CHAPTER ONE

DEFINITION AND SCOPE OF ECONOMICS

Objectives

At the end of this chapter, you should be able to:

1. Define economics as a subject

2. Explain the scopes of economic ( in very broad terms)
3. Discuss the methods of study used in economics;
4. Distinguish (normative from positive economics and) microeconomic from
macroeconomics; and
5. Understand basic concepts used in ( why marginal units are import for
decision making)

Definition and scope of Economics

What is Economics?
Defining economics precisely and concisely to anyone new to the discipline is almost a
impossible task. Such lack if a concise definition is not only peculiar to economic but applies to
some other science. Through listing problem areas, the scope for economic can be outlined in a
better way than with a short definition. However, a scrutiny of the following working definition
will help introduce the subject.
Generally, economics studies how a society allocates scarce resources among alternative ends;
distributes output among members; change allocation, distribution and production over time, and
mangers efficiencies and inefficiencies within the economic system.
Economics therefore studies how communities in individual in a society make decision related to
production of goods and services for purpose of satisfying their wants. One basic economic
problem is how to most effectively use resources that are scarce to meet the need of the society.
Resources take various forms such as time, money, machinery, agricultural land, water
petroleum etc. Resources are not only limited but also have alternative uses. Any identified
resource can be employed to produce various good and services. Land can be used to produce

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maize, wheat, coffee, tea, sugarcane, fish pond, swimming pool(recreation), park (tourist)
building materials ( sand and gravel) if deposits exist beneath the surface) etc.
In addition to the above unique nature of resources, human desires or wants are also infinitely
diverse and never fully satiable. These desires range from good health, sumptuous food
comfortable shelter, financial sufficiency, long life, quick transport, instant services, adequate
recreation, etc. Practically, all human wants whether individual or communal are unlimited. In
the case of national economy a country’s resources are also scarce while the welfare desires for
the whole nation are infinite. The reconciliation of these limited means and unlimited and
alternative ends is also the concern of economics, inflation, and international trade imbalance.
Future desirable welfare changes are also accommodated in economics within development
targets and growth of national output.
In summary therefore, economics is a social science that studies how individuals in a society or
community as a whole make choices concerning allocation of scarce resources among alternative
uses to best meet the unlimited material welfare needs both now and in the future.

Earlier Definitions of Economic

Adam smith’s Definition
The earliest definitions of economics were directly related to wealth. Adam Smith also regarded
as e father of political economy, defined it as ‘An inquiry into the nature and causes of the
wealth of nations.’ Other economists adopted the view and called economics ‘a science of
wealth’. Out of this, many who were influenced by religious beliefs condemned economics as
teaching selfishness or mammon worship came in called a dismal science
Arising from this economics John Stuart Mill viewed economics as “the practical science of
production and distribution of wealth’ – a definition adopted by the Concise Oxford Dictionary
Davenport on the other hand, stressed price determined as important aspect economics when he
describe it as “a science that studies phenomena with reference to price”. Professor Pious defined
economics in relation to welfare emphasizing the human perspective being distinct from the
material aspect of the subject.
Marshall’s Definition
Alfred Marshall defined economics as “the study of mankind in the ordinary business of life”.
Economics is an inquiry into how humans acquire and use income. Economics is therefore on
one hand study of wealth, and on the other hand, a part of the study of mankind. From this
definition though economics still studies wealth, the welfare of man is of primary importance. In
other words, wealth has been given secondary place, since it is for the sake of the welfare of
mankind that wealth is studied. Wealth is not an end in itself but a mean of meeting the welfare
of man

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Criticism
Though Marshall’s definition remained outstanding for long, in the early 1930s, Lord Robbins
challenged it. His main points of criticism being were:-
1. It narrowed the study of economics to dealing mainly with material welfare, whereas we
know that non-material services contributed to economic welfare.
2. It ignored a person who does not live with a society but have economic problem.
3. The distinction made between ordinary business of life and extraordinary life is not clear.
4. Defining economics as a study of welfare rather than wealth is confusing. For instance,
anti-social products such as intoxicants (e. cigarette, alcohol) contribute to wealth as
defined in economics, yet their use is not conducive to human welfare.

Robins’ Definition
Arising from these criticisms, Robbins defined economics as “a study of human behavior as a
relationship between ends and scarce means that have alternative uses.’ The following can be
deduced from this definition.
1. Wants if human beings are infinite in number with each wants also unlimited in
magnitude. Multiplicity of wants call for the fro a perpetual effort on part of individuals
to meet their satisfaction. One can never be completely satisfied even in case of a single
want. If wants are limited, they can be fully satisfied hence further incentive to economic
efforts would cease.

2. Means to satisfy these wants are limited in supply. Most resources that people use are
scarce. If they had been unlimited, no economic problem would have arisen. Scarcity
herein refers to limited availability relative to its use in meeting our requirements. A
commodity may exist in a quantity but may not be scarce because it is insufficient to
meet our needs.

3. Scarce means are capable of being employed/used to produce/meet varied alternative

commodities/ends. If a commodity could be put on use few economic problem would
have arisen.
Until the last four-five decades, Robins’ definition was considered satisfactory and adequate.
However, developments in economics especially the emergence of the Keynesian theory of
income and employment determination, and the economics of growth, have necessitated a
restatement of the definition. Accordingly a concise definition must cover not only a study of the
administration of scarce resources but also determines of income and employment in an
economy and the determined of its growth over time. Hence, economics is better defined as a
social science concerned with the proper uses and allocation of scarce (limited) resources for the
achievement and maintenance of growth with stability t the welfare of mankind.

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Nature and Scope of Economics
Introduction
The easiest way to present the scope of economic is to explain briefly the way the discipline is
organized. First, there are two major divisions of economics, namely, microeconomics and
macroecominics. Macroeconomics is the branch of economics that examines the economics
behavior of aggregates such as income, employment, output and related aspects on a national
scale. Instead of trying to understand what determines the output of a single firm or industry or
the consumption patterns of a single household or group of households, macroeconomics
examined the factors that determine national output or products.
Macroeconomics, which is the subject of this course, is the branch of economics that examines
the function of individual industries and the behavior of individual decision-making units, that us
business firma and households. It explores the decisions that individuals businesses and
consumers make. Firms’ choice about what and how much to buy, help to explain why the
economy produces the things it does. Macroeconomics is concerned with household income;
while macroeconomics deals with national income. It considers the individual units, namely the
household, the firm and the industry. It sees and examines the trees.’ Macroeconomics perceives
the whole or the aggregate. It sees and analyses the ‘forest’.
There are three major components to microeconomics. The first deals with the behavior of
consumers of consumers as they face their own version of their scarcity problem, which is how
to allocate a given income among the various goods available. Second, microeconomics
examines the questions of production in a capitalist economy. It mainly deals with the theory of
the profit maximizing firm output, levels of factors utilization and pricing in the markets for both
factors and outputs. The third major component of microeconomics concerns the problems of
co-ordinating the choices of firms and consumers in an account of the behavior of firms and
households are to be consistent with one another and with the overall resource constraint on the
economy.
Microeconomics and Choice
Because resources are scarce, choices have to be made. There are three main categories of choice
that must be made in society.
a) What goods and serviced will be produced and in what quantities, given that there are
not enough resourced to produce all the things people desire? How many cars how
much wheat, how many pop concrete, how many coats etc. will be produced?

b) How will various products and services be produced given that there is normally
more than one way of producing things? What resources will be used and I what
quantities? What techniques of production are going to be adopted? Will cars be
produced by robots or by assembly line workers? Will cars be produced by robots or

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 by assembly line workers? Will electricity by produced from coal, oil, gas, nuclear
fission, renewable resources or a mixture of these?

c) For whom will the products and serviced be produced? In other words how is the
nation’s income to be distributed? After all, the higher your income the more you can
consume of the nation’s output. What will be the wages of firm workers, printers,
cleaners and accountants? How much will pensioners receive? How much profit will
owners of private companies receive or how much will state-owned industries make?

All societies have t make these choices, whether by individuals, by groups or by the government.
These choices can be seen as microeconomic choices since they are concerned not with the total
amount of national output, but with the individual goods and services that make it up; what they
are, how they are made, and who gets the income to buy them.
Choice and opportunity cost
Choices are necessary because resourced are scarce. Because a country cannot produce
everything its citizens would like to consume , there must exist a mechanism to decide what will
be done and what will be left undone; which goods will be produced and which ones will be left
unproduced, what quantity of each will be produced; and whose wants will be satisfied and
whose left unsatisfied.
If one chooses to have more of one thing, then, one must have less of something else. For
example, think of a man with certain amount of income who considers buying bread. We would
say that the cost of this extra bread id so many shillings per loaf. A more revealing way of
looking at cost, however is in terms of what other consumption he must forego in order to obtain
this bread.
Now consider the same problem at the level of the whole society. If the government elects to
build more roads and finds the required money by building fewer schools, then the cost of the
new roads cab ne expressed as so many school per kilometer of road.
The economist’s term the cost of expressed in terms of foregone alternatives is opportunity cost.
The concept of opportunity cost emphasizes the need for choice by the measuring the cost of
anything that is chosen in terms of the best alternatives that could have been chosen instead. The
sacrificed alternative measures the cost of obtaining what is chosen, that is the value of the
second - best alternative, forgone measures, the real or economic cost of the chosen alternative
(the opportunity cost).
Rational Choices
Economics often refer to rational choices. This means the weighing-up of the costs and benefits
of any activity, whether by firms choosing what and how much to produce, by workers choosing
whether to take a particular job or to work extra hours, or by consumers choosing what to buy.

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Imagine you are doing your shopping in a supermarket and you want to buy some meat. Do you
spend a lot of money and buy the best steak or do you by cheap mince instead? To make a
rational or sensible decision, you will need to weigh-up the cost and the benefits of each
alternative. The best steak may give you a lot of enjoyment, but it has a high opportunity cost;
because it is expensive, you need to sacrifice the consumption of other goods if you decide to
buy it. If you buy the mince, however, although you will not enjoy it so much, you will have
more money left over to buy other things; buying minced meat rather than steak has lower
opportunity cost.
Thus rational making by consumers involves choosing those items that give the best value for
money – that is, the greatest benefits relatives to cost. The same principles apply to firms when
deciding what to produce. The decision/choice made by an economic entity is assumed to be
rational or optimal, that is the decision given prevailing conditions.

? Revision Questions
1. a) Discuss the meaning and purpose of the science of economics.
b) What is meant by the statement that economics is a social science?’
2. Economics is about money or goods and services rather than about people. Discuss.
3. ‘The subject matter of economics is work’. Critically examine this definition of the study
economics.
4. ‘Studying economics instead of going to town and partying is like building a boat instead
of lying on the beach’ Explain this statement carefully using the concepts of capital and
opportunity cost.
5. Suppose that the costs due to crime and the opportunity cost of resourced used in law
enforcement are as follows:-

Proportion of criminals Cost due to Total cost used in Opportunity

that are caught and crime (shs) law enforcement costs of
convicted (shs) resources
(billions of
shs)

0.4 60 10 70
0.5 50 - 68
0.6 40 30 -
0.7 30 50 80
0.8 - 80 100

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 Fill in the blanks above
a) What proportion of criminals should society try to catch and convict?
b) Supposed the costs due to crime were to increase by Ksh 5.0 at each possible level of law
enforcement in other words, supposed that each of the figures in the second column of the
table (headed costs due to crime) were crime that society should try to catch and convict?
6. Which of the following are microeconomic issues, which are macroeconomic ones and which
could be either depending on the context?
a) Inflation
b) Low wages in certain service industries
c) The rate of exchange between the pound and the D-mark.
d) Why the price of cabbages fluctuates more than that of cars.
e) The rate of economic growth this year compared to last year
f) The decline of tradition manufacturing industries.
7. Distinguish between microeconomic and macroeconomics
8. Why do we study economics?
9. a) Assume that the Vietnam War suddenly ended in mid -1968 ( in peace) and the government
expenditure for arms and the taxes to support them were cut by $20 billion Given your
present understanding of the operation of modern economic systems, would you expect
there to be a problem of any kind as a result of this development? What action (s) would
you recommend the government to take up?
b) Describe the analytical tools in the field of economics that would assist in improving your
answer to a.
c) Assuming that you had the necessary tool of economic analysis outline the steps you would
consider essential to a reasonable approach to the questions.
10. How would the principle of” weighing up marginal cost and benefits” apply to worker
deciding how much overtime to work in a given week?

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 CHAPTER TWO
COMPARATIVE ECONOMIC SYSTEMS
Objectives

At the end of this chapter, you should be able to:

1. Define and understand the various economic systems namely :- capitalism, socialism,
free market and welfare state;
2. Describe how in theory and practice, the decision about economic co-ordination and
ownership are made in each of the economic systems;
3. Evaluate market and planned economies with respect to (i) choice of goods to produce
(ii) production efficiency iii) distribution of income, (iv) economic growth and (v)
fluctuations in economic activity ; and
4. Describe the role of the ‘profit motive in capitalism.

Introduction
The scarcity of resource means that choices must be made about how the resources will be
allocated. There are five fundamental problems or questions which each economy must solve in
allocation decisions.
a) What goods and serviced should be produced and in what quantities?
What does the society want? Is it guns, cars, books, and how much? This will depend on
what consumers want to buy and what they will pay for each products or service. The
decision about what will be produced relate to demand and supply: (i) demand means the
demand from customers of consumers and satisfied demand in actual consumption; (ii)
supply of goods and services is referred to as production.

b) How will these good and services be produced? The producers or suppliers of goods and
services may be small companies, large companies. Monopolies, state-owned enterprises
or the government itself. What technology will be used, what resources, by who, and
also on.
c) To whom will the goods and services be distributed? Some goods and serviced are
provided free by the state (e.g. in the U.K, some health care and educational services) but
others have to be paid for. The distribution of goods and services will therefore depend
on the distribution of income and wealth in society. This in turn will depend in what

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 individuals and organizations earn and the theory of distribution in economics is
concerned with what rewards are earned by the owners of resources; land, labour, capital
and entrepreneurships. Thus for whom do we produce the goods and services? Who will
consumers or benefit from the production?
d) Where will the goods and services be produced? Will they be produced locally, branded,
near the resource?
e) When will goods and services be produced? This refers to the time dimension that is
timing of production. How long will it take to produce; will a factory be open although
or five days a week? etc.
The type of an economic system a country adopts can be influenced by several factors e.g.
i) The level of economic development of the country
ii) Political ideology adopted by the economy
iii) International economic order or contact
iv) Regional integration (economic regions); etc.
The way in which these resourced decisions are resolved depends on the type of economic
system. By economic system, we mean the way allocation production and distribution decisions
are made. Broadly speaking, there are three types of the economic systems the main difference
between them being who undertakes the entrepreneurial functions and who own the means of
production. These systems are:
a) Private enterprise (which is sometimes referred to as a free enterprise, individualism or
capitalism). In a free market economy decision and choices about resourced allocation
are left to the market forces of supply and demand and the workings of the price
mechanism. In other words, what producers will make and what consumers will buy are
kept in balance by the price that producers will want for their output and the price that
consumers are willing to pay.

b) Collectivism (which is sometimes called enterprise, centrally planned or command

economy; socialism or communism). In centrally planned economy or command
economy, the decision and choice about resource allocation are made by the government.
Money values are attached to resource and to goods and service, but it is the government
that decides what resourced should be used, how much should be paid for tem, what
goods should be made and what their prices should be.

c) A mixed system is one which the state owns a number of industries and services but the
greater part of production is carried out by private enterprise. I such economy, the
decision and choices are made partly by free market forces of supply and demand, and
partly by free market forces of supply and demand, and partly by government decision.
All national economies are mixed economies although with differing proportions of free
market and centrally planned decision making from one country to the next.

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The free Enterprises Economy
By private enterprise (for capitalism) we mean all farms, factories and other means of production
are the property of private individuals and firms. The owners are free to use them with a view to
making profit or not to use them if it suits them. People are also free to spend their incomes on
the goods and services of their choices.
Under such a system, everybody is free to take up any line of production he/she like and he/she
is free to enter into contracts with others. Although the modern states do impose certain
restrictions on the economic freedom of citizens in the interest of general welfare, yet even these
restrictions let people use their property in any manner they like; they can start any business they
think is most profitable to themselves and enter into any contract they think are necessary to
advance their own interests.
Salient Features of Private Enterprise (capitalism)
1. Every individual has a right to acquire private property, to keep it, and after death, to pass
it on to his/her heirs. The result of this system is that inequalities of wealth distribution
are perpetuated with the rich becoming richer and the poor becoming poorer.

2. The instruments of production are owned by private individuals and are managed by the
owners exclusively for their own benefit.

3. Production in such economic systems is driven by the profit motive. The producer’s
main goal is profit maximization.

4. Under this system the society is divided into two classed, namely, the ‘have’ and the
‘have-nots’ which are constantly at war with each other

5. Under this system there is economic freedom that is it as Laissez-Faire economy. This
freedom implies three things:-

a) Freedom of enterprise
b) Freedom of contract
c) Freedom of using one’s property

6. There is no conscious regulation or certain direction of economic activity. Production is

conducted as a result of the decision of numerous isolated entrepreneurs. It is at the same
time influenced by the vast army of individual consumers who make their decisions
without consulting one another.

7. Another noteworthy feature of this system is the important role that the price mechanism
plays in its working. All the central decision of the economy like what to produce and

10
 how much to produce, are arrived at through the price mechanism. All decision are made
by the price mechanism, what Adam Smith called “the invisible hand’ in the market that
is, the forces of supply and demand.
8. Consumers Sovereignty: Under such a system the consumer is the king is consumers’
preference, which finally decides what should be produced and what should not be
produced. They furnish the demand side and eh uncoordinated activities of the producers
provide the supply side. Somewhat, demand and supply adjust themselves to each other.
Under the capitalist system or free enterprise, it is consumers who decide what goods and
services to be produced and in what quantities. Thus under this system, every time a
consumer makes a purchase, he/she in fact voting for the continued production of that
commodity. Ad increase in consumers’ demand for a commodity will raise its price and
so encourages producers to increase their output of it.
If consumers’ demand decline. Price will fall and producers will reduce output. Since
consumers’ demand determined the quantity of a commodity that can be sold at a given
price, it is said that even a monopolist is subject to the consumer sovereignty, since,
though he/she can either fix the price of his/her product or decide how much he/she will
produced he/she cannot do both of these things at eh same time
9. Ni government controls or regulation in the market. Only minimal intervention
measures.
Limitation on consumer sovereignty
1. The most important limitation arises from the size of eh consumer income.

2. The satisfaction of he consumers depends on the goods actually available in the

market. There are physical limitations too. Actual production depends on the input
factors of land, labour, capital entrepreneurship and organization. Consumers’
preferences are generally a head of what can be produced at any given time. There is
scarcity yet wants are unlimited.

3. High pressure salesmanship and persistent advertisement thwart the wishes of the
consumers. As, a result, consumers are induced to buy something different for what
they would have purchased otherwise.

4. Monopolists also exercise control over consumers. The monopolist controls the
supply. Eth consumers are helpless under this condition.

5. The government may prohibit or restrict the consumption of a commodity

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Advantaged and disadvantages of market economy
Advantages
1. Competition I the market. This lead to efficiency in production. Lower costs, lower prices
in the market and optimal allocation or resource.
2.
3. There is also increased production in economy.

4. Invention and innovation through research, leading to modern and more efficient
technologies, hence increase in the technological stock of the economy. etc.
Disadvantages
1. Inequalities in income distribution. Leading to a society of few rich and poor masses.

2. There are many market failures where by the market mechanism cannot perform e.g. in
supply of public/ collective goods, externalities in production, environmental degradation
etc.
3. Mid-allocation and mis-use of scarce resources

4. Exploitation of the consumers or the weak in society.

The Centrally planned Economic System
Under this system, the allocation of resourced, production and distribution are decided not by
consumers through the price mechanism but by the state. In order to achieve this objective, the
government has first to estimate consumers’ wants and then decide which goods to be produced
and in what quantities, how, where to produce.
Salient Features of collectivism
While different forms of collectivism (or socialism) may exist, there are certain essential features
that are common to them all. These are as follows:-
1. Under this system, farms factories mines, railways banks etc, are allowed by the society
rather than by private individual or firms. There is thus no private property in respect of
the mean so production.
2. The means of production are operated with the object of promoting and servicing the
goods of the whole society rather that for the benefit of a few individuals.

3. Unlike private Enterprise under which the price mechanism allocates resourced among
the various produce activities, under collectivism this allocation is den by a central
authority with a view to maximizing social welfare. This is done trough planning’

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 4. Under this system, all means of production are under state ownership and there is no
system of private, hence inequalities of wealth cannot arise.
Advantages of command Economic system.
1. Equality in the distribution of income
2. Increased welfare in the economy
3. Allocation of resource is according to need through planning etc.
4. No consumer exploitation.
Disadvantaged of command Economic system
1. Bureaucratic and totalitarian regimes
2. Inefficiencies in production because of lack of completion and the profit motive.
3. High production costs and low output, etc.
Examples of socialistic economies are Cuba, North Korea, china etc. The former USSR and
Eastern Europe economies were very good examples.
The mixed Economic System
In the real world, no country nowadays ha an economy which s exclusively based on private
enterprise or exclusively on collectivism. In recent years a third type of economic system has
evolved. It called mixed economy under this system the economy has both the public and
private sector existing and function side by side and there is the joint responsibility of the
individual enterprise and the state to undertake the entire functions of production and
distribution.
The economic system operated by East Africa countries is generally considered as mixed. Some
planning of production is undertaken by governments, directly or through their nationalized
industries, while the greater part is left to private enterprises. The three governments of Kenya
Uganda and Tanzania undertake the following:-
 Provision of essential services such as roads and communications, health education and
range of social serviced
 Investing in some of the major financial institutions
 Ensuring that legal or regulatory frameworks exist to check any harmful effects of private
enterprise
 Some economic planning and government intervention in the market.
Salient features of the mixed Economy
 In a mixed economy both public and private sectors exist and function together
 This type of economy is operated both by price system and government directives.
As far as the public sector is concerned, economic decisions relating to production,
price and investments are made by governments. But the private sector is operated
using the price mechanism. I other words, in the industries operated by the private

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 sector , decisions regarding investment , private entrepreneurs make production and
prices.
 In mixed economy, government adopts necessary measures to regulate and influence
the private sector, so that the interest of he nation is not subordinate to the interest of
the private entrepreneurs. The measures can be inducements (incentives) or
disincentives.
 In a mixed economy, the government protects the weaker sections of society,
especially labour from exploitation by the capitalists (or private entrepreneurs)
 In addition, government takes measures to reduce inequalities resulting from unfair
distribution of income and wealth.
? Revision Questions
1. Give a brief account of how various economic systems seek to solve economic
problems.
2. a) Explain what is meant by “consumer’s sovereignty.’
b) What are the limitations on the sovereignty of the consumers?
3. Describe the salient features of private enterprises?
4. The failure of command economies in the former Soviet Union and in Eastern
Europe has led to well publicized criticism of such systems. Write down what are
the main disadvantages of command economy. Try to think of the advantaged
therein.
5. What is collectivism (socialism)? Identify its main features.
6. Outline the various types of economic systems operating n the world and the salient
features operating in each type of system.
7. What do you understand by mixed economy? Explain its main features
8. Discuss the role of the government in a mixed system?
9. What are the characteristics of a mixed economic system?
10. “A capitalist economy is more efficient than a planned economy ‘. Discuss
11. Developing countries require neither planned more capitalist economic systems.”
Can this statement be justified “give reasons for you answer?

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 CHAPTER THREE
THEORY OF DEMAND
Objectives

At the end of this chapter, you should be able to:

1. Describe the major determinants of demand and how they impact demand;
2. Explain the law of demand
3. Explain the characteristics of demand curve;
4. Distinguish between a shift in, and movement along the demand curve; and
5. Describe the concept of elasticity of demand and compute elasticity from numerical
observations.

Definition of Demand, Demand Schedule Demand Curve and Demand Equation.

It is usual for textbooks of economies to cover microeconomics before macroeconomics, and the
structure of economics in military Science program is on exception. In this chapter, we begin to
look at microeconomic. In microeconomics, the theories of demand , supply, consumer
behavior, firm behavior and price determination, all aim to explain how economic decision are
reached.
Some of the key questions microeconomic deals with here include:-
 What make consumers decide what they are going to buy, and in what quantities?
 What makes firms decide what goods and services they are going to produced and in
what quantities.
 How are market price arrived at?
Many concepts such as price, demand and supply are in everyday use. Ti is important to eb
about the precise way in which economists use such concepts. For example, note the difference
between an individual household demand (or consumer’s demand) and market demand. The
establishment of equilibrium in a market is a key idea here.
The concept of Demand
Economists use “demand “and supply “in a very precise way. And is thus important to explain
what these terms mean to an economist. The economist’s view is that demanders and suppliers

15
respond to incentive. This means they respond to price changes. Demand refers to the quantity
of commodity that a buyer is willing and able to buy at a given price within a given period of
time, holding all other factors constant (ceteris paribus).
It is important to appreciate the concept of demand properly. Demand does not mean the
quantity that potential purchasers wish they buy. For example, potential purchasers may desire
to have one million units of a good but they may actually buy one hundred units at a given price
within a given period of time, holding all other factors constant (ceteris paribus).
It is important to appreciate the concept of demand property. Demand does not mean the quantity
that potential purchases which they could buy. For example, potential purchaser may desire to
have millions units of a good, but they may actually buy one hundred units at a given price.
Demand is what would be the actual amount brought at a given time and at a given price level.
Several factors influence the total market demand for a good. These factors are also referred to as
determinants of demand. One of these factors is obviously its price, but there are other factors
too, and to help you- to appreciate some of these others factors, you need to recognize that
household buy not just one goods with their money, but a whole range of goods and services.
The factors on which the quantity demanded for an individual good depends include:-
a) Price of the goods
b) Price of other related good( product and services)
c) Size of household income;
d) Tastes , fashions and preferences
e) Distribution of wealth among household- i.e. how wealth is spread amongst the
population.
f) Size and composition of the population
g) Government policy
h) Future expectations ; and
i) Seasons or weather.
Each of these factors is discussed at greater length later in this chapter. Eth total quantity
demanded is referred to as the market demand. Whenever factor (a) to (d) can affects buying
decisions by individuals households, factors (e0 and (f) are important because they influence the
potential aggregate size of the market as a whole.

To be able to understand how quantity demanded is influence by the above factors, it is

important that you help grasp the concept of what is called “demand function.” The demand
function expressed the relationship between the total quantity demanded and the price of a
product. Making use of functional notation, the demand function can be summarized as
follows:-

16
 QDN = D (Pn, P0, Y T, WD, P, G, E, W, etc) ………………………………
(3.1)
Where; QDN = quantity demanded of some products n,
Pn = Price of this products;
Po = Prices of all other related product
Y = Consumer’s income
T = tastes fashions and preferences
Wd = wealth (income) Distribution
P = Population size and composition
G = Government policy
E = Expectations
W = Weather/climate conditions
The form of the function D is determined by these factors. Since it is not possible to understand
the separate influences of each of the above variable if we ask what happens when everything
changes at once. We resort to the assumption that all except one variable, say P n are held
constant. In other words, only one variable in this case P n, is allowed to change. This means we
study the effect of change in one influence on the quantity demanded assuming that all other
influences unchanged, or, as economists are fond of putting it, ceteris paribus, meaning all other
things being equal.
Thus QDn = D(Pn) Ceteris Paribus
Demand and the Price of a Good
In order to understand how products get priced, we need to study the relation between the
quantity demanded of product and that products own price using a market demand function. A
basic economic hypothesis is that the lower the price of a product, the quantity demanded, ceteris
paribus. (Other things being equal) This is the law of demand.

It is common sense that at a higher price , a good does not give the same value for money as tic
would a lower price and so households would not be able to buy more, and vice versa.
The Demand Schedule, Demand Curve and Demand Functions
The relationship between and price can be shown in three ways, for both the individual and the
market demands, as follows:-

17
 1. Demand Schedule
This is a table showing the various quantities demanded at each price level. The table
contains price and quantity data, either for the individual or the market.
Table 1 A typical Individual Demand Schedule

Price per Kilogram € Quantity demanded (in kilogram)

1 9 2/3
2 8
3 6 1/2
4 41/2
5 22/3
6 1
If there are many consumers I the market, you sum up quantities demanded at each price
level to get the total market demand schedule.
2. This is a graph showing the relationship between the price of a commodity and the
quantity. How much is demanded by an individual consumer or the market at each price,
ceteris paribus.

Figure 3.1 Graph of Demand Schedule (Individual Demand Curve)

6 A B
Price in $

2 E

1
C F

0 1 2 4 6 8 10
Quantity demand F in
The area of each rectangle represents consumers’ total money outlay at the specified price. For
example, at a price of €6, demand would be 1 kilogram and total spending could be €6,

18
represented by rectangle ABC). Similarly, at a price €2, demand would be 8 kilograms and eth
total spending of €16 is represented by rectangle GEFO.
If we assume that there is a complete divisibility, so that price and quantity can both change in
infinitely small steps, we can draw a demand curve joining the point as shown in Figure 3.1 by a
continuous line, DD. This is the consumer’s demand curve fro soap power in the particular
market we are looking at. Here, the demand curve happens to be a straight line. Straight-lien
demand curves are often used as an illustration in economics because it is convenient to draw
them this way. In reality, a demand curve is more likely to be a curved line, convex to the origin
(See Figure 3.2). A convex demand curved means that there are progressively larger increases in
quantity demanded as price falls.
Figure 3.2 A Demand curve in convex to the origin

D
P3
Price

P2
D
P1

0 Q3 Q2 Q1
Quantity Demanded
Changes in quantity demand caused by changes in price are represented by movements along the
demand curve, from one point to another. The price changes, and the quantity demanded equally
changes, but the demand curve itself remain the same. From Figure 3.2, the quantity demanded
QD increases when the price P increased. At a price of P 1 the quantity demanded is Q1. When the
price is increased to P2, the quantity demanded decreases to Q 2. This relationship is called the
law of demand. This law demand states that other factors remaining constant, the higher the
price the lower the quantity demanded, and vice versa.
In this simple example, we are looking at the demand curve a of a single consumer or
household. A market demand curve is similar curve, drawn from a market demand
schedule, expressing the expected total quantity of the goods that would be demanded by
all consumers together, at any given price.

19
 Market demand refers to the total quantities of a product that all household would want to
buy at each price level. A market demand schedule and a market demand curve are,
therefore, simply the sum of all the individual demand schedules and demand curves put
together. Market demand curved would be similar to these in Figure 3.2 and 3.2, but with
quantities demanded at same level of price being higher, thus total market demand.

The market demand curve generally slopes down from left to right for the following
reasons:-
 Substitution effect of a price change. For the individual consumer, a fall in the
price of a goods make is relatively cheaper compared to other goods, and with a
limited budge, expenditure will be shifted to the goods whose price has fallen. It
is the relative price of the goods that is important. A fall in the relative price of
good increases the demand for it.
 Income effect of price change. When the price of a good or service falls, the
purchasing power (the real income) of the consumer increases without a change in
the nominal income. He or she can buy more of that good. Thus the lower the
price, the higher the rate of income and eth higher the demand and vice versa.
 Price effect. A fall in a good’s price means that people with lower incomes will
also be able to afford it. The overall size of the market for the good increases.
The reverse argument applies to an increase in prices. That is, as a price goes up,
consumers will lower incomes will no longer be able to afford the goods, or will
buy something else whose price is relatively cheaper and the size of the market, as
the market will shrink.
 New buyer. A fall in price for good or service attracts new customers for that
commodity. Some consumers who could not afford the commodity before the
price decreases can now buy it. Thus increasing the demand, and vice versa.
This analysis indicates that the relationship between price and quantity demanded is an
inverse one. As price rises, demand falls; and as price falls change increases. A demand
curve shows how the quantity demanded will change in response to a change in price
provided that all other conditions affecting demand are unchanged.
3. Demand Functions
The quantity demanded by an individual or the market can also be expressed
mathematically in from of a demand equation, such as the following:
Qdx = a – bpx ceteris paribus
Where Qdx = quantity demanded of a good x.
a = A constant, whose economic interpretation is the quantity
Demanded if the price if zero. This is also the intercept of
the demand curved on the X –axis.

20
 b = the inverse of the slope of the demand curve, which is
negative, showing the inverse or indirect relationship
between price and quantity demanded. It is the change
in quantity demanded due to a unit change in price of the
commodity.
Px = the price of the commodity X.
For example “Qdx = 1600 – 200pPx.
Factors influencing demand for a commodity
The demand for a commodity may change due to certain factors. Lets us look at a commodity
we consume every day – bread. At Kshs. 4.10, the quantity demanded of bread may be 5 loaves
per week. It may happen that at the same price (sh. 4.10), the quantity demanded changes to 10
loaves per week. In this case, the quantity demanded has increased, although there is no change
in the price of bread.
Therefore, a part from the price, the are other factors that determine the demand for a
commodity. Earlier on we discussed the influence of price on demand. Here, we specially
discuss the effect of eh other factors on demand for commodities.
Prices of other Related Commodities
Changes in eth price of one good will not necessarily change the demand for another goods. For
example, we would not expect an increase in eth price of cocoa to affect the demand for
motorcars. However, there are goods for which the market demand is in some way affected by
the price of interrelated goods. The relationship between interrelated goods can be in the form of
wither substitutability or complementarily.
Substantial Goods
There are those commodities that serve the same purpose, thus they are alternatives to each
other. They compete in demand. Examples of substitute goods are:
 Rival brands of eh same commodity, for example, Coca-Cola and Pepsi Cola
 Tea and Coffee;
 Bus rides and car rides
 Different forms of entertainment
 Butter and margarine
 Beef and mutton
When two goods substitute, a price change in one will affect the quantity demanded of the other.
Switching demand from one goods to another rival good is referred to as substitution, if for
example, the price of butter increase, this will make butter relatively more expensive than
margarine. People may therefore decide to buy less of butter and switch to buying more
margarine because of the relatively cheaper price of the latter. So the price increase in butter

21
may cause more margarine to be bought, although there is no change in eth price of margarine.
This is illustrated in Figure 3.3
Figure 3.3 The Effect of change in the Price of Butter in the Quantity
Demanded of Margarine D1
D D0
Butter Margarine
P1 P2
Price

Price
P0 D1
D D0

0 Q1 Q0 0 Q2 Q3
Quantity Quantity

Initially, the price of butter is OPo and quantity demand OQo

The price of margarine is OP 2 and eth quantity demanded OQ 2. When the price of butter
increases to Op1 quantity demanded reduced to OQ1. As a result people begin to demand more
of margarine since it is now relatively cheaper. So at the same time price of OP 2, more
margarine is bought, and the new quantity demanded is OQ3. The demand curve for margarine
shifts to the right from Do DO to D1D1. On the other hand, a fall in price of butter may cause the
demand for margarine to decrease. In case, the demand curve shifts to the left.
Complements
These are goods that tend to be bought and used together. For complementary goods therefore,
the use of one commodity necessitates the use of another, Exampled of complements are cups,
and saucers; bread and butter; motor cars and motor spares; cars and petrol; pens and ink; and
skirts and blouses.
The price of one complementary good will affect the demand for the other. If price of cars
increases, few cars may be demanded, and this may lead to less petrol being demanded. This is
illustrated if Figure 3.4

22
Figure 3.3 The effect of an increase in the Price of Cars on the Quantity of
Petrol Demand

D D1
Cars D0 Petrol
Price

P1 P1

Price
P0
D1
D0

0 Q1 Q0 0 Q1 Q0
Quantity Quantity
Initially, the price for cars s OP 0 and quantity demanded OQ0. Price of petrol is OP 2 and quantity
demanded OQ2. IF the price of cars increases to OP 1 quantity of cars demand reduces to OQ 1.
This decreased demand in cars reduced the demand for petrol such that at the same time price,
less petrol is bought. The result is a shift of eth demand curve fro petrol to the left from D 0D0 to
D1D1. Quantity of petrol demanded reduced to OQ 3. The opposite occurs if price of cars
decreases.
Household Income
Level of income determined individuals’ purchasing power. So the quantity of a commodity
demand by an individual depends on his/her income. If a person’s income increases, their
demand for a commodity is likely to increase because can afford to buy more than commodity.
On the other hand, a fall in income may result in a decrease in demand.
This general relationship between quantity demanded of commodity and changes in income is
represented in figure 3.5. At an income of Ksh. 500 per month, the consumer buys only 2 loaves
of bread per week. When his income rises to Ksh. 1500 per month, he consumes 7 loaves per
week. In this case an increase in income lead to an increase in the quantity demanded of bread.

23
 Quantity ( Loaves of bread per
Figure 3.5: Relationship between Quantities demanded of bread and changes in Consumer
Income.
Income per month (Ksh.)

week)

500 0
1000 1500 2000
Income per month
However, it is not always the case that a rise in household income will increase market demand
for all goods and services. The effect of a rise in income of demand for an individual good will
depend on the nature of the good. Commodities can be classified as normal (necessities,
luxuries) and inferior goods.
Demand and the level of income increase may be related in different ways (see figure 3.6).
 A rise in household income may increase demand for good. This is what we may
normally expect to happen, and goods for which demand rises as household income gets
bigger are called normal goods.
 Demand may rise with income up to a certain point, but then falls as income rises beyond
that point. Goods whose demand eventually falls as income rises are called inferior
goods, for instance, tripe, cheap wine. The reason for falling demand is that as income
rise, demand switched to superior products, for example, beef instead of tripe and better
quantity wines instead of cheaper variety.

24
 Quantity (Per week)
Figure 3:6 Relationship between Quantities Demanded in Income changes for different
types different types of goods.

Luxuries

Q1 Necessities

Inferior goods

0 11 12
Income per month
Figure 3.6 shows that as income increase, the quantity demanded of necessities may increase up
to a certain amount Q1. Thereafter, it remain the same, For example, there is a limit to the
amount of salt, sugar or even meat, a household can consumer per week, however high its
income. The consumer does not increase quantity of the necessities demanded, though income
continues to increase.

The quantity of luxuries consumed increase as income rises. In Kenya for example, more cars
are bought as people become richer, they tend to spend money on television and on more
expensive clothes and shoes.

Inferior goods are those good that are consumed when people are poor. As income increase, less
of inferior goods are brought, because people substitute better goods for inferior ones. For
example, as people’s income rises, easy chairs may be substituted for stools, and sukuma wiki
for meat stew.

Note that what may be considered as a luxury or an inferior good in one community may be
taken as necessity in another community. The use of these terms may depend on the needs of the
community, but the income relationship, in general, remains as described above. The response
of demand for a good to a change in the consumer’s income is indicated by the income elasticity
of demand. This will be discussed further in another section of the chapter.

25
Tastes, seasons, Fashions and preferences
Demands for a commodity also depend on people’s tastes, fashions and preferences. If
something goes out of fashion, demand for it declined even if prices remain unchanged. For
example, miniskirts were very popular with women in the 1960s. Later the fashions changed and
manufacturer found that the demand for miniskirts was less notwithstanding the price change. If
people’s tastes and preferences favor a certain product, the demand for it increases.

Demand may also change because of the weather or climate. During the rainy season,
For example, demand for umbrellas and/or raincoats be likely to increase,

Tastes and preferences may be influenced by many factors such as age, gender, education and
culture. For instance, beef would have no demand in communities where religion or culture
forbids its consumption, and low rated of literacy cause a low demand for books.
Future Expectations
If consumers believe that prices will rise, or that shortages will occur, they may attempt to stock
up on the product, thereby creating excess demand in short term that will increase prices. This
can then lead to panic buying exampled include fear of war, the budget presentation days and the
effect of strikes or rumors.
Number of people

The Distribution of National Income

Number of people

Market demand for a good is influenced by the way in which the national income is shared
among households. Consider the following patterns of income distribution (figure 3.7).
Figure 3.7 Different patterns of Income Distribution
40 40
35 35
30 30
25 25
20 20
Middle

High

Middle

High
Low

15 15
Low

10 10
5 5
0 0
Annual Income Annual Income
(a) (b)

26
In Figure 3.7 (a), which ha many rich and poor household and few middle income ones, there
may be a large demand for luxury cars and yachts, and also for staple foods such as bread and
potatoes. Incase (b), there should be high demand for medium-size cars and TV sets, and other
middle income goods.

Income distribution in a country will affect demand fro commodities in that country. For
instance, when the income of a country is unevenly distributed, money will be in hands of few
people. Therefore, only a few people can afford to buy most of the goods. If this income is
redistributed more equitably more people will afford to buy most of the goods and demand will
generally increase. Also income distributed affects the types of commodities demanded. If
income is in the hands of few rich people, then demand for luxuries is likely to be very high.

Size and Composition of the populations

A large population increases demand, since there are more people to feed cloth and transport.
The composition of the population may also affect demand in that when a population is
composed mainly of young people; there will be a higher demand for schools and education
generally, with all textbooks, uniforms and contributions that go with education.

If the population is mainly composed of elderly people, you may find that there will be a higher
demand for homes for the aged, walking sticks, false teeth and hair dyes, than would be
otherwise. If a population has more females than male, then female commodities like cosmetics
hair salons and skirts are likely to be demanded more than commodities for men.

Government Policy

A government can affect the demand for a commodity through taxation or subsidies. If a
government wants to discourage the consumption of a commodity, it will impose a high tax on it,
and this will increase its price and therefore, reduce the demand. For example in Kenya, the
government imposes taxes on certain imports such as cars. Taxation increases price hence
making it more costly and discourages potential buyers.

To summaries, the market demand curve relates to the total quantity of a commodity demanded
to its own price, on the assumption that all other prices household incomes, the distribution of
total income among household, assets expectations and other factors, are held constant .

Change in Quantity Demanded and Change in Demand

According to the law of demand as the prices changes, demand also changes in other words, if
the price of a good goes up or down, given no changes in the other factors that directly affect
price, there will be a movement in the quantity demanded along the demand curve.

27
When there is a change in other factors that affect demand, the relationship between demand
quantity and price also changes, and there will be a different price/quantity demand schedule
and hence a different demand curve. We refer to these changes as a shift of the demand curve.

This is an important distinction that requires repetition in a slightly different form to consolidate
your understanding of it.

 Movements along a demand curve for a good are caused by change in its price.
 Shifts in the demand curve for a good are caused by change in any of the other factors
that affect demand for good, other than its price.

Let us first consider movements along a demand functions. The total quantity demanded
increases when the price of the products drops. Changes in quantity demanded due to changes in
price are called, extension or expansion and contradiction of demand. By extension of demand,
we mean increases in quantity demanded due to a fall in price. Similarly, by contraction of
demand we mean a decrease in quantity demanded due to a rise in the price level. In the case of
extension and contraction of demand curve remains the same, but demand point shifts from one
place to another. The extension and contraction of demand can be explained with then schedule
depicted in Table 3.2 and the general diagram. Figure 3.8.

Table 3.2 Schedule Depicting Extension and Contraction of Demand

Price ($) Quantity Demanded (Units)

3 10
Extension
2 15
3 10
Contraction
4 5

28
Figure 3.8 Movement along a Demand Curve Extension and contraction of Demand

Contraction

4 a
Price

3 h Extension

2 C

0 5 10 15
Quantity Demanded

Figure 3.8 shows that if the price is 3, the quantity demanded to 10 units per period. If the price
decreases to 2, there is a movement along the demand curve as the quantity demanded increases
(extends) from 10 to 15 units conversely, if price rises from 3 to 4, quantity demanded decreases
involves a change in the price of the product in question, and a change in the total quantity
demanded of he product, other factors remaining constant.

Change in Demand

So far, we have focused on what happens to the quantity demanded of a product when the price
of the items changes. However, as we saw earlier, the price is only one of several determinants
of the total quantity demanded. Changed in the variable unlike a change in the price of the
product. Shift the position of the demand function entirely into a new position. When demand
rises, the demand curve shifts from left to right or upwards. In the case of a fall in demand, the
demand curve shifts from right to left or downwards. These two situations are known as changes
demand.

Figure 3.9 illustrations the concept of a shift in the demand function. In figure (a) the demand
curve shift for D0 D0Do D1 D1 because of changes in the other non-price determinants of demand
leading to an increase in demanded increases. For example, at the price of P 1 the quantity
demanded increases from Qo to Q1, due to the shift of the demand curve to the right.

29
 Figure 3.9 Shifts in the Demanded Function

D0 D1 D1 D0

Increase Decrease

P1 P1
price

price
D1

D1

D0

0 Q0 Q1 0 Q2 Q
Quantity Quantity
(a) (b)
Figure 3.9 (b) depicts a fall in demand at each price level that is represented by shifting to the left
of the demand curve, from ‘old’ curve D 0 D0 to new D1 D1. This curve shift may be changes in
the other non-price determinants which may lead to fall in demand. For example, at price P the
demand will fall from D0 to D2.

To summarized, a shift of demand curve to the right portrays an increase in the quantity
demanded at any given level. Whilst a shift of the curve to the left portrays a reduction in the
quantity demanded at any given price level.

Factors that cause change in Demand

We have seen that price brings about a change in quantity demand. When demand changes due
to the change in price. It is called extension or contraction of demand. There are certain other
factors that can bring about change in demand independently or a change in price. Price of any
commodity and factors of change in demand are also known as determinants of demand. Factors
that necessitate increases and decreases in demand include the following.

30
 Change in fashion, tastes and preferences.
Due to change in taste, fashion and consumer preference, demand may increase or
decrease. If the changes favour the commodity, demand will increase and the demand
curve shift to the right to the right and vice versa.
 Change in fashion
Due to increase in income of a consumer demand rises and vice-versa. A rise in
consumers’ income shifts the demand curve for normal products to the right, indicating
that more will be demanded at each possible price level. Conversely, a fall in consumer
income shifts the demand curve for normal products to the indicating that less will be
demanded at each possible price level.

But a rise in consumers’ income shifts the demand curve for inferior goods and services
to the left, indicating that less will be demanded at each possible price level, and vice
versa.
 Change in price of other related commodities
Demand of any commodity may change due to change in price of any substitute or
complimentary commodity. For example, if a price of coffee rises, demand for tea may
increase and if the price of cars increases, demand for petrol may decrease.

a) Generally speaking a rise in the price of a product substitute shifts the demand
curve for the product to the right. More will be purchased at each price and vice
versa(see figure 3.8)
b) A fall in the price of one product that is complementary to a second product will
shift the second product’s demand curve to the right. More will be purchased at
each price ; and vice versa (See figure 3.9)

 Change in population
When population increases, demand for goods and services rises and vice versa.

 Change in wealth Distribution

When wealth is more distributed the demand for goods and services will rise and vice-
versa. In summary, when the distribution of income changes, demand will rise for those
goods favoured by those losing income.
 Economic conditions
When there is economic prosperity in the country, demand will be greater, and during
depression, demand will be smaller.

31
Abnormal Demand Curves and Inter-Relation Demand

We have seen that demand curves slope downwards from left. But there are seen in which the
demand curve does not slope downwards from left to right. Such demand curves referred to as
abnormal demand curves. Cases of abnormal demand are discussed below.

Inferior Goods

Inferior goods are those commodities that are consumed when one’s income is low. When
income increases, the consumer may not increase the consumption of such products, but rather
switch to substitute of a higher quantity, which he may not have been able to afford before the
increase in income. For example, an increase in one’s income may induce a consumer to switch
from plastic to leather choose. A person driving old second hand cars may switch to a brand new
one if his income rises. The term inferior is used regardless of whether a consumer can afford
them or not. Also a good is inferior in relation to the consumer’s standard or living.

If the price of an inferior good falls, the effect is to increase the real income of the consumer.
The consumer is likely to spend less income for the same amount of the inferior good he needed
before, and he might use the extra income for other commodities, which he could not have
afforded before the price fall. The effect on demand for inferior goods will most likely be a
reduction on the overall quantity demanded.

Giffen Good

Giffen goods are inferior goods, which are also necessities. Sir Robert Giffen a British
economist first identified them in the late 19 th Century. He noted that there are certain goods,
especially foodstuffs, which are consumed by low income earners in combination with other
goods, which are relatively more costly. For example, poor people buy inferior quality of food
like maize poor people will prefer to buy some rice. If the price of maize falls, then poor people
will prefer to buy some rice instead of maize. In this case, when price of maize falls, its demand
will decrease.’

In Kenya, ugali is often eaten together with beans or roast meat. If the price of maize meal goes
up, consumers may buy more of it and reduce the consumption of roast meat any more, and since
they cannot abandon ugali that is a necessity in their diet, they will have more of it but without
the meat. For Giffen good therefore, there are ranges of prices within which a rise in price will
increase the quantity demanded of the commodity. As the price rises, a consumer cling to the
Giffen goods and reduces the consumption of the relatively more expensive commoditized.
They buy more of the Giffen goods in order to cater for the loss in quantity due to the
abandoning of the other goods. In the case of ugali and meat, people may eat more ugali to
compensate for the roast meat they would miss due to an increase in the price of ugali.

32
 Figure 3:10 A possible Demand Curve for Giffen Good

P3
price

P1

O Q1 Q2
Quantity demanded
Note that for inferior goods, the change in quantity demanded is due to change in income,
whereas for Giffen goods, the change in quantity demanded is mainly due to changes in the price
of the commodity. Also, necessities. Therefore, all Giffen goods are inferior goods, but not all
inferior goods are Giffern goods, from Figure 3:10, it can be seen that when the price of giffen
good increases from P1 to P2, quantity demanded increases from Q1 to Q2.

Goods of Ostentation

There are commodities that are bought because they are prestigious. These commodities are
mainly bought by the wealthy class who believes in having an increase the quantity demanded of
that product. But if price is reduced, more people may be able to buy that product and therefore,
it will no longer be prestigious to buy the commodity. Hence, the individual may reduce his
demand for the commodity because prices have gone down. The main examples of goods of
gestation are jewels, expensive brands of motorcars, watches, and clothes. These goods are
bought because consumers believe that the product is better when the price is higher. Such
buyers associate quality with high price. This may be true to exclusive consumers, namely
consumers who wish to appear different from others, or those with snobbish consumption traits.

Ostentatious goods are sometimes associated with countries of origin or even an “expensive”
part of town. For example, many east Africans prefer imported clothes, especially from north
European countries and North America, in spite of quality. Also ostentatious buyers might boast
that they bought a shirt on Nairobi city’s Kenyatta Avenue for kshs 2,000 whereas the same item
would have cost them ksh. 500 on river road.

Thus, the demand curve for such goods will be positively sloped. The higher the price, the higher
the demand.

33
Anticipated Trends in the Price of a Commodity

Anticipated changes in the price of a commodity may cause the quantity demanded of the
commodity to increase or decrease. For instance, an increase in the price of a commodity may
compel people to buy more of that commodity so as to avoid paying even higher prices in future
if they expect the rise in prices to persist. A fall in price may lead to no increase in quantity
demanded if people expect the price to continue falling. This phenomenon is true in the case of
prices for shares at the stock exchange.

Speculators may not buy more shares until the prices of the shares reach a certain anticipated
minimum. In inflationary situations, people may buy more of a commodity when its price rises
because they expect further increases in price. In 1987 when the price of a oil began to fall,
countries did not increase their purchases of oil immediately because they expected further falls
in price thus expected changes in price may make the demand curve of a commodity to behave
abnormally, having a positively slope demand curve.

Further cases

Additional cases that represent abnormal demand curves are perfectly elastic and perfectly
inelastic demand curves. These are also abnormal demand curves in that they do not slope
downwards from left to right. The perfectly elastic demand curve is horizontal parallel to the X-
axis , meaning that at a given price level Po1 any amount for that good can be demanded e.g. Q 1,
Q2, Q3………

Figure 3.11 Perfectly Elastic Demand Curve

P2 D
price

0
Quantity Demanded

The perfectly inelastic demand curve is perpendicular to the x-axis, meaning that a fixed amount
of the commodity, Qo will be demanded at any price level.

34
 Figure 3.12 Perfectly Inelastic Demand Curve

P3
price

P2

P1

0 Q0
Quantity Demanded
Inter-Related Demands

Sometimes demand for one commodity is affected by changes in the demand for the other
commodities. Various forms of inter-related demands are discussed below.

 Joint demand. Some goods are demanded jointly. These goods are needed to satisfy any
particular want. If two or more goods are demanded together, then these have joint or
complementary demand main examples of joint demand are motorcars and petrol, tea
leaves, sugar and milk, and student’s needs for books and stationery.
 Competitive demand. Some goods substitute one another. The demand for such goods
is known as competitive demand. For example tea and coffee substitute of each other. In
this case, the increase in demand for tea will result in the decrease in demand for coffee
and vice versa.
 Composition demand. Some goods are used for different purpose. The total demand
for such goods for all uses is known as composite demand. For example, steel is used to
manufacture motor cars, machine and buildings. The total demand for steel for all these
purposes are composite demand.
 Derived demand. When goods are demanded by consumers to satisfy their wants, the
goods are said to have direct demand, for example, demand for food and cloth. Some
goods are demanded in order to produce some other goods. The demand for cash goods
is called derived demand. For example, cotton is required to produce cloth. If the

35
 demand for cloth is greater, than more cotton will be demanded and vice versa. In this
case, the demand for cotton is derived demand

Elasticity of Demand

The Responsiveness of Quantity demanded to a change in price

When the price of a good rises, the quantity demanded will fall. That much is fairly obvious.
But in most cases, we will want to know more than this. We will want to know by just how
much the quantity demanded will fall. In other words, we will want to know hoe responsive
demand is to a rise in price.

Such information is vital to any firm considering whether to put up prices. Take the case of
two firms facing very different demand curves. These are shown in figure 3.13. Note that
we are now dropping the assumption tat firms are price takers. We are assuming that they
can choose price and face a downward-sloping demand curve.

Figure 3.13 Demand for and Individual Firm’s Product

10 10

6 6
Price Ksh.
Price Ksh.

0 90 100 0 90 100
Quantity Quantity
Firm A can raise its price quite substantially-from Kshs. 6/= to Ksh.10/= and yet its level of
sales only falls by a relatively small amount –from Ksh 100 units to 90 units. This firm will
probably be quite keen to raise its price. After all, it could make significantly more profits on
each unit sold (assuming not rise in costs per unit), and yet only sell slightly few units.

Firm B, however, will think twice about raising its price. Even a relatively modest increase
in price –from Kshs. 6/= to Kshs. 7/= will lead to a substantial fall in sales from 100 units to
40 units. What is the point of making a bit more profit on those units that it manages to sell if
in the process it ends up selling a lot fewer units. In such circumstances, the firm may
contemplate lowering its price.

36
 Economics too will want to know how responsive demand is to a change in price. It also
important to know just how responsive demand is to a change in other determinants.

 How much will demand rise when income rises?

 How much will demand rise when the price of a substitute good rises?
 How much will demand fall when the price of a complementary good rise?
 Similarly, it is important to know responsive supply is to a change in price, or to some
other determinant

Given the importance of knowing the responsiveness of demand and supply to a change
in one of the determinants, we will need some way to measuring this responsiveness.
Elasticity is the measure we use.

Defining Elasticity

Elasticity of Demand- Micro Topic 2.3 (youtube.com)

https://www.youtube.com/watch?v=HHcblIxiAAk

https://www.youtube.com/watch?v=J82_xd5XxXg

What we will want to compare is the size of the change in quantity demanded (or supplied) of a
given product with the size 01' the change in the determinant that caused it. Elasticity does just
that. The formula for elasticity is:

Elasticity (Z) = Proportionate (or percentage) change in quantity (4.2)

Proportionate (or percentage) change in the determinate

There are four particular types of elasticity in common use: Price elasticity of demand, cross-
price elasticity of demand, income elasticity of demand, and price elasticity of supply. In this
chapter, we examine the three types of elasticity of demand and defer that of supply to chapter 4.

Price Elasticity of Demand / Own Price Elasticity of Demand

The concept of elasticity of demand is generally associated with the name of Alfred Marshall. As
has been stated earlier, the law of demand is a qualitative statement of a relationship between the
price of a commodity and its quantity demanded by the consumer. The law of demand does not
specify any quantitative relationship between the two magnitudes, thus, between price and the
quantity demanded. The reason is because there is no quantitative uniformity in the behaviour of
goods vis-a-vis changes in their respective prices. The quantities demanded for some
commodities are more responsive to a given change in price than the quantities demanded for
other goods. We express this tendency in economics by saying that the demand for certain
commodities is more elastic than the demands for other goods.

37
The law of demand states that when the price of any commodity increases, demand decreases,
ceteris paribus, and vice versa. The relation between changes in price and demand is indicated in
the concept of elasticity of demand. Elasticity of demand may be defined as: Responsiveness of
demand to a change in price. In other words, it is the rate at which demand changes due to a
change: in the price level. In the words of Joan Robinson:

"The elasticity of demand at any price or any output is the proportionate change in the amount
purchased in response to a small change in price divided by the proportionate change of price."

Elasticity of demand may, therefore, be defined as the extent to which the quantity dernanded of
a commodity changes in response to a given change in price. More precisely, elasticity of
demand refers to the sensitiveness or responsiveness of demand to change in price. a is the
capacity of demand to expand or contract in response to given changes in price.

Price e1asticity of demand is given by proportional changes in the quantity dernanded of a good
to a given proportionate change in price of that good. Mathematically, the price elasticity of
demand can be computed using following formula: -

P£d = Proportionate (or percentage) change in quantity demanded

Proportionate (or percentage) change in price

= change in quantity x '100 / change in price x 100

Quantity before change price before change

Where P£d is the price elasticity of demand .., (3. 3)

If the percentages are known, then the numerical size of P£ d can be easily calculated. Let us
suppose that the percentages are 3 for quantity, and 1 for price, and that the price fails. Since it
falls, the price changes by rninus 1 percent then,

P£d = 3% = -3
-1%

If the price is increased, Ulan the demand will fall and hence
P£d = 3% = -3
-1%
Clearly then, £p is always negative, because of the inverse relationship between price and the
quantity demanded of a commodity. But since we are interested in the magnitude or the degree
of the responsiveness of demand to a price change, not the direction of change (not the sign),
then we multiply by negative one (-1) after the calculation to make it a positive value.
Alternatively, you can ignore tile negative sign (where a variable decreases) from the beginning,

38
Let us consider an example. Assuming that the price of commodity Y is US $5.00 per unit and
demand is 10 units. Suppose further that when price fall from $5.00 to $4.00 per unit, quantity
demanded increases from 10 to 12 units. Calculate the price elasticity of demand.

Solution: P£d = [(12-10) ÷ 10] ÷ [(4-5) ÷ 5) ]

= [2+10] ÷ [-1 + 5]

= [2+ 10] ×[-5+ 1] = -1.0 x -·1 = 1.0

Measurement of Elasticity

Two methods have been suggested for the measurement of elasticity. These are the Point
Method and the Arc Method.

Factors influencing Price Elasticity of Demand

We have stated above that demand may be more or less elastic. The several factors that
determine the elasticity of demand,

Degree of Necessity

The greater the degree of necessity of a commodity to a consumer, the more likely is the demand
for a commodity to be elastic. Other things being equal, the demand for necessities is less elastic
than the demand for comforts and luxuries. The reason is simple. The necessities must be bought,
whatever the price, because without them, we cannot live. But comforts and luxuries can be
dispensed with. Thus, a rise or fall in price of a basic necessity, such as wheat or salt, will not
ordinarily affect in any appreciable manner the demand for such a commodity. But a rise or fall
in the price of a luxury good is bound to affect its demand in an appreciable manner. The
demand for luxuries is more elastic in the sense that a little change in the price level brings a
greater change in demand. Televisions and video machines are examples of such things.

Proportion of consumer’s income spent on the commodity

The demand for a commodity on which the consumer spends only a small proportion of his
income is less elastic, A fall in the prices of such commodities will not increase their demand in
any substantial measure, An increase in price will also not decrease their demand since the total
expenditure by consumer relative to his income is small (little impact).

Existence of substitutes

39
Tile demand for a commodity is more elastic if it has a number of substitutes. A small rise in the
price of such a commodity will induce the consumers to for its substitutes, assuming that their
prices do not rise.

Habit

Tile demand for a commodity to which the consumer is accustomed is generally inelastic, for
example, a person accustomed to smoking a particular brand of cigarette will not, in the short
run, reduce his consumption even if its price goes up, But if the price rise persists for at long
period, the consumer will certainly reduce his purchases of that brand of cigarettes, because in
the long run even habits and customs undergo change

Service uses of commodity

The demand for a commodity is said to be more elastic when it can be put to a variety of uses.
Electricity, for example, is a multi-use commodity. A fall in its price will result in a substantial
increase in demand. A rise in its price on the contrary will result in restricting its consumption to
the most essential USE~S. Another example of a commodity with many uses is coal. When coal
is cheap, its use for less urgent needs will extend and when its price rises, it will be put only to
more urgent uses and its demand will decrease to a great extent.

Postponement

The demand for a commodity whose consumption can be postponed is more elastic than that of
the commodity the use of which cannot be, postponed. The consumption of oranges can be
postponed if their price g06'S up, but the rise of Medicare cannot be put off, even if its price
rises. Hence, the demand for oranges is elastic while the demand for medicine is inelastic.

We have described above certain rules regarding the elasticity of demand, but it is not possible to
lay down hard and fast rules as to which commodities have more elastic and inelastic demand. It
all depends upon the circumstances.

Price Elasticity of Demand and Total Revenue

Economists have developed a measure called the price elasticity of demand to determine the
responsiveness of the quantity demanded, and the total revenue to a price chance. Sometimes we
may wish to know how the responsiveness of one product changes over time, or we may wish to
compare the responsiveness of several products of several alternative demand curves for one
product.

The price elasticity of demand compares the average percentage change in quantity to the
average percentage change in price. Roughly speaking, if tile percentage change in quantity
demanded is larger than the percentage change in price, then the total revenue will change in a
direction opposite tile price change. For example, a price decrease increases total revenue. To

40
explain this further, consider Figure 3.14. Let the demand function for a product that the firm
sells be DO. If the price is P 1, the quantity demanded is Q1. The total revenue R the firm receives
equals the price per unit times, the quantity demanded.

R = PQ (Total Revenue) .. (3.4)

Figure 3.14: The change in Total Revenue when the price decreases

P1 R
Price Ksh.

1 Qd=D(p).Cet Par

P2 S

2 3 D

0 Q1 Q2
Quantity
If tile price is P1, total revenue is OP 1RQ1, the sum of areas 1 and 2. When the price falls to P2
the quantity demanded increases to Q2. Total revenue is now OP2SQ2 or the sum of areas 2 and 3.
The change in total revenue received by a firm is the net effect of two opposing changes. .At the
higher price of P1, the quantity demanded is only 0 1 unit. At the lower price of P2, demanders
purchase them at the quantity of O2 units. This effect reduces total revenue, and the size of the
loss is equal to area 1. At the lower price of P 2 the firm can sell more units because the quantity
demanded increases from Q1to Q2. This effect increases total revenue, and the size of the increase
is equal to area 3. Whether a price change increases or decreases total revenue depends on the
relative sizes of these two opposing effects, namely, area I compared to area 3.

Based on this analysis, the way revenue changes when price changes can be described as
follows:

 If the total revenue chances in the direction opposite the price change, for example, total
revenue decreases due to price increase, the demand is price-elastic.
 If the total revenue does not change when the price changes, the demand has unitary
elasticity.

41
  If the total revenue changes in the same direction that the price changes, for instance,
total revenue increases due to price increase, the demand is price-inelastic.

Table 3.3 summarizes how total revenue changes for increases and decreases in price when the
demand is Price-elastic, has unitary elasticity, or is price-inelastic. Table 3: 3: Revenue changes
due to price change for different values of Arc Price Elasticity.

Price Elasticity P£d Price change ΩP Revenue change ΩR

Price Elastic , P£d < -1 ΩP>0 ΩR<0
ΩP>0 ΩR<0
Unitary P£d = -1 ΩP>0 ΩR<0
ΩP>0 ΩR<0
Price- inelastic 0> P£d ΩP>0 ΩR<0
0> P£d>-1 ΩP>0 ΩR<0

Important of price Elasticity of Demand

The concept of elasticity of demand is of great practical importance. The following facts indicate
the application of this concept.

 For a consumer. When a consumer has to spend his income on the purchase
commodities, he has to keep in view the elasticity of different commodities. Normally, a
consumer spends the major portion of income on the purchase of those commodities that
have less elastic demand.
 For producer. A monopolist can charge any price for his product, because he has
complete control on the supply of that product He will change a higher price for those
commodities that have less elastic demand and vice-versa (See Table 3.5).

Table 3.4 Example of the monopolist's use of price elasticity of demand.

Price($) Demand (Units) Income ($)

100 10 1,000} less Elastic
80 11 880}
Price ($) Demand (Units) Income ($)
100 10 1,000 }more Elastic
80 20 1,600}
Thus all producers need to know elasticity of demand in various market structures.

Government Policies e.g

42
 i. Devaluation Policy. Devaluation means lowering the value of domestic currency in
terms of foreign currency. Due to devaluation, exports become cheaper for the: foreigners
and imports become expensive for the residents. An increase in exports and decrease in
result in the improvement of the balance of payments. It is possible only when the
elasticity of demand 'for exports and imports is high Table 3.5 illustrates this point.

1$ = 120Ksh , 1$ = 130Ksh

Table 3.5 Use of Price Elasticity in Devaluation Policy

EXPORTS
Price $ Demand (units) Total Expenditure ($)
10 10,000 100,000} more elastic
8 20,000 160,000}
10 10,000 100,000} Less elastic
8 11,000 88,000}
IMPORTS
Price $ Demand (units) Total Expenditure ($)
1.00 5,000 5,000} less elastic
1.25 4,800 6,000}
1.00 5,000 5,000} more elastic
1.25 2,000 2,500}

ii. Taxation. When Government imposes taxes on both consumers and producer’s goods
elasticity factors are kept in view. The commodities that have less price elastic demand
Government with more income, tax revenue, if tax is imposed on them.

Cross Elasticity of Demand / Cross Price Elasticity of Demand

Cross elasticity is the ratio at which quantity demanded for a commodity change due to a change
in the price of another commodity. Cross Elasticity of demand can be calculated using the
formula:

Cd = Proportionate (or percentage) change in quantity demand of

commodities X Proportionate (or percentage ) change in price of
commodity.
= Change in quantity of commodity X quantity before change
÷ Change in price of Y price before change (3,5)
Using the mid-point approach therefore:

43
 PC d = ΩQdx x Py1 + Py2
ΩPy Qdx1 +Qdx2
Note that the mid-point (averages) approach is more accurate than point measurements.

Numerical Examples

 A rise in the price of butter is likely to increase the quantity demand of margarine. If the
price of butter rises from Shs.20.00 to 30.00 per Kg, the quantity demanded of margarine
may rise from 12 Kg to 18 Kg. In his case, cross elasticity of demand for margarine is :

Cd =6 x 50 = 1
10 30
In this case the cross elasticity of demand is positive
A rise in the price of one commodity may lead to a fall in the quantity demanded of another
commodity as in complementary goods. In case, cross elasticity of demand would be negative.
 Suppose that a rise in the price of petrol from Sh. 10.00 to Sh 20.00 per liter leads to a
fall in the number of vehicles bought per month from 100 to 90 cars. The cross elasticity
of demand for cars will be:
Cd = 10 x 30 = 0.171
10 190
In this case the cross elasticity of demand is negative.

Demand and Importance of Cross Elasticity of Demand

Generally, if the cross elasticity of demand is positive, then the commodities are substitute If it is
negative, then the commodities are complementary. In the case of substitute, if the magnitude of
cross elasticity of demand is greater than one (C d >1), then the commodities are close
substitutes. IF cross elasticity is between zero and unity (0< C d<1) then the commodities are not
necessary substitutes. When cross elasticity of demand is zero, then the commodities are not
related. However, note that all goods are related because they complete for the consumer’s
income (see consumer choice decisions).

Cross elasticity of demand is important in that it reveals the relationship between two or more
commodities. It is helpful to sellers because they gain knowledge of how price changes for one
commodity affects the revenue from the sale of the related product.

Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of the quantity demanded due to a
change in income of the consumer, it is measured by dividing the proportionate in demand by the
proportionate change in income. Income elasticity is positive for normal good ad negative for
inferior goods. Lets us assume that the income of a consumer is Ksh, 1,000 and his demand for

44
sugar 5 units. After this, his income increases from Ksh. 1,000 to Ksh, 1,200 and demand
increase for 5 to 7 units. Hence income elasticity demand will be:

Yd = Proportionate (on percentage) change in n quantity demanded

Proportionate (or percentage) change in income ………… (4.6)

(Average methods)
Thus Yd = 2 x 11,000 = 0.9 ; (7-5/1200-1000 )* 1000/5 = 2/200 * 200 = 2
2000 12

Income elasticity of demand may help in determining the nature of commodity, namely, whether
it is a necessity, an inferior or a luxurious good. If elasticity is positively big, we can conclude
that the commodity is a luxury. If it is negative, then the commodity is an inferior good. If it is
positively small, then the commodity is a necessity.

Moreover, income elasticity of demand can be used to gauge the effects of income redistribution.
If income is redistributed from the rich to the poor, it is likely that aggregate demand for goods
would rise because the poor would spend more on goods, which they had hitherto considered
luxuries.

1. The Point Elasticity Technique

If the demand curve is not a straight line and the distance between two points on the demand
curve is too small then we use the point elasticity technique, For this purpose, it is assumed
that changes in price and demand are too small or invisible, Point elasticity of demand is
measured by the slope of the tangent to the demand curve at the point.

Rather than measuring elasticity between two points on a demand curve, we may want to
measure it at a singles point: for example, point '1"' in Figure 3,15, In order to measure point
elasticity, use the following approach,

Yd = Proportionate (on percentage) change in n quantity demanded P_

Proportionate (or percentage) change in income price (ΩP). Qd

= ΩQd x 100 = ΩQd = ΩQd ÷ ΩP

Qd Qd Qd P
ΩP x100 ΩP
P p

= ΩQd x P = ΩQd x P
Qd ΩP ΩP Qd

45
For the. P Q variables you can use the initial price and the initial quantity
Qd before the change, since the changes are small. Also note that at that the variable ΩQ
is the inverse of slope on the demand curve to that point
ΩP
Figure 3:5: Measuring Elasticity at a point

30
PRICE

0 40 100
Quantity Demanded
Since we want to measure price elasticity at a point on this demand curve, rather than between
two points, it is necessary to know how quantity demanded would react to an infinitesimally
small change in price. In the case 'r' in Figure 3.15, we want to know how the quantity demanded
would react to an infinitesimally small change from a price of 30

An infinitesimally small change is signified by the letter’d’. The formula for price elasticity of
demand, thus, becomes:

dQ X P
do Q
dQ/dp is the differential calculus term for the rate of change of quantity with respect to a change
in price. And conversely, dP/dO is the rate change of price with respect to a change in quantity
demanded. At any given point the demand curve dp/dq is given by the slope is given by the
slope of the curve (its rate of: range). The slope is found by drawing a tangent to the curve at that
point r is shown in Figure 3:21. Its slope is 50/100. d/p/dQ is thus, 50/100and dQ/dp is the
inverse of this, -100/50 =2.

Returning to the formula dQ/dp x P/Q elasticity at point ‘r’ equals:-2 x 30/40 = =1.5. Rather
than having to draw the graph and measure the slope of the tangent, the techniques of the
differentiation can be used to work out point elasticity as long as the equation for the demand
curve is known.

46
Example 1

Supposed the demand curve for a particular commodity is represented by the equation:

Qd =60 – 15P + P2, where Qd is measured in 000s of units. Calculate price elasticity of demand
at price is Ksh. 3.

Solution:

Point elasticity can be calculated from such a demand equation using calculus. To do this, you
will need to know the rules of differentiation. Remember the formula for point elasticity: Pd-
dQ/dP x P/Q.

The term dQ/dP can be calculated by differencing the demand equation/function.

Given Qd=60 -15P +P2

Then dQ/dP = -15 + 2P

Thus, at a price of Ksh.3, DQ/dp = -15 + (2x3) = -9

Thus, price elasticity of demand at a price Ksh.3

= 9 x P/Q
= -9/8(which is elastic).

The Arc Method

This is also known as the averages method or the mid-point approach. Arc elasticity is the
elasticity of a specific part of the demand curve at two price points. Two demand points can be
represented on the demand curve, and are elasticity will be the elasticity of that part of the
demand curve that lies between these two points (the arc).
A common mistake that students make is to think that one can talk about the elasticity of a whole
curve. The mistake here is that in most cases, the elasticity will vary along the length of the
curve" Take the case of the demand curve illustrated in Figure 3.16. Between points 'a' and 'b' the
total revenue rises {P2Q2 > P1Q1): Demand is, thus, elastic between these two points, Between
points 'b' and 'c', however, total revenue falls (P3Q3< P2()2). Demand here is inelastic. This will
be clear later in the chapter when we cover elasticity and total revenue.

47
Figure 3.16: Different Elasticities along different portions of a Demand curve

P1 a

P2 b
PRICE

P3 c

Normally, we only refer to the elasticity of a portion of the demand curve, not of the, whole
curve. There are, however, some exceptions to this rule. For example if the demand curve is
perfectly elastic, perfectly inelastic, or at the middle part of a smooth demand curve where
elasticity is unitary.

Although we cannot generally talk about the elasticity of a whole curve, we can nevertheless talk
about the elasticity between any two points on it this is known as arc elasticity. Arc elasticity
refers to the measurement of elasticity between two points on a curve, Remember the formula we
used was;
Proportionate ΩQ (where means 'change in')
Proportionate ΩP

The way we measure a proportionate change in quantity is to divide that change by the level of
Q: i.e./Q. Similarly we measure a proportionate change in price by dividing that chance by tile
level of P: i.e. ΩP/P, Price elasticity of demand can thus now be calculated CIS:

48
P d = ΩQd x 100 ÷ ΩP x 100 = ΩQ x P1 + P2
Q1 + Q2 P1 + P2 Q1 +Q2 2
2 2 2 ΩP

ΩQ x P1 + P2
Q1 + Q2 ΩP

Thus Pd= ΩQ x (P1 + P2)/2

ΩP (Q1+ Q2)/2

This averages method is better than the point measurement, its more accurate.

Example 2: Consider the demand schedule given is Table 3.6 and graphed in Figure 3.17, What
is the elasticity of demand between points 'm' and 'n'? To answer this, we need to identity ΩQ
and P. Let us start with quantity.

Figure 3.17: Measuring Elasticity using the Arc; Methods

8
Price (in $)

0 10 20 30 40 50
Quantity demanded (in 000s)

Price in Ksh. Quantity of Oranges

8 10
6 20
4 30
2 40

49
Quantity

The difference in quantity (ΩQ) between 10 (point 'n') and 20 (point 'm') is 10. i.e. ΩQ=10. But
what is the proportionate change in Q (ΩQ/Q)? Is it 10/10, taking Q=10 (paint 'n') as the base
from which to measure the change in Q? Or is it 10/20, taking Q=20 (point M)? To avoid this
problem, the average of the two quantities is used: In other words, the midpoint between them:

Q =15 i.e. [(10 +20) ÷2}

Therefore ΩQ/Q= 10/15

Price

The difference in price between 8 (point 'n' and I :) (Point 'rn') is 2: Ω.P =2. The proportionate
change in P is found the same way as the proportionate change in Q. The base price is taken as
the mid-point between the points

P= 7 i.e. [(8 + 6) ÷ 2]

Therefore ΩP/P=2/7

Elasticity

Now that we have worked out figures for ΩQ, Q, ΩP, and P, we can proceed to work out
elasticity. Using the average (mid-point,) formula, price elasticity of demand is given by:

ΩQ ÷ ΩP
Average Q average P
In our example, this would give the following elasticity between 'm' and 'n'.

-10/15 ÷ 2/7 = -7/3 = -2.33 x -1 = 2.33

Note that the arc price elasticity is; the slope of the demand function between tile two points
(ΩQ/ΩP), times a factor equal to the sum of tile two prices, divided by the sum of the two
quantities.

The arc price elasticity is not equal to the slope of the demand function. Consider the expression
for ell straight-tine (linear) demand function:

Q = a –bp .(3.9)

Where a and b are constants. The slope of the demand functions is

ΩQ = -b ….(3.10)
ΩP

50
Therefore, the slope of a linear demand function is constant and independent of price. The arc
price elasticity for a linear demand function is:

Pd = -b .P1=P2 ... (3.11)

Q1+Q2
Thus, the value of the price elasticity changes when moving along a straight-line demand
function.

Degree of Price Elasticity of Demand

The change in demand is not always proportionate to the chance in price. In certain cases, a little
change in price may lead to a greater change in demand. In such cases, demand is considered
more elastic. Sometimes, a big change in price may bring a little change in demand and this
situation is known as less elastic demand. Similarly, when, in spite of any change in price,
demand remains the same, it is known as inelastic: demand. If demand for any commodity is
infinite at any price, then it is considered as infinite elastic demand. Price elasticity of demand is
generally classified under five subheadings. Let us now present each of the cases.

Perfect Elastic Demand

This refers to that situation where the slightest rise in price causes the quantity demanded of a
good to fan to zero, and the slightest fall in price causes an infinite increase in the quantity
demanded (i.e. Pd =00). It is illustrated in Figure 3.18 as a horizontal curve. A consumer will
purchase any amount at one given price, but if the price raises even fractionally above this level,
demand will fall to zero. In practice it is difficulty to find an example of a product whose
demand is perfectly elastic.

Figure 3. 18: Perfectly Elastic Demand

Perfectly Elastic Demand

D
price

Quantity demanded

51
Perfectly Inelastic Demand

Perfectly inelastic demand refers to the situation where even substantial changes in price leave
the demand unaffected. In other words, the price may change (rise or fail) considerably, but the
quantity demanded of that commodity remains unchanged. The demand in such a case is
insensitive or non-responsive, and the price elasticity of demand is zero (i.e. Pd=O)

Consumers will buy the same quantity of a commodity whatever the price. Examples of products
where the demand is perfectly inelastic are foodstuffs that are essential to us. Salt, sugar and
water are commodities that consumers must have, and if their prices change, it is unlikely that
the quantity bought will change. Figure 3.19 illustrates the perfectly inelastic demand curve.

Figure 3.19: Perfectly in Elastic Demand

Price

Perfectly inelastic Demand

Quantity demanded

Relatively Elastic Demand

This refers to that situation where a small proportionate change in the price of a commodity is
accompanied by a larger proportionate change in its quantity demanded. Here the price elasticity
of demand is greater than one but less than infinity (i.e. 1< Pd<00). In Figure 3.19, price has
risen from OP to OP1, resulting in demand falling from 00 to OQ1. This fall in demand is clearly
more than proportionate to the increase in price.

52
Figure 3.20: Relatively Elastic Demand ~

P1

Relatively elastic demand

D
Price

0 Q1 Q Quantity
Most products that have close substitutes have a relatively elastics demand. Even a small rise in
the price of one product is likely to induce the consumer to switch his demand to a substitute. For
instance, the different brands of petrol are perfect substitutes for each other. If the price of one
brand is raised by only a few cents per litre, motorists will generally stop buying that brand and
switch to others, resulting init more than proportionate fall in demand.

Relatively Inelastic Demand

This degree of price elasticity of demand refers to a situation where a big proportionate change in
the price of a commodity is accompanied by a smaller proportionate change in its quantity
demanded. In other words, the price elasticity of demand is greater than zero but less than one
(i.e., 0 < Pd < 1). Figure 3.21 is an example of a demand curve that is relatively inelastic. It is
clearly seen that the fall in quantity demanded from OQ to OQ1 is less than proportionate to the
price increase from OP to OP1.

53
Figure 3.21: Relatively Inelastic Demand

P1 Relatively inelastic demand

0 Q1 Q Quantity

Many commodities have, a relatively price inelastic demand. Cigarettes and .tobacco are
demanded in much the same quantities even if their price rises, because most smokers cannot do
without them. After a price increase, there: is a small reduction in quantity demanded as some
smokers stop smoking and I others cut down their consumption. The general rule, however, is
that the fall in demand is proportionately less than the increase in price. Similarly, the. Demand
for newspapers, such as The Daily Nation and The East African: Standard is hardly affected
when their prices increase. The products are a relatively cheap and readers are not greatly
affected by the price increase.

Unit Elasticity of Demand

In this case, the elasticity of demand equals one (I .e. Ped =1). Any change in price will lead to
an exactly proportionate change in demand as illustrated in Figure 3.22. The curve is known as a
rectangular hyperbola. At the middle part, (middle arc) elasticity is equal to unit.

54
Figure 3.22: Unitary Elasticity of Demand

P1

Price
P

0 Q1 Q Quantity

The increase in price from OP to OP1 is proportionate to the fall in demand, from 0Q to 0Q 1. It is
difficulty to give examples of products that have an elasticity of demand equal to unity. There
can be situations where the demand for a particular product is to unit elasticity, over a certain
range of prices, but there is no specific reason for it.

Table 3.7 gives the hypothetical responses of demanders to a 10 per cent price increase in four
markets. Insulin is absolutely necessary to an insulin dependent diabetic, and the quantity
demanded is unlikely to respond to an increase in price.

Table 3.7 Hypothetical Price Elasticities of demand for four products.

Product % change in % change in Price elasticity Type

Price (% ΩP) quantity Pd =(%ΩQd +
demanded % ΩP)
(%ΩQd)
Insulin + 1-% 0% 0.0 Perfect
inelastic
Basic telephone + 10% -1% -0.1 Inelastic
service
Beef +10% -10% -1.0 Unitarily
Elastic
Bananas +10% -30% -3.0 Elastic

55
Elasticity of a Straight-line Demand Curve

A straight-line demand curve will have a different elasticity at each point on it. The only
exceptions are a vertical demand curve (Pd =0), and horizontal demand curve (Pd = 00).

The reason for this differing elasticity is demonstrated in figure 3.20 (example 2 for
measurement of arc elasticity). Using the point elasticity formula: dp/dQ x P/Q the slope of the
demand curve (dP/dQ) is constant, thus -10/50. Thus, dQ/dP is constant, thus,=50/-10=-5 x -1 =5.

The value of P/Q, however, differs along the length of the demand curve. At point 'n', P/Q =
8/10. Thus: dQ/dP xP/Q == -5 x a / 10 = -4 x -1=- 4.

At point 'rn', however, P/Q = 6/20. Thus: dQ 1 clP x P/Q = -5 )<:6/20:::: -1.5 x -1 1.5.

Main Limitation

The main drawback of the point method is that it is only applicable when we posses information
about the minutest changes in the price and the quantity demanded for the commodity. Actually
in real life we do not posses such information about minute changes in price and quantity. We
may come across demand schedules in which there are big gaps in price as well as the quantity
demanded. In such cases, the application of the point method does not y1et yield satisfactory
results. Economists have, therefore, devised another method of measuring elasticity where there
are big gaps in the price and quantity data. This method, known as the! arc approach, uses; the
midpoints between the old and the new data in the Cases of price, income and quantity
demanded. The arc method studies a portion or a segment of the demand curve between the two
points. An arc is a portion of a curved line, and hence a portion or a segment of a demand curves.
The formula and procedure for measuring arc elasticity has already been presented in an earlier
section.

56
Revision Questions
1. Try to think less abstractly for a moment about the effect of the distribution of household
wealth on demand What do you think may be the demand for swimming pools amongst a
population of five household enjoying a total annual income of £1 m, if the: distribution of
income is as follows:
Annual Income

Assumption 1 Assumption 2
£ £
Household 1 950,000 200,000

Household 2 12,500 200,000

Household 3 12,500 200,000

Household 4 12,500 200,000

Household 5 12,500 200,000

2. Refer to Figure 3.2 in the text. Suppose the price of the, commodity is £3 what will be the
(approximate) demand for the commodity? What happens if the price falls to £2?
3. (a) Consider the demand for flower vases. What will happen to the price and demand for
vases if the price of cut flowers goes up sharply?

(b) Consider the demand for Channel crossing tickets by ferry. The price of channel
crossings by tunnel goes up. What happens to the price and demand for crossings by
ferry?

4. What factors influence demand for a good?

5. What is the difference between individual and market demand?

6 What are (a) substitutes and (b) complements?

7. What factors determine the demand for a particular good?

8. What is the difference between a movement along a demand curve and a shift of the demand
curve?

9. Write short notes on the following:

(a) Abnormal demand curve,
(b) Joint demand,
(c) Composite demand.

57
10. The demand curve usually slopes downwards from left to right. Are there any exceptions to
this rule?

11. (a) Explain what is meant by the tern own price, income and cross elasticities of demand.

(b) How and when is the concept of elasticity applied in economic policy decisions?

'12. Discuss the concepts and importance of income elasticity and cross elasticity

(a} If the price of X rises from kSh. 100 to K.Sh. 150 and demand falls from 1,000,000 units
to 13,000,000 calculate the price elasticity of demand between these two points on the
demand curve.

(b) If the price of X Irises from KSh. '140 K.Sh 180 and the demand falls ~. 220,000 units to
180,000 units, what would be the price elasticity of demand?

(c) Comment on both answers

'13. Describe briefly the practical importance of the concept of elasticity to:

(a) A firm and

(b) A government.

10. What do you understand by price elasticity of demand? Illustrate using diagrams the various
type of elasticity of demand,

11. Explain the importance of the concept of elasticity of demand to economic policy.

17. Distinguish between point elasticity and cross elasticity.

18. Suppose that the market demand curve for mink coats is as follows:

Price (dollars) Quantity of mink coats

500 500
1,000 500
1,500 200
2,000 100

(a) What is the price elasticity of demand for mink coats when the price is between $1,500 and!
$2,000?

(b) What is the price elasticity of demand when the price is between $500 and $1,OOO?

58
(c) According to the text, an increase in price results in increase in total expenditures on a
product if its price elasticity demand is less than 1, and less total expenditure on a product if
its price elasticity of demand is greater than 1. Show that this proposition is true if the price of
min coats is raised from $5, 00 to $1,000.

{d) Show that he propositions in part (c) is true if the price of mink coats is raised from $1,500 to
$2 000.

19.Distinguish between "short period" and "long period".

20. Using examples, explain how elasticity of demand is measured.

21. Suppose that the relationship of between the price of Aluminum and the quantity of
Aluminum demanded is as follows:

Price (dollars) Quantity

1 8
2 7
3 6
4 5
5 4

59
 CHAPTER FOUR
THEORY OF SUPPLY
Objective
At the end of the chapter, you should be able to:-

1. Describe the major determinates of supply and how they impact on supply;
2. Explain the law of supply
3. Explain the characteristic of the supply curve
4. Distinguish between a shift and a movement along the supply curve.
5. Discuss the effect of time on supply
6. Describe the concept of elasticity of supply ; and
7. Compute elasticities from numerical observations.

Definition of supply Scheduled, supply curve and Supply Equation

Supply is the quantity of a commodity that sellers are willing and able to sell at a given price
within a given period of time ceteris Paribus. In economics the term commodity refers to both
goods and services.

As in the case with demand: supply relates to a period of time, for example annual rate of supply,
or a monthly rate. Again as with demand a distinction should be made between market supply
and individual supply. Market supply is the total quantity of the commodity that all firm’s in the
market can supply at a given price and; an individual firm's supply which is the quantity of the
commodity that an individual firm can supply to the market at any given price, holding all other
factors constant.

 Market supply, which is the total quantity of the good or service that all firms in the
market want to supply at a given price; and
 An individual firm's supply is the quantity of the good or service that the individual firm
wants to supply to the market at any given price.

Determinants of supply Quantity

The Quantity supplied of a good depends on:

 The price obtainable 'for the good.

60
  The prices of other goods; an increase in the price of other goods will' make the supply.

 The cost of making the good, which in turn, depends on the prices of factors of
production that is, wages, interest rates, land rents and profit expectations. A rise in the
price of one factor of production (say labour), will cause producers to shift away from
supplying goods whose costs and profits are closely related to the price of labour,
towards the supply of goods where the cost of labour is less significant.

 Changes in technology. Technological developments which reduce costs of production

(and increase productivity) will raise the quantity of supply of a good.

 Changes in the weather may affect the availability of supply (e.g. agricultural goods).

In this course, our main interest is in the influence of price on supply and demand. The influence
01' costs on output decisions by firms, and on supply to the market, will be discussed more fully
at al later stage.

Supply and the Price of a Good.

The quantity supplied is the amount of goods and services that firms or sellers are willing and
able to supply (offer for sale) in the market or a given time period and a given price, ceteris
paribus.

In general, suppliers will want to supply a greater quantity of their output at higher prices. For
example, if the price of product X is £5 per unit, a supplier might be willing to supply 1,000 units
of the product to consumers in the market at that price. If the price rises to £10, the supplier will
be willing to supply more than 1,000 units of the product. Just how many more than 1,000 he
will want to supply will depend on the prevailing market circumstances.

Why would a supplier be willing to supply more output at a higher price? It may seem logical to
suppose that higher prices mean higher profits, and so the firm will be attracted by the prospect
of bi9ger profits into supplying more units of output. This, however, is not the full answer. We
must also ask why, in our example, the supplier is willing to supply only 1,000 units of product
X at a price of £5.

Before reading on, try to work out the answer to this question yourself. As a hint, remember that
the supplier is interested in his own profits: he is interested not just in the amount of revenue he
earns, but in the costs involved in earning it.

The answer must presumably be that it will not be worthwhile, and that the unit cost of making
extra output will exceed the sales price of £5 per unit This may be, for example, because the

61
supplier's capacity is already fully extended, and the costs of increasing capacity (anything from
overtime premiums to the cost of a new factory) will not be covered by the £5 per unit sale price.
At a higher selling pr-ice per unlit, the output limit where unit costs be'9in to exceed unit prices
will be at a higher level, and so the supplier will now be willing to produce more at the new
higher price.

Supply can be shown in thee ways just as in demand, i.e. a supply schedule. Supply curve and
supply equation.

The supply schedule

A supply schedule is a table showing the amounts of a commodity the seller will be willing to
sell at a given price within a particular time period. A supply schedule and supply curve can be
drawn (a) for an individual supplier; or (b) for all firms which produce the good. This total
supply curve of all suppliers is the market supply curve. For example, suppose that the supply
schedule for product Y is as indicated in Table 4.1.

Table 4.1: Individual Supply Schedule for Product Y

Price per Unit Quantity that suppliers will supply at these

price (units)
100 10,000
150 20,000
300 30,000
500 40,000

Supply Curve

This information can also be presented graphically. The graph representing the amount of a
commodity that sellers are willing and able to sell at a given price within a given period of time'
is called a supply curve. A supply curve is constructed in a similar manner to a demand curve
(from a schedule of supply quantities at different prices) but shows the quantity suppliers are
willing to produce at different price levels. It is an upward-sloping curve from left to right
because greater quantities will be produced higher prices.

It is worth mentioning at this point that a supply schedule and supply curve can be drawn;

a) for an individual supplier or (individual supply curve)

b) for all firms which produce the good (market supply curve)

Contrast the inverse relationship between price and quantity demanded which we examined in
our analysis of demand. In the case of supply the relationship bE3tween price and quantity

62
supplied is positive: as price rises, so too does the quantity that producers are willing to supply.
The relationship between output and price, using the data in our example, is shown as a supply
curve in Figure 4.1.

Figure 4.1: An Individual Supply Curve

500

300
Price

150

100

0 10,000 20,000 30,000 40,000

Quantity supplied (units)

In the case of supply, unlike demand, the relationship between price and the quantity supplied is
positive. As price rises so too does the quantity that suppliers are willing to supply. This
relationship can be observed in the above schedule and curve. The relationship can be
summarized that whenever the price of a commodity increases, 'the quantity supplied of the same
product increases too, other factors remaining the same (ceteris paribus). This is what in
economics referred to as the law of supply, i.e. the hi9her the price the higher the quantity
supplied, holding all other factors constant, and vice versa.

A supply curve shows how the quantity supplied will change in response to a change in price,
provided that all other conditions affecting supply remain unchanged (ceteris paribus). If supply
conditions (the price of other goods, or costs of factors of production, or changes in technology)
chance, a different supply curve must be d .. P]. In other words, a change in price will cause a
change in the quantity supplied along the supply curve. A change in other supply conditions will
case a shift in tile supply curve itself. This corresponds to the important point made earlier about
demand curves, and again needs to be repeated.

a) Movements along a supply curve represent changes in the total quantity of a good that
suppliers want to provide when there is a change of the price of a good.

63
 b) Shifts of the supply curve represent changes in tile total quantity of a good that suppliers
want to provide at all prices, because of a change in the cost of supply, for example,
technological progress, or a change in the price of other goods

Reasons why the supply curve is positive sloped

Before discussing changes that shift supply curves, we shall discuss in greater details why
increases in price increase the quantity supplied, ceteris paribus. At low prices, only the most
efficient chocolate producers will be able to make any profits from the production process. As
prices rise, producers who could not previously compete will find that they can now make a
profit in the chocolate business and VI/ill wish to supply. Moreover, previously existing firms
maybe able to expand output by working over time, or buying fancy/sophisticated equipment not
justified when selling chocolate at lower prices. In general, higher prices are needed to provide
an incentive for firms to produce more chocolate. Other things being equal, supply curves slope
upward as we move to the right.

In order to ascertain tile factors that determine the quantity of a product firms will supply to the
market, two fundamental assumptions must be made:

 The principal objective of firms is to maximize profits. Firms may have other objectives
besides profit maximization, but for the time being we must assume that this is the:
overriding aim. Thus higher prices mean higher profits and therefore increase In supply.
 Costs of production include normal profit. When a firm receives a price equal to either
marginal cost or average cost, it is making normal profits. Normal profit is defined as the
minimum level of profit that a find must earn for it to stay in hat industry. If profits fall
below this level, firms will leave the industry. For this reason, normal profit: is
considered to be a cost of production, in the same way that wages are a cost, because if a
worker does not receive a wage, he will soon leave a particular firm. It should be noted
that normal profits refer to a minimum level. It is quite likely that firms will earn more
that this. Any excess over and above normal profits is referred to as abnormal profits.
Thus higher prices are needed to cover production costs, hence increase in production if
prices are high.

Having made these assumptions, we are now in a position to consider how a firm's supply is
determined. As a firm attempts to maximize its profits, and profit is determined by the
relationship between price received and the cost of production these factors will be the major
considerations in determining the firm's supply. A firm will produce an extra unit of output and
supply it to the market; so long the price It receives is at least equal to the cost of producing the
extra unit (the marginal cost). Furthermore, it will only supply the extra unit, if the marginal cost
and the price received are equal to or greater them, the average cost of production. No firm will
supply goods if the price is less than the average cost, as this would involve a loss on all units
sold. This area will be covered in detail under theory of production and costs.

64
The Market Supply Function

So far we have considered the supply curve of the individual firm. The market supply curve is
obtained by adding together the supply curves of individual firms that supply goods to that
particular market if the market price increases, total supply will increase, partly because existing
firms will supply more and partly because less efficient firms will enter the industry, Conversely
a fall in the market price will cause total supply to fall, as all firms are likely to reduce their
individual supply and some marginal firms may leave the industry,

As already noted, the four major determinants of the quantity supplied in a particular market are:

• The price of the product.

• The prices of the factors of production.

• The goals of producing firms.

• The state of technology,

This can be summarized in a supply function as:

Qsn = S (Pn, PO F’1, "Fm, T, W). …. (4.1)

Where Qsn = quantity supplied for production;

Pn = price of that product

Po = price of other commodities

F1,.. “Fm:: shorthand for the prices of all factors of production

T = technology

W = weather/climate conditions

The goals of producers and the state of technology determine the form of the function S. In
summary, the supply function expresses the relationship between the total quantity supplied and
price received by suppliers, Just as the market demand function shows, how consumer respond to
price changes. Figure 4.3 shows a representative supply function. Holding all other factors other
than the own price, the supply function can be written thus: QSn = S(P); ceteria paribus.

Figure 4.3: The Market Supply Function

65
 S

Qx=S(D)

P2

Movement along supply curve

Price

P1 S

C Q1 Q2
Quantity

Figure 4.3 shows that suppliers offer Q1unilts of a good if the price they receive is P 1, and a
larger total quantity of 02 units it the price they receive is P2. The changes in the price and
quantity supplied result in a movement along the supply function.

The slope of the supply function in figure 4.3 is positive, but this is not always tile case. When
the slope is positive as in this case, producers increase the quantity supplied from 0 1 to Q2 only if
the price they receive increases from P 1 to P2. The total quantity supplied increases at higher
prices because (a) existing producers supply a larger quantity at the higher price and (b) some
firms that are not particularly efficient at producing this item stay out of the industry when the
price is 10\1\1 and enter the market when the price is higher.

The Supply Equation

The supply function can he expressed mathematically as in the following equation:

Qsx = C + dPx

Where Qsx = quantity 'Supplied of a good x

Px = price of that commodity

C = constant showing quantity supplied if price is zero

If forms the X -Intercept.

For example a market supply function can be given as:

Qsx: = -400 + 700 Px.

66
Change in Quantity Supplied and change in Supply

Change in Quantity Supplied

The market supply curve is the aggregate of he supply curves of individual 'firms in the market.
A change in quantity supplied is often caused by a change in the price of the product, in which
case supply is said to extend (expand) or contract. Such extensions (expansions) or contractions
are shown on a single supply curve as, in figure 4.4 below.

Figure 4.4: Movement along Supply curve: Extension and Contraction of Supply

P1 b

Extension

P a
Price

Contraction

P2 c

0 Q1 Q Q1

Quantity Supply

In Figure 4.4, as price rises from Op to OP 1, supply extends from OQ to OQ1 if price falls from
OP to OP2 supply contracts from OP2 to OQ2. The movement will be from Point a to Point b
(extension) or Point a to Point c (contraction).

Change in Supply

Just as we investigated the 'other things equal' along a demand curve, we now examine
categories. of 'other things equal' along a supply curve. These categories include: technology
available to producers, the cost of inputs (labour, machines, fuel, and raw materials), government
regulation (policy), prices of other goods and services, weather, etc.

67
Along any particular supply curve, all of these are held constant. A change in any of these
categories will shift the supply curve by changing the quantity

Producers wish to supply at each price. In either words, a shift of the market supply curve occurs
when supply conditions, thus, factors influencing supply, other than the price of the good itself,
change (e.g. the price of factors of production, the prices of other goods, technology etc).

A change in supply is caused by a change in the conditions of supply, the non-price supply
determinants. This is because a change in the conditions of supply often results in supply
increasing or decreasing. Such changes are shown by the supply curve shifting to the ri1~ht or
left, as the case may be. This is shown in Figure 4.5. The original supply curve is SS and the firm
supplies 0Qat a price air OP. If conditions of 'Supply change in such a way as to increase the
supply of the product to OQ2 the supply curve shifts to S1S1. but 'the price remains at OP'.
Conversely if conditions of supply change and cause supply to fall to OQ 2 the supply change
and cause supply to fall to OQ 2, the supply curve shifts to S 2S2, although price is till OP. If
supply increases, the curve shifts to the right (downwards); and if supply decreases the curve
shifts to the left (upwards).

Figure 4.5: Shift in the Supply Curve: Rise and Fall in Supply

S2 S S

P
Price

S2 S S1

0 Q2 Q Q1
Quantity supply
A recapitulation of the main conditions of supply which cause such changes is as follows:

The cost of Factors of Production

68
If is there is an increase in the cost of raw materials, wages, rent or interest rates" the firms costs
will increase. The supply curve will shift to the left indicating that the firm will supply less of the
products at each price level. In Figure 4.5, this can be seen where the supply curve shift from SS
to S2S2 if there is a fall in any of the costs of production the supply curve shifts to the right, from
SS to S1S1 in Figure 4.5

The technique of production

A firm may introduce new and more efficient production methods, so that with the same input
factors of production, it can produce a greater output, and thus supply more to the market. In this
situation, the supply curve will shift to the right. As machinery wears out, however, and becomes
less efficient or obsolete, the output produced from a given input of factors is likely to fall,
resulting in a smaller supply and the supply curve shifting to the left.

Government Policies e.g. Taxation and Subsidies

The imposition of a tax on a product will have the effect of increasing marginal cost by the
amount of the tax. The supply curve will shift to the left showing that firms will supply less at
any given price.

A subsidy is a grant given to producers by the government to encourage the production of a

particular commodity. For example, the market price of maize might be Ksh.100 per 50 kg bag,
but if the government gives a subsidy of Ksh.20 per bag, the amount received by a farmer is
Ksh.120 per bag. Such a subsidy will result in the supply curve shifting to the right, as the firms
will be willing to supply more at each price level. In figure 4.5, the effect of a tax being imposed
on a product is shown by the supply curve shifting from SS to S2S2.

Other Factors

There are many other variables or factors which might cause supply to change. Climate is likely
to have an important effect on the supply of agricultural products. An excellent growing season
will result in a bumper harvest and supply will increase; A. period of unfavorable weather may
lead to a crop failure and a fall in supply. In 1976, the Brazilian coffee crop was damaged by
frost, and the supply of coffee onto the world markets was greatly reduced. The market price rose
steeply as a result.

Number of firms/suppliers can change if there is ease of entry or exit from the market. This will
also chance market supply. The supply of manufactured goods is more likely to be affected by
industrial disputes, such as strikes and work rules, which will reduce the supply of a product. The
car industry in the UK has been plagued by such industrial disputes in recent years, and the
supply of cars has been less than it would have been, had these disputes not occurred.

Political factors may also have an effect on supply. The Middle East War of 1973 caused a
reduction of crude oil to Europe, as the Arab producing countries implemented an ernbargo. The

69
closure of the Kenya-Tanzania border in 1977 reduced the supply of Kenyan beer to the
Tanzania market and thl3 supply of Tanzania tobacco to Kenya.

A rightward shift of the curve shows an expansion of supply and may be caused by a fall in costs
of factors of production or a fall in the price of other goods, The production of other goods
becomes relatively less attractive as their prices fall. We therefore expect that (ceteris paribus)
the supply of one good will rise as the prices of other goods fall (and vice versa). Technological
progress reduces unit costs and also increases production capabilities.

In effect, a shift of the supply curve is the result of the changes in costs, either in absolute terms
or relative to the costs of other good. Note that we need to distinguish between long run and
short run responses of both supply and demand. In the short run both supply and demand are
both unresponsive to changes in price, as compared to the long fun. In the case of supply,
changes in the quantity of a good supplied often require the laying off or hiring of new work.ers,
or the installation of new machinery. All of these changes brought about by the management
decisions must take sometime to implement.

In the case of demand, it takes time for consumers to adjust their buying patterns, although
demand will always respond more rapidly than supply to changes in the price or other demand
conditions.

In some markets, such as the market for chocolate bars, responses to changes in price are
relatively rapid; in others, such as the markets for military aircraft, response times are much
longer.

The position of the supply function shifts when a change occurs in:

(a) The price of input (labour, machinery, raw materials) used to produce the product.

(b) The state of technological knowledge that allows firms to combine inputs to produce the
goods. Figure 4.6 shows that producers supplied Q1 units at a price of P1, before a rise in
wage rates or in the price of raw materials. At the same price P1, they are willing to supply
only 02 units when the cost of production increases. The supply function therefore, shifts to
the left. In fact, a rise in the price of any input shifts the supply curve to the left, indicating
that less will be supplied at any given price; a fall in costs of input shifts the supply curve to
the right.

Figure 4.6: A shift in the position of the Supply Curve because of Wage Rate Increase

70
 S1 S

P2
Price

S1 S

0 Q2 Q1
Quantity
When a technological breakthrough allows firms to economize on the use of some inputs, the
cost of production declines and the supply function shifts to the right. Producers are wiling to
offer a larger- quantity at cash price, because the technological breakthrough allows them to
provide the product at a lower cost than before.
Abnormal Supply Curves and Inter-Related Supply

Abnormal Supply curves

It has bee noted that the typical supply curve moves from left to right upward, meaning that more
of a commodity will be supplied when prices are high than when prices are low. However, there
are some exceptional cases in which this rnay not be true, thus cases when the supply curve
moves from left to right downward. Such cases are referred to as abnormal and are the subject of
this section. The general structure of abnormal supply curve is depicted in Figure 4.7.

Figure 4.7: Abnormal Supply Curve

71
 S

Price

0 Quantity Supply

The cases of abnormal supply curve are not common. Only in very rare cases will apply curve be
of the abnormal shape. Let us present three common examples.

Fixed supply for Agriculture products

If supply is fixed, then the quantity supplied is the same irrespective of changes in price. In this
case, the supply curve is vertical, as shown in Figure 4,8, Figure 4.8 shows that even when price
increases from OPo to OP1, quantity supplied remains unchanged at OQ 0· For example, within
short periods, it is difficult to change the supply of agricultural products. This applies to those
goods which take long to produce; or those requiring heavy capital investments.

Figure 4.8: Fixed Supply of Agricultural Products

P1

P0
Price

0
Quantity

Perfectly Elastic Supply Curve

72
When the supply is perfect elastic, any quantity can be sold in the market at the given price.
Such a supply is horizontal, as shown in the Figure 4.9. It can be seen from a diagram that even
though the quantity supplied is changed from 0Q0 to OQ1 will the price remain same at OP0

Figure 4.9 Perfectly Elastic Supply Curve

P0
S
Price

Q0 Q1
Quantity supply
Backward-bending supply of lobour

There is one good example of an abnormal supply curve of labour (see Figure 4:10). The supply
curve for labour for an individual; worker may be such that after a certain wage rate, the labour
for an individual worker may be such that, after a certain wage rate, the labour supplied becomes
les and less. This may be the case when the worker prefers more leisure to work. It is also the
case with target worker. A target worker is the one who wants to achieve only a specific amount
of income. If paid a higher wage rate, he will work fewer hours because he can achieve his
target with a shorter period.

73
Figure 4:10 The Background Sloping Supply Curve for labour

S
Wage rate

W0

0 H

Hours of work

The backward-bending supply curve of labour shown on Figure 4.10 shows that beyond a
specific wage level any rise in wages will result in a decrease in working hours. The curve is
normal up to a wage rate of OW" after which it becomes regressive (i.e., the working hours
decrease). This is the case with target workers, some peasant farmers, etc. When the worker
attains a certain income or production, he or she reduces supply of labour (man-hours) and
enjoys more leisure.

Inter-Related Supply

There are various forms of inter-related supply. These include the following:

Joint Supply

Some goods are produced together. The supply of those goods that have a common process of
production is known as joint supply. The supply of such products is increased or decreased
simultaneously. This is true of by- products.

Examples include the following: (a) wool and mutton are produced jointly; (b) from crude oil,
different types of petroleum products such as diesel, engine oil, super and regular petrol are
obtained; (c) the production of cotton leads to the production of cotton seed; and (d) the
production of beef leads to production .

74
Looking at the beef-hide relationship to illustrate effect on supply, it is likely that if the price of
beef increases, then the quantity of beef supplied will increase, and the supply of hides will in
turn be increased. The effect of the increase on the price of beef is to shift the supply of hides to
the right.

Composite Supply

Composite supply refers to the production and offer for sale of goods that are substitutes for one
another. Examples include (a) supply of mutton, beef and chicken, (b) supply of tea and coffee,
and (c) supply of soft drinks like Coca- cola, Pepsi cola.

Competitive Supply

There are some alternative uses of land, labour and capital. If these factors are used for the
production of one product, then the supply of other commodities is affected. For example, if
more land is used to produce wheat, then production of maize will decrease. The supply of these
goods is said to be competitive supply.

If the price of one such commodity increases, ceteris paribus, then producers will be inclined to
produce more of that commodity because it is more profitable. As they produce more of the
commodity whose price has increased, they employ mom factors of production, leaving less
input factors for the commodity whose price has remained unchanged.

For instance, in Kenya cash crops compete with food crops for land. If prices for cash crops
increased on the global market, farmers may shift land use to the growing of more cash crops and
less food crops. Thus, the opportunity cost of more revenue from cash crops due to increased
prices might be decreased supply of food crops, and often does.

Elasticity of Supply

Definition

Elasticity of supply is the degree of responsiveness of quantity supplied to changes in price of a

product. In other words, the relationship between a proportionate change in the price of a product
and the resulting change in the quantity supplied is known as the elasticity of supply. Elasticity
of supply is calculated using the following formulae:

P€d = proportionate (or percentage) change in quantity supplied

Proportionate (or percentage) change in price

75
The formulae can also be simplified as follows:

P€d = Change in quantity supplied + Change in Price

Quantity supplied before price change Price before change

In most cases, the elasticity of supply will be positive, as changes in price and the quantity
supplied are normally in the same direction.

Numerical Examples

1. If the price of bread rises from Ksh.16 to Ksh.20 per loaf and as a result a bakery increases
its supply from 200 to 210 loaves the elasticity of supply is:

P€d = Change in quantity supplied + Change in Price

Quantity supplied before price change Price before change

= { ( 10 + 200) + 100 + {[4+16] x 100}

= 1+5

= 0.2

2. Suppose that when the price of Lollipop sweets changes from Sh5 to Sh.7, the quantity
supplied by House of Man] increases from 20 Kg to 30 Kg. The elasticity of supply is:

P€d =Change in quantity supplied + Change in Price

Quantity supplied before price change Price before change

= {(30 -20) +20} .;- {(7 - 5) + 5}

= {10.+m20}x{5 ÷ 2}

=1.25

But as we said with price elasticity of demand, we mostly use the mid-point (averages) approach.

Thus P€s = ˄Qs x P1 =P2

˄P Q1 + Q2

Degree of Elasticity of Supply

76
Degrees of Elasticity of Supply There are five degrees/levels of elasticity of supply: perfectly
Inelastic Supply

Perfect Inelastic Supply

In this situation the elasticity of supply is zero (i.e. PLS =0). A change in the price has no effect
on quantity supplied. Examples can be found in agriculture, where it is difficult to increase the
supply of a commodity in the short run. The amount of coffee which will be supplied to the
market in a given year cannot be influenced by farmers, as it takes several years before new
coffee plants will yield a crop. The perfectly inelastic curve is illustrated in figure 4.11.

Figure 4.11: Perfectly Inelastic Supply Curve

P3
Price

P2

P1

0 Q0
Quantity supply

Irrespective of the price level, quantity 00 will be supplied.

Relatively Inelastic supply

This refers to a situation where the elasticity of supply for a product is greater than zero, but less
than unity (i.e., 0< P€s < 1). In this case a change in price leads to a less than proportionate
change in quantity supplied. An example of this is the manufacturing firm that finds it difficult to
increase supply if price increases, but can do so by a small amount. It may be that a high
proportion of its factors of production is fixed. Figure 4:2 shows the typical shape of the inelastic
supply curve.

77
Figure 4.12: Relatively Inelastic Supply Curve

Price

0
Quantity supply
Unity Elasticity of Supply
Here the elasticity of supply is equal to one, and any given change in price leads to an equal
proportionate change in quantity supplied (i.e. P2:S 1), A typical supply curve having unit
elasticity is shown in figure 4.13 a and b.

Figure 4. 13: Unit Elasticity Supply

P
S

S P
Price

Price

7450

0 Quantity
0 Quantity Supplied
(a) (b)

The middle arc of smooth supply curve tends to have unitary elasticity. Perfectly Elastic Supply

78
Perfectly Elastic Supply

This represents a situation where the elasticity of supply is equal to infinity (P €s = 00). At a given
price, a firm is prepared to supply as much of the commodity as the market wants. If price falls
below this level, however, the firm will supply none of the commodity to the market. In real life
it is improbable that such a situation will arise. Figure 4.14. Illustrates the perfectly elastic supply
curve.

Figure 4.14: Perfectly Elastic Supply

P0 S
Price

0 Q1 Q2 Q3 Q4

Quantity Supplied

Relatively Elastic Supply

In this situation the elasticity supply is greater than one, but less than infinity, it lies between one
and infinity (i.e.1 < P€s <00). A given change in the price of a product result in a more than
proportionate change in the quantity supplied. A firm is likely to be in this situation in the long
run, when it can increase supply relatively easily by introducing more fixed factors of
production. An example of an elastic supply curves shown in Figure 4.15.

Elastic Supply S

79
 P2

Price P1

0 Q1 Q2

Quantity supplied

Determinants of Elasticity of Supply

Now that we have defined what is meant by elasticity, we must consider the factors determine
the elasticity of supply of a particular product. These include:

The Availability of spare capacity

Some firms may be using all their fixed factors of production to their fullest extend machinery is
used on a three-shift basis and it is difficult for the firm for the increase its output and supply,
however great the increase in price and supply will be elastic. On the other hand, if a firm is
using its fixed factors at less full capacity, it is relatively easier for the firm to produce and
supply more in response to a change in price. In this situation supply is inelastic.

The Availability of Variable Factors of production

When firm is increasing output, it requires not only fixed factors but also factors of production. If
these are not readily available, then supply will be elastic, even if the firm has spare capacity in
its fixed factors of production. The firm must be able to employ extra units of variable factors
easily, and combine these with the spare fixed factors available before supply will be elastic.

The Length of the Production Process

Some products take a longer time to manufacture and put onto the market. For example, whisky
must mature for three years before it is ready for sale. Most agricultural commodities take six
months to a year to grow. Such products are in inelastic supply because it is difficult to supply
more to the market, even if the price rise is substantial. Other products are made in a much
shorter period of time. Bread can be baked in a few hours. Fish can be caught and supplied to the

80
market in a matter of few days. These products are elastic in supply because a rise in price can
lead to an increase in the amount supplied.

The Ease of Entry of New Firms into the Industry

The preceding three factors have explained why a firm's supply will be elastic or inelastic. The
total market supply of a product, however, will be determined by the number of firms in the
industry. If there is an increase in price of the product, and new firms enter an industry easily
thereby increasing market supply, then supply will be elastic. Sometimes it is difficult for firms
to enter an industry, perhaps because of the amount of capital required, or there may be legal
barriers restricting the entry of firms. In this situation supply is inelastic.

Since 1974, there has been a rapid growth in the number of Matatus in Kenya, implying that the
supply of Matatu services is elastic. On the other hand, despite successive increase in the price of
beer, there are only two breweries supplying beer in Kenya.

Mobility of factors of production

For resources that cannot easily be switched from one line of activity to another, the supply of
commodities produced using such resources tends to be inelastic. For instance, if a country's land
can only be used for coffee production, then if the price of coffee decreases, this land has to
continue being used for coffee production, and hence the supply of coffee will be inelastic for a
period of time.

Time and Supply

The concept of long run and short run is very important in economies. We must now consider it
in the context of elasticity of supply. In analysis of the behavior of a firm's supply in response to
price changes, there are three time periods.

The Market Period

This is the time period immediately following the change in price, when it is difficult for the firm
to alter its supply. If price increases, the firm will want to expand its supply in order to increase
its total profits. However it will be difficult to increase output as it takes time to employ more
factors of production and to manufacture the goods, especially if they have a long p:roduction
process. The only way open to the firm to increase supply in the market period is to use any
stocks of the finished product that it might hold. Similarly if the firm wants to reduce supply in
response to a price fall, it will take time to organize the reduction in output, as there will be a
certain amount of work in the production line. Although it is difficult to reduce output in the -
market period, the firm can reduce its supply by putting the output into stock.

81
1 the market period, supply will be highly inelastic and if the firm does not normally hold stocks
of its finished product, it will be perfectly inelastic. All factors of production cannot be varied
(they are fixed) in such a short period.

The Short Run

In this period at least one factor of production is fixed. The firm alters its supply by changing the
number of variable factors that it uses. If the price of its products rises, it will buy more raw
materials, employ more labour and use more power to operate its machinery, usually by working
longer hours. Conversely if the price falls, the firm will initially reduce output by making some
of its labour force redundant, by purchasing fewer raw materials and by operating its machinery
less and, involving the use of less power. However, the extent by which the firm can change its
output and supply by altering its variables is limited. The law of non-proportional return will
operate in such a situation. Although supply is more elastic than in the market period, it will still
be totally inelastic.

The Long Run

This is the time period when the firm increases its output by using more fixed factors of
production. Ali factors of production are variable in the long run. In the event of an increase in
price, and this higher price being sustained, the firm will want to expand supply by introducing
more fixed factors of production. It will extend its buildings or build new ones. New machinery
will be installed and the administrative staff will be increased to cope with the higher level of
business. Conversely a permanent price 'reduction will cause the firm to cut its supply by selling
off some of its buildings and its machinery and its admininistrative staff will be reduced
accordingly. In the long run, therefore, the firm is able to change supply by a considerable
amount in response to changes in price. Figure 4.16 shows a typical supply curve for the market
period, the short run and the long run.

82
Figure 4. 16: Time periods in the context of elasticity of supply y

S(Market period)

Y S (short run)

S (Long run)
Price

Supply X

Significance of the Concept of Elasticity of Supply

The concept of elasticity of supply is of practical use, it facilitates the decision-making process
of the producers, consumers and governments.

Producers

Prior knowledge of the price elasticity of supply would serve and guide individual producers in
relation to production planning. For example, a producer who knows that his commodity is price-
inelastic could expand his production capacity in order to take advantage of favorable changes in
future.

Governments

The concept of price elasticity of supply can have various implications on government policy.
This is because the government may want to control the supply of certain commodities through
such measures as price control and taxation. It may also want to raise revenue through taxation
of commodities the effectiveness of such measures may depend partly on the price elasticity of
supply. For example, if the government wanted to control the supply of a commodity through
taxation, or higher prices, this would only be effective where the supply is elastic. Similarly, if
the government wanted to raise revenue through taxation, this would only be effective if the
supply is inelastic.

83
Consumer

A consumer is normally interested in getting steady supply of goods and s services at a

reasonable price. Knowledge of the elasticity of supply would able her to understand the likely
effects of changes in price on the supply of the goods and services that she requires. Where such
changes might lead to shortages as in the case of price-elastic goods, she could build up stocks or
get alternative sources of supply.

Equilibrium Analysis

The market attains an equilibrium position when the forces of demand and supply in the market
are equal. The price thus established is called the equilibriurn price, and the quantity demanded
or supplied is the equilibrium quantity. The quantity supplied equals to the quantity demanded
and the market clears.

Using demand and supply schedules, the equilibrium is attained art that price e lei where the
quantity demanded equals the quantity supplied. For example:

Demand and Supply Schedules

Px Qdx Qsx
6 2000 8000
5 3000 6000
4 4000 4000
3 5000 4000
2 6000 0
1 7000 -2000
0 8000 -4000
From the above schedules, the equilibrium price is 4, and the equilibrium quantity is 4000 units.

You can also establish the equilibrium point graphically, using the demands and supply chores.
This is attained at the point of intersection between the supply and demand curves. From the
above schedules in table 4.2 you can draw the demand and supply curves.

84
Figure 4.17: Equilibrium Price and Quantity

7 D

6 S

-2000 1000 0 1000 2000 3000 4000 5000 6000 7000 8000 9000
Quantity

The equilibrium quantity is 4000 and equilibrium price is 4.

Lastly, the equilibrium can be calculated using the demand and supply equations. For example,
given the following demand and supply equations:

Qd = 1600 – 400p

Qs = 400 + 600P

At equilibrium Qd = Qs. Thus: 1600 - 400P = 400 + 600P

2000 = 1000P

P =2. This is the equilibrium price.

Substituting for P in either the demand or supply equation, you can solve for the equilibrium
quantity-

For example: Qd = 1600 - 400P

85
 1600 - 400 (2) = 800

or

Qs = 600P = -400 + 600P

= 1200 – 400 = 800

Thus, the equilibrium quantity is 800

Note that if either the supply curve or the demand curves changes, the equilibrium will also
change. Supply can shift, or demand can shift, therefore the equilibrium will change according
depending on the directions of the supply or demand shifts.

? Revision Questions
1. Define supply.

2. What factors affect the supply quantity?

3. What is the market supply curve?

4. "The supply influences the demand curve, because the more a commodity is produced, the
more people want it (or the more producers convince them to demand). Discuss and evaluate
your answer.

5. What is the difference between a movement along a supply curve and a shift of the supply
curve?

6. What other factors cause a change in the supply of a product apart from a change in its price?

7. Write short notes on:

(a) Abnormal supply curve (b) Joint supply

(c) Composite supply (d) Competitive supply

8. Differentiate between joint demand and joint supply of products.

9. Give the reasons why the supply of manufactured goods is normally considered to be more
elastic than the supply of agricultural commodities.

10. Define the term elasticity of supply and outline it’s the main categories.

11. Describe briefly the practical importance of the concept of elasticity to (a) a firm and (b) a
government.

12. Distinguish between the short run and the long run in economics.

86
13. Explain the importance of the concept of "elasticity of economic policy.

CHAPTER FIVE
THEORY OF CONSUMER
BEHAVIOUR
At the end of the chapter, you should be able to:-

1. Define, understand, and use correctly the following terms and concepts;
utility, preference and choice, indifference curve, budget line, income
consumption curve, price consumption curve, income and substitution
effect and consumer surplus.
2. Explain whether utility is measurable or not and the role of marginal
utility :
3. Use the indifference map and budget line to show how the consumer
achieves equilibrium (i.e. arriving at the combination of goods and
service which offers him/her maximum satisfaction); and
4. Distinguish between income and substitution effect of a price change for
a normal, inferior and giffen goods.

The study of consumer behaviour forms the background of the demand curve and attempts to
explain precisely why demand curves are downward sloping. It is based on three important
theories-

1. Utility theory

2. The indifference curve theory

3. The Theory of Revealed preference

Preference and choice

Persons differ widely in their preferences so that one person's pleasure is another's pain. The way
people rank available alternatives provide information about their likes and dislikes. It indicates
what alternatives are preferred and how consumer would choose among them. Preferences are
represented by the rankings consumer give to alternative opportunities.

Choices are necessary because resources are scarce and human wants are unlimited. A consumer
cannot purchase everything he wants because income is limited. There must exist a mechanism

87
to decide what foods will be purchased and which ones will be left out. Preferences are but one
determinant of choice. Choices of the quantities of each good to consume also depends on the
prices of items desired and on the income a person has available to spend.

Preferences are likes and dislikes. Persons must reconcile their dreams about what they would
like to have with their actual budgets. Budgets depend on income and on the prices of the goods
and services desired. Consumers must choose how to best satisfy their preferences without
spending more than their budgets permit. The model of consumer choice is based on the
following assumptions about individual preferences for goods and services:

(a) Rationality: The consumer is assumed to be rational in decision making, i.e. he makes
optimal choices or decisions.

(b) Ability to rank alternatives. 'When a person is confronted with two different baskets
containing different amounts or kinds of goods, she/he is presumed to be capable of
indicating that she/he prefers one basket to the other or that he/she is indifferent between the
two.

(c) Preferences are transitive. Transitivity means that if a person prefers the basket of good A
to the basket B and also prefers B to basket C, he/she must also prefer A to C. Also he is
assumed to be consistency is his decisions, i.e. if A is preferred to S, cannot be preferred to
A.

(d) More of a good is preferred to less

Marginal and Total Utility

Utility is the satisfaction one gets from consuming a good or service. May also be defined as the
power of a commodity or service to satisfy human wants. It is subjective and relates to inner
sentiments and emotions. It has no physical or material existence. It is not inherent in the
physical commodity. Utility resides in the minds of the consumers. For example a soldier may
enjoy intense satisfaction from wearing combat uniform, which is disliked by an employee of
ABC Company.

Suppose a consumer eats 10 oranges. The total satisfaction he gets from this is called total utility.
Suppose he now consumes an extra orange. The extra satisfaction he gets from consuming this
orange is called the marginal utility of the eleventh orange. So marginal utility refers to the
change in satisfaction resulting from consuming a little more or a little less of the commodity.
We assume that the consumer compares the utility of different commodity bundles and chooses
the one with the highest utility from among all the bundles he can afford.

Total utility (Tu)= U1 (X1) + U2 (X2) + ------ + Un (Un (Xn);

Where X1-----------Xn are the consumption goods or services.

88
Marginal Utility (Mu) = Tu X

Note that Mu increases first, and then diminishes as more of a good or service is consumed.

Measurement of utility

There are two commonly used approaches to the measurement of utility; viz cardinal utility and
ordinal utility.

Cardinal Utility

The cardinalist school postulated that utility can be measured. Various suggestions have been
made for the measurement of utility. Utility can be measured in monetary units, by the amount of
money the consumer is willing to sacrifice for another unit of a commodity. Others suggest the
measurement of utility in subjective units, called utils

Diminishing Marginal Utility

The law of diminishing marginal utility states: The utility any household derives from successive
units of particular commodity will diminish as total consumption of the commodity increases, the
consumption of all other commodities being held constant.

Marginal utility decreases as more and more units are consumed. The assertion that products are
characterized by diminishing marginal utility as consumption rises is an empirical one and this
assertion is widely believed despite the absence of generally accepted measuring devices for
utilities. If Mu becomes negative, the T u decreases.

Table 5.1: Relationship between Total and Marginal Utility

Orange Total Utility Marginal Utility

0 0 -
1 20 20
2 36 16
3 50 14
4 53 2
5 55 2
6 56 1
7 56 0
8 55 -55
9 53 -2
10 50 -3

89
As can be observed, marginal utility 50 decreases as more and -3 more units are consumed.

Total utility will be increasing as long as marginal utility is greater than O. At point of maximum
utility (i.e. 56 above) marginal utility is O. If the consumer

Maximizes her utility in this case, she will be consuming seven oranges. Beyond seven oranges,
rnu is negative. Note that under this model, the consumer attains equilibrium (maximizes utility)
when Mux = Px; i.e. he can either buy or retain his money income. If Mux > P x, he can increase
his welfare by purchasing more of x, and vice versa.

The above can be plotted in the figures below.

Index of Utillity

figure 5.1 Total Utility Figure 5.2 Marginal Utility

Index of Utillity
TU

MU
Oranges Orange

Total utility curve rises but the marginal utility curve falls as the quantity consumed rises.

The law of diminishing marginal utility is based on the following assumptions.

1. The commodity is taken in suitable and reasonable units. If the units are too small, then the
utility will at first increase instead of decreasing.

2. The commodity is taken within a certain time, or else the law will not hold.

3. The character of the consumer does not change.

4. Taster, fashions, customs and habits of the consumer remain unchanged.

5. Income of the consumer does not change.

6. The law is not applicable in the case of rare collection i.e. collection of ancient coins or
stamps. The greater the stock the greater the satisfaction.

90
Ordinal Utility

The main ordinal theories are the indifference curves approach and the revealed preference
hypothesis.

The Ordinalist school! Postulated that utility is not measurable, but is an ordinal magnitude. The
consumer need not know in specific units the utility of various commodities to make his choice.
But the consumer is able to rank the various 'baskets of goods' according to the satisfaction that
each bundle gives him He must be able to determine his order of preference among different
bundles of goods.

The indifference Curve Approach

An indifference curve is the locus of points - particular combinations or bundles of goods _

which yield the same utility (level of satisfaction) to the consumer, so that he is indifferent as to
the particular combinations he consumes. The figure below shows an indifference curve,

Figure 5.3: An Indifference Curve of a Consumer

B D

5
Apples

3 C Indifferent curve

0 5 8 Orange

It shows the combination of oranges and apples from which the consumer derives the same level
of satisfaction (Le, indifferent about). For example point B represents a bundle containing 5
apples and 5 oranges. Point C depicts a combination of 3 apples and 8 oranges. Because these
two points lie on the same indifference curve, we know that this consumer derives same
satisfaction from either combination of the two goods.

All points above the indifference curve corresponds combinations where the consumer has more
apples and no fewer oranges, or more oranges and no fewer apples (e.g. at point D) than the
points on the indifference curve. So these points represent higher level of satisfaction. At point
A, below the indifference curve has to be a point on a lower indifference curve showing low
levels of satisfaction.

91
Indifference Map

An indifference map shows all the indifference curves, which rank the preference of the
consumer.

Figure 5.4: An Indifference Map

Apples

IC2
IC2
IC1

Oranges

Combination of goods situated on an indifference curve yield the same utility. Combinations
lying on a higher indifference curve yield higher level of satisfaction and are preferred.
Combinations of goods on a lower indifference curve yield a lower utility.

Properties of Indifference Curves

1. An indifference curve has a negative slope which denotes that if the quantity of one
commodity (Apples) decreases, the quantity of the other (oranges) must increase, if the
consumer is to stay on the same level of satisfaction.
2. The further away from the origin an indifference curve lies, the higher the level of utility
it donates bundles of goods on a higher indifference curve are preferred by a rational
consumer.

92
 Figure 5.5: Indifference Map

Apples
1C3

1C2

1C1

Oranges

The market baskets on IC3 are preferred to market baskets on IC1 because they have has
more apples and oranges than those contained in IC1.

3. Indifference curves cannot intersect. If they did, the point of their intersection would
imply two different levels of satisfaction which is impossible.

Figure 5.6: Intersection of the Indifference Curves

1C2

C
Apples

1C1>1C2 A

1C2>1C1 1C1

Oranges

The market basket A is the paint of intersection common to both indifference curves.
Because the market basket A is on indifference curve IC1, it follows that the consumer will
be indifferent between A and 8. Similarly, basket C is on curve IC2 along with basket A
Therefore the consumer is also indifferent between A and C. It must follow that the consumer
will also be indifferent between baskets Band C.

93
 Because the consumer cannot simultaneously prefer C to B and be indifference between the
two, the intersection of the two indifference curves implies a contradiction

4. As we move along an indifference curve, giving up apples in exchange for some more
oranges, we find that the indifference curve is first very steep and then gradually flattens out.

The slope of indifference curve decreases as we move from left to right. Thus diminishing
marginal rate substitution (OMRS). The number of units of X the consumer is willing to
sacrifice in order to obtain an additional unit of Y decreases. It becomes increasingly difficult
to substitute X for Y as we move along the curve.

5. Indifference curves are convex to the origin.

Three extreme cases of indifference curves are worth noting.

1. Indifference curve is a straight line. The slope of indifference curve decreases as we

move from left to right. Thus diminishing marginal rate of substitution (OMRS). The
number of units of X the consumer is willing to sacrifice in order to obtain an additional
unit of Y increases as the quantity of Y decreases. It becomes increasingly difficulty to
substitute X for Y as we move along the curve.

Figure 5.7: Straight Line

1C1 1C2 1C3

0 X
Orange
This is a case of perfect substitutes. A person with these preferences would be willing to
give up the same amount of y to get one more X no matter how much X was being
consumed. Such a situation might describe the relationship between different brands of
what is essentially the same product. For example, many people do not care where to buy
petrol. A litre of petrol is a litre of petrol either bought from Calder or Mobil.

94
 2. Indifference Curves are L- shaped a case of perfect complements.

Figure 5. 8: L~ Shaped Indifference Curve

1C3

1C2

1C1

0 x
The preference would apply to goods that 'go together' i.e. coffee and cream, peanut butter and
jelly. The indifference curves imply that these pairs of goods will be used in the fixed
proportional relationship represented by the vertices of the curves. p" person who prefers 1 ounce
of cream with 8 ounces of coffee will want 2 ounces of cream with 16 ounces of coffee. Extra
coffee 'without cream is of no value to this person just as extra cream would be of no value
without coffee. Only by choosing the goods together can utility be increased.
3. Positively sloped indifference curve

Figure 5.9: Positively Slopped Indifference Curve

1C1 1C2 1C3

This illustrates a case in which one of the goods (say, Y) is really a "bad" or it is a negative
externality (negative spill-over effects). A person wills choose more Y only if compensated with
additional X also. Commodity Y might represent mosquito contacts whereas X could represent

95
beach quality. The positive slope of the curve implies that this person will choose to swim at a
mosquito - infested beach only if the sand and surface are of exceptional quality.

Marginal Rate of Substitution

Consider the indifference curve below. It gives the combination of oranges and apples that the
individual is indifferent about.

Figure 5.10: Marginal Rate of Substitution

Y A

IC

How much apples are the consumer prepared to give up to get one more unit of oranges
measures what is called the marginal rate of substitute of apples for oranges. The marginal rate
of substitution (MRS) is the amount of one commodity a consumer would be prepared to give up
to get one more unit of another commodity.

MRS x for y + Change in y = Y

Change in x x

At point A, in figure 5.10: the consumer is willing to give up a lot of apples to acquire another
unit of oranges. At point B he is willing to sacrifice only a very small amount of apple for
another unit of orange. We call this flattening out of indifference curve the Diminishing marginal
rate of substitution. Diminishing marginal rate of substitution means that the consumer
willingness to give up apples in exchange for extra units of oranges (x) declines as more and
more oranges and less and less apple are in the basket, as consumer moves from point A to B.

96
The notion of diminishing marginal rate of substitution ties with the idea of diminishing marginal
utility. As we move to the right along an indifference curve above, the consumption of oranges is
increasing and the consumption of apples is decreasing. Therefore, the marginal utility of
oranges is decreasing and that of apples is increasing.

The Budget constraint

The budget line consists of all the possible combinations of the two commodities that the
consumer can purchase with a given total expenditure (budget),

Suppose the price of orange is 20 cents per orange and the price of apple is 25 cent per apple and
our consumer can spend 10 shillings. Then his or her budget is said to be Ksh.10. She can buy a
maximum of 50 oranges and no apple: or a maximum of 40 apples and no orange: or some
combinations of apples and oranges like 25 oranges and 20 apples. The line joining these
extreme points is the budget line,

Figure 5.11: Budget Line and Feasible Purchases

40 Combination not within the consumer budget Ksh. 100

All feasible
Purchases

0 Orange 50

The consumer can buy less and save money (be within her budget). But she cannot buy more.
Thus all the feasible purchase are on the budget line or lie under it i.e. shaded region. The budget
line is negatively sloped and its absolute slope is given as 1-Px IPy1. for example:

97
Figure 5. 12: Budget Constraint

M
Py Budget constraint

0 M/Px X

If X and Yare the quantities of good X and y and if the prices are Px and Py respectively, then
the equation of the budget line is
(X.px)+ (Ypy)> M

Where M is the total money the consumer has to spend

Note that X.Px is the amount of money spent on good X while Y.py is the amount of money spent
on good Y, they must sum to total expenditure (M).

Now if the consumer buys only good X, she can just afford M/Px with her budget so that M/Px is
our horizontal intercept. Similarly, the vertical intercept is M/Py. in going from the vertical
intercept to horizontal intercept !1 Y I !1X= (M/Py) / (M/Px) = -Px/Py which is the scope of the
budget line.

Shift in the Budget Line

Two factors can cause the budget line to shift

1. Change in the budget (income)

2. Changes in the prices of the commodities.

With a change in the budget but no change in prices, we have parallel shifts in the budget line
as shown below.

98
Figure 5.13: Parallel shifts of the budget line as income changes

Ksh 300

Ksh.200

Ksh.100

0 B1 B2 B3 X

With an increase in the budget, for example, both intercepts increase, but the price ratio (the
absolute value of the slope) is unaffected. In the above figure the budget line shifts from 81 to B2
to B3 as budget increases from Ksh. 100 to 200 to 300. The budget line will also shift in a
parallel manner if both prices are changed proportionately, because the price ratio and hence, the
slope will be unaffected.
If the price of one commodity increases, then the intercept (M/P) decreases. The opposite is true
for a price reduction.

Figures below, shows the effect of change in price of commodity X and Y, income being held
constant.

Figure 5.14: Shifts of the budget line as price ratio change

Y Y (b)

(a) A2

A A

A1

0 B1 B B2 X

99
 0 B
X
Y
Y A

A1

0 B B1 X 0 B1 B X

© (d)

AB = Original budget line

(a) If Px increases, the new budget line is AS1; and if Px decreases the new budget line is AB2.

(b) Py increases the budget line changes to A1B; and a decrease in Py tilts the budge line A2B.

(c) Px and Py both decline but Px declines proportionately more than Py. More of both x and y is
bought, as shown by new budget line A1B1,

(d) Px declines and Py rises. So more of X is bought and less of Y is bought. New budget line is
A1B1.

The slope declines in absolute terms in cases AS2, A1S, and A1S1. If both prices change in the
same direction but by different amounts, then again both the intercepts and the slope are altered.

100
Equilibrium of the Consumer

To find the consumer's equilibrium, we have to superimpose the budget line on the indifference
map. The indifference map shows what is desirable. The budget line shows what is feasible. We
now match the feasible and desirable. This is shown in the figure below.

Figure 5.15: The Equilibrium of the consumer

Y1 C IC3

IC2

Ic1
Feasible
F
region

0 X1 B X
IC1, IC2,IC3 are indifference curves. IC2 gives a higher utility than IC 1. IC3 gives a higher utility
than IC2 and so on. AS is the budget line. The consumers feasible combinations of the goods X
and Yare given by the points on the budget line AS or in the triangle area under AS. The point of
tangency C gives the optimal bundle of X and Y. Points on the curve IC3 are not within the reach
of the consumer. As for IC1 the consumer can do better, since all points in the shaded area are
still within the consumers’ budget and yet yield more satisfaction.

So the consumers' satisfaction is maximized at point C where an indifference curve is tangent to

the budget line, and consumes X1 and Y1 bundles.

Reaction of the Consumer to a change in Income

A change in income leads to parallel shifts of the budget line inward toward the origin when
income falls and outward away from the origin when income rises. For each level of income
there will be an equilibrium position at which an indifference curve is tangent to the relevant
budget line. Each such equilibrium position means that the household is doing as well as it
possibly can for that level of income. If we move the budget line through all possible levels of
income and if we join up all the points of equilibrium we will trace out what is called income
consumption line, shown in the below figure.

101
Figure 5. 16: Income Consumption Curve

A4

A3

A2 E4

E2 E3

A1 1C4

E1 1C3

1C1 1C2

B1 B2 B3 B4 Good X

The line (curve) shows how the households' purchases react to a change in income with relative
prices held constant.

Reaction of the consumer to a price change

A change in the relative prices of the two goods changes the slope of the budget line. Given a
price of Y, for each possible price of X there is an equilibrium consumption position for the
consumer. Connecting these positions traces out a price consumption line, shown below.

Figure 5:17 Price Consumption Curve

Price consumption
curve

E1 E1sss

IC1 1C1 1C1

0 B C D E Good X

102
The price - consumption curve (line) in this case shows how the consumer's purchases react to a
change in one price with money income and other prices held constant. Here the price of Y is
held constant while that of X decreases; hence more of X is bought.
Income and Substitution Effect of a Price Change

The case for a Normal Good

If the money income and the price of good Y stay the same but the price of good X rises, then the
consumer will feel poorer, and if the price of good X fails, the consumer will feel richer. This
observation has led economists to try to separate the impact of a price change on quantity
demanded into 2 components.

1. The substitution effect, which involves the substitution of good X for good Y or vice -
versa due to a change in the relative prices of the two goods.
2. The income effect, which results from an increase or decrease in the consumers' real
income or purchasing power as a result of the price change. The sum of these two effects
is called the total effect of a price change or just the price effect The decomposition of the
price effect into substitution income effects components is explained by the figure below,

Figure 5. 18: Income and Substitution Effect for a Normal Good

A3

E3

E2

E3 IC2

IC1

0 X1 X2 B X3 B3 B2 Good X

103
AB1 is the original budget line, but then a fall in the price of good X shifts the budget line to
AB2. (Income and price of the other good remain constant), initially, the optimal bundle was E 1
on the indifference curve IC1 and X1 was quantity of X consumed. After the decline in the price
of X the new consumer optimum becomes E2 on the indifference curve IC2. The total effect of
the price change is thus a movement from E 1 to E2, or an increase in the quantity demanded of X
from X1 to X2

Now, what would the consumers' optimal bundle be if he faced the new lower price for X but
experienced no change in real income? The answer is E 3 with X3 units of X demanded, to see
this, one must realize that holding consumer's real income constant amounts to keeping them on
the same indifference curve IC1. And with the new price ratio, the new optimum on IC 1 is at E3,
where a line with the slope of the new budget line (or parallel to the new budget line) is tangent.
We do a compensating variation to get a new "compensated" budget Line A3B3.

Thus, we argue that the movement from E 1 to E3, or the increase in quantity demanded from X 1
to X3 is solely in response to a change in relative prices. This is the substitution effect.

The remainder of the total effect is due to a change in real income, the movement from E, to E"
or the increase in quantity demanded from X, to X, is thus the income effect. The increase in real
income is evidenced by the consumer movement from IC1 to a higher indifference curve, IC,
Total effect is the movement from E, to E, or the increase in quantity demanded from X, to X 2

The Case for inferior goods and Giffen Goods

In the above figure, note that the substitution effect and income effect both led to an increase of
the consumption of X when the price of X fell This was a case for a normal good. However this
need not always be the case.

The substitution effect will always be positive, that is the decline in the relative price of X will
lead to a substitution of Y for X However the income effect need not be positive, It is negative
for inferior goods, If the income effect is so strongly negative that it swamps the positive
substitution effect, the total effect will be negative, and we thus have the result that a decline in
the price of X results in a decrease in quantity of good X demanded, This is the case with giffen
goods Thus, giffen goods are inferior goods, but not all inferior goods are giffen goods. This is
illustrated below.

104
Figure 5.19: Income and Substitution effect for inferior good.

E1 E2

A3

E3

X1 X2 X3 B1 B2 Good X

Substitution effect is positive i.e. E 3 or quantity X1X3, while income effect is negative i.e. E 3, to
E2 or quantity X3 X2. Total effect is positive E1 to E2 or quantity demanded X 1X2. Note that
inferior goods are those goods in which increase in income leads to a decrease in quantity
demanded (X3X2).
Note that the negative increase income effect is not strong enough to overcome the positive
substitution effect. Thus a positive total effect.

Figure 5.20: Income and Substitution Effect for a Giffen good

105
 A E2

1C2

A3 E1

E3

1C1

0 X2 X1 X3 B1 B3 B2 Good X
Income Effect
In this case substitution effect is E1 to E3 or X1X3, which is positive. Income effect E3 to E2 or
quantity X3X2 which is negative, and total effect is i.e. E1 to E2 or X1X2. With a giffen good,
quantity demanded decreases as price decreases. In this case total effect is negative.

The Theory of Revealed Preference

This theory is under the ordinalist school and was developed by Paul Samuelson in 1938.

The theory attempts to explain the response of consumers to price changes without the need to
make any assumption about their motives that is without recourse to the concept of utility or
satisfaction. The revealed preference approach states that if it can be observed that a consumer
buys more of a product when his income rises, we can deduce that he will also buy more of that
product when its price falls, since the price fall will be equivalent to a rise in real income.

This theory is based in the following assumption

1. Consistency - The consumer behaves consistently, that is, if he chooses bundle A in a

situation in which bundle B was also available to him, he will not choose B in any other
situation in which A is also available i.e. if A> 8, the B >A.
2. Rationality - The consumer is assumed to behave rationally, in that he prefers bundle of
goods that include more quantities commodities.
3. Transitivity. If in any particular situation A>B and B>C, then, :( A>C means A is
preferred to C).
4. The revealed preference axiom. The consumer choosing a collection of goods in
anyone budget situation, reveals his preference for that particular collection. The chosen
bundle is revealed to be preferred among all other alternative bundles available under the
budget constraint. The chosen 'basket of goods' maximizes the utility' the consumer. The

106
 revealed preference for a particular collection of goods implies the maximization of the
utility of the consumer.

The revealed preference theory is considered as a break through in the theory of demand,
because it has made possible the establishment of the law demand' directly (on the basis of the
revealed preference axiom) without the use of indifference curves and all their restrictive
assumption, but by observation.

The Consumer’s Surplus

Introduced by A Marshall, who maintained that it can be measured in monetary units, and is
equal to the difference between the amount of money that the consumer actually pays to buy a
certain quantity of a commodity X and the amount that he would be willing to pay for this
quantity rather than do without it.

Figure 5.21: Consumer Surplus x

P1

P2

P3

P4

0 q1 q2 q3 q4 B

Graphically, the consumer's surplus may be found by his/her demand curve for commodity X
and the current market price, which he/she cannot affect by his purchases of this commodity.
Assume that the consumer's demand for X is a straight line (AS) and the market price is P. At
this price, the consumer buys q units of X and pays an amount (q). (p) for it. However, he would
be willing to pay P1 for q1, P2 for q2, P3 for q3 and so on. The fact that the price in the market is
lower than the price he would be willing to pay for the initial units of X implies that his actual
expenditure is less than he would be willing to spend to acquire the quantity q. This difference is
the consumers' surplus, that is, the difference between what he was willing to pay and what he
actually pays in the market. This consumer surplus is given by the area below the demand and
above the price line. For example in the above diagram, if the price is P 3, the consumer surplus is
the area of the triangle P3Ac.

Revision Questions

107
1. Explain how scarcity and choice are important in the study of economics.

2. What is utility? Differentiate between ordinal and cardinal utility theory.

3. Explain the assumptions under which the model of consumer behaviour is based on.

4. Differentiate between rationality and consumer sovereignty.

5. State the law of diminishing marginal utility and explain the assumptions on which the law is
based on.

6. Explain fully the concept of opportunity cost by giving examples. How does opportunity cost
differ from real cost?

7. Investigate how people in your traditional society solved problems of scarcity and choice.
Write a report on your findings.

8. Define indifference curve and explain its properties.

9. A consumer has K.Sh. 1000 and wants to spend all this income in the purchase of either
commodity X and Y or a combination of the two. If the price of X is 20 shillings per kilo, while
price of Y is 10 shilling per kg; then (a) Construct the budget line of the consumer?

(b) If income of the consumer decreases to K.Sh. 500, show what will happen to the budget line.

(c) Suppose the price of X halves while that of Y remains constant.

Show what will happen to the budget line. (income remains K.Sh. 1000)

(d) Suppose the price of Y doubles while that of X increases to 25 shilling per kg while income
remain constant, what happens to the budget line.

10. Show how the consumer maximizes his satisfaction.

11. Differentiate between a normal good, inferior good and Giffen good.

12. The price of commodity X increases from K.Sh.10 to K.Sh. 15 per kilogram. The income and
price of other commodities remain constant. Assuming commodity X is inferior good,
decompose the effect of the price change into income and substitution effect.

13. Differentiate between income consumption curve and price consumption curve and explain
their relevance to the study of consumer behaviour.

14. lf we all like more money, why does the government not print a lot more?

Could it not thereby solve the problem of scarcity at a stroke?

108
 CHAPTER SIX
Theory of Production

109
Objective
At the end of the chapter, you should be able to:-

1. Define and understand the following terms and concepts, production

periods’ marginal, average and total product; isoquant curve, issicostline,
expansions path, Returns to scale, production possibility curve,
isorevenue curve, fixed costs, and variable cost;
2. Use marginal cost, average variable cost and total cost to explain the
economic region of production
3. Use the isoquant and isocostiline to show and explain the equilibrium of
the firm (i.e. the choice of optimal combination of factors of production).
4. Show various combination of goods and services which can be produced
using given factors of production possibility curve and Isorevenue
curve ; and
5. Understand the various cost facing the producer and the relationship
between short run and long run cost curve.

Production is the process of using the service of labor and equipment in combination with natural
resources and materials to make goods and services available. The productive services of labor,
capital and natural resources are the inputs into the process.

Productive relationships are primarily technologies; they are determined by engineering, physical
and human capabilities. Technology is the knowledge of how to produce goods and services in
the economy. These are the methods, ways or processes of producing the goods and services.

Production function is a purely technical relation, which connects factor inputs and outputs. It
describes the laws of proportion, that is, the transformation of factor inputs into products (output)
at any particular time period.

The production functions represent the technology of a firm, of an industry, or the economy as a
whole. It shows the maximum output that can be produced from given inputs. In abstract term it
is written as; Q; f (X1, X2, ... xm)

Where Q is the maximum quantity of output and X 1,X2 ... xn are quantities of various inputs. If
there are only two inputs, labor (L) and Capital (K) we write; Q= f (L, K).

Production Periods

There are three time periods:

1. Market period or very short period

110
This is a time period, so short that the supply of a given output cannot be changed because both
variable and fixed factors of inputs cannot be varied. If a sudden and once for all increase in
demand takes place, there win be a rise in market price. But in the market period, there will be no
change in the amount supplied because firms can sell what they already produced. Increase in
supply can only be from the firm's stocks, some existing capacity or over utilization of existing
factors.

2. The short Run Period

This is the period in which the quantity of some inputs cannot be varied. The firm cannot change
the quantity of some inputs (fixed factors), that it has on hand.

Inputs which can be varied in the short run are called variable factors. The fixed factors is
usually an element of capital such as plant and equipment, but it could be land, the services of
management, or even supply of skilled labor.

The short-run does not correspond to a definite number of months or years. In some industries, it
may extend over many years, in others; it may be only a matter of months or weeks. For
example, in the electric industry, it takes time to acquire and install a steam -turbine generator.
Even if demand increases, it takes time to be met. This is in contrast to a mechanic shop, which
can acquire new equipment in very few weeks in the event of demand increasing.

3. The Long Run. Period

In the long run, the firm can vary inputs as much as it finds it necessary. All inputs are variable.
This means that the firm can choose the size of the plant, the type of machines it wants and the
location if prefers. All factors of production can be varied.

This is the period in which firms have sufficient time to change the size of their plants or build
new other and also new firms can enter into the industry. We can also talk of the very long run
when firms can overhaul everything including technologies.

Total, Average, and Marginal Products

Suppose that we want to produce apples. We have land, fertilizers, water, machinery etc, all
fixed at certain quantities. The only input we can adjust is labor. Thus labour is our only variable
input. If labour input is 0, the output of apples is of course 0. As we increase the labour input, we
will increase the output of apples. But a point will come where increasing labor will not increase
the output of oranges at all and, in fact might even decrease it. For example, a very small apple
garden where 10 workers can harvest the crop, if we employ a hundred workers, they will crowd
the farm and they might even eat all the apples.

Table 6.1: Total Output of Apples and fixed for different quantities of Labour and Land
Average

111
Labour Units (L) Total Product (TP) Marginal Product Average Product
(MP) (Employees) (AP)

0 0 - -

1 10 10 10

2 25 15 12.5

4 45 20 15

5. 60 15 15

6 70 10 15

7 72 0 10.3

8 64 -12 8

9 52 -12 5.8

10 35 -17 3.5

Total output is usually called total product (TP). From the data we can derive the marginal
product (MP), which is the increase in total product due to a one -unit increase in labour (the
variable factor).

MP =\ TP/L

Average product can be calculated, and it is simply the output per unit of labor

AP=TP/L

Marginal product is the additional output that can be produced by hiring one more unit of a
specific input, holding all other inputs constant. Looking at the MP values, we see that initially
MP is increasing. The second and third workers add more to output than the workers before
them. With only one unit of labor, that worker must do everything with more workers, they can
divide the work and specialize thus increasing the productivity of each worker. Eventually,
though MP begins to decline. This is what is known as the law of diminishing marginal
productivity. It is also sometimes called the law of diminishing retums, or law of variable
proportions.

112
The law of diminishing returns states that, if increasing amounts of a variable factor are applied
to a given amount of a fixed factor, eventually a situation will be reached in which each
additional unit of the variable factor adds less to total product than did the previous unit.

In the table above, there are increasing returns to labor for the first three units of labor employed,
The law of diminishing returns sets in with the fourth worker. The law of diminishing returns is
reasonable, Remember that capital, land and other factors are fixed. Eventually additional
workers will not have a tractor or other equipment to use. Hence they will add less to output than
earlier workers who had access to ample quantities of the other inputs, Notice that with the 8th
worker; the MP becomes negative and this point should not be confused with the point of
diminishing returns.

Relationship between MP and TP Curve.

MP =  TP/L
MP=TP/L-So graphically it is the slope of the TP curve
If MP>O,TP will be rising as L increases
IF MP= 0, TP will be constant as L increases If MP<O, TP will be falling as L increases This is
shown in the below figure
Figure 6,1: Total Product Curve to explain the relationship between TP and MP

C
TP
Total amount

A inflection point

0 Quantity of

Notice that when:

1. MP>O and increasing (from 0 to A)
2. MP>O but decreasing (from A to C )
3. MP=O at the point C
4, MP<O after the point C.

113
The point A where MP stops increasing and starts decreasing is called an inflection point
because the curvature of the TP curve changes at this point. It is here that diminishing returns
sets in.
AP Curve its relationship to the and TP Curves

The total product curve above shows the total product steadily rising first at an increasing rate,
then at a decreasing rate. This causes the average and MP curves to rise at first and then decline.
The point of maximum AP (point of diminishing average productivity is) 8 where TP is tangent
to the ray from the origin.

Notice that MP=AP at the quantity of labor where AP is maximized.

If MP>AP,AP will be rising as L increases

If MP<AP,AP will be falling as L increases. So MP=AP where AP is at maximum. These

relationships can be shown below.

Figure 6.2: The relationship between Total Product, Average Product and Marginal
Product

Notice that

1. MP >AP is rising thus MP>AP

2. MP>O, but AP is falling, MP<AP but TP is increasing
3. MP<),so TP is falling

114
At the point S, AP is maximized and so AP= MP. At point C, total product reaches maximum.
Thus MP = a at this point. Notice that the economically meaningful range of production is
between Sand C. Between point A and S, the producer has no reason to stop producing since AP
is increasing and TP is increasing while beyond point C it is uneconomical because total product
is decreasing. The level of labour force employment should not exceed L3·

Equilibrium of the Firm Choice of Optimal Combination of Factors of Production

In showing the equilibrium of the (producer) we will use isoquant map and isocost-lines.

Isoquant

The word "ISO" is of Greek origin and means 'equal' or 'same'. An Isoquant is a curve along
which quantity is the same. Quantity in this case, refers to quantity of output or total product.
With two inputs, labor and capital, the isoquant gives the different combinations of labor (L) and
capital (K) that produce the same maximum total output

As we move from one point on an lsoquant to another we are substituting one factor for another
while holding output constant. If we move from point a to b, we are substituting one unit of L for
three units of capital.

The marginal rate of Substitution (MRS) measures the rate at which one factor is substituted for
another with output held constant. The MRS is measured by the slope of the Isoquant at a
particular point.

Isoquants satisfy two important conditions

1. They are downward sloping-meaning that each factor input has positive marginal
product. if the input of one factor is reduced and that of the other is held constant, output
will be reduced. Thus, if one input is decreased, production can only be held constant if
the other factor input is increased. The MRS has a negative value: increases in one factor
must be balanced by decreases in the other factor if output is to be held constant.
2. They are convex to the origin: To understand convexity, consider what happens as the
firm moves along the Isoquant downward to the right. Labor is being added and capital
reduced to keep output constant. If labor is added in increments of exactly one unit, how
much capital may be dispended with each time? The key answer is that both factors are
assumed to be subject to the law of diminishing returns. Thus the gain in output
associated with each additional unit of labor added is diminishing while the loss of output
associated with each additional unit of capital foregone is increasing. It therefore takes

115
 ever-smaller reduction in capital to compensate for equal increases in labor. This implies
that the lsoquant is convex to the origin.

Isoquant Map

Each Isoquant refers to a specific output and connects alternative combination of factors that are
technologically efficient methods of achieving that output. If we plot several isoquants on a
single graph we get an isoquant map.

Figure 6.2: The relationship between Total Product, Average Product and Marginal Product

TP

TP

Quantity of
labour

0 L1 L2 L3

116
 MP,AP

AP

0 L1 L2 L3

MP

Quantity of labour

Notice that

4. MP >AP is rising thus MP>AP

5. MP>O, but AP is falling, MP<AP but TP is increasing
6. MP<),so TP is falling

At the point S, AP is maximized and so AP= MP. At point C, total product reaches maximum.
Thus MP = a at this point. Notice that the economically meaningful range of production is
between Sand C. Between point A and S, the producer has no reason to stop producing since AP
is increasing and TP is increasing while beyond point C it is uneconomical because total product
is decreasing. The level of labour force employment should not exceed L3·

Equilibrium of the Firm Choice of Optimal Combination of Factors of Production

117
In showing the equilibrium of the (producer) we will use isoquant map and isocost-lines.

Isoquant

The word "ISO" is of Greek origin and means 'equal' or 'same'. An Isoquant is a curve along
which quantity is the same. Quantity in this case, refers to quantity of output or total product.
With two inputs, labor and capital, the isoquant gives the different combinations of labor (L) and
capital (K) that produce the same maximum total output.

Figure 6.3: Isoquanti Curve

12 a

9 h

Isoquant

0 4 5 Quantity of labour

As we move from one point on an lsoquant to another we are substituting one factor for another
while holding output constant. If we move from point a to b, we are substituting one unit of L for
three units of capital.

The marginal rate of Substitution (MRS) measures the rate at which one factor is substituted for
another with output held constant. The MRS is measured by the slope of the Isoquant at a
particular point.

Isoquants satisfy two important conditions

3. They are downward sloping-meaning that each factor input has positive marginal
product. if the input of one factor is reduced and that of the other is held constant, output
will be reduced. Thus, if one input is decreased, production can only be held constant if
the other factor input is increased. The MRS has a negative value: increases in one factor
must be balanced by decreases in the other factor if output is to be held constant.
4. They are convex to the origin: To understand convexity, consider what happens as the
firm moves along the Isoquant downward to the right. Labor is being added and capital

118
 reduced to keep output constant. If labor is added in increments of exactly one unit, how
much capital may be dispended with each time? The key answer is that both factors are
assumed to be subject to the law of diminishing returns. Thus the gain in output
associated with each additional unit of labor added is diminishing while the loss of output
associated with each additional unit of capital foregone is increasing. It therefore takes
ever-smaller reduction in capital to compensate for equal increases in labor. This implies
that the lsoquant is convex to the origin.

Isoquant Map

Each Isoquant refers to a specific output and connects alternative combination of factors that are
technologically efficient methods of achieving that output. If we plot several isoquants on a
single graph we get an isoquant map.

Figure 6.4: Isoquant map

IS3

IS2

IS1

L
The higher the level of output along a particular isoquant, the further away from the origin it will
be. So that in the figure above, IS3 represents more output than 1S2 and IS1.
Isocost line

Finding the efficient way of producing any output requires finding the least cost factor
combination. To find this combination when both factors are variable, factor prices need to be
known. The ISOGOST LINE is used to show alternative combination of factors a firm can buy
for a given outlay. A series of lsocost lines is shown below.

119
 Capital inputs
Figure 6.5: Isocost Line

Higher cost

Lower
O cost C1 C2 C3

Labour inputs

Each Isocostline shows alternative factor combinations that can be purchased for a given money
outlay. The figure shows Isocostline G1,C2, and C3. The line labeled C1 represents all
combinations of two factors that a firm Gould buy with that outlay (say Ksh. 120), while C 2
represents the combination of the two factors that can be purchased with that outlay, (say
Ksh.180). C3 shows a higher outlay (say Ksh.200).

Equilibrium of the firm

Suppose the producer wants to produce an output Q. Then by imposing the lsoquant for Q on the
lsocost lines, we see that the minimum cost corresponds to the level of cost for which an isocost
line is tangent to the isoquant. This is shown below.

Figure 6.6: Equilibrium of the firm K

120
 B

A IS4

IS3

IS2

IS1

0 C1 C2 C3

Equilibrium is attained at point A-where the firm can produce output IS 2 a lowest cost of C2 (cost
minimization). Note that the same output 182:2 produced at a higher cost i.e. C 3 at point B or
point C which is not economical for the producer.

Alternatively a firm can have a given cost outlay. To maximize output superimpose the isocost
line on an isoquant map. This is output maximization given the cost level. Find point of tangency
between the isocost and isoquant

121
 B

IS3

IS2

IS1

0 C0

Equilibrium is attained at Point B, where the firm can produce output IS2. Expansion Path
Expand Path

In the figure 6.6, we considered the optimal input combination and minimum cost for producing
an output Q. i.e. a point of tangency between an isocost and isoquant line. We can do this for
various levels of output. Then the points of tangency give us the minimum cost and the optimal
input usage for successive levels of output. The line joining these points of tangency is called
long-run expansion path.

Equilibrium is attained at point B, where the firm can produce output 1S2.

122
Figure 6.7: The Long run and Short run Expansion Path

The long run expansion path

B IS3

A IS2

Short run expansion path

IS1

N C1 C2 C3 Labour input
In the case of LR expansion path, we assume that there is enough time to adjust the quantities of
all inputs to the optimal levels for the given outputs

In the short run, we may treat capital as fixed. In this case only the labor input can be changed. If
the producer expands output from the level IS1 assuming the capital input is fixed at K1, the SR
expansion path will be just a straight line with capital input equal to K1 i.e. incur more labor cost
to increase output.

Returns to Scale

How does output respond to increase in all inputs together? For example, suppose that all inputs
were doubled: would output double or would the relationship not be quite so simple? This is a
question of the returns to scale. Two forces come into operation when inputs are doubled. First, a
doubling of scale permits a greater division of labor and specialization of function. Hence there
is some presumption that efficiency might increase, production might be more than double.
Second, doubling of the inputs also entails some less in efficiency because managerial
overseeing may become difficult given the larger scale of the firm. Which of these two
tendencies will have a greater effect is an important empirical question.

123
If the production function is given by q=f(k,L) and all inputs are multiplied by the same positive
constant, m (where m>1), we classify the returns to scale of the production function by.

1. f (mk,ml)=mf(k,l)= mq, implies constant returns to scale. in other words if proportionate

increase in outputs increase output by the same proportion, the production function
exhibits constant returns to scale.
2. f(mk,mL) < mf(k,I)= mq Decreasing returns to scale. If output increases less than
proportionately, the function exhibits diminishing returns to scale.
3. f(mk,ml»mf(k,l) := mq Increasing returns to scale. That is, if output increases more than
proportionately, there are increasing returns to scale

The production Possibility Curve (Fronter)

Also known as the production boundary, or production transformation curve. The production
possibility frontier shows those alternative combinations of two outputs that can be produced by
a firm or country, with fixed quantities of inputs if those inputs are employed efficiently, and
with a given technology.

Let’s assume that the producer wants to spend his resources in the production of two products,
namely guns and apples. The society's resources are limited and hence there are restrictions on
the amount of guns and apples that can be made as shown by the production possibility curve.

Figure 6.8: Production Possibility Curve

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 G1

G2 a

PPC
AG
AGA

G3 h

AA n

G4 C o

0 A2 A3 A4 A1 Quantity of apples

The curve from G1A1 shows the various combinations of guns and apples that a society can
make, if it used its limited resources efficiently (Le. there is full employment).

Point C1 shows a combination which is attainable but inefficient in the sense that if the society
were to make G4 of guns and A2 apples, it would be under utilizing its resources. The same
applies for all points under the curve G 1-A1. Point 0 shows a combination which is unattainable
because the resources available are not enough or will be over utilized.

All points along the curve are efficient and attainable. The production possibility curve is
negatively sloped and can concave to the origin, because in a fully employed economy more of
one good can be produced only if resources are freed by producing less of another goods. For
example, moving from point a to point b, implies producing an additional amount of apples
indicated by A at an opportunity cost of a reduction in guns indicated by amount G; there is
always a trade -off. This opportunity cost increases as you move downwards along the curve.

When the availability of resources increases, or there is a development in technology, the

production possibility curve may shift. Increases are made possible by developments such as a
bigger labor force, more efficient methods of working, more efficient machinery or a new
discover! of natural resources such as oil, natural gas or minerals. Conversely, the curve can shift
inwards if resources are depleted/exhausted, decrease in labour force, inefficient or obsolete
technology, etc.

Figure 6.9: Shifting of Production Possibility Curve

125
 G2

G1

PPC1 PPC2

0 A1 A2 Apples
G2A2 represent greater production possibilities than curve G 1A1, If a society's PPC shifts out from
G1A1 to G2A2 there is economic growth. Suppose that the prices of products, guns and apples are
PG and PA respectively. Then the producers total revenue will be; R=GP G + APA where G and A
are the quantities produced of guns and apples. We can plot isorevenue line for different values
of R as shown below.
Figure 6:10 Isovenue Line

Guns G3

G2

G1 = R1
PG

0 A1 =R1 A2 A3
PA

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To get Revenue of R1 if the producer is producing Guns only, the required output will be
G1=R1/PG. The producer can produce other combinations in between. Likewise, to get the
revenue R1 if the producer is producing apples

only, the required output will be Al = R1 same applies for A2, A3 and G2, G3
PA
Superimposing the lscrevenue lines on the production transformation curve we get the outputs of
G and A that give the highest revenue. These output are given as go and a0;

Figure 6. 11: Optima! Production and Revenue Maximization

G3

PPC

G2

R3

G1 R2 A- Point of maximum revenue

Go A

R1

0 A1 a0 A2 A3 Apples
R3 cannot be attained, while R 1 can be improved upon. The maximum revenue is R 2. The
isorevenue line corresponding to R2 is tangent to the product transformation curve at the point A.
The output combination at A gives the maximum revenue.

? Revision Questions
1. Define production.

2. Distinguish between short-run and long-run periods.

3. With the aid of diagram, explain the relationship between the marginal product and the
average product of a typical firm as it increases output.

4. Explain the law of diminishing returns. What is the importance of this law in the production
decisions of a firm.

5. Define total, average and marginal product. Discuss the relationship between average and
marginal product.

127
6. Outline the operation of the law of diminishing returns showing its importance to the cost
curves of a firm.

7. Define isoquant and explain the principles underlying its shape.

8. Using diagram, differentiate between long-run and short-run expansion path.

9. Define production possibility curve and using diagram show how a firm maximizes its
revenue.

10. Define marginal rate of substitution and explain its importance in the production of a firm.

Costs of Production Introduction.

The cost of a certain course of action is the value of the best alternative course of action that
could have been pursued instead. This is the doctrine of opportunity or alternative cost.
Opportunity cost is defined as the value of a resource in its best use. Suppose Mr Kamau quits
his job which he used to be paid Ksh. 10,000 per month and opens a private business. Although
the accounting cost of Mr Kamau's labor to his business is zero, the opportunity cost is ksh.
10,000 per month, the earnings he foregoes by working for his own firm. If Mr Kamau cannot
cover this cost then he will probably return to his old job. Opportunity cost (economic cost) is the
most relevant to economic decisions.

Explicit and Implicit Costs

Explicit costs are the 'visible' or direct costs of a firm e.g. payments for rent, electricity, wages
etc. Explicit costs are usually in many forms and are the ones recorded in books of accounts.

Implicit costs are the costs of self-owned or self-employed resources. These are not in money
form as such and may not be found in accounts book of a firm. Examples include, opportunity
costs, environmental disruption etc To economists, the costs of a firm include both explicit and
implicit costs, or committed costs, or non committed costs.

Cost Concepts

1. Total cost (TC) means the total cost of producing any given level of output. Total cost is
divided into two parts, total fixed costs (TFC) and total variable costs (TVC). Fixed costs
- are those costs that do not vary with output, they will be the same if output is 1 unit or 1
million units. These costs are referred to as overhead costs or unavoidable costs.

All costs that vary directly with output, rising as more is produced and falling as less is
produced are called variable costs. Variable costs are often referred as direct cost or
avoidable costs, or non committed cost.

128
2. Average total Costs (ATC) also called Average Costs (AC) is the total cost of producing any
given output divided by the output. ATC may be divided into Average Fixed Costs (AFC) and
Average variable costs (AVC)

Although average variable costs may rise or fall as production is increased, it is clear that
average fixed cost decline continuously as output increases. A doubling of output always
leads to halving of fixed costs per unit of output, but they never fall to zero.

3. Marginal cost (MC), sometimes called incremental cost, is the increase in total cost resulting
from raising the rate of production by one unit. Because fixed costs do not vary with output,
marginal fixed costs are always zero. Therefore marginal costs are necessarily marginal
variable costs and a change in fixed costs will leave marginal costs unaffected.

MC=TVC This is because the fixed cost doesn't vary.

Q
Table 6.2: Hypothetical Total Cost (TC), Marginal Cost (MC) and Average Cost (AC).

Unit of Total Total Total Marginal Average Average Average

Output fixed Variable Cost (TC) Cost Fixed Variable Total
(Q) Cost Cost (MC) Cost Cost Cost
(TFC) (TVC) (AFC) (AC) (ATC)
0 50 0 50 - - - -
1 50 50 100 50 50 50 100
2 50 90 14 40 25 45 70
3 50 120 170 30 16.7 40 56.7
4 50 140 190 20 12.5 30 40
5 50 150 200 10 10 30 40
6 50 156 206 6 8.3 26 34.3
7 50 175 225 19 7.2 25 32.1
8 50 208 258 33 6.3 26 32.3
9 50 270 320 62 5.6 30 35.6
10 50 350 400 80 5.0 35 40

Looking at the values MC above, we see that it is first decreasing and then increasing. The
Average total cost values, it is initially decreasing and later increasing.

Relationships between the total cost curve, total variable cost curve and total fixed cost curve is
shown below. Also the relationship between various Average and marginal curves is shown.

129
Figure 6:11 (a) TC,TVC curves Figure 6.11 (b) MC, ATC, AVC

And AFC curve

In figure 6.11 (a) Total fixed cost does not vary with output. Total variable cost and the total of
all costs (TC::::TVC+ TFC) rise with output, first at a decreasing rate then at a increasing rate.

Notice that since total fixed costs are constant, the TFC curve is simply a horizontal line at 50.
And because total cost is the sum of total variable costs and total fixed cost, the Te curve has the
same shape as the TVC but lies above it by a vertical distance of 50.

In figure 6.11 (b) we observe the following relationships:

1. If MC<ATC, then ATC is falling, if MC>ATC, then ATC is rising.

2. If MC<AVC, then AVC is falling, if MC>AVC, then AVC is raising.

This implies that MC must intersect ATC at its minimum point and that the MC must also
intersect AVC at its minimum point. Note also that ATC will reach its minimum at an output Q 2
larger than that at which AVC reaches its minimum Q 1. This is because ATC=AVC+AFC, And
even though AVe has began to rise, AFC is still declining, pulling ATC down, Eventually, the
increase in AVC will off set the decrease in ,A,FC and ATC, too, will begin to increase.

Cost curves in the Long run

In the long run all factors are variable, thus, the producer has an opportunity of minimizing the
costs of the chosen output with respect to all factors. The Long Average Cost (LRAC) curve is
determined by the technology of the industry (which is fixed) and by the price of the factors of
production,

130
The LRAC curve falls at first and then rises. This curve is often described as U- shaped, although
'saucer shaped' is more accurate.

The shape of LRAC curve can be explained below.

Decrease Costs

Over the range of output from zero to am, (in the figure below) the firm has falling long-run
average costs. An expansion of outputs results in a reduction of LRACs, since the prices of
factors are assumed to be constant, the reason for the decline in LRAC must be that output
increases faster than inputs as the scale of the firms production expands. Over this range of
output the firm is often said to enjoy long run increasing returns.

Increasing returns may arise due to external and internal economies of scale. Internal economics
are those obtained by one particular firm. These may be administrative, financial, marketing or
technical. They may also result from specialization and division of labor. External economies are
those economies which are obtained by all firms in any particular industry or location these
include government policy, research and development facilities and communication facilities and
availability of other factors.

Figure 6. 12: Long Run Average Cost Curve

Cost per unit

LRAC

0 Qm Output

Increasing costs

Over the range of outputs greater than Qm the firm encounters rising costs An expansion in
production, even after sufficient time has elapsed for a[ adjustments to be made will be
accomplished by a rise in average costs per unit of output. Such a firm is said to suffer LR
decreasing returns. Decreasing returns imply that the firm suffers diseconomies of scale. As its
scale 0: operations increases, diseconomies are encountered that increase its per unit costs of

131
production. Diseconomies of scale include overproduction, labor relations problems, managerial
problems, congestion, or over crowding, etc.

Constant returns

The firm's LRAC curve might have a flat portion over a range of output around Om. With such a
flat portion, the firm would be encountering constant costs over the relevant range of output.
This would mean that the firms average cost per unit of output do not change as its output
changes. Since factor prices are assumed to be fixed, this must mean that the firm's output is
increasing exactly as fast as its inputs are increasing. Such a firm is said to be encountering
constant returns.

The long run and short-run average cost curves have the same U-shape. But it is important to
remember that the reasons they have this U-shape are different. The assumption of initially
increasing and then eventually diminishing marginal productivity accounts for the shape of the
short-run average cost curve. Economies and diseconomies of scale account for the shape of the
long-run average cost curve.

Relationship between Long-run and Short-run cost curves

In the long run all factors are assumed to be variable. The LRAC curve IS a planning curve, in
the sense that it is a guide to the entrepreneur in his decision to plan the future expansion of his
output. The long run average cost curve is derived from the short run cost curves. Each point on
the LRAC curves corresponds to a point on the SRAC curve, which is tangent to the LRAC at
that point. This is how the LRAC curve is derived from the SRAC curves.

Assume that the available technology of the firm at a particular point of time includes three
methods of production, each with a different plant size; a small plant, medium plant and large
plant. The small plant operates with costs denoted by the curve SAC11 the medium-size plant
operates with the costs on SAC2 and the large size plant SAC3, in the figure below.
Cost per unit

Figure 6.13: Short Run Average Cost curves SRAC2

C1 SRAC1 SRAC3

C2

C1

C3

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 0 X11 X1 X2 X21 X3
Outputs

If the firm plans to produce output X 1 it will choose the small plant. If it plans to produce X 2, it
will choose the medium plant. If it wishes to produce X 3, it will choose the large-size plant. If the
firm starts with the small plant and its demand gradually increases, it will produce at lower costs
(up to level X,) beyond that point cost start increasing. If its demand reaches the level X 1) the
firm can either continue to produce with the small plant or it can install the medium size plant.
The decision at this point depends not on costs but on the firm's expectations about its future
demand. If the firm expects that the demand will expand further than X 1 it will install the
medium plant, because with this plant outputs larger than X 1, are produced with a lower cost.
Similar considerations hold for the decision of the firm when it reaches the level X 2, If it expects
its demand to stay constant at this level, the firm will not install the larger plant, given that it
involves a larger investment which is profitable only if demand expands beyond X 2, For
example, the level of output X3, is produced at a cost C2, with the large plant, while it costs C, if
produced with the medium size plant (C 2>C3). Points a, band c are minimum point for each plant
size. If you join them you get a simple sketch of LRAC curve.

Now, lets assume that there are many plant sizes, each suitable for a certain level of output. so
that the points of intersection of consecutive plants are more numerous. In the limit, if we assume
that there is a very large number (infinite number) of plants, we obtain a continuous curve, which
is the LRAC curve of the firm. Each points of this curve shows the minimum (optimal] costs for
producing corresponding level of output.

Figure 6. 14: Long-run and Short-run Curies SRAC8

Cost per unit

SRAC7

SRAC1 SRAC6

SRAC2 SRAC5

SRAC3 SRAC4

0 Qm Output

133
The LRAC curve is the locus of points denoting the least cost of producing the corresponding
output. It is a planning curve because on the basis of this curve the firm decides what plant to set
up in order to produce optimally (at minimum cost) the expected leve! of output. The LRAC
curve is U-shaped and it is often called the "envelope curve" because it 'envelopes' the SRAC
curves as shown in the figure above.

? Revision. Questions

1. Distinguish between the following: fixed costs, variable costs, social costs and opportunity
costs.
2. Distinguish between the views of costs held by an accountant and an economist.

3. In what ways are marginal cost and average cost important to the firm

4. Outline the relationship between short-run and long- run costs.

5. Explain with the help of diagrams the difference between increasing, decreasing and constant
costs of production.

6. Using diagram, explain why the long run cost curve is U-shaped.

7. Differentiate between 'decreasing returns' and increasing returns' to scale.

8. Differentiate between internal and external economies to scale.

134
 CHAPTER SEVEN
MARKET STRUCTURE

At the end of the chapter, you should be able to:-

1. Understanding the concept of, firm, industry, and kindled demand curve.
2. Comprehend various market structures; perfect competition, monopoly,
monopolistic competition, oligopology and duopology;
3. Understand different cost curves and revenue facing diffident market
structures;
4. Explain how the equilibrium of firm is determined in a perfectly competitive
market, monopolistic and oligopolistic market; and
5. Understand the concept, misallocation of resources and how it applies to
different market structures

In ordinary' sense, market means a geographical place where people come together to make buy
and sell goods. However, in economics the term market refers to the institutional arrangements in
which buyers and sellers interact for the purpose of buying and selling goods and services.

A market is said to exist when buyers and sellers of both goods and services are in contact.
Buyers and sellers can be in contact by meeting in one place, through telephone, with the help of
print and electronic media or through agents. Hence a market is not necessarily a geographical
place. It can be any situation or set of circumstances in which buying and selling takes place.

The following are features of a market.

1 Existence of buyers

2. Existence of sellers

135
3. Goods or services to be bought or sold

4. A medium of exchange

5. Interaction between buyers and sellers for the purpose of buying and selling.

Markets can be described according to the area they cover. Thus, we can refer to a local market,
a home market, a foreign market or world market. A market can also be described according to
the commodity or item to be sold or bought, for example, coffee market, money market, fish
market, foreign exchange markets, stock markets, etc. Markets can be open-air or indoor. They
can be free or controlled depending on whether the state intervenes in it or not.

We will consider a few models of market structures. 8'1 market structure we mean how markets
are organized e.g. in allocation of resources, production, distribution, pricing, etc, decisions.

1. Perfect competition

2. Monopoly

3. Monopolistic Competition

4, OIigopoly

The Profit Maximization Rule

We assume that the goal of a firm is profit maximization. The profit maximizing firm chooses
both its inputs and its outputs with the sole goal of achieving maximum economic profits. That is
the firm seeks to make the difference between its total revenues and its total economic costs as
large as possible.

n = TR-TC
Where n = profits
TR= Total Revenue = P. Q (price per unit times quantity).
TC= Total cost

The firm is in equilibrium when it produces the output that maximizes the difference between
total receipts and total cost. The equilibrium of the firm may be shown graphically in two ways.
Either by using the TR and TC curves or the MR and MC curves.

136
Table 7.1: Revenues of a Firm

Q P TR(P.Q) AR=TR/Q MR = TR/Q

0 20 - - -
1 20 20 20 20
2 20 4 20 20
3 20 60 20 2
4 20 80 20 20
5 20 100 20 20
6 20 120 20 20
7 20 140 20 20
8 20 160 20 20
9 20 180 20 20
10 20 200 20 20
The figure below shows the relationships between Te and TR curves of a firm.

Figure 7.1: Profit Maximization using TC & TR curves

Cost Revenue

Losses

Profit is maximum

Losses

0 q1 qm q2 Output

The TR curve is a straight line that passes through the origin. TR is shown to increase as sales
increase. The slope of TR is the marginal revenue (MR). The shape of Te is almost S shaped.

137
The firm maximizes its profit at the output qm, where the distance between the TR and Te curve
is the greatest. At lower and higher levels of output (below or above qm) total profit is not
maximized, whereas at levels smaller than q1 and larger than q2 the firm incurs losses.

The second method uses the MC and MR functions of the firm. MR is defined as the revenue
obtained from selling one more unit of output and is relevant to the profit -maximizing firm's
output decision. We assume that the goal of the firm is profit maximization. This assumption
generally implies that output will be expanded to the point where MR= MC. This is illustrated in
fig.7.2 below. First in case (a) with an increasing MC then in (b) with a decreasing MC.

Figure 7. 2: Profit Maximization using MC and MR curves

MC MC MC

MR MR

MC

MR MR

0 Xx Output 0 Xx
Output

(a) Increasing marginal cost (b) Decreasing marginal cost

The profit maximizing output occurs at X*. If we consider an output level less than X* the MR is
greater than MC (MR>MC). This means that if the firm expands output, it will add more to its
revenues than to its costs, thus increasing profit. But once the firm reaches X* it has no further
incentive to increase output. This is because beyond X* the MR is less than MC (MR<MC).
Thus, by increasing output past X* the firm will add more to its costs than to its revenues, thus
reducing profit. Hence, the profit-maximizing output occurs at X* where MR=MC. This profit
maximizing output is also called the equilibrium output.

Additionally, in order to have a determinate level of profit-maximizing output, we must also

have the MR curve steeper than the MC curve as shown in (b). The opposite case is illustrated in
fig.7.3 below where the condition MC=MR does not give the profit maximizing output. In this
case, the firm can increase profit by increasing output beyond X*, since MR>MC for levels of
output beyond X*. Unless MC rises above MR the profit of the firm will keep on increasing as
output increases.

138
Figure 7.3: A case where profit is not maximized at the point MC=MR

MC

MR

MR

MC

0 X* Output
If Me eventually does rise above MR, then the second point of intersection of these two curves
gives the profit-maximizing (equilibrium) output. This is shown below.
Figure 7. 4: Profit Maximizing Output

MC MC

MR

MR

0 X1 X2 Output

139
In both X1 and X2 we have MR=MC, but it is at output X2 (not X1) that the firm is at
equilibrium.

Summarizing therefore, a firm maximizes profits (at equilibrium) at an output where,

1. Marginal cost is equal to marginal revenue (MC=MR), and

2.The marginal cost curve must cut the marginal Revenue curve from below i.e. the slope of MC
is greater than the Slope of the MR, and must be rising.

These two basic conditions for equilibrium of a firm must be satisfied in the market according to
economic theory. However, the nature of the revenue curves may vary from one market to
another.

Perfect Competition.

The first market structure that we will consider is the perfectly competitive market. The
following basic requirements have to be met under perfect competition (assumption or
characteristics of perfect competition).

1.The industry referred to consist of number of buyers and sellers. Each firm produces only a
very small part of the total output. This means that it is not possible for the actions by one
firm to influence the price of the product. Similarly no single consumer can affect the market.

2. The product dealt with in the market is homogeneous. In the eyes of the consumer, the
product of one seller is identical to that of another seller This ensures that buyers are
indifferent as to the firm from which they purchase. If a firm could differentiate its product
from that of others, it would have at least a partial control over price.

3. The industry is characterized by freedom of entry and exit. Any new firm is free to set up
production if it so wishes, and any existing firm can stop production and leave the industry if
it so wishes.

4. There is free mobility of resources. All factors of production are perfectly mobile from one
industry to another. This implies that a given resource/factor can be transferred from
employment in the production of one product to another. For instance, labor is mobile
geographically and among jobs (occupationally).

5. The participants in the market have perfect knowledge concerning the market. This means
that consumers and producers have complete knowledge about the quality, quantities, prices
and costs of the product in the market.

6. No government intervention or regulations in the market. This means there is no taxation,

subsidies, etc.

140
 7. All firms aim at profit maximization as the main goal.

From the above assumptions, it is clear that an individual firm cannot determine the price at
which it will sell its output. It must accept the prevailing market price. Firms in this case are
price takers for they cannot fix their prices. In the pursuit of profit-maximization they must
therefore take whatever price the market determines. They are however free to determine their
level of output. No market, in actual practice, satisfies all these conditions, it’s unrealistic; but
the usefulness of any theoretical model lies in the predictions it can generate. And the accuracy
of such predictions depends in part on whether there are empirical examples that come close to
the theoretical model. For example stock markets, foreign exchange markets, markets for same
agricultural products e.g. tomatoes etc, come close to this type.

Short-Run Equilibrium

By short-run we mean a length of time during which,

1. No new firms enter the industry

2. No existing firms exit the industry

3. The individual firms cannot make any adjustment to fixed inputs.

The price and output in a competitive market in the short run are determined by the short run
supply and demand curves for the industry.

Fig. 7. 5 The Determination of Market Equilibrium

Market Equilirium

Price Market supply curve

Pe

Market demand curve

Oe Quantity
The market equilibrium is determined by the market supply and demand forces. In the above
diagram, this equilibrium results in an equilibrium price, Qe and equilibrium quantity Qe for the
whole market. Since, the essential feature in a competitive industry is the existence of a large
number of firms selling the same homogeneous product. In this case a competitive firm is a price
taker. it takes the market price as given and can sell any amount it wants to at that price. The firm

141
can sell nothing above that price and has no reason to sell below it (if it sells at a lower price its
objective will no longer be of maximizing profit). Thus the demand curve that a competitive firm
faces in relation to its output is depicted as a horizontal line as shown in fig.7.6 below.

Figure 7. 6: The Demand Curve a firm faces in a competitive market

P0 D

0 Output

Equilibrium of a Competitive Firm

Since the competitive firm is a price taker, it will compute its revenues taking price as given or
constant. Since price is constant, MR and AR are constant and equal to price. Thus, the
equilibrium of the firm in order to maximize profit will be determined at a quantity where;

AR=P=MR=MC

Note that a firm under perfect competition faces the usual market costs. The equilibrium output
is shown below.

Figure 7.7: Equilibrium of a Competitive Firm

Price per unit

MC AVC

MR=AR=D

142
 0 qe Output
Note that the firm does not necessarily produce an output corresponding to the point where the
average variable cost (AVC) is at minimum. The optimal level of output is q, where P=MC =
MR. It is not necessarily true that the firm makes a profit at this level of output. Since AR>AVC,
the revenues of the firm will more than cover the variable costs. Whether they cover total costs
depends on what the fixed costs are, In the SR the firm must pay the fixed costs even if it
chooses not to produce, but in the long run, the fixed inputs and, hence the fixed costs can be
eliminated if the firm exits the industry.
The Supply curve of the Firm and Industry

The figure below shows how much output the competitive firm produces at a given price. By
varying the price, we get different levels of output, and thus derive the short run supply curve of
a competitive firm.

Figure 7. 8 (a) and (b): The Short-run Supply Curve of a competitive firm

MC AVC

Price
S

P2 P2

P1 P1

P0 P0

0 Q0 Q1 Q2 Quantity 0 Q0 Q1 Q2
Quantity

The minimum output the firm will produce is Qo where price Po is equal to the minimum point
on the AVC curve. For any price below Po the firm's revenues do not even cover variable costs
and it does not pay for the firm to produce any output.

143
In figure (a), we plot the MC and AVC curves. For different levels of the price, we get different
quantities supplied by equating price to MG. In (b) we plot these prices and quantities to get the
supply curve.

Tile supply curve obtained is a firm's short run supply curve because we have assumed that the
minimum price Po is equal to the minimum AVC. That is, we have assumed that the revenues of
the firm must cover variable costs. In the long run, unless the revenues cover fixed costs as well,
the firm cannot stay in production. Thus in the short run, the firms supply curve is the same as its
Me curve above the minimum point of AVC; and in the long run, supply curve is same as Me
curve above the minimum point at ATC.

In deriving the SR-industry supply curve we sum up the horizontal output of all the individual
firms in the industry.

Short-Run Profitability of the Firm

The fact that a firm is in SR equilibrium does not necessarily mean that it makes excess
(super/abnormal) profit. Whether the firm makes super profit or losses depends on the level of
the ATC at the short-run equilibrium. If the ATC is below the price at equilibrium, the firm earns
excess profits (supernormal profits), If, however, the ATC is above the price the firm makes a
loss. In this case, the firm will continue to produce only if it covers its variable costs. Otherwise
it will close down. The point at which the firm is just able to cover its variable costs is called the
closing - down point. If the ATC: Price, the firm makes normal profits which covers for the
reward towards entrepreneurial input.

Figure 7.9: (a) A firm making losses Figure 7.8(b)

(a) SMC SATC (b)

SMC

a SAV
SRA

P2 P1 E

P1 E MR MR=A

0 q1 Output 0 q1
Output

144
Figure 7.9 © A firm making normal profit s
© SMC

SRAC

P4 MR=AR

P5

0 q3 Output

In each part of the diagram, E is the point at which MC=MR=P. Since in all three cases prices
exceed AVC, the firm is in short run equilibrium.

In: (a) The firm is making losses equal to P 1 P2 aE. P1 Note that point W is the closing down
point.

(b) The firm is making normal profit. Note MC= MR=P=AC.

(c) The firm is making supernormal profits equal to P4 Eb P5. Normal profits (zero economic
profit) are those profits which are just sufficient to induce entrepreneur to stay in the
industry, where they can cover both explicit and implicit costs.

Long Run Equilibrium

The key to long run equilibrium under perfect competition is free entry and exit.When firms are
in SR equilibrium, they may be making profits or losses or breaking even. Since costs include the
opportunity cost of capital, the firms that are just breaking even are doing as well as they could if
they invested their capital elsewhere. Thus there will be an incentive for new firms to enter the
industry, for capital can earn the same return elsewhere in the economy.

If, however, existing firms are earning profits in excess of the opportunity cost of capital (firms)
will enter the industry to share in these profits. If existing firms are making losses, capital (firms)
will leave the industry because a better return can be obtained elsewhere in the economy.

Therefore Long Run equilibrium in a competitive industry requires that all incentives for entry or
exit be eliminated. This means that price must equal minimum LRAC for a typical firm. The

145
typical firm must also be in equilibrium so that it has no incentive to adjust either output or plant
size. This requires that

P=LRMC and SRAC =LRAC

P=LRMC=LRAC=SRAC=SRMC

This is shown in the below figure:

Figure 7.10: Long-run equilibrium of a competitive firm

SRMC LRMC LRAC

SRAC

Price = MR=AR

0 qm Output

Some Advantages of Perfect Competitive Market

There is efficient allocation of resources which includes an in-built ability to adjust to market
changes in an environment that preserve and encourage producer freedom and consumer
sovereignty,

The goods and services produced in a competitive system are dictated by market demand in
relation to production costs, Supply and demand determines the equilibrium price for goods and
resources.

Free entry and exit assures society of the elimination of any abnormal profit in the long-run.

Limitations of the Model

Perfect competitive market system constraints technology and economies of scale since it may
not entail the use of most efficient production technique, since in the long-run, firms earn normal
profit, then inventions requiring heavy research and development expenditures or large capital
outlay could be retarded.

146
Perfect Market Competition also limits consumer choice because of standardized products with
no varieties.

? Revision Question

1. What do you understand by the term 'perfect competition'? Of what use is this concept in
economies?
2. Show how the perfectly competitive firm maximizes profits?
3. "Firms in perfectly competitive industry are price takers." Discuss this statement.
4. What are the main assumptions of a perfect competition market model?
5. Why is the demand curve, Average revenue and marginal revenue curves straight lines
(i.e. why P=AR=MR)?
6. Examine the relationship between total revenue, average revenue and marginal revenue
under conditions of perfect competition.
7. Firms in perfectly competitive market can earn supernormal profits, normal profit or
losses. Using diagrams show how this happens.
8. Under what circumstances will it be necessary for a firm to leave the perfectly
competitive industry?
9. "Firms in perfectly competitive market earn normal profits in long run" Discuss this
statement.
10. Show with the aid of diagrams how a perfectly competitive firm will react to (a) an
increase in price, and (b) a decrease in price.
11. What is meant by the term equilibrium? When will (a) the perfectly competitive firm (b)
the perfectly competitive industry, be at equilibrium?
12. Explain the main advantages and disadvantages of perfectly competitive market over any
other market structure.

Monopoly.

The word 'monopoly' comes from the Greek words 'monos polein', which means "alone to sell".
This is interpreted to mean a single (only) seller in the market. A sale supplier or seller of a
product or service in a market is called a monopolist.

Monopolists are called price setters because they determine the market price and supply the
entire quantity demanded. The market supply curve is actually the monopolist's individual supply
curve whereas the market demand curve is the demand curve facing the monopolist. Hence the
market model in the case of a monopolist is also the firm's model. This implies that the
equilibrium of the monopolist firm is synonymous to the market equilibrium. For a monopolist to
have effective control over the pricing of a product, the monopolist product should have no close
substitutes. Otherwise, if the monopolist raises the product's price, consumers can switch to other
products.

147
A monopoly can persist in the industry as long as there are barriers to entry. A monopolist need
not always make a super profit. Monopoly does not imply an existence of a single producer,
because monopolist need not produce their own product. There can be many producers in the
industry supplying the product to a monopolist. The essence of monopoly is that there is a single
seller (or a group of sellers) that sets the price. The number of producers is not relevant. An
example is the OPEC (Organization of Petroleum Exporting Countries), which consists of eleven
major producers that collectively set the prices of oil.

Monopolists Demand and Revenue Curves

Unlike the firm in perfect competition, a monopolist faces a downward-sloping demand curve.
The monopoly firm knows that it faces a trade-off between price and quantity; sales can be
increased only if price is reduced, while price can be increased if sales are reduced. Thus he can
not set both the price and the quantity to sell simultaneously.

Given a market demand curve, the monopolist's average revenue and marginal revenue curves
can be readily derived. Since the market demand curve represents the quantities of a commodity
all buyers are able and willing to purchase in the market at given prices and time period, it is
identical to the average revenue curve. Hence, the market demand curve is also the average
revenue curve for the monopolist. If then, the market's average revenue curve is downward
sloping to the right the marginal revenue curve will also be sloping downward and will lie below
the average revenue curve. This is shown in the fig.7.11 below.

Figure 7. 11: Marginal Revenue and Demand Curve for a monopoly

D=AR

MR Output

MR curve does not equal price. The demand curve is the AR curve while the MR curve is below
and steeper than the AR curve because it is derived from the demand curve which slopes
downward. The MR curve is twice as steeper as the D-curve and cuts the x-axis mid-point.

Note that monopolist cost curves are the same in shape as in the perfect competition market.
However, the specific shape of the cost curves does not make any difference in the way the

148
equilibrium of the firm is determined, provided that the slope of the MC is greater than the slope
of the MR curve.

Monopolist’s Equilibrium

To describe the profit maximizing position of a monopolist, we bring together information about
the monopolist's revenues and its costs. Since the monopoly firm faces a downward-sloping
demand curve, its actions influence price. A monopolist produces at an output where P is greater
that MC unlike a competitive firm which produces at an output where P= MC.

A profit maximizing monopoly is at equilibrium where MC= MR and slope of MC is greater

than the slope of MR.

Figure 7. 12: Equilibrium of a Monopoly

MC

Pe

E (DD=) AR

MR

0 Qe Output

The Monopolists Profits

The profit maximizing monopolist produces at an output where MR= MC and profits may exist,
and indeed they may persist for a longtime because as long as the firm retains its monopoly.
Since there is no entry of new firms price cannot fall to the level of average total cost. However
nothing guarantees that a monopolist will always make profit, the firm can break even or suffer
losses depending on the nature of cost curves.

149
Figure 7. 13 (i) Monopolist Supernormal Profit

MC ATC
A

Pe a Pe

AR

p D=AR E

MR MR

0 qe Output 0 qe Output

(i)Super normal profits (ii) Normal profits

(i)

MC

a ATC

P1

P0

MR

0 qe Output
Profit maximizing output is Qe where MR=MC, price is above that point. Rules for profit
maximization require MR=MC and slope of MC be greater slope of MR. But, the actual
existence of profits depends on the position of the ATC curve, To have super profits it is required
further that the price be greater than the ATC. If price is less than ATC, the firm will end up with

150
loses instead of profits even when MC=MR. In figure (i) where average total cost is ATC1
profits are realized as represented by the shaded region. In case (ii) where average total cost is A
TC2, profits are zero. If average total cost is as shown in figure (iii), the monopolist would suffer
loss which is represented by the shaded area,

Equilibrium of the Firm Industry

a monopolist is the only producer in an industry, there is no need for separate theories of the firm
and the market (or industry) as is necessary with perfect competition. The monopolist is the
industry, Thus the profit maximizing position of the firm is also the equilibrium position of the
market or industry.

Circumstances that create and sustain Monopoly

Barriers to entry serve as a major factor that creates monopoly. These form of various
impediments to the entry of new firms into an industry and include the following.

1. Control over strategic (key) resources or raw materials needed for the production of the
commodity.
2. Patents over inventions. Patents are exclusive rights to the production of an innovated
product. Patents we granted because they encourage inventions. Without patents many
firms (and individuals) would have much incentive to invest money and resources on
research.
3. Large costs of establishing an efficient plant, especially in relation the market. This is a
case where the technology may be such as to exhibit substantial economies of scale, which
require only a single plant. Example, electric and telephone companies etc. it does not
make sense to have two electric or railway transport companies in same area.
4. Market franchises. The government by law gives exclusive rights to a firm to sell a certain
good or service in a certain area.
5. A monopoly may also be perpetuated by force or by threat. Potential competitors can be
intimidated by threats ranging from sabotage to a price war in which the established
monopoly has sufficient financial resources to ensure victory. They are market leaders and
large firms enjoying economic of scale in production and distribution.
6. A case where firms form cartels i.e. competing firms come together to form one big firm.

Monopoly and Resource Allocation.

The profit maximizing monopolist forces a scarcity of output on the society by producing where
MR=MC. The monopolist may earn a long run supernormal profit through charging a higher
than competitive price that exceeds marginal cost and producing less output than would be
produced under perfect competition. Moreover, the monopolist that maximizes profit or
minimizes loss is not likely to produce a quantity of output consistent with minimum ATC as a

151
competitive firm is forced to do. The inefficient resource allocation in monopoly is shown
diagrammatically below.

Figure 7. 14: Resource Allocation under Monopoly MC

ATC

Pm

E MR=AR

Pc

MR

0 Qm Qc Output

A perfect competitive firm will produce at Qc and sell at Pc. i.e. firms produce at the minimum
ATC, so that P (and MR)=MC=ATC minimum. Suppose the market becomes a monopoly, the
perfectly competitive industry demand curve becomes the demand curve for the one
monopolistic firm in the industry, Assuming ATC and MC remain unchanged, the monopolist
maximizes profit by charging a price Pm and producing Qm where MR=MC.

Note that the monopolist cannot simultaneously produce at minimum ATC and maximize profit
because MR and MC are equal at the lower level of output .: monopolist did produce Qc units of
output at minimum ATC, the economic profit thereof would disappear because price and unit
cost would be equal. Sc monopolist does not produce at efficient level where P=MC=ATC
minimum or normal profit.

Monopoly and Price Discrimination

Discriminating monopoly or price discrimination' occurs where a rnonopolist charges different

prices for different units of a commodity, even though these units are identical in their physical
characteristics. For price discrimination essential conditions must be met.

1. It must not be possible for the product to be easily transferred from customer in one
market to those in another. Reselling should not be possible.
2. Markets must be separated into distinct segments.
3. There price elasticities of demand in the two markets must be different.

152
Revision Questions

1. What do you understand, by the term 'monopoly'? In what ways may a firm obtain 'monopoly
power'?

2. Show how the monopolist will maximize his profits.

3. 'A monopolist is a price maker.' Discuss this statement?

4. Explain the situation under which a monopoly VI/iii make losses but continue to operate.

5. Why are the monopoly's demand and revenue curves downwards sloping?

6. "Monopoly is evil in the eyes of a consumer." Discuss,

7. Explain the main difference between monopoly and perfectly competitive firm?

8, Monopoly continues to earn supernormal profits even in the long-run.

Explain this statement.

9. What is price 'discrimination'? Under what condition can price discrimination take place?

Monopoly Competition

Monopoly and perfect competition are really two extremes and many industries fall in between.
There are very few pure monopolies, since there are very few commodities for which close
substitutes do not exist. Similarly, there are very few commodities that are entirely homogeneous
to make the assumption of perfect competition realistic.

The term "Monopolistic' refers to the small monopoly power that firms have by virtue of their
differentiated product. The term 'competition' implies that there is a large number of firms and
there is freedom of entry and exit so that firms cannot make above-normal profits in the long-
Run. Because of the monopolistic component, the demand curve facing each firm is downward
sloping. Each firm has some control over the price of its product

Monopolistic competition is said to exist when there are many firms, as in perfect competition,
but each firm produces a product that is slightly differentiated from that of others. Examples of
this are numerous, retail clothing stores, restaurant, barber shops, dry cleaners etc.

Monopolistic competition is based on the following assumptions.

1. There are a large number of sellers and buyers.

153
 2. The products of the sellers are differentiated and therefore heterogeneous, yet are close
substitutes of one another. Differentiation gives each firm some monopoly power while
the presence of close substitutes provides competition. There are many sources of
differentiation i.e. chemical! Composition, advertising, packaging, brand names, location,
design, after sales services, etc.
3. There is free entry, and freedom of exit from the market. When firms in an industry are
making a profit, new firms enter the industry with slightly differentiated products and
drive profits down. Thus, in the long-run, no firm is able to make an abnormal profit.
4. The goal of the firm is profit maximization, both in the short run and in the long run.
5. Prices of factors and technology are given and constant.
6. There is an independent behavior such that the economic impact of one firm's decision is
spread sufficiently evenly across the entire group so that the effect on any single
competitor goes unnoticed.

Equilibrium in Monopolistic Competition

Whereas demand is perfectly elastic for a perfectly competitive firm, successful differentiation of
a product tilts the demand curve in the direction of less elasticity It is however important to point
out that the demand curve for monopolistic competitive firm tends to be more elastic than the
demand curve for a monopoly.

Figure 7. 15: Equilibrium of a Monopolistic Competitive Firm

Price per

MC
unit

P0

MR D

Qm Output

Equilibrium is obtained at Qm output, and the price will be Po.

Output and Price under Monopolistic Competition

Like perfect and monopoly firms, the firm operating under monopolistic competition may earn a
supernormal profit or it may incur a loss in the short run, however in the long-run, firms in
monopolistic competition tend to earn a normal Profit. This is illustrated in the below figure.

154
Figure 7. 16: Monopolistic Firms Profits and Losses

MC 1 BAC

P1
AR1

a
Pe
AC1 E1 AR2

P2 F2 MR1

MR2

0 Qe Q1 Q*

In the short run, equilibrium price and quantity are determined at point E1 where MR1=MC and
Q1 units are produced. Super profits equivalent to P1- AC1 is made by the firm. In the long run,
price competition and entry into the industry by other firms will results in a shift of AR from AR
1 to AR2 which causes a corresponding shift in the MR from MR1 to MR2. A new equilibrium
will be established at point E2 with equilibrium quantity Qe and price Pe. Note that the
equilibrium price is equal to the (long-run) average cost.

If the firm is making losses in the short-run some of the existing firms will leave the industry
hence the demand curve of the remaining firms shift right ward until normal profit is attained. So
in the long-run the firm earns normal profits as indicated by demand curve AR2 where Qe output
is produced at price Pe.

Although in the long run firms earn normal profits, it is observed that there exists resources
misallocation in monopolistic competition. The equilibrium quantity produced by each firm is
not quantity at which cost is minimized i.e. the firms earns normal profit by producing Qe units
and not Q* (as shown by the arrow in the above diagram) where costs are minimum. In the
monopolistic competition, firms operate short of minimum LRAC a condition that suggests that

155
existing resources are underutilized by each firm. Their equil!brium price Pe tends to be higher
than those changed by perfect competitive firm and the quantity produced is also relatively less,
other things being equal.

Although misallocation of resources exists in a monopolistic competition there are certain

relative advantages. The product differentiation allows a wider array of consumer choice and
monopolistic competitive firm earns normal profits in the long-run unlike monopoly

Oligopoly

Oligopoly is a type of market structure where we find a few firms producing the total output of
the product. Duopoly is a case where two firms operate in the market and is a special case of
oligopoly. Under oligopoly, product-price manipulation is not common, but producers do
practice non-price competition such as advertising; but not price wars.

Interdependence is an integral part of the theory of oligopoly. In this case each firm in the
industry believes that its own actions will have important effect on the decisions and actions of
each other. Each firm's price and output decisions are therefore influenced by its views or
expectations about how other firms will react to its decisions.

There exists price rigidity in the oligopoly market which is explained by two fundamental
methods. One way is where firms establish a virtual monopoly by agreeing upon one common,
uniform price in the market through forming cartels or collusions (this is an illegal practice). In
the other method industries appear to develop price policies based upon "follow-the-Leader"
Philosophy - i.e. one dominant firm acts as the standard-bearer for the 1'"1C'_3:-, - - -:: -: a price
change.

Firms in oligopoly market face kinked demand curve which is illustrated below

156
Figure 7. 17: Equilibrium of an Oligopoly Firm

AR

MR MC

AC

AR=D

P1

B MR

0 Q1 Output
Once prices have been established in the market each firm believes its own demand curve is
kinked around the present price. At PI the firm will produce Q1. If it increases price its MR will
decline as it loses sales to other firms. If it lowers its price and the other follow, its MR curve
suddenly drops as shown by the vertical part of the MR curve A-B. Also firms disregard price
increases but follow price decreases by a competition. This follows from the change in the price
elasticity of demand for the firm's product, shown by the bend in curve. If the cost curves are Me
and AC, it wi!1 make supernormal profits (P1-C) 01. If there is any change in the firms cost
curves the price and output decisions wiil remain the same provided that the new Me cuts the
MR curves between points A and B, for this will still be the profit maximizing position.

This explanation of Oligopoly suggests that there will be stability in the relative prices of
different firms. Each of them believes it has little to gain from a price reduction or increase.
However, this does not necessarily mean that prices will remain at their present level. If costs
rise to all firms, each firm may conclude that others will increase prices since their costs (due to
increase in factors of production input prices) has also increased.

Although oligopoly firms do not engage in price competition does not mean they don't compete.
They use other forms of competition such as advertising and marketing campaigns to attract
customers.

157
Revision Questions

1. What do you understand by the term "monopolistic competition"?

2. What condition gives rise to 'Monopolistic Competition?'
3. Firms in Monopolistic Competition earn zero profits in the long-run
4. Explain this statement.
5. How is equilibrium output and price determined in monopolistic competition?
6. Product differentiation' is crucial in the model of monopolistic competition, explain
7. Firms under monopolistic competition although earn supernormal profits in the long run,
do not allocate resources efficiently, Explain this statement using diagrams,
8. What do you understand by the tem 'duopoly'?
9. Two main conditions are important in the model of duopoly, Explain
10. Duopolistic firms face kinked demand curve, explain how equilibrium is achieved,
11. Explain the main differences between monopoly and monopolistic competition.

158
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