Principles of Economics Lecture Notes PDF

Lecture Notes
PRINCIPLES OF ECONOMICS
Aman Sharma | Contact Number: (91) 9459209292 | E-Mail: hp15god@gmail.com

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Principles Of Economics
PRINCIPLES OF ECONOMICS
Aman Sharma | Contact Number: (91) 9459209292 | E-Mail: hp15god@gmail.com 1

Contents
Lecture One: The Economic Problem

Lecture Two: Basic Concept of Price Theory and Introduction to the Theory of Demand and Supply
Lecture Three: The Theory of Consumer Demand
Lecture Four: Consumer Equilibrium
Lecture Five: The Theory of Supply
Lecture Six: The Production Function
Lecture Seven. Cost Analysis
Lecture Eight: The Equilibrium of a Profit Maximizing Firm
Lecture Nine: The Theory of Perfect Competition
Lecture Ten: The Theory of Monopoly
Lecture Eleven: Theories of Imperfect Competition
Lecture Twelve: Theories of Imperfect Competition: Pricing and Output under Oligopoly
Lecture Thirteen: The Demand for and Supply of Factors of Production
Lecture Fourteen: Wages and Collective Bargaining
Lecture Fifteen: The Pricing of Factors in Competitive Markets

LECTURE ONE
The Economic Problem
Introduction
Economics is very primary to the lives of individuals and the society at large. In this central role, one can agree
with Karl Marx, in describing economics as a foundation on which rests other superstructures, political, social,
etc. of the society.
The study of economics dates back to the time of Aristotle who described it as economique. The classical
economists treated economics as political economics. However, from the time of Alfred Marshall, economics
assumed the specialised form for which it is known today. In other words, it attempted to remove itself from the
value/ethical consideration and move more in the direction of scientific analysis.
Objectives
At the end of this lecture, you should be able to:
1. define the meaning of economics;
2. explain the basic source of economic problems faced by individuals and the society;
3. discuss the importance of economics as a science; and
4. explain the basic tools of economic analysis.
Pre-Test
1. What do you understand by the term 'economics'?
2. Why do we study economics?
3. What do you understand by the following terms?
a. Scarcity
b. Choice
c. Opportunity costs
d. Scale of preferences
4. Is economics an art or a science subject?
CONTENT
The meaning of Economics
Many economists have attempted to define economics from a narrow perspective and thereby leaving out the
main substance of the subject matter. Aristotle considers economics "as the study of the household". Marshall
defines it as the "study of mankind in the ordinary business of life". Ardisson on his own defines economics as a
social science which covers the action of individuals in the processing, exchanging and consuming of goods and
services.
Although these definitions one way or the other deal with some aspects of the subject matter, they however
leave out the central problems which are scarcity, choice, accumulation and capital utilization.
A more appropriate definition has been given by Lord Robbins. He defined economics as the "Science which
studies human behaviours as a relationship between ends and scarce means which have alternative uses.
The above definition is more relevant because it not only highlighted the role of economics as a science but
also focuses on the major problems of economics.
The Source of Economic Problems

Every society is endowed with human and natural resources. These resources include, land (a free gift of nature),
labour, capital and entrepreneur. These resources are collectively known as factors of production. It is these
resources that are combined by the producers to produce commodities.
Commodities can be broadly divided into goods and services. Goods are tangible such as television,
pressing irons and cars; while services are intangible. Examples of these include, insurance, hair-cut, and
teaching. When we sum up all the commodities which are produced in a given country over a period of time,
we have what is commonly referred to, as Gross National Product.
As all of us are aware, we do not desire goods and services for their own sakes, rather we desire them
because they help us in satisfying our wants. Thus, the whole essence of production in our economy is the
satisfaction of human wants (or consumption).
However, looking around us today will make us realize that the available resources cannot totally satisfy our
wants. The more we satisfy certain wants, the more we desire better things, Practically speaking, we all desire
better foods, clothing, housing, cars and other good things of life. Though we say human wants are unlimited,
we also know that the resources needed to satisfy these wants are finite or limited. For instance, while we all
desire good cars not everybody can afford one. This therefore gives rise to one of the basic problems
encountered in most aspects of economics, the problem of SCARCITY
The divergence between wants and resources make choice inevitable. Because it is impossible to satisfy all
our wants, we have to satisfy some and leave others unsatisfied. Thus, a mechanism is needed to choose which
of our wants that must be presently satisfied. The satisfaction of some wants implies the sacrifice of others. A
means of determining which of the wants to satisfy is by constructing a SCALE OF PREFERENCE where wants are
arranged in descending order of their importance. A rational consumer will prefer to satisfy the most pressing
needs before going to less pressing ones.
The act of sacrificing one want for the satisfaction of the other one is called OPPORTUNITY COST OR THE
REAL COST. Let us consider a practical example here, if an individual is faced with the option of buying either a
textbook or a sandal because he cannot afford the two. And he eventually buys the textbook, the sandals which
he had foregone is called the opportunity cost of the textbook. OPPORTUNITY COST IS SOMETIMES DEFINED AS
THE ALTERNATIVE FORGONE.
On a larger scale, firms and governments also engage in this process. The firms make a choice between the
production of a type of commodity or the other. For example, a firm may want to decide between using a capital
intensive means of production or labour intensive one. The one it eventually chooses will have a real cost.
The provision of services by the government also involves opportunity cost, If government decides to build
more schools, and finds the necessary money by cutting down on defence expenditure. The latter that is
foregone is the opportunity cost of building more schools. Thus, we can see that because human wants are
unlimited and the means to satisfy them are scarce, a choice has to be made and this gives rise to opportunity
cost.
Basic Economic Problems

Every economy - capitalist or socialist, is faced with resolving six basic economic questions. The manner by which
they resolve these questions highlights the similarities and differences between different economic systems.
1. Determining whether the resources of the country are being fully utilized, or otherwise. Each country has
a production possibility Frontier (PPF) which determines the maximum output of commodities which the
country can produce if it is operating its resources efficiently.

Fig.1 Production Possibility Frontier

If a country is inside the boundary of the curve, say for example, at point A then this implies that some of its
resources are idle or inefficiently utilized. On the other hand, if the country is at point B, i.e. on the curve, there
is optimal utilization of resources.
However, it is a point of fact today that most economies are inside their PPF. This is why we have
unemployment problems in all economies of the world. It is the responsibility of economists to find how this
problem can be solved.
2. Determining which commodities to produce and in what quantities? This is the allocation of scarce
resources among alternative uses. In a free-market economy (or capitalist economy), what to produce
and in what quantities are determined by the price mechanism. On other hand, in a socialist economy, it
is the central government that would determine what to produce.
3. Determining what methods of production to use in producing these commodities. There are two
methods of production, labour-intensive or capital-intensive. When for example, more of labour relative
to capital is used in production, and then we say .that the production process is Labour-intensive and
vice-versa. A society might decide to use more of labour or capital resources depending on the
proportion of the available resources at her disposal.
Fig. 2 Method of Production
At point A' more of capital is used while at B' more unit of labour is used.
4. Determining for whom the goods are to be produced. That is those who consume the goods produced.
In real life, we know that few people consume disproportionately large output of the society while the
bulk of the society has to take the remaining. The economic explanation for this has since the time of
Adam Smith been of major concern for economists. In socialist economies, the government often
interferes in the economy to correct the lopsidedness in resource distribution.
5. Determining whether production and distribution system of the society is efficient. In economic sense,
we say production is efficient if it is impossible to relocate resources in such a way as to produce more of
one commodity without producing less of others. The commodities so produced are said to be efficiently
distributed if it will be impossible to redistribute them among the individuals in the society and make at
least one person better off without simultaneously making someone else worse off.

6. Determining whether the country's capacity to produce output is growing overtime or if it is static. In this
case, economists are concerned with how to shift the PPF of the economy. This is what we refer to as
economic growth.
Y
Yb
Ya
0 Xa Xb X
Fig. 3 The upward shifting of the PPF by economic growth
Is Economics a Science Subject?

In this section, we want to discuss the issue of economics as a science or arts.
Generally, economics is often regarded as a science subject. However, a distinction is made between
physical science and social science. Physical science refers to biological or natural sciences, such as, physics,
chemistry and biology. Economics is not a physical science but a social science. This is because it is a scientific
study of human beings.
Economics is regarded as a science because its method of analysis is that of science. Science involves the
formation of hypothesis about reality. However, in order to be able to validate such hypothesis observations are
generated that will provide evidence for or against any hypothesis that we wish to test. While such tests are
usually carried out in laboratory settings in the physical sciences, this is very difficult to do in economics. But all
the same, data are collected on the subject of interest and statistical and mathematical tools are then used to
see whether available data confirms the predictions of the hypothesis. Thus, economics is regarded as scientific
in as much as it attempts to relate question to evidence.
Tools of Economic Analysis

In economics, two methods of analysis are often used. The first is functional representation. This is a situation
where economic relationships are represented visually by graphical methods or symbols (mathematical
approach).
The second method is through logical influence. This is alternatively referred to as logical deduction or
theorizing and economic investigations. In these latter methods we formulate a theory and then test this theory
against real world situations. Six steps are involved in formulation of a theory. These are:
a. Identification of problem;
b. Assumptions about the phenomenon;
c. Formulation of theories;
d. Verification;
e. Correction if need be; and
f. Application
Often in any study of economics, these two methods of analysis are usually employed.
Economic theory is based on relations between magnitudes and variables. Variables in economic analysis
are categorized into two; endogenous and exogenous variables.
Endogenous and Exogenous Variables

Endogenous variables are the ones, which have their explanation in the theory that is in focus. It can be known
with the model under consideration. Exogenous variables have their explanation outside a model. The
relationship among variables whether exogenous or endogenous variables can be expressed mathematically
by the concept of functional relationship.
The Concept of Functional Relationship

S = f (p) ------------- (1)
Supply is a function of price that is supply depends on price
C = f (y) ------------- (2)
Consumption is a function of income.
These are general functions in the sense that we are not specific as to the nature of the relationship between
the dependent and the independent variables in (1) and (2)
If C = a + by. This is specific
C = dependent variable
Y = independent variable
a and b are called the parameters of the function
a = the intercept
b = the slope
C= a+by
0 Y
Fig 4: Graphical relationship between C and Y
Summary
"Economics is a science which studies human behaviour as a relationship between ends and scarce means,
which have alternative uses". Basic concepts which underline the study of economics are; scale of preference,
scarcity, choice and opportunity cost. Every economy is faced with resolving some basic economic questions,
but the manner by which they resolve these questions highlights the similarities and differences between
different economic systems. Economics is regarded as science because it involves the formation of hypothesis
about reality. Two methods of analysis used in economics are; functional representation and logical deduction.
Post-Test
1. Define economics?
2. Define the following economic concepts:
a. Scarcity.
b. Choice.
c. Opportunity costs.
d. Scale of preference.
3. What are the six basic problems faced by every economic system?
4. Why do you feel that economics is a science subject?
References
Aboyade O. (1983) Integrated Economics: A Study of developing economies: Addison-Wesley Publishers Ltd.
Edwin Mansfield (2000) Microeconomics Ninth Edition Norton Publisher.
Jhingan M.L. (2007) Microeconomic Theory. Sixth Edition Vrinda Publications (P) Ltd.
Joel N. Okafor (2005). Essentials of Modern Economics. Joanee Educational Publishers Ltd.
Oyeniyi T. A. (2005) Microeconomics , Theory and Applications. Third Edition; Cedars Publishers (Nig) Ltd.
Skaggs,N.T. and Carlson J.L(1996).Microeconomics: individual choice and its Consequences: Blackwell
Publishers, Second edition.

LECTURE TWO
Basic Concept of Price Theory and Introduction to the Theory of

Demand and Supply
Introduction
In the previous lecture, you were introduced to the subject matter of economics. You also know the basic
concepts which underlined the study of economics. In lecture two you will be taken through the normal process
of market mechanism. All the concepts and discussions in this lecture are those things you are already familiar
with. However, a scientific presentation of such a 'daily affair' is made in this lecture.
Objectives
1. explain what is meant by demand and factors that affect it;
2. explain what is meant by supply and the factors which affect it;
3. comprehend the determination of prices in a free market;
4. explain the differences between change in demand and changes in quantity demanded; and
5. explain the different concepts under the theory of demand and supply.
Pre-Test
1. What do you understand by the term market?
2. Define the following terms.
a. demand
b. supply
c. equilibrium price.
3. What is the difference between wants and effective demand?
4. Give four factors that would influence your demand for a commodity?
5. Can you distinguish between a change in supply and changes in quantity supplied?
CONTENT
Agent in the Economy and the Institution of the Market
It is possible to identify three principal agents in the economy. These are: the households, the firms and the
central authorities.
The household is the smallest economic unit. The main objective of the household is to maximize its
satisfaction. All their decisions are towards the fulfillment of this objective. In addition, it is assumed that all
resources in the economy are owned by the household.
Firm is the second principal agent in the economy. They are charged with the responsibility of turning inputs
into outputs of goods and services. They do this by purchasing resources from the households. The goal of the
firms is the maximization of their profits.

Central authorities embody all the agents and institutions of the government. That is, the police, the civil
service, public corporations and other bodies owned or under the control of the government.
Market
If you are asked what a market is? The natural answer that will come to your mind is that it is a place where
buyers and sellers come together to transact business. However, this definition is highly restrictive. The benefit
of civilization has made it possible to look beyond this narrow definition of the market. It is now possible for
transactions of the market to be carried out across international borders. Thus, market can be defined as "an
area over which buyers and sellers negotiate the exchange of a well defined commodity".
Public versus Private Sector

The public sector refers to all production activities that are in the hands of the public while private sector refers
to all production that are in private hands. The distinction between the two is a function of the ownership of
means of production. In the private sector, organization of production revolves round the individuals and firms,
and in the public sector, it is owned by the state. The predominance of either the public or private sector in an
economy determines the nature of the economy system. The Socialist system is characterised by the dominance
of the public sector while in the Capitalist system it is the other way round.
The Elementary Theory of Demand and Supply

In a free market economy, the interplay of the forces of demand and supply determines the allocation of
resources in the economy. Hence, it will be useful to have a basic understanding of the nature of these forces
and their interplay in order to have a good grasp of the economy.
The Nature of Demand

Demand is the amount of a commodity that consumers are willing and able to buy at a given price and over a
period of time. Two things immediately come to mind here. First, is the notion of effective demand which simply
means demand backed by ability to pay? This separates demand from ordinary wants. The second thing which
comes to mind is that demand is a flow concept. It encompasses the dynamism of time. Demand is only mean-
ingful when it is related to a given period of time say a week, a month, a year, etc.
It is also useful to distinguish between individual demand and market demand. While the former term is
very clear, the later term simply refers to a horizontal summation of all individual demand curves.
Factors Influencing Demand

Various factors determine the quantity of a commodity consumers are willing and able to buy over a given
period of time. These factors include:
1. Price of the commodity
2. Prices of other related commodities
3. Size of the household income
4. Tastes and Fashion
5. Population size of the society
6. Income distribution.
We can formulate the above relationship between demand and factors influencing it in a formalized
manner. This is called demand function. It can be expressed as
qdn = D (Pn,P1, ..., Pn-1. Y, T, X, YD)
Where qdn is the quantity demanded of commodity n;
Pn is the price of the commodity, P1 ... Pn-1 is a shorthand notation for the prices of other commodities, Y is
household's income, T, tastes of the household members, X is the population, and YD is the distribution of
income in the society.
At this juncture, we shall digress and examine a typical demand curve and its characteristics. The table below
shows a hypothetical relationship between the price of oranges and the quantity demanded.
Table 2.1: A household's demand schedule of oranges

Price (N) Quantity demanded
(per month)
10 30
20 25
30 20
40 15
50 10
The above schedule can then be converted into a demand curve by plotting the price on the y axis and
quantity demanded on the x axis.
Price
50
40
30
20
10 D
0 10 15 20 25 30 Quantity
Fig. 2.1: A household's demand curve for oranges.
The demand curve shows at a glance the price-quantity relationship. For instance from Fig. 2.1, we can see
that when price per ton of oranges is N50.00, 10 oranges were purchased per month. Quantity however rose to
30 when the price fell to N10.00 per ton.
This functional relationship expressed by the demand curve can be written as
Qdo = f (Po)
That is, quantity demanded of oranges is a dependent function of the price of oranges.
This functional relationship however assumes that other factors affecting demand such as income, tastes,
etc are held constant.
Characteristics of Demand Curve

There is an inverse relationship between demand and price. That is to say, when price falls, quantity demanded
increases and vice-versa. This makes the demand curve to be downward sloping. The reasons for this are
obvious.
1. When price falls, more people who were unable to purchase the commodity at a higher price can now
afford it.
2. Those who are already buying might increase the quantity they purchase. (Note that when price falls,
marginal utility becomes greater than price, hence to equalize them, households needs to increase their
demand).
3. If the good has a substitute, people might buy less of the substitute and now consume more of the good.
Factors Affecting Demand

Earlier on in this chapter, we enumerated the factors that affect quantity demanded. A brief discussion of these
factors at this juncture might be appropriate.
1. Price of the commodity: As we have seen in our earlier discussion, there is an inverse relationship between
price and quantity demanded. When the price of a commodity falls, the quantity demanded of the
commodity will increase, all things being equal. This relationship is pictorially summarised in Fig. 2.1.
2. Prices of other related commodities: For any two different commodities, there are two possible
relationships. Either they are substitutes or complements. One example of each here will suffix. Fish and
meat can be regarded as substitutes while petrol and car are complements. Whereas there is no direct
relationship between biro and fish, however, when the price of fish increases relative to meat consumers
will shift to meat and vice versa. However, for complements, for example, car and petrol, a fall in the price
of car will lead to increase in the demand for car and by extension petrol. Hence, there is a negative
relationship between the price of one and the quantity demanded of the other complement good.
3. The size of the household's income: Ordinarily we would expect a rise in income to be associated with a
rise in the quantity of goods demanded. Commodities that obey this rule are called NORMAL GOODS.
Two possible exceptions need to be noted. In some cases, a change in income might leave the quantity
demanded completely unaffected. This is especially true when the consumer has been satiated. In the case of
the other commodities, it is possible for a rise in income beyond a certain level to lead to a fall in the quantity
that the household demands. This is particularly true of INFERIOR GOODS like potatoes, gari, etc.
The three cases enumerated above are shown in the curves below
Income
Fig. 2.2 the relationship between the quantity of oranges demanded and household income
Curve 1 is the case of normal goods. Curve 2 illustrates the case of inferior goods while Curve 3 represents
a situation where income no longer affects demand after Y2.
4. Tastes and Fashion: Tastes and fashions change with time. When taste change in favour of a particular
commodity, then demand for such commodity will increase. For instance, when in the '70's it was
fashionable for women to wear wigs, the demand for wigs shot up.
5. Population size: The size and distribution of the population also affects demand. For a big country, the
total demand for commodities will be higher than that of a small country.

6. Distribution of Income: If income is evenly distributed, there will be greater demand for commodities than
when it is skewed to a particular income group.
Changes in Demand
There are two basic changes in demand. These are:
i. Change in quantity demanded and
ii. Change in demand
i. Change in quantity demanded involves the movement along the demand curve. The motivating factor
here is the price of the commodity with all other factors affecting demand being held constant. e.g
movement from point A to B.
Fig. 2.3 Movement along a demand curve
ii. Change in demand on the other hand involves the shift in demand curve either outward or inward. See
Fig.2.4
Fig. 2.4 Shift in demand curve.
In the case of a change in demand, price is kept constant while other factors affecting demand are allowed
to vary, e.g. income, taste, population size, etc.
Exceptional Demand Curve

The first law of demand and supply states that the lower the price, the greater the quantity demanded of a
commodity and vie-versa. However, there are some situations and commodities which do not conform to this
'law'. In other words, the above law is modified to read "the higher the price, the greater the quantity
demanded". In such cases, the demand curve is upward sloping. (See figure below).

Figure 2.5: Exceptional demand curve

In Fig. 2.5, when price increase from P1 to P2' the quantity demanded of a commodity also increased from q1
to q2. Various reasons have been adduced to account for this strange behaviour. Such reasons include:
Ostentatious purpose, given goods, and expectation of future rise in price.
Elementary Theory of Supply

Supply refers to the amount of a commodity producers are willing and able to offer for sale at the market ruling
price over a given period of time. Again, like demand, supply is a flow concept.
Factors Influencing Supply

Several factors influence supply of a commodity.
These include the following:
1. The Price of that Commodity: As the price of the commodity increases there will be an increase in the
quantity supplied and vice versa. This is so because the goal of the supplier is profit maximization. The
relationship between price and quantity supplied is direct. The higher the price, the higher the quantity
supplied and vice versa.
Fig. 2.6 The Supply Curve
2. Prices of other Commodities: As the price of other commodities increases, production of the commodity
whose price does not rise becomes less attractive than it was previously. Hence, ceteris paribus, the supply
of the commodity will fall as the prices of other commodities rise.
3. The Prices of Factors of Production: An increase in the price of a factor of production will increase the cost
of production of goods that makes use substantially of that factor and only a small increase in the cost of
producing those commodities that use a small amount of such factors. This will therefore change relative
profitability of different lines of production. This will cause producers to shift from one line to another
and so cause changes in the quantities of the various commodities that are supplied.
4. The Goals of Firms: If producers of some commodities wants to sell as much as possible, even if it costs
them some profits to do so, more will be offered for sale than if they wanted to make maximum profits.
If producers are reluctant to take risks, we would expect smaller production of any good whose
production is risky.
5. The State of Technology: Improvement in methods of production automatically leads to increase in
output. With modern pace of industrial development there is now increased and varied output of all
goods.
All these factors influencing supply can also be functionally represented:
qS n = quantity supplied of commodity n
Pn = Price of the Commodity.
Pi... n-l = Price of other commodities
Pf = Price of factors of production
Te = technology
S
Therefore q n = S (Pn, Pi ... n-l, Pf, Te)
To derive a supply schedule and curve, the equation above reduced to qsn = f(Pn) where Pi, ..., n-l, Pf, Te are
all constant,
The table below represents a hypothetical supply of oranges over a month.
Table 2.2. Supply Schedule of Oranges for a Month

Price (N) Qs/Kg
10 100
20 150
30 200
40 250
50 300
The corresponding supply curve is as shown below:
Price
50 +
40 +
30 +
20 +
10 +
0 100 150 200 250 300 Quantity
Fig 2.7 Supply Curve of oranges

Supply curve shows a direct relationship between prices and quantity supplied. That is, the higher the price,
the greater the quantity supplied and vice versa. This is the second law of demand and supply
Change in supply versus change in quantity supply

As in demand, there are also two basic changes in supply. The first is the change in supply which is the shift of
supply curve either forward or backward. This shift is however independent of own-price change. It is elicited
by other factors affecting demand other than the price of the commodity itself. (Fig.2.7b).
A change in quantity supplied results in different quantities of the commodities being supplied at different
prices, other factors remaining constant. This change in quantity supplied leads to a movement along the same
supply curve. Fig.2.8a.
Change in quantity supplied Change in supply
Fig. 2.8.a Change in quantity supplied

Fig. 28.b Change in supply
Exceptional Supply Curves

Whereas a normal supply curve slopes upward from left to right, we sometimes have a supply curve that does
not follow this pattern.
1. Fixed Supply Curves:
Fig. 2.9 A fixed supply curve.
In the above case, a change in price does not elicit supply response, this is particularly true of those goods
whose supply cannot be increased. E.g. land.
2. Backward Bending Supply Curve: This depicts the response of labour to changes in wage rates. Initially, a
worker would tend to work more when his present wage is increased. However, increase over time will
actually make the worker to prefer leisure to work since by working fewer hours he will still be
comfortable.
Wages

24 hours labour/leisure
Fig. 2.9 Supply of labour.
Determination of Market Price

At this juncture, we need to bring together our knowledge of demand and supply in order to determine the
market equilibrium price. The objective of economics is to achieve market clearance. At equilibrium, the market
is stable.
Using our various examples of Demand and Supply, we have
Price(N) Quantity Quantity Supplied

Demanded
50 100 400
40 150 350
30 250 250
20 300 200
10 350 150
Putting the above information in a diagram we have
Price S
D
50 *
40 *
30 *
20 *
10 *
S D
0 100 150 250 300 350 400 Quantity
Fig. 2.10 Equilibrium Price Determination.

Thus for any price other than N30.00 equilibrium will not be achieved in the market. Thus N30.00 is called
the EQUILIBRIUM PRICE which is a general term referring to the price at which quantity demanded equals quan-
tity supplied. The amount that is bought and sold at the equilibrium price is called the EQUILIBRIUM QUANTITY.
The equilibrium point is both stable and unique.

Shifts in Demand and Supply
It is relevant at this juncture to examine the effects of shifts in either the demand or the supply curve on price
and quantity.
We start by considering an increase in demand. In Fig. 2.11, the original demand and supply curves are Dl
and S1 respectively. The corresponding price and quantity are PI and ql. Now assume that the demand curve
shifts to D2.
Fig 2.11 The effects of shifts in demand curve.
With this shift in demand, excess demand (q3 ql) develop at price p1, this therefore forces the price up until
equilibrium is achieved at price P2 and demand falls to q2. When this price is attained, quantity demanded once
again equals the quantity supplied. This analysis establishes our first implication concerning the effects of shifts
in demand and supply curves. A rise in the demand for a commodity caries on increase in both the equilibrium
price and the equilibrium quantity bought and sold and vice-versa. The effect of a rise in supply is shown in fig.
2.12.
In the figure 2.10 above, demand and supply are only equal when price is N30.00. At this price, quantity
demanded and quantity supplied equal 250. At this point, the quantity the sellers are willing to sell equal to the
quantity the buyers are prepared to buy. In this situation the market is cleared and excess demand and supply
are zero. At any other price above or below N30.00, there is excess supply or excess demand respectively. When
there is excess demand, households will be unable to buy all they demand; when there is excess supply, firms
will be unable to sell all they wish to supply. In both cases there is no harmonization of activities.
However, in such a situation, traditional economists believe that equilibrating forces will be thrown into
action and bring about equilibrium. When there is excess supply, producers unable to sell all they brought into
the market will be forced to reduce their prices. As they reduce their prices, demand will increase and this will
continue until price falls to N30.00, in which case demand will be equal to supply.
On the other hand, when there is excess demand, for example, at price N20.00 demand is greater than
supply. This will make households to compete among themselves offering higher prices. These higher prices
would induce supplies.
S1
Price D S2
P2
P1
S1

S2 D
0 q1 q2 q3 Quantity
Fig. 2.12 the effects of shifts in the Supply Curve
The shift in the supply curve is to the right, from Sl to S2 indicating an increase in supply. At each price more
is now offered for sale than was previously offered. This time, however, the shift of the curve causes a glut to
develop at the old equilibrium price. When the curve shifts the quantity offered for sale increases from ql to q3
but the quantity demanded remains uncharged at q1. The excess supply causes price to fall. The fall in price
causes supply to diminish and demand to expand; this process continues until equilibrium is again achieved at
price P2 and quantity demanded and supplied are equal at q2. This gives us our second implication: A rise in the
supply of a commodity causes a decrease in the equilibrium price and an increase in the equilibrium quantity
bought and sold
Summary
Demand is the amount of a commodity that a consumer is willing to buy at a given price over a period of time.
Demand is also a flow concept. Several factors influence the amount of a commodity demanded by consumers.
Such factors include: the price of the commodity, prices of other related commodities, income of the consumers
population, taste and fashion, etc.
The first law of demand and supply states that, the lower the price the higher the quantity demanded and
vice-versa. However, we have seen that it is not in all cases that this law is obeyed. Exceptions to the law are
found in the case of inferior goods, ostentations goods, etc.
Supply on the other hand is the amount of a commodity that sellers, are willing to sell at a given price over
a period of time. Several factors also affect supply. These are, price of the commodity, prices of other
commodities, cost of production, weather, etc. You are also made aware of the exceptional types of supply
curves we have, i.e. the fixed supply curve, the backward sloping supply curve, and expectation to future rise in
price.
You were further told that equilibrium price is determined at the intersection of demand and supply curves.
At this equilibrium price, there is no excess demand or excess supply, demand is exactly equal to supply.
Post Test
1. What is demand?
2. Distinguish between change in quantity demanded and change in demand.
3. What are the factors that influence quantity demanded?
4. State the first law of demand and supply? Are there exceptions to this law?
5. Why do the quantities demanded of a commodity vary inversely with its price?
6. Explain what you understand by equilibrium in economics.
References
Jhingan M. L. (2006) Modern Microeconomics. Second Edition Vrinda Publications (P) Ltd.
Joe U. Umo (2007). Economics; An African Perspective. Second Edition. Millennium Text Publishers Ltd
Lipsey, R.G ; and Chrystal, A.K (2004) Economics: Oxford University Press. Tenth Edition
Robert, F; and Bernanke, B. (2001) Principles of Economics: McGraw Hill Irwin. Second Edition
Skaggs, N.T. and Carlson J.L. (1996).Microeconomics: individual choice and its Consequences: Blackwell

LECTURE THREE
The Theory of Consumer Demand
Introduction
By now you are already conversant with the basic concepts of demand and supply. You should not be surprised
to know that although these concepts seem elementary, they are the foundation of economics. Some people
have even said that economics is simply the study of demand and supply.
In this lecture, we shall extend our knowledge of economics further to include the elasticity of demand and
supply. The laws of demands and supply states that when price changes quantity demanded and supplied will
also change, ceteris paribus. What this law fails to tell us however is the extent of change of either quantity
demanded or supplied to a little change in price.
Price elasticity of demand and supply tries to measure the degree of responsiveness of demand and supply
to a change in price.
Objectives
1. explain the meaning of elasticity of demand and supply;
2. discuss how to calculate elasticity of demand and supply;
3. familiarise with the different types of elasticity we have; and
4. discuss the factors which affect elasticity of demand?
Pre-Test
1. Define price elasticity of demand.
2. What do you understand by the following concepts?
a. elastic demand
b. inelastic demand
c. perfectly inelastic supply
d. unitary elastic supply
3. Distinguish between income and cross elasticity of demand.
4. Mention four factors that determine the nature of elasticity of demand for a commodity.
5. What is the formula for calculating price elasticity of demand?
CONTENT
Price Elasticity of Demand
Price elasticity of demand is defined as the responsiveness of demand to a little change in price. In other words,
we are interested in knowing by what percentage demand will change if price is changed by a given percentage.
Price elasticity is usually symbolized by the letter , and it can be defined in equation form as:
`

Percentage change in quantiy demanded of Commodity x
= (-1) Percentage change in price of commmodity x
This is the percentage method. The formular can be simplified thus:
New demand Initial demand

Initial demand
New price initial price
Initial price
qq
= P
P
q P
= p q
Negative sign (-) is introduced in the formula in order to avoid a negative solution. In other words, to avoid
dealing with negative numbers we multiply the equation by (-1).
There are various types of price elasticity of demand. These include:

1. Elastic Demand: This occurs when a little percentage change in price brings about a greater percentage
change in quantity demanded. That is, the numerical value of is greater than unity.
Fig. 3.1 Elastic Demand Curve

In the figure above, a little change in price (P1 - Po) has brought about a greater quantity change (q1 - qo).
Examples of goods with elastic demand include durable goods like cars, shoes, etc.
2. Inelastic Demand: This occurs when a percentage change in price brings about a lesser percentage
change in quantity demanded. Here the value of is less than unity.
Fig. 3.2 Inelastic Demand Curve

Examples of commodities with inelastic demand include salt, matches, cigarettes, etc.
3. Unitary Elasticity Demand: This occurs when a percentage change in price brings about the same
percentage change in quantity demanded. In this case, assumes the value of unity.
De
Fig. 3.3 Unitary elasticity demand
4. Perfectly or completely or infinitely elastic demand
Fig. 3.4 Perfectly elastic demand.
The consumers in this case are prepared to buy all they can see or find at price P1 and none at all at a price
slightly higher than Pl. It is perfectly elastic since a small change in price will bring about an infinitely large
change in demand. The value of in this case is infinite.
5. Perfectly Inelastic Demand: Here a given percentage change in price brings about no change in quantity
demanded. In this case, the consumer is perfectly satiated and a change in price will not have effect on
its demand. The numerical value of n is zero.
E
Fig. 3.5 Perfectly Inelastic Demand Curve
Some Numerical Examples

Table 3.1
Changes in Prices and Quantities for two Commodities
Initial New Initial New
Commodit Price (N) Price (N) Quantity Quantity

y

Bread N40.00 N60.00 500 300
Cigarette N10.00 N25.00 20 18
Using our elasticity formula to derive the elasticity of demand for bread:
q P
= (-1) q P
= ( 1) 300 - 500
500
60 - 40
40
( 1) -200
= 500
20
40
= ( 1) -200 40
500 20
= 4
5 = 0.8 (inelastic)
However, the above is for an increase in the price of bread. For a fall in price in which case the initial price
and quantity of bread are N60.00 and 300 respectively while the fall in price to N40.00 per loaf increases the
demand to 500 loaves. The elasticity of demand becomes:
q P
n = (-1) q P
= (-1) 500-300
300
40 - 60
60
= (-1) 200
300
- 20
60
= (-1) 200 60
300 -20
= 6
3
= 2 (elastic).
The point we are trying to make in this example is that elasticity value depends on the direction of

movement of price. To avoid getting double value for our elasticity we can take percentage change in price to
be the change in price divided by the average price. And the percentage change in quantity to be the change
in quantity divided by the average of the original and new quantities. Hence our new elasticity formula becomes:
n = (-1) q
q1 + q2
2
P
P1 P 2
2
(-1) q P1 + P2
________ ______
q 1 + q2 2
______ ______
2 P
(- 1) 200 40 + 60
= _______ ______
300 + 500 2
______ ______
2 - 20
= -200 100
800 2
2 -20
= -200 1 100 1
800 2 2 -20
= 5/2 = 2.5 (elastic).

Hence, by taking the average of the original and the new prices or quantities we can get a single value for
our elasticity irrespective of direction of movement of the change.
Note: Candidates are required to try the same process for the change in price of cigarette.
Demand Elasticity and Total Expenditure

Money spent by the purchasers of a commodity is received by the sellers of the commodity. The total amount
spent by purchasers is thus the gross revenue of the sellers. Often in economics, we are interested in knowing
how total expenditure by purchasers .of a commodity or total gross receipts of sellers of the commodity reacts
when the price is changed.
If the price of a product falls, there will be an increase in quantity sold; what happens to total revenue
depends on the amount by which sales rise in response to a given price cut. Usually this depends on the elasticity
of demand for the commodity. If elasticity of demand exceeds unity (demand elastic), a fall in price increases
total consumer expenditure and a rise in price reduces it.
If elasticity is less than unity (demand inelastic) as fall in price reduces total expenditure and a rise in price
increases it.
On the other hand, if elasticity of demand is unity, a rise or fall in price leaves total expenditure unaffected.
The simple case of our bread producer can illustrate our discussion above. While the price of bread was
N60.00 per loaf, the producer was able to sell 300 loaves, making total revenue of N18, 000.00. However, by
reducing his price to N40.00, he is now able to sell 500 loaves, making total revenue of N20, 000.00. Thus, for the

seller of a commodity that has elastic demand, it is advisable to reduce price in order to increase revenue.
Determination of Elasticity of Demand

1. Availability and cost of close substitutes: If a commodity has a close substitute whose price does not
change, a rise in price of the commodity will divert consumers expenditure from the commodity to the
substitutes. Hence, its demand becomes relatively price elastic. Examples are butter and margarine,
Toyota cars and Datsun cars, etc.
However, when there is no close substitute for a given commodity, e.g. salt, housing, etc., a change
in their prices will bring little change in quantity demanded. Hence, they have inelastic demand.
2. Necessities and Luxuries: Commodities can be classified into two; necessities and luxuries. Necessities
have highly inelastic demand. This is because they are necessary to life and when their prices rises
consumers have no choice but to cut back expenditures on other products and go on buying the
necessities e.g. salt, pepper, housing, etc.
On the other hand, luxurious goods are dispensable and hence when their prices rise, people will in
fact dispense with them; thus they have a highly elastic demand e.g. cars, shoes, etc.
3. Durability/Time: In the area of time, what is relatively inelastic in the short run will be relatively elastic in
the long run. The reason is that there will be an adjustment. Secondly, in the long run, substitutes could
be developed. Also, while durable goods are price elastic, non-durable goods in most cases are price
inelastic.
4. Habit: Goods such as cigarettes to which some people are strongly addicted usually have inelastic
demand. Changes in price might not bring about a change in demand.
Other Demand Elasticities

Beside the commodity's own price, it is important to know how changes in income and the prices of other
commodities can affect Quantity demanded
a. Cross Price Elasticity of Demand: This measure the responsiveness of quantity demanded of one
commodity to changes in the prices of other related commodities. It can be defined in equation form as
Percentage change in quantity demanded of commdity x
c = Percentage change in price of commodity Y
Cross price elasticity can vary from minus infinity to plus infinity. Complementary goods have negative cross
elasticities and substitute goods have positive cross elasticities. Bread and butter, for example, are
complements: a fall in the price of bread causes an increase in the consumption of both commodities.
Changes in the price of bread and the quantity of butter demanded as a result will therefore have
opposite signs.
Fig.3.6 Effect of a fall in price of a commodity on quantity demanded of its complement

Butter and margarine on the other hand are substitutes. A fall in the price of butter increases the quantity
of butter demanded but reduces the quantity of margarine demanded. Changes in the price of butter and in the
quantity of margarine will therefore have the same sign.

Fig. 3.7 Effect of a fall in price of a commodity on quantity demanded of its substitute
However, in a situation where there is no relation between two commodities, we may expect their cross-
elasticities to be close to zero.
b. Income Elasticity of Demand: Income elasticity measures the response of quantity demanded to
changes in income. Mathematically, this can be expressed as
Percentage change in quantity demanded
y = Percentage change in Income
For most commodities, increases in income leads to increase in demand, and income elasticity is therefore
positive. Goods with positive income elasticities are called normal goods. Goods with negative income elas-
ticities are called inferior goods; for them a rise in income is accompanied by a fall in quantity demanded. Normal
goods are much more common than inferior goods. The boundary between normal and inferior goods occurs
when a rise in income leaves quantity demanded unchanged so that income elasticity is zero.
The three phases of income elasticity of demand is illustrated in the figure below:
Fig. 3.8 A relation between expenditure on a single commodity and household income
Elasticity of Supply
Just as elasticity of demand measures the responsiveness of quantity demanded to little changes in price so also
the elasticity of supply measures the responsiveness quantity supplied to little changes in the price of the good
produced. However, in this paper we shall focus mainly on the commodity's own price. For this reason we shall
be concerned mainly with Price elasticity of Supply.
Elasticity of Supply is defined as the percentage change in quantity supplied divided by the percentage
change in price that brought it about. Letting the Greek letter epsilon E, stand for this measure its formula is
Percentage change in quantity supplied
E= Percentage change in price
Since the supply curves slopes upward from left to right, elasticity of supply, as defined by the above formula
will normally be positive. As with demand elasticity, it is best to calculate elasticity of supply by percentage
changes on the average of the new and old prices and the new and the old quantities when applying the above
formula.
Interpreting Supply Elasticity

The figures below illustrate 3 cases of supply elasticity.
1. The case of zero elasticity is one in which the quantity supplied does not change as price changes. This
would be the case, for example, if suppliers persisted in producing a given quantity q1 in Fig. (3.9a) and
dumping it on the market for whatever it could bring.
Fig. 3.9a fig. 3.9b
Price
0 Quantities
Fig 3.9c Unit Elasticity of Supply
2. Infinite elasticity is illustrated in Fig. (3.9b). The Supply elasticity is infinite at the price P1, because
nothing at all is supplied at lower prices, but a small increase in price to P1 causes supply to rise from zero
to an infinitely large amount, indicating that producers would supply any amount demanded at that
price.
3. The case of unit elasticity of supply is illustrated in Fig. (3.9c). Any straight-line supply curve drawn
through the origin has, in fact, an elasticity of unity.
Some numerical examples of supply elasticity

Unlike demand, elasticity of supply is always positive because supply and price moves in the same direction.
Elasticity of supply is a pure number like demand.
Table 3.2 changes in prices and quantities for two commodities
Commodity Initial price New price Initial Quantity New

Quantity (N) (N)
Biro 10 20 300 400

Knife 50 80 500 1000
Es = New supply Initial supply

Initial supply
New price initial price
Initial price
Algebrically,
q P
Es =
p q
Using our elasticity formular above, we can derive the elasticity of supply for biro
q P
p q
= 400-300 100
300 = 300
20-10 10
10 10
= 1/3
= 0.33 (inelastic)
We can also calculate elasticity for a decrease in the price of biro.
Summary
Price elasticity of demand is defined as the responsiveness of demand to a change in price. There are different
types of price elasticity of demand. These are elastic demand, inelastic demand unitary elasticity demand,
perfectly elastic demand and perfectly inelastic demand.
Several factors were identified as the determinant of elasticity of demand. These include the availability and
cost of close substitutes, the degree of necessities, the period of time and habit of the consumers.
You were also made aware of other types of elasticity of demands. Firstly cross elasticity of demand which
measures the responsiveness of quantity demanded of one commodity to changes in the prices of other related
commodities. Goods that are complementary have negative cross elasticity while substitutes have positive cross
elasticity.
Secondly, there is also the income elasticity of demand. These measures the responsiveness of quantity
demanded to changes in income. Goods with positive income elasticity are called normal goods while inferior
goods have negative income elasticity.
Similarly to price elasticity of demand, you are also made to understand, the price elasticity of supply which
also measures the responsiveness of supply to changes in price.
Post-Test
1. Define price elasticity of demand.
2. With the aid of diagrams explain the following terms.
a. elastic demand
b. inelastic demand
c. perfectly inelastic supply
3. Distinguish between income and cross elasticity of demand.
4. What are the factors which you think can affect the elasticity of demand for a commodity.
5. If as a result of increase in the price of cigarette from N10 to N25 per stick, quantity demanded changes
from 20 to 18 sticks, calculate the value of price elasticity of demand for cigarette. Is the demand for
cigarette elastic or inelastic?

References
Jhingan M.L. (2006) Modern Microeconomics. Second Edition Vrinda Publications (P) Ltd.
Mankiw, N.G (1998) Principles of Economics: Dryden Press Ltd
Skaggs, N.T. and Carlson J.L (1996)Microeconomics: individual choice and its Consequences: Blackwell

LECTURE FOUR
Consumer Equilibrium
Introduction
This lecture will introduce you to the theory of consumer equilibrium. In this lecture, you will be introduced
formally to two of the most important theories of consumer behaviour. These are the utility theory and the
theory of the indifference curve. The utility theory is commonly associated with the classical economists while
the theory of the indifference curve belongs more to the modern economists.
Objectives
1. define the concept of utility theory;
2. explain why commodities have prices;
3. explain why the demand curve slopes downward from left to right; and
4. be conversant with the indifference curves and be able to perform simple manipulations with
indifference curve.
Pre-Test
1. Define the term utility.
2. What do you understand by the paradox of value? Why is water, a necessity of life cheaper than diamond
which is a luxury good?
3. State the condition(s) for consumer equilibrium?
4. Explain what you understand by indifference curve.
CONTENT
The Utility Theory
Utility can be described as the satisfaction a consumer derives from the consumption of a commodity. It is useful
to distinguish between total utility and marginal utility.
Total utility refers to the total satisfaction derived from consuming some commodities. Marginal utility on
the other hand is the change in satisfaction resulting from consuming a unit more or less of that commodity.
Utility Schedule and Graphs

The table below will help you to understand better the utility theory.
Number of plates of Total utility Marginal utility

rice consumed
0 0
1 4 4

2 7 3
3 9 2
4 10 1
5 10 0
Table 4.1 Total and marginal schedule
The marginal utility column is derived from the changes in total utility by consuming an additional plate of
rice. For instance when you increase the plates of rice you consumed form 2 to 3 plates, your total utility increase
from 7 to 9 utils. This increase in your total utility (which is 2) gives the value for marginal utility.
A cursory look at the marginal utility column in Table 4.1 will tell you one important characteristic of
marginal utility. This is the successive decline in marginal utility from additional consumption of plates of rice.
While you can observe that total utility has been increasing, marginal utility has been decreasing as
consumption of rice increases.
A question that may naturally come to your mind is, can marginal utility ever reach zero? The answer is yes,
as you can see from Table 4.1. With more commodities consumed, there is a level of marginal consumption after
which additional consumption is zero. Commodities include, water, beverages and even reading.
Figure below illustrates Total and Marginal Utilities
Fig. 4.1 Total and Marginal Utilities
Relationship between Total Utility and Marginal Utility

If total utility is increasing at a decreasing rate as depicted in our example, then the marginal utility declines with
increase in consumption. When total utility reaches its maximum point (at point C) then the marginal utility is
equal to zero. This is because after the point any additional unit consumed would lead to a fall in total utility.
The declining slope of the Marginal Utility curve reflects the law of diminishing marginal utility which states
that the more of a given commodity consumed, the less the addition to total utility.
Maximizing Utility
Certain assumptions are made with respect to the utility theory of consumer behaviour. These assumptions
include that commodities are available, prices and incomes are fixed. Perhaps, the most basic assumption is that
members of the household seek to maximize their total utility.
The basic problem that faces the household is how to adjust its expenditure and to maximize the total utility
of its members. A rational household would go about this by arranging its expenditure among commodities in
such a way that the utility gained from the last Naira spent on all commodities are equal. An example will make
this point clear. If a consumer is faced with two commodities X and Y with prices Px and Py respectively.
Furthermore, let MUx and MUy be the marginal utilities of the last unit of commodities X and Y respectively.
If marginal utility derived from the last Naira spent on commodity X is greater than that of Y: then the
consumer will continue to substitute X for Y; as quantities of X consumed increases, its marginal utility would
fall: (law of diminishing marginal utility); while the fall in quantity of Y will raise its marginal utility. This process

of substitution of X for Y will continue until the marginal utility per naira spent on X and Yare equal.
Algebraically, this implies that the ratio of MU of X to its price is equal to the ratio of marginal utility of Y to
its own price. i.e.
MUx MUy
........(1)
Px Py
This is the fundamental equation of the utility theory of demand. Each household demands each
commodity up to the point at which the marginal utility per naira spent on it is the same as the marginal utility
per naira spent on every other commodity. When this condition is met, the household cannot increase its total
utility by shifting a kobo of expenditure from one commodity to another.
For consumer equilibrium, two conditions must be met. The first is the one given by equation (1) above.
That is the ratio of marginal utility of one commodity to its price is equal to the ratio of marginal utility of the
other commodity to its own price.
The second requirement is that the total expenditure on the commodities be equal to the household's
income. That is in our former example
XPx + YPy = I. . . . . . . . . . . . . . . . (2)
where XPx is total expenditure on good X,
YPy is total expenditure on Y.
I is total income.
Px and Py represents price of X and price of Y respectively.
Re: Paradox of Value:

Early economists were unable to explain the paradox of value because they erroneously believed that
commodities with high total utilities should be expensive because people valued them highly and vice-versa.
They were thus arguing that market values should be related to total utilities. These economists referred to
market values as exchange values and to total utilities as use values. They posed their problem by saying what
use values should be, but were observed not to be related to exchange values.
However, we know that in real life, market behaviour is not related to total utility but marginal utility.
Water is cheap because there is so much of it that people consume it to the point at which marginal utility
is very low and they are not prepared to pay a high price to obtain a little more of it. Diamonds are very expensive
because they are scarce and people have to stop consuming them at the point where marginal utility is still high.
Thus, consumers are prepared to pay a high price for an additional diamond consumed.
Indifference Theory
The indifference theory of household behaviour was developed by Sir John R. Hicks in his book, Value and
Capital, published in 1939. The major innovation of this theory was that unlike the utility theory, it did not invoke
the notion of a measurable concept of utility.
An Indifference Curve
An indifference curve shows all combinations of commodities that yield the same level of satisfaction to the
household. A household is indifferent between the combinations indicated by any two points on one
indifference curve.
Bundle Clothing Food
A 30 5
B 18 10
C 13 15
D 10 20
E 8 25
Table 4.2: Alternative bundles of Food and Clothing giving equal satisfaction to a household
The table above could be converted into an indifference curve. See the figure below.
Fig. 4.2 An Indifference Curve
The household who owns the indifference curve above is indifferent between points a, b, c, d and e.
Features of an Indifference Curve

1. Its downward sloping indicating that if the household is to have less of one commodity, it must have
more of the other to compensate. For instance, in the figure above, for the household to move from point
a to b, it he must reduce the quantity of clothing consumed from 30 units to 18 units while quantity of
food consumed increase from 5 units to 10 units.
2 The Indifference Curve is also convex. Moving down the curve to the right, its slope gets flatter and flatter.
The slope of the curve is the marginal rate of substitution, the rate at which one commodity must be
substituted for the other in order to keep total utility constant.
An Indifference Map
A set of indifference curves is called an indifference map. The farther from the origin an indifference curve is the
higher the level of satisfaction associated with that indifference curve. Thus, any curve above and to the right of
an indifference curve will be preferred to the one below it.
Fig. 4.3: An Indifference map for the household.
The Budget Line

An important assumption under the theory of demand is that the household spends all of its income on goods
and services for current consumption; it neither spends more than its income nor saves any of it.
If for instance, we assume that a household income I is spent on two commodities, clothing and food, then
the budget line of such a household will reveal the amount of clothing and food the household could afford
given his income I, and the prices of the two commodities.
Fig. 4.4 The budget line
The Equilibrium of the Household

Whereas the indifference map describes the wish of the household (i.e. what he wants), what he could actually
demand is dictated by his budget line
Figure 4.4 below brings together the household's taste as shown by its indifference curve and possibilities
open to it, as shown by the budget line.
Fig. 4.5 The equilibrium of the household

Any point on the budget line is attainable. But the question is which one the household will choose in its
objective of maximizing satisfaction.
Suppose that it starts from point a in Fig. 4.4 where it is on indifference curve I1. If it moves to point b, it is
still on its budget line, but it has moved to a preferred position (since I2 is greater than I1). This process continues
until it reaches point c, any point beyond point c, say d or e will result in lower indifference curve.
Thus, it could be seen that the household reaches its maximum satisfaction at point c. At this point, the
indifference curve is tangential to the budget line. Hence, at point c, the slope of the indifference curve (the
marginal rate of substitution of the goods in the household's preferences is equal to the slope of the budget
line. The opportunity cost of one good in terms of the other is determined by market prices.
Effects of Changes in income and prices on the Consumer Equilibrium

A Change in Income
Changes in income lead to a parallel shift of the budget line - inwards to the origin when income falls, and
outwards from the origin when it rises. For each level of income there will be an equilibrium position at which
an indifference curve is tangent to the relevant budget line. Each such equilibrium position means that the
household is doing as well as it possibly can for that level of income.

Fig. 4.6: The Income-Consumption line.

In Fig. 4.5 as the household's income is twice increased, the budget line moves outwards from a tangency
with indifference curve I1 to I2 to I3. As we move the budget line through all possible levels of income and join all
the points of equilibrium, we will trace what is called an Income Consumption line. This line shows how
consumption bundles changes as income changes, with relative prices held constant. In other words, income
consumption line shows the reaction of the household to changes in its money income with money prices held
constant.
A Change in Price
A change in the relative price of the two commodities, food and clothing changed the slope of the budget line.
For instance, given a budget line ab, a half cut in the price of food, (Pr) while price of clothing (Pc) is kept constant
shifts the budget line to ag and if price is doubled the price increase will' shift the budget line to ah.
Fig. 4:7: The price consumption line.

Therefore the locus of tangency between an indifference curve and a budget line as the prices of food
changes while price of clothing is held constant, gives, the Price Consumption line. This line shows how consump-
tion of the two commodities varies as the price of one changes, the price of the other and the household's money
income being kept constant.
Summary
In the course of this lecture you have been introduced to some important concepts in consumer equilibrium
theory. These include utility and the indifference curve theory.
These two different theories are alternative ways of explaining consumer behaviours. However, while utility
curve is based on the assumption of cardinal analysis (i.e. it is measurable) that of the indifference curve is ordinal
(in other words, analysis is not based on measurability of consumer satisfaction).
Post-Test
1. Define the term utility.
2. What do you understand by the 'paradox of value'? Explain using water and diamond as illustration.
3. State the condition(s) for consumer equilibrium.
4. Define the following concepts.
a. Total utility
b. Marginal utility
c. price consumption line
d. Income consumption line.
References
Lipsey, R.G; and Chrystal, A.K (2004) Economics: Oxford University Press. Tenth Edition

LECTURE F1VE
The Theory of Supply
Introduction
In the last previous three lectures we have been concerned with the behavior of one of the agents in the
economy - the household. In this lecture, we shall lay the foundation for the study of behaviour of another
important economic agent - the firms.
A firm is the economic agent which is concerned with the production and sale of commodities. A firm covers
all types of business organisations from the sole proprietorship to Joint Stock Company.
Objectives
At the end of this lecture, you should be able to discuss the basic concepts which underline the operation of this
important economic agent.
Pre-Test
1. What is the driving objective of a firm?
2. Define the following economic concepts;
a. cost
b. profit
3. Distinguish between short run and long run in economics.
CONTENT
The Theory of Supply
The main assumption underlying the study of firms in economics is that they seek to maximize their profit in
other words; the goal of every firm is to maximize profit. This assumption is useful because it helps us to
understand and also predict the behaviour of the firms under different situations.
However, this assumption is not always true in real life because many firms often have more than one
objective such as, increasing scale of operation, creating goodwill among its customers, etc. Hence the firm
always seeks to pursue its activities in such a way that acceptable balance is forged among these different
objectives.
In spite of this obvious limitation, economic analysis of the firm still assumes that the goal of the firm is profit
maximization. Profit ( ) is the difference between revenue realized from the sale of commodities (R) and the
cost of producing these commodities (C) i. e.
= R C.
In other words, it is possible to break the activities of the firms into two, its revenue and cost of production.
It is in respect of these two concepts that much of the theory of supply is based. Cost refers to the monetary
value of producing a particular commodity.
However, this is the accountant's definition of cost. To an economist, "cost of using some thing in a particular
venture is the benefit foregone by not using it in its best alternative use. However, computational problems
arise from this definition. While some costs are easily identifiable and can be estimated, deriving the opportunity
costs of some others may be subjective.
A cost must also be assigned to factors of production that the firm neither purchases nor hires because it
already owns them. The cost of using such factors is called imputed costs. They are estimated at values reflecting
what the firm could earn if it shifted these factors to their next best use.
Exceptional Supply
An exception to the law of supply has been found in the backward bending supply curve. This is based on the
postulate that although an individual will normally be willing to offer more hours of work L, with increasing
wage rate W, a point will be reached where any additional increase in wage rate will lead to a desire for more
leisure and therefore a decrease in the number of hours offered for work, thus the supply curve for an individual
is shown below.
O L
Fig. 5.1 Exceptional Supply Curve
Short run, Long run and the Very Long run

Short run or long run does not refer to a specific calendar period. It refers to the time period necessary for
economic resources to adjust its condition. The short run is defined as the period of time over which inputs of
some factors, called fixed factors, cannot be varied. In the short run, production may be varied by changing the
quantities used of those inputs that can be varied; these are called variable factors.
The long run is defined as the period long enough for the inputs of all factors of production to be varied,
but not so long that the basic technology of production changes. The special importance of the long run in
production theory is that it corresponds to the situation facing the firm when it is planning to go into business,
or to expand or to contract the scale of its operations.
Unlike the short and the long run, the very long run is concerned with situations in which the technological
possibilities open to the firm are subject to change, leading to new and improved products and new methods
of production.
Summary
In this short lecture we have tried to highlight some important concepts which are fundamental to the theory
of the firms. You have been told that it is possible to actually divide the study of behaviour of the firm into two.
The first is its revenue behaviour while the second is the cost behaviour.
You were also made to realise the distinction between the two time dimensions which depends on whether
some factors are fixed or not. When some inputs or factors of production are fixed, then we talk of short run and
vice-versa for long run, i.e. all factors become variable.
Post-Test
1. The only goal of the firm is profit maximization. True or False
2. Define the following economic concepts:
a. cost

b. profit
3. Distinguish between short run and long run in economics?
References
Mankiw, N.G. (1998) Principles of Economics: Dryden Press Ltd.

LECTURE SIX
The Production Function
Introduction
In our previous lecture, we mentioned that one of the major functions of the firm is to turn inputs into outputs
of commodities. The technological process of performing this important function is called production function.
In other words, the production function shows the technological relationship between inputs and outputs. It
shows the maximum units of output to be expected from a given input combination. In this lecture, you will be
introduced to the important concepts of the theory of production in economies.
Objectives
1. explain what production function in economics is all about; and
2. be familiar with important concepts under the theory of production.
Pre-Test
1. Define the following concepts
a. Total product
b. Average product
c. Marginal product
2. What do you understand by the 'law' of Diminishing Returns?
CONTENT
The Production Function
You have been told that the production function expresses a technological relationship between inputs and
outputs.
In mathematical notations, a production function can be written as
q = f (Xi, Yi). (1)
Where
Xi = variable factors
Yi = fixed inputs
i = 1n.
In most treatment of production function in economics, two major factors of production are usually
presumed to be adequate for expressing production relations. These are labour and capital. This will then give
a simple production function as:
q = f (K, L).. (2)
Where q is tons of output per given time, say a day, L is total labour hours/days employed while k is

employed as units of capital services (e.g. machine days) used.
You would realize that since output depends on inputs, in order to increase total output then the inputs
used must also be increased. But the firm cannot vary all its inputs with the same ease. For instance, while it is
easy to increase the number of workers at very short notice, it takes a relatively longer time to install a new
production plant.
Usually a commodity may be produced by various methods of production. For example a unit of commodity
X may be produced by the following processes:
Process A Process B Process C

Labour Units 3 4 5
Capital Units 4 3 2
Activities may be presented graphically by the length of lines from the origin to the point determined by
the labour and capital inputs. The three processes above are shown in fig 6.1.
K
4 A
3 B
2 C
0 3 4 5 L
Fig 6.1 Production Processes
A method of production A is technically efficient relative to any other method B, if A uses less of at least one
factor and no more from the other factors as compared with B. for example, commodity Y can be produced by
two methods:
A B
Labour 3 4
Capital 4 4
Method B is technically inefficient as compared with A. The basic theory of production concentrates only on
efficient methods. Inefficient methods will not be used by rational entrepreneurs. If process A uses less of some
factors and more of some others as compared with any other process B, then A and B cannot be directly
compared on the criterion of technical efficiency. For example, the activities below are not directly comparable.
A B
Labour 3 2
Capital 4 5
Both processes are considered as technically efficient and are included in the production function (the
technology). Which one of them will be chosen any particular time depends on the prices of factors. The theory
of production describes the laws of production. The choice of particular techniques (among the set of technically
efficient processes) is an economic one, based on prices, and not a technical one
The Short run

In the theory of the firm, we make a distinction between two periods of analysis - the short run and the long run.
In the short run, we assume that only few production factors can be varied while some others are fixed. On the
other hand, in the long run, all production factors are variable.
Taking the short run period; we may assume for simplicity sake, that in the production functions, labour is
variable and capital is fixed. That is to say, our equation two above can be rewritten as:
q = f (L, K ) . . . . . . (3)
Where K implies that capital is fixed
Thus in the short run, output can only be increased by increasing the amount of the variable input to a fixed
input.
It is therefore useful at this point to define some important concepts.

i. Total Product (TP)
This is the total amount produced during some period of time by all factors of production employed. If
the inputs of all but one factor are held constant, total product will change as more or less of the variable
input is used.
i.e. q = f(L)
ii. Average Product (AP)
This is merely the total product per unit of the variable factor, which is labour in the present illustration:
AP = TP/L
iii. Marginal Product (MP)
Sometimes called incremental product is the change in total product resulting from the use of one more
(or one less) unit of the variable factor.
MP = TP/L
Where, TP stands for the change in the total product and L stands for the change in labour input that
caused TP to change.
The table below gives a hypothetical example. Capital is fixed at twenty units.
(1) (2) (3) (4)

Quantity of Total Product Average Product Marginal Product
Labour (TP) (AP) (MP)
1 6 6
2 14 7 8
3 26 8.7 12
4 37 9.3 11
5 46 9.2 9
6 52 8.7 6
7 57 8.1 5
8 60 7.5 3
9 61 6.8 1
10 58 5.8 -3
Table 6.1: Variation of output (one fixed, one variable factor).

Fig. 6.2 showing the relationship among Total Product (TP) Average Product (AP) and Marginal Product
(MP)
From both the table and the curve, it is seen that as more of the variable factor is used, average product first
rises and then falls. The point where AP reaches a maximum is called the POINT OF DIMINISHING AVERAGE
PRODUCTIVITY. At this point also, MP and AP are equal. It can also be observed from the curve that MP reaches
its maximum at a lower level of labour input than does AP.
The Hypothesis of Diminishing Returns

This is one of the famous hypotheses in economics. It is also sometimes referred to as the law of diminishing
returns. This law seeks to explain the behaviour of output as a result of applying more or less of variable factor
to a fixed factor. The law states that "if increasing quantities of a variable factor are applied to given fixed factors,
the marginal product and the average product of the variable factor will eventually decrease".
There are many practical demonstrations of this law in real life. It is the reason for the present fear about
food crisis in most countries today. In countries with a high population growth rate, it is feared that the increased
number of workers on the fixed land will bring about an inexorable decline in the marginal productivity of each
worker and thus a shortage of food output. The only way out of this trap of diminishing food returns is by im-
proving on the technique of production.
Summary
By now you would have been familiar with basic concepts in production relations. You have leant that
production function only expresses relationship between quantities of input and output.
In production function, we made distinction between the short run and the long run. This classification
depends on the variability of factor inputs. While in the short run we have fixed and variable inputs, in the long
run all factors of production are variable.
The law of diminishing returns also states that the increasing application of variable inputs to a fixed factor
of production will after a time lead to diminishing marginal output. This law you have been told is also valid in
many real life situations.
Post-Test
1. States the law of diminishing returns: Give one of its applications in real life.
2. Explain the following concepts.
a. Production function.
b. Total product.
c. Marginal product.
d. Average product.
3. Illustrate with examples your understanding of production processes
4. What is the important distinction between the short run and long run in economic analysis?
References
Koutsoyiannis, A(1979). Modern Microeconomics: Macmillan Press Ltd. Second Edition

LECTURE SEVEN
Cost Analysis
Introduction
In one of our previous lectures we defined cost in economics as an opportunity cost of a given action. Cost could
be either explicit or implicit. Explicit costs are those direct payments which a firm makes on factors of production
for their contribution towards the production process. Implicit cost on the other hand refers to the cost for a firm
using its own resources considering the fact that such resource, if put into alternative uses could be expected to
yield some returns.
Objectives
1. explain the theory of the firm; and
2. examine the important cost concepts commonly applied in economics analysis.
Pre- Test
1. What do you understand by the term 'cost' in economics?
2. With the aid of appropriate diagrams explain what you understand by the following concepts.
a. Total fixed cost
b. Average fixed cost
c. Marginal cost
d. Total cost
e. Total variable cost
3. Explain the relationship between marginal cost and average cost functions.
CONTENT
Short run Cost Functions
A firm's cost will vary, depending on whether they are based on the short or long run. In the short run, the firm
cannot vary the size of plant and equipments it uses. These are the firm's fixed inputs, and they determine the
scale of its operations.
1. Total Fixed Costs: This is the total expenditure spent by the firm on its fixed inputs over a period of time.
Since the inputs are fixed, the total fixed cost will be the same whatever the firm's level of output. Ex-
amples of fixed cost include, managers salaries, rent, interest on bonds issued in the past, depreciation
of machinery etc. The figure below shows an example of fixed cost. The total fixed cost function is always
a horizontal line, since fixed costs do not vary with output
Costs

N100 fixed cost
0 1 2 3 4 Quantity
Fig 7.1 Fixed cost
2. Total variable Cost: This represents the firm's total expenditure on variable inputs per period of time. Since
higher output rate requires greater utilization of variable inputs, this implies higher total variable cost.
For instance, a firm that wants to increase output will need to employ more labour, purchase more raw
materials, etc. All these will add to total cost of the firm. Example of total variable cost is illustrated by the
figure below:
Fig. 7.2: Total Variable Cost
The shape of the total variable cost looks like that of an inverted 'S'. This is due to the law of diminishing
marginal returns, total variable cost increases first at a decreasing rate, then at an increasing rate.
3. Total Costs: This is the sum of total fixed cost and total variable cost.
This is illustrated below:
Cost
Fig 7.3 Total Cost

The total cost curve has the same shape as the total variable cost curve, since they differ by only a constant
amount (equal to total fixed cost).
Average Costs in the Short Run

An entrepreneur cares about his average cost as well as the total cost incurred in his operations, so do
economists. Average cost tells how much a product costs per unit of output. There are three types of average
cost functions, one corresponding to each of the three total cost functions.

Fig. 7.4 Average Fixed Cost Curve
1. Average Fixed Cost: This is simply total fixed cost divided by the firm's output. Average fixed cost (AFC)
must decline with increases in output, since it equals a constant total fixed cost divided by the output
rate.
2. Average Variable Cost: This is total variable cost divided by output, the average variable cost (AVC) is
shown below:
Fig. 7.5 Average Variable Cost Curve

From the figure above we can see that at first, increase in the output rate results in decreases in average
variable cost, but beyond a point, they result in higher average variable cost. This is because the law of
diminishing marginal returns is in operation. As more and more of the variable inputs are utilized, the extra
output they produce decline beyond some point, so that the amount spent on variable inputs per unit of output
tends to increase.
3. Average Total Cost (ATC): This is simply the total cost divided by output. At any level of output, average
total cost equals average fixed cost plus average variable cost. This is easy to prove.
Total Cost Total Fixed cost total variable cost

A TC Output output
total fixed cost total variable cost

= output output
= Average Fixed Cost + Average Variable Cost

The fact that average total cost is the sum of average fixed cost and average variable cost helps explain the
shape of the average cost function, if, as the output rate goes up, both average fixed cost and average variable
cost decrease, ATC must decrease too. But beyond some point, average total cost must increase because
increases in average variable cost eventually more than offset decreases in average fixed cost. However, average
total cost achieves its minimum after average variable cost, because the increases in average variable cost are
for a time more than offset by decrease in average fixed cost.
Marginal cost in the Short Run

Marginal cost is the addition to total cost resulting from the addition of the last unit of output. Algebraically, this
can be expressed as
TC TCn 1 TCn
MC = Q = Qn 1 Qn
where MC = Marginal cost, D represents change, TC is total cost and Q is output. The subscript n, n + 1 are present
and next period changes in the cost and output variables.
In general, marginal cost will vary depending on the firm's output level.
Figure 7.7 shows the marginal cost function graphically.
Fig. 7.7: Marginal Cost.
Figure 7.7 indicates that marginal cost, after decreasing with increases in output at low output levels,
increases with further increases in output. In other words, beyond some point it becomes more and more costly
for the firm to produce yet another unit of output.
Relationship between Marginal Cost and Average Cost Functions

The relationship between the marginal cost function and average cost functions must be noted. Figure 7.8
shows the marginal cost curve together with the three average cost curves.

Figure 7.9: MC, APC, AVC and ATC curves.
The traditional theory of cost postulates that in the short run the cost curves (AVC, ATC and MC) are U shaped
reflecting the law of Variable proportion. The minimum point of the ATC occurs to the right of the minimum
point of the AVC. This is due to the fact that ATC includes AFC, and the latter falls continuously with increases in
output. After the AVC has reached its lowest point and starts rising, its rise is over a certain range offset by the
fall in the AFC, so that the ATC continues to fall despite the increase in AVC. However the rise in AVC eventually
becomes greater than the fall in the AFC so that the ATC starts increasing. The AVC approaches the ATC
asymptotically as output increases.
The long run Average cost curve is derived from short run cost curves. Each point on the LAC curve
correspond to a point on a short run cost curve, which is tangent to the LAC at that point (see fig 7.9)
Cost
LAC
Output
Fig. 7:10 Long Run Average cost curve
Let us examine the U shape of the LAC. This shape reflects the laws of return to scale. According to these
laws, the unit costs of production decreases as plant size increases, due to the economies of scale which the
larger plant sizes make possible.
Summary
The cost function is the mirror-image of the production function. The short run cost curve, total fixed costs, total
costs, total variable costs are all the opposite of their corresponding production functions.
You were also shown the relationship between the marginal cost function and the average cost function.
The marginal cost curve intersects both the average variable cost curve and the average total cost at their
minimum point. When the marginal cost is greater than average cost the average cost must be rising and vice-
versa. This therefore implies that the average cost can be only at a minimum when it equals the marginal cost.
The long run cost functions also plays important role in the decision making of the firm, - especially during
the planning period. In the long run, the firm will be optimal when it operates at the minimum point on its long
run average cost curve.
Post-Test
1. Explain carefully the following- terms:
a. fixed cost
b. average cost
c. marginal cost
d. average fixed cost
e. variable cost
2. Why does the marginal cost curve intersect the average variable cost curve at the latter minimum point?
3. Why is the long run cost curve important in firms decision making?
4. Explain carefully your understanding of the term 'cost' in economics?
References
Koutsoyiannis,A(1979). Modern Microeconomics: Macmillan Press Ltd. Second Edition
Mankiw, N.G(1998) Principles of Economics: Dryden Press Ltd.

LECTURE EIGHT
The Equilibrium of a Profit Maximizing Firm
Introduction
You will recollect that we said in lecture five that the objective of the firm is profit maximization. In the present
lecture we shall develop the rules for profit maximizing behaviour which applies to all firms whether perfect
competitive, monopolist, etc. It will also furnish you with preliminary knowledge of much of what we shall be
discussing in the next few lectures.
Objectives
1. explain all revenue concepts; and
2. explain behavioral rules for profit maximization.
Pre- Test
a. Total revenue
b. Average revenue
c. Marginal revenue
2. What are the rules that determine whether a firm is maximizing its profit or not at the present level of
output.
CONTENT
Definition of concepts
Revenue refers to the total amount of money which a firm realises from the sales of its products. Revenue can
be sub-divided into three. That is:
1. Total Revenue (TR): This is also called revenue. It is the total amount that a firm receives from the sales of
its products. In normal cases, this revenue will vary directly with the firms sales. That is to say, the higher
the quantity of the products sold, the higher the total revenue of the firm.
Total Revenue is equal to the quantity sold multiplied by the selling price of the commodity, i.e.
TR = Pq.
Where P is the price per unit, q is the quantity
2. Average Revenue (AR): This is the total revenue divided by the quantity of the products sold.
i.e. AR = TR/Q.
You will notice that this is also equal to the price of the commodity.
3. Marginal Revenue (MR): This is the change in total revenue resulting from increases in total sales by one

unit per period of time.
i.e. MRn = TRn + 1 - TRn
Where n refers to the number of units sold.
Behavioural Rules for profit Maximization

There are essentially three rules here. We shall now discuss these three rules one after the other.
a. A rule to decide whether to produce or not to produce

A firm has the option of either producing or not to produce at all. If it produces nothing it will have an
operating loss equal to its fixed cost. The firm will however choose the option of producing provided the
output produced will add more to total revenue than to costs. Thus, the first rule is that a firm should
produce only if total revenue is equal to or greater than total variable cost". Put differently, a firm should
produce only if average revenue (i.e. price) is equal to or greater than average variable cost.
b. A rule to ensure that profit are either at a maximum or at a minimum

A firm needs to decide on how much of a good it should produce. Generally, it pays a firm to increase its
output when marginal revenue of the last unit she produces is greater than its corresponding marginal
cost. If on the other hand, the firm finds that the marginal cost of an additional unit of output exceeds
the marginal revenue that firm should reduce output.
Thus the second rule states that if a firm is to be in a position where it does not pay its output i.e. in a
profit maximizing position - it is necessary that marginal cost be equal to marginal revenue.
c. A rule to ensure that profit is maximized rather than minimized

The fulfillment of the second rule however does not guarantee that profit if it exists is at a maximum. The
figure below will help you in understanding our point here.
Fig. 8.1: Minimum and Maximum Profit Positions

Marginal cost = marginal revenue is a necessary but not a sufficient condition for a maximum profit.
In fig. 8.1, There are 2 output levels q1 and q2 that satisfy rule two (that MR = MC). Output q1 however is a
minimum profit position because a change in output in either direction would increase profit.
On the other hand output q2 is a maximum profit position since at output, above it MC exceeds MR and
profit can be increased by reducing output towards q2.
Thus the condition for profit maximizing output is that the mc curve should intersect the MR curve from
below. This ensures that MC < MR to the left of q2 and MC > MR to the right of the profit maximizing output.
All the above three rules determine the output that will be chosen by any firm that maximizes its profits.
Summary
Profit which is the difference between revenue and cost is the most important driving force for a profit
maximizing firm. In this lecture you have been told the principal rules that determine whether a firm is
maximizing profit or not. These three rules can be stated briefly as follows:
1. Total revenue should be equal to or greater than total cost.
2. At the maximum output level, marginal revenue should be equal to marginal cost.
3. The MC curve should intersect the MR curve from below.
Post-Test
a. Total revenue
b. Marginal revenue
c. Average revenue
2. What are the rules that ensure that a firm is maximizing its profit at its present level of output?
References
Koutsoyiannis, A. (1979). Modern Microeconomics: Macmillan Press Ltd. Second Edition
Mankiw, N.G (1998) Principles of Economics: Dryden Press Ltd.

LECTURE NINE
The Theory of Perfect Competition
Introduction
A useful method of market classification is the degree of competition available. Hence, a distinction is usually
made between perfect and imperfect competition.
The theory of' perfect competition is built on a number of assumptions. These are:
1. The firm is assumed to be a PRICE TAKER. This means that no individual is so big as to influence the market
price. Hence, the firm must accept as given whatever price is ruling in the market.
2. The industry is also characterised by freedom of ENTRY AND EXIT. This implies that any firm is free to join
or leave the industry. Existing firms cannot bar the entry of new firms and there are no legal restriction
on entry' or exit.
3. The industry or market includes a LARGE NUMBER OF FIRMS (AND BUYERS), so that each individual firm,
however large, supplies only a small part of the total quantity offered in the market. The buyers are also
numerous so that no monopolistic power can affect the working of the market.
Other important assumptions includes: perfect information about market prices, perfect mobility of
products dealt with, While it is perfectly true that a market structure in which all these situations are present is
rare in the real world, we have some approximations, e.g. agricultural goods and industrial raw materials. In spite
of this, there is no doubt that perfect competition is an ideal situation.
Objectives
At the end of the lecture, you should be able to:
1. discuss the characteristics and behaviours of the perfect competitive market;
2. discuss the main features of perfect competition;
3. discuss both the short run and long run equilibrium condition of the market; and
4. discuss the relationship between the firms, market supply and the marginal cost curve.
Pre-Test
1. What are the major features of a perfect competitive market?
2. What is the nature of demand curve faced by an individual in a perfect competitive market/industry?
3. The firm in a perfect competitive industry cannot make profit both in the short and long run, True or
False? Explain.
4. Distinguish between the short run and long run equilibrium position of a firm in a perfect competition.
CONTENT
Demand and Revenue Curve of the Perfectly Competitive Firm
A firm in a perfect competition is a price taker; therefore it faces a perfectly elastic demand curve for its products.
Also, since the market price is unaffected by changes in its output, it follows that the marginal revenue resulting
from an increase in volume of sales is constant and equal to the price of the product. An example will make this
point clearer. Lets assume that a farmer faces a perfectly elastic demand for yam at a market price of NI00.00
per tuber. This implies that for each additional tuber sold, the farmer would realise N100.00 (this is his marginal
revenue). But this amount is also his average revenue (which is total revenue divided by number of units sold).
Thus, the demand curve facing the firm is then identical with both the average marginal revenue curve. Thus, P
= AR = MR: all remaining constant as output varies. It is however, important to mention that since price is
constant, each additional unit sold will increase total revenue of the farmer. It therefore follows that total
revenue rises steadily as output rises.
Price
TR
TR
AR = MR = P
P TR2
TR1
Output Output
O q1 O q1 q2
Fig 9.1a Average and marginal revenue

Fig 9.1b. Tota1 Revenue
Short Run Equilibrium

Equilibrium Output of a Firm in Perfect Competition
Since the term in perfect competition faces a given market price the firm adjusts to different market situations
by changing its output. But, in the short run the firm is faced with a set of fixed and variable factors. Hence, its
practical method of adjustment is via the variation of its output decision.
Perfect competitive firm like any profit maximizing firm will seek to produce at the point where marginal
revenue is also equal to the marginal cost. And since, marginal revenue of a firm is also equal to its price; it
follows that the firm will equate marginal cost of its product with the price of its output. Hence, the short run
equilibrium position of the firm can be represented as follows.
Fig. 9.2. The equilibrium output of the perfect competitor

Any other output is inefficient. For instance at output q2, MC > P, thus it will pay the firm to reduce its output.
Conversely, at output ql, price > MC and it pays the firm to increase its output level.
It should be reiterated that in the short run, the firm can make profit or losses or break-even. The actual
position of the firm depends on the position of the average cost. If at the equilibrium output level of the firm,
price is greater than its average cost then it will make profit. On the other hand, it could make a loss if it is not
covering average cost. Even when the firm is making a loss at this point, it could still continue in business
provided it is able to cover at least its average variable cost (AVC).
Short run Supply Curves

The supply curve shows the relation between quantity supplied and price. As we said earlier the competitive

firm is a price taker. Therefore in order to derive its supply curves we need to know how much the firm will supply
at each different prices.
The figure below shows a firm's marginal cost curve with three alternative demand curves. The marginal
cost curves show the quantity the firm is willing to supply at each price level. For prices below AVC, the firm will
supply zero. For prices above AVC, the firm will equate price and marginal cost
Fig 9.3. i. MC and AVC curves ii. The supply curve
As price rises in the figure from 2 to 3 to 4, the firm wishes to increase its production from ql to q2 to q3. For
prices below N2; output would be zero because the firm is better off if it shut down. The point El where price
equals AVC is called the shut-down point. These points are then transferred to curve ii to show the supply curve.
In perfect competition therefore the part of the firm's MC curve above the AVC curve has the same shape as
the firm's supply curve.
The Determination of short run equilibrium price:

The equilibrium price in the industry is determined by the forces of demand and supply in the industry.
The industry's supply curve is simply the horizontal sum of the marginal cost curves of all the individual
firms in the industry. Lets assume there are two firms A and B in the industry. If their individual supply curves
are as shown below, then the industry supply curve is simply the horizontal summation of the two supply curves.
Fig. 9.4: The derivation of an industry supply curve
Although, no one firm can influence market price significantly, the collective actions of all firms in the
industry (as shown by the industry supply curve) and the collective actions of the households (as shown by the
industry's demand curve) together determine the market price at the point where demand and supply curves
intersect. (See Fig. 9.2 (iii) above.
At this equilibrium point, there is stability in the market and there is no motivation to change in the short
run. Also each firm is operating at the profit maximizing point at which its price is equal to its marginal cost.
Long Run Equilibrium

The long run equilibrium under perfect competition is characterized by free entry and exit. Earlier, we have said
that in the short run equilibrium situation, firms may be making profits or losses or just breaking even. If existing
firms are making profits, new firms may be attracted to the industry to share in the profit. On the other hand, if

existing firms are making losses, some firms will leave the industry and seek better returns elsewhere. However,
when firms are just breaking even, there is no incentive for other firms to enter the industry or for firms in the
industry to leave. These three situations can be further illustrated as follows
i ii iii
Fig. 9.5: Alternative Short Run Equilibrium Position of a Competitive Firm.
In Fig.9.5 (i), firms in the industry are making losses since price is lower than SRATC. This will force some
firms to leave the industry for elsewhere. When this happens, supply will decrease and price will increase. This
will continue until Fig. 9.5 (ii) position is attained. The converse argument holds for Fig. 9.5 (iii).
In the Long run equilibrium situation three distinct features are obtained.
1. No firm will want to vary the output of its existing plants. Short run marginal cost (SRMC) must equal
price.
2. Profits earned by existing plants must be zero. This implies that short run ATC must equal price.
3. No firm can earn profits by building a plant of a different size. This implies that each existing firm must
be producing at the lowest point on its long run average cost curve.
These conditions mean that all firms in the industry should be in the position illustrated in Fig. 9.6.
Fig. 9.6: The equilibrium position of a firm when the industry is in the long run equilibrium.
In the above situation, the firm is operating the optimum plant size (as represented by the minimum point
on its LRATC). Any plant size to the left or right of qx would be sub-optimal and it will pay well to advice the firm
to increase or decrease output as the case may be as regards its existing plant size.
An industry is nothing more than a collection of firms; for an industry to be in long run equilibrium each firm
must be in their long run equilibrium. It follows that when a perfectly competitive industry is in long run
equilibrium, all firms in the industry will be selling at a price equal to SRATC that is, and they must be in zero
profit equilibrium.
Summary
Perfect competitive market is characterised by certain attributes. These include, free entry and exit, perfect
information by the sellers and buyers, large number of buyers and sellers, homogeneity of products sold and no
discrimination by seller or buyer. The perfect competitive market is however very rare in the real life.
Like any other profit making organisation, the perfect competitive producer output equilibrium is at a level
where its price is equal to marginal cost. Although the firm in perfect competition can make profit or loss in the
short-run, in the long run the firm can only break into the industry if it is making excess profit other firms will be
attracted into the industry and if it is a loss, it will quit the market.
The industry supply curve is simply the horizontal summation of the individual firm's marginal cost curves.
And for the industry to be in the long run equilibrium, individual firms in the market must be in long run
equilibrium.
Post-Test
1. Explain the main characteristic of a perfect competitive market.
2. Why does the firm in perfect competition face a perfectly elastic demand curve?
3. Why must a perfect competitive firm in the long run be just breaking even?
References
Skaggs, N.T. and Carlson J.L. (1996). Microeconomics: individual choice and its Consequences: Blackwell

LECTURE TEN
The Theory of Monopoly
Introduction
A monopoly and a perfect competition represent two polar extremes of market situation. Monopoly occurs
when there is a single seller in the market. In this case, it is impossible to distinguish between a firm and an
industry. Also unlike the firm under perfect competition which cannot influence market price, a monopolist has
power to influence the market price. By changing the level of his output, it can influence the ruling price level.
There are two major features of the market. First, a monopolist firm is the only producer of its product.
Hence, the demand curve it faces is the market demand curve.
Secondly, the average revenue of the monopolist which is the same as the market demand curve is
downward sloping. Furthermore, the marginal revenue curve is not equal to the demand curve. This second
feature represents a major difference between this type of market and that of perfect competition.
Objectives
1. discuss the main features of monopoly;
2. discuss equilibrium position of the monopoly;
3. explain the reasons for the existence of monopoly; and
4. discuss the difference between ordinary monopoly and price discriminatory monopoly.
Pre-Test
1. What are the distinguishing features of a monopolist?
2. What are the difference (s) between the cost and revenue curves of a monopoly and a perfect
competitive firm?
3. Describe the equilibrium position of the monopolist? Is there any difference between the equilibrium
position of a firm and an industry under a monopoly market?
4. What are the factors that give rise to or maintain a monopoly?
CONTENT
The Relationship between a Monopolist's Average and Marginal Revenue
You were informed in the introductory section of this lecture that there are some important differences between
the average and marginal revenue cost of the monopolist and the perfect competitive firm. Under perfect
competition, both the marginal and average revenue curves are the same and perfectly elastic. In the case of
the monopolist, both are downward sloping and they are not equal. The marginal revenue curve is below the
demand curve, since the sale of an extra unit reduces the price at which all the units are sold resulting in a net
addition to revenue of an amount less than its own selling price.

A simple example can be used to illustrate our discussion at this juncture.
Table 1: Alternative price and sales combination for a monopolist with the corresponding revenue
curves.
Price Rate of sales Total Marginal Average
per year revenue revenue revenue
Scenario 1 N30.00 100 N3000 30
Scenario 2 N29.50 102 N3009 N4.5 29.5
Scenario 3 N29.00 104 N3016 N3.5 29
In Table 1, you can see that when the price of the commodity is N30.00, the monopolist was making a sale
of 100 units per year bringing total revenue of N3000. However , for the monopolist to boost its sales to 102
units he has to reduce price, this reduction will not only affect the 102 units but all the previous 100 units, this
will lead to increase in total revenue, However, the marginal revenue N4.5 is below the price and the average
revenue.
The relationship between total, average and marginal revenue is illustrated below:
Fig. 10.1: The relationship between total, average and marginal revenue.
The Equilibrium of a Monopolist

The technological facts of life are the same for the monopoly as for a competitive firm, so the short run cost
curves have the same stage in both cases. The difference lies in the demand conditions. While the perfectly
competitive firm is faced with a perfectly elastic demand for its product, the monopoly is faced with a downward
sloping demand curve.
Fig. 10.2: Monopoly Downward Sloping Demand Curve

The equilibrium output and price are ql and Pl. This equilibrium meets the several conditions for profit
maximizing behaviour. Marginal cost equals marginal revenue; marginal cost cuts marginal revenue from below;
and price is greater than average variable cost.
The net profit in this case is represented by the shaded portion. However, there is nothing that guarantees
that a monopolist will make profit in the short run. Whether he makes profit or not depends on the position of
the ATC. Where the ATC is tangential to the demand curve, the monopolist earns zero profit and output ql as
shown below:
Firm and Industry, Short run and Long run

A monopoly is the only producer in an industry. Thus, there is no distinction between the firm and the industry.
Unlike under perfect competition where there is no barrier to entry, the existence and continuous operation
of a monopolist depends on its ability to bar other firms from entering into the industry where he is largely
successful. There might not be much difference between the short run and long run equilibrium position of the
firm. In other words, if the firm is making profit in the short run, this can also extend into the long run if it can
successfully discourage other firms from coming into the market.
Reasons for the Existence of Monopolies

1. Patent Laws: Patent laws may create and perpetuate monopolies by conferring on the patent holder the
sole right to produce a particular commodity. The government may grant a firm a charter or a franchise
that prohibits competition by law.
2. Economies of scale: Monopolies may also rise because of economies of scale. The established firm may
retain a monopoly through a cost advantage because it can produce at a lower cost than could any new
and necessarily smaller competitors.
3. Access to Raw Materials: In a situation where one firm has the sole access to the raw material used for
producing a commodity, other firms may not be able to enter into the industry
4. A monopoly may also be perpetuated by force: Potential competitors can be intimidated by threats
ranging from sabotage to a price war which the established monopoly has sufficient financial resources
to win.
Price Discrimination
In general, price discrimination occurs when a producer sells a commodity to different buyers at different prices
for reasons not associated with differences in cost. For example, doctors, lawyers, barbers sometimes vary their
fees according to the incomes of their clients. Cinemas also charge lower admission prices for children.
Price discrimination occurs because different units of a commodity can be sold at different prices, and it will
be profitable for the seller to take advantage of this if he can.
However, for price discrimination to be possible, certain conditions must be present. First, that it can control
what is offered to a particular buyer and second, that it can prevent the resale of the commodity by one buyer
to another.
The first of the two conditions - control over supply is the feature that makes price discrimination an aspect
of the theory of monopoly. Monopoly power in some form is necessary (but not sufficient) for price
discrimination.
The second of the two conditions - ability to prevent resale tends to be associated with the character of the
product, or the ability to classify buyers into readily identifiable groups. Services are also easily resold than
goods.
Equilibrium of a Price - Discriminating Monopolist

Consider a monopoly firm that sells a single product in two distinct markets, A and B. Let's also assume that there
is no possibility of resale from one market to another. Since the firm can discriminate, it is under no obligation
to charge the same price in market A that it charges in market B. How then will it behave in each market? The
marginal cost of producing another unit for sale in market A will depend on how much is being produced for
sale in market B and vice-versa. To determine what overall production should be, we need to know the overall
marginal revenue, to find this we merely sum the separate quantities in each market that corresponds to each
marginal revenue. The firms total profit maximizing output is at Ql where MR1 and MC1 intersect at a value Cl,
the firm will allocate sales between the markets until the marginal revenue of the last unit sold in each market
are the same.
Fig. 10.4 i. Market A ii. Market B iii. Both Markets.
Summary
You have been told that a monopolist is a single seller of a commodity. He can influence either the price or
quantity sold of his commodity but not both. The revenue curves under the monopolist are downward sloping
and are not identical like the situation under perfect competition.
The equilibrium condition of the monopolist is the same with that of a perfect competitive firm. They both
produce at the point at which their marginal revenue curve intersects with their marginal cost curve. It is also
possible for a monopolist to make profit both in the short and long run.
The continuous existence of a monopolist depends on its ability to bar entry into the industry. Several
factors influence the existence of a monopolist. These include, patent laws, control over source of raw material,
government guaranteed monopoly, etc.
A discriminatory monopoly arises in a situation where a monopolist can charge different prices for different
units of the same commodity, for reasons not due to cost of production.
Post-Test
1. Distinguish between the cost and revenue curves of the monopolist and a perfect competitive firm.
2. Describe the equilibrium position of the monopoly. Is there a difference between the equilibrium
position of a firm and an industry under monopoly market?
3. What are the factors that give rise to or maintain a monopoly?
4. What is price discrimination? What is its distinguishing feature?
References
Lipsey, R.G; and Chrystal, A.K (2004) Economics: Oxford University Press. Edition


LECTURE ELEVEN
Theories of Imperfect Competition
Introduction
In the last previous two lectures, we have discussed two extreme types of markets. However, you would realise
that the two markets, that is, monopoly and perfect competition are not common in the real world rather what
one sees around is the mixture of the two extremes. The attempt to be more relevant to reality gives rise to the
study of the imperfect competition. Two foremost economists, that pioneered the study of this type of market
are; Joan Robinson and Chamberlain.
While under perfect competition, sellers face a perfectly elastic demand curve and are price takers. In all
other market forms, say for example, the monopolist monopolistic- competition and oligopoly, the firms have
some control over their price. In such circumstances we say that the firms in the latter category can administer
their own prices.
In our discussion of the theories of imperfect competition, the monopolistic-competition and the oligopoly
will be discussed. However, in the present lecture we shall discuss the monopolistic-competition.
Objectives
1. discuss the characteristics and behaviours of one of the commonest type of markets, the monopolistic-
competition; and
2. explain the major differences between this and other forms of market.
Pre-Test
1. What is monopolistic-competition? Give three examples of monopolistic-competitive firms you know in
the real world.
2. What are the differences/similarities between perfect competition and monopolistic competition?
3. Describe the conditions for equilibrium under monopolistic-competition.
4. Are there differences between the short and long run equilibrium of the monopolistic-competitive firm?
CONTENT
Monopolistic-Competition
The term monopolistic-competition describes a situation similar to perfect competition, with the singular
important difference that each producer sells a product that is somewhat differentiated from the products sold
by his competitors.
Product differentiation implies that each firm does not face a perfectly elastic demand curve. The firm is
faced with a downward sloping demand curve; implying that if the firm raises its price it will lose business to its
competitors, but it will not lose all of its customers just because its prices rise slightly (because he sells a
differentiated product). The slope of the demand curve will however depend on the extent to which the firm's
product is differentiated from its competitors.
The figure below denotes the short run equilibrium of the firm. The firm is faced with a downward sloping
but rather flat, demand curve. The firm will of course, have the usual U -shaped short run cost curve. The short
run equilibrium of the firm is exactly the same as that of a monopolist. The firm is not a passive price taker; it
may juggle price and quantity until profits are maximized. This occurs at output qt and price Pt in the figure.
Fig. 11.1: The short run equilibrium of a firm
Long Run Equilibrium

The firm shown in the figure above is earning profits equal to P1 UVW1 and if it is typical of the other firms in the
industry, new entrants will be attracted. As more firms enter, the market demand for the product must be shared
out among the larger number of firms, so that each can expect to have a smaller share of the market. Thus, at
any given price, each firm can expect to sell less than it did before the influx of new firms; each firm's demand
curve shifts left. This must continue until no profits are being earned; as long as profits exist, there is an attraction
for new firms to enter and the industry will continue to expand
The final position must be like what is indicated in the figure below. The demand curve touches the average
total cost curve at only one point, x, corresponding to quantity q1 and price P1: the demand curve is tangential
to the average cost curve at point x At this output, cost is just being covered, since average revenue equals
average total costs. Losses occur at any other level of output, since average revenue is less than average total
costs.
Fig. 11.2: The Long-run Equilibrium of a Firm under Monopolistic- Competition.

Two major lessons are derived from this equilibrium position. The first is that despite the fact that the
monopolistic-competitive firm is faced with a downward sloping demand curve; zero profit equilibrium is still
possible. The second lesson is that the firm now operates at a position of excess or unused capacity. Although
the firm could expand its output to q2 and thus reduce its ATC, but this does not pay the firm since the fall in
price would be greater than the fall in costs. Thus, the best position to operate is denoted by x above.
Advertising expenditure
Firms operating monopolistic competition engage in advertising as a means of differentiating their products
from others. A relevant question is, how much should a profit maximizing firm spend on advertising?
A very simple model expresses quantity sold as a linear function of advertising expenditure and assumes
diminishing marginal returns to advertising. An additional assumption is that changes in advertising do not alter
price or marginal cost
If price is denoted by P and marginal cost by MC, then the gross marginal profits is P-MC. By deducting
additional advertising outlay from this we obtain net marginal profit
To maximize total net profit, the firm must ensure that advertising expenditures are at the level where an
extra gross profit equals to the extra naira of advertising cost. In other words, if Q is the number of extra units
of output sold due to an extra naira of advertising, advertising expenditures must be such that
Q (P-MC) = 1
Where the right hand side represents the extra naira spent on advertising and the left hand side is the
marginal gross profit due to the last advertising naira. If both sides of the equation above are multiply by P/ P-
MC, we obtain
PQ = P
P-MC
Since for profit maximization MR must equals to MC, the equation can be written as
PQ = P
P-MR
Given that MR = P {1-1/Ed}
P
P-MR = Ed
While PQ = MR
In other words for profit to be maximized marginal revenue has to be equated with the elasticity of demand
Differences between Perfect Competition and Monopolistic-Competition

1. This is a derivative of our discussion above. The equilibrium output of the monopolistically competitive
firm is less than the output where total cost is at a minimum. (This is known as excess capacity theorem).
2. Under monopolistic-competition, equilibrium price is higher and output is lower, ceteris paribus, than
under perfect competition.
3. Under monopolistic-competition, equilibrium price is greater than marginal cost.
4. Monopolistically competitive firms will offer wider variety of brands, styles and possibly qualities than
firms in perfect competition.
5. Monopolistically competitive firms will engage in non- price competition whereas perfectly competitive
firm will not.
Summary
Monopolistic-competition refers to a market situation where there are many sellers of slightly differentiated
products. This type of market is very common in the real life. Like a monopolist, the firm in this type of market is
faced with a downward sloping demand curve. While the short run equilibrium of the firm is similar to that of
the monopolist, in the long run, no firm in the industry could make profit. Any presence of positive profit will
attract other firms into the industry bringing about increase in market supply and a fall in price. This will continue
until all excess profit has been wiped off.
Pre-Test
1. Define monopolistic-competition.
2. Illustrate the short and long run equilibrium conditions under monopolistic-competition. Are there any
differences between the two equilibria.
3. Mention the differences between monopolistic-competition and
a. Perfect competition.
b. Monopoly.
4. Highlight the similarities between monopolistic- competition and
a. Perfect competition
b. Monopoly.
5. What do you understand by advertising expenditures?
References

LECTURE TWELVE
Theories of Imperfect Competition: Pricing and Output under

Oligopoly
Introduction
This is the second form of market under the theories of imperfect competition. This market is characterised by
few firms. Most manufacturing-industries in the capitalistic economies belong to Oligopoly. A special type of
oligopoly exists. This is a duopoly, which is an industry with only two producing firms.
In this lecture, we shall examine the types of oligopoly we have, the equilibrium under oligopoly and its
other features.
Objectives
1. explain the meaning of oligopoly;
2. discuss the types of oligopolies we have;
3. explain equilibrium condition of an oligopolist; and
4. discuss
a. oligopoly
b. kinked demand curve
c. price rigidity
d. discontinuity.
Pre-Test
1. Define Oligopoly.
2. What are the types of oligopolies we have? Give examples of each.
3. Describe the equilibrium' condition for an oligopolist.
4. What are the major methods of 'warfare' among oligopolistic firms?
CONTENT
Pricing and Output under Oligopoly
Oligopoly refers to a market situation where there are few sellers of a particular commodity such that the
activities of one of the sellers are particularly important to the others. The pricing, output, sales promotional
activities of a seller must take the reactions of others into account. Usually, a single seller occupies a position of
sufficient importance (market leader) in the product market for changes in his market activities to have
repercussions on others.
Oligopolies can be classified according to the degree of collusion achieved by the three:
i. organised collusive oligopoly;
ii. unorganised collusive oligopoly; and
iii. non-collusive oligopoly.

The first one refers to a cartel arrangement whereby a central organisation is set up which determines the
output and pricing arrangement among members of the cartel. A good example of this is the Organisation of
Petroleum Exporting Countries (OPEC).
The second category goes on an informal basis. There is a gentleman agreement among members as to
prices and output decisions. However, this might not be binding on members who can flout this decision and
yet escape prosecution.
The third category is a pure oligopolistic system whereby firms take independent actions of their own.
Activities of any of the firms can lead to bitter rivalry among the firms, for instance, a price war.
Short Run Equilibrium Position under Oligopoly

For our purpose we shall take the case of non-collusive oligopoly. This one is characterised by price wars and
price rigidity. One seller may lower his price to increase sales. This takes customers away from rivals and they
may retaliate with a vengeance. The price war may spread throughout the industry with each firm trying to
undercut the others. The end result may be disastrous for some individual firms.
The 'kinked' demand curve is the analytical devise frequently used to explain oligopolistic price rigidity
curve. The framework is however based on certain assumptions. First, that the industry is a mature one, either
with or without product differentiation. A cluster of prices or a price fairly satisfactory to all has been established.
Second, if one firm lowers price, others will follow or undercut it in order to retain their shares of the market.
Thus, price decreases might not work to the advantage of the firm. Third, if one firm increases prices, other firms
may not follow the price increase. This firm would lose his customers to other firms who have not increased their
prices.
The demand curve faced by a single firm in such a situation is pictured diagrammatically in the figure below
as FDE.
Fig. 12.1: Short Run Equilibrium Position of an Oligopolistic Firm.

The firm has established a price at P. If it reduces its price below P, other firms follow and it retains his share of
the market. The demand curve faced by the firm for price increases is PD. The demand curve FDE is not smooth
but is kinked at the established price P.
The kinked demand curve has implications for the marginal revenue of the firm. The MR curve is
discontinuous at output X. The portion of the MR curve FA and SC corresponds to the two portions of the
demand curve FD and DE respectively.
Cost curves SAC and SMC are such that at price P some profit can be made. The MC curve cuts the MR curve
within its discontinuous part. Output X and price P are, in fact, the firm's profit maximizing output and price. If
output were less than X, MR would exceed MC and the firm's output would be increased by expanding output
to X. For outputs exceeding X, MC exceeds MR and profits will decrease.
One implication of the discontinuity in the MR curve of the oligopolistic firm is that as long as MC cuts MR
curve at the discontinuous part of the marginal revenue curve, there is no incentive for the oligopolist to change
either price or output. e.g. SMC
The Long Run

Two types of adjustments are possible in oligopolistic industries in the long run. In the first place, individual firms
are free to vary the size of their plant; thus the relevant cost curves for the firms are the long run average cost
curve and the long run marginal cost curve. Second, some industry adjustment may be possible in the form of
entry into the industry or exit of old firms from the industry. Non-Price Competition:
While Oligopolists may be reluctant to encroach upon each other's market shares by lowering product price,
they appear to use other methods to achieve this. Product differentiation offers a more subtle and a much safer
way of accomplishing approximately the same results, Product differentiation occurs in two major ways:
1. Advertising; and
2. Variation in design and quality of product.
Summary
You have been told that oligopoly refers to a market situation where
there are few sellers of a particular commodity such that the activities
of one of the sellers are particularly important to the others.
There are three types of oligopolies. These are
i. organised, collusive oligopoly
ii. unorganized collusive oligopoly, and
iii. (iii) non-collusive oligopoly.
A major feature of this type of market is the use of price wars and
price rigidity. Apart from price wars, the oligopolistic firms also use
other promotional methods to compete with each other.
Post- Test
1. What is oligopoly? Give examples of oligopolies in your country.
2. Describe the short run equilibrium position of the firm.
3. What are the important differences between short run and long run equilibrium condition for
oligopolistic firms?
4. What are the major methods of 'warfare' among oligopolistic firms?
References
Mankiw, N.G(1998) Principles of Economics: Dryden Press Ltd.
Skaggs, N.T. and Carlson J.L. (1996).Microeconomics: individual choice and Consequences: Blackwell

LECTURE THIRTEEN
The Demand for and Supply of Factors of Production
Introduction
From this lecture to lecture fifteen, we shall be discussing the theory of distribution. In other words, you shall be
told the factors that determine the returns earned by each factor of production, land, labour, capital and
entrepreneur.
In the present lecture, you will learn about the factors that determine the demand for and, the supply of
factors of production and how demand and supply consideration helps in determining the true quantity and
income of factors of production.
Objectives
At the end of this lecture, you should be familiar with the following:
1. the meaning of some important concepts under the distribution theory;
2. factors that influence the demand and supply of factors of production; and
3. the direction of the demand curve for factors of production.
Pre-Test
1. What are the factors you think affect the amount of money earned by a factor of production?
2. What do you understand by functional distribution?
3. What is the relationship between marginal revenue product demand curve?
CONTENT
Theory of Production
For their part in the production process, the factors of production receive income. Functional distribution of
income relates to how this income is then shared among the factors of production. However, when we classify
income according to the totality of income we are dealing with size income.
The traditional theory states that distribution is simply a special case of price theory. The income of any
factor of production depends on the price that is paid for the factor and the amount that is used. In this 'NEUTRAL
CONCEPTION OF DISTRIBUTION', income received by a factor is simply its price multiplied by the amount of the
factor used.

In Fig. 13.1, the price and quantity of the factors are p1 and q1 respectively. The total income earned by this
factor is then equal to the rectangle Op1 eq1
The Demand for Factors

In other to produce commodities, firms require the services of factors of production such as land, buildings, raw
materials, machine and equipment, etc. The demand for these factors is however conditioned on the demand
for the commodities which they help to produce. Thus we say the demand for factors of production is DERIVED
DEMAND. The aggregate derived demand for a factor in all its productive activities gives the total demand for
the factor.
The Quantity or Factor Demanded in Equilibrium
The principle governing the operation of profit maximizing firms such as monopoly and perfect competition as
we have discussed in earlier lectures is also true when it comes to their purchase of factor inputs. While it is true
that these firms produce at the point at which marginal cost equals marginal revenue, so it is true that all profit
maximizing firm, will hire a unit of the variable input up to the point at which the marginal cost of the factor (i.e.
the addition to the total cost resulting from the employment of one more unit) equals the marginal revenue is
however distinguished from the one under production by referring to it as marginal revenue product.
Marginal revenue product is defined simply as the addition to total revenue by the employment of one
additional unit of the input. This equilibrium condition for the profit maximizing firm can be written as:
Marginal cost of the variable factor (MC) = marginal revenue products of that factor (MRP)
Under perfect competitive market, the marginal cost, for example, of employing one extra person on the
payroll is the wage that must be paid to the person.
The Derivation of the Demand Curve from the Marginal Revenue Product Curve
To derive demand curve from the marginal revenue product (MRP), two assumptions are made, first, that the
firm is a price taker (in factor markets) and secondly, there is only a single variable factor of production. This
allows us to use condition (2) to derive the firm's demand for a factor as soon as we have the MRP curve.
Figure 13.2 shows a MRP for some factors. This shows how much would be added to revenue by employing
one more unit of the factor for each level of total employment of the factor, Condition (2) states that the profit
maximizing firm will employ additional unit of the factor up to the point which the marginal revenue product
equals the price of the factor.

If for example, the price were N400 per year, it pays to employ 30 workers. (There is no. point in employing
a 31st worker since that would add just less than N400 to revenue but N400 to costs, and hence would reduce
total profits).
The curve in Figure 13.3 shows the quantity of labour employed at each price of labour. This is similar to the
MRP case. For example at N400 per year, the firm will also employ 30 workers. Since Figure 11.3 relates price of
the variable factor to the quantity employed. Hence, it is the demand curve for the variable factor. Thus, the
marginal revenue product curve of a factor has the same shape as the firms demand curve for that factor.
Composition of the Marginal Revenue Product Curve

It is made up of two components, first, the physical component called the Marginal physical product (MPP),
which is the extra output produced by successive increment of the variable factor.
And secondly, the value component called the marginal revenue product (MRP). In order to be able to
convert the MPP into MRP, we need to know the value of the extra physical product. There are two cases to
consider, in a perfectly competitive market the price is given, and it accurately measures the value of an
additional unit to the firm. That is under perfectly competitive firm.
MRP = MPP Price of the Product.
If on the other hand, the firm faces a downward sloping demand curve for its product, the value to the firm
of an extra unit of output will be less than its price, because to sell the extra unit it will have to reduce the price
of all other units to be sold. Thus, we have
MRP = MPP MR associated with the sale of extra unit.
The Supply Factors

This relates to the factors determining total effective supply of land, labour, natural resources or capital to the
economy.
Labour: The number of people willing to work is called the labour force; the total number of hours they are
willing to work is called the supply of labour. The supply of labour is a function of three things:
a. Population: Populations vary in size, and these variations are influenced to some extent by economic
factors. For instance, birth rate might be higher during good times than in hard times. Much of variations
in population, is however, explained by factors outside of economics.
b. The Labour Force: The labour force varies considerably in response to variations in the demand for labour.
Generally, a rise in the demand for labour, and an accompanying rise in earnings will lead to an increase
in the proportion of the population willing to work.
c. Hours worked: The number of hours worked contributes to the supply of labour, recently, increased in
real wages in most western countries leads household to consume more commodities and also to
consume more leisure. This means that they are willing to work fewer hours per week and thus a decline
in the supply of labour.
Land: If by 'land' we mean the total area of dry land, then its supply is pretty well fixed. Rise in. earnings of land
cannot result in much of an increase in supply, unless land under water can be drained. The traditional
assumption in economics is that the supply of land is absolutely inelastic. However, if by 'land' we meant all the
fertile land available for cultivation then the supply of land is subject to large fluctuations. Considerable care and
effort is required to sustain the productive power of land, and if the return to land is low, its fertility may be
allowed to be exhausted within a short period of time. On the other hand, a high return to land may provide
incentives for irrigation, drainage and fertilization schemes that can greatly increase the supply of Arable land.
Land is also usually defined to include the natural resources found in or on it.
Capital: Capital is a man-made factor of production. The supply of capital in a country consists of the existing
machines, plants, equipments, etc. and it is called the capital stock. This capital is used up in the course of

production and the supply is thus diminished by the amount that wears out. The total amount of capital goods
produced is called Gross Investment. While net additions to the capital stock, are called Net Investment and
expenditure on capital goods is called Investment Expenditure.
The supply of capital has been observed to increase considerably over time in all modem countries. The
volume of net investment determines the rate of increase of the capital stock. There is considerable evidence
that net additions to the stock of capital vary considerably over the trade cycle, being low in periods of slump
and high in periods of boom.
Factor Mobility
This refers to the readiness of factors to respond to signals that indicate where factors are wanted. If a factor is
highly mobile in the sense that owners will quickly shift from the use of A to B in response to a small change in
the relative factor price, then supply will be highly elastic and vice versa.
Summary
In this lecture you have been taken through the fundamentals of income determination in a market economy.
The income to a factor of production is simply the product of its price and the quantity supplied. You were also
informed that the demand for factors of production is a derived demand. In other words, their demand is a
function of the demand for the products they help to produce.
Profit maximizing firms would also employ a factor up to the point at which its marginal cost is equal to its
marginal revenue product. Under a perfect competition, marginal cost is also equal to the price of the factor.
Post- Test
1. Distinguish between functional and size distribution of income.
2. What are the factors that affect the supply of labour in an economy?
3. Marginal revenue product curve and the demand curve are the same, true or false? Explain.
4. How is the price of a factor of production determined in a market economy?
Reference
Robert, F; and Bernanke, B. (2001) Principles of Economics: McGraw Hill Irwin. Second Edition.

LECTURE FOURTEEN
Wages and Collective Bargaining
Introduction
Labour is one of the most important factors of production. The income earned by labour for its production
activities is known as wages. The wages paid to labour depends on the type of labour market- perfect
competition or a monopoly and also whether there is a trade union or not. In this lecture, we shall look at the
determination of wages earned by labour.
Objectives
At the end of the lecture, you should be able to:
1. explain how wages are determined under different market situations;
2. discuss the process of collective bargaining under unionized labour situations; and
3. discuss the factors influencing the success or otherwise of collective bargaining.
Pre-Test
1. What do you understand by the term monoposonist?
2. How are wages determined under monoposonistic market situation?
3. Describe the process of collective bargaining?
CONTENT
The Determination of Wages without Unions
In the absence of labour unions, the determination of wages depends on the type of market situation. There are
two types of market situations. 'The first is where labour is supplied and demanded competitively. The second
market situation is where supply of labour is done competitively but demanded monopolistically. We shall
consider each of these situations separately.
Case 1: When labour is supplied and demanded competitively

Under perfect competition there are many buyers and sellers of labour such that no one can influence the wage.
In such a case, it is the forces of demand and supply that determines the ruling wage rate in the market and also
the size of labour employed. This situation is illustrated in the figure below.

Fig. 14:1: The determination of wages in a competitive market.
In this figure, the market wage rate is We and total quantity of employment is qe
Case 2: When labour is supplied competitively and demanded monopolistically.

Monophony refers to a market situation where there is only a single buyer in the market. In a situation where
labour is demanded monopolistically, the monopsonist can offer labour any wage rate she pleases. Workers are
however free to work at such wage rate or to seek employment in other markets.
In fixing its wage rate, the monopsonist is guided by his marginal cost curve which is also the supply curve.
The monopsonist who is a profit maximising firm will always equate the marginal cost of labour with its marginal
revenue product. He will continue to hire labour until this equality is achieved
Fig. 14.2: The determination of wages when labour is sold competitively but bought monopolistically
At equilibrium, the monopsonist will equate marginal cost with the marginal revenue product and not the
wage. But because marginal cost exceeds the wage rate, it follows, that the wage rate will be less than the
marginal revenue product. Also, since the supply curve of labour is upward sloping, the volume of employment
input will be less than it would be under perfect competition.
This analysis is illustrated in the figure above where Wc and qc are the competitive wage and the volume of
employment, while wage Wm and qm are the corresponding position under monopsony. Since the monopsonist
wishes to employ a quantity of labour equal only to qm, she needs to pay a wage of only Wm to call forth that
quantity. Thus, monopsony results in a lower level of employment and a lower wage rate than when labour is
purchased competitively
The Determination of Wages with Unions

For the moment lets assume that the union can fix any price of labour that it wishes by unilateral action or by
negotiation, but that the volume of employment is determined by the amount employers wish to hire at the
union determined wage.
Case A: When Labour is supplied monopolistically but Purchased Competitively

Lets assume that a union enters the competitive market and attempts to raise the wage above its equilibrium
level. See the figure below:

Fig 14.3: The Effect on Wages and Employment of the entry of Union into a Competitive Market.
As shown in Fig.14.3 above, if the union raises the wage from Wc to Wu this creates a perfectly elastic supply
of labour up to the quantity qu. The supply curve now becomes Wu, Y and equilibrium is at x where the demand
curve cuts the new supply curve. The union has succeeded in raising the wage rate above its competition level,
but at a cost of reducing employment qc to qa
Case B: When Labour is Supplied monopolistically and demanded Monopsonistically

Given a demand, supply and marginal cost curves as shown in the figure below, it can be proved that in this
market, the union can raise wages by substantial margin and at the same time raise the volume of employment.
In the figure, the wage and employment levels without a union are Wm and qm. Now assume that the union
negotiates a wage of W1. This creates the kinked supply curve W1 xS and a marginal cost curve W1xyMC. The
monopsonistic purchaser of labour will now be in equilibrium of employment qt, since up to that level of
employment the marginal cost of labour is less than the marginal revenue product, while for levels above ql, the
reverse is true. The union has raised both wages and employment.
Fig.14.4: The Effect on Wages and Employment of the entry of a Union into a Monopsonistic Labour
Market
The above result is achieved because before the entry of the union, the monopsonist: purchases kept
employment down because it was aware of those already employed. The introduction of the union wage now
faces the purchaser with a perfectly elastic supply curve, so that there is no point in keeping employment low
for fear of driving up the wage.
Collective Bargaining
The term collective bargaining refers to the whole process by which unions and employers (or their
representatives) arrive at and enforce agreements. it usually describe a situation of monopoly versus
monopsony in which there is one seller, the union, and one buyer, either a single firm or an employers'
association.
Under collective/bargaining both sides must agree to the wage. There is always a substantial range for
compromise. In particular cases, the actual range will depend on the goals of the two negotiating parties.
Methods and the Objectives of the Modern Union Wages

The major objective of modern unions is to seek and obtain a favourable wage rate for their members. Unions
try to achieve this by using either or a combination of two alternatives. The first is to try to determine the quantity
of labour supplied and then let the wage be that which equates to demand and supply.
The second policy is to restrict entry into the occupation by methods such as lengthening apprenticeship

periods and rationing places for trainees. Such tactics will make it more expensive or otherwise more difficult to
enter the occupation. Thus, at any given wage rate, the quantity supplied will be reduced; and the supply curve
shifts to the left and thus wage rate increases.
Which of the two tactics that will appeal to a particular union will depend on many factors, such as the ease
with which supply can be restricted, the ease with which unions wages can be negotiated and enforced, and
the public reactions to these two tactics in particular situations.
Wages versus Employment

In many cases (as shown in our previous examples), the union faces a trade off between wages and employment.
But in some cases it is possible to avoid the conflict by bargaining with the employer about both wages and
employment. This can be accomplished by meaningful agreements thereby forcing employers to use more
labour than they need for a given level of output; such agreements are very common in the U.K.
Wages versus Job Security

Union leaders are also much concerned about job security of their members. They adopt both defensive and
offensive attitude to the labour market.
Summary
The return to labour, one of the factors of production is wages. In the lecture you would have found out that the
determination of a wage is not a straight matter. It depends on the type of market in which the labour operates.
For instance, under perfect competition, wages are determined at the point of intersection between the demand
and supply curve of labour. But where labour is unionised, conditions under which labour is made to work is a
jointly agreed process by which this is done has been described as "collective bargaining".
Post-Test
1. What is meant by the term monopsonist?
2. How are wages determined under monopsonistic market situations?
3. Describe the process of collective bargaining.
4. What are the factors which influence the process of collective bargaining between labour unions and
employers?
References
Joe U. Umo (2007). Economics; An African Perspective. Second Edition. Text Publishers Ltd
Skaggs, N.T. and Carlson J.L. (1996). Microeconomics: individual choice and its Consequences: Blackwell

LECTURE FIFTEEN
The Pricing of Factors in Competitive Markets
Introduction
One distinguishing feature of the market economy is that resources allocation is done by the forces of demand
and supply. Not only does the market determine the amount of commodities bought and sold but it also
determines the prices paid to factors of production and the total income received by each factor.
In this lecture, we shall look at the dynamics of price determination and the failure of market forces in the
real life when pricing of factors are concerned.
Objectives
1. explain why different or the same factors earn different prices; and
2. explain the difference between economic rents and transfer earnings.
Pre-Test
1. How are factor prices determined in a competitive market economy?
2. Why are different units of the some factor e.g. labour paid different prices.
3. Distinguish between transfer earnings and Economic Rent in Pricing of factors.
CONTENT
Pricing of Factors in Competitive Market
Under the traditional theory of factor pricing, factor prices are determined at the point at which their demand is
equal to the quantity of factor services supplied.
Given a hypothetical situation, when there is only one factor of production in which all these units are
identical and also subject to the same conditions of service, then one would expect that there will be mobility.
From occupations with low prices to occupations with high price and that this process will continue until the
price paid to the factor is' the same in all its uses.
However, in real life, a number of factors combine to make the discussions above an ideal "case. Looking
around you; you will see different units of the same factor, say labour are paid different amounts in different
Occupations. Several reasons account for this.
1. The difference in the quality of labour in terms of experience and skill. A university graduate deserves to
earn more than a non-graduate in the same job, all things being equal.
2. Workers in growing industries often earn higher pay than their counterparts in declining industries.
Perhaps, the attractiveness of a banking job to many people today can be a good illustration of our point
here.
3. The social prestige associated with different occupation. For instance, an individual in the academics
might be willing to earn less than his counterpart in the private sector because of the social prestige
which is attached to being a university don.
4. Differences in the degree of difficulty or unpleasantness of the work. For example miners work under
unpleasant conditions relative to farmers
5. Differences in the risk of occupation. For example a racing driver or an air plane pilot runs more Risks
than a college teacher
6. Differences in the stability of employment. Construction work and athletic coaching are subject to
frequent layoffs and hence have little job security, whereas tenured university teachers have a high level
of job security
Transfer Earnings and Economic Rent

The discussions on earnings of factors bring us to the difference on transfer earnings and economic rent. Transfer
earnings are the amount that a factor must be paid in order to remain in its present place of employment. It is
the minimum price that the factor is willing to take to continue in employment.
Economic rent on the other hand is the amount which a factor receives in excess of these transfer earnings.
It is the difference between the factor's actual earnings and its transfer earnings.
In real life, the total amount which a factor is paid is a composite of these two types of payments. It is
possible, however, to imagine limiting cases in which all earnings fall into either of these categories. Consider
the case of a firm which is faced with a perfectly elastic supply curve of a factor of production; it will be possible
to obtain any quantity of this factor at the going rate but, at any lower price, it will be unable to obtain any of
the factors. In such a case, which is illustrated in Fig. 15.1, the whole price paid to the factor represents transfer
earnings.
Fig. 15.1 transfer earning

All of the incomes earned by the factor are transfer earnings. Let us consider another case, say that of a
factor which the owner put up for sale at any price on the belief that any earnings, is better than nothing at all.
Let us assume further that the supply of this factor is fixed and the factor is owned by several people such that
there is no incentive for any of the owners to withhold his supply. In this case, the whole amount paid to the
factor is economic rent because even if a lower price were paid the factor would still be supplied. Figure 15.2
below illustrates this analysis.
Fig. 15.2 Economic Rent
In the figure above, the total earnings which is equal to the rectangle OPeq1 is economic rent. We have said
earlier on that most of the earnings in real life are made up of economic rent and transfer payments. This is a
normal feature for normal behaved demand and supply curves. All the areas below the supply curve represents

transfer earnings and others above the supply curve up to the equilibrium price represents economic rent. The
figure bellow illustrates our argument here.
Price D S
P3
P2
P1
S D
0 Q1Q2 Q3 Quantities
Fig. 15.3 Transfer Earning and Economic Rent
Some of the factors earned by the factor are transfer earnings and the remainder is an economic rent.
P2 and Q2 represent equilibrium price and employment level respectively. The prices represent the amount
that will guarantee the employment of the total labour q2. For each unit below the total employment q3, say q2,
the workers would be prepared to receive a price less than p3 i.e. p2, but since all the workers q3 would now be
paid p3, therefore, the amount above p2 to p3 represents economic rent to all q2 workers.
The following example will drive home our point here: If universities increase the salary paid to lecturers in
Economics Department in order to attract additional economists away from industry and government into
university teaching, those economists, persuaded to make the switch will be receiving only transfer earnings.
But those economists who were already in employment as economics lecturers will find that their salaries have
increased as well, and for them this increase will be economic rent.
Summary
In this lecture, we have examined been told the reasons why different units of the same factor could be paid
different prices in different occupations. These reasons include social factor, differences in quality and skill of
these different units and the industry environment.
You a1so know that it is "possible to break earnings of factor into transfer payments and economic rent,
although in some very rare cases, gross earning of a factors can belong exclusively to either of these divisions.
Post-Test
1. How are the prices of factors determined in a perfect competitive economy?
2. What are the factors responsible for differential payments to different units of the same factor of
production?
3. Distinguish between transfer earnings and economic rent using local examples.
References
Mankiw, N.G (1998) Principles of Economics: Dryden Press Ltd.
Skaggs, N.T. and Carlson J.L(1996).Microeconomics: individual choice and its Consequences: Blackwell


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Aman Sharma | Contact Number: (91) 9459209292 | E-Mail: hp15god@gmail.com

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Lecture One: The Economic Problem

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The Economic Problem

The Source of Economic Problems

Basic Economic Problems

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Fig.1 Production Possibility Frontier

Fig. 2 Method of Production

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Fig. 3 The upward shifting of the PPF by economic growth

Is Economics a Science Subject?

Tools of Economic Analysis

Endogenous and Exogenous Variables

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The Concept of Functional Relationship

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Basic Concept of Price Theory and Introduction to the Theory of

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Public versus Private Sector

The Elementary Theory of Demand and Supply

The Nature of Demand

Factors Influencing Demand

Table 2.1: A household's demand schedule of oranges

Fig. 2.1: A household's demand curve for oranges.

Characteristics of Demand Curve

Factors Affecting Demand

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Fig. 2.3 Movement along a demand curve

Fig. 2.4 Shift in demand curve.

Exceptional Demand Curve

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Figure 2.5: Exceptional demand curve

Elementary Theory of Supply

Factors Influencing Supply

Fig. 2.6 The Supply Curve

Table 2.2. Supply Schedule of Oranges for a Month

The corresponding supply curve is as shown below:

0 100 150 200 250 300 Quantity

Fig 2.7 Supply Curve of oranges

Change in supply versus change in quantity supply

Change in quantity supplied Change in supply

Fig. 2.8.a Change in quantity supplied

Exceptional Supply Curves

1. Fixed Supply Curves:

Fig. 2.9 A fixed supply curve.

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Fig. 2.9 Supply of labour.

Determination of Market Price

Price(N) Quantity Quantity Supplied

Putting the above information in a diagram we have

Fig. 2.10 Equilibrium Price Determination.

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Fig 2.11 The effects of shifts in demand curve.

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