Eco 211

OLABISI ONABANJO UNIVERSITY
OPEN AND DISTANCE LEARNING CENTRE
AGO-IWOYE
ECO 211: Introduction to Microeconomics

COURSE DEVELOPMENT TEAM
Dr. I.O. Oseni – Subject Expert
Prof. E.O. George – Course Reviewer
Dr. Segun Omosule – Language Editor
Prof. Oyesoji Aremu – ODL Expert
Mr. A.O. Okutimiren – Instructional Designer
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Vice Chancellor’s Message
It is with great pleasure that I welcome you as learners to the Olabisi Onabanjo University
Open and Distance Learning Centre.
Massive and Democratisation of higher education via Open and Distance Learning as
advocated globally has since been one of the goals of Olabisi Onabanjo University
Management, hence, Open and Distance Learning constitutes one of the areas of focus since
my assumption of duty. Through the efforts of the University Governing Council and Senate,
the establishment of the Open and Distance Learning Centre was approved in July, 2016.
Open and Distance Learning is a mode of study that affords tertiary education opportunities
to all and sundry regardless of age, gender, location, space and other limiting factors.
Quite a large number of qualified applicants for tertiary education are denied admission
yearly, there are also several others who wish to advance educationally but could not, because
of their job which is their means of livelihood.
Olabisi Onabanjo University via its Open and Distance Learning Centre offers quality,
technology driven, flexible, self-directed and cost effective tertiary education. It is a viable
option for learners who wish to study online from their location and at desired time.
This course material provides learners with vital information relevant to our programme and
schedules. I advise learners to make judicious use of it. I congratulate our Open and Distance
Learning Centre Staff, Department and Faculty for their effort towards the production of this
handbook.
I hope your learning experience with the Olabisi Onabanjo University Open and Distance
Learning Centre is memorable and exciting.
Prof Ganiyu Olatunji Olatunde

Vice Chancellor OOU
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Course Study Guide
Introduction
Introduction to Microeconomics for students studying towards acquiring a Bachelor of

Science in Accounting. The course is divided into 10 study sessions. It will first introduce
students to Micro-economic theory; problem of scarce resources and allocation of resources
in product. These are then followed by supply and demand theory and the cobweb theory are
introduced along with introductory dynamics and consumer behaviour. Finally, the student is
introduced to the pricing of production factors and theory of comparative costs.
The course guide, therefore, gives you an overview of what ECO 211 is all about, the
textbooks and other materials; what you are expected to know in each study session and how
to work through the course materials.
Recommended Study Time
This course is a 3-unit course divided into 10 study sessions. You are to spend at least 3 hours
to study the content of each study session.
What you are about to learn in this course
The overall aim of this course, ECO 211 is to introduce you to basic micro-economic theory.
At the end of this course, you will be introduced to the following: Micro-economic theory;
problem of scarce resources and allocation of resources in product and factor markets with
application to Nigeria and other economies; equilibrium concept, possibility of
disequilibrium, partial equilibrium and general equilibrium analyses are discussed. Supply
and demand theory and the cobweb theory are introduced along with introductory dynamics
and consumer behaviour. Other topics include general equilibrium of exchange; production
theory; and cost curves. The course concludes by examining pricing of production factors and
theory of comparative costs.
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Course Aim
This course aims to introduce students to the basic micro-economic theory. It is expected that
the knowledge will enable the reader to apply micro-economic theories in his/her profession.
Course Objectives
It is important to note that each session has specific objectives. Students should study them
carefully before proceeding to subsequent sessions. Therefore, it may be useful to refer to
these objectives in the course of your study of the session to assess your progress. You should
always look at the unit objectives after completing a session. In this way, you can be sure that
you have done what is required of you by the end of the module.
The aim of this course is to give you an understanding of the problem of scarce resources and
allocation of resources in product as well as supply and demand theory along with
introductory dynamics and consumer behaviour.
Working through this course
In order to have a thorough understanding of the course units, you will need to read and
understand the contents and practise all the discussions in this session.
This course covers approximately ten (10) weeks and it will require your devoted attention.
You should do the exercises in the Tutor-Marked Assignments and submit to your tutors via
the Learning Management System.
The major components of the course are;
1. Course Guide
2. Printed Lecture materials
3. Text Books
4. Interactive DVD
5. Electronic Lecture materials via LMS
6. Tutor Marked Assignments
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Assessment
There are two aspects to the assessment of this course. First, there are tutor-marked
assignments and second the written examination. Therefore, you are expected to take note of
the facts, information and problem-solving procedure gathered during the course. The tutor-
marked assignments must be submitted to your tutor for formal assessment in accordance to
the deadline given. The work submitted will count for 30% of your total course mark.
At the end of the course, you will need to sit for a final written examination. This
examination will account for 70% of your total score. You will be required to submit some
assignments by uploading them to ECO 211 page on the LMS.
Tutor-Marked Assignment (TMA)
There are TMAs in this course. You need to submit all the TMAs. The best 10 will be
counted. When you have completed each assignment, send it to your tutor as soon as possible
and be certain that it gets to your tutor on or before the stipulated deadline. If for any reason
you cannot complete your assignment on time, contact your tutor before the assignment is
due to discuss the possibility of extension. Extension will not be granted after the deadline
unless an extraordinary case can be established.
Final Examination and Grading
The final examination for ECO 211 will last for a period not more than 2hours and has a
value of 70%. The examination will consist of questions which reflect the Self-Assessment
Questions (SAQs), In- text Questions (ITQs)s (ITQs) and tutor- marked assignments that you
have previously encountered. Furthermore, all areas of the course will be examined. It would
be better to use the time between finishing the last unit and sitting for the examination to
revise the entire course. You might find it useful to review your TMAs and comment on them
before the examination. The final examination covers information from all parts of the
course. Most examinations will be conducted via Pen-On Paper (POP) and Computer-Based
Testing (CBT) modes.
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Tutors and Tutorials
There are a few hours of face-to-face tutorials provided in support of this course. You will be
notified of the dates, time and location together with the name and phone number of your
tutor as soon as you are allocated a tutorial group. Your tutor will mark and comment on your
assignments, keep a close watch on your progress and on any difficulty you may encounter
and provide assistance to you during the course. You must submit your tutor- marked
assignments to your tutor well before the due date. At least two working days are required for
this purpose. They will be marked by your tutor and returned as soon as possible via the same
means of submission.
Do not hesitate to contact your tutor by telephone, e-mail or discussion board if you need
help. The following might be circumstances in which you would find help necessary. Contact
your tutor if:
You do not understand any part of the study units or the assigned readings.
You have difficulty with the self-test or exercise.
You have questions or problems with an assignment, with your tutor’s comments on an
assignment or with the grading of an assignment.
You should endeavour to attend the tutorials. This is the only opportunity to have face-to-face
contact with your tutor and ask questions which are answered instantly. You can raise any
problem encountered in the course of your study. To gain the maximum benefit from the
course tutorials, have some questions handy before attending them. You will learn a lot from
participating actively in discussions.
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Recommended Texts
The following texts and Internet resource links will be of enormous benefit to you in learning
this course:
1. Ademola Adebayo. Economics: A Simplified Approach, Volume 1; Second Edition

(Year).
2. Jhingan, M. L. Microeconomics, Latest Edition. (Year).
3. Subhendu, Dutta. Introductory Economics: A Textbook for Class XII. New Age
International (P) Limited, 2006
4. Other Relevant Microeconomics Textbooks
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Table of Contents
Vice Chancellor’s Message........................................................................................................ 3
Course Study Guide ................................................................................................................... 4
Introduction ............................................................................................................................ 4
Table of Contents ................................................................................................................... 9
Study Session 1: Field of Microeconomics ............................................................................. 20
Introduction .......................................................................................................................... 20
Learning Outcomes for Study Session 1 .............................................................................. 20
1.1 What is Microeconomics? ......................................................................................... 21
1.1.1 Scope of Microeconomics.................................................................................. 21
1.1.2 Importance of Microeconomics ......................................................................... 22
1.1.3 Limitations of Microeconomics ......................................................................... 23
1.2 Distinction between Microeconomics and Macroeconomics.................................... 23
1.3 Positive and Normative Economics .......................................................................... 25
1.3.1 Positive Economics ............................................................................................ 25
1.3.2 Normative Economics ........................................................................................ 26
1.4 Economic Problems of an Economy ......................................................................... 28
1.4.1 Economic Problems ........................................................................................... 28
1.5 Production Possibility Curve (PPC) .......................................................................... 30
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1.5.1 Production Possibility Set and Curve ................................................................ 30
1.5.2 Production Possibility Schedule and Curve ....................................................... 31
1.5.3 Features of Production Possibility Curve .......................................................... 32
1.5.4 Shifts in Production Possibility Curve ............................................................... 33
1.5.5 Opportunity Cost ................................................................................................ 33
1.5.6 Marginal Opportunity Cost ................................................................................ 34
Summary of Study Session 1 ............................................................................................... 36
Self-Assessment Questions (SAQs) for Study Session 1 .................................................... 37
Glossary of Terms ................................................................................................................ 38
References ............................................................................................................................ 39
Study Session 2: Basic Tools of Economic Analysis .............................................................. 40
Introduction .......................................................................................................................... 40
2.1 Basic Mathematical Concepts and their Economic Applications ............................. 41
2.1.1 Variables ................................................................................................................. 41
2.1.2 Functions ................................................................................................................. 41
2.1.3 Graph.................................................................................................................. 42
2.1.4 Systems of Equations ......................................................................................... 43
2.1.5 Derivatives ......................................................................................................... 43
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2.2 Economic Applications of Derivatives ..................................................................... 44
2.3 Basic Statistical Concepts and their Economic Applications.................................... 46
2.3.1 Estimation of Demand Curve............................................................................. 46
2.3.2 Application of Some Statistical Concepts.......................................................... 48
2.4 Price Index................................................................................................................. 50
2.4.1 Economic Application of Price Index ................................................................ 51
References ............................................................................................................................ 56
Study Session 3: The Price System .......................................................................................... 57
Introduction .......................................................................................................................... 57
3.1 Definition of Price System ........................................................................................ 58
3.2 Demand and its Features ........................................................................................... 58
3.2.1 Features of Demand ................................................................................................ 59
3.3 Law of Demand ......................................................................................................... 59
3.3.1 Assumptions of the Law of Demand ...................................................................... 60
3.3.2 Rationale for the Law of Demand ...................................................................... 60
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3.3.3 Exceptions to the Law of Demand ..................................................................... 62
3.4 Demand Schedule and Demand Curve...................................................................... 64
3.5 Individual Demand and Market Demand .................................................................. 66
3.6 Demand Function and Factors affecting Individual Demand for a Good ................. 68
3.6.1 Demand Function ............................................................................................... 68
3.6.2 Factors affecting Individual Demand for a Good .............................................. 68
3.7 Demand and Income: The Engel Curve .................................................................... 72
3.8 Movement along and Shifts in Demand Curve ......................................................... 74
3.8.1 Shifts in the Demand Curve ............................................................................... 75
3.9 Types of Demand ...................................................................................................... 77
References ............................................................................................................................ 83
Study Session 4: Supply........................................................................................................... 84
Introduction .......................................................................................................................... 84
4.1 Meaning of Supply .................................................................................................... 85
4.1.1 Supply Schedule................................................................................................. 85
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4.1.2 Supply Curve ..................................................................................................... 85
4.2 The Law of Supply .................................................................................................... 87
4.2.1 Meaning of the Law of Supply .......................................................................... 87
4.2.2 Assumptions of the Law of Supply.................................................................... 87
4.3 Rationale for the Law of Supply ............................................................................... 88
4.4 Factors affecting the Supply of a Commodity .......................................................... 89
4.5 Movement Along and Shifts in Supply Curve .......................................................... 91
4.6 Types of Supply ........................................................................................................ 93
References ............................................................................................................................ 98
Study Session 5: Market Equilibrium (The Interaction of Demand and Supply) .................... 99
Introduction .......................................................................................................................... 99
5.1 The Determination of Equilibrium Price and Quantity ........................................... 100
5.1.1 Some Applications of Demand and Supply Analysis ...................................... 101
5.2 Price Legislation ...................................................................................................... 103
5.2.1 Maximum Price Legislation ............................................................................. 103
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5.2.2 Minimum Wage Legislation ............................................................................ 103
5.3 Functions of the Price System ................................................................................. 105
Summary of Study Session 5 ............................................................................................. 106
Self-Assessment Questions (SAQs) for Study Session 5 .................................................. 107
Glossary of Terms .............................................................................................................. 108
References .......................................................................................................................... 109
Study Session 6: The Supply Curve under Different Market Conditions.............................. 110
Introduction ........................................................................................................................ 110
Learning Outcomes for Study Session 6 ............................................................................ 110
6.1 Law of Supply ......................................................................................................... 111
6.2 The Short Run Supply Curve of the Industry under Perfect Condition .................. 111
6.3 The Long-Run Supply Curve of the Industry under Perfect Competition ................... 113
6.4 Curve under Monopoly or Imperfect Competition ................................................. 115
References .......................................................................................................................... 120
Study Session 7: Elasticity of Demand .................................................................................. 121
Introduction ........................................................................................................................ 121
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7.1 Meaning and Types of Elasticity of Demand .......................................................... 122
7.2 The Price Elasticity of Demand .............................................................................. 123
7.2.1 Kind of Price Elasticity of Demand ................................................................. 123
7.2.2 Measurement of Price Elasticity of Demand ................................................... 127
7.2.3 Determinants of Price Elasticity of Demand ................................................... 130
7.3 The Income Elasticity of Demand ........................................................................... 133
7.3.1 Types of Income Elasticity of Demand ........................................................... 134
7.3.2 Measurement of Income Elasticity of Demand ............................................... 135
7.3.3 Determinants of Income Elasticity of Demand ................................................ 136
7.4 The Cross – Price Elasticity of Demand ................................................................. 137
Types of Cross–Price Elasticity of Demand .................................................................. 137
7.4.2 Measurement of Cross Price Elasticity of Demand ......................................... 138
References .......................................................................................................................... 143
Study Session 8: Elasticity of Supply .................................................................................... 144
Introduction ........................................................................................................................ 144
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8.1 Meaning of Elasticity of Supply.............................................................................. 145
8.2 Types of Price Elasticity of Supply ......................................................................... 146
8.3 Determinants of Elasticity of Supply ...................................................................... 149
8.4 Some Applications of the Elasticity Concept .......................................................... 151
References .......................................................................................................................... 158
Study Session 9: Theory of Production ................................................................................. 159
Introduction ........................................................................................................................ 159
9.1 Meaning of Production ............................................................................................ 160
9.2 Production Function ................................................................................................ 161
9.2.1 Meaning of Production Function ..................................................................... 161
9.2.2 Short-run and Long-run Production Function.................................................. 161
9.3 Concept of Product .................................................................................................. 162
9.3.1 Total Physical Product (TPP) or Total Product (TP) ....................................... 162
9.3.2 Average Product (AP) or Average Physical Product (APP) ............................ 164
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9.3.3 Marginal Product (MP) or Marginal Physical Product (MPP) ........................ 165
9.4 Relationship between TP, AP and MP .................................................................... 167
9.4.1 Relationship between TP and MP .................................................................... 168
9.4.2 Relationship between AP and MP.................................................................... 168
9.5 Returns to a Factor and Returns to Scale ................................................................ 170
9.5.1 Law of Variable Proportions/Law of Diminishing Returns ............................. 170
9.5.2 Assumptions of the Law .................................................................................. 170
9.5.3 Three Phases of Production ............................................................................. 171
9.5.4 Reasons behind Increasing and Diminishing Returns to a Factor ................... 173
9.5.5 Postponement of the Law................................................................................. 173
References .......................................................................................................................... 178
Study Session 10: Introduction to Consumer’s Behaviour .................................................... 179
Introduction ........................................................................................................................ 179
Learning Outcomes for Study Session 10 .......................................................................... 179
10.1 Consumer’s Equilibrium with Utility Approach ................................................. 180
10.1.1 Utility – Different Concepts............................................................................. 180
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10.2 The Law of Diminishing Marginal Utility .......................................................... 183
10.3 Assumptions of the Utility Approach .................................................................. 186
10.4 Meaning of Consumer’s Equilibrium .................................................................. 186
10.5 Consumer’s Equilibrium with Indifference Curve Approach ............................. 191
10.5.1 Ordinalist or Indifference Curve Theory ......................................................... 191
10.5.2 Indifference map .............................................................................................. 194
10.6 Deviation of the Demand Curve: Consumer Equilibrium ................................... 195
10.7 Derivation of the Engel Curve ............................................................................. 201
10.8 Consumer Surplus................................................................................................ 203
Summary of Study Session 10 ........................................................................................... 205
Self-Assessment Questions (SAQs) for Study Session 10 ................................................ 206
References .......................................................................................................................... 208
Notes on SAQs for Study Session 1 ...................................................................................... 209
Notes on SAQs for Study Session 2 .................................................................................. 210
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Notes on SAQs for Study Session 10 ................................................................................ 217
References .......................................................................................................................... 220
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Study Session 1: Field of Microeconomics
Introduction
Microeconomics is one of the branches of economics that studies the economic

actions of individuals and small groups of individuals. It includes particular
households, firms, industries, commodities, individual prices, wages, and incomes.
Thus, microeconomics studies how resources are allocated to the production of goods and
services and how efficiently they are distributed. But microeconomics does not study the
problem of allocation of resources to the economy as a whole.
In this study session, you will be introduced to the following: meaning of microeconomics,
difference between microeconomics and macroeconomics, positive and normative
economics; economic problems of an economy as well as production possibility curve.
Learning Outcomes for Study Session 1
On completion of this study session, you should be able to:
1.1 Explain microeconomics

1.2 Discuss the distinction between microeconomics and macroeconomics
1.3 Explain positive and normative economics
1.4 Discuss the meaning of economic problems of an economy
1.5 Explain production possibility curve (PCC)
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1.1 What is Microeconomics?
Microeconomics is the study of the economic actions of individuals and small groups of
individuals. This includes “the study of particular firms, particular households, individual
prices, wages, income, individual industries, and particular commodities”. It concerns itself
with the analysis of price determination and the allocation of resources to specific uses.
In other words, microeconomics studies the interrelationships of individual household, firms

and individual industries to each other. In this sense, macroeconomics involves the study of
economy as a whole. It deals with national income, the aggregate level of employment, the
general price level, total expenditure (i.e. consumption), savings and investment in the
economy, total imports and exports, and the demand for and supply of money, it analyses the
causes and prescribes possible solutions to the problems of low per capital income,
unemployment, inflation and deflation, low levels of savings and investment, problems of
payment deficits in international trade, and economic fluctuations.
1.1.1 Scope of Microeconomics
Microeconomic encompasses the theory of product pricing which includes the theory of
consumer behaviour and the theory of production and cost; the theory of factor pricing, which
entails theory of wages, rent, interest and profits; and the theory of economic welfare. Thus,
microeconomic studies
i. How resources are allocated to the production of particular goods and services.
ii. How the goods and services are distributed among the people, and
iii. How efficiently they are distributed. While studying the conditions in which the price
of a particular good is determined, microeconomics assumes how the total quantity of
resources are given and seeks to explain their allocation to the production of that
commodity.
In microeconomics, the analysis of price determination and allocation of resources are

studied in three different stages. These include:
i. The equilibrium of individual consumers and producers.
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ii. The equilibrium of a single market, and

iii. The simultaneous equilibrium of all markets.
However, individual consumers and producers are unable to influence the prices of goods
bought and sold. A consumer is faced with given prices and he buys that much of the
commodity that maximises his utility. Finally, in microeconomics, the interrelations between
the different markets are taken so as to determine all prices simultaneously. However, it is
generally said that microeconomics is related to partial equilibrium analysis that is the
study of the equilibrium position of an individual, a firm, an industry or group of industries,
yet it is also a study of their interrelationships and interdependences within the economy that
falls under the general equilibrium analysis.
1.1.2 Importance of Microeconomics
i. Microeconomics is of utmost importance in understanding the working of a free

enterprise economy. In such economy, there is no agency to plan and coordinate the
working of the economic system.
ii. It provides the analytical tools for evaluating the economic policies of the state.
iii. Helpful in the efficient employment of scare resources
iv. It helps to explain the gains from international trade, balance of payments
disequilibrium and the determination of the foreign exchange rate
v. It is helpful in understanding the problems of taxation and examining the conditions
of economic welfare as well as basis for production.
vi. Microeconomics is used for constructing economic models for better understanding of
the actual economic phenomena.
vii. It gives an overall view of the growing complexities of an economic system and
provides powerful tools to explain the working of the complex economic systems.
viii. It provides the basic and logical framework for formulating appropriate
macroeconomic policies (e.g., for inflation, poverty, unemployment, etc.) to direct
and regulate economy towards desirable goals.
ix. It helps in analysing the reasons for economic fluctuations and provides remedies.
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1.1.3 Limitations of Microeconomics
Despite the fact that microeconomics has numerous benefits, it also suffers from the
following deficiencies: These include:
i. It is based on the unrealistic assumption of full employment in the economy.

ii. Microeconomics is based on the assumption of laissez-faire which ended with the
Great Depression of the 1930s as a result makes the study unrealistic.
iii. It is concerned with the study of parts and neglects the whole.
iv. It is not capable of explaining the functioning of an economy as a whole.
v. It cannot be used for solving the problem relating to public finance, monetary and
fiscal policy etc.
vi. It ignores structural changes in an individual unit of the aggregate while the
conclusions drawn on the basis of aggregate variables may be misleading.
In- text Questions (ITQs)
Define microeconomics
In-text Answers (ITAs)
Microeconomics is the study of economic actions of individuals and small groups of

individuals.
1.2 Distinction between Microeconomics and Macroeconomics
i. Microeconomics is the study of economic actions of individuals and small groups of

individuals which includes particular household, firms and industries while
macroeconomics deals with aggregates of these quantities not with individual incomes
but with the national income; not with individual prices but with price level; and not
with individual output but with the national output.
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ii. The objective of microeconomics on the demand side is the creating of satisfaction or
to maximize utility whereas on the supply side is to maximize profits at the minimum
cost while the main objectives of macroeconomics include full employment, price
stability, economic growth, favourable balance of payment and evenly distribution of
income.
iii. The basis of microeconomics is the price mechanism which operates with the help of
invisible hands i.e. the forces of demand and supply which helps to determine the
equilibrium price and quantity in the market while the basis of macroeconomics is the
national income, output, employment and general price level which are determined by
aggregate demand and aggregate supply.
iv. In microeconomics, the study of equilibrium conditions is analysed at a particular
period and does not explain the time element i.e. it considered as a static analysis
while macroeconomics is based on time lags, rate of change and past and expected
values of the variables. Thus, it is concerned with dynamic analysis.
This can be demonstrated in the table 1.1
Table 1.1: Difference between Microeconomics and Macroeconomics
Basis Microeconomics Macroeconomics

Definition Microeconomics is that part of economic Macroeconomics is that part of economic
theory which studies the behaviour of theory that studies the behaviour of
individual units of an economy. aggregates of the economy as a whole.
Tools of Analysis Demand and Supply. Aggregate Demand and Aggregate Supply.
Main Objective It aims to determine price of a commodity It aims to determine income and
or factors of production. employment level of the economy.
Basic Assumptions It assumes all the macro variables to be It assumes that all the micro variables, like
constant, i.e., it assumes that national decisions of households and firms, prices of
income, consumption, saving, etc. are individual products, etc. are constant.
constant.
Other Name It is also known as ‘Price Theory’. It is also known as ‘Income and
Employment Theory’.
Examples Individual Demand, Firm’s Output. National Income, National Output.
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In- text Questions (ITQ)
What are the distinction between microeconomics and macroeconomics?
In-text Answer (ITAs)
i. Microeconomics is the study of economic actions of individuals and small groups of

individuals while macroeconomics deals with aggregates of these quantities not with
individual incomes but with the national income
ii. The objective of microeconomics on the demand side is the creating of satisfaction
while the main objectives of macroeconomics include full employment, price stability,
economic growth, favourable balance of payment and evenly distribution of income.
iii. The basis of microeconomics is the price mechanism which operates with the help of
invisible hands while the basis of macroeconomics are the national income, output,
employment and general price level
1.3 Positive and Normative Economics
1.3.1 Positive Economics
Positive economics entails what is or how an economic problem facing a society is truly
solved. Robbins that considered that economics should be neutral argued this or silent
between ends, i.e., there should be no desire to study the principles of economic decisions. He
further conceded that economists learn human decisions as facts that can be verified with
actual data in positive economics. For instance, positive economics include:
i. Nigeria is highly populated with her citizens 70% poorer than other developing
country.
ii. A fall in the price of a good leads to a rise in its quantity demanded.
iii. The forces of demand and supply in a perfectly competitive market determine prices.
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iv. A profit maximising firm will set its price where marginal revenue is equal to
marginal cost.
v. Increase in real per capita income increases the standard of living of people.
1.3.2 Normative Economics
Normative economics deals with what ought to be or how an economic problem should be
solved. Alfred Marshall and Pigou noted that in normative economics there is no reservation
on passing value judgment on moral rightness or wrongness of things. Normative economics
gives prescriptive statements. Examples of normative economics are:
i. Government should guarantee a minimum wage for every worker.

ii. Government should stop Minimum Support Price to the farmers.
iii. Nigeria should not take many loans during a period of recession.
iv. Nigeria should spend more money on defence in order to fight for unnecessary land
insecurity.
v. Palliative in terms of money should be given to the citizens during the period of
COVID 19 since their tastes are different.
Table 1.2: Difference between Positive and Normative Economics
Positive Economics Normative Economics

1. It expresses what is. 1. It expresses what should be.
2. It is based on cause and effect of facts. 2. It is based on ethics.
3. It deals with actual or realistic situation. 3. It deals with idealistic situation.
4. It can be verified with actual data. 4. It cannot be verified with actual data.
5. In this value judgements are not given. 5. In this value judgements are given.
It is neutral between ends. 6. It deals with how an economic problem

should be solved.
6. It deals with how an economic problem is
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solved. 7. Economists of normative school are
7. Economists of positive school are Adam Marshall, Pigou, Hicks, Kaldor, Scitovsky.
Smith and his followers. 8. Compare these examples:
8. Observe these examples: (a) What is a fair price rise?
(a) What determines the price rise? (b) Unemployment is worse than inflation.
(b) Government has adopted policies to (c) The rate of inflation should not be more
reduce unemployment. than 6 per cent.
(c) The rate of inflation in India is 6 per cent. (d) Ethics.
(d) Chemistry.
Explain the following:
i. Positive economics
ii. Normative economics
i. Positive economics entails what is or how an economics problem facing a society is

truly solved.
ii. Normative economics deals with what ought to be or how an economic problem
should be solved.
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1.4 Economic Problems of an Economy
An economy refers to the whole collection of production units in an area (geographical area
or political boundary) of a country by which people receive their living. An economy is
classified into market economy and planned economy and these economies can be subdivided
into closed economy and open economy.
Box 1.1: Meaning of an Economy
An economy is a system in which people earn their living by performing different economic
activities like production, consumption and investment.
1.4.1 Economic Problems
Economic problem is the problem of choice. The problem of choice has to be faced by every
economy of the world, whether developed or developing. Human beings have wants which
are unlimited. When these wants get satisfied, new wants crop up. Human wants multiply at a
fast rate. The economic resources to satisfy these unlimited wants are limited or scarce. These
resources are not only scarce but they also have alternative uses. All these necessitate a
choice between which goods and services to produce first. The economy comprising of
individuals, business firms, and societies must make this choice. Furthermore, the economic
problem is the problem of choice or the problem of economising, i.e., it is the problem of
fuller and efficient utilisation of the limited resources to satisfy maximum number of
wants. As a result of limited resources, the decision of what to produce becomes an outcome
of choice. Hence, economic problems are caused by unlimited human wants, limited
economic resources and alternative uses of resources. Therefore, there are three fundamental
and interdependent problems in an economic society. These are: what, how and for whom to
produce.
i. What Goods to Produce and How Much to Produce?
Due to limited resources, every economy has to decide what goods to produce and in what
quantities. If the means were unlimited, then it would lead to a stage of salvation. But the
means are limited and the economy must decide the efficient allocation of scarce resources so
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that both output and output-mix are optimum. An economy has to make a choice of the
wants which are important for the economy as a whole. Thus, an economy has to decide
what goods it would produce on the basis of availability of technology, cost of production,
cost of supplying and demand for the commodity.
ii. How to Produce?
It is the question of choice of technique of production. Since resources are scarce, an

inefficient technique of production, which would lead to wastage and high cost, cannot be
applied. A technique of production that would maximise output or minimise cost should
be used. We generally consider two types of techniques of production: labour-intensive and
capital-intensive techniques. In labour-intensive technique, more labour and less capital is
used. In capital-intensive technique, more capital and less labour is used. The guiding
principle of this problem is to adopt such technique of production that has least cost to
produce per unit of the commodity. At macro level the most efficient technique is the one
which uses least quantity of scarce resources. Hence, producers must always produce
efficiently by using the most efficient technology. Thus, every economy has to choose the
most efficient technique of producing a commodity.
iii. For Whom to Produce?
This is the question of how to distribute the product among the various sections of the
society. National product is the total output generated by the firms. Goods and services are
produced in the economy for those who have the ability (i.e. capacity) to buy them. Thus,
guiding principle of this problem is output of the economy be distributed among different
sections of the society in such a way that all of them get a minimum level of consumption.
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Mention the three fundamental problems in an economic society
i. What to produce
ii. How to produce
iii. For whom to produce
1.5 Production Possibility Curve (PPC)
1.5.1 Production Possibility Set and Curve
Production possibility set refers to different possible combinations of two goods that can be
produced from a given amount of resources and a given level of technology. Production
possibility curve or frontier (PPF) shows the various alternative combinations of goods and
services that an economy can produce when the resources are all fully and efficiently
employed.
Box 1.2: Assumptions of production possibility curve
The underlying assumptions of production possibility curve are:
i. Economy produces only two goods, X and Y.

ii. Amount of resources available in an economy are given and fixed.
iii. Resources are not specific, i.e., they are shifted from the production of one good to
the other good.
iv. Resources are fully employed, i.e., no wastage or idle of resources.
v. State of technology in an economy is given and remains unchanged.
vi. Resources are efficiently employed
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1.5.2 Production Possibility Schedule and Curve
PP schedule explains the tabular presentation of different possible combinations of two goods
that an economy can produce with given resources and available technology. Table 1.2, gives
a production possibility schedule.
Table 1.3: Production Possibility Schedule
Production Possibility Good X Good Y

P 0 21
A 1 20
B 2 18
C 3 15
D 4 11
E 5 6
P 6 0
Fig. 1.1: Production possibility curve
Source: Introductory Microeconomics by Deepashree
Fig. 1.1 illustrates a production possibility curve. Good X is shown on the x-axis and good Y
is shown on the y-axis. PP' is the required production possibility curve. It shows, the
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maximum amount of good X produced, given the amount of the other good. All points on the
curve are attainable. The problem is that of choice, i.e., to choose among the attainable points
on the curve. It depends upon tastes and preferences of an individual. This is the basic
problem of an economy. Any point inside the curve, such as point F, indicates unemployment
of resources or inefficient use of resources. Any point outside the curve, such as point G, is
unattainable given the scarcity of resources. Thus, an economy always produces on a PPC.
1.5.3 Features of Production Possibility Curve
Two features of production possibility curve are:
i. PPC slopes downward
A production possibility curve slopes downward from left to right because under the
condition of full employment of resources, production of one good can be increased only
after sacrificing production of some quantity of the other good due to limited resources.
Hence, production of both goods cannot be increased at the same time. That is why PPC
slopes downward.
ii. PPC is concave to the origin
A production possibility curve is concave to the point of origin because of increasing

marginal rate of transformation (MRT) or increasing marginal opportunity cost (MOC). Slope
of PPC is defined as the quantity of good Ygives up in exchange for additional unit of
good X.
Δ𝑌 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑌 𝑙𝑜𝑠𝑡

𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑃𝑜𝑠𝑠𝑖𝑏𝑖𝑙𝑖𝑡𝑦 𝐶𝑢𝑟𝑣𝑒 = =
Δ𝑋 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑋 𝑔𝑎𝑖𝑛𝑒𝑑
= 𝑀𝑅𝑇(𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡)
Marginal opportunity cost is opportunity cost of good X gained in terms of good Y has
given up. It is also called Marginal Rate of Transformation (MRT).
Concave shape of PPC means that slope of PPC increase which implies that MRT increases.
It means that for producing an additional unit of a good, sacrifice of units of other good (i.e.
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opportunity cost) goes on increasing. It is because resources are not equally efficient for the
production of both goods. Thus, if resources are transferred from production of one good to
another, cost increases i.e., MRT or MOC increases. It is called law of increasing
opportunity cost.
1.5.4 Shifts in Production Possibility Curve
This occurs when new stock of resources is discovered or there exists advancement in
technology by increasing the productive capacity of an economy. Thus, the economy can
produce more good X or more good Y or more of both goods.
PPC will shift to the right when:
i. New stock of resources is discovered.

ii. There is advancement in technology.
PPC will shift to the left when:
i. Resources are destroyed because of national calamity like earthquake, fire, war, etc.
ii. There is use of outdated technology.
1.5.5 Opportunity Cost
The question of opportunity cost arises whenever resources have alternative uses. These
resources are not always physical resources; they may be monetary resources or time. In
terms of production possibility curve, the slope of the curve at every point measures the
opportunity cost of producing more units of good X in terms of good Y given up. The
concept of opportunity cost can be shown with the help of alternative options given by PPC.
Box 1.3: Definition of Opportunity Cost
Opportunity cost is defined as the cost of alternative opportunity given up or surrendered.
In Fig 1.2, movement along production possibilities frontier, PP1, shows a decrease in the
output of food and increase in output of clothing. For example, movement from point A to
point B shows decrease in food production from F1 to F2 (ΔF) and increase in the production
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of clothing from C1 to C2 (ΔC). It implies that ΔC amount of clothing can be produced only
by sacrificing ΔF amount of production of food. It means that ΔF amount of food becomes an
opportunity cost for ΔC amount of clothing.
Figure 1.2: Opportunity Cost
1.5.6 Marginal Opportunity Cost
Production possibility curve is also called opportunity cost curve because slope of the curve
at each and every point measures opportunity cost of one commodity in terms of alternative
commodity given up. The rate of this sacrifice is called the Marginal Opportunity Cost.
Box 1.4: Marginal Rate of Transformation (MRT)
It is defined as the ratio of number of units of good sacrificed to produce one additional unit
of other good. MRT measures the slope of PP curve. MRT = slope of PPC. Actually MRT is
the rate at which the transfer of resources from production of one good to production of other
good takes place i.e. MRT = ΔY/ΔX
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Fig. 1.3: Shape of PPC with Different Marginal Opportunity Costs
Define production possibility set
Production possibility set refers to different possible combinations of two goods that can be
produced from a given amount of resources and a given level of technology.
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Summary of Study Session 1
In this study session, you have learned the following:
1. Microeconomics study the interrelationships of individual household, firms and

individual industries to each other
2. Three fundamental and interdependent problems in an economic society are: what,
how and for whom to produce
3. An economy refers to the whole collection of production units in an area
(geographical area or political boundary) of a country by which people receive their
living.
4. Production possibility set refers to different possible combinations of two goods that
can be produced from a given amount of resources and a given level of technology.
5. Opportunity cost is defined as the cost of alternative opportunity given up or
surrendered.
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Self-Assessment Questions (SAQs) for Study Session 1
Having completed this study session, you can measure how well you have achieved its
learning outcomes by answering these questions. You can check your answers with the Notes
on Self-Assessment Questions at the end of this session.
SAQ 1.1 (Tests Learning Outcome 1.1)
1. Define microeconomics as discussed in this study session

2. What are the importance of microeconomics?
What are the differences between microeconomics and macroeconomics

as discussed in this study session?
Explain:
(i) Positive economics

(ii) Normative economics
What is an economy?
What are the assumptions of production possibility curve?
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Glossary of Terms
Economic system: A system of resource allocation and resource ownership
Exchange rate: The amount of one country’s currency that is traded for one unit of another
country’s currency.
Full employment: A situation in which there is no cyclical unemployment.
Normative economics: The study of what should be; it is used to make value judgments,
identify problems, and prescribe solutions.
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References
Ademola Adebayo. Economics: A Simplified Approach, Volume 1; Second Edition (Year).
Jhingan, M. L. Microeconomics, Latest Edition. (Year).
Other Relevant Microeconomics Textbooks
Subhendu, Dutta. Introductory Economics: A Textbook for Class XII. New Age
Should you require more explanations on this study session? Please

do not hesitate to contact your e-tutor via the LMS.
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Study Session 2: Basic Tools of Economic Analysis
Introduction
Economic problems arise from human economic activities which include

production, consumption and distribution that are described in various measures
such as prices, income, expenditure, output, profit, interest, rent wages, and so on.
All these and related measures which take different quantitative values are known as
economic variables.
In this study session, you will learn about some of the elementary basic tools of economic
analysis such as mathematical and statistical concepts, economic applications of derivatives
and price index.
2.1 Explain basic mathematical concepts and their economic application

2.2 Discuss economic applications of derivatives
2.3 Explain basic statistical concepts and their economic application
2.4 Explain price index
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2.1 Basic Mathematical Concepts and their Economic Applications
2.1.1 Variables
A variable is a quantity which assumes different values that may be measured or counted in
some numerical units. Examples of variables that are often encountered in economics are:
i. Dependent and Independent Variables
To express a cause and effect relationship between two variables, the effect is dependent or
endogenous while the cause in independent or exogenous e.g.
Q = 50 – 0.5p 1
Where: Q = quantity demanded
P = commodity’s own price.
In this equation, P is the independent or exogenous while Q is the dependent or endogenous

variable.
ii. Exogenous and Endogenous Variables
Endogenous variables are ones that are explained within a theory, whereas exogenous
variables are ones that influence the endogenous variables but which are determined by
factors outside the theory e.g.
Q = 75 – 2P + 0.01Y 2
Equation 2 implies that the quantity demanded of the commodity has a positive or direct
relationship with consumer’s income Y. Q is the endogenous while P and Y are the
exogenous variables.
2.1.2 Functions
This is a relation or expression that involves two or more variables or an expression that
defines the relationship between one variable (the independent variable) and another
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variable (the dependent variable). For instance, y = f(x); this function implies that the value
of y depends upon the value of x.
Box 2.1: A function
If a function is stated in such a way that the value of one variable is made to depend in some
definite way upon the value of the other variable, it is called an explicit function.
Types and examples of economic functions include:
i. Linear function i. Q = 80 – 0.2P (demand function)

ii. Q = - 50 + 5P (supply function)
iii. C = 75 + 0.5Y (consumption function)
ii. Quadratic function i. Q  30 P (supply function)

ii. Q = 70P2 (demand function)
10
iii. AC  10   4Q  QP 2 (Average cost function)
Q
iii. Cubic function: TC = 100 + 5Q = 2Q2 + Q3 (Total cost function)
2.1.3 Graph
The use of graphs in economics has the advantages of making discussions more concise and
less ambiguous as against lengthy discussions in verbal presentation.
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P
Vertical axis
Origin
0 Horizontal axis
Figure 2.1: A graph
It is a convention in economics to represent the dependent variable on the vertical axis and
the independent variable on the horizontal axis.
2.1.4 Systems of Equations
The mathematical knowledge of systems of equations is applicable in economics when facing

with economic problems as determining the equilibrium of a commodity by demand and
supply, the equilibrium (or profit maximizing) output of a firm by equating marginal cost of
production to marginal revenue, the equilibrium national income for economy, etc.
For example, if Q =D (P) is the demand and Q = S (P) is the supply curve, this explains two
equations in two unknowns, Price and Quantity. To determine the equilibrium price, these
equations are solved simultaneously.
2.1.5 Derivatives
In economic policy formulations, the need often arises to measure the rate of change in a
dependent variable relative to a change in the independent variable.
Functions and their derivatives
y
i. y  3x 3   19 x 2
x
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6 y
ii. y   12 x
x 2 x
y
iii. y  10  5 x  5
x
In- text Question (ITQ)
What is a variable?
In- text Answer (ITA)
A variable is a quantity which assumes different values that may be measured or counted in
some numerical units
2.2 Economic Applications of Derivatives
Practically, most decision processes in economics involve marginal and elasticity concepts.
To illustrate economic applications of derivatives, three concepts are discussed: Price
elasticity of demand, Marginal cost and Marginal revenue.
i. Price Elasticity of Demand
It is a measure of the rate at which the quantity demanded of a commodity changes in respect
to a change in the commodity’s price. One of the several reasons for measuring price
elasticity of demand for a commodity is to guide an entrepreneur in making decisions to
increase or reduce his products’ price in order to boost sales and profits.
It is denoted as Ed,
P P
Ed  .
Q Q
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Suppose the demand curve is linear,
𝑄 = 𝑎 – 𝑏𝑃
Therefore, the price elasticity of demand at a given value of P and Q is,
P
Ed  b.
Q
ii. Marginal cost and Revenue:
Marginal cost is defined as the change in total cost resulting from the production of an
additional unit of output. On the other hand, marginal revenue is the change in total revenue
resulting from the sale of an additional unit of output.
Given Total Cost and Total Revenue function as:
TC = f (Q)
TR =f (Q)
TC TR TC TR

MC  ; MR  OR MC  ; MR 
Q Q Q Q
1. What is price elasticity of demand?

2. Define: (a) marginal cost (b) total revenue
1. It is a measure of the rate at which the quantity demanded of a commodity changes in

respect to a change in the commodity’s price.
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2. (a) Marginal cost is defined as the change in total cost resulting from the production
of an additional unit of output.
(b) Marginal revenue is the change in total revenue resulting from the sale of an
additional unit of output.
2.3 Basic Statistical Concepts and their Economic Applications
2.3.1 Estimation of Demand Curve
This demonstrates how the statistical concepts of arithmetic mean, regression equation,
correlation co-efficient, co-efficient of determination are used in giving quantitative
expression to price and demand relations.
i. Arithmetic Mean
The arithmetic mean of a series is obtained by adding the values of all observation and
dividing by the total number of observation i.e.
x1  x2  x3  ...xn
N
OR
x
X 
N
Where, x1, x2, x3, …, xn = values of variables
∑ = the sum of
N = Number of observations
X  Arithmetic mean of x’s
For instance, if the prices charged on a commodity at five different periods were N6, N8, N9,
N12 and N15 respectively, the mean price is
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N 6  8  9  12  15 N 50 
X  
5 5 = N10
ii. Linear Regression Equation
This is an equation which describes the relationship between two or more variables.
Q = a + bP
If the value of the constants a and b are known, the computation of the value of Q for any
given value of P can be easily done. Recall for b < 0, there is an inverse relationship between
Q and P while for b >0; there is a direct or positive relationship between Q and P. The values
 pq  npq
of a and b are found with the help of the following two formulae. b
 p 2  np 2
a  q  bp
Where
p - Arithmetic mean of p’s
q - Arithmetic mean of q’s
iii. The Coefficient of Determination
It is a measure of the proportion of the variation in the dependent variable (Q) that can be
explained by the variation in the independent variable. It is denoted by r2.
  pq  npq 
r2   

  p 2

 np 2 q 2  nq 2  
 1
iv. Coefficient of Correlation
It is a device to measure the degree to which two variables are related. Usually designated
by,
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  pq  npq 2 
r  

  p 2

 np 2 q 2  nq 2  
 2
From 1, we know that the coefficient of correlation between two variables is the square root
of the coefficient of determination.
2.3.2 Application of Some Statistical Concepts
Wanke Bottling Company is a manufacturer of a brand of soft drink known as Odun. The
sales department of the company gave the data of price and quantity purchased of the product
between 2010 and 2018 as shown in the table below.
Case Study
Market demand schedule for Odun (2010 – 2018)
Year Price (N10 per crate) Quantity demanded (per week in

thousands)
2010 1 35
2011 2 28
2012 3 20
2013 4 24
2014 5 26
2015 6 21
2016 7 32
2017 8 25
2018 9 23
a. Determine the equation of demand curve for Odun

b. As a consultant of Wanke Bottling Company, advise the company on the quantity of
the product to produce if the management has decided to charge a higher price of
N100 per crate.
c. Calculate the coefficient of determination.
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Solution
a. To determine the equation of demand curve for the product means to find the
regression equation of q in p using equations 1 and 2.
p q p2 Pq q2
1 35 1 35 1225
2 28 4 56 784
3 20 9 60 400
4 24 16 96 576
5 26 25 130 676
6 21 36 126 441
7 32 49 224 1024
8 25 64 200 625
9 23 81 207 529
∑p = 45 ∑q = 234 ∑p2 = 285 ∑pq = 1184 ∑q2 = 6280
From the table, n = 9
p
p  5; p 2  25
n
q
q  26; q 2  476
n
Demand equation is given as:
Q = a + bP
To find b, see equation 1
1134  9526
b  0.6
285  925
To find a, see equation 2
a  26  0.65  29
The estimate of the demand equation for Odun is
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Q = 29 – 0.6P
b. To determine the quantity that would be effectively demanded or sold at price N100
per crate. Substitute p = 10 in demand equation in a above,
Q = 29 – 0.6(10) = 23, 000 crates.
c. This requires the computation of the coefficient of determination r2.
1134  9526
2
 
r 
2   0.109
 285  9256280  9676 

Explain Arithmetic Mean
The arithmetic mean of a series is obtained by adding the values of all observation and
dividing by the total number of observation
2.4 Price Index
Price index is a statistical device that is used to measure price fluctuations in a series of prices
between two periods. Methods of constructing price indices include the base weighted
Laspeyre’s index, current weighted Paasche index and Fishers total index. This Laspeyre’s
method in which the base year quantities are used as weights can be defined as:
∑ 𝑃1 𝑞𝑜
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 =
∑ 𝑃𝑜 𝑞𝑜
Where p1 = prices of the various commodities in the current year
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p0 = prices of the various commodities in the base year
q0 = quantities of the various commodities in the base year
2.4.1 Economic Application of Price Index
i. Measures of Inflation
Illustration: Average Prices and Quantities Supplied in an economy in 1990 and 1992.
1990 1992
Commodity Price Quantity Price Quantity
A 5 50 10 40
B 4 20 7 10
C 3 10 5 8
Using Laspeyre’s approach, the consumer price index CPI is:
 p92 q90
CPI   100
 p90 q 09
690
  100
360
 192
The above result indicates that the general price level in 1992 has increased by 92% over that
of 1990. Since 1990 is regarded as the base year, the price index of 1990 is taken as 100.
ii. Measurement of Terms of Trade
The most important and commonly used concept of the terms of trade is the net barter terms
of trade. The net barter terms of trade is the ratio of export price index to import price index.
Px
Tnb 
Pm
Where Px – export price index
Pm – import price index
Page 51 of 220
Define price index
Price index is a statistical device that is used to measure price fluctuations in a series of
prices between two periods
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In Study Session 2, you have learned that:
1. A variable is a quantity which assumes different values that may be measured or

counted in some numerical units.
2. Function is a relation or expression that involves two or more variables or an
expression that defines the relationship between one variable (the independent
variable) and another variable (the dependent variable)
3. Graph - The use of graphs in economics has the advantages of making discussions
more concise and less ambiguous as against lengthy discussions in verbal
presentation.
4. Systems of Equations - The mathematical knowledge of systems of equations is
applicable in economics when facing with economic problems as determining the
equilibrium of a commodity by demand and supply
5. Derivatives - In economic policy formulations, the need often arises to measure the
rate of change in a dependent variable relative to a change in the independent
variable.
6. Price index is a statistical device that is used to measure price fluctuations in a series
of prices between two periods
∑𝑃 𝑞
7. 𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 = ∑ 𝑃1 𝑞𝑜
𝑜 𝑜
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Now that you have completed this study session, you can assess how well you have achieved
its Learning Outcomes by answering these questions.
Explain explicit function
Define: (a) marginal cost (b) total revenue
Explain linear regression equation
What is the formula for finding price index using Laspeyre’s method?
Page 54 of 220
Glossary of Terms
Dependent variables: Variables which are changed by the independent variables
Exports: Goods and services produced domestically, but sold abroad
Imports: Goods and services produced abroad, but consumed domestically
Independent variables: Variables which do not depend on other variables
Page 55 of 220
References

Page 56 of 220
Study Session 3: The Price System
Introduction
A price system is a component of any economic system that uses prices expressed
in any form of money for the valuation and distribution of goods and services and
the factors of production. Except for more economically isolated communities, all
modern societies use price systems to allocate resources, although price systems are not used
exclusively for all resource allocation decisions.
In this study session, you will study the following: meaning of price system, demand and its
features as well as the law of demand.
3.1 Define price system

3.2 Explain demand and its features
3.3 State the law of demand
3.4 Explain demand schedule and demand curve
3.5 Explain individual demand and market demand
3.6 Discuss demand function and factors affecting individual demand for a good
3.7 Explain the Engle curve
3.8 Explain movement along and shifts in demand curve
3.9 State the type of demand
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3.1 Definition of Price System
The price system is the process by which the monetary value of a commodity, service or
factor of production is determined by the interplay of the forces of supply and demand – what
Adam Smith called” the invisible hand”. It is one of the systems of allocating scarce
resources among alternative uses.
More specifically, the price system relates primarily to a capitalist economy in which raw
materials, machines and equipment factories and all sorts of factor inputs are privately
owned.
Define price system
factor of production is determined by the interplay of the forces of supply and demand
3.2 Demand and its Features
From economists’ point of view, demand for a commodity or service does not mean a desire
that cannot be fulfilled, rather, it means a desire which can effectively be backed by ability to
pay.
Demand for a commodity may be defined as the quantity of that commodity which
consumers are willing and able to purchase at each alternative prices during some specified
period of time. Quantity demanded refers to the particular quantity which buyers are willing
and able to buy on a given price during a given period of time.
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3.2.1 Features of Demand
The main features of demand for a commodity are:
i. Demand depends upon satisfaction of the commodity.

ii. Demand always means effective demand i.e., demand for a commodity or the desire
to own a commodity should always be backed by purchasing power and willingness
to spend.
iii. Demand is a flow concept, i.e., so much per unit of time.
iv. Demand means demand for final consumer goods.
v. Demand is a desired quantity. It shows consumer’s wish or need to buy the
commodity.
Explain demand
In- text Answers (ITA)
Demand for a commodity may be defined as the quantity of that commodity which consumers
are willing and able to purchase at each alternative prices during some specified period of
time
3.3 Law of Demand
The law of demand expresses the functional relationship between price and quantity
demanded of a good. It is one of the most important laws of economic theory. According to
this law, other things remaining constant (ceteris paribus), if the price of a commodity falls,
the quantity demanded of it will rise and if price of the good rises quantity demanded will
fall. Thus, there is inverse relationship between price and quantity demanded. Symbolically,
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Qdx = f(Px), ceteris paribus
Qdx = Quantity demanded of good X
Px = Price of the good X
Note:
The law of demand states that if remaining things are constant then as price of a commodity
increases demand for the commodity decreases and as price of a commodity decreases
demand for the commodity increases.
3.3.1 Assumptions of the Law of Demand
The law is valid only when the following assumptions hold:
i. The price of the related goods remains the same.
ii. The income of the consumers remains unchanged.
iii. Tastes and preferences of the consumers remain the same.
iv. All the units of the goods are homogeneous.
v. Commodity should be a normal good.
vi. Prices of substitutes and complements do not change.
3.3.2 Rationale for the Law of Demand
Basically, the inverse relationship between price and quantity demanded of a product can be
explained as the consequence of three factors.
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Figure 3.1: Rationale for the Law of Demand
i. The Income Effect
A fall in a commodity’s price causes the consumer’s real income i.e. the quantity of that
commodity that the consumer can buy to increase. For example, with a constant money
income of N600 per week, you can buy 20 tins of milk at a price of N30 per tin. But if the
price of milk falls to N25 per tin and you still want to spend all your weekly income on milk
you will be able to buy 24 tins. Generally, with a fall in price, the consumer is able to buy
more with the same amount of money income, vice versa. This is referred to as the income
effect of a change in price.
ii. The Substitution Effect
The substitution effect describes the fact that as the price of a commodity falls we substitute it
for a similar commodity whose price remains unchanged. Actually, a lower price increases
the relative attractiveness of a product and makes the consumer willing to buy more of it and
vice versa. Therefore, the purchase of more (less) of a commodity at lower (higher) price, due
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to the fact that the price of its substitute remains unchanged, is called the substitution effect
of a change in price.
iii. Buyer´s Reservation Price
The largest amount of money the buyer would be willing to pay for a unit of a good. If the
reservation price (benefit) exceeds the market price (cost), the consumer will purchase the
good. The benefit will exceed the cost for fewer buyers at higher prices than at lower
prices.
3.3.3 Exceptions to the Law of Demand
There are numerous factors that invalidate the law of demand. These factors include:
i. Giffen Goods
In case of such goods, the law of demand does not hold good. Giffen goods are named after
Sir Robert Giffen, who was attributed as the author of this idea by Marshall in his book
Principles of Economics. Sir Francis Giffen observed that when Irish potato prices increased
in bad years, people curtailed spending on other commodities and increased their spending on
potatoes. Because with high potato prices and no increase in their money incomes, they were
now too poor to afford meat and other foodstuffs. So they had to sustain themselves by eating
more potatoes. That is, people demanded more potatoes when their prices increased and vice
versa. This is called Giffen Paradox.
Giffen goods have positive price elasticity of demand. It is known that most products, price
elasticity of demand is negative. In other words, price and demand pull in opposite directions;
price goes up and quantity demanded goes down, or vice versa. Giffen goods are an
exception to this. When price goes up the quantity demanded also goes up, and vice versa. In
order to be a true Giffen good, price must be the only thing that changes to get a change in
demand. The classic example given by Marshall is of inferior quality staple foods whose
demand is driven by poverty, which makes their purchasers unable to afford superior
foodstuffs. As the price of the cheap staple rises, they can no longer afford to supplement
their diet with better foods, and must consume more of the staple food.
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There are three necessary preconditions for this situation to arise:
 The good in question must be an inferior good,

 There must be a lack of close substitute goods, and
 The good must comprise a substantial percentage of the buyer’s income.
ii. Veblen Goods
A commodity is a Veblen good if people’s preference for buying it increases as a direct

function of its price. The definition does not require that any Veblen goods actually exist.
However, it is claimed that some types of high-status goods, such as expensive wines or
perfumes are Veblen goods, in that decreasing their prices decreases people’s preference for
buying them because they are no longer perceived as exclusive or high status products. The
Veblen effect is named after the economist Thorstein Veblen, who invented the concepts of
conspicuous consumption and status-seeking. The Veblen effect is one of a family of
theoretically possible anomalies in the general theory of demand in microeconomics. The
other related effects are:
 The snob effect: preference for good decreases as the number of people buying it
increases;
 The bandwagon effect: preference for good increases as the number of people buying
it increases;
 The Counter-Veblen effect, in which preference for good increases as its price falls.
In case of conspicuous consumption, as observed by Thorstein Veblen, the demand curve

does not slope downwards. Sometimes people buy some products to show their status in the
society. The possession of such commodities, they feel, may confer a higher level of social
status on their holder. These goods are diamonds and other precious stones etc. Rich class
buys such goods at very high price to show that they belong to a prestigious class.
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iii. Ignorance Level
The law of demand also not applies to a commodity whose quality is judged by its high price.
At high prices, some people buy more of such commodity than at lower price thinking that
high priced commodities are better than those priced lower. This perception is borne out of
sheer ignorance.
iv. Speculation
If the price of commodity is increasing and people expect a further rise in the price, they will
tend to buy more of the commodity at higher price than they did at the lower price. It is
observed that when there is a hike in edible oil prices recently, some people purchased more
of it in the expectation that future prices will be even more.
In- text Question
State the law of demand
In- text Answers
The law of demand states that if remaining things are constant then as price of a commodity
increases demand for the commodity decreases and as price of a commodity decreases
demand for the commodity increases.
3.4 Demand Schedule and Demand Curve
A demand schedule is a table showing the quantity of a product that would be purchased at
each of the possible prices. In other words, is a tabular statement that shows the different
quantities of a commodity that would be demanded at different prices. It expresses what
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quantities of a good will be purchased at different possible prices. A demand schedule is

shown in the table 3.1
Table 3.1: The demand schedule for a brand of soft drink
Prices (per 35cl bottle) P Quantity demanded (bottles per week) Q

A 17 2
B 16 4
C 15 6
D 14 8
E 13 10
On the basis of the above demand schedule, we can derive an individual’s demand curve. A
Demand curve is the graphical representation of the demand schedule. This is shown in the
figure 3.1.
P D
17 a
16 b
c
15
d
14
e
13
D
0 2 4 6 8 10 Q
Fig. 3.2: The demand curve
Both the demand schedule and the demand curve are drawn under the ceteris paribus
assumption. Each reveals that when the price of the soft drink per 35 centiliter bottle is N17,
quantity demanded is 2 bottles per week. If the price falls to N16, quantity demanded would
be 4 bottles per week and so on.
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Define demand schedule
each of the possible prices
3.5 Individual Demand and Market Demand
Individual Demand refers to the quantities of a commodity which a single consumer would
be willing and able to purchase at the various possible prices. On the other hand, the Market
Demand is the sum of the various quantities that would be purchased by all the consumers of
the product at each alternative prices.
The market demand schedule is obtained by summing up the individual demand schedule.
Graphically, the market demand curve is found by summing horizontally the individual
demand curve of all consumers in the market. The diagram below shows the illustration of
individual (D1D1& D2D2) and market demand curves (DD).
Table 3.2: Individual and Market Demand Schedule for a brand of soft drink
Price per 35cl bottle Kunle’s Demand Sade’s Demand Market demand
(quantity per week)
17 2 3 5
16 6 4 10
15 9 7 16
14 11 9 20
13 13 11 24
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Fig. 3.3: Individual Demand Curve and Market Demand Curve
Source: Introductory Microeconomics by Deepashree
Define: (a) individual demand (b) market demand
(a) Individual Demand refers to the quantities of a commodity which a single consumer
would be willing and able to purchase at the various possible prices.
(b) Market Demand is the sum of the various quantities that would be purchased by all
the consumers of the product at each alternative prices.
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3.6 Demand Function and Factors affecting Individual Demand for a

Good
3.6.1 Demand Function
Demand function shows the functional relationship between demand for a commodity and its
determinants. Symbolically, it is expressed as:
Qxd  f ( Px , Pz , Y , T , E , N , Yd )
where, Qxd = Demand of commodity X
Px = Price of commodity X
Pz = Prices of related goods
Y = Consumers’ income
T = Taste and preference of consumer
E = Future expectation
N = Number of consumers
Yd = Distribution of income
3.6.2 Factors affecting Individual Demand for a Good
The following factors affect the demand of a commodity:
i. Price of the Commodity
There is inverse relationship between price of a commodity and demand for a commodity.
In general, demand for a commodity is more at lower price and less at a higher price and vice
versa. But this relationship does not exist in Giffen goods. In case of Giffen goods there is
direct relationship between price and demand.
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ii. Prices of Other Goods
Demand for good x is influenced by the prices of other good (z). It is called cross price
demand. The relationship depends upon the relation between two goods x and z. Two
situations can arise:
(a) When X and Z are Substitutes
Box 3.1: Substitute Goods
Substitute goods are those which are an alternative to one another in consumption.
They satisfy same human want with equal ease. Examples are: tea or coffee; wheat or rice,
close up or oral B and so on. This substitute relationship arises because the goods have a
similar technology or have a similar price. An increase in the price of a substitute good
increases the quantity demanded of the other good. If there is an increase in the price of a
substitute good, the demand curve shifts rightward.
Box 3.2
Demand for a good usually moves in the same direction to a change in price of its substitutes
(b) When X and Z are Complements
Box 3.3: Complementary Goods
Complementary goods are those which are jointly used or consumed together to satisfy a
want. Examples of Complementary Goods are tea and sugar; car and petrol; pen and ink;
bread and butter; cigarettes and cigarette lighter.
If there is increase in the price of complementary good, the demand curve shifts leftward.
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Box 3.4
Demand for a good move in the opposite direction to a change is price of its complementary
good.
iii. Consumers’ Income
Changes in money of the consumer changes the budget constraint facing the consumer,
causing him to change his demand for goods. It is called income demand. How a change in
the income will affect the demand for a good depends upon the type of the good:
(a) If x is a normal good then with an increase in income, consumer buys more of the
good. Goods whose demand rises when income rises are called normal goods.
Example: clothes, books, etc.
(b) If x is an inferior good then an increase in income causes its demand to decrease.
This is because as income rises, purchasing power rises and consumers substitute
more superior goods for inferior goods. Goods whose demand falls when income
rises are called inferior goods. Example: Coarse cereals.
Fig. 3.4: Effect of Rise in Consumer’s Income on Demand
iv. Consumer’s Tastes and Preferences
Any change in consumer’s tastes causes demand to change. If there is a change in tastes in
favour of a good, then it will lead to increase in demand and any unfavourable change will
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lead to decrease in demand. Increased preference for a good is shown by increase in demand,
i.e., rightward shift of demand curve from d to d2. It shows that more is demanded at each
price. At price OP, the consumer will now demand a larger quantity OQ2 compared to OQ
(OQ is the amount demanded before the change in taste). Decreased preference for a good is
shown by decrease in demand, i.e., leftward shift of demand curve from d to d1. It shows that
less is demanded at each price. At price OP, the consumer will now demand a smaller
quantity OQ1 compared to OQ.
Fig. 3.5: Shift in Demand Curve due to change in Consumer’s Taste and Preferences
v. Future Expectations of Buyers
Future expectation is also one of the factor which causes change in demand. If it is expected
by the consumer that the price of the commodity will rise in future, he will start buying more
units of the commodity in the present, at the existing price. Similarly, if he expects that price
will fall in future, he will buy less quantity of the commodity in the present, even if the price,
in present is less than the price in past.
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Fig. 3.6: Shift in Demand Curve due to change in consumer’s expectations
Highlight the factors affecting the demand for a commodity
i. Price of the Commodity

ii. Prices of Other Goods
iii. Consumers’ Income
iv. Consumer’s Tastes and Preferences
v. Future Expectations of Buyers
3.7 Demand and Income: The Engel Curve
A graph showing the relationship between an individual’s income and his demand for a
specified good is called an Engel curve. The curve is named after a nineteenth century
German economist and statistician Ernest Engel who did pioneering work related to such
curves. The Engel curve can be drawn either for an individual or for the market as a whole.
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Table 3.3: A consumer’s income and demand for rice
Consumer’s income (N000 per month) Quantity demanded (kg per month)
4 5
5 20
6 30
7 40
8 50
P
8
Income N’000 per month
6
Engel curve
4 0
10 20 30 40 50 Q
Quantity (kg per month)
Fig. 3.7: Engel curve for rice
The Engel curves are useful in distinguishing between normal and inferior goods. An upward
sloping Engel curve like on in figure 3-6 illustrates a normal good, whereas an Engel curve
that is downward-sloping to the right will illustrate an inferior good.
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What is Engel Curve?
Engel curve is a graph showing the relationship between an individual’s income and his
demand for a specified good
3.8 Movement along and Shifts in Demand Curve
A distinction between movement along the demand curve and shifts in the demand curve is
very important while studying demand theory. Movement along the demand curve takes
place when there is a change in price of a good, other things remaining same. This is also
termed as a change in Quantity demanded. That is changes in demand due to a change in the
price of a commodity, other things being equal. In other words, when either due to increase or
decrease in the price of a good, the demand increases, then it is seen that the demand curve
remain the same; only the equilibrium position on the demand curve is changed. This is
called extension and contraction in demand. Thus when quantity demanded of a good rises
due to the decrease in price alone, it is said that extension of demand have taken place. And
quantity demanded falls due to rise in price; it is called contraction in demand. This is
illustrated in the figure 3.7.
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Fig. 3.8: Movement along the Demand Curve
Assuming other factors such as tastes, income and price of related goods constant, demand
curve DD is drawn. At OQ price, OM of the commodity is demanded so that the equilibrium
point is at B. If price falls to OP, the quantity demanded increases to OS but the consumer
remains on the same curve DD; only equilibrium position moves from B to C. In case of rise
in price to OR, demand shrinks to ON and the equilibrium position also moves to the left
from B to A. This is called contraction in demand. The extension and contraction in demand
take place only due to changes in the price of a commodity, other factors remaining same.
3.8.1 Shifts in the Demand Curve
A demand curve either shifts to the right or left, due to changes taking place in other factors
and not price of the commodity. The change in the position of the demand curve due to these
changes can be termed as the increase and decrease in demand. When due to changes in the
factors such as tastes, fashion, price of related commodities, income etc, the demand curve
shifts upwards or to the right, increase in demand is said to have taken place. Similarly, when
less is demanded at the same price due to changes in other factors, it is called decrease in
demand. Here, the demand curve gets shifted leftward. Thus increase in demand is due to the
following factors:
a. Taste and fashion/preferences are more favourable for the good.

b. Income of the consumer increases.
c. Price of substitutes has risen.
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d. Price of complementary goods has declined.

e. Propensity to consume of the people has increased.
f. Numbers of consumers have increased.
Likewise, decrease in demand may take place due to the following reasons:
a. Taste and fashion/preferences are not favourable for the good.

b. Income of the consumers has fallen.
c. Price of substitutes has fallen.
d. Price of complementary goods has risen.
e. Propensity to save of the people has increased.
Increase and decrease in demand (shifts in the demand curve) is shown in the Fig. 3-8. DD is
the demand curve when price is OP. At this price, ON quantity is bought. When consumer’s
income falls, price remaining same, demand curve shifts to the left as D" D". The consumer
buys less of the same commodity, i.e., ON" now. When income rises, price remaining same,
consumer is able to buy more, i.e., ON'. In such case, the demand curve shifts to the right as
D'D'.
Fig. 3.9: Shift in Demand Curve
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Highlight the factors that lead to increase in demand
In- text Answers (ITAs)
i. Taste and fashion/preferences are more favourable for the good.

ii. Income of the consumer increases.
iii. Price of substitutes has risen.
iv. Price of complementary goods has declined.
v. Propensity to consume of the people has increased.
vi. Numbers of consumers have increased.
3.9 Types of Demand
Figure 3.10: Types of Demand
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i. Joint or Complementary Demand
There is a joint demand for two goods if they are used together such that one is not useful
without the other. For instance, if commodities X and Y are jointly demanded, an increase (a
decrease) in the quantity demanded of X caused by a fall (rise) in X’s price will lead to more
(less) of Y being demanded at its current price. For instance, increase in the price of
kerosene, will lead to decrease in the use of stove since both kerosene and stove are used
jointly to satisfy a need. Thus, they are (kerosene and stove) examples of goods of
complementary demand.
ii. Competitive Demand
Two or more goods are said to be in competitive demand if they are close substitutes. There
is competitive demand for Betamalt and Maltex, Bournvita and Ovaltine etc. Given that
commodities X and Y are in competitive demand an increase (a decrease) in the quantity
demanded of X caused by a fall (rise) in X’s price will lead to less (more) of Y being
demanded at its current price.
iii. Derived Demand
Demand for a commodity or resource is a derived demand if the commodity or resource is

demanded as a result of the fact that other commodities or resources are deviant. For instance,
the demand for labour is an example of derived demand since this good is demanded to
satisfy the needs of other commodity.
iv. Composite Demand
There is composite demand for a commodity or resource if it can be used for two or more
purposes e.g. flour which is the basic raw material for bread, cake, sausage roll etc.
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Mention the types of demand

iii. Derived Demand
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In this study session, you have learned the following:
1. Factors affecting Individual Demand for a Good:

a) Price of the Commodity
b) Prices of Other Goods
c) Consumers’ Income
d) Consumer’s Tastes and Preferences
e) Future Expectations of Buyers
2. Types of demand
a) Joint or Complementary Demand
b) Competitive Demand
c) Derived Demand
d) Composite Demand
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Having completed this study session, you can measure how well you have achieved its
learning outcomes by answering these questions. You can check your answers with the Notes
on Self-Assessment Questions at the end of this Session.
What is price system?
List the features of demand
nWhat are the assumptions of the law of demand?
What is a demand schedule?
Define market demand
Explain demand function
Explain Engel Curve
Highlight the factors that lead to decrease in demand
List the types of demand

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Glossary of Terms
Change in demand: A shift of a demand curve in response to a change in some variable

other than price
Demand schedule: A list showing the quantities of a good that consumers would choose to
purchase at different prices, with all other variables held constant.
Derived demand: The demand for an input that arises from, and varies with, the demand for
the product it helps to produce.
Invisible hand: A phrase used by Adam Smith to refer to the way in which an individual's
pursuit of self-interest can lead, without the individual's intending it, to good results for
society as a whole
Inferior good: A good that is less demanded as income rises.
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References

Page 83 of 220
Study Session 4: Supply
Introduction
Firms operate independently of each other, making decisions about what to sell,
and how much to sell, depending on the price. Just like households, firms try to
maximize their utility when making selling decisions. It is usually assumed that
sellers derive utility from profit, that is, the more money a seller makes from a sale, the
happier he or she will be. Firms will maximize their utility by selling whatever will make
them the most money.
In this study session, you will be introduced to the following: the meaning of supply, law of
supply, rationale for the law of supply, factors affecting the supply of a commodity and types
of supply.
4.1 Explain the meaning of supply

4.2 State the law of supply
4.3 State the rationale for the law of supply
4.4 Highlight the factors affecting the supply of a commodity
4.5 Explain the movement along and shift in supply curve
4.6 Discuss the types of supply
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4.1 Meaning of Supply
Supply of a commodity is the quantity of that commodity which producers are able and
willing to offer for sale at each alternative prices during some specified period of time.
Supply also refers to the amount of good offered for sale in the market at a given price.
Supply should be distinguished from stock. Stock is the amount of good which can be
brought into the market for sale at a short notice. Thus supply is the quantity actually brought
in the market but stock is a potential supply. Like demand, supply is a flow concept, it is not
properly defined if reference is not made to specific time period. Hence, Market Supply is the
total amount of goods supplied at various prices by all producers/sellers in a market. Supply
definition is complete when it has the following elements:
i. Quantity of a commodity that the producer is willing to offer for sale,

ii. Price of the commodity, and
iii. Time during which the quantity is offered for sale.
4.1.1 Supply Schedule
Supply schedule represents the relation between prices and the quantities of good supplied. It
is a list of quantity supplied by producers at different prices. The supply schedule illustration
is shown in table 4.1
Table 4.1: An individual supply schedule for soft drink
Prices (per 35cl bottle) P Quantity supplied (bottles per week) Q

17 60
16 50
15 40
14 30
13 10
4.1.2 Supply Curve
Supply curve is the graphical representation of the supply schedule. A supply curve is shown
in the figure 4.1. In the Fig. 4.1, x-axis measures quantities of good supplied and y-axis
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measures price of the commodity. SS is the supply curve sloping upwards to the right,
indicating that when price of the commodity increases supply also increase. It should be
noted here that if price of the product falls too much, producers refuse to supply any good.
Thus the price below which the seller will refuse to sell is called the reserve price.
Fig. 4.1: Supply Curve
Define Supply of a commodity
Supply of a commodity is the quantity of that commodity which producers are able and
willing to offer for sale at each alternative prices during some specified period of time
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4.2 The Law of Supply
4.2.1 Meaning of the Law of Supply
Law of supply derives the relationship between price and quantity supplied. According to the
law of supply, other things remaining the same, quantity supplied of a commodity is directly
related to the price of the commodity. In other words, other things remaining the same, when
price of a commodity rises, its quantity supplied increases and when the price falls, quantity
supplied also falls. Symbolically, the law of supply is expressed as:
Sx = f (Px), ceteris paribus
4.2.2 Assumptions of the Law of Supply
The law of supply is based on the assumption that all factors, other than the price of the
commodity, that affect the supply remain the same.
These are following:
a. Prices of the related good should remain unchanged.

b. Prices of factors of production (i.e., prices of inputs) should remain unchanged.
c. Level of technology should remain unchanged.
d. Government policy regarding taxation should remain unchanged.
e. Goals of the firm should remain unchanged.
The law of supply shows a positive relationship between price and quantity supplied as
shown in the figure 4.2 below:
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P
P S
S
P2
P2
P1
P1
S
S
Q1 Q2 Q
Q SupplyQCurve
Fig. 04.2: Q
2
10
State the law of supply
The law of supply says that when price of a commodity rises, its quantity supplied increases
and when the price falls, quantity supplied also falls (other things remaining the same)
4.3 Rationale for the Law of Supply
i. The Law of Increasing Cost
The law of increasing cost states that; it becomes increasingly costly to produce equal
increases in output of any good or service, ceteris paribus. This is due to the fact that as the
producer increases output by using more resources, the production capacity becomes
increasingly strained causing production efficiency to drop. Consequently, the cost of
additional units of output rises. Therefore, producers must receive a higher price to produce
these additional units.
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ii. Profits maximizing motive
One of the most realistic assumptions in economic analysis is that producers seek to
maximize their profits. The term profit means the difference between the receipts from the
sale of the product and cost of product. For example, suppose a producer is producing
commodities X, Y and Z. As the market price of X rises, ceteris paribus, the producer will
shift his resources from Y and Z to X because it is more profitable to do so. Therefore, the
producer has a greater incentive to produce more of a good at a higher price than at a lower
price.
What is the rationale for the law of supply?
1. The law of increasing cost

2. Profits maximizing motive
4.4 Factors affecting the Supply of a Commodity
Supply of a commodity depends upon a number of factors. The important determinants of

supply can be grouped together in a supply function as follows:
SX = f (PX, PY, F, T, G)
Supply function expresses the functional relationship between supply of a commodity (X)
and other determinants of supply, i.e., price of the commodity (PX), prices of related
commodities (PY), price of the factors of production (F), technology (T) and goals (G) or
general objectives of the producer.
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Thus, the following factors determine the supply of a product:
i. Price of the Product
As already stated, price determines the supply of a product. When price is high, supply is
more and vice versa. Producers are encouraged to produce more when price is high because
of high profit margin.
ii. Technology
The change in technology also affects supply of a product. It may reduce the cost of
production and as a result supply will be more. Automatic and digital photocopier machines
have increased the speed of photocopy per unit and hence large production.
iii. Price of Factors
Changes in prices of factors also cause a change in cost of production and thereby bring
changes in the supply of the product. When costs of factors comedown, it reduces the overall
cost of production and as a result producers are induced to produce and supply more.
iv. Prices of other products
Prices of substitutes and complements also affect the supply of a product. For example, if
prices of tea rise, it will result in the reduction in the production and supply of coffee as the
producers will withdraw resources from the production of coffee and devote these to the
production of tea.
v. Future Price Expectation
If sellers expect the prices to rise in future, they would reduce supply of a product in the
market and hoard the commodity to sell in the future.
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Highlight the factors that determine the supply of a product
1. Price of the Product

2. Technology
3. Price of Factors
4. Prices of other products
5. Future Price Expectation
4.5 Movement Along and Shifts in Supply Curve
A movement along the same curve simply indicates changes in quantities offered as a result
of a change in the price. When supply changes not due to changes in the price of the product
but due to other factors, such as change in technology, changes in the prices of related
commodities, changes in price of inputs etc, it is said to be shifts in supply curve.
Fig.4.3: Shift in Supply Curve

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Supply is said to increase (supply curve shifts to the right) when, price remaining same, more
is offered for sale and decrease (supply curve shifts to the left) when, at the same price, less is
offered for sale in the market. This is illustrated in the Fig. 4-3 above. SS is the supply curve
before the change. S'S' shows a decrease in supply because at the same price OM' (OM' <
OM) is offered for sale. S''S" shows an increase in supply because at the same price OH,
more is supplied (OM" > OM).
When there is a change in price (rise/fall), supply also changes (increases/decreases) and the
phenomena is called extension and contraction in supply. In this case, equilibrium point
moves along the same supply curve-either to left or right. In Fig. 4-4, SS is the supply curve
and the equilibrium point is ‘E’ at OP price. When price falls to OP", supply gets reduced
by N"N and supply increases to ON' when price rises to OP'. The equilibrium point E moves
to E' when price falls and moves to E', when price rises.
Fig. 4.4: Movement along the Supply Curve
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Explain movement along supply curve
Movement along supply curve occurs when a movement along the supply curve indicates
changes in quantities offered as a result of a change in the price.
4.6 Types of Supply
Figure 4.5: Types of Supply
1. Joint Supply: This is the case of two or more goods that are jointly produced, that is,
where it is naturally inevitable to produce one without the other. For instance, beef
and hides, palm oil and palm kernel etc.
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2. Competitive Supply: This type of supply is more applicable to the supply of factors
of production for which there are competing demand. Since supply of factors of
production is limited, if they are used for one form of production, obviously they will
not be available for use in another production process.
3. Composite Supply: A number of products may provide a composite supply to satisfy
a particular demand. This is the case for tea, sugar and milk.
Mention the types of supply
1. Joint Supply
2. Competitive Supply
3. Composite Supply
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In this Study Session 4, you have learned that:
1. Supply is a schedule of how much producers are willing and able to sell at all possible
prices during some time period
2. Production is the making of goods available for use
3. Supply increase is an increase in the quantity supplied at every price; a shift to the
right of the supply curve
4. Supply decrease is a decrease in the quantity supplied at every price; a shift to the left
of the supply curve
5. Law of supply is the principle that price and quantity supplied are directly related
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Now that you have completed this study session, you can assess how well you have
achieved its Learning Outcomes by answering these questions.
What is supply curve?
What are the assumptions of the law of supply?
Highlight the rationale for the law of supply
List the factors that determine the supply of a product
SAQ 4.5(Tests Learning Outcome 4.5)
Explain movement along supply curve
List the types of supply
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Glossary of Terms
Equilibrium: A state of rest; a situation that, once achieved, will not change unless some
external factor previously held constant, changes.
Price: It is the amount of money expected, required, or given in payment for something
Output: This is the amount of something produced by a person, machine, or industry
Goods: Items that satisfy human wants and provide utility
Service: An intangible act or use for which a consumer, firm, or government is willing to pay
Page 97 of 220
References

Page 98 of 220
Study Session 5: Market Equilibrium (The Interaction of Demand

and Supply)
Introduction
The interdependent relationship between supply and demand in the field of

economics is inherently designed to identify the ideal price and quantity of a given
good or service in a market.
In this study session, you will be introduced to the following: the determination of
equilibrium price and quantity, meaning of price legislation and functions of the price system.
5.1 Explain the determination of equilibrium price and quantity

5.2 Explain price legislation
5.3 State the functions of the price system
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5.1 The Determination of Equilibrium Price and Quantity
The equilibrium price or the market price is the price at which the quantity demanded is equal
to the quantity supplied. Sometimes, it is referred to as market clearing price because it is a
price at which there is no excess supply (surplus) or excess demand (shortage). Note that, an
excess supply or surplus exists when the quantity supplied exceeds the quantity demanded.
But when the quantity demanded exceeds the quantity supplied, there exists an excess
demand or shortage. It follows that at any price other than the equilibrium price, the market is
said to be in disequilibrium and such a price is called a disequilibrium price.
P
S
N17 D
Excess Supply
Price per bottle
16
E
15
14 S
D
13 0 100 200 300 400 500 Q

Quantity (1000 bottles per week)
Fig. 5.1: Equilibrium Price and Quantity
From the figure 5.1, the market is in equilibrium at point E. At this point, the equilibrium
price of N15 per bottle is determined by intersection of the market demand curve DD, and the
market supply curve SS. At a price above N15 per bottle, suppliers would offer more than
consumers are willing and able to purchase i.e. there would be an excess supply.
i. Stable and Unstable Equilibrium
Equilibrium is said to be a stable equilibrium if when the equilibrium price is displaced a

little; the new price sets up economic forces which tends to restore it.
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On the other hand, equilibrium is unstable when a small displacement of the equilibrium
price sends the system away from it, never to be restored. This is the case for all goods that
invalidate the law or demand such as Giffen or Veblen goods.
Price
S
D
P1
D
S
Q1 Q2 Q0 Q3 Q4
Quantity
Figure 5.2: An Unstable Equilibrium
ii. Changes in Demand and Supply: A Partial Equilibrium Analysis
A partial equilibrium analysis is carried out when we analyse the forces of demand and
supply in any single market in complete isolation from all other markets.
iii. A General Equilibrium Analysis: Product and Resource Market
A general equilibrium analysis is carried out when we investigate how the buying and selling
decisions in one market affect the happenings in another market.
5.1.1 Some Applications of Demand and Supply Analysis
i. Fixing Exchange rate of Naira against US-Dollar
A foreign exchange rate is rate at which one currency can be exchanged for another.
Alternatively, it can be regarded simply as the price of one currency in terms of another.
Under a regime known as floating exchange rate system, this rate is determined by the free
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interplay of the forces of demand and supply. This was the case of Nigeria under the
Structural Adjustment Programme (SAP) introduced by the Babangida Administration.
The Consequences of Fixing Exchange Rate
D S
Price $1 in Naira
P2P
2P
1P
Price
N22
0 ceiling
D
S
0
Quantity of dollar
0
Fig. 5.3: Price Ceiling Legislation
The above figure gives us an insight into some economic implications of fixing exchange
rate. Obviously, the N22 to $1 is below-equilibrium price because the market determined
price of US $1 was about N45 before the budget was announced.
Explain: (a) stable equilibrium (b) unstable equilibrium
(a) Equilibrium is said to be a stable equilibrium if when the equilibrium price is

displaced a little; the new price sets up economic forces which tends to restore it.
(b) Equilibrium is said to be unstable when a small displacement of the equilibrium price
sends the system away from it, never to be restored.
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5.2 Price Legislation
Price legislation otherwise known as price control policy refers to the situation whereby the
government wishes to influence the price at which some products are bought and sold. One of
the measures that can be taken by the government when the economy is encountering the
problem of inflation is to pass maximum price legislation. This will involve fixing maximum
price below the equilibrium price, such as P1 in figure 5.4.
5.2.1 Maximum Price Legislation
It is often called “price-ceiling”. It refers to how government set maximum permissible

prices. Government of medieval cities sometimes sought to protect their citizens from the
consequences of crop failures by fixing a maximum price at which bread could be sold. In
modern times, many governments have employed rent controls in an attempt to make housing
available at a price that many poor countries set the prices of some basic foodstuffs well
below their market equilibrium values.
a b
A S A S
D
D
A A
P2 P2 Ceiling
Pn Pn
Price
Price
P1 Ceiling P1
S S
D D
0 0 Q1 Qn Q2 Quantity
Q1 Qn Q2 Quantity
Fig. 5.4: Maximum Price Legislation: Price Ceiling
5.2.2 Minimum Wage Legislation
The Federal Government of Nigeria requires employers to pay workers a specified minimum
wage which is reviewed from time to time subject to the prevailing rate of inflation in the
country. The reason is to ensure that the least paid workers receives a wage that is sufficiently
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high to give him access to the basic necessities of life, what government does, in most cases,
is to fix the minimum wage. It can be illustrated graphically below.
(a) Minimum Wage Legislation (b) Rent Ceiling
DL Drh
SL
Srh
Wf N4000
Wage floor
N3000
We Ceiling
N2000
SL Drh
Srh
DL
0 L1 Le L2 0 L1 Le L2
Figure 5.5: Wage and Rent Controls
In the final analysis, it may be discovered that the rent control policy is far from being a
relevant measure to tackle the problem of housing in the urban areas.
In- text Question
Another name for price legislation is called __________
In- text Question Answer
Price control policy
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5.3 Functions of the Price System
i. It distributes scarce productive resources among firms and private individual resource
users or entrepreneurs.
ii. It induces supply of goods and services to respond to changes in demand.
iii. It shows changes in consumer’s wants – preferences and taste from time to time.
iv. It influences the types, quantity and quality of goods to be produced and services to be
provided in the economy.
v. It facilitates the determination of the appropriate rewards to the various factors of
production.
vi. It indicates the sectors of the economy in which factors of production command
highest rewards.
Mention the function of the price system
a) It distributes scarce productive resources among firms and private individual

resource users or entrepreneurs.
b) It induces supply of goods and services to respond to changes in demand.
c) It shows changes in consumer’s wants
d) It influences the types, quantity, and quality of goods to be produced and services to
be provided in the economy.
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1. Stable equilibrium: When the equilibrium price is displaced a little; the new price sets
up economic forces which tend to restore it.
2. Unstable equilibrium: When a small displacement of the equilibrium price sends the
system away from it, never to be restored.
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Now that you have completed this study session, you can assess how well you have achieved
its Learning Outcomes by answering these questions.
Explain unstable equilibrium
What is price legislation?
What are the functions of the price system?
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Glossary of Terms
Excess demand: The excess of quantity demanded over quantity supplied
Floating exchange rate: An exchange rate that is freely determined by the forces of supply
and demand.
Government is the system or group of people governing an organized community, generally

a state
Price: Money value of a unit of a good, service or resource
Page 108 of 220

References

Page 109 of 220

Study Session 6: The Supply Curve under Different Market

Conditions
Introduction
The supply curve is an analytical tool used to study the determination of prices and
output of goods and services.
In this study session, you will be introduced to the following: the meaning of theory of
supply, the law of supply and supply curve.
6.1 State the law of supply

6.2 Explain the short run supply curve of the industry under perfect condition
6.3 Explain the long-run supply curve of the industry under perfect competition
6.4 Discuss curve under monopoly or imperfect competition
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6.1 Law of Supply
The word “supply” implies the various quantities of a commodity offered for sale by
producers during a given period of time at various prices. The law state that ‘the lower the
price, the smaller the supply and the higher the price, the larger the supply’. This is the law
of supply which shows the functional relationship between price and quantity offered for
sale.
Explain supply
Supply is the various quantities of a commodity offered for sale by producers during a given
period of time at various prices
6.2 The Short Run Supply Curve of the Industry under Perfect
Condition
The short-run is such a period in which the fixed factors like plants, machinery, etc. cannot be
changed. The firm can therefore, raise output by increasing the quantities of variables factors
like labour, raw materials etc.
The supply curve of a firm shows the various quantities of a commodity offered for sale at
various alternatives prices. A perfectly competitive firm will sell that output at which its
marginal cost equal price (𝐴𝑅 = 𝑀𝐶). Under perfect competition the price is fixed by the
industry for the firm. Therefore, the, price line is parallel to the x-axis as by the dotted lines
in fig 6-1. In the short-run it must however, cover its variable cost. Thus, the short-run supply
curve of the firm is that portion of its marginal cost curve which lies above its average
variable cost curve. This is shown in fig. 6.1 below where the SMC curve intersects the AVC
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at point B and OQ2 quantity is sold. The SMC curve lies below the AVC curve at that volume
of output less than this. The firm would not produce below OQ2 since it would not be
covering its AVC to the left of point B. at the OP price, the firm will be selling OQ quantity
and earning normal profits.
Firm Industry
SRS
SMC
D P2
P1 P1
E SAC P1
P P
AVC
B P
P2 P2
0 Q2 Q Q1 0 M2 M M1 Quantity
Quantity
Fig. 6.1: Short Run Supply Curve
At higher price OP1, it would be earning super normal profits by selling OQ1 units. Thus, that
portion of the SMC curve which is rising and lies to the right and above the point of
intersection with the AVC curve is the firm’s short-run supply curve.
The short-run supply curve can also shift upward or downward with the expansion or
contraction of variable input by all firms simultaneously which being changes in their
prices. If the expansion of inputs of the firms increases their prices, the shifting of cost curve
of the firms upward will also shift up the industry supply curve. On the other hand,
contraction of inputs by firms caused their prices to fall which bring a downward shift in the
cost of the firms and in the supply curve of the industry.
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What is short run?
The short-run is such a period in which the fixed factors like plants, machinery, etc. cannot
be changed.
6.3 The Long-Run Supply Curve of the Industry under Perfect

Competition
The long-run supply curve of a perfectly competitive industry indicates the various quantities
of a product offered at various prices. In the long-run, the firms can change the existing plant
and equipment and they can enter or leave the industry, so that price is always equal to both
the marginal cost (Price = LMC = LAC). However, the entry or exit of firms affects the cost
of productive resources and thereby causes shifts in the cost curves of the individual firms.
This, the long run supply curves can be upward sloping, horizontal or downward sloping
depending upon the law of returns under which the industry is operating.
i. Increasing–Cost-Industry
An industry is a cost increasing cost industry whose long-run supply curve slopes upward
from left to right when factor prices rises as industry output expands.
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Firm Industry
S S1
SMC LRS
SAG
P1 G SMC P2
B
LAG
SAC
P P1
LAC
P2 P
H A
D1
D
0 Q1 Q Q2 0 M N Output
Output
Fig. 6.2: Long-run Supply Curves – Increasing Cost
ii. Constant–Cost–Industry
An industry is said to be constant cost industry if its long-run supply curve is horizontal when
factor prices remain constant as industry output expands. A constant cost industry is subject
to both external economics and diseconomies in such a way that they counter balance each
the other so that there are constant costs in the long-run.
Industry
Firm
S
SMC
SAC LAC S1
G B
P1
P2 A
H P C
LRS
D D1
0 Q Q1 Output 0 M N Output
Fig. 6.3: Long-run Supply Curves–Constant Cost
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iii. Decreasing–Cost Industry
In the case of a decreasing cost industry, the long-run supply curve is downward sloping
because factor prices fall as industry output expands.
What is long run supply curve?
of a product offered at various prices
6.4 Curve under Monopoly or Imperfect Competition
There is no unique supply curve under imperfect competition or monopoly. The reason is that
price is simultaneously determined along with output. Unlike perfect competition, the price is
not given to the producer under monopoly. He is a price maker who can set the price to his
maximum advantage and his output or supply is determined by the consumer demand for his
product.
Price
Price
P1
P1
MR2 P
AR2
AR2 AR1
E1 MR1 AR1
E MR1
MR2
0 Q1 Q2
0 Q Quantity
Quantity
Fig. 6.4: Supply Curve under Monopoly
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It shows two demand curves AR1 and AR2 faced by the producer under monopoly.
______ is a price maker
Monopoly
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In this Study Session 6, you have learned that
1. Supply implies the various quantities of a commodity offered for sale by producers
during a given period of time at various prices.
2. The short-run is a period in which the fixed factors like plants, machinery, etc. cannot
be changed
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What is supply?
Explain short run
Explain long run
Who is a monopolist?
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Glossary of Terms
Exit: A permanent cessation of production when a firm leaves an industry.
Long run: A time horizon long enough for a firm to vary all of its inputs.
Price: Money value of a unit of a good, service or resource
Variable input: Input whose quantity can be changed in the time period under consideration
Page 119 of 220

References

Page 120 of 220

Study Session 7: Elasticity of Demand
Introduction
Elasticity refers to the relative responsiveness of a supply or demand curve in

relation to price. The more elastic a curve, the more quantity will change with
changes in price while the more inelastic a curve, the harder it will be to change
quantity consumed, even with large changes in price. Goods with elastic demand tend to be
goods which aren't very important to consumers or goods for which consumers can find easy
substitutes. Goods with inelastic demands tend to be necessities or goods for which
consumers cannot immediately alter their consumption patterns.
In this study session, you will be introduced to the following: the meaning and types of
elasticity of demand.
7.1 Explain the meaning and types of elasticity of demand

7.2 Discuss the price elasticity of demand
7.3 Explain the income elasticity of demand
7.4 Discuss the cross – price elasticity of demand
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7.1 Meaning and Types of Elasticity of Demand
Elasticity of demand refers to the degree of responsiveness of a change in quantity demanded

as a result of infinitesimal change in price, price of other goods and consumer’s income.
Figure 7.1: Types of Elasticity of Demand
Explain elasticity of demand
Elasticity of demand refers to the degree of responsiveness of a change in quantity demanded

as a result of infinitesimal change in price, price of other goods and consumer’s income
Page 122 of 220
7.2 The Price Elasticity of Demand
The price elasticity of demand for a product measures the responsiveness of demand to a
change in price. Price elasticity of demand measures the responsiveness of demand of a
good to a change in its price. Alfred Marshall was the first economist to formulate the
concept of price elasticity of demand as the ratio of a relative change in quantity demanded to
a relative change in price. A relative measure is needed so that changes in different measures
can be compared. These relative changes in demand and price are measured by percentage
changes. The percentage changes are independent of units. The coefficient of the price
elasticity of demand denotes Ed is defined as ratio of the percentage change in the quantity
demanded to percentage change in price. It can be expressed as:
Percentage change in quantity demanded

Ed 
Percentage change in Pr ice
Box 7.1
The ratio is a negative number because price and quantity demanded are inversely related. In
numerical sums, the minus sign is dropped from the numbers and all percentage changes are
treated as positive.
7.2.1 Kind of Price Elasticity of Demand
i. Elastic demand (1<εp<∞)
Demand for a commodity is price elastic of a given percentage change in price giving rise to
a greater percentage change in quantity demanded. Demand for a commodity will be said to
be more than unit elastic if a change in price results in a significant change in demand for this
commodity. If 10 percent change in price results in 14 percent change in demand, it is elastic
demand. Fig. 7.2 below shows elastic demand.
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Figure 7.2: Elastic Demand Curve
ii. Inelastic demand (0 <εp< 1)
Demand for a commodity is price inelastic if a given percentage change in price gives rise to
a lesser percentage change in quantity demanded. Demand for commodity will be said to be
inelastic (or less than unit elastic) if the percentage change in quantity demanded is less than
the percentage change in price. If 10 percent change in price results in 6 percent change in
demand, it is inelastic demand. This is shown in figure 7.3.
Figure 7.3: Inelastic Demand Curve
iii. Unit elastic demand (εp = 1)
Demand for a commodity is said to be unit price elastic if a given percentage change in price
gives rise to an equal percentage change in quantity demanded. Demand for a commodity
will be said to be unit elastic if the percentage change in quantity demanded equals the
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percentage change in price. If 10 percent change in price results in 10 percent change in

demand, it is unit elastic demand. The demand curve in such case is called rectangular
hyperbola shown in the adjacent figure 7.4.
Figure 7.4: Unit Elastic Demand Curve
iv. Perfectly elastic demand (εp = ∞)
Demand for a commodity is perfectly or infinitely price elastic if at a given price, consumers
are ready to buy all they can obtain, and none at all at any other price. This is the case for the
product of a firm that is operating under the conditions of perfect competition. Demand for a
commodity is said to be perfectly elastic, when a small change in its price results in an
infinite change in its quantity demanded. If 10 percent change in price results in (α) percent
change in demand, it is exactly elastic demand. In this case, demand curve is horizontal
straight line parallel to X-axis as shown in figure 7.5.
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Figure 7.5: Perfectly Elastic Demand Curve
v. Perfectly inelastic demand (εp = 0)
This is other wisely referred to as zero elasticity meaning that the consumers remain
completely indifferent to changes in price. Therefore, the demand for a product is perfectly
price inelastic if the quantity demanded remain the same whatever change in price. Demand
for a commodity will be said to be perfectly inelastic, if the quantity demanded does not
change at all in response to a given change in price. If 10 percent change in price results in
zero percent change in demand, it is exactly inelastic demand. The demand curve, in this
case, is vertical straight line perpendicular to Y-axis as shown in figure 7.6.
Figure 7.6: Perfectly Inelastic Demand Curve
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7.2.2 Measurement of Price Elasticity of Demand
The price elasticity of demand is a measure of the responsiveness of demand to changes in

the commodity’s own price. There are two appropriate to the measurement of consumer’s
sensitivity or reaction to a price change. The percentage method which is called the point
elasticity of demand, and the arc-price elasticity of demand which is obtained by the mid-
points formula.
i. The Point Elasticity of Demand
Let ∆P be a change in the price of the good, and ∆Q be the resulting change in quantity
demanded of it. If ∆P is very small, we can compute point elasticity of demand using the
formula.
Q P
Ed   
P Q
P – Original or old price
Q – Original or old quantity demanded,
∆Q – Q2 – Q1
∆P – P2 – P1
Note: Q1 = Q and P1 = P
Box 7.2
The price elasticity of demand will always be negative because price and quantity demanded
are inversely related.
ii. The Arc – Price Elasticity of Demand
This approach takes the average of the original and new quantities as bases. It can be
calculated using what is called the Midpoints Formula.
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Q P1  P2
Ed   
P Q1  Q2
P1 & Q1 – The Original price and quantity respectively
P2 & Q2 – The new price and quantity respectively.
∆Q= Q2 – Q1
∆P = P2 – P1
Case Study 1: The price of a biro in a certain market rises from N10 to N12.50, leading to a
decrease in the quantity demanded of the product per week from 500 to 300.
a. Compute: The point – price elasticity of demand,
b. The arc – Price elasticity of demand for the product
Solution:
a. The formula for the point-price elasticity of demand is
Q P
Ed   
P Q
Where; ∆Q = 300 – 500 = -200
∆P = 12.51 – 10 = 2.5
P = 10
Q = 500
 200 10
Ed    
2 .5 500
= 1.6 (demand is elastic)
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b. The formula for the arc-price elasticity of demand is
Q P1  P2
Ed   
P Q1  Q2
Where; ∆Q = 300 – 500 = -200
∆P = 12.51 – 10 = 2.5
P1 = 10, P2 = 12.5;
Q1 = 500, Q2 = 300
  200 10  12.5 
Ed    
 2.5 500  300 
= 2.25 (demand is elastic)
Box 7.3
Price elasticity of demand coefficient fall into five classes.
If Ed > 1, demand is elastic
If Ed < 1, demand is inelastic
If Ed = 1, demand is of elasticity
If Ed = ∞, demand is perfectly inelastic
If Ed = 1, demand is perfectly elastic
0  Ed  
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7.2.3 Determinants of Price Elasticity of Demand
The factors which determine the price elasticity of demand for a commodity or service are:
i. Availability of Close Substitute
A good having close substitutes will have an elastic demand and a good with no close
substitutes will have an inelastic demand. Example: commodities such as pen, cold drink, car,
etc. have close substitutes. When the price of these goods rises, the price of their substitutes
remaining constant, there is proportionately greater fall in the quantity demanded of these
goods. That is, their demand is elastic. Commodities such as prescribed medicines and salt
have no close substitutes and hence, have an inelastic demand.
ii. Income of the Consumers
If the income level of consumers is high, the elasticity of demand is less. It is because change
in the price will not affect the quantity demanded by a greater proportion. But in low income
groups, the elasticity of demand is high.
iii. Luxuries versus Necessities.
The price elasticity of demand is likely to be low for necessities and high for luxuries. A
necessity is a good or service that the consumer must have such as food (bread, milk) and
medicines. Luxuries are goods that are enjoyable but not essential.
Case Study
Eating in a 5-Star hotel. If the price of necessities rises, then demand will not fall by a greater
proportion because their purchase cannot be delayed. That is why the price elasticity of
demand in case of necessity is low.
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iv. Proportion of Total Expenditure Spent on the Product
The higher the cost of the good relative to total income of the consumer, the more will be the
price elasticity of demand. If the price of bread, ink, salt, match box, etc., which is relatively
low, doubles it would have almost no effect on the quantity demanded of them. On the other
hand, if price of car doubles then the quantity demanded will fall by a greater proportion
showing high price elasticity of demand.
v. Number of Uses of the Commodity.
The more the number of uses a commodity can be put to, the more elastic is the demand. If a
commodity has few uses, it has an inelastic demand. Examples: goods like milk, eggs and
electricity can be put to many different uses and hence, enjoy elastic demand, i.e., when
prices are low, demand increases by a greater proportion as the goods can now be put to less
important uses also.
vi. Time Period
If the time period needed to find substitutes of the commodity is more, the price elasticity of
demand is more and vice versa. Example: flying by aeroplane has inelastic demand as no
substitutes are available in the short run.
vii. Possibility of postponement of consumption
If there is a possibility of postponement of consumption of a commodity, then demand will be

elastic otherwise inelastic. Demand for certain goods can be postponed for some time such as
computers, printers, scanners etc. People may wait till they become cheaper. Therefore, their
demand is elastic. But the demand for food or electricity cannot be postponed. As such their
demand is inelastic.
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viii. Fashion
Commodities, which are in fashion, will have inelastic demand. Fashion minded people do
not compromise with price. Even if price is high, some people will demand more just because
goods are in fashion.
ix. Change in Taste
A habitual commodity or a commodity for which consumers have developed a taste will have
inelastic demand. A chain smoker always requires a cigarette, whatever the price may be.
Likewise, a habitual paan (betel nut) chewer cannot leave his habit, in spite of rise in price. In
such cases, therefore, demand is elastic.
x. Price of the Commodity
Very high priced or very low priced goods have low elasticity whereas moderately priced
commodities are quite high-elastic. If a good is very expensive, demand will not increase
much even if there is little fall in its price. And demand will not increase even at very low
prices, because people have already purchased their requirement at low prices.
What are the factors which determine the price elasticity of demand for a commodity?
i. Availability of Close Substitute.

ii. Income of the Consumers.
iii. Luxuries versus Necessities.
iv. Proportion of Total Expenditure Spent on the Product
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v. Number of Uses of the Commodity.

vi. Time Period.
vii. Possibility of postponement of consumption:
viii. Fashion
7.3 The Income Elasticity of Demand
The income elasticity of demand provides a measure of the responsiveness of demand to a

change in income. It is defined as the ratio of the percentage change in the quantity demanded
of a product to the percentage change income.
Percentage change in quantity demanded

Ey 
Percentage change in Income
Where Ey stands for income elasticity of demand coefficient.
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7.3.1 Types of Income Elasticity of Demand
Fig. 7.7: Types of Income Elasticity of Demand
i. Elastic Demand (1 <Ey< ∞)
Demand increases by a greater percentage than the income. In this case, Ey is greater than 1
but less than infinity. Goods whose demand is income elastic are referred to as normal goods.
ii. Inelastic demand (0<Ey<1)
Percentage change in quantity demanded is greater than percentage change in income, but by
a smaller proportion for this range of goods, Ey is greater than Zero but less than 1 such
goods are described as normal goods as long as income demand relation is positive, and they
are also called necessities.
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iii. Negative Income Elasticity of Demand (Ey<0)
This is the case to those goods for which the consumers reduce their purchase as their income
rises. They are called inferior goods and Ey is less than zero.
iv. Unit Income Elasticity (Ey=1)
Increase in income gives rise to exactly the same percentage increase in quantity demanded.
The income elasticity of demand coefficient Ey is equal to 1.
v. Perfect Inelastic Demand (Ey=0)
The Income elasticity of demand is zero if with a change in income quantity demanded
remains unchanged.
7.3.2 Measurement of Income Elasticity of Demand
This measurement enables us to distinguish between normal good and inferior good using the
coefficient of income elasticity of demand. Note that the use of this measurement enables us
to classify normal good into three. These are luxury good if coefficient of income elasticity is
greater than one (1 <Ey< ∞); essential or comfort good (Ey= 1); necessity good (0<Ey<1).
Q Y1  Y2
Ey  
Y Q1  Q2
Where; Y1 and Q1 = original income and quantity respectively

Y2 and Q2 = new income and quantity respectively
∆Q – Q2 – Q1 (Change in quantity demanded)
∆Y – Y2 – Y1 (Change in income)
If a demand function in which the consumer’s income is one of the independent variables is
given, and where change in quantity demanded results from a small change in the consumer’s
income, the income elasticity of demand is precisely,
Q Y
Ey  
Y Q
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Q
Where; = the derivative of Q with respect to Y
Y
Q = the original quantity demanded
Y = the original money income of the consumer
If 1 <Ey< ∞, demand is income elastic
If 0<Ey< 1, demand is income inelastic
If Ey< 0, negative income elasticity
If Ed = 1, unit income elasticity
If Ed = 0, demand is perfectly income inelastic
This implies that;
Ey  1  Ey  0
7.3.3 Determinants of Income Elasticity of Demand
i. The Initial income level of a country
For Instance, goods such as TV sets, air conditioner, and refrigerator are luxuries in this so
called third world countries with low per capital income, whereas they are necessities in the
first world countries with higher per capital income.
ii. The nature of the need covered by the commodity
The proportion of income spent on food and some other basic necessities declines as income
increases. This conception is expressed in Engels law and it has sometimes been used as a
measure of economic welfare and of the development stage of an economy.
iii. The time period
Normally a consumption pattern does not adjust instantly with charges in income.
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Mention types of income elasticity of demand
a) Elastic Demand (1 <Ey< ∞)

b) Inelastic demand (0<Ey<1)
c) Negative Income Elasticity of Demand (Ey<0)
d) Unit Income Elasticity (Ey=1)
e) Perfect Inelastic Demand (Ey=0)
7.4 The Cross – Price Elasticity of Demand
The cross – price elasticity of demand is a measure of the responsiveness of the demand for a
commodity to a change in the price of a related commodity. It can be expressed as:
Percentage change in demand for A

E AB 
Percentage change in demand for B
Types of Cross–Price Elasticity of Demand
i. High cross – elasticity (1 <EAB< ∞)
A given percentage increase (fall) in the price of B leads to a greater percentage increase
(fall) in the demand for A.
ii. Low – cross – elasticity(0<EAB<1)
A given percentage increase (fall) in the price of B leads to a less percentage increase (fall) in
the price for A.
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iii. Unit cross elasticity (EAB= 1)
A given percentage increase (fall) in the price of B leads to exactly the same percentage
increase (fall) in the demand for A.
iv. Negative cross elasticity (EAB<0)
A rise (fall) in the price of B lead to a fall (rise in the demand for A. E AB< 0, for
complementing goods).
v. Zero cross elasticity (EAB= 0)
For two goods that are not any way related, the cross price elasticity of demand between them
is zero
vi. Infinite cross elasticity (EAB= ∞)
A fall in the price of B reduces demand for A to nothing. Goods A and B are said to be
perfect substitutes.
7.4.2 Measurement of Cross Price Elasticity of Demand
Both points are approaches that can be used in the measurement of cross price elasticity of
demand. The point cross price elasticity of demand will be
Q A PB
Ed  
PB Q A
Q A PB
Ed  .
PB Q A
For arc cross-elasticity of demand we have,
Q A PB1  PB 2
Ed  
PB Q A1  Q A2
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Box 7.4: Determinants of Cross Price Elasticity of Demand
The main determinant of the cross price elasticity of demand between two goods is the extent
to which good can either be substituted for the other or complement the other.
What are types of cross–price elasticity of demand?
1. High cross – elasticity (1 <EAB< ∞)

2. Low – cross – elasticity (0<EAB<1)
3. Unit cross elasticity (EAB= 1)
4. Negative cross elasticity (EAB<0)
5. Zero cross –elasticity (EAB= 0)
6. Infinite cross elasticity (EAB= ∞)
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1. Elasticity of demand refers to the degree of responsiveness of a change in quantity

demanded as a result of infinitesimal change in price, price of other goods and
consumer’s income.
2. Types of elasticity of demand are:
(i) The Price Elasticity of Demand
(ii) The Income Elasticity of Demand
(iii) The Cross-Price Elasticity of Demand
3. The main determinant of the cross price elasticity of demand between two goods is
the extent to which good can either be substituted for the other or complement to the
other.
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SAQ 7.1 (Test Learning Outcome 7.1)
Mention the types of elasticity of demand
Mention the kind of price elasticity of demand
What are determinants of income elasticity of demand?
List the types of cross–price elasticity of demand
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Glossary of Terms
Change in quantity demanded is a movement along a demand curve in response to a

change in price.
Commodity: A basic good used in commerce that is interchangeable with other goods of the
same type
Normal good: A good that experiences an increase in its demand due to a rise in consumers'
income
Price: Money value of a unit of a good, service or resource.
Page 142 of 220

References

Page 143 of 220

Study Session 8: Elasticity of Supply
Introduction
The elasticity of supply establishes a quantitative relationship between the supply

of a commodity and its price. Conversely, the supply of a good will decrease when
its price decreases. However, the major factor controlling the supply of a
commodity is its price.
In this study session, you will be introduced to the meaning of elasticity of supply and its
types.
8.1 Explain the meaning of elasticity of supply

8.2 State the types of price elasticity of supply
8.3 State the determinants of elasticity of supply
8.4 Explain some applications of the elasticity concept
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8.1 Meaning of Elasticity of Supply
The concept of elasticity of supply is traceable to the contribution of Alfred Marshall in the
field of economics. Price elasticity of supply is defined as the responsiveness of quantity
supplied of a commodity to changes in its own price. The value of elasticity of supply will
give the degree or quantity of change in supply to a change in price. It can be calculated
using:
% in Qty Supplied
es 
% in Pr ice
Qs P
es   
P Qs
where,
eS = Coefficient of price elasticity of supply. It is independent of units.
P = Initial price of the good.
Q = Initial quantity supplied.
ΔQ = Change in quantity supplied.
ΔP = Change in price.
The positive sign indicates that price and quantity supplied of a good are positively related,
i.e., greater units of the good will be placed in the market only at higher prices and vice-
versa.
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What is price elasticity of supply?
Price elasticity of supply is defined as the responsiveness of quantity supplied of a commodity

to changes in its own price.
8.2 Types of Price Elasticity of Supply
i. Elastic Supply (1 <eS< ∞)
When percentage change in supply is more than the percentage change in price, supply is said
to be elastic or more than unitary elastic. In this case, the value of the eS is more than one. It
is shown in figure 8.1
Figure 8.1: Elastic Supply Curve
ii. Inelastic Supply (0 <eS<1)
When percentage change in quantity supplied is less than percentage change in price, supply
is said to be inelastic or less than unitary elastic. Graphically presents in figure 8.2
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Figure 8.2: Inelastic Supply Curve
iii. Unitary Elastic Supply (eS= 1)
Supply of a commodity is said to be unitary elastic if percentage change in supply equals the
percentage change in price. In this case, the coefficient of eS is equal to one. This is shown in
figure 8.3
Fig. 8.3: Unitary Elastic Supply Curve
iv. Perfectly Elastic Supply (eS= ∞)
Supply of a commodity is said to be perfectly elastic when its supply expands (rises) or
contracts (falls) to any extent without any change in the price. The coefficient of eS= ∞
(infinity). It is shown graphically in figure 8.4
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Figure 8.4: Perfectly Elastic Supply Curve
v. Perfectly Inelastic supply (eS= 0)
When supply of a commodity does not change irrespective of any change in its price, it is
called perfectly inelastic supply. Supply is perfectly inelastic if a change in price causes no
change in supply as shown in figure 8.5.
Figure 8.5: Perfectly Inelastic Supply Curve
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Case Study
Price of a good falls from N15 to N10 and the supply decreases from 100 units to 50 units.
Calculate elasticity of supply.
Solution: Q = 100, P = 15, Q1 = 50, P1 = 10, ΔQ = 50, ΔP = 5
∆𝑄 𝑃 50 15
Elasticity of supply = ∆𝑃 𝑋 𝑄 = 𝑋 100 = 1.5
5
Since elasticity of supply is greater than 1, it is elastic supply.
Highlight the types of Price Elasticity of Supply
i. Elastic Supply (1 <eS< ∞)

ii. Inelastic Supply (0 <eS<1)
iii. Unitary Elastic Supply (eS= 1)
iv. Perfectly Elastic Supply (eS= ∞)
v. Perfectly Inelastic supply (eS= 0)
8.3 Determinants of Elasticity of Supply
The important factors affecting price elasticity of supply are:
i. Time Factor
The longer the time period, more is the time available to adjust the supply more elastic is the
supply curve.
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ii. Nature of the Good
Inelastic supply in case of perishable goods (e.g. milk, bread, etc.) because its supply can
neither be increased nor be decreased within a short period. Elastic supply in case of durable
goods.
iii. Production Capacity
If unlimited production capacity exists (i.e., production can be increased easily), then there is
elastic supply. If limited production capacity exists, then there is inelastic supply.
iv. Production Methods and Techniques.
If an industry uses complicated methods and techniques of production, supply of the

commodity produced by that industry will be of production, supply of the commodity
produced by that industry will be relatively elastic.
v. Stage of Laws of Return.
If the law of diminishing return is applied on the production of a commodity, elasticity of

supply for such a commodity will be inelastic. On the contrary, if the law of increasing return
is applied on the production of a commodity, supply of such a commodity will be elastic.
vi. Future Price Expectation.
If the producers expect that the price will rise in future, then they will supply less quantity in
the market presently. Thus, supply will become inelastic. If the producers expect that the
price will fall in the future, supply will be more elastic.
vii. Number of Products being produced by an Industry.
If an industry is producing many products, supply is elastic as the producers can switch over
to the production of other goods and vice versa.
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Highlight the determinants of elasticity of supply
i. Time Factor
ii. Nature of the Good
iii. Production Capacity
iv. Production Methods and Techniques.
v. Stage of Laws of Return.
8.4 Some Applications of the Elasticity Concept
i. Monopoly Price and Revenue:
The knowledge of the price elasticity of demand for his product in fixing his product price.
To obtain a higher total revenue and probably a higher profit, a monopolist should:
a. Increase price if demand for his product is relatively price inelastic.

b. Increase price if demand for his product is perfectly inelastic, because the same quantity
will still be purchased at higher price.
c. Reduce price, if demand is fairly price elastic, since a small reduction in price will cause a
substantial increase in sales
d. Leave price unchanged if demand is perfectly elastic, because demand and hence total
revenue will fall to zero at a slightly higher price.
e. Leave price unchanged if price elasticity of demand is unit.
ii. Labour union agitation for higher wages and increase of national minimum wage
government
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Wage is the price of labour. If demand for labour in a particular industry is wage elastic, a
little increase in wages will lead to a substantial fall in demand for labour services thereby
worsening the problem of unemployment. In such industry, strikes and other trade union
pressure tactics cannot be effective in raising wages.
But if demand for labour services is inelastic, a mere threat of strike will be enough to induce
the employers to raise wages of workers in the industry. In the Nigerian economy most of the
labour union have not succeeded in bargaining for higher wage and improved fringe benefits
because demand for their services is wage elastic. This is due majorly to the glut of labour
services and ready availability of close substitutes. Note: if demand for the bulk of labour
service is highly elastic, an increase in minimum wage rate may lead to a higher level of
unemployment.
iii. Incidence of Tax and Government Tax Policy
One of the major sources of government revenue is excise taxes which are levied on goods
produced within the country. The concept of incidence of tax is used to describe the final
effect of tax in the consumers and the producer in terms of higher prices paid or lower prices
received.
S0 S1
P Spi
P2 Sc
P1
S1
P0
S
0 Q
Figure 8.6: Price elasticity of supply and incidence of excise tax.
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iv. Granting or Removal of Subsidy:
 Granting a subsidy: A subsidy is money contributed by government to keep down a

commodity price. Some industries need to be granted subsidy to be able to survive or
operate profitably.
 Removal of subsidy: It has the same effect as the imposition of excise tax or value added
tax. That is, shifting supply curve upward. The removal of subsidy shift supply curve
from initial point to another and it cause prices to increase and the quantity traded on the
market to fall.
(a) Granting of subsidy

P S0
S2
D
D
Price
P0
P D
S0 D
0 Q0 Q Qd Q
Quantity
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(b) Removal of subsidy

P D
D
S1
P
Price
P1 S
P0
S1
D
D
S
0 Q0 Q Q2 Q
Quantity
Figure 8.7: Granting of Subsidy and Removal of Subsidy
v. Government employment policy and the relevance of the income elastic of demand.
vi. Solving problem of international trade.
List some of the applications of the elasticity concept
i. Monopoly Price and Revenue

ii. Labour union agitation for higher wages and increase of national minimum wage
government
iii. Incidence of Tax and Government Tax Policy
iv. Granting or Removal of Subsidy
v. Government employment policy and the relevance of the income elastic of demand
vi. Solving problem of international trade
Page 154 of 220
1. Price elasticity of supply is defined as the responsiveness of quantity supplied of a

commodity to changes in its own price
2. Types of Price Elasticity of Supply are:
 Elastic Supply (1 <eS< ∞)
 Inelastic Supply (0 <eS<1)
 Unitary Elastic Supply (eS= 1)
 Perfectly Elastic Supply (eS= ∞)
 Perfectly Inelastic supply (eS= 0)
3. Determinants of Elasticity of Supply are:
 Time Factor
 Nature of the Good
 Production Capacity
 Production Methods and Techniques.
 Stage of Laws of Return.
 Future Price Expectation.
 Number of Products being produced by an Industry.
Page 155 of 220

Define price elasticity of supply
Mention the types of Price Elasticity of Supply
What are the determinants of elasticity of supply?
Mention the applications of the elasticity concept
Page 156 of 220

Glossary of Terms
Change in quantity supplied: A movement along a supply curve in response to a change in

price.
Change in supply: A shift of a supply curve in response to some variable other than price.
Market: A group of buyers and sellers with the potential to trade with each other.
Perishable goods: Goods having a short span of life
Page 157 of 220

References

Page 158 of 220

Study Session 9: Theory of Production
Introduction
The theory of production explains the principles by which a firm decides how
much of each commodity that it sells i.e. outputs or products it will produce and
how much of each kind of labour, raw material, fixed capital goods, etc., that it
employs i.e. inputs or factors of production it will use.
In this study session you will be introduced to the following: nature of production, production
function and difference between the long run and short run of firm.
9.1 Explain the meaning of production

9.2 Discuss the production function
9.3 Explain the concept of product
9.4 State the relationship between TP, AP and MP
9.5 Describe returns to a factor and returns to scale
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9.1 Meaning of Production
Inputs are the raw materials or other productive resources used to produce final products i.e.,
output. In technical terms, production means the creation of utility or creation of want-
satisfying goods and services. Any good become useful for us or satisfies our want when it is
worth consumption. Thus, a good can be made useful by adding utility. For example, inputs
of sugar cane, capital and labour are used to produce sugar. Production includes not only
production of physical goods like cloth, rice, etc., but also production of services like those of
a doctor, teacher, lawyer, etc.
Utilities can be created in three ways. These are the following:
i. By changing form or shape and size of a good
The powdery wheat flour has been changed to slices of bread. Thus form of the good has
been changed. Likewise, a carpenter giving shape of a chair to a piece of wood or a chef
turning a lump of dough into delicious pizzas, are the examples of changing shape or size of a
good/s and thereby creating utility.
ii. Using the scarce goods and services in proper time when they are most required
Government maintains a buffer stock so that during the time of crisis, it releases food grains
in the market to meet the demand.
iii. By transferring a good from one place to another where its use is worthwhile
Sand transferred from river side to construction site increases its utility. Thus, production is
the process of adding utility to a good through form utility, place utility and time utility.
Box 9.1: Definition of Production
Production is defined as the transformation of inputs into output
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What is production?
Production means the creation of utility or creation of want-satisfying goods and services
9.2 Production Function
9.2.1 Meaning of Production Function
The term production function means physical relationship between inputs used and the
resulting output. Production function is a purely technical relation which connects the
quantity of inputs required to produce a good and the quantity of output produced.
Production function is the process of getting the maximum output from a given quantity
of inputs in a particular time period. It includes only technically efficient combinations
of inputs (i.e., those which minimise the cost of production).
A production function is an expression of quantitative relation between change in inputs and

the resulting change in output. It can be expressed using only two inputs: labour (L) and
capital (K) required to produce a good as:
𝑄 = 𝑓 (𝐾, 𝐿)
Thus a production function shows the maximum amount of output that can be produced from
a given set of inputs in the existing state of technology.
9.2.2 Short-run and Long-run Production Function
There are two types of production function:
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(a) Short-run Production Function: It refers to production in the short-run where there is at
least one factor in fixed supply and other factors are in variable supply. In short-run,
production will increase when more units of variable factors are used with the fixed factor.
Fixed factors refer to those factors whose supply cannot be changed during short-run. For
example, land, plant, factory building, minimum electricity bill, etc.
(b) Long-run Production Function: It refers to production in the long-run where all factors
are in variable supply. In the long-run, production will increase when all factors are increased
in the same proportion. Variable factors refer to those factors whose supply can be varied or
changed. For example, raw materials, daily wages, etc.
What is production function?
Production function means physical relationship between inputs used and the resulting
output
9.3 Concept of Product
9.3.1 Total Physical Product (TPP) or Total Product (TP)
In the short-run, TP can be increased by employing more units of the variable factor. In the
long-run, TP can be increased by employing more units of all factors.
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Box 9.2: Total Physical Product (TPP) or TP
It is defined as the total quantity of goods produced by a firm with the given inputs during a
specified period of time.
Shape of TP Curve
TP curve starts from the origin, increases at an increasing rate, then increases at a decreasing
rate, reaches a maximum and after that it starts falling. Thus, as more units of variable factor
are employed, it will not always increase the TP. It is illustrated with a TP curve in Fig. 9.1.
TP curve confirms that in the beginning total production increases at an increasing rate. TP
starts increasing at a decreasing rate with the employment of the fourth unit of labour. When
seventh unit of labour is employed, TP becomes stable at 30 units and with the employment
of the eighth unit, it starts declining.
In Figure 9.1, units of labour are shown on the x-axis and total product on the y-axis. As the
units of labour increase, TP curve increases at an increasing rate till point A. Then TP curve
increases at a decreasing rate till point B. TP is maximum at point C. It falls after point C.
Figure 9.1: Total product Curve
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9.3.2 Average Product (AP) or Average Physical Product (APP)
Average Product (AP) is defined as the amount of output produced per unit of the
variable factor (labour) employed. Symbolically, AP =Total Physical Product / Labour
𝑇𝑃
Input or AP = 𝐿
Case Study
10
If the TP with 5 units of variable factor is 10 units then, AP will be equal to = 2 units.
5
Shape of AP Curve
As the units of variable factor are increased, AP curve starts from the origin, increases at a
decreasing rate, reaches a maximum and then starts falling. AP curve is Inverted-U shaped.
As long as TP is positive, AP is positive. It can be illustrated with the help of an AP curve
given in Fig. 9.2.
From the AP schedule, it is clear that initially AP is zero when no labour is employed, then it
increases till three units of labour are employed, reaches a maximum when four units of
labour are employed and then starts declining.
Figure 9.2: Average Product Curve
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In figure 9.2, values of AP are shown on the y-axis and units of labour on the x-axis. AP curve
is inverted U-shaped.
9.3.3 Marginal Product (MP) or Marginal Physical Product (MPP)
Box 9.3: Definition of Marginal Product
Marginal Product (MP) is defined as the change in TP resulting from the employment of an
additional unit of a variable factor (labour).
Symbolically, MP can be written as:
𝛥𝑻𝑷
MP = Change in Total Product/Change in labour Input or MP = 𝜟𝐿
MP can also be calculated from the values of TP by the formula: MPn = TPn – TPn – 1
where n = Number of labour units
Shape of MP Curve
The MP curve rises initially, reaches a maximum and then starts falling. When TP falls, MP
is negative. It can be illustrated with an MP curve given in Fig. 9.3. In the MP curve, it is
clear that initially MP value increases till the employment of three units of labour, then MP
value starts declining to become zero with employment of seven units of labour and then
becomes negative after that.
Box 9.4
When TP is maximum, MP is zero
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Figure 9.3: Marginal product Curve
In figure 9.3 units of labour are shown on the x-axis and marginal product is shown on the y-
axis. MP curve is increasing in the initial stages of production, reaches a maximum with 3
units of labour and then declines. It becomes zero when 7 units of labour are employed and
TP is maximum. If the units of labour are increased beyond 7 units, marginal product curve
will become negative. MP curve is inverted U-shaped.
Define the following concepts:
i. Total product
ii. Marginal product
i. Total product is defined as the total quantity of goods produced by a firm with the
given inputs during a specified period of time.
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ii. Marginal Product is defined as the change in total product resulting from the
employment of an additional unit of a variable factor
9.4 Relationship between TP, AP and MP
The relationship between TP, AP and MP is as follows:
i. AP curve is the slope of the straight line from the origin to each point on the TP curve.
MP curve is the slope of the TP curve at each point
ii. When AP is maximum, MP = AP.
iii. When TP is maximum, MP = 0.
iv. When TP is falling, MP is negative
v. As long as TP is positive, AP is positive
vi. Both AP and MP curves are inverted U-shaped
Figure 9.4: Relationship between TP, AP and MP
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9.4.1 Relationship between TP and MP
i. In Fig. 9.4 MP at any point on the TP curve is the slope of the TP curve at that point.
The value of slope rises, then falls till TP is maximum. (At that point slope of TP
curve is zero) and beyond that it is negative.
ii. MP curve rises initially, reaches a maximum and declines after that.
iii. When TP increases at increasing rate, MP increases.
iv. When TP increases at decreasing rate, MP decreases and is positive.
v. When TP is maximum, MP is zero.
vi. When TP falls, MP is negative. Its economic meaning is that additional labourer
slows down the production process, i.e., total output falls. This implies that MP of that
worker is negative.
vii. TP is the area under the MP curve.
9.4.2 Relationship between AP and MP
Figure 9.5 brings out the relationship between AP and MP as follows:
𝑇𝑃 𝛥𝑻𝑷
i. Both AP and MP curves are derived from the TP curve since AP= 𝐿 and MP = 𝜟𝐿 .
ii. When MP >AP, AP rises.
Box 9.5
MP curve lies above AP curve. MP achieves its maximum point and starts falling still AP
rises. When both AP and MP curves are rising, MP curve rises at a faster rate. The reason for
rise in both AP and MP values is underutilisation of the fixed factor.
iii. When MP = AP, AP is maximum. MP curve cuts AP curve at its maximum point.
iv. When MP <AP, AP falls.
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Box 9.6
MP curve lies below AP curve. When both AP and MP curves are falling, MP curve falls at a
faster rate. The reason for all in both AP and MP values is full utilisation of the fixed factor.
v. Both AP and MP curves are inverted ‘U’ shaped curve.
vi. When MP is at its maximum, it is called point of inflexion.
Figure 9.5: Relationship between AP and MP
What are the relationship between TP, AP, and MP?
i. AP curve is the slope of the straight line from the origin to each point on the TP
curve. MP curve is the slope of the TP curve at each point
ii. When AP is maximum, MP = AP
iii. When TP is maximum, MP = 0
iv. When TP is falling, MP is negative
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v. As long as TP is positive, AP is positive

vi. Both AP and MP curves are inverted U-shaped
9.5 Returns to a Factor and Returns to Scale
There are generally two types of production functions mostly used in economics. First, the
production function when the quantities of some inputs are kept fixed and the quantity of one
or few input/s are changed. This kind of production functions are studied under law of
variable proportions. These are also called short-run production function. The short-run is a
period during which one or more factors of production are fixed in amount. There is no time
to change plants or equipment of an enterprise.
Secondly, the production functions in which all inputs are changed. This forms the subject
matter of the law of returns to scale. These are also called long-run production function. The
long run is a period during which all factors become variable. A new plant can be constructed
in place of an old one.
9.5.1 Law of Variable Proportions/Law of Diminishing Returns
Law of variable proportions occupies an important place in the economic theory. It examines
the production function with one factor variable, keeping the quantities of other factors
constant. This law tells us how the total output or marginal output is affected by a change in
the proportion of the factors used. The law states that when one factor is increased keeping
others fixed, the marginal and average product eventually declines. According to Stigler, “As
equal increments of one input are added; the inputs of other productive services being held
constant, beyond a certain point the resulting increments of product will decrease, i.e., the
marginal products will diminish.” Thus, an increase in the quantities of a variable factor to a
fixed factor results in increase in output to a point beyond which it eventually declines.
9.5.2 Assumptions of the Law
The law assumes the following:
i. The state of technology is assumed to be constant.
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ii. There must be some inputs whose quantity is kept fixed.
iii. The law is based upon the possibility of varying the proportions in which the various
factors can be combined to produce a product. It cannot be applied to the cases where
the factors must be used in fixed proportions to yield a product.
9.5.3 Three Phases of Production
These three phases of the short-run law of production are graphically illustrated by the
relationship between TP and MP curves. It is given in Fig. 9.6.
Phase I: Phase of Increasing Returns
It goes from the origin to the point where the MP curve is maximum (i.e., from origin to point
B). In these phases, TP curve is increasing at an increasing rate. MP curve rises and reaches a
maximum.
Box 9.7: The reasons for increasing returns
i. Underutilisation of fixed factor (land),
ii. Indivisibility of factors, and
iii. Specialisation of labour.
A rational producer will not operate in this phase because the producer can always expand
through phase I. It is a non-economic range.
Phase II: Phase of Diminishing Returns
It is the most important phase out of the three phases. Phase II of production ranges from the
point where
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MP curve is maximum to the point where the MP curve is zero (i.e., from point B to C). MP
curve is positive but declining. TP curve increases at a decreasing rate and reaches a
maximum. A rational producer will always operate in this phase. The law of diminishing
returns operates in phase II.
Box 9.8: The Reasons for Diminishing Returns
i. Optimal use of fixed factor, and
ii. Lack of perfect substitutes between factors.
Phase III: Phase of Negative Returns
It covers the entire range over which MP curve is negative. In this phase, TP curve falls (after
point C). A rational producer will not operate in this phase, even with free labour, because
he could increase his output by employing less labour. It is a non-economic and an inefficient
phase.
Box 9.9: The reason for negative returns
Over utilisation of fixed factor.
Figure 9.6: Stages of Production of the Short-run Law

Page 172 of 220
9.5.4 Reasons behind Increasing and Diminishing Returns to a Factor
The reasons for increasing returns to a variable factor are:
i. Underutilisation of fixed factor
The fixed factor, land, is underutilised in relation to labour employed on it. This helps in
better utilisation of the fixed factor. It results in increasing returns.
ii. Indivisibility of factors
The factors employed in the production process are indivisible, i.e., they cannot be divided
into smaller parts. Thus, when more units of the variable factor are combined with the fixed
factor, returns are increasing.
iii. Specialisation and Division of Labour
As the number of labourers is increased, specialisation and division of labour will lead to
increasing returns.
The reasons for diminishing returns to a variable factor are:
 Optimum use of fixed factor
Returns start diminishing when the fixed factor, land, is fully utilised in relation to labour
employed on it. In other words, the quantity of fixed factor is just right in relation to the
quantity of the variable factor.
 Lack of perfect substitutes between factors
All factors of production are in scarce supply. When there is an imperfect substitute of a
factor with another factor, returns start diminishing.
9.5.5 Postponement of the Law
The law of variable proportion can be postponed if:
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i. Improvement in technology takes place
It means that for some time due to improvement in the technology of production the law
becomes inoperative.
ii. Some substitutes of the fixed factor are discovered
It means that all factors have become variable. The law will become inoperative till the newly
discovered substitute factors are used.
Mention three phases of production
(i) Phase I: Phase of Increasing Returns

(ii) Phase II: Phase of Diminishing Returns
(iii) Phase III: Phase of Negative Returns
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1. Production is the creation of utility or creation of want-satisfying goods and services.

2. Utilities can be created in three ways:
3. Total Physical Product (TP) is defined as the total quantity of goods produced by a
firm with the given inputs during a specified period of time.
4. Marginal Product (MP) is defined as the change in TP resulting from the employment
of an additional unit of a variable factor (labour).
5. Average Product (AP) is defined as the amount of output produced per unit of the
variable factor (labour) employed.
6. Three Phases of Production are:
 Phase I: Phase of Increasing Returns
 Phase II: Phase of Diminishing Returns
 Phase III: Phase of Negative Returns
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Mention three ways utilities can be created
Explain:
a) Short-run production function

b) Long-run production function
Define average product
a) When MP = AP, ______ is maximum. MP curve cuts AP curve at its maximum point.
b) When MP <AP, ______ falls
Mention the assumptions of the law of variable proportion
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Glossary of Terms
Consumption: It is the part of GDP purchased by households as final users
Production function: It is a mathematical method of describing the relationship between the

quantity of inputs utilized by a company and how much it produces with them (output)
Technology: This is the application of scientific knowledge for practical purposes, especially
in industry
Page 177 of 220

References

Page 178 of 220

Study Session 10: Introduction to Consumer’s Behaviour
Introduction
A consumer is one who buys goods and services for satisfaction of wants. The
objective of a consumer is to get maximum satisfaction from spending his income
on various goods and services at given prices.
Suppose a consumer wants to buy a commodity. How much of it should he buy? Two
approaches are used for getting an answer to this question. These are: (i) Utility approach and
(ii) Indifference curve approach
In this study session you will be introduced to the following: the concept of marginal product,
concept of marginal rate of technical substitution using isoquant approach and the implication
of short-run variations in Input.
10.1 Explain consumer’s equilibrium with utility approach

10.2 State the law of diminishing marginal utility
10.3 List the assumptions of the utility approach
10.4 Explain the meaning of consumer’s equilibrium
10.5 Discuss the consumer’s equilibrium with indifference curve approach
10.6 Explain the consumer equilibrium
10.7 Describe the derivation of the Engel curve
10.8 Explain the consumer surplus
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10.1 Consumer’s Equilibrium with Utility Approach
10.1.1 Utility – Different Concepts
i. Utility
Utility denotes the want satisfying power of a commodity or service. In other words, the
satisfaction a consumer receives from consuming a product is called utility. It also implies
realised satisfaction to a consumer when he is willing to spend money on a stock of
commodity which has the capacity to satisfy his want. Expected satisfaction is different from
realised satisfaction. Realised satisfaction takes place only after the commodity has been
consumed. Expected willingness to buy it. A commodity has utility for a consumer even
when it is not consumed.
Further, the same commodity has different utility for different persons, and also to the same
person at different points of time. Utility is essentially a subjective concept depending upon
the intensity of consumer’s desire or want for that commodity at that time. Thus, utility
differs from person to person, place to place and time to time.
Utility is a cardinal concept i.e., it can be measured. Benham formulated the unit of
measurement of utility as utils (i.e., say consumption of 2 units of X gives 10 utils).
According to Marshall, money should be used to measure utility (i.e., say consumption of 2
units of X gives utility worth 10utils).
ii. Total Utility (TU)
It is the sum of all the utilities that a consumer derives from the consumption of a certain
amount of a commodity. This refers to the total amount of satisfaction obtained by a
consumer from the consumption of some quantity of a good or service. Mathematically, TU
can be obtained by the sum of marginal utilities from the consumption of different units of
the commodity.
TUn = MU1 + MU2 + ...+ MUn
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For instance, the total utility of a commodity X depends on the quantity of the commodity
consumed. This statement can be referred to as a utility function. TUx = f(X)
iii. Marginal Utility (MU)
It is addition made to the total utility as consumption is increased by one more unit of the
commodity. Marginal Utility is the additional satisfaction a consumer derives from an
additional unit of a commodities, when the levels of consumption of all other commodities
are held constant.
TU X
MU X 
QX
The basic assumption or concept of utility is “The Law of Diminishing Marginal Utility”.
The law states that as more and more units of particular good are consumed during a specific
period of time, total utility increases, but at a diminishing rate, the consumption of all other
goods being held constant. The law of diminishing marginal utility is illustrated in figure 10-
1 below as a graphical counterpart of total and marginal utility data given in table 10-1.
Table 10.1: Total and Marginal utility of beer for Mr. Wale
Quantity of beer consumed Total utility from beer Marginal utility of beer (MUB)
per day consumption
0 0 -
1 40 40  0
40 
1 0
2 70 70  40
30 
2 1
3 90 90  70
30 
3 2
4 100 100  90
10 
43
5 100 100  100
0
5 1
6 90 90  100
 10 
65
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Table 10.1 provides the following information:
 As the consumer has more of the good, the TU increases less than in proportion and
the MU gradually declines but is positive.
 When TU is maximum, called saturation point, MU is zero.
 When TU falls, MU becomes negative.
 If consumer is rational, he will stop at 5 units. This is because if he consumes more
than 5 units, then TU will decline and MU will become negative (the good will give
disutility).
iv. Relationship between TU and MU Curves
The relationship is as follows:
 TU curve starts from the origin, increase at a decreasing rate, reaches a maximum and
then starts falling.
TU X
 MU curve is the slope of the TU curve, since MU X 
QX
 When TU is maximum, MU is zero, it is called saturation point. (since slope of TU
curve at that point is zero). Units of the good are consumed till the saturation point.
 As long as TU curve is concave, MU curve is downward sloping and remains above
the x-axis.
 When TU curve is falling, MU curve becomes negative.
 The falling MU curve shows the law of diminishing marginal utility.
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Figure 10.1: Relationship between Total and Marginal Utility Curves
What is utility?
Utility denotes the want satisfying power of a commodity or service
10.2 The Law of Diminishing Marginal Utility
The law states that as a consumer consumes more and more units of a commodity, marginal
utility derived from each successive unit goes on diminishing.
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A stage comes when marginal utility becomes zero. At this point total utility becomes
maximum. If the consumer consumes beyond this stage, marginal utility becomes negative
and total utility falls. It means that consumer starts getting disutility i.e. dissatisfaction instead
of getting satisfaction. Since, economists believe that a consumer is a rational being, he wants
to maximize his satisfaction. A consumer would not like to go beyond zero marginal utility.
Assumptions of the Law of DMU
The law of DMU holds good when the following assumptions are satisfied:
i. Standard unit of measurement is used
If the unit of measurement is very large or very small, then the law will not hold. Examples of
inappropriate units are: rice measured in grammes, water in drops, diamond in kilograms.
ii. Homogeneous commodity
All units of the commodity consumed are homogeneous and perfect substitutes.
iii. Continuous consumption
The law of DMU holds only when consumption of successive units of a commodity is
without a time gap.
iv. Mental and social condition of the consumer must be normal
The law will hold when consumer’s mental condition is normal. His income and tastes are
unchanged and his behaviour is rational.
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State the law of the diminishing marginal utility
The law of diminishing marginal utility states that as a consumer consumes more and more
units of a commodity, marginal utility derived from each successive unit goes on diminishing.
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10.3 Assumptions of the Utility Approach
The assumptions of the cardinal utility approach are:
i. Utility can be measured, i.e. can be expressed in exact units. Utility is measurable in
monetary terms
ii. Consumer’s income is given.
iii. Prices of commodities are given and remain constant.
iv. Constant Marginal Utility of Money. It means that importance of money remains
unchanged. Marginal utility of money is addition made to utility of the consumer as
he spends one more unit of the money income. This is assumed to be constant
Mention the assumptions of the cardinal utility approach
i. Utility can be measured

ii. Consumer’s income is given
iii. Prices of commodities are given and remain constant
iv. Constant Marginal Utility of Money
10.4 Meaning of Consumer’s Equilibrium
In economics, consumer is the one who takes decisions about what to buy for satisfaction of
wants. Consumer takes decision on the basis of his preferences, his income and the prices of
the commodities which are prevailing in the market.
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Box 10.1: Consumer’s Equilibrium
A consumer is said to be in equilibrium when he maximizes his satisfaction, given income

and prices of the commodities.
Case I: One Commodity Case
Let us suppose that a consumer has a given income with which he consumes only one
commodity X. Since both his money income and commodity X have utility for him, he can
either spend his money income on commodity X or retain it with himself. If the consumer
holds his income, the marginal utility of commodity (𝑀𝑈𝑥 ) becomes greater than marginal
utility of money income (MUM). In that case, total utility can be increased by exchanging
money for good X.
Thus, c
i.e., MU of the good = Price of the product or 𝑀𝑈𝑥 = 𝑃𝑥
Thus, the consumer’s equilibrium condition is geometrically illustrated in Fig.10.2 at point E,

where 𝑀𝑈𝑥 = 𝑃𝑥 . The equilibrium price is given at OP. The consumer will buy OQ quantity
of X in order to maximise his utility. Total gain falls if more is purchased after equilibrium.
Fig. 10.2: Consumer’s Equilibrium – Case of One Good
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Case II: Two Commodities Case–Law of Equi-Marginal Utility
Here, it is assumed that a consumer consumes only two commodities X and Y and their
prices are 𝑃𝑋 and 𝑃𝑌 respectively.
In such a case, the law of DMU is extended to two goods which the consumer buys with his
income. The condition required by a consumer to maximise his utility for two commodities X
and Y is given as:
MU x  PX
MU y  Py
Divide equation I by 2, we have:
MU X MU Y

PX PY
This is called the law of equi-marginal utility. The law states that a consumer will so
allocate his expenditure so that the utility gained from the last kobo spent on each
commodity is equal.
This law is graphically explained as follows:
Figure 10.3: Law of Equi-Marginal Utility

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However, when there is disequilibrium between the ratios of MUx to Px and MUy to Py i.e.
MU X MU Y
 , the following conditions occur:
PX PY
MU X MU Y
i. When  : In this case, the consumer is getting more marginal utility per
PX PY
rupee in case of good X as compared to Y. Therefore, he will buy more of X and less
of Y. This will lead to fall in MUX and rise in MUY. The consumer will continue to
MU X MU Y
buy more units of X till 
PX PY
MU X MU Y
ii. When  : The consumer is getting more marginal utility per rupee in case
PX PY
of good Y as compared to X. Therefore, he will buy more of Y and less of X. This
will lead fall in MUY and rise in MUX. The consumer will continue to buy more of Y
MU X MU Y
till 
PX PY
Case Study 1: The following table gives the total utilities schedule for the consumption of
banana and cigarettes by a hypothetical consumer.
Total Utility
Quantity Banana Cigarettes
1 100 420
2 700 720
3 1150 960
4 1550 1140
5 1850 1260
6 2000 1320
Suppose the consumer has N370.00 to spend on the two goods determine how many units of
each he would buy to maximize his utility subject to his budget constraint, and gives that the
price per unit of banana and cigarettes are N50 and N30, respectively.
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Solution
The problem requires the computation of the marginal utility price ratios for banana and
cigarettes i.e. MUB/PB and MUc/Pc at each level of consumption.
Units of TUa MUa MU a Units of 𝑻𝑼𝒄 𝑴𝑼𝒄 MU c

Banana Pa cigarettes Pc
1 100 - - 1 420 - -
2 700 600 12 2 720 300 10
3 1150 450 9 3 960 240 8
4 1550 400 8 4 1140 180 6
5 1850 300 6 5 1260 120 4
6 2000 150 3 6 1320 60 2
MU B MU c
 is fulfilled at two different level of consumption.
PB Pc
MU B MU c
First   8 for 4 units of banana and 3 units of cigarettes
PB Pc
MU B MU c
First   6 for 5 units of banana and 4 units of cigarettes
PB Pc
However, the first condition is necessary but not sufficient for utility maximization.
The Second Condition:
Y = PB QB + PcQc (Budget constraint)

=N50 (5) + N30 (4)
= N250 + N120
= N370
Thus, 5 units of banana and 4 units cigarettes will yield maximum satisfaction.
Note: The first combination of 4 units of banana and 3 units of cigarettes will amount to
N290, whereas consumer income is N370.
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Explain consumer’s equilibrium
A consumer is said to be in equilibrium when he maximizes his satisfaction, given income and
prices of the commodities.
10.5 Consumer’s Equilibrium with Indifference Curve Approach
10.5.1 Ordinalist or Indifference Curve Theory
The indifference curve theory is based on the concepts of the budget line, indifference curve
rate substitution.
i. The budget line
It is a line in commodity space showing different commodity space showing different

combinations of two commodities the consumer can buy given his money income and the
market prices of the two commodities.
Figure 10.4: Consumer’s Budget Line

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The slope and location of the budget line are determined by the prices of the two
commodities A& B. therefore, if the consumer spent Px and PY respectively, it follows that:
M= PxQx + PYQY 1
Equation 1 transforms into the equation of the budget line
M PY
Qx   QY 2
Px Px
The slope of the budget line is the ratio of the two prices given as the coefficient of QY in
equation 2 i.e.
PY
Slope  
PX
Note
The budget line is also referred to as budget constraint consumer possibility line and the
income line.
ii. An Indifference curve
An indifference curve joins together all points representing different combinations of two
goods which yield equal utility to the consumer.
Properties of the indifference curves
 An indifference curve has a negative slop.
 Indifference curves can never intersect.
 Indifference curves are convex to the origin.
 As the distance of the indifference curve to the origin increase, the level of utility
denoted by the indifference curve becomes higher and higher.
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 Axiom of transitivity: If some combination X of two goods e.g. food and cloth is
preferred to another combination Y and Y is preferred to Z then (by transitivity) X is
preferred to Z, if X > Y, and Y > Z, then X > Z.
25 U
20
Cloth
W
15
X
10 Y
Z
5 0 4 8 12 16 20
Food
Figure 10.5: An indifference curve
iii. Marginal Rate of Substitution
It refers to the amount of one commodity that is required to compensate the consumer for
giving up an amount of another commodity such that the consumer maintain the same level
of utility. The marginal rate of substitution of food for cloth denoted MRSfc is rate at which
food can be substituted for cloth leaving the consumer, at the same level of utility.
Geometrically, MRCFC is the negative slope of the indifference curve in figure 4.9 for
instance, the slope of the indifference curve in figure 4.9 is obtained at point X as:
QC
MRCFC 
QF
MU F
MRCFC 
MU C
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The law of demanding marginal rate of substitution illustrated in figure 5.4 can be stated as:
The less of cloth the consumer gave up and the more of food he obtained in the process, the
less willing he is to give up a unit of cloth for all additional unit of food.
10.5.2 Indifference map
An indifference map is a set of indifference curves with all consumers’ preferences. The
closer an indifference curve is to the origin, the lower the level of utility described.
C
Cloth
B
A
I1
I2
I3
0
Food
Figure 10.6: An indifference Map
From the figure 10-6, that point B on indifference curve I2 & C on I1 have higher levels of
utility than A. the rational will prefer combination of food and cloth described point c to that
of point A or B.
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Define the following:
i. Budget line
ii. Indifference curve
i. Budget line is a line in commodity space showing different commodity space showing
different combinations of two commodities the consumer can buy given his money
income and the market prices of the two commodities.
ii. An indifference curve joins together all pints representing different combinations of
two goods which yield equal utility to the consumer.
10.6 Deviation of the Demand Curve: Consumer Equilibrium
The assumptions of the indifference curve approach are:
i. Utility is ordinal: i.e. it is possible for the consumer to express his preference of one
bundle for the other.
ii. Preferences are ranked: Ranking is done in terms of indifference curves based on the
axiom of diminishing marginal rate of substitution.
iii. The consumer is rational and consistent: He aims at maximizing his utility within the
limit of his income, and given the market prices of the two goods.
Under the indifference curve approach, the consumer equilibrium is achieved when the
consumer reaches the highest possible indifference curve given the limitations imposed by his
budget line.
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W
Z
Cloth
X
C
I3
I2
Y I1
0 F1 Q Food
Fig 10.7: Consumer Equilibrium Position
In figure 10.7, the consumer can afford to buy any of the combination of food and cloth
described by points W, X and Y income given by the budget line PQ.
However, he refers the combination on point x because it gives him greater utility than any of
the combination on points W and Y (note that X is on a higher indifference curve I2) at point
x the quantities of cloth and food consumed are C1 and F1 expecting he should have preferred
Z but that is beyond the limit of his budget. Therefore, a consumer maximizes his satisfaction
at the point where the budget line is just tangent to an indifference curve.
MU F PF
 (i)
MU C PC
MU F MU C
 (ii)
PF PC
Equation 1 and 2 are identical equations given as a necessary condition for consumer
equilibrium under the marginal utility approach.
To derive the demand curve using the indifference curve approach, we will adopt two
concepts:
Page 196 of 220
i. Price consumption curve
ii. Income and substitution effects.
i. Price Consumption Curve
Originally, the budget line PR is tangent to indifference curve I, at point x given Q1 as the
quantity demanded.
X
Y Z PCC
Cloth
I1
I3
I2
0 Q1 Q2 Q3 R S T
Food
Figure 10.8: Price Consumption Curve
Suppose that the price of food falls, ceteris paribus, this will have the effect of shifting the
budget line PR to PS. The new budget line PS is tangent to higher indifference curve I2at
point Y giving new quantity demanded as Q2. Since Q2 is greater than Q1, the law of demand
is confirmed. A further fall in the price of food will shift budget line from PS to PT and the
new equilibrium point Z will give yet a greater quantity demanded Q3 of food. The curve
joining consumer equilibrium points such as X, Y and Z are called the price consumption
curve.
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ii. Income and Substitution Effects
The substitution effect is the change in demand that would occur as the relative price
changes, after adjusting the consumer’s money income so as to keep his real income constant.
This adjustment is called compensating variation and the budget line arising out of such
adjustment is called compensated budget line. If the price of food falls, ceteris paribus, the
consumer’s money income will be reduced i.e. compensating variation will be negative to
keep the budget line parallel towards the origin until it is tangent to the initial indifference
curve.
The income effect, on the other hand, is the change in demand that would occur as the
relative price changes leaving the consumers money income unchanged and thereby leading
to a change in his real income. For example, a fall in the price of food, ceteris paribus, will
cause a rise in consumer’s real income i.e. He will now be able to buy a greater quantity of
food.
P
P1
Cloth
X Y
Z
I1
I2
0 Q1 Q2 Q3 Q R R
Food
’
Figure 10.9: The substitution and income effects of a fall in the price of food
In figure 10.9, the original budget line PQ is tangent to indifference curve I, at point X giving
Q1 as the quantity of food demanded. Suppose the price of food falls, ceteris paribus the
effect is the shift in the budget line from PQ to PR.
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The new budget line PR is tangent to a higher indifference curve I2 at the point Y giving Q2 as
the new quantity of food demanded. The movement from X to Y representing an increase in
quantity demand by Q2 – Q1 is called total effect. The movement can be broken into two; the
substitution effect and the income effect. Assuming the consumer’s money income is reduced
i.e. negative compensating variation to leave his real income unchanged, the budget line PR
will shift, inward parallel to itself giving P’ R’ as the compensated budget line, P’ R’ tangent
to the initial indifference curve I1 at point Z giving Q3 as the quantity demanded of food as a
result of negative compensating variation.
The movement from X to Z representing Q3 – Q1 more units of food demand as a result of a

fall in its price is called the substitution effect. This is consistent with the slut sky’s Theorem
which states that the substitution effect of a price change is always negative.
The movement from Z to Y representing Q2–Q3 more of food is called the income effect. The
substitution and income effects of a rise in the price of food
P’
P
Cloth
Y Z
I1
I2
0 Q2 R Q3 Q1 Q
Food
Figure 10.10: The substitution and income effects of a rise in the price of food
We can also explain the substitution and income effects with the assumption of a rise in the
price of food. In the figure above initial budget line PQ is tangent to indifference curve I2 at X
giving quantity demanded of food as Q1. The movement from X to Y showing Q1 - Q2less of
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food demanded is called the ‘total effect’ with a positive compensating variation in
consumer’s money income the budget line PR shift parallel outward to P’RI and tangent to
the initial indifference curve I2 at Z giving Q3. The movement from point X to Z i.e. Q1 – Q3.
The movement from point X to Z i.e. Q1 – Q3 less of food is substitution effect. The
movement from Z to Y representing Q3 – Q2 less of food is the income effect.
The mathematical formula expressions for the separation of a consumer’s reaction to a price
change into income and substitution effects have been called the Slutsky – Equation, named
after the Russian economist Slutsky Eugen (1880 – 1948) who derived it.
Note
Price Effect = Income Effect + Substitution Effect
What are the assumptions of the indifference curve approach?
1. Utility is ordinal: i.e. it is possible for the consumer to express his preference of one
bundle for the other.
2. Preferences are ranked: Ranking is done in term of indifference curves based on the
axiom of diminishing marginal rate of substitution.
3. The consumer is rational and consistent: He aims at maximizing his utility within the
limit of his income, and given the market prices of the two goods.
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10.7 Derivation of the Engel Curve
The Engel curve describes the positive relationship between consumer’s income and demand
for a normal good. This curve is alternatively referred to as the income consumption curve
(ICC) and its derivation is also explained under the indifference curve analysis.
16 T
8
4
R
4 ICC
P4
Z
4
Y I3
Cloth
X
I2
I1
Q S U
0 8 16 32
Food
Figure 10.11 (a): Income Consumption Curve
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(b)
Income Engel
curveS2
0 Q1 Q2 Q3 Quantity
demandedP1
Figure 10.11(b): Engel Curve
Let us assume that the original or initial money income of a consumer is 200. We assume
further that the consumer spends this amount entirely on food and cloth whose unit price (Pr
and Pc) are N25 and N30 respectively. This information is depicted. In figure 10-10 by the
budget line PQ and the quantity of food demanded is Q1 at the equilibrium point X.
The consumer is pushed to a higher indifference curve I2, and the new point of consumer
equilibrium is Y giving the new quantity demanded as Q2. A further rise in income from
N400 to N800 causes and outward shift in the budget line from RS to TU. The new budget
line TU is tangential to the highest indifference curve I1 at point Z giving the new quantity
demanded as Q3. In essence, this means that as income rises quantity demanded increases. A
line joining the points X, Y and Z or consumer equilibrium points is called the income
consumption curve (ICC). The ICC is identical to the Engel Curve.
Page 202 of 220

Explain Engel curve
for a normal good.
10.8 Consumer Surplus
The term consumer’s surplus refers to the difference between what the consumer would be
willing to pay to purchase a given quantity of a commodity and what he actually pays for this
quantity rather than forgoing it. It arises because the consumer pays for all units of the
commodity the price he is just willing to pay for the last unit purchased, whereas the marginal
utility MU on earlier units is greater.
D
12
11
Price
10
(N)
0 1 2 3 4 Quantity per month
Figure 10.12: Consumer’s Surplus
From figure 10.12, the consumer’s demand curve is given as DD. The consumer purchased 4
units of the commodity to N36 (i.e. each at unit market price of 9) But the first unit of the
Page 203 of 220
commodity yields him so much utility that he would have offered to pay N12, for the second
unit N11, for the third unit N10, and for the fourth and the last unit N9. These would have
amounted to N42 altogether. Therefore, the consumer’s surplus is N6. That is N42 less N36.
Geometrically, the consumer’s surplus is represented by the area under the demand curve and
price above the price line.
Explain consumer’s surplus
Consumer’s surplus refers to the difference between what the consumer would be willing to
pay to purchase a given quantity of a commodity and what he actually pays for this quantity
rather than forgoing it.
Page 204 of 220

1. Utility denotes the want satisfying power of a commodity or service. Utility is a

cardinal concept i.e., it can be measured
2. Total Utility (TU) is the sum of all the utilities that a consumer derives from the
consumption of a certain amount of a commodity
3. Marginal Utility (MU) is addition made to the total utility as consumption is increased
by one more unit of the commodity.
4. The Law of Diminishing Marginal Utility states that as a consumer consumes more
and more units of a commodity, marginal utility derived from each successive unit
goes on diminishing.
5. Assumptions of the Law of DMU are:
i. Standard unit of measurement is used
ii. Homogeneous commodity
iii. Continuous consumption
iv. Mental and social condition of the consumer must be normal
6. A consumer is said to be in equilibrium when he maximizes his satisfaction, given
income and prices of the commodities.
7. The budget line is a line in commodity space showing different commodity space
showing different combinations of two commodities the consumer can buy given his
money income and the market prices of the two commodities.
8. An indifference curve joins together all points representing different combinations of
two goods which yield equal utility to the consumer.
9. Two concepts to derive the demand curve using the indifference curve approach are:
 Price consumption curve
 Income and substitution effects
10. Consumer’s surplus refers to the difference between what the consumer would be
willing to pay to purchase a given quantity of a commodity and what he actually pays
for this quantity rather than forgoing it
Page 205 of 220

What are the relationships between TU and MU curves?
State the assumption of diminishing marginal utility
Highlight the assumptions of the cardinal utility approach
State the law of equi-marginal utility
Mention the properties of the indifference curves
Explain:
a) Substitution effect
b) Income effect
Explain Engel curve
Explain consumer’s surplus
Page 206 of 220

Glossary of Terms
Normal good: A good that people demand more of as their income rises.
Variable factors: These are those factor inputs which change with the change with the
change of output in the short run
Consumer: This is a person who purchases goods and services for personal use
Page 207 of 220

References

Page 208 of 220

Notes on SAQs for Study Session 1
SAQ 1.1
1. Microeconomics is the study of the economic actions of individuals and small groups of
individuals
2. (i) Microeconomics is of utmost importance in understanding the working of a free
enterprise economy. In such economy, there is no agency to plan and coordinate the
working of the economic system.
(ii) It provides the analytical tools for evaluating the economic policies of the state.
(iii) Helpful in the efficient employment of scare resources
(iv) It helps to explain the gains from international trade, balance of payments
disequilibrium and the determination of the foreign exchange rate
(v) It is helpful in understanding the problems of taxation and examining the
conditions of economic welfare as well as basis for production.
SAQ 1.2
Basis Microeconomics Macroeconomics

Definition Microeconomics is that part of economic Macroeconomics is that part of economic
theory which studies the behaviour of theory that studies the behaviour of
individual units of an economy. aggregates of the economy as a whole.
Tools of Analysis Demand and Supply. Aggregate Demand and Aggregate Supply.
Main Objective It aims to determine price of a commodity It aims to determine income and
or factors of production. employment level of the economy.
Basic Assumptions It assumes all the macro variables to be It assumes that all the micro variables, like
constant, i.e., it assumes that national decisions of households and firms, prices of
income, consumption, saving, etc. are individual products, etc. are constant.
constant.
Other Name It is also known as ‘Price Theory’. It is also known as ‘Income and
Employment Theory’.
Examples Individual Demand, Firm’s Output. National Income, National Output.
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SAQ 1.3
i. Positive economics entails what is or how an economic problem facing a society is

truly solved
ii. Normative economics deals with what ought to be or how an economic problem
should be solved.
SAQ 1.4
An economy is a system in which people earn their living by performing different economic
activities like production, consumption and investment.
SAQ 1.5
i. Economy produces only two goods, X and Y.

ii. Amount of resources available in an economy are given and fixed.
iii. Resources are not specific, i.e., they are shifted from the production of one good to
the other good.
iv. Resources are fully employed, i.e., no wastage or idle of resources.
v. State of technology in an economy is given and remains unchanged.
vi. Resources are efficiently employed
SAQ 2.1
A function is said to be explicit if a function is stated in such a way that the value of one
variable is made to depend in some definite way upon the value of the other variable.
SAQ 2.2
a) Marginal cost is defined as the change in total cost resulting from the production of an
b) Marginal revenue is the change in total revenue resulting from the sale of an
Page 210 of 220

SAQ 2.3
This is an equation which describes the relationship between two or more variables
SAQ 2.4
∑ 𝑃1 𝑞𝑜
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 =
∑ 𝑃𝑜 𝑞𝑜
SAQ 3.1
factor of production is determined by the interplay of the forces of supply and demand
SAQ 3.2
i. Demand depends upon satisfaction of the commodity.

ii. Demand always means effective demand
iii. Demand is a flow concept
iv. Demand means demand for final consumer goods.
v. Demand is a desired quantity.
SAQ 3.3
i. The price of the related goods remains the same.
ii. The income of the consumers remains unchanged.
iii. Tastes and preferences of the consumers remain the same.
iv. All the units of the goods are homogeneous.
v. Commodity should be a normal good.
SAQ 3.4
each of the possible prices
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SAQ 3.5
Market Demand is the sum of the various quantities that would be purchased by all the
consumers of the product at each alternative price.
SAQ 3.6
Demand function shows the functional relationship between demand for a commodity and its
determinants
SAQ 3.7
A graph showing the relationship between an individual’s income and his demand for a
specified good
SAQ 3.8
i. Taste and fashion/preferences are not favourable for the good.

ii. Income of the consumers has fallen.
iii. Price of substitutes has fallen.
iv. Price of complementary goods has risen.
v. Propensity to save of the people has increased.
SAQ 3.9

iii. Derived Demand
SAQ 4.1
Supply curve is the graphical representation of the supply schedule
Page 212 of 220

SAQ 4.2
a) Prices of the related good should remain unchanged.

b) Prices of factors of production (i.e., prices of inputs) should remain unchanged.
c) Level of technology should remain unchanged.
d) Government policy regarding taxation should remain unchanged.
e) Goals of the firm should remain unchanged
SAQ 4.3
a) The law of increasing cost

b) Profits maximizing motive
SAQ 4.4
a) Price of the Product

b) Technology
c) Price of Factors
d) Prices of other products
e) Future Price Expectation
SAQ 4.5
Movement along supply curve occurs when a movement along the supply curve indicates
changes in quantities offered as a result of a change in the price.
SAQ 4.6
a) Joint Supply
b) Competitive Supply
c) Composite Supply
SAQ 5.1
Equilibrium is said to be unstable when a small displacement of the equilibrium price sends
the system away from it, never to be restored.
Page 213 of 220
SAQ 5.2
Price legislation refers to the situation whereby the government wishes to influence the price
at which some product is bought and sold.
SAQ 5.3
i. It induces supply of goods and services to respond to changes in demand.

ii. It shows changes in consumer’s wants – preferences and taste from time to time.
iii. It influences the types, quantity and quality of goods to be produced and services to be
provided in the economy.
iv. It facilitates the determination of the appropriate rewards to the various factors of
production.
v. It indicates the sectors of the economy in which factors of production command
highest rewards.
SAQ 6.1
Supply is the various quantities of a commodity offered for sale by producers during a given
period of time at various prices
SAQ 6.2
The short-run is such a period in which the fixed factors like plants, machinery, etc. cannot be
changed.
SAQ 6.3
of a product offered at various prices
SAQ 6.4
Monopolist is a price maker who can set the price to his maximum advantage and his output
Page 214 of 220

SAQ 7.1
(i) Price elasticity of demand

(ii) Cross price elasticity of demand
(iii) Income elasticity of demand
SAQ 7.2
(i) Elastic demand

(ii) Inelastic demand
(iii) Unit elastic demand
(iv) Perfectly elastic demand
(v) Perfectly inelastic demand
SAQ 7.3
a) The initial income level of a country

b) The nature of the need covered by the commodity
c) The time period
SAQ 7.4
a) High cross – elasticity (1 <EAB< ∞)

b) Low – cross – elasticity (0<EAB<1)
c) Unit cross elasticity (EAB= 1)
d) Negative cross elasticity (EAB<0)
e) Zero cross –elasticity (EAB= 0)
f) Infinite cross elasticity (EAB= ∞)
SAQ 8.1
Price elasticity of supply is defined as the responsiveness of quantity supplied of a

commodity to changes in its own price.
Page 215 of 220
SAQ 8.2
a) Elastic Supply (1 <eS< ∞)

b) Inelastic Supply (0 <eS<1)
c) Unitary Elastic Supply (eS= 1)
d) Perfectly Elastic Supply (eS= ∞)
e) Perfectly Inelastic supply (eS= 0)
SAQ 8.3
a) Time Factor
b) Nature of the Good
c) Production Capacity
d) Production Methods and Techniques.
e) Stage of Laws of Return.
SAQ 8.4
a) Labour union agitation for higher wages and increase of national minimum wage
government
b) Incidence of Tax and Government Tax Policy
c) Granting or Removal of Subsidy
d) Government employment policy and the relevance of the income elastic of demand
e) Solving problem of international trade
SAQ 9.1

SAQ 9.2
a) Short-run production function refers to production in the short-run where there is at

least one factor in fixed supply and other factors are in variable supply.
Page 216 of 220
b) Long-run production function refers to production in the long-run where all factors
are in variable supply.
SAQ 9.3
Average Product is defined as the amount of output produced per unit of the variable factor
employed
SAQ 9.4
(i) When MP = AP, AP is maximum. MP curve cuts AP curve at its maximum point.
(ii) When MP <AP, AP falls
SAQ 9.5
a) The state of technology is assumed to be constant.

b) There must be some inputs whose quantity is kept fixed.
c) The law is based upon the possibility of varying the proportions in which the various
factors can be combined to produce a product.
SAQ 10.1
a) TU curve starts from the origin, increase at a decreasing rate, reaches a maximum and
then starts falling.
TU X
b) MU curve is the slope of the TU curve, since MU X 
QX
c) When TU is maximum, MU is zero, it is called saturation point.
d) As long as TU curve is concave, MU curve is downward sloping and remains above
the x-axis.
e) When TU curve is falling, MU curve becomes negative.
SAQ 10.2
a) Standard unit of measurement is used
Page 217 of 220

b) Homogeneous commodity
c) Continuous consumption
d) Mental and social condition of the consumer must be normal
SAQ 10.3
a) Utility can be measured

b) Consumer’s income is given
c) Prices of commodities are given and remain constant
d) Constant Marginal Utility of Money
SAQ 10.4
The law of equi-marginal utility states that a consumer will so allocate his expenditure so that
the utility gained from the last kobo spent on each commodity is equal.
SAQ 10.5
a) An indifference curve has a negative slop.

b) Indifference curves can never intersect.
c) Indifference curves are convex to the origin.
d) As the distance of the indifference curve to the origin increase, the level of utility
denoted by the indifference curve becomes higher and higher.
SAQ 10.6
a) The substitution effect is the change in demand that would occur as the relative price
changes, after adjusting the consumer’s money income so as to keep is real income
constant.
b) The income effect is the change in demand that would occur as the relative price
changes leaving the consumers money income unchanged and thereby leading to a
change in his real income.
SAQ 10.7
for a normal good.
Page 218 of 220
SAQ 10.8
Consumer’s surplus refers to the difference between what the consumer would be willing to
pay to purchase a given quantity of a commodity and what he actually pays for this quantity
rather than forgoing it.
Page 219 of 220

References
Page 220 of 220

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OLABISI ONABANJO UNIVERSITY

OPEN AND DISTANCE LEARNING CENTRE

ECO 211: Introduction to Microeconomics

COURSE DEVELOPMENT TEAM

Dr. I.O. Oseni – Subject Expert

Prof. E.O. George – Course Reviewer

Dr. Segun Omosule – Language Editor

Prof. Oyesoji Aremu – ODL Expert

Mr. A.O. Okutimiren – Instructional Designer

Vice Chancellor’s Message

Prof Ganiyu Olatunji Olatunde

Course Study Guide

Introduction to Microeconomics for students studying towards acquiring a Bachelor of

Recommended Study Time

What you are about to learn in this course

Working through this course

The major components of the course are;

Tutor-Marked Assignment (TMA)

Final Examination and Grading

Tutors and Tutorials

You have difficulty with the self-test or exercise.

1. Ademola Adebayo. Economics: A Simplified Approach, Volume 1; Second Edition

Vice Chancellor’s Message........................................................................................................ 3

Course Study Guide ................................................................................................................... 4

Table of Contents ................................................................................................................... 9

Study Session 1: Field of Microeconomics ............................................................................. 20

Learning Outcomes for Study Session 1 .............................................................................. 20

1.1 What is Microeconomics? ......................................................................................... 21

1.1.1 Scope of Microeconomics.................................................................................. 21

1.1.2 Importance of Microeconomics ......................................................................... 22

1.1.3 Limitations of Microeconomics ......................................................................... 23

1.2 Distinction between Microeconomics and Macroeconomics.................................... 23

1.3 Positive and Normative Economics .......................................................................... 25

1.3.1 Positive Economics ............................................................................................ 25

1.3.2 Normative Economics ........................................................................................ 26

1.4 Economic Problems of an Economy ......................................................................... 28

1.4.1 Economic Problems ........................................................................................... 28

1.5 Production Possibility Curve (PPC) .......................................................................... 30

1.5.1 Production Possibility Set and Curve ................................................................ 30

1.5.2 Production Possibility Schedule and Curve ....................................................... 31

1.5.3 Features of Production Possibility Curve .......................................................... 32

1.5.4 Shifts in Production Possibility Curve ............................................................... 33

1.5.5 Opportunity Cost ................................................................................................ 33

1.5.6 Marginal Opportunity Cost ................................................................................ 34

Summary of Study Session 1 ............................................................................................... 36

Self-Assessment Questions (SAQs) for Study Session 1 .................................................... 37

Glossary of Terms ................................................................................................................ 38

Study Session 2: Basic Tools of Economic Analysis .............................................................. 40

Learning Outcomes for Study Session 2 .............................................................................. 40

2.1 Basic Mathematical Concepts and their Economic Applications ............................. 41

2.1.1 Variables ................................................................................................................. 41

2.1.2 Functions ................................................................................................................. 41

2.1.4 Systems of Equations ......................................................................................... 43

2.1.5 Derivatives ......................................................................................................... 43

2.2 Economic Applications of Derivatives ..................................................................... 44

2.3 Basic Statistical Concepts and their Economic Applications.................................... 46

2.3.1 Estimation of Demand Curve............................................................................. 46

2.3.2 Application of Some Statistical Concepts.......................................................... 48

2.4 Price Index................................................................................................................. 50