increase in the
number of producers lead to the change in supply.
 3.2.4 Shift in the supply curve
Although price of a commodity is the most important determinant
of its supply, it is not only determinant, there are many other
determinants influencing the supply of a commodity.
Therefore, whenever, there is change in other determinants, the
supply curve shifts rightward or leftward depending on the
effects of such changes.
The change in any of factors other than price of commodity causes
supply curve to shift either upward (leftward)or downward
(rightward).
Upward shift of the supply curve indicates a decrease in supply
while downward shift indicates an increase in supply.
Shift in supply curve
Price s’ s s”

Quantity
 Cont..
The shift from S to S” indicates an increase in supply by
downward shift of the curve while the shift from S to S’
indicates a decrease in supply by upward shift in supply curve
Factors for the shift in Supply Curve
1. Change in input (resources) prices
When inputs go down the use of inputs increases or more inputs can be used at a
given total cost. As a result products supply increases and the supply curve shifts to
the right and vice versa.
Or An increase in the price of resources will lower the profit on each unit sold at
current price, there by reducing the supply of the good and shifting the supply curve
to left and vice versa

2. Technological progress:-
Technological changes that reduce cost of production or increases factor efficiency
increases the product supply. For instance introduction of high yielding varieties of
paddy and new technology of cultivation increases per acre yield of rice. Such
changes make the supply curve shift to the right 
 Cont…
3. Price of related goods (substitute/complimentary):-
Fall in price of one of the products substitutes may lead to the rise in the supply
of the other due to capacity utilisation for profit maximization 
If price of substitute say tea rises ,it will result in the reduction in production
and supply of another product say coffee for the case of substitute
If the price of one good (car) rises induces the increase in production of another
good (petrol) hence increase in supply of another good(petrol) for the case of
complementary7 goods
4. Government policy:-
When the government impose restrictions on the production e.g., import quota
on inputs, excise taxation, etc. production tend to fall. Such restrictions make
supply to shift left ward
 Cont..
5. Subsidies
Subsidies will have the effect of the lowering the cost of production and hence
increasing the supply
6. Non economic factors:-
The factors like war, drought, flood, epidemic etc. also affects adversely the
supply of commodities. Therefore the supply curves shift leftward.
7.Nature and size of industry, The supply of commodity depends also on
whether an industry is monopolised or competitive.
Under monopoly , supply is fixed. When a monopolized industry is made
competitive, the total supply increases. Besides, if size of an industry increases
due to new firms joining the industry, the total supply increases and supply
curve shift rightward.
 Cont..
8. Change in future price expectation
The expectation of prices to rise in future induces less sales
now thus decrease in supply while, the expectation of further
fall in price in future induces more supply now thus an increase
in supply of the commodity.
Movement along the supply Curve
A movement along the same curve simply indicates changes
in quantities offered for sale as result of a change in the
price.
When supply changes not due to changes in the price of the
product but due to other factors, such as change in technology,
price of related commodities, change in price of inputs etc. Its
also called change in supply
Quantity supplied of a good falls as the price likewise as the
price raise the quantity supplied increases too.
 Cont..
Price s
P1
Po
P2
s
Q2 Qo Q1
3.2.5 The supply function
The law of supply states only the nature of relationship between the
price and the quantity supplied. A supply function quantifies this
relationship.
Supply function is a mathematical statement which states the relationship
between the quantity supplied of a commodity ( as dependent variable)
and its determinants ( as independent variables).
The supply function is based on the law of supply.
Therefore, the supply of a commodity depends on its price, Cost of
production (Price of factor of production, price of inputs/raw materials,
indirect tax) and production technology.
In other words, Supply of a product X is the function of its price (Px), cost
of Production (Cx) and Technology of its production (Tx).
  Qx =ƒ(Px, Cx ,Tx)  
Cont…
In simple theory of supply, however, the law of supply is expressed generally in
terms of price-quantity relationship; function is expressed as :
 Qx =ƒ(Px) 
i.e. Recall, demand Qd=a –bPx,
hence,
Qs= a + b Px, where, b = slope of supply curve

Then, Qx = sPx
 
where Qx = quantity supplied of commodity x,
s= ∆Qx slope of supply curve
∆Px
Px=Price of a commodity x
 Cont..
Given this supply function, schedule can be generated by
substituting numerical value for Px and assuming s= 10.
if Px =2, Qx =10x 2
= 20 etc.
 3.3 Market Equilibrium
In the context market analysis, Equilibrium refers to a state of market in
which the quantity demanded of a commodity equals to the quantity
supplied of the commodity.

The equality of demand and supply produces an equilibrium price.

 At equilibrium price, demand and supply are in equilibrium. The

equilibrium price is also called market clearing price because at this price,
the quantity that a supplier wants to supply equals the quantity that buyer
are willing to buy.

Determinant of price in a Free Market

A free market is one in which market forces of demand and supply are
free to their own course and there is no outside control of price, demand and
supply.
The Concept Of Market Equilibrium
In physical sense, the term equilibrium means the
“state of rest”
In general sense, It means balance in opposite
forces.
In the context of market analysis, Equilibrium
refers to a state of market in which quantity
demanded of a commodity equals to quantity
supplied of a commodity.
 Cont…
A market is in equilibrium when both of these conditions are
fulfilled;
i. No agent wants to change her decision or strategy
ii. The decisions of all agents are compatible with each other,
so that they can be carried out simultaneously.
 Equilibrium price: The price that arise when there is an
equilibrium in the market
 Equilibrium quantity: The quantity that is brought and
sold when there is an equilibrium in the market.
 Cont..
3.3.1 Determination of market equilibrium price
The equilibrium price in a free market is determined by the forces of
demand and supply.
In order to analyse how equilibrium price is determined, we need to
integrate the demand and supply curve
From the table below, there is only one price of shirts (Tsh.3000) at
which the market is in equilibrium. i.e., quantity demanded and the
quantity supplied is equal at 40 shirts.
That is, at equilibrium price, demand and supply are in equilibrium. The
equilibrium price is also called Market clearing price. Market is cleared
in the sense that there is no unsold stock and no unsupplied demand.
 Cont…
When the market is in state of disequilibrium, At other prices, the shirt
market is in disequilibrium as either demand exceeds supply or supply
exceeds demand.
The disequilibrium is the state of imbalance between supply and demand
As the table show shows , all prices below Rs 3000, the demand exceeds
supply showing SHORTAGE of shirt in the market.
Likewise, at all prices above RS 3000, supply exceeds demand showing
EXCESS SUPPLY

3.3.2 THE EFFECTS OF SHIFTS IN DEMAND AND SUPPLY ON THE

MARKET PRICES
In the free market, disequilibrium it creates the condition for equilibrium.
 Cont..
Prices of Shirt Demand Supply Market Effect on
(Tshs) positions Price
1000 80 10 Shortage Rise
2000 55 28 Shortage Rise
3000 40 40 Equilibrium Stable
4000 28 50 Surplus Fall
5000 20 55 Surplus Fall
6000 15 60 Surplus Fall
 Cont..

S
Pric
S’’
e

3000

40

Quantity
The effects of shifts supply , demand
on the market prices
When there is an increase in supply/excess supply (i.e., rightward shift of
supply curve), it forces downward adjustments in the prices and increase
quantity supplied and vice versa.
When there is excess demand, if forces upward adjustment in the price and
quantity demanded.
Therefore , whenever there’s a shift in the demand and/or supply curve, there’s
also a shift in the equilibrium point
The process of downward and upward adjustments in price and quantity till the
price reaches Rs 3000 and quantities supplied and demanded balance at 40
thousands shirts. This process is automatic.
The process of price and quantity adjustments are called “Market Mechanism”
or is the process of interaction between the market forces of demand and supply
to determine equilibrium prices.
 Cont…
Shift in demand Curve
The effect of the shift in demand curve on the equilibrium is shown
below. Suppose that the initial demand curve is given by the curve DD’
and supply curve by SS’.
The demand and supply curve intersect each other at point P. The
equilibrium price is determined at PQ and equilibrium quantity at OQ.
Let the demand curve now shift from its position DD’ to DD”, supply
curve remain the same. The demand curve DD” intersect with supply
curve SS’ at point M.
Thus, shift in demand curve causes a shift in the equilibrium from
point P to point M
 Cont…
At equilibrium, quantity demand and supplied increases from
OQ to ON and prices increases from PQ to MN.
Note: The supply curve remaining the same, a rightward shift in
the demand curve result in a higher equilibrium price and
quantity.
 Cont..
Shift in Demand Curve and Equilibrium.
Price DD” S’
DD’ M

S’ DD”

DD’
Q N Quantity
 Cont..
Shift in supply curve
Effect of shift in the supply curve on the equilibrium. Suppose that the demand
curve is given DD’ and initial supply curve SS’.
The curve DD’ and SS’ intersect at point P, determining equilibrium prices at
PQ and equilibrium quantity at OQ.
Let the supply curve now shift from its position SS’ to SS”, demand curve
remaining unchanged.
The new supply curve SS” intersects the demand curve at point M. Thus, a
new equilibrium takes place at point M where equilibrium price is MN and
equilibrium quantity ON
Note that, a rightward shift in supply curve, demand curve remaining the
same, causes equilibrium price to fall and output to increase.
 Cont..
Shift in Supply Curve and Equilibrium.
Price D’ SS’

P SS”
M

SS’
SS”
D”

Q N Quantity
 Simultaneous Sift in Demand and
Supply Curve
We have seen above that the right shift in demand curve
causes a RISE in market price and a rightward shift in supply
curve causes a FALL in the market price.
Let us now look at the effect of simultaneous and parallel
shifts in demand and supply curve on the equilibrium price and
output.
 The effect of a simultaneous and parallel right ward shift in
demand and supply curve on the equilibrium price and output
depends on how big or small is the relative shift in demand
and supply curve.
 Cont…
If the shift in the supply curve is a bigger than in the demand curve,
then the equilibrium price decreases and output increases.
For example, suppose that the initial demand and supply curve are given
by DD’ and SS’, respectively, intersect at point E1 and determining
equilibrium price at P1 and output at Q1.
Let the demand curve shift to DD” and supply curve from SS’ to SS”’,
intersect at point E3.
Note that shift in supply curve is bigger than that in the demand curves.
As a result, equilibrium price FALL to Po and output increases to Q3.
BUT , if demand and supply curves shift in equal measure, as shown in
DD” and SS”, equilibrium price remain unchanged though output
increases to Q2.
Parallel shift in Demand and Supply curve
and its effect on the equilibrium price and
output
Price SS’
DD” SS”
DD’ SS”’
P1 E1 E2
Po E3
SS’
SS”
SS”’

Q1 Q2 Q3 Quantity
 Cont…
Similarly, the effect of bigger shift in demand curve on the
equilibrium price and output.
It can be shown below that the shift in demand curve from
DD’ to DD” is bigger than the shift in supply curve from SS’ to
SS”. In this case both equilibrium prices and output increases.
Parallel shift in Demand and Supply
curve and its effect on the equilibrium
price
Price
and output
DD” SS’
DD’ SS”
P2 E2
P1 E1
SS’
SS” DD”
DD’

Q1 Q2 Quantity
 Price Determination : Numerical
example
In the previous section. We illustrated how equilibrium of
demand and supply is determined at the point of intersection of
demand and supply curves.
If the demand and supply functions are known, the
equilibrium quantity and equilibrium price can also be
determined numerically.
 Cont..
Algebra of demand and supply equilibrium
Let the demand function for a commodity X be given as
Qd= 150 - 5Px and

supply function Qs=10Px

 
Since we know that at the equilibrium, quantity supplied and quantity demanded is equal

Therefore Qs= Qd

150 - 5Px=10Px
150 =10Px+ 5Px
150/15 =15Px/15
10= Px
 Cont..
Thus price at equilibrium is Px=10, given this equilibrium price, the
equilibrium quantity demanded and the quantity supplied can be easily
worked out,

From Qs= Qd and Qs=10Px

 
The equilibrium quantity supplied and demanded will be obtained by
substituting the price (Px=10) in any of two equation above.
Qs=10(10)
Qs=100
 
 Cont..
Px Dx Sx
Qd=150-5Px Qs=10Px

10 P

20 40 60 80 100 Quantity
3.3.3 Maximum Price Control
Maximum price control is situation whereby a government
imposes the price below the equilibrium price. If a government
imposes a maximum price control given by Pmax, there will be a
SHORTAGE of the commodity given by (Q2-Q1).
This shortage of commodity in the market will lead to the
increase in price in the market to attain it equilibrium Pe.
See figure below
 Cont..

Price
D Max Price control
S
P *

(shortage)
Pe

P max
Price ceiling
D

Q1 Qe Q2 Quantity
 Cont..
The effect of maximum price controls, e.g petrol, diesel market etc
3.3.4 Minimum price control
Minimum price control is situation whereby a government
imposes the price above the equilibrium price, when government
considers that the price that is determined by force of demand and
price is too low.
Minimum price controls are geared to protecting producers
from low prices and thereby encouraging certain lines of
production. The likely effects of such decision are;- in case of
producer it will create excess supply in the market, price controls
may contribute to industrial peace especially if they constitute part
of a comprehensive income policy e.g. minimum wage legislation;
price control may in a certain cases be associated with a decrease in
price and an increase in output.
 Cont..
The effect of minimum price controls.
Price D S
P min Price floor
Pe (price mini)
P*

Q1 Qe Q2 Quantity
 PRICE FLOOR
A price floor is a government- or group-imposed price control or limit
on how low a price can be charged for a product.
 A price floor must be greater than the equilibrium price in order to be
effective.
When a "price floor" is set, a certain minimum amount must be paid
for a good or service. If the price floor is below a market price, no
direct effect occurs.
If the market price is lower than the price floor, then a surplus will
be generated. Minimum wage laws are good examples of price floors.
Price floors, prohibit prices below a certain minimum, cause
surpluses, at least for a time
 Cont…
A price floor exists when the price is artificially held above the equilibrium
price and is not allowed to fall .

Effect on the market

A price floor set above the market equilibrium price has several side-effects.
Consumers find they must now pay a higher price for the same product. As a
result, they reduce their purchases or drop out of the market entirely.
Meanwhile,
suppliers find they are guaranteed a new, higher price than they were
charging before. As a result, they increase production.

Taken together, these effects mean there is now an excess supply (known as a
"surplus") of the product in the market to maintain the price floor over the
long term.
Cont..
 PRICE CEILING
If the price ceiling is above the market price, then there is no direct effect.
If the price ceiling is set below the market price, then a "shortage" is
created; the quantity demanded will exceed the quantity supplied.
A price ceiling occurs when the price is artificially held below the
equilibrium price and is not allowed to rise.
There are many examples of price ceilings. Most price ceilings involve the
government in some way. For example, in many cities, there are rent control.
Charging more than this maximum price would be guilty of fraud. Price
ceilings provide a gain for buyers and a loss for sellers.
Sellers would like to avoid the loss if they can. One way to do so is called a
black market.
 Cont…
Price ceilings, which prevent prices from exceeding a certain
maximum, cause shortages
Effect of price ceiling in market
The End.
 3. 4 Elasticity of demand and supply 
Introduction
The law of demand and supply state only the nature, do not bring out
the extend of the responsiveness of demand and supply to the change in
price,
In simple words, the law of demand and supply don’t give the measure of
change in quantity demanded of supplied in response to a certain
percentage change in price
For example, the law of demand does not tell us the percentage change in
quantity demanded due to a certain percentage change in price.
 However, Price Elasticity Of Demand measure the extent of relationship
or degree of responsiveness of demand to changes in its determinants.
 Cont..
In this topic we shall discuss the following
The concept of elasticity and different methods of measuring
elasticities of demand and supply and the uses of elasticity
concept
Price elasticity
Cross elasticity
Income elasticity
 3.4.1 Price elasticity of demand
THE ELASTICITY OF DEMAND
Is a measure of responsiveness of demand for a commodity to the change in any of its
determinant, viz., price of commodity, price of substitute and compliments,
consumers income and consumer expectations regarding prices.
Accordingly, there are several kinds of elasticities of demand-Price elasticity, cross
elasticity, income elasticity

PRICE ELASTICITY OF DEMAND

The price elasticity of demand is defined as the degree of responsiveness or
sensitiveness of demand for a commodity to the change in its price. 
Or
Price Elasticity of demand is the percentage change in quantity demanded of a
commodity as a result of a certain percentage change in its price.

Percentage change in quantity demanded of commodity X

Percentage change in price of commodity X
 Cont…
The measure of price elasticity ( ℓp) is called coefficient of price
elasticity
General formula for calculating coefficient of price elasticity is
given as
ℓp =Q1-Q2 / P1-P2=
Q1 P1 = - ∆Q / ∆P
Q1 P1
= - ∆Q * P1
∆P Q1
 Cont..
Where
Q1 = the original quantity demanded
P1 = original price
∆Q = change in quantity demanded (Q2-Q1)
∆P = Change in price (P2 – P1)
Example: To measure price elasticity numerically by using given formula given, suppose
price of commodity X decreases from Rs 10units to Rs 8 and quantity demanded of X
increases from 50 units to 60 units per time unit.
Thus, ∆P =Rs 10-Rs 8=2Rs
∆Q= 50-60 =-10.
By using substituting these values in elasticity formula

ℓp = -10 * 10 = 1.0
2 50
Thus, the elasticity coefficient (ℓp)= 1
 Cont..
Note that: A minus sign (-) is inserted in formula with view to making elasticity
coefficient a non-negative value
 The coefficient of price elasticity calculated without minus sign in the formula
will always be negative, because either ∆P or ∆Q will carry a negative sign
depending on whether price increases or decreases.
But negative sign of elasticity is rather misleading because elasticity can not be
negative –less than zero.
The minus sign is, therefore, inserted in the price-elasticity formula as a matter
of “linguistic convenience” to make a the coefficient of elasticity a non –negative
value.
Sometime its advised to ignore the negative sign of ∆P or ∆Q . The price
elasticity measure is, however, always reported with negative sign just to indicate
inverse relationship between price change and quantity demanded.
3.4.2 Point and arc elasticity of
demand
The elasticity measured on a finite point of a demand curve is called Point elasticity
and the elasticity measured between any finite points is called Arc elasticity.
 
The point elasticity of demand is defined as the proportionate change in quantity
demanded in response to a very small proportionate change in price-not
significantly different from zero

Is the measure of price of price elasticity at a finite point on a demand curve
The concept of point elasticity is useful where the change in price and the
consequent change in quantity demanded are very small. Besides it offers alternative
to the arc elasticity

The point elasticity may be symbolically expressed as

ℓp = - ∆Q * P
∆P Q
 Cont..

R P

O Q N Quantity
 Cont…
To illustrate the measurement of point elasticity on a linear
demand curve, lets suppose demand curve is given by MN
That we need to measure elasticity at point P. Let us now
substitute the values, it obvious from the figure that P=PQ and
Q= OQ. What we find now are the value for ΔQ and ΔP
 Cont..
The value of can be obtained by assuming a very small
decrease in the price. But it will be difficult to depict these
changes in figure as ∆P O and hence ∆Q O.
In fact, the derivative ∆Q gives the slope of the demand
curve MN. ∆P
The slope of a straight line demand curve MN, at point P
geometrically is given by QN/PQ 
 Cont..
According to geometrical properties of similar triangle, the ratio of any
two sides of a triangle is equal to the ratio of corresponding side of the other
triangles
Therefore, in ΔPQN and ΔMR
QN=RP
PN PM
Note that, PN and PM are two lower and upper segments of the demand
curve, MN. It may be said that the price elasticity at any point on a straight
line demand curve is given by
ℓp=Lower segment
Upper segment
 Cont..
b) Measuring Arc elasticity
Arc elasticity is a measure of the average of
responsiveness of the quantity demanded to a
substantial change in the price.
 Cont..
In other words, the measure of price of demand between two
finite points on a demand curve is known as arc elasticity.
For example the measuring elasticity between point J and K in
the figure below
Price

25 J

10
D

30 50 quantity
 Cont…
The movement from point J to K along the demand curve DD shows the fall in price
from tshs. 25 to tshs 10 so that change (Δ) in price = 25-10= 15. The consequences
increases in demand 30-50 = -20.
A formular for Arch elasticity is
ℓp =- ΔQ * (P1+P2)
ΔP (Q1+Q2)
ℓp = -20 * 10+25
15 30+50
=- 4 * 35
3 80
= - 140
240
pℓp = -(- 0.58)
ℓp = 0.58 inelastic
 Cont..
Interpretation: Elasticity coefficient is interpreted as
percentage change in demand due to one percentage change in
price
For example: Elasticity coefficient is 0.58. The elasticity
coefficient 0.58 will be interpreted as a 1 percentage decrease
in price of commodity x results in 0.58 percentage increase in
demand for it.
Price Elasticity Along the Demand Curve
Nature of demand curves and elasticity
Generally, elasticity of demand varies through out its length. It
varies from zero to infinite ∞.
Price ℓp = Undefined

ℓp >1

ℓp = 1

ℓp <1

ℓp = 0
 Cont…
ℓ> 1 elastic
ℓ <1 = inelastic
ℓ = 1 unitary elastic demand
ℓ = 0 = A perfectly in elastic demand through its length and is
straight vertical line.
ℓ = ∞ elastic demand curve along its length is infinity and it is
a straight horizontal line
Constant elasticity demand curve
The elasticity of most demand curve is not the same throughout. It varies from zero
(0) to close to infinity, i.e., 0<ℓp<∞.
In case of some demand curves, however, elasticity remains the same throughout
their length.

P p
ℓp=o P
ℓp=1
ℓp=∞

Q
Determinants of price elasticity of demand
Price elasticity of demand varies from commodity to
commodity. Some are highly elastic and others are highly in
elastic. The main determinants of the price elasticity of
demand are:-
1) Availability of substitutes
The closer the substitutes, the greater the elasticity of demand
for such commodities. e.g., therefore if the price one of these
goods increases, its demand decrease more than proportionate
increases in its price because consumer’s switch over to the
relatively cheaper substitutes.
 Cont..
 2) Nature of commodity
The nature of commodity also affects the price elasticity of its demand.
(Luxury, Normal and inferior goods)
 Normal goods are those which are demanded in increasing quantities as
consumers’ income rises.
In economic terminology, however a commodity is deemed to be inferior if
its demand decreases with the increase in consumers` income.
The demand for luxury goods such gold is more elastic than the kind of other
goods, because consumption of it is higher when price is high and vice versa.
The demand for comfort is generally more elastic than that of necessities.
Consumption of necessary goods e.g., sugar, salt is in elastic.
 Cont…
3) Proportion of income spent
Another factor that influences the elasticity of demand for a
commodity is the proportion of income which consumers spend
on a particular commodity. If proportion of income spent on a
commodity is very small, its demand will be less elastic and vice
versa. e.g., salt, matches, toothpaste, which claims a very small
proportion of consumer’s income. Demand for these goods is
generally inelastic because in the price of such goods doesn’t
substantially affect consumer’s consumption pattern and the total
purchasing power. Therefore people continue to purchase almost
the same quantity even when their price increases.
 Cont…
4) Time factor, Price- elasticity of demand also depend on the depends on
time consumers take to adjust a new price: The longer the time taken, the
greater the elasticity.
For, consumers are able to adjust their expenditure pattern to price changes
over a period of time. For instance, if price of TV sets is decreased, demand
will not immediately increase unless people possess excess purchasing
power
5) Range of alternative uses of commodity, the wider the range of
alternative uses of a product, the higher the elasticity of its demand.
Therefore, the demand for such a commodity generally increases more
than proportionate decrease in its price. For instance, milk can be taken as it
is, it may be converted in to curd, cheese, ghee and butter milk. The
demand for milk therefore is highly elastic
 Cont..
2. Cross-Elasticity of Demand
Here we will discuss elasticities of demand with respect to its other determinants
often used in economic analysis
Cross-Elasticity of demand is the measure of responsiveness of demand for a
commodity to the changes in the price of its substitutes and complimentary
goods.
eg. Cross- elasticity of demand for tea (T) is the percentage change in its quantity
demanded with respect to the change in the price of its substitute, coffee(C).

ℓtc = Proportionate change in demand for tea (Qt)

Proportionate change in price of coffee (Pc)

ℓtc = ΔQt * PC
ΔPC Qt
 Cont..
e.g., Suppose that price of coffee (Pc) increases from Tshs. 10/=
to Tsh.15/= per kg and as a result demand for tea increases from
20 tons to 30 tons per week, price of tea remaining constant.
Calculate the cross elasticity of demand for tea with respect to
price of coffee.
ℓtc = 30 - 20 * 10
15- 10 20
ℓtc = 10* 1
5 2
ℓtc = 1.0
 Cont…
Interpretation of coefficients.
If cross-elasticity between two goods is positive, the two
goods may be considered as substitutes for each other.
Also the greater the cross –elasticity the closer the substitute.
Similarly, If cross elasticity of demand for two related good is
negative, the two may be considered as complementary of
each other, the higher the negative cross –elasticity the higher
the degree of complementarily.
 Cont..
3. INCOME ELASTICITY OF DEMAND
A part from price of a product and its substitute, another important determinant of
demand for a product is consumer’s income
As noted earlier ,the relationship between demand for normal and luxury goods and
consumer ‘s income is of positive nature, unlike the negative price-demand relationship
The responsiveness of demand to the change in consumer’s income is known as Income
Elasticity Of Demand. Income elasticity of demand for a product, say X (i.e; ℓ y) is
defined as
ℓ y = DQx * Y
DY QX
 
Where QX = quantity of X demanded;
Y = disposable income;
ΔQx = change in Quantity demanded of X and
ΔY = change in income.
 
 Cont..
In simple words, the demand for normal goods and services
increases with increases in consumer’s income and vice versa.
Unlike price elasticity of demand(which is negative except in
case of Giffen goods), income-elasticity demand is positive
because of positive relationship between income and quantity
demand of product.
There is exception of this rule. Income elasticity of demand
for inferior good is negative, because of negative income effect.
The demand for inferior goods decrease with increase in
consumer income’s income and vice versa
 Cont..
Interpretation of income elasticity coefficient
The good whose income elasticity is positive for all levels of income are
termed as “normal goods”. The good for which income elasticity are
negative beyond a certain level of income are termed as “inferior goods”.
 THE USES OF ELASTICITY
1. Decision makers
The concept of elasticity of demand plays a crucial role in business decisions
regarding maneuvering of prices with a view to making larger profits. E.g When
cost of production is increasing, the firm would like to pass incremental cost to the
consumer by raising the price.
2. Formulating of government policies
The concepts elasticity can be used also in formulating government policies
particularly in its taxation policy meant to raise revenue or to control prices, in
granting subsidies, in determining prices for public utilities, in determining export
& import duties etc.
3. Economic analyst’s
The concept of elasticity is useful in economic analysis, at least for specifying the
relationship between the dependent & independent variables.
 Cont..
Summary of pattern: Price elasticity and marginal
Revenue/total revenue
Elasticity Nature of Change in Change in TR
coefficient Demand Price

ℓ> 1 Elastic Increase Decrease

Decrease Increase
ℓ< 1 In elastic Increase Increase
Decrease Decrease
ℓ=1 Unitary Increase No change in
TR
Decrease

ℓ=0 Perfect Increase Increase

inelastic
Decrease Decrease
ℓ=∞ Infinitely
 Cont..
Interpretation
When ℓ= 0 the demand is said to be perfect in elastic. It implies that
no changes in quantity demanded when price is changed. Therefore a
rise in price will increase the total revenue and vice versa.
ℓ <1 an inelastic demand, quantity demanded increases less than the
proportionate decreases in price and hence the total revenue falls
when price falls. Total revenue increases when prices increases
because quantity demanded decreases less than the proportionately.
ℓ = 1 for a unitary elasticity, quantity demanded increases (or
decreases) in proportion of decrease (or increase) in the production.
Therefore total revenue remains unaffected.
 Price Elasticity Of Supply
The price elasticity of supply is the measure of responsiveness of the quantity
supplied of a good to the changes in its market price.
The coefficient of price elasticity of supply (ℓp ) is the measure of percentage
change in quantity supplied of a good due to a given percentage change in its price.

ℓp= % change in quantity supplied (Qs)

% change in price (p)
ℓp = ΔQ * P
ΔP Q
Note: The formula for measuring the Price elasticity of supply is the same as for the
price elasticity of demand, without a minus sign.
 Cont…
Example: Suppose that the supply curve for a commodity is given as
SS’ and we want to measure the price elasticity of the supply between
point j and p for the rise in price.

SS’
Price

7.5 P

5 J
SS’
60 100 Qs
 Cont…
ℓp = ΔQ * P
ΔP Q

ΔQ=60-100= -40
ΔP= 5-7= -2.5
P=5
Q=60
ℓp = 1.33
 Cont..
The price elasticity of a supply curve, like demand curve, may vary
between zero and infinity depending on the levels of the supply.
(1) ℓ > 1 elastic
ℓ <1 = in elastic
ℓ = 1 unitary elastic supply
ℓ = 0 = A perfectly inelastic supply through its length and is
straight vertical line.
ℓ = ∞ elastic supply curve along its length is infinity and it is a
straight horizontal line
Determinant of Price Elasticity of supply
The price elasticity of supply depend on the following factors
i) Time period is the most important factor in determining the
elasticity of the supply curve. In a short period, the supply
of most goods is fixed and inelastic. In long run, the supply
of most of products has maximum elasticity because of
increase in and expansion of firms, new investments,
improvement of technology and greater availability of inputs.
ii) Law of diminishing return, here if the law of diminishing
returns comes in force at an early level of production, cost
increases rapidly. As a result, supply tends to become less and
less elastic
End of topic
THEORY OF THE FIRM
A firm is the basic unit or organisation for productive activities. It
transforms inputs into outputs subject to the limitations of its technical
knowledge and guided by its objective.
 A producer uses raw materials, capital and labour and turns them
into outputs for sale in the output/product market.
 A producer is a consumer in the input/factor market.
The desire to maximise profits is assumed to motivate all decisions
taken within a firm and such decisions are assumed to be unaffected
by the peculiarities of the person taking the decisions and by the
organisational structure in which they work.
There are two key assumptions in this theory:
i) All firms are profit maximizers
ii) Each firm can be regarded as single, consistent decision taking unit.
Cont..
Production of goods is essential to fulfill demand of consumers.
Output of goods depends on price of factors of production.
The relation between price of factors of production and amount of
output are studied under the theory of firm
Circular flow of income shows transaction of household and firm.
Firm- independent business unit/single production unit/single business
unit
Plant-is the processing machine used to produce goods and services in
factory(building +machine )
Industry- a group of firm produce/sell similar products
 Cont..
Market Household Firm
Market Supply factors of Use factors of production
production to the firm and to produce goods and
use their income to buy services
goods and services
Factor market Supply services i.e. labour Pay profit to household and
to factor of production and pay them for the use of
receive income factors of production
Goods market Spend gods and services by Sell goods and services of
firm household
THEORY OF PRODUCTION
We were concerned with the demand side of the market. In this part we
move to the supply side of the market. Supply is created through
production
Production is an activity of transforming inputs in to outputs. The rate at
which a given quantity of inputs is transformed into output is governed by
the laws of production
The laws of production, are also called the law of return or the theory of
production
Theory of production states the quantitative relationship between inputs
and outputs.
It tells how output is more likely to change in response to change in
quantity of inputs, given technology.
 Cont…
Inputs, are also called factors of production, include
everything that goes into the process of production, e.g., land,
labour, capital, time, space, materials, water, power, fuel and
managerial skills.
However, economist clarify factors of production as labour,
land, capital and entrepreneurship. None of these inputs is
available free of cost. All inputs have price.
This means that production of commodity involves cost of
production. Cost of production is the main determinant of
supply of a commodity
 Cont..
The rate at which cost of production change with the change
in output depends on cost-output relationship.
This relationship is based on the law of returns to inputs.
The relationship between production and cost of production is
studied under the theory of cost. To be discussed later…..
 Production with one variable input
4.0 Meaning of production
The term Production means a process by which inputs or factors
of production (land, labour, capital etc) are converted or
transformed into an output.
In other words, production means transforming inputs (Labour,
machines, raw materials) into an output. This kind of production is
called manufacturing.
In the process of production, inputs may be intangible (service)
and output may be intangible too. e.g. in the production of legal,
medical, social and consultancy services both input and output are
intangible.
 Input -Output relations
4.1 Factors of production
Factor of production refers to inputs or resources of society
used in the process of production. Classifications of factors of
production are:- Land, labour, Capital and Entrepreneurship.
Land is taken to refer to all the natural resources which
people have the power of disposal and which may be used to
yield an income. Land includes farming land, building land,
forests, rivers, lakes and mineral deposits. The total supply of
land in world is limited although the supply of land for some
particular use is not fixed.
 Cont..
Labour refers to the exercise of human mental and
physical effort in the production of goods and service
Capital is a man-made input. It can be classified as
working capital or circulating capital referring to
stocks of raw materials, partly finished goods and
finished goods held by producers. Fixed capital
which consists of
Entrepreneurship refers to the organization of all the
factors of production with a view to profit. 
 4.2 Some concepts
An input is a good or service that is used into the process of
production.
In other words of Baumol, “input is simply anything which
the firm buys for use in its production or other process.
An output is any commodity which the firm produces or
processes for sale”. An output is any good or service that
comes out of production process. An output may be tangible or
intangible.
 Cont…
4.2.1 Fixed and variable inputs.
For the sake of analytical convenience, inputs are further
classified into Fixed and variable inputs.
A Fixed input is one whose quantity remains constant for a
certain level of output. e.g., Plant, building, machinery etc, the
supply of fixed inputs remains inelastic, in short-run
A variable input is defined as one whose quantity changes
with change in output. The supply of such inputs (as labour and
raw materials) is elastic in short-run.
 Cont..
4.2.2 Short–run and Long-run
Short–run is refers to a period of time in which the
supply of certain inputs (e.g., plant, building and machine
etc) is fixed or inelastic. Therefore production of a
commodity can be increased by increasing the use of
variable inputs (labour and raw material).
Long-run refers to a period of time in which the supply of
all the inputs is elastic. Production of a commodity can be
increased by employing more of both variables and fixed
inputs
 4.2.3 Production Function
A production function is the technological relationship between output of a good and
the inputs required to make that good. It specifies the maximum quantity of commodity
that can be produced per unit of time with given quantities inputs and technology.
A production function may take the form of;
i) A schedule or table,
ii) A graphed line or curve,
iii) An algebraic equation or of mathematical model.
A general empirical form of production can be expressed as
Q=ƒ (L, K,LB,M,T,t,e)
where
Q= Quantity, L= labour, K= capital, LB= Land/building, M = materials, T= technology,
t= time and e=managerial efficiency.
 Cont..
All these variables enter the actual production function of a firm.
The economists have however reduce the number of variables used in a
production function to only two, viz., capital and labour, for sake of
convenience and simplicity in the analysis of input-output relations. i.e.,
 (i) Q=ƒ (L) in short-run ¯K is fixed and
(ii)Q=ƒ (L, K) in long-run
By definition, supply of capital is (fixed) inelastic in short run and
elastic (variable) in long run
Assumptions of Production function
The production functions are based on a certain assumptions:
i. Perfect divisibility of both inputs and output;
ii. Limited substitution of one factor for another;
iii. Constant/Given technology; and
iv. Inelastic supply of fixed factors in the short-run.

When a production function is graphed, it takes a graphical form of production

function. The resulting curve is called Total product (TP) curve. Horizontal axis
shows number of workers (L) and Vertical axis shows the quantity of output (Q).
Total Product is the total amount of commodity produced during a given period
a given period time in a given number of factors of production
 Cont…
The total product (or total physical product) of a variable
factor of production identifies what outputs are possible using
various levels of the variable input.
It can be estimated in two ways;
i. A summation of Marginal Product of various units of
factors i.e. T.P= ∑M.P
ii. As average product times number of units of factors
employed i.e. T.P=A.P * N
 Cont…
Tota
l
Prod
uct
TPL

0
Labour (on one acre of land)
 Cont..
4.2.4 Marginal Product( Incremental product)
The concept of marginal product pays an important role in explaining the law of
returns. Therefore we will define the marginal product of variable input, labour and
derive margin product (MP) curve.
The Margin products (MPL) may be defined as the change in output (Q) resulting
from a very small change (∂L) in labour employed, other factors held constant.
In fact, the MPL is a partial derivative of the production function with respective to
labour.
 
i.e., Marginal product = Change in total output (output)
Change in quantity of labour employed (input)

  Thus MPL= ∂Q
∂L
or ∆TQ = ∆TP
∆L ∆L

 Marginal Productivity of labour (MPL) it find trend in the contribution of the

marginal labour
 Cont..
M.P is the change in T.P resulting from use of more unit of
variable factor.
It measure the rate at which total product is changing as one
factor is changing.
Geometrically, MPL is given by the slope of the curve, TPL=
Q= ƒ (L)
Given the definition of MPL, the MPL, curve may be derived
from the TPL, as shown below
 Cont..
Total
Produ
ct

TPL

0
MPL Labour (on one acre of land)
 Cont..
4.2. 5 Average Product
Another important concept used in discussion of production theory is average product. The
average product of labour (APL) may be defined as a ratio of Output (Q) per labour (L)
Average product = Total output
No. of units of the variable factors
( e.g. labour)
APL = TQ
L
Average Productivity of labour (APL) it find the average contribution of labour
Is the T.P divide by number of unit of factor, Thus average means per unit output
i.e. A.P= T.P/L
 Cont…
A hypothetical production function for small scale maize farmer
can be shown in the following table
Land No. of Total Average Marginal
workers (N) Product Product Product
(TP) (AP) tons (MP)
1 0 0 0 -
1 1 29 29 29
1 2 72 36 43
1 3 133 44 51
1 4 186 46.5 53
1 5 233 47 47
1 6 274 45.7 41
1 7 297 42.4 23
1 8 298 37.3 1
 Cont..
Total
Produ
I II III
ct TPL

Average Product Labour

Marginal product

APL

MPL Labour
 Cont..
These curves show the relationship between the Total product,
average product and marginal product.
The APL curve rises at first reaches a maximum, then falls, but it also
remains positives as long as the TPL is positive. The MPL curve also rises
at first, reaches a maximum (before the AP L reaches its maximum) and
then declines.

The MPL becomes zero when the TPL is maximum and negative when
the TPL begins to decline. The falling portion of MP L curve illustrates the
law of diminishing returns.
 
RELATION BETWEEN T.P and M.P

i. When T.P increases at increasing rate, M.P also increase

ii. When T.P increases at diminishing rate, M.P decline
iii. When T.P reaches its maximum, M.P becomes zero
iv. When T.P began to decline, M.P becomes negative
RELATION BETWEEN A.P and M.P
i. When M.P is greater than A.P, The A.P rises
ii. When M.P=A.P, A.P reaches maximum
iii. When M.P< A.P, A.P start decline
iv. Both M.P and A.P increases in the beginning, after reaching
maximum start decline but maximum point of M.P comes
first than A.P
PRODUCTION WITH ONE VARIABLE INPUTS

THE SHORT-RUN LAWS OF PRODUCTION(LAW OF VARIABLE

PROPORTION)
The traditional theory of production analyses the marginal input-output
relationship under
i) Short run and
ii) Long run conditions
In short run , input-output relations are studied with one variables
input (labour), the other input (capital) held constant
The law of production under these conditions are called “The law of
variable proportion”, the “law of return to variable input” and the
“Law of Diminishing Marginal Return”
 Cont..
Law of Variable Proportion in short run, tells us what
happens when additional units of one variable factor of
production are combined with fixed stock of some factors of
production
 Cont..
Long run production function (Return to Scale)
In long run, Input-output relations are studied assuming all
inputs to be variable.
The long run input output relations studied under “Laws of
return to scale”(Long run law of production)
Law of return to scale, tells how output varies with change
in scale of production
Factors affecting Production function
Production function depend on;
1. Quantity of resources used-S.R
2. State of technical knowledge-L.R
3. Size of the firm-L.R
4. Nature of firm Organization-S.R
5. Relative price of factors of production and manner in which
the factors of production are combined i.e. labour intensive
and capital intensive
 Cont..
4.3 LAW OF VARIABLE PROPRTION(The law of diminishing Marginal
Returns)
According to Prof. Watson, the law of variable proportions also known as
Law of diminishing return which states that “When total output of production
of commodity increases by adding a unit of variable inputs while quantity of
other inputs held constant, then increase in T.P becomes after some points
smaller and smaller”
The law of diminishing Returns states that “ceteris paribus” as additional
units of variable factors are added to a given quantity of fixed factor, total
output will initially increase at an increasing rate, but beyond a certain
level of output it will increase at a declining rate, and eventually decline.”
The ultimate law is, the marginal increase in total output eventually decreases
when additional units of variables factors are applied to a given of fixed factors.
 Cont..
In other words of Hirshleifer, “if one factor (or group of factors)
is increased while another factor (or group of factors) is held fixed,
output or Total Product (Q) will at first tend to rise. But eventually
at least, a point will be reached where the rate of increase, the
marginal product [MPl=ΔQ/ΔL] associated with increments of the
variable factor, begins to fall: this is the point of “diminishing
marginal returns”
Baumol states the law of diminishing returns in similar terms:” As
more and more inputs i, is employed, all other input quantities
being held constant, eventually a point will be reached where
additional quantities of input I will yield diminishing marginal
contribution to the total output”
 Cont..
Law of variable proportion or (Law of return to a variable
factor) state that “With the increase in variables factors keeping other
factors constant the M.P rising to some extent and then becomes
smaller and smaller

WHY IS IT LAW OF VARIABLE PROPORTION

1. The factor proportion/ratio varies as one inputs varies and other are
held constant
2. The return also varies with the change in factor ratio i.e. when one
factor is varied keeping other factor constant, the input-output also
undergo changes
4.3.1 Key Assumptions of the Law of
Diminishing Returns
The law of diminishing return is based on the following Assumptions:
The state of technology is unchanged/given and organization i.e. other
wise the marginal and average curve will rise instead of diminishing
Successive units of variable factors are assumed to be equally efficient
i.e. labour is homogeneous, mean all units of variable inputs are alike
Production takes place in short run where at least one factor of
production is fixed, b/se in long run all inputs can be variable
There is only one input of and other are held constant variable factor
of production under consideration
Input price is given
Law operates not only on land but to any factor whose supply is fixed
 Cont…
To illustrate the law of diminishing returns with the help of our coal
mining example, lets assume
i. That coal- mining firm has a set of mining machinery as its capital (K),
fixed in short run and
ii. That it can employ more mine-workers to increase its coal production.
Thus , the short run production function for the firm will take the following
form.
Qc= f(L,¯K)
Where Qc= Quantity of coal produced
L= Labour and ¯K= Capital (held constant)
 Cont…

Let’ s assume that labour-output relationship in coal production is given by cubic
production function of the following form.
Qc=-L3 + β L2 +αL

When estimated with actual data, it takes the following form.
Qc= -L3 + 15L2 +10L

Given the production function, we may substitute different numerical values for L in
the function and work out a series of Qc. i.e. the quantity of coal that can be produced
with different number of workers, given the mining machinery and equipments.

For example, if L=5, then by substitution,

Qc= -L3 + 15L2 +10L
 = -53 + 15(5)2 +10(5)
=300

A tabular array of output levels associated with different number of workers from 1 to
12 in our hypothetical coal –production example

What we need now is to work out marginal productivity of labour (MPl) to find trend
in the contribution of the marginal labour and average productivity labour (APL) to
find the average contribution of labor
 Table: Total, Marginal and Average Product
No. of workers Total Product Marginal Average Stage of return
(L) (TPl) tonnes Product Product (Apl)
*(MPl)
(1) (2) (3) (4) (5)
1 24 24 24 I
2 72 48 36 Increasing
3 138 66 46 return
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66 II
8 528 66 66 Diminishing
9 576 48 64 return
10 600 24 60
11 594 -6 54 III
12 552 -42 46 -ve return
 Cont..
*MPl=TPn- TPn-1
MARGINAL PRODUCTIVITY OF LABOUR (MPl)
 MPL can be obtained by differentiating the production function with respect to labour

MPL= ΔQc = -3L2 + 30L2 +10

ΔL
By substituting numerical numerical value for labour (L), MPl can be obtained at
different levels of labour employed. However , this method can be used only where
labour is perfectly divisible and ΔL O. Since , in our example , each unit of L=1,
calculus method can not be used. Alternatively, where labour can be increased at least
by one unit. MPl can be obtained as
 MPLn=TPL-TPL-1
 Cont..
AVERAGE PRODUCTIVITY OF LABOUR (APL)
APL can be obtained by dividing production function by L.
 APL=Qc = -L3 + 15L2 +10L
L L
= -L2 + 15L +10
Now, APL can be obtained by substituting numerical values
for L
 4.3.2 The Three Stages of Production
The economists identify three stages of production on the basis of
the marginal and average returns to the variable inputs, i.e. labour
(L) in our case. The features of the three stages of production may
be described as follows.
STAGE I: Marginal Product input (labour) is higher than its
average i.e., MPL > APL
STAGE II: Marginal product of the variables inputs (labour) falls
below its average product, i.e., in stage II MPL<APL, but both
remaining greater than zero.
STAGE III: Marginal product of the variable inputs (labour) turn
negative, while average product remains greater than zero.
 Cont…
The stages of production implied by the law of diminishing
returns can be illustrated in the diagram that follows:
 Cont…
II III
I

TPL

TPL

APL

MPL

APL

Labour
MPL
 Cont..
Stage I
Stage I starts from origin, ends where MPL equals to APL when APL is at maximum.
In stage I there are increasing returns to the variable factor. In this stage, TPL is
increasing at increasing rate whole MPL and APL are also rising with marginal
product higher than the APL at any point. This is an indication of the increasing
efficiency of the proportion in which the factors are combined since fixed factors are still
underutilised and there is scope for greater specialization.
 
 Stage II
Stage 2 represents decreasing returns to the variable factor, Total product is
increasing at decreasing rate. MPL and APL are positive but are falling during this stage,
with APL higher than the MPL. Stage II goes from where the APL is at maximum level to
the point where the MPL is zero. Stage II is the only stage of production for the rational
producer.  This shows decline in efficiency of labour.
 Cont…
Stage III
This stage represents the stage of negative returns to the
variable factor. At this stage marginal product is negative and
as result Total product is declining. This represents a stage of
extreme inefficiency of labour when factor of production are
probably getting into each other’s way. The producer will not
operate in stage III, even with free labour. 
Factors Behind the Laws of Return
(CAUSES OF DIMINISHING RETURN TO OPERATE)
i. Indivisibility of fixed factors (capital)
The quantity of fixed inputs per unit of variable inputs, there fore it must decrease
amount of total output, as it result in under utilisation of capital if labour is less than
its optimum number.
ii. Scarcity of factor, refer short in supply therefore if productive factors had not been
limited the law will cease to operate
i.e. Fall in quantity of fixed factor inputs per unit of variable factor inputs add decreasing
return to the total product. In other words fixed factors becomes too small
iii. Lack of perfect substitution between factors/ Imperfect substitution between
factors of production. Here since factors of production cant be substituted fully, e.g.
labour, capital cant be substituted in sphere of land
iv. Use beyond optimum capacity: After achieving optimum combination of variable
and fixed factors, efficiency start declining when more units of variable factors are
employed and MP starts declining
v. Due to diseconomies beyond a certain stage, management and coordination becomes
difficult.
Application of the law of diminishing
return
The law of diminishing return is an empirical law, often
observed in various production activities. This laws, however
may not apply universally to all kinds of productive activities
since the law is not as true as the law of gravitation.
In some productive activities, it may operate at early stage of
production; in some it operate in agricultural production.
The reason is, in agriculture, natural factors play a
predominant role where as man-made factors play major role in
industrial production.
Despite the limitation of the law, if increase in unit of an input
are applied to the fixed factors, the marginal return to the
variable inputs decrease eventually
Limitation of the law of Diminishing
Return
i. Improved methods of cultivation i.e. uses of fertilizer, crop
rotation
ii. Virgin/immature soil, in new soil the law of diminishing
return doesn’t apply in the begin
iii. Insufficient capital, with sufficient capital at early stage is
exception of the law of diminishing return
Note: Samuelson regarded this law of diminishing return
natural law because its applicable in the field of production
that is why its called Universe of law of production.
 THE LEAST COST FACTOR COMBINATION

The law of diminishing returns shows the tendency of output

per unit of the variable factor when the proportions between the
factors are varied.
However, in order to determine the most profitable way of
combining factors of production, one has to consider their
prices as well as their productivity. Physical productivity deals
with technical efficiency. Entrepreneurs are more concerned
with economic efficiency.
 4.4 Production with two variable inputs
We discussed theory of production with one variable factor (labour) i.e. the
technological relationship between inputs and output assuming labour to be the only
variable input and capital remaining constant.
This is the short run phenomenon
In a long run phenomenon we discuss theory of product with two variable inputs
(labour and capital)
In the long run, supply of both the inputs (labour and capital) is supposed to be elastic.
There fore firm can increase the use of both inputs to increase that level of output
A firm’s long run production function is then expressed as Q= f(L,K). With
simultaneous increase in both the inputs (labour and capital), a firm’s scale of production
increases.
The input-output relationship under increasing scale of production is also known as
laws of return to scale
 Cont..
The graphical technique (showing TP,AP and MP curve) used to illustrate the law
of diminishing returns cannot be used conveniently to illustrate input-output
relationships with two variable inputs
The long-run technological relationship between input and output is general
expressed in Isoquant curve. This is based on the assumption that two variable
inputs are combined to produce the same level of output.

4.4.1 The concept of an Iso quant

The term “Isoquant” has been derived from a Greek word “ iso” meaning equal
and a Latin word “quantus” meaning quantity
The ‘Isoquant curve’ is therefore also known as Equal Product Curve and
Production Indifference curve.
 Cont..
An isoquanty curve is analogous to consumer indifference
curve with two differences:
i. While an indifference curve represents different
combination of two goods yielding the same level of
satisfaction, an isoquant curve represent different
combinations of two producer (labour and capital)
producing same quantity of commodity
ii. While an indifference curve represents immeasurable
“utility” i.e. level of satisfaction, an isoquanty represents a
measurable quantity
 Cont…
An Isoquant curve is a locus of points representing the
various (different) combinations of two inputs- capital and
labour – yielding the same output.
The fact that different inputs combinations can produce the
same output is based on the assumption that capital and labour
can be substituted for one another but at a diminishing rate.
Assumptions of Isoquant curve
To draw an Isoquant curve, the following assumptions are made:
i. A producer uses only two inputs, labour (L) and Capital (K) to
produce a commodity say X;
ii. The two inputs (L and K) can be substituted for one another at
a diminishing rate up to certain limit
iii. That the technology of production is given/constant for the
period under reference; and
iv. That the production function of the firm is continuous, i.e.,
labour and capital are perfectly divisible and substitutable in
any small quantity.
 Cont….
Given the assumptions, the production function takes the
following forms:
Q=ƒ (L, K)
The production function being continuous, it cannot be
conveniently presented in a tabular form, however it can be
conveniently presented graphically  
 Cont…

Capital
(K)

I=300

I=200

I=100

0
Labour (L)
 Cont..
It is important to note that movement along an Isoquant
means substitution of one factor for another.
e.g., movement from point A to B i.e. -ΔK/ ΔL

Capital

A
K2

c B
K1

L1 L2 Labour
 Cont..
Means that L1 L2 (= CB) units of labour is substitute for K1 K2
(=CA) Unit or capital can produce as much as L1 L2 unit’s of
labour. The rate at which one factor can substitute another is called
Marginal Rate of Technical Substitution.

4.4.2 Marginal Rate of Technical Substitution

The slope (Marginal Rate of Technical Substitution) of an
Isoquant measures the rate at which capital can substitute for
labour, keeping output constant. Marginal rate of technical
substitution (MRTS) of capital for labour is refers to the amount
of labour that a firm can give up by increasing the amount of capital
by 1 unit and still remaining on the same Isoquant. Marginal Rate
of Technical Substitution capital for labour is also equals to MP k /
MPL.
 Cont…
Since the slope of an Isoquant moving down the Isoquant is given by
∆K/ ∆L =∂ K/∂ L
MRTS = ∆K/∆L
MRTS = Slope of the Isoquant
 
The condition that the total output should remain constant; this Implies that
marginal product of capital (i.e., MPk) must be equal marginal product of Labour (i.e.,
MPL).
That is
(- ∆K x MPk) = (∆L x MPL)
By rearranging this - ∆K/ ∆L = MPL/MPk
Since - ∆K = MRTS
∆L
Therefore MPL/MPk = MRTS
 Thus, MRTS of L for K is the ratio of the marginal product labour (MP L) to the marginal
product of capital (MPk).
 Cont…
A table below presents 5 alternative combinations of capital
(K) and Labour (L) that can be used to produce a given
quantity say 10 units of a commodity.
Alternative methods of producing 10 units of a commodity

Capital Labour ΔK ΔL MRTS=ΔK/ΔL

10 2 - - -
8 4 -2 2 -1.0
5 10 -3 6 -0.5
1 20 -4 10 -0.4
 Cont..
As we move down the table, the MRTS declines. This is an
important factor in determining the shape of the Isoquant.
The downward movement on an Isoquant indicates
substitution of capital for labour. The amount of capital
decreases while the number of workers (labour) increases, so
that output remains constant. The units of labour which can
substitute one unit of capital go on increasing.
As a result, the MRTS (- ∆K/ ∆L) decreases. This is because
both factors are subjected to the law of diminishing
marginal return.
4.4.3 Properties of Isoquant Curves
Like indifference curve, Isoquants have the following properties. They
are explained below in terms of inputs and output, under condition that
the two inputs are not perfect substitute
a) Isoquants have a negative slope
An Isoquant has a negative slope in the economic region or in the
relevant range. Economic region is the region on the Isoquant plane in
which substitution between inputs is technically possible. It is also
known as profit maximizing region. The negative slope of the Isoquant
implies that If one of the inputs is reduced, the other inputs has to be
increased, that output remains unchanged/unaffected.

b) Isoquants are convex to the origin

Convexity of Isoquant implies not only the substitution of one factor
for another but also diminishing marginal rate of technical substitution
(MRTS) between iputs in the economic region.
 Cont..
This rate is indicated by the slope of the isoquant. The MRTS decreases for two
reasons;
i. No factor is a perfect substitute for another
ii. Inputs are subject to diminishing marginal return
Therefore, more and more units of an inputs are needed to replace each
successive units of other inputs

c) Isoquants can not intersects or be tangent to each other

The intersection or tangency of two Isoquants implies that a certain quantity of a
commodity can be produced with a smaller inputs combination as well as with a
larger input combination. This is not consistent with the theory of production so
long as marginal productivity of an input is greater than zero.
 Cont..
Capital
M
N

2000

1000

L1 L2 Labour
 Cont..
The upper the isoquants represent a higher level of output, Between
any two isoquants, the upper one represents a higher level of output than
the lower one.
The reason is that any point on an upper isoquant implies a larger input
combination, which in general, produces a large output. Therefore, upper
isoquants indicates a higher level of output.

4.4.3 Isoquant map and Economic region.

An Isoquant map is a set of Isoquants presented on a two dimensional
plane as shown by Isoquants Q1, Q2, Q3 and Q4 in the figure below.
 
 Cont..
Upper
ridge
line
Lower
d ridge line
Capital c h

b Q4
g Q3

f Q2
a
e
Q1

Labour
 Cont…
Each Isoquant shows various combinations of two inputs that can be used to
produce a given level of output. An upper Isoquant is formed by a greater
quantity of one or both of the inputs than that indicated by lower Isoquants. Q 1
> Q2 > Q3 > Q4. This implies that the higher Isoquant, the higher output level
than the lower. It is noteworthy that the whole Isoquant map or production
plane is not technically efficient, nor is every point on Isoquants technically
efficient.
Due to convexity of Isoquant, the MRTS decreases along the Isoquant. The
limits to which MRTS can decrease is zero. The zero MRTS implies that there
is a limit to which one input can be substitute another. It determines also the
minimum quantity of an input which must be used to produce a given output.
Beyond this point, an additional employment of one input will necessitate
employing additional units or the other input.
 Cont…
The ridge lines are locus of points on the Isoquants where the marginal
products of the inputs are equal to zero.
The upper ridge line implies that Marginal product of Capital is zero
along the line, od;
The lower ridge line implies that Marginal product of labour is zero
along the line, oh.
The area between the two ridge lines, od and oh is called Economic
Region or technical efficient region of production. Any production
i.e., capital-labour combination, within the economic region is
technically efficient to produce a given output. And any production
technique outside this region is technically inefficient since it requires
more of both inputs to produce the same quantity.
4.5 LAWS OF RETURNS TO SCALE
A long run phenomenon, supply of both labour and capital is supposed to be
elastic
In long run, the laws of returns to scale explain how a simultaneous and
proportionate increase in both labour and capital affects the total output at
various levels of input combination. 
The concept of returns to scale refers to changes in output as all the factors
are changed by the same proportion. When a firm increases all its inputs
proportionately, technically there are three possibilities;-
Total outputs may:-
increases proportionately;
More than proportionate;
Or less than proportionately.
Thus this kinds of input-output relationship gives Three Laws of Return to
Scale (i)Constant returns to scale, (ii)Increasing returns to scale and (iii)
Diminishing /Decreasing returns to scale.
 (I)Increasing Returns to Scale (IRS)
i.e. When production increases more than proportionate increase in variable factors.
If a proportionate change in both the inputs K and L leads to more than proportionate
change in output, it exhibits increasing returns to scale. e.g. if quantities of both the inputs K
and L, are doubled and the output is more than doubled, the returns to scale is said to be
increasing.
Here Marginal product increase with increase quantity of variable factors
The Causes for operation of Law of IRS
1) Technical and managerial indivisibility:-
Capital equipments and managerial skills used in production process can not be divided in
smaller size to suit a smaller scale production. Therefore, when scale of production is
increased by increasing all inputs, the productivity of indivisible factors increases
exponentially.

2) Higher degree of specialization

Another factor causing increasing returns to scale is higher degree of specialization of both
labour and machinery, which becomes possible with increase in scale of production. The use
of specialized labour and machinery increases productivity per unit of inputs. Their
cumulative effects contribute to the increasing returns to scale.
 Cont…
3)Dimensional relations, when labour and capital are doubles, the output is more than
doubled over some level of output i.e. optimum combination of various factors of
production.

Why Law of Increasing Return to scale

i) Economies of Scale (market economies)
 Advertising space(magazine and new papers) and Radio, TV and number of sales
man don’t have to rise proportionately with the sales. Hence the selling cost per
unit of output fall with scale.
ii) Labour economies i.e. economies of division of labour and specialization are
more and more in large scale i.e. labour acquire great skills by devoting his
attention to particular job. Thus quality of spend worker improve and increase in
specialization and increase in return to scale.
iii) Managerial economies , large firm make possible the division of managerial tasks
thus increase the efficiency of management including high degree mechanisation.
 Cont..
iv) Technical efficiency (principle of indivisibility)
By employ technique of production .i.e. size of capital goods
increased, its total output capacity increase far more rapidly
than cost of making it
v) Economies related to transport and storage cost
By using his own transport facilities per unit transport cost will
fall similarly storage cost.
 II) Law of Constant Returns to Scale
(CRS)
i.e. When production increases in the same proportion as increased in
variable factor. i.e. With increase in variable factors M.P remain
constant.
When a proportional changes in output equals the proportional change
in inputs, it exhibits constant returns to scale. i.e., If quantities of both
the inputs K and L are doubled and output is also doubled. The constant
returns to scale are said to occur in the field where factor of
production are perfectly divisible.
Causes
The constant returns to scale are attributable to the limits of economies
of scale. With the expansion in the scale of production, economies arise
from such factors as indivisibility of certain factors, greater possibility
of specialization of capital and labour, use of labour saving technique of
production etc. But there is a limit to the economies of scale.
 III)Diminishing Returns to Scale
i.e. When the increase in output is less than proportionate to a
given increase in quantity of all factor inputs i.e. doubling input
cause less than doubling of output.

Labour Capital Output (bags)

(No. of people) (No. of people)
6 2 300
12 4 500
 Cont..
This arises where all inputs are increased in a given proportion
and output is increases less than proportionately. For example
if both labour and capital are both increased by 20 percent,
output rises by less than 20 percent. See numerical illustration
above.
 Causes of Diminishing Return to Scale
i. Decreasing returns to scale may arise because as the scale of
operations increases, communication difficulties may arise
which may complicate the effective running of the business
result into diseconomies of scale.
ii. Also managerial efficiency decrease resulted from expansion
of the firm’s operation. 
iii. Limitedness or exhaustibility of natural resources. e.g.,
doubling of coal mining may not double the coal output, or
doubling of fish processing industry may not necessary double
the output of fish output 
iv. Sometimes weather condition may lead to decreasing return to
scale e.g., flood, drought may cause decreasing returns to scales.
 
Comparison of Law of Variable Proportion and Law of Return to
Scale
There ‘s difference between return to variable factor and return to
scale as follows;
(1) Return to variable factor
With the increase in the unit of variable factors keeping other
factor constant, the increase, the increase in total production
becomes smaller and smaller. i.e. M.P first increases, become
constant and finally decline and becomes negative.
Hence, the laws has three stages
a) Increasing marginal return
b) Diminishing marginal return
c) Negative return
 Operate in short run, where supply of capital is Inelastic
 Only one factor input is varied
 Cont..
(2) Return to scale, refers to change in output as all factor input change in
long run
Thus , increasing in output be more than, equal to or less than
proportional to the increase in factor.
So return to scale has three
a) Increasing return to scale
b)Constant return to scale
c) Diminishing return to scale
It operate in long run, supply of all input is Elastic
All factor inputs are varied
 Cont…
Review Questions
1. What is factor of production?
2. Brief discuss the factors which lead to increasing and
decreasing returns to scale in the production process
3. Discuss the difference between the laws of diminishing
marginal returns and the laws of returns to scale.
4. A typical production function has three stages” Explain and
illustrate the relationship between the production function
and the shape of Total Cost curve.
 OPTIMUM COMBINATION OF INPUTS
 We have discussed the laws of return to scale assuming (implicitly) that firm can
expand the scale of production to any level, they have no resource constraint.
In reality however, firms have limited resources and are supposed to maximize their
profit from their given resources.
A profit maximizing firm has to minimise its cost for a given output or to maximise
the output from given total cost
Given the technology, a given output can be produced with different input
combinations. But all inputs combinations do not conform the least cost criterion
In our analysis it does not provide any rule or criterion for cost minimisation.
We will now show how a firm finds the Least cost combination of inputs for a given
output and how it can maximize the output given the costs
The problem now, is how to find the input-combination that gives the minimum cost
of production
 Cont…
The least-cost combination of inputs can be determined by
the firms production and cost function
We know that firm’s production function is represented by
isoquants.
What we need here is to derive the firm cost function and
find possible input combinations with given cost.
Derivation of ISOCOST
In order to construct cost function, lets assume that a firm has limited
money to spend as its total cost, C , on both K and L and the price of
capital (Pk) and the price of labour (Pl) are given
Given these conditions firm cost function can be expressed as
C=K*Pk +L*Pl
The quantity of capital, K, and labour, L, that can be hired out of the
total cost, C, can be obtained as follows
K=C/Pk-Pl/Pk(L); and L=C/Pl-Pk/Pl(K)
Yields of the curve represent the alternative combination of K and
Labour that can be hired from given total cost, C. This curve is known as
ISOCOST
 Cont..
Isocost is also called budget line or the budget constraints
line
Consider a set of three isocost, each is drawn on the
assumption that a firm has option to spend its total cost (C)
either on K or on L, or on both.
For example consider, consider isocost K1L1. If total
resources are spent on K and nothing on L, then the firms can
buy, OK1 units of K and no units of L as shown below:
OK1=C/Pk-Pl/Pk(L) (where L=0)
 Cont…
Similarly, if the firm spends total C on L, it can buy OL1 units of L
with K=0 as shown below

OL1=C/Pl-Pk/Pl (K) (where K=0)

The total quantity of capital OK1 (where L=o) is marked at point
K1 and the total quantity of labour, OLL1 (where K=0) is marked at
point L1.
By joining point K1 and L1 by line called isocost
Isocost show all range of combination of K and L that can be
hired, given total cost and factor price
 Cont..
An ISO COST is curve or locus of points showing the
combination of inputs that have that same market cost.

Properties of Iso costs:

They are negatively sloping
In an iso cost there is the same level of cost
The higher the iso cost, the higher the cost
Iso cost is a straight line
 Cont..
Isocost
Capial,
K3
K2
K1

Δk
ΔL

0 L1 L2 L3 Labour
 Cont..
Given the factor prices, if cost increases larger quantities of
both K and L can be hired, making the isocosts shift upward to
the right as shown by K2L2 and K3L3.
Its important to note here that the slope of the isocosts (i.e. –
ΔK/ΔL) gives the Marginal rate of Exchange (MRE)
between K and L, more important factor price-ratio, PL/PK
Since factor prices are constant, marginal rate of exchange
between the inputs is constant and equal to the average rate of
exchange all along the line
THE LEAST COST CRITERIA
There are two criteria, called first order and second order criteria that must be
fulfilled for the least combination of inputs
1. The first order criteria also called necessary conditions, for the least-cost
input combination, can be expressed in both physical and value terms
 Given the two inputs K (capital) and L (labour), the first order criterion in
physical term can be stated as MRE must be equal to Marginal productivity
ration of labour and capital.
 i.e. –ΔK/ΔL=MPl/MPk
 Where –ΔK/ΔL is the exchange ratio between K (capital) and L (labour) at
market price and MPl/MPk is the ratio of Marginal productivity of L and K
i.e. Input combination at which factor exchange ratio (given factor prices) and
marginal productivity ratio are equal, is the Least cost input combination
 Cont..
In term of money value, the first order criterion for least cost of optimal
input combination may be expressed as;

MPl/MPk=Pl/Pk or MPl/Pl=MPk/Pk

Slope of Slope of
Isoquant Isocost
Therefore it means that the least cost combination of inputs is given by
the point where isoquant is tangent to the isocost
5.0 THEORY OF COST OF PRODUCTION
Here we are going to discuss relationship between the output and cost
of production.
Costs of production consist of payment to factors of production and are
therefore closely linked to the theory of production.
Cost of production refers to expenditure incurred by producer .
Cost of production affect supply in two ways;
(i) Determine the quantity to be produced by particular firm
(ii)Determine number of firms in production of commodity
Note: The knowledge regarding the cost of production is essential to
understand supply. (supply is nothing else than output)
 Concepts of costs
In this section will know what are:- Actual cost and opportunity Business cost and full
cost, Explicit and implicit/imputed cost as well as Total average and marginal costs

Actual cost and opportunity cost

Actual cost are the expenditure which are actually incurred by the firm in payment of
labour, material, plant, building, machinery, equipments, traveling and transport, fuel
etc.
The Total money expenses recorded in the books of accounts are actual costs.
Opportunity cost as discussed earlier on, it is the returns expected from the second
best use of the resources which is forgone for availing the gain from the use of the
resources.
It s the loss of income due to opportunity forgone. Its also called alternative or
economic cost/economic rent
Economic rent is the difference between actual earning and opportunity cost
 Cont..
Business cost and full cost
A business cost includes all the expenses which are incurred in carrying
out a business. This cost concept similar to the actual or real cost.
It includes all the payments and contractual obligations made by the firm
together with the books cost of depreciation on plant and equipment.
Both these concepts are used in calculating actual profits and losses in the
business, in filling returns for income-tax, and for other legal purposes
The concept of full cost includes two other costs: opportunity cost and
Normal profit.
Normal profit is a necessary minimum earning, in addition to opportunity
cost, which a firm musts get to remain in its present occupation.
 Cont..
Total money cost includes;
i. Explicit cost (things paid directly)
Is the actual payment made by firm for purchasing or hiring resources from factor owners
actual money expenses directly incurred for purchasing resources
ii. Implicit cost (estimated cost owned by producer him/herself)
refer to the imputed cost of factors of production owned by producer himself which are general
left out in calculation of the expenses of the firm e.g. Rent of his own land, interest of his own
capital or salary of his own service as a manager.
iii. Normal cost/Profit(minimum amount you get for service)
is the minimum amount required to keep an entrepreneur in the production
Or is the minimum amount required to induce
Where
AC=AR or TC=TR
 Cont…
Thus
Total =Explicit+ Implicit+ Normal profit
money cost cost cost
Economic =T.R- (Explicit+ Implicit cost)
Profit cost
Accounting = T.R- Explicit cost
profit
 Cont..
Explicit and implicit/imputed costs
Explicit costs are those which fall under actual cost or
business cost entered in books of accounts. e.g., the payment of
wages, salaries, utilities, interests, rent, license fee, insurance
premium and depreciation charges.
Implicit costs may be defined as the earning of owner’s
resources employed in their best alternative uses. For example
suppose an entrepreneur doesn’t utilise his services in his own
business and work as a manager in some other firms on a salary
basis. If he joins his own business, he forgoes his salary as
manager.
 Total, Average and Marginal Costs
Total Cost (TC)
represents the value of the total resources used in the production of goods and services.
It refers to the total outlays of money expenditure, both explicit and implicit on the resource
used to produce a given output.
TC=f(q)
Can be obtained by adding T.F.C + T.V.C
Average cost is of statistical nature. It is obtained simply by dividing the Total cost (TC) by
the total output (Q).
A.C =TC/Q
Marginal cost is the addition to the total cost on account of producing one additional units
of the product. Marginal cost is the cost of marginal unit produced.
 MC = ∆TC
∆Q
 Fixed and variable costs
Fixed costs are those which are fixed in volume for certain given
out put.
Fixed costs do not vary with the variation in the output between
zero and a certain level of output. e.g., managerial and
administration staff, depreciation of machinery, building and other
fixed assets etc.
Variable costs are those which vary with the variation in the total
output. Variable costs are the functions of the output e.g., running
cost of the fixed capital such as fuel, ordinary repairs, routine
maintenance expenditure, direct labour charges associated with
the level of output and the costs of all inputs that vary with output.
 Private and Social costs
Private costs are those cost which are actually incurred or provided for by
an individual or a firm on the purchase of goods and services from the
market. For a firm, all the actual cost, both explicit and implicit are privates
cost.
Social costs are the cost society bear s on account of production of
commodity. Are all expenses fall which fall in society during a course of
producing commodity e.g. externality like pollution, road maintenance,
medical
are those costs not paid by the firms including use of resources freely
available plus the disutility created in the process of production. It implies
the cost which a society bears on account of production of commodity.
 
 Cont..
Since cost function is dependent of the production function, it may change
due to the change in production function.
Short run cost function may be symbolically written as

C= ƒ`(Q, T, Pf, K)

 C= Total cost
Q= quantity produced
T= Technology
Pf= Factor prices
 K= Capital, the fixed factor
 Cost output relations
The traditional theory of cost analyses cost behaviour in response
to change in production. Cost behaviour is analysed under:
(i) Short run conditions and
(ii) Long run conditions
 The short run and long run conditions are the same under
which law of production are discussed
 Recall, Short run of certain inputs (capital) is fixed and such
that are used in fixed quantity while in long run, supply of all
inputs is variable and more and more of all inputs can be used
in the process of production, given technology
 Cont..
In short run therefore, cost output relations depends in return
to the variable factor
In long run, cost- output relationship depends on return to
scale
We will discuss
(i) Short run cost-output relations, and
(ii) Long run cost-output relationships
Short run cost- output relations
Cost functions depend on
i)Production functions, and
ii) Market supply function of inputs
The inputs that are used in the process of production in the short run can be
classfied as
(i) Fixed factor, include land, plant, building and equipment
(ii) Variable factors, includes such inputs as direct labour, raw material, fuel
 In short run total cost incurred in fixed inputs is called Fixed cost and total cost
incurred on variable inputs is called Variable cost
Thus, the Total Short Run Cost (STC) consist of (i) Total Fixed Cost (TFC) and
Total Variable Cost (TVC)
i.e. STC =TFC + TVC
Distinction between V.C and
F.C
FIXED COST VARIABLE COST

Don’t vary with quantity of output Varies with quantity of output

Related with fixed factor Related with variable factor

Never becomes zero Becomes zero when production is closed

Firm continue on production even at the Production continue only when variable
less of fixed factor cost met i.e. for production to take place
it depend on variable factors
 Cont..
Since the basic cost concepts used in analysis of cost behaviour
are Total, average and marginal Costs,
The Total Cost is defined as the total actual cost that must be in
incurred to produce a given quantity of output.
The Short run, Total Cost (TC) is composed of two major
element, Total fixed cost (TFC), and Total Variable Cost (TVC). 
Thus, TC= TFC + TVC
For a given quantity of output, (Q) the Average Total Cost (ATC or
AC) Average fixed cost (AFC) and average variable cost (AVC)
can be defined as follows:
 Cont..
AC = Total Cost(TC)
Output (Q)
 
AFC= Total Fixed cost (TFC)
Output (Q)
AVC = Total Variable cost (TVC)
Output (Q)
Since TC= TFC + TVC
Note: TFC=Qf x P
TVC=Qv x P
 Cont…
AC = TC = TFC + TVC
Q Q Q
 AC = AFC + AVC
Marginal cost (MC) is defined as the change in the total cost
divided by the change in the total output
MC = ∆TC
∆Q
Since ∆TC = ∆TF + ∆TVC
 Cont..
Because in short run ∆TFC = O
∆TC = 0 + ∆TVC

Thus in short run MC = ∆TVC

∆Q
For the matter of analysis let us see a table below through
hypothetical cost function which assumes production of a
single commodity with one variable input
 Cont..
Short cost-output relation

TC Q(unit) TFC TVC AFC AVC AC MC

140 0 140 0 - - - -
210 10 140 70 14.0 7.0 21.0 7.0
250 20 140 110 7.0 5.5 12.5 4.0
320 30 140 180 4.7 6.0 10.7 3.5
420 40 140 280 3.5 7.0 10.5 10.0
590 50 140 450 2.8 9.0 11.8 17.0
860 60 140 720 2.3 12.0 14.3 27.0
1260 70 140 1120 2.0 16.0 18.0 40.0
1820 80 140 1680 1.8 21.0 22.8 56.0
 Cont…
The relationship between output & costs as presented in the
table above can be summaries as follows

1.As out put increases the TFC remains constant (by assumption)
2.As Q increases, TVC increase first at decreasing rate (till Q = 20 unit) and then at increasing
rate
3.As Q increases , The TC ( TFC + TVC) increasing first at a diminishing rate and then at an
increasing rate following the rates of increasing in the TVC
4.With increase in Q, the AFC decreases continuously, Because TFC remains constant for
whole range of output
5.As Q increases, the AVC decrease till the rate of increases in TVC decreases, beyond that it
increases
6The MC decreases till the output of 30 units and then increases. The MC also fall the TVC in
the short run

 
 Cont..
Graphical Representation

TFC remains fixed for whole range of output and hence takes
the form of a horizontal line. As explain above the pattern of
TVC stem directly from the law of increasing and diminishing
return to the variable inputs
 Cont..

TC
TC
TVC
TFC

TVC

TFC
140

Output
 Cont…

MC
Cost
AC

AVC

AFC

Output
 Cont…
Interpretation
As the figure above shows
In the initial stage of production, both AFC and AVC are
declining because of internal economies of scale. Since AFC
and AVC are both declining, the AC is also declining.
But beyond a certain level of output (i.e. 20 units) while AFC
continuous to fall, AVC starts increasing because of faster
marginal increase in the TVC. Consequently, the rate of fall in
AC decreases.
 Cont..
The AC reaches its minimum when output increases to 40
units. Beyond that level of output, AC starts increasing rapidly
due to law of diminishing returns coming into operation; MC
curve represents the pattern of change in both the TVC and TC
curve as output changes. A downward trend in true MC shows
increasing marginal product of the variable input which mainly
because of internal economic resulting from increases in
production.
 Cont..
5.2 The relation between AC & AVC
a) Since AC = AFC + AVC, AC falls when AFC & AVC fall.
b) When AFC falls but AVC Increases, change in AC depends
on the rates of change in AFC and AVC, on the following
pattern
i. If increase in AFC> Increase in AVC, AC falls,
ii. If decrease in AFC = increase in AVC, AC remains
constant; and
iii. If decease in AFC < increase in AVC, AC increases.
 5.3 The relationship between MC and AC
i) When MC falls, AC falls too. But the rate of fall in MC is greater than that of AC, because in
case of MC, the decreasing marginal cost is attributed to a single marginal unit, while in case of
AC, the decreasing marginal cost is distributed over the whole output. When MC curve lies
below the AC curve, MC pulls AC downwards and when MC is above AC, it pulls the AC
upwards
ii) Similarly when MC increases, AC also increasing but at lower rate for reason given above. MC
increases while AC continuous to fall.

MC starts increasing, while AC continues to decrease. The reason is when MC falls; it falls at a
rate higher than the rate of fall in the AC. When MC starts increasing, it does so at a relatively
lower rate which is not sufficient to push the AC up. i.e., why AC continues to fall over some
range of output even if MC increases.
 
iii) MC intersects AC at its minimum. The reason is, when MC decreases it pull AC down and
when MC increases, it pushed AC up, and when AC is at its minimum, it is neither being pulled
down nor being pushed up; by MC. That is MC = AC at its minimum  
 Cont…
Since A.C=T.C/Q or its per unit cost, while M.C is the incremental T.C that
increases from producing an increase of one unit of labour.
Cost

MC

AC

Output
 Cont…
CAN A.C FALL WHEN M.C IS RISING?
Its clear from above schedule and diagram that A.C can fall
can fall even when M.C is raising
The condition is that Mc may rise but it should remain below
A.C. So long M.C remain below A.C; A.C will fall even when
M.C is rising.
CAN A.C RISE WHEN M.C IS FALLING?
No; Its not possible. When M.C is falling A.C can not rise but
it has to fall.
 5.4 Optimum Output and Cost Curves.
In Short run, optimum level of output is one which can be
produced at a minimum average cost of given technology.
The minimum level of AC is determined by the point of
intersection between AC & MC, curves
At that level of output AC = MC , AC being the minimum
Any other level of production, below or beyond this level will
be in-optimal.
Note: optimal level of output is not necessarily the maximum
profit output
 Cont..
TPL

TPL

Labour
Co
st AC

Output
 Cont..
Question one
a) Distinguish between fixed and variable costs
b) The data below shows a tabulation on the
production of a hypothetical products

Output 0 1 2 3 4 5 6 7 8
(Q) units
Total Cost 25 32 38 42 48 58 67 78 98
(TC) ‘000
Tshs.
 Cont..
I. Total fixed cost
II. Average variable cost when output equals 6 units
III. Marginal cost of the 3rd unit of output.

Soln.
IV. Total fixed cost = 25 000
V. Average variable costs(AVC)= TVC = (TC-TFC)
Q Q
= 67 000-25 000
6
= 42 000
6
=Tshs. 7 000
 Cont…
iii. Marginal cost of the 3rd unit of output
MC = ∆TC
∆Q
= 42 000- 38 000
3-2
= 4/1= 4
Tsh.4 000
The Short run Cost Curve and The Law of
Diminishing Return
Recall; Law of variable proportion states that, when more and more units of a
variable factor inputs are applied , other factor inputs held constant, the returns
from marginal units of the variable inputs may initially increase but it decreases
eventually.
The same law can also be interpreted, in term of decreasing and increasing
costs.
The law can be more stated as, if more and more units of a variable inputs are
applied to a given amount of fixed inputs, the marginal cost initially crease, but
eventually increases
Both interpretations of the law yield the same information
(1) One, in terms of marginal physical productivity of the variable inputs, and
(2) Other , in term of marginal costs in money terms
 5.5 LONG RUN COST – OUTPUT
RELATION
Long run is the period during which all the input becomes variable
Long run total cost is the horizontal summation of Short run TC curves.
Similarly Long run AC is the horizontal summation of Short run AC curves
There are three costs in longrun
1. Long run Total Cost (LRTC)
2. Long run Average Cost (LRAC)
3. Long run Marginal Cost (LRMC)
Long run curve
The long run marginal cost curve (LMC) is derived from the short run MC
curves (SMCs)
 Cont..
1.LRTC
Is the cost which varies with output since in long run all factors are variable
2. LR A.C
This show the lowest possible cost of producing different levels of output
given the productive function and the factor price are reflected from the firm
iso cost curve
The shape of LRAC is U-shaped just like short run AC curve but source of
U-shaped is increasing and decreasing return rather than diminishing return
to the production factors
Note: LRAC curve decline the firm experiencing ECONOMIES OF SCALE
and when rising indicates firm face Diseconomies of scale
 Cont..
3. LRMC
Is determined from LRAC curve arise below LRAC is fallen and above
the long run AC curve achieving its maximum
 When a firm is producing at all output which is LRAC is falling, LRMC
is less than LRAC
 When LRAC is increasing , LRMC is greater than LRAC
NOTE:LRAC and LRMC curve are also U-shaped curve but they are flatter
than the short run cost curve
The reason is that, in the Long run, TFC can be varied to consider able extent
Also, T.F.C can be reduced so as ATC may be lowed.
 Cont…
5.6 Optimum size and Long run cost curves
 An optimal size (or scale) of a plant is one which lead to the
most efficient utilization of resources at given state of
technology over time.
There is technically a unique size of the firm and level of
output that determine the optimal size of the firm. This can be
obtained with the help of LAC and LMC i.e., SAC = SMC =
LAC=LMC. This assures the most efficient utilization
resources
 Cont..

C
OS SAC
TS LAC
SAC
SAC

SAC
SAC

OUTPUT
 Cont..
5.7 Cost Function
Cost function may take a various forms yielding different kinds of cost curves
I.e. – Linear

- Quadratic } Cost function

- Cubic

TC= a + bQ linear

Where TC = Total cost

a = Fixed cost
b = is constant /shape of the cost function
bQ = variable cost
 
 Cont…
A quadratic cost function is of the following firm
Tc = a + bq + Q2

Ac = TC = a + b + Q
Q Q
 And MC = ΔTC = b + 2Q
ΔQ
 Cont..
Review Questions
1.The total cost equation in the production of bacon at some hypothetical factory
is given as follows:

C= 1000+ 100Q- 15Q2 + Q3

Where C= cost measured in shillings, while Q = quantity measured
in kilograms

a. Compute the total and average costs at the output level of 10 and 11 kilograms
b. What is the marginal cost of the 12th kilogram?
 Cont…
c. Explain the shape and relationship between AC, AVC, MC and AFC
curves using relevant diagrams
2. Suppose a cost for is given by as C= 135 + 75Q – 15Q2 + Q3
 a) Prepare a cost schedule showing total cost, marginal cost, average cost
and average variable cost.
b) Draw the cost curves on the basis of cost data obtained from the cost
function of firm X.
 5.8 Profit maximizing condition
Profit Maximization is the maximum amount of output of the
firm can produce without incurring any loses
Total profit (∏) is defined as the difference between total revenue
received by the firm and the total costs it incurs.
i.e., ∏= TR – TC
 
Where TR =Total revenue and TC = Total cost. There are two
conditions that must be fulfilled for TR – TC to be maximized.
Profit maximization requires that the following two conditions are
satisfied:
i) Necessary condition, (first under condition )
ii)Secondary or supplementary condition (second order condition)
 Cont..
First order condition requires that for profit to be maximized, marginal
revenue (MR) must be equal to marginal cost (MR).
i.e. MR=MC
 
By definition marginal revenue is the revenue obtained from the
production and sale of one additional unit of output and MC is the cost
arising due to the production of one additional unit output.
The second order condition requires that the necessary condition must
be satisfied under the condition of decreasing MR and rising MC. The
fulfillment of the two conditions makes the sufficient condition.
 
 Cont…
The sufficient condition states that, the slope of the Marginal Revenue curves must be less
than the slope of the Marginal Cost curve at the point where they are equal. This implies that
the Marginal Cost curve must cut the Marginal Revenue curve from below.
 
Technically profit maximizing firm seeks to maximize
∏= TR – TC

Mathematical logical the first and 2nd order condition of profit maximization

a) First order condition

The first order condition of profit maximization is that the first derivative of the profit
function ∏= TR – TC must be equal to zero. Differentiating the total profit function and
setting it equal to zero
 Cont..
we get
∂∏ = ∂TR – ∂TC
∂Q ∂Q ∂Q

Therefore ∂∏=0
∂Q
∂TR – ∂TC = 0
∂Q ∂Q
 
∂TR = ∂TC
∂Q ∂Q
 
Thus first order condition for profit maximization MR= MC
 
 Cont…

Marginal revenue &

cost P1
MC

P2

MR

Output
 Cont…
b)Second order condition as stated above, the second order condition of
profit maximization requires that the first order condition is satisfied under
rising MC and decreasing MR.

Since MC and MR curves intersect at two point P1 and P2. Thus the first
order condition is satisfied at both points, but second order condition of profit
maximization is satisfied only at point P2. Technically, the second order
condition requires that its 2nd derivative of the profit function is negative  

i.e. ∂∏= ∂2TR – ∂2TC

∂Q ∂Q2 ∂Q2
 The second order condition requires that
Cont..
∂2TR – ∂2TC <0
∂Q2 ∂Q2
 
Since ∂2TR gives slope of MR and
∂Q2

∂2TC gives slope of MC,

∂Q2

The 2nd order condition is

Slope of MR< slope of MC
 
Since we know
TR=P*Q and
Q = ƒ(P) i.e., demand function.
 
 Cont..
Suppose that demand function is given as Q= 50-0.5P and the price function
P= 100- 2Q
 
TR= (100-2Q)Q----------------------------equation (i)
 
Again suppose that the TC is given as TC=10+0.5Q 2
 
∂TR = 100-4Q
∂Q
 
∂TC=0.5(2)Q2-1
∂Q
∂TC = Q
∂Q
 Cont…
MR=MC
100-4Q= Q
100=5Q
Q=20
 
2nd order condition
∂MR - ∂TR <0
∂Q ∂Q

-4-1<0
 
Therefore the 2nd order condition also satisfied at output 20.
 
 Cont..
Question one
a)Find out maximum profit output and b) Maximum profit from cost function
C= 50 + 6Q2 and price function P= 100 - 4Q. Also derive MC and MR.
Soln
C=50 + 6Q2 AND P=100 – 4Q

MC=MR Condition for profit maximization

MC = ∂TC =50 + 6Q2 = 12Q

∂Q

 MR= ∂TR = (100-4Q)Q= 100-8Q

∂Q
Therefore, since MC=MR
 Cont…
12Q=100-8Q
20Q=100
Q=5
b) Since Q=5
TC=50 + 6Q2 TR=100Q – 4Q
50 + 6(5)2 100(5)-4(5)
=200 =400
Therefore , Since ∏= TR – TC
=400-200
=200
Cont..
Question two
Suppose cost (c) and revenue (R) functions are given as
C = 100 + 5Q2
R = 150Q – 2.5Q2

Find
a) п maximizing output
b) maximum profit and
c) profitable range of output

 
 Cont..
Soln
a) MC = ∂TC =100 + 5Q2 = 10Q
∂Q
 MR= ∂TR = (150Q- 2.5Q2)= 150-5Q
∂Q
Therefore, since MC=MR
10Q=150-5Q
Q=10
 
 Cont.…
b)Since Q= 10
And ∏= TR – TC
Where
TC=100 + 5Q2
100 +5(10) 2
600
TR=150Q – 2.5Q2
150(10)-2.5(10) 2
1500 -250
1250
 Cont.….
Therefore ∏= TR – TC

TR – TC = 1250-600

∏ =650
 Cont…..
c) C = 100 + 5Q2
Since Q=10
Then 100
And 100 + 5Q2
100 +5(100)=600
Therefore C:(100<c<600)
TOPIC 6

MARKET STRUCTURE
 6.MARKET STRUCTURE
Market
According to Prof. Chapman is the situation where buyer and seller come
together to exchange commodities. Therefore in market buyer and seller
affect price of goods sold.
Business organizations operates in two types markets
(i) For factors of production such as labour, and
(ii) For output.
 This topic deals with the output markets. The structure of the markets in
which firms operate may vary. The implications of these variations are
vital for an understanding of the environment in which a business
operates.
 6.1 The Market Structure
The market structure, refers to nature and degree of competition
within a particular market.
 refers to the organizational feature of an industry that influences
the firm’s behavior in its choice of price and output.
Market structure is an economically significant feature of the
market. It affects the behavior of firms in respect of their production
and pricing behavior
Market structure can be classified in number of ways such as
degree of competition, number of firms, distinctiveness of plants,
elasticity of demand and degree of control over the price of the
products.
 Cont..
By a degree of competition we find the following market structure
i)Perfect competition/market, is the market condition no individual
buyer/seller can influence market price. Therefore price is operated
automatically.
ii) Monopoly, is the market condition where supply of product controlled by
one firm.
Note: Pure monopoly firms has no competitors
ii)Imperfect competition
a)Monopolistic competition, situation where there many firm producing differentiated
product
b)Oligopoly , Few firm dominated the market i.e. few seller many buyers e.g. GAPCO,BP
c)Duopoly , Here two seller dominate the market. It’s a special category of oligopoly
Kinds of Market Structure
Type of Market No. of firms Nature of Product Firm’s control
over price
1. Perfect Many firms Homogeneous None
Competition product wheat,
sugar
2. Imperfect
competition

a)Monopolistic many Real/perceived Some

competition difference in
product(most retail
trade)
b) Oligopoly Few i)Product without Some
differentiation, e.g.
bread, steel and
chemicals
ii) Differentiated
product e.g. tea,
toothpaste ,soaps ,
detergent, auto
mobile
Monopoly Single Products without Fully generally
WHY MARKETS ARE
IMPERFECT?
(Source of Imperfect Competition)
Imperfect competition arises mainly from the barrier to entry. Barrier to
entry are created by several factors
1. Large size firms which enjoy economies of scale can cut down their
price to the extent that can eliminate new firms or prevent their entry
to the industry , if they so decide
2. Licensing policy of the government creates barrier for the new
firms to enter in industry
3. Patent of rights to produce as well as established product or a new
brand of a commodity prevents new firms producing that commodity.
4. Sometimes entry of new firms to an industry is prevented by a law
with view to enabling the existing so that prices are low
 
6.2 PRICE AND OUTPUT DETERMINATION

6.2.1 Perfect competition

A perfect competition market is characterized by complete absence of rivalry among
individual firms
Is the market situation where large number of buyer and sellers of homogeneous product
can’t influence market price. It’s a rare phenomenon.

Features /characteristic of perfect competition

1. A large number of buyers and sellers
There are many buyers and sellers so that the actions of an individual cannot have
significant impact on the market price. This is because each buyer or seller is too small in
relation to the market to be able to affect the price of the commodity by his/her own action.
Therefore Firms are price takers, not price marker, no single buyer or a group of
buyers can influence the market price e.g., water, sugar, vegetables.
 Cont…
2. A homogeneous product
The commodities supplied by all firms of an industry are assumed to
be homogeneous or approximately identical i.e., buyers do not
distinguish between products supplied by various firms of an industry.
This assumption eliminates the power of all firms supplier to charge
a price higher than the market price.
3. Perfect mobility of factor of production
It assumes that factor of production (especially labour and capital) are
feely mobile between the firms. The producers can enter and exit on
the industry freely in respond to the prices signal.
 Cont..
4. Free entry and fee exit
There is no legal or market barrier on entry of new firm to the industry.
5. Perfect knowledge about the conditions
All buyers and sellers have fully information regarding the prevailing and future price
and availability of the commodity. that is no price differential will exist. As Marshal put
it…though every one acts by himself, his knowledge about what others are doing is
supposed to be generally sufficient. There is no uncertainty in the market

6. No government intervention
Government doesn‘t interfere in any how with the functioning of the market. There is no
taxes or subsidies, no licensing system etc. i.e. government follow free enterprises policy
7. No transport cost
 Cont..
8. Absence of collusion and independent decision making
There is no collusion between the firms i.e. they are not in league with
one another inform of cartel. There are no consumer association
 Perfect Vs. Pure competition
The distinction between the two is a matter of degree. While ‘Perfect
Competition’ has all features above, under ‘Pure Competition’ there is
no perfect mobility and of factors and perfect knowledge about market
conditions.
Pure is pure in the sense that it has absolutely no element of monopoly.
A firm in Perfect Competitive Market
In a perfectly competitive market structure an individual firm is one among a very
large number of firms producing an almost identical commodity.
Firm status in perfect competition is as follows;
(i)Firms have no control over price, the market share of an individual firm is so
small that firm can not influence the prevailing market price by changing its supply.
(ii)Firms are price takers . Under perfect competition, an individual firm do not
determine the price of its product. The price of its product is determined by the
market demand and market supply.
At this price, a firm can sell any quantity. It implies that the demand curve for an
individual firm is a straight horizontal line with infinitely elasticity. A horizontal
AR=MR curve in perfect competition
(iii) No control over cost, Because of its small purchase of inputs (labour and
capital) a firm has no control over input prices
 Market demand and supply
Price D S

0
Demand for and individual firm

Price Perfect elastic demand

(Infinity elastic)
d P(AR)=MR d
Cont..
The shape of AR curve suggest that the firm under perfect
competition is a PRICE TAKER not PRICE MAKER.
Note: Here firm don’t lower price because he will loose buyer
and he will not increase price because he will be avoided in the
competition because of homogeneous product.
 Criticism /Justification of
Perfect competition
In real world we can’t find such type of perfect market
Reasons
1. In real world we don’t have number of buyers who can’t determine
the price
2. We cant have homogeneous products produced by all firm
3. In real world we don’t enjoy freedom of entry and exit and exit
simply there are some barriers
4. Buyer and seller cant have perfect knowledge
5. Transport cost will also be there
6. Perfect mobility of factors of production is also not possible
because of some barriers cf. skills, knowledge.
 Cont..
Perfect Competition is Imaginary Concept/Myth why
studying it?
Reasons:
1. Simple analysis, it furnishes us a simple and logic analysis
to understand the process of price determination.
2. Ideal situation, price is fixed there fore assist in policy
formulation
3. Price control, helpful to the government fixation and price
control
Short run Equilibrium of the
firm
A profit maximizing firm is in equilibrium at the level of
output which equates its MC=MR
A firm is in equilibrium when its profit is at maximum. i.e.,
MR = MC where MC is rising
The nature of cost and revenue function depends on whether
one is considering short- run and long-run
The short run cost function is difference from the long run
cost function because in short run, some input e.g. capital are
held constant while all factors are variable in long run
Assumption of short run equilibrium firm
(i) Capital is fixed but labour is variable
(ii) Price of inputs are given
(iii) Price of commodity are fixed
(iv) Firm is faced with U shaped cost curve
 Cont..
Price determination in perfect competition
Important thing to note in a perfect competition each firm
faces a demand curve that is horizontal (perfectly elastic)
because variation in the firm’s output have no noticeable effect
on price (individual firms have zero market power).
A long as the market price is always which to the price at
which the output is sold
 Cont…
Quantity Price (P) Tshs TR=P*Q Tshs. AR=TR/Q MR= ΔTR/ΔQ
demanded (Tshs) (Tshs)
units
10 3 30 3 3

11 3 33 3 3

12 3 36 3 3

13 3 39 3 3
 Cont..
The above table illustrates that as the quantity demanded
increases, the price remains unchanged. This implies that each
additional unit sold increases the revenue by the amount equals
to its prices. The relationship can be illustrated graphically in
figure below

R
ev
en
ue

AR=MR

Output
 Cont…
The demand curve for a perfectly competitive firm is
infinitely elastic. The price is determined by the market and
cannot influence by an individual firm whose output is too
small relative to total industry output. The market prices apply
to each firm and determined by the market forces of demand
and supply.

The industry demand curve, unlike the individual demand

curve, slopes downward because if the industry as a whole
reduces its price it will sell more.
 Cont…
Figure below shows demand curve for the product of an
individual firm is perfectly elastic whereas the market demand
curve for the out put of industry will be a normal shape in that
it slopes downwards from left to right. DD and SS are the
industry demand and supply curve respectively.
 Cont…

Price D
S
Pric
e

P ------------------------------ D

S D
0 0
Q Quantity Quantity
 Cont…
The individual and market demand curve in perfect
competition
Given the price OP in figure (a) individual firm can produce
and sell any Quantity at this price, but any quantity will yield
maximum profit. A firm can sell any quantity at price OP, the
demand for firm’s product is given by a horizontal straight line
AR = MR. Price being constant, its average revenue (AR) and
marginal revenue (MR) are equal. Since we know maximum
profit is produce at point MR= MC when arising. The point Q2
indicates the profits maximization output
 Cont..
In the short run (AR>AC) super normal profit
Assuming the objective of the firm is maximization of profit.
There fore condition for profit maximization MC=MR , But
AR (P) may be greater /less to AC
Thus, AR(P) >AC= Profit maximization
AR(P)< AC = Losses
 Cont..

MC

Revenue and Super normal AC

Cost Profit
P P=AR=MR

MC=MR
0
Q1 Q2
output
 Cont..
Figure above shows, the necessary and sufficient conditions for
profit maximization.
In the short run perfect competition firms can make normal or
supernormal profit or losses.

Normal profits (AR(P)=AC) refer to the minimum level of profits

which a firm must acquire in order to induce it to remain in
operation. The level of normal profits will vary from one industry to
another. Normal profits may be considered as a cost of production
since production will not continue unless at least this level of profit
is attained. See the figure below.
Normal profit in short
run(AR=AC)
MC
AC

P P=AR=MR

0
Q1 Output
 Cont..
Normal profits in perfect competition market
The profit maximizing level of output is Q1 where the
necessary and sufficient conditions are satisfied.
Normal profits are made when the price is equal to Average
cost, this implies that when price exceeds average cost, the
firm is said to be earning abnormal or supernormal profits.
Supernormal profits are used to categorise those firms which
are earning a return which exceeds the minimum necessary to
induce them to remain in the industry they currently occupy.
Super Normal Profit(AR>AC)

MC

AC

///////////////
P P=AR=MR

A C
C

Q2 output
 Cont..
Supernormal profits in perfect competition market 
When the level of output is Q2 the cost per unit is CQ2 while
the price is equal to BQ2. Supernormal profit per unit, is
therefore, equal to BC. Total supernormal profit is equal to
APBC which is represented by the shaded area.
Firm in perfect competition can also make losses in the short
run. Losses occur where firms operate under conditions
where the average cost exceeds the average revenue. Figure
below indicates losses under perfect competition market.
Losses in short run(AR<AC)
MC
AC

E
D

P
/////////////// P=AR=MR
F

0
Q3 output
 Cont…
Losses under perfect competition
 A firm may continue in production for a time even when it
sells at loss. Consider the above figure, the loss is shown by the
shaded area PDEF within the firm producing at the loss
minimizing level of output Q3.
 Cont..
MC

AC

P3
AVC

P2

A
P1
Break even

0
Q1 Q2 Q3 output
 Cont..
The break even price and shut-down price of the firm
 In order to maximize profits, the firm will produce output Q3
because at that price and output, MR=MC.
However, if the price falls to P2 the output will be reduced to
Q2. This is the firms break-even price since below this level
the firm will start to make loss as the price fall below
average cost. Even if the prices falls below P2 it may still be
worthwhile to continue producing and selling at a loss, at least
in the short run. Provided the price covers the variable cost
 Cont…
loss will be less than the fixed costs the firm will incur if it produced
nothing, since prices contributes to the recovery of fixed costs. The firm
will cease production at the point when in order to sell its goods; it has to
reduce its price to P1. At this point, the firm just covers its variable costs.
The length of time for which a firm can sustain losses in the short run
depends on the extent to which the firm can cover losses, e.g., through
borrowing. Important considerations in this regard are also the possibilities
the firm has of reducing costs or increasing its revenue in future.
The portion above the point “A” relates the price to the output the firm
will produce. Since is this is the function of a supply curve, the perfectly
competitive firm’s marginal cost curve above its average variable cost
is its supply curve.
 6.2.2 Monopoly
A MONOPOLY is the market structure where production is under the
control of single supplier.
Is a market situation where single seller accommodate the market with no
close substitute.
Since the monopolist is the sole source of supply in the market, the
individual curve is also the industry demand curve. This implies that the
monopolist faces a downward sloping demand where if the monopolist
wants to sell more he must reduce the price. In this average revenue is not
the same as marginal revenue.
Monopoly has power to determine either PRICE or OUTPUT but not both
at the same time. This is because he cant control demand of people.
Price and output determination under monopoly
The term pure monopoly signifies an absolute power to
produce a product which has no close substitute .
In other words a monopoly market is one in which there is
only one seller of a product having no close substitute
The cross elasticity of dd for a monopolized product is either
zero or negative
The monopolist power to determine price depend on;
(i) Non availability of close substitute
(ii) Power to restrict entry of new producers
Features/characteristics of
Monopoly
1. Single producer
2. No close substitute
3. Barrier to entry, as new firm admitted to the market
monopoly breaks.
4. Firm and industry, since a monopoly is a single firm therefore
the industry will act as a monopoly. A monopoly between
firm and industry is dominant in firms than industry
5. Down slope AR and MR curve, here monopolist lower price
in order to sell more output.
 Cont..
Px y

MR AR(P)

0X
 Cont..
The down sloping AR and MR curve of the monopolistic
where MR remain below AR Thus, Down sloping curve
indicates a monopoly is a Price maker.
6.Price discrimination, this is possible under monopoly where
product produced by monopoly are bought to different price.
Note: this is possible only with:
(i) Absence of close substitute
(ii) Restriction of entry
 Sources and Kinds of Monopolies
The emergence and survival attubated to the factors which
prevent the entry of other firm into the industry.
The major sources of barriers entry to monopolized market are
;
i) legal restrictions some monopolies are created by the w in
public interest. Most of the state monopolies in the public utility
sector including generation of distribution of electivity railways,
air lines and states roads . Some monopolies are intended to
reduce cost of production by economies of scale and investing
in technological innovations ( franchise monopolies )
 Cont..
ii) Patent rights – this is the source of monopoly for a product
process patent right are granted by the government to a firm to
produce a commodity of specified quality and character or to
use a specified technique of production.
Patent rights gives a firm exclusive rights to produce the
specified commodity or to use the specified technique of
production i.e. Patent monopolies.
 Cont…
iii) Control over key raw materials, some firms acquire monopoly power
because are their nature control over certain and key raw materials , which are
essentially for the production of certain goods e.g. Tanzanite in Tanzania ,
1v)Efficiency – A primary and technical reason for growth of monopolies is the
economies of scale . The large size firms finds it profitable, in the long run, to
eliminate competition by cutting down its price for a short period. Once
monopoly is established, it become almost impossible for the new firms to enter
the industry and survive. Monopolies born out of efficiency are called Natural
monopolies
v)Product differentiation, Here a firm can create a monopoly position through
product differentiation, There are advertising to establish brand name is very
important process. High income countries such as USA, UK, France the cost
advertising and brand name are so high thus new firm may find difficult to
compete.
 REVENUE CURVES UNDER
MONOPOLY
The cost curves- the AC and MC curve- faced monopoly firm are U
shaped, just as those faced by the firms under perfect competition.
However, the demand or AR and MR curve that a monopoly firms
faces are different from those faced by firms under competition.
Under monopoly, however, there is no distinction between the firm
and the industry.
The monopoly industry is a single- firm industry and industry demand
curve has a negative slope. Its important to note here that, given the
demand curve, a monopoly firm has the option to choose between price
to be charged or output to be sold.
Once it chooses price, the demand for its output is fixed.
 Cont..
The nature of revenue curves under monopoly depends on the
nature of dd curve a monopoly firm
A monopoly firm faces a dd curve Z a negative slope,
monopoly pricing is result between firm’s SR curve and it is
MR curve. AR=D let as look at technical results up between
can be specified in the following way.
Recall TR = PXQ
= PQ
 Cont..
This relationship can be proved as follows. Lets assume that a monopoly firm faced
with a price function or Average revenue function as
P= a-bQ
We know that TR=Q*P
By substituting P
TR=Q(a-bQ)
=aQ-bQ2
Since, MR equals the first derivative of the TR function,
MR=δTR/ δQ= δ(aQ-bQ2) =

δQ
= a-2bQ
Note that: slope of price function equals b where as slope of MR function equals 2b,
it means the slope of MR function is twice that of AR function. It implies that MR
curve is always to the left of AR curve and MR bisects the demand at all level of
price
 Profit maximization
Price and output determination by monopoly in the short run has been
discussed above theoretically by TR-TC and MR-MC approaches
Now we illustrate the determination of equilibrium price output by a monopoly
firm through a numerical l examples assuming hypothetical demand and cost
function
Demand function Q=100-0.2P
Cost function TC=50 +20Q+Q2
The problem before the monopoly firm is to find the profit maximising output
and price. The problem can be solved as follows.
We know that profit is maximum at a point which equalize MR and MC. The
first step is to find MR and MC functions from demand and costs functions,
respectively
 Cont…
We have noted earlier that MR and MC are first derivative of TR and TC functions,
respectively. TC function is given but TR function is not.
So, lets find TR function first
TR P*Q
since P=500-5Q
TR= P*Q
=(500-5Q)Q
TR= 500Q-5Q2

Now MR functions can be obtained by differentiating the TR function

MR= δTR/ δQ= 500Q-10Q
Likewise, MC function can be obtained by differentiating TC function
MC= δTC/ δQ=20+2Q
Now, that MR and MC function are known , profit maximizing output can be easily obtained.
The profit maximizing output can be obtained by equating the MR and MC functions given
above
 Cont…
MC=MR
5oo-10Q=20+2Q
480=2Q
Q=40
The output Q=40 is the Profit maximising output
Now profit maximising price can be obtained by substituting 40 for Q in
the price function
Thus, P=500-5(40)
300
Profit maximizing price is Rs 300
 Cont…
Given the price, total profit (∏) can be obtained by using TR-TC
approach as follows
∏= TR-TC
By substituting
∏=500Q-5Q2) )-(50 +20Q+Q2
 =500Q- 5Q2 -50 -20Q-Q2
By substituting profit maximizing output (40) for Q, we get
∏ =500(40)- 5(40)2 -50 -20(40)-(40)2
=9550

Thus, the maximum profit is Rs 9550. No other output can increase firms
profit.
 Cont..
Quiz
1.What is price discrimination? Explain and distinguish
between the first, second and the third degree of price
discrimination.
PRICE DISCRINATION BY A
MONOPOLY
The theory of pricing under monopoly as discussed above, gives the impression that
once a monopolistic fixes the price of its product, the same price will be charged
from all the customers.
This however is not the case generally. A monopolist, simply by virtue of its
monopoly position, is capable of charging different prices from different consumers
or group of consumers
Price discrimination is the action of charging different prices from consumers or
groups with the same or slightly differentiated) product consumers are discriminated
in respect to prices on the bases of their incomes or purchasing powers geographical
location, age sex, quantity they purchases, their association with the sellers
frequency of visit to the shop., the purpose of the use of commodity or service and
on other grounds which the seller may find suitable
When a monopolist sells an identical product at different prices to different buyers,
its called a discriminatory monopoly
 Cont…
Monopoly can employ price discrimination in two ways;
(i) By charging different price to different people for the same
commodity. This is possible when there is no competition
(ii)By charging different price in different markets. This can b
applied to the market which are separate, so that those who low
price don’t resell
Note: Price discrimination is the process of charging different
customers different prices for the same commodity
MARKET SEPARATION (FOR DISCRIMINATION)
Factors necessitate price discrimination
i. Geographically, here when exporters charge different prices
to overseas market than in home market
 Cont..
ii. Type of demand, for example demand for milk by household
differ from industry demand for milk for cheese making, ice
cream, here because industry demand high will buy at high
price hence price discrimination
iii. Time, typically a lower price is charged in off risk period
incase of electricity, tel, travel industries (tourism)
iv) Nature of products, with medical treatment when one
person treated that unable to resell that treatment to the other
hence price discrimination
Necessary conditions for Price discrimination to be of
Benefit
1. The firm must conform to down ward sloping demand
curve
2. There must be two groups of customers whose “price
elasticity of demand differs” i.e. customers with elastic
demand that respond to price change hence consume at low
price and customers with inelastic demand that don’t
respond to price change hence consume at high price
3. Seller must be capable to prevent customer who buy from
low price and resell to those buy at high price.
 Cont…
CUSTOMER WITH INELASTIC DEMAND
y
P MC=MR Profit max.
MC

MR
Qn X
 Cont..
Note: Here increase in price doesn’t affect demand “Inelastic”
hence consume at high prices.
CUSTOMERS WITH ELASTIC DEMAND
Here demand of people respond to price change, also the
seller maximize profit by equating MC=MR Thus customer
purchase at lower price simply because high price will generate
low revenue
 Cont..
Elastic demand consumer

P
MC
Db
MR
 Cont..
Note: Because monopolist is the sole producer therefore reduces the price in
order to sell extra unit of output
AR>MR
ADVANTAGES OF MONOPOLY
1. Economies of scale (AC<AR), under monopoly AC is less than AR
because production is undertaken under large scale e.g. elasticity supply
2. Large output low price of commodity, here monopolist can reduce price
and increase output
3. Advertising and brand cost, under monopolist resources are not wasted
on advertising and branding because has no close substitute/
competition
DISADVANTAGE OF MONOPOLY
(Why monopoly are Undesirable)
i. Misallocation of resources (Po & Qm), Here monopolist
locate inefficiency therefore profit maximization
monopolist restrict output below the level
Smaller output monopolist restrict supply of goods and
services in the market.
The producer does not achieve best use of factors of
production hence misallocation of factors of production.
 Cont..
Price
Monopolist Output

Po Ideal output (MC (Opp. Cost)

P1 ATC
D(AR)
MR
QM QN Output
 Cont..
ii. Reduction of incentives, Here due to absence of competition
monopolist lack incentives
iii. Technological progress. Monopolist restrict entry of
innovation unless when there is competition.
iv. Charge High price (AR>AC), Monopolist is a price maker
therefore the price s/he determine is always higher i.e. AR>AC
or AR>MC
 Cont…
P Rev/cost ATC
Mc

PMc1
PM1

MR D(AR)
 Degree of Price discrimination
Degree of price discrimination refers to the extent of which a seller can divide the
market and can take advantage of market division in extracting the consumer surplus.
According to Pigou there are three degrees of price discrimination practiced by
monopolists
1. First degree Price discrimination(willing t0 pay)
The discriminatory pricing that attempts to take away the entire consumer surplus
is called first degree discrimination.
i.e. monopolist knows buyer’s demand curve for the product. What the seller does is
that he first sets price at the highest possible level at which all those who are
willing to buy, purchase at least none unit each of the commodity.
This procedure is continued until the whole consumer surplus available at the price
where MR=MC is extracted. Also consider the case of services of exclusive use,
e.g. medical services
 Cont..
SECOND DEGREE PRICE DISCRIMINATION
Is to charge different prices for the different quantities of
purchase. Is also called Block pricing system .
A different price is charged from different category of consumers
The second degree price discrimination is feasible where;
(i) The number of consumers is large and price rationing can be
effective, as of utilities like telephones and natural gas
(ii) Demand curve of all consumers are identical
(iii)A single rate is applicable for a large number of buyers
 Cont…
THIRD DEGREE PRICE DISCRIMINATION
Here, markets are segregated i.e. price difference across different
markets.
When profit maximizing monopoly firm sets different prices in
different markets having demand curve with different elasticity.
Therefore, uniform price cannot be set for all markets without losing
the possible profits
The monopolist is therefore required to allocate total output between
different markets so that profits can be maximised in each market.
Profit in each market would be maximum only when MR=MC
 Cont…
Market A Market B Total Market
Cs/Rev.

A B MC

Da T AR=D

MRa MRb Db MR

Qa Qb Q=Qa+Qb Q
Distinction between Perfect and
Monopoly
PERFECT MARKET
1. Large number of firm
2.A firm can’t adopt independent price
policy. Its price taker
3.AR and MR curve are one and the same 3. MR and AR are down slope. MR
and parallel to axis i.e. P(AR)=MR
4. Price discrimination is possible
5. Full freedom of entry and exit
6. Firm can get only normal profit in
Long run
MONOPOLY MARKET
1. Single firm
2. A firm has independent price policy.
Price maker thus under monopoly price is
higher. P>MC and P>AC
remain down AR curve i.e. MR<AR
4. Price discrimination is possible
5. No entry
6. Firm can get supernormal profit in
Long run
 cont..
DEAD WEIGHT LOSS UNDER MONOPOLY
Its argued that monopoly firms are less efficient than competitive
firms. Monopoly causes loss of welfare and distortion in resources
allocation.
The suboptimal allocation of resources and loss of social welfare are
illustrated assuming a constant-cost industry which has LAC=LMC.
Given the cost and revenue conditions, a perfectly competitive
industry will produce OQ2 at which is LAC=LMC=AR. Its price will
be OP1.
Monopoly firm produces an output that equalises its LMC and MR.
Thus monopoly firm produces OQ1 and charges price OP2
 Cont..
Cost/Rev

P2 M Dead weight loss

P1 K L LAC=LMC
AR(D)

MR
Q1 Q2 Output
MONOPOLISTIC COMPETITION
Note: In real world its impossible to find perfect competition and pure
monopoly, the actual situation are some where between perfect and pure
monopoly since pure monopoly and perfect competition are unrealistic.
This is because there are many imperfect which cause the real market to be
imperfect
MONOPOLIST COMPETITION
Is the market situation in which large number of sellers produce
differentiated products which are close substitute with each other on their
sell.
It combines basic elements of both perfect competition and monopoly.
Here each firm has power to measure his monopolist thus its POLYPOLY
In other words Monopolist is the long run market in which there is entry in
the market
 CHARACTERISTICS OF MONOPOLISTIC COMPETITION

1.There is a large number of buyers of sellers in the market, here each firms share small of
total output of industry.
2. Independent price policy and downward sloping AR=MR, shows that monopolist is a
price maker
3. Each seller sells a product differentiated from the of others
4. The differentiated products are close substitute, here product save same purpose but
differentiated e.g. Cigarette, Sweet menthol, Aspen, Sports
5.There is free entry, free exit of firm.
6. The firm seek to maximize their profits in both short of long runs.
7.Selling cost, Unlike firm under perfect competition and monopolies , firm under
monopolistic make heavy expenditure on advertisement and other sales promotions
8.Downward sloping demand curve. As in case of monopoly, monopolistically competitive
firm can, by exercising its monopoly power, increase the demand for its product by
decreasing price because of relatively higher cross elasticity of the competitive products.
 IN SHORT RUN( AR>AC)

Here monopolist enjoy supernormal profit since no entry in

the market
MC
Cs/Rev AC
P C
A B
AR
MR
o M Q
 Cont..
At OM is equilibrium MR=MC
OP price sold where AR>AC
Hence super normal profit ABCP= AR>AC

IN LONGRUN (Normal Profit=AR=AC)

Here, other monopolist attracted because of supernormal
profit and cause supply to increase hence Normal profit where
AR=AC
 Cont..
Cos/Rev
MC AC

P
AR Other join
MR

M MI Quantity
 OLIGOPOLY
Is the market situation where there few sellers of products
accommodate the market
Is the market structure where there are few seller selling
homogeneous and differentiated products
Economists do not specify how few is the number of sellers in an
oligopolistic market.
However, two sellers is the limiting case of oligopoly . When there
are only two sellers , the market is called DUOPOLY (smaller size
oligopoly) hence duopoly is a special case of oligopoly.
Oligopoly is interdependence among the firms, this is due to small
number of firms. Thus each firms contributed significant portion of
the total sell
 CHARACTERISTIC OF OLIGOPOLY

1. Few seller but many buyers

2. Every seller has perceptible effect on the other seller
Each firm has to take account of the action of other seller in the market
3. Homogeneous/ differentiated products both are possible
4.Interdependence among various firms, here if one producer rice the price the
other must quote identical price.
5. Price war, might force price down to such level that looses would result and
price rigidity result kinked demand
6. No price competition, producer compete on giving out product but not price.
Note: Price high don’t react because he will loose buyers and vice versa
 Types of Oligopoly
1. PERFECT OLIGOPOLY
Is the oligopoly with homogeneous product. This incase product sold are
uniform e.g. petrol
 Under such situation the seller make agreement concern the price change
for their product.
 In order to earn a lot of revenue each oligopolist will make attractive
conditions, in order to attract more buyers e.g. provide gift, bonus if buyer
purchases more than certain amount.
 Under perfect oligopoly price must be at level which allow each firm to earn
at least Normal profit i.e. AR=AC, other firm would leave and industry
become monopoly
2.Imperfect Oligopolist
Is the oligopoly with product differentiated.
Here few sellers supply commodities which are differentiated but
save the same purpose as the result commodities are substituted to
one another e.g. Beer and wisk
Here monopolist determine the price of his product but he must take
in account the price offered by his rivals
Under imperfect oligopoly there is relationship of a CONCLUSIVE
OLIGOPOLY (a CARTEL) in which firms act together as monopoly
Here adjust price and output to secure maximum revenue and
distribute the monopoly profit among their members by output quotas
 Cont..
BUT, CARTEL is likely breakdown in a Long run as
individual producers have incentives to cheate by producing
excess of their goods and undercutting the agreed price.
 A CARTEL
Price

Profit

Pm A
Pc B AC=MR
AR
MR
Qm
 Cont..
Above diagram show that a Cartel operating as monopoly

THE END……