Introduction to microeconomics - Mukonda F

INTRODUCTION
TO
MICROECONOMIC
S
MUKONDA FTN
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INTRODUCTION
O Economics is a study of how society
makes decisions, regarding the allocation
of scarce resources.
O Economics as a subject is divided into two
parts; Microeconomics &
Macroeconomics.
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Difference between
microeconomics and
macroeconomics
microeconomics macroeconomics
O Microeconomics
deals with
behavior and
decision making by
small units such as
individuals and
firms.
O Macroeconomics
deals with the
economy as a
whole and decision
making by large
units such as
governments.
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Needs and wants
needs wants
O Cannot do without
O They are for basic
survival
O anything other than
what people need
for basic survival
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Scarcity and shortage
scarcity shortage
O Scarcity always
exists because of
competing
alternative uses for
resources
O shortages are
temporary.
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Circular flow
of income,
O The interaction between the individual
decision makers.
O Households as resource owners supply
factors of production to firms, and earn an
income. In return households demand goods
and services produced by firms, and spend
their income.
O Firm in general demand and pay for factors of
production from households and in return,
supply goods and services at a price, to
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Normative and Positive
statement
Normative economics Positive economics
O Economic and
social value
judgments of what
society thinks
ought to happen in
an ideal scenario,
such as Zambia
winning the world
cup!
O objective
explanations of
what has happened
in the past, and
based on that, what
is likely to happen in
the future.
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Ceteris Paribus
O Economics is a social science subject; it
deals with human behaviour, which is
diverse. Therefore, it is difficult to come up
with blanket conclusions. The assumption,
ceteris paribus “all things remain
equal”, usually applies.
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the basic Economic problem
O Scarcity is the basic economic problem that requires
people to make choices about how to use limited
resources.
O As much as we would like to do and buy anything we want
at any time, this is not always possible because there are
not enough resources to produce all the things people
would like to have. Scarcity forces us to make choices
about what, how, and for whom we produce.
O Human wants are unlimited or insatiable. Maybe because
goods wear out and have to be replaced, or, new and
improved products become available on the market, or
people are just tired of what they own and want a change.
O Economic resources, which are required for the production
of goods and services to satisfy human wants, are
limited.
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Factors of production
O The factors of production are the
resources of land, labor, capital, and
entrepreneurship used to produce goods
and services
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groups of factors of
production
O Land - natural resources and surface
land and water
O Labour - human effort directed toward
producing goods and services.
O Capital - previously manufactured goods
used to make other goods and service
O entrepreneurship: when individuals take
risks to develop new products and start
new businesses in order to make profits
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productivity
O productivity: the amount of output
(goods and services) that results from a
given level of inputs (land, labor, capital,
and entrepreneurship)
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scarcity
O Scarcity means that people do not and
cannot have enough income and time to
satisfy their every want. What you buy as
a student is limited by the amount of
income you have. Even if everyone in the
world were rich, however, scarcity would
continue to exist, because even the
richest person in the world does not have
unlimited time.
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Importance of scarcity
O Scarce resources require choices about
uses of the factors of production.
O In other words scarcity forces people to make
choices about how they will use their
resources.
O For example, one day you may choose to
either go to work for a company or open your
own business. Such a decision would affect
many aspects of your life, including how much
you earn and how you manage your time.
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Trade off
O Economic decisions always involve
trade-offs that have costs.
O Because of scarcity, The economic
choices people make involve exchanging
one good or service for another. If you
choose to buy an iPod, you are
exchanging your income for the right to
own the iPod.
O Exchanging one thing for another is called
a trade-off.
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The Cost of Trade-Offs
O The cost of a trade-off is what you give up
in order to get or do something else. Time,
for example, is a scarce resource—there
are only so many hours in a day—so you
must choose how to use it. When you
decide to study economics for an hour,
you are giving up any other activities you
could have chosen to do during that time.
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Opportunity Cost
O Among things sacrificed or forgone, there
is the most best alternative to that chosen.
O Economists call this an opportunity cost.
O opportunity cost: value of the next best
alternative given up for the alternative that
was chosen.
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Example of opp cost
O You may have many trade-offs when you
study—exchanging instant messages with
your friends, going to the mall, watching
television, or practicing the guitar, for
example. But whatever you consider the
single next best alternative is the
opportunity cost of your studying
economics for one hour.
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Considering Opportunity
Costs
O Being aware of tradeoffs and their resulting
opportunity costs is vital in making economic
decisions at all levels. Whether they are aware of it or
not, individuals and families make trade-offs every
day.
O Businesses must consider trade-offs and opportunity
costs when they choose to invest funds or hire
workers to produce one good rather than another.
O Consider an example at the national level. Suppose
parliament approves $220 billion to finance new
highways. parliament could have voted instead for
increased spending on medical research.
O The opportunity cost of building new highways, then,
is less medical research.
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PRODUCTION
POSSIBILITY CURVE
O The relationship between scarcity, choice
and the forgone alternative is exhibited by
a production possibilities curve or frontier,
also known as the transformation curve,
opportunity cost curve. It helps to explain
the important Economic concept of
opportunity cost.
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PRODUCTION
POSSIBILITY CURVE
O graph showing the maximum
combinations of goods and services that
can be produced from a fixed amount of
resources in a given period of time.
O This curve can help determine how much
of each item to produce, thus revealing
the trade-offs and opportunity costs
involved in each decision.
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PRODUCTION
POSSIBILITY CURVE
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PRODUCTION
POSSIBILITY CURVE
O Any point along the PPF is the maximum of all possible
combinations of the two products X and Y. Society can
choose a specific combination of output, a single point
along the PPF such as point A, B, C, and D.
O At point A the existing resources are all being used to
produce commodity Y and no X is being produced.
Alternatively, at point D the economy chooses to produce X
without Y, or decide on large quantities of Y and small
quantities of X (at point B), or vice versa, at point C.
O Any point inside the PPF (e.g. point E) or an inward shift to
the left, is an indication that the economy is producing
beneath its full potential, and therefore operating
inefficiently or some resources are lying idle. An inward shift
normally occurs when a country is at war and or the
economy is contracting. There is no Economic growth.
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PRODUCTION
POSSIBILITY CURVE
O An outward shift to the right, as shown by the
dotted lines, shows an increase in the
productive capacity of the economy,
Economic growth.
O Economic growth can occur from either
better use of existing resources, increased
productivity, or effective use of newly acquired
inputs or resources, that is increased
production. Increased output may also be due
to division of labour and specialization.
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ECONOMIC SYSTEMS
O The way a nation determines how to use
its resources to satisfy its people’s needs
and wants.
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basic questions
O What to Produce? - Because of scarcity,
no nation can produce every good it
needs or wants.
O How to Produce? - Trade-offs exist
among the available factors of production.
O For Whom to Produce? – Economic
systems determine how people will
receive goods and services.
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Types of economic system
O There are four basic types of economic
systems: traditional, command,
market, and mixed.
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O traditional economy - system in which
economic decisions are based on
customs and beliefs that have been
handed down from generation to
generation.
O command economy: system in which
the government controls the factors of
production and makes all decisions about
their use
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O market economy: system in which
individuals own the factors of production
and make economic decisions through
free interaction while looking out for their
own and their families’ best interests.
O mixed economy: system combining
characteristics of more than one type of
economy
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Real world scenario
O Looking at the real world, most economies
have a the mixed Economic system
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SUPPLY AND
DEMAND
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SUPPLY AND DEMAND
O A market is where buyers and sellers
meet, it does not necessarily mean a
geographical location.
O What determines what and how much of
anything to produce is the price, and
price results from the operation of
demand by buyers and supply from
sellers.
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SUPPLY AND DEMAND
O In a free market, prices, which are
basically determined by demand and
supply, combine to solve the problem of
resource allocation. Prices act as a signal
of what people want to buy, indicating to
producers where their scarce factors will
most profitably be utilized.
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DEMAND
O demand: the amount of a good or
service that consumers are able and
willing to buy at various possible prices
during a specified time period.
O Again market: the process of freely
exchanging goods and services between
buyers and sellers.
O Market demand is the total quantity,
which all customers are willing and
able to buy at a particular price.
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The Law of Demand
O The law of demand states that as price
goes up, quantity demanded goes
down, and vice versa.
O For example, if the price of a DVD is $15
many people will buy it. If the price went
up to $20 fewer people would buy it, but
many people who wanted the DVD would
still buy it. Only a few people would buy
the DVD if the price went up to $75. This
example shows how the law of demand
works.
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DEMAND
O quantity demanded: the amount of a
good or service that a consumer is willing
and able to purchase at a specific price
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Factors determine
Relationship btwn Qty Dd &
price
O real income,
O possible substitutes,
O and diminishing marginal utility.
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Factors determine Qty Dd
O real income effect: economic rule stating
that individuals cannot keep buying the
same quantity of a product if its price rises
while their income stays the same.
O substitution effect: economic rule stating
that if two items satisfy the same need
and the price of one rises, people will buy
more of the other.
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Factors determine Qty Dd
O utility: the ability of any good or service
to satisfy consumer wants.
O marginal utility: an additional amount of
satisfaction.
O law of diminishing marginal utility: rule
stating that the additional satisfaction a
consumer gets from purchasing one more
unit of a product will lessen with each
additional unit purchased.
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Marginal utility
O A consumer’s spending of a good is in
equilibrium where the marginal utility is
equal to price.
O Therefore the equilibrium for a
combination of goods is MUA/PA
=MUB/PB = MUC/PC
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the Demand Curve
O demand schedule: table showing
quantities demanded at different possible
prices.
O A demand curve is a graph that shows
the relationship between the price of an
item and the quantity demanded.
O demand curve: downward sloping line
that shows in graph form the quantities
demanded at each possible price.
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Change in demand & change
in quantity demanded
Change in quantity Dd Change in Dd
O This is caused by a
change in the price
of a good, and it is
shown as a
movement along the
demand curve.
O This is caused by
something other
than a change in the
product’s price, and
it causes the entire
demand curve to
shift to the left or
right.
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Determinants of Demand
O Many factors can affect demand for a
specific product or service. Among
these factors are changes in population,
changes in income, changes in people’s
tastes and preferences, the availability
and price of substitutes, and the price of
complementary goods.
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Changes in these factors
O When population increases, opportunities to
buy and sell increase.
O Changes in Income, The demand for most
goods and services depends on income.
O Changes in Tastes and Preferences One of
the key factors that determine demand is
people’s tastes and preferences. Tastes and
preferences refer to what people like and
prefer to choose. When a product becomes a
fad, more of the products are demanded and
sold at every possible price. The demand
curve then shifts to the right, as shown in the
graph on the right.
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O Substitutes: The availability and price of
substitutes also affect demand. For example,
people often think of butter and margarine as
substitutes. Suppose that the price of butter
remains the same and the price of margarine
falls. People will then buy more margarine and
less butter at all prices of butter. This shift in
the demand curve for butter is shown in the
graph on the right. If, in contrast, the price of
the substitute (margarine) increases, the
demand for the original item (butter) also
increases.
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O Complementary Goods Complements are
products that are generally bought and sold
together. Digital cameras and flash memory, for
example, are complementary goods. When two
goods are complementary, the decrease in the
price of one will increase the demand for it as well
as its complementary good. If the price of digital
cameras drops, for example, people will probably
buy more of them. They will also probably buy
more flash memory to use with the cameras.
Therefore, a decrease in the price of digital
cameras leads to an increase in the demand for
flash memory. As a result, the demand curve for
flash memory will shift to the right, as shown in the
graph on the right.
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supply
O supply: the amount of a good or service
that producers are able and willing to sell
at various prices during a specified time
period.
O The law of supply states that as price
goes up, quantity supplied goes up, and
vice versa.
O quantity supplied: the amount of a good
or service that a producer is willing and
able to supply at a specific price.
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supply schedule/curve
O supply schedule: table showing
quantities supplied at different possible
prices.
O supply curve: upward sloping line that
shows in graph form the quantities
supplied at each possible price.
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Change in Supply vs. change
in Quantity Supplied
change in Quantity
Supplied Change in Supply
O This is caused by a
change in the price
of a good, and it is
shown as a
movement along the
supply curve.
O This is caused by
something other
than price, and it
causes the entire
supply curve to shift
to the left or right
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The Determinants of Supply
O Many factors can affect the supply of a
specific product.
O Four of the major determinants of supply
(not quantity supplied) are the price of
inputs, the number of firms in the industry,
taxes, and technology.
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O Price of Inputs If the price of the inputs
needed to make a product—raw
materials, wages, and so on—drops, a
producer can supply more at a lower
production cost. This causes the entire
supply curve toshift to the right.
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O Number of Firms in the Industry - As
more firms enter an industry, greater
quantities of their product or service are
supplied at every price, and the supply
curve shifts to the right. The larger the
number of suppliers, the greater the
market supply.
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O Taxes If the government imposes more taxes on the
production of certain items, businesses will not be willing
to supply as much as before because the cost of
production will rise. The supply curve for products will
shift to the left, indicating a decrease in supply.
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O Technology The use of science to
develop new products and new methods
for producing and distributing goods and
services is called technology.
O Any improvement in technology will
increase supply, as shown in the graph on
the right. This is because new technology
usually allows suppliers to make more
goods for a lower cost. The entire cost of
production is cut, and the supply curve
shifts to the right.
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The Law of Diminishing
Returns
O When a business wants to expand, it
has to consider how much expansion
will really help the business.
O law of diminishing returns: economic
rule that says as more units of a factor of
production are added to other factors of
production, after some point total output
continues to increase but at a diminishing
rate.
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Returns.
O Diminishing returns refers to a situation where
a firm is trying to expand by using more of its
variable factors, but finds that the extra output
they get each time they add one more
variable factor to a fixed factor of production
such as land, gets progressively less and
less. This usually arises because the capacity
of land for example, is limited in the short-run
and the combination 3 of the fixed and
variable factors becomes less than optimal.
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Returns
O The law, with reference to land, states,
“after a certain point, successive
application of equal amounts of resources
to a given area of land produces less than
proportionate return”.
O If, for example, a farmer has one hectare
of land (fixed factor) and produces the
following bags of maize by employing
more workers (variable factor).
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Returns
#workers Output per year Addition to
Output
1 100 100
2 210 110
3 300 90
4 250 -50
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Returns
O Note that diminishing returns start after the
second worker is employed, when the
additions to output start to decline from
110 to 90, and eventually being negative. It
is no longer worthwhile to employ more
workers on only one hectare of land, it costs
more to employ than the additional revenue
from an additional worker. Additional workers
can only be employed when more land is
acquired, but this can only be achieved in the
long run.
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PRICE DETERMINATION
O In free markets, prices are determined by
the interaction of supply and demand.
O equilibrium price: the price at which the
amount producers are willing to supply is
equal to the amount consumers are willing
to buy.
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PRICE DETERMINATION
O Consumers and producers both act rationally.
Consumers want to maximize their utility and
therefore want to purchase goods as cheaply
as possible, while producers also act
rationally and aim at profit maximization, they
charge high prices. The equilibrium market
price therefore is determined by the
interaction of the market forces of demand
and supply. The point where the demand and
supply curves intersect is the compromise
price, both consumers and producers are
satisfied at this point.
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PRICE DETERMINATION
O At the equilibrium price, there are neither
surpluses nor shortages. The price is
stable unless there are changes in either
supply or demand conditions listed above
under changes in demand and supply.
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PRICE DETERMINATION
O Note that the marginal utility of consumers
vary, with some consumers willing and
able to pay for a product than the
prevailing market price, since they are
paying less, there is a consumer
surplus.
O A producer surplus also arises when some
suppliers are willing to sale at less than
the prevailing market price, since they are
selling at a higher price there is a
producer surplus.
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consumer surplus &
producer surplus
O price
O S
O CONSUMER SURLUS
O PRODUCER SURPLUS
O
O D
O
O quantity
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Change in Equilibrium Price
O When the supply or demand curves shift,
the equilibrium price also changes. Note
that the old equilibrium price was $15. But
now the new demand curve intersects the
supply curve at a higher price—$17.
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Prices as Signals
O Under a free-enterprise system, prices
function as signals that communicate
information and coordinate the activities
of producers and consumers.
O Shortages: A shortage occurs when, at the
current price, the quantity demanded is
greater than the quantity supplied. If the
market is left alone—without government
regulations or other restrictions—shortages
put pressure on prices to rise. At a higher
price, consumers reduce their purchases,
whereas suppliers increase the quantity they
supply.
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Prices as Signals
O Surpluses: At prices above the equilibrium price,
suppliers
O produce more than consumers want to purchase in
the
O marketplace. Suppliers end up with surpluses—
large, undesired inventories of goods—and this
and other forces put pressure on the price to drop
to the equilibrium price. If the price falls, suppliers
have less incentive to supply as much as before,
whereas consumers begin to purchase a greater
quantity. The decrease in price toward the
equilibrium price, therefore, eliminates the
surplus.
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Prices as Signals
O Market Forces One of the benefits of the
market economy is that when it operates without
restriction, it eliminates shortages and surpluses.
Whenever shortages occur, the market ends up
taking care of itself—the price goes up to eliminate
the shortage.
O Whenever surpluses occur, the market again ends
up taking care of itself—the price falls to eliminate
the surplus. (See Figure 7.12 below for more
information.) Now, let’s take a look at what
happens to th availability of goods and services
when the government— not market forces—
becomes involved in setting prices.
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Price Controls
O Under certain circumstances, the
government sometimes sets a limit on
how high or low a price of a good or
service can go.
O The government sometimes gets involved
in setting prices if it believes such
measures are needed to protect
consumers or suppliers. Also, special
interest groups sometimes exert pressure
on elected officials to protect certain
industries.
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Price Ceilings (maximum
Price)
O A price ceiling is a government-set
maximum price that can be charged for
goods and services. For example, city
officials might set a price ceiling on what
landlords can charge for rent. As Graph A
of Figure 7.13 below shows, when a
price ceiling is set below the equilibrium
price, a shortage occurs.
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O surplus k100
O ep k50 shortage
qe
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Causes of shortage
O More people would like to rent at the
government-controlled price, but
apartment owners are unwilling to build
more rental units if they cannot charge
higher rent. This results in a shortage of
apartments to rent.
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Price Floors (minimum p)
O A price floor, in contrast, is a government-set
minimum price that can be charged for goods and
services. Price floors—more common than price
ceilings—prevent prices from dropping too low.
When are low prices a problem? Assume that
about 30 of your classmates all want jobs after
school. The local fast-food restaurant can hire 30
students at $4.15 an hour, but the government has
set a minimum wage—a price floor—of $5.15 an
hour. At that wage, not all of you will get hired,
which will lead to a surplus of unemployed workers
as shown in Graph B of Figure 7.13. If the market
was left on its own, you and all of your classmates
would be working at the equilibrium price of $4.15
per hour.
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ELASTICITY
O Elasticity of demand measures how
much the quantity demanded changes
when price/income goes up or down.
O price elasticity of demand: economic
concept that deals with how much
demand varies according to changes in
price.
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O The law of demand is straightforward: The higher
the price charged, the lower the quantity
demanded—and vice versa. If you sold DVDs, how
could you use this information? You know that if
you lower prices, consumers will buy more DVDs.
By how much should you lower the price,
however? You cannot really answer this question
unless you know how responsive consumers will
be to a decrease in the price of DVDs.
O Economists call this price responsiveness
elasticity. The measure of the price elasticity of
demand is how much consumers respond to a
given change in price.
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CATEGORIES OF PRICE
ELASTICITY OF DEMAND
O elastic demand: situation in which a
given rise or fall in a product’s price
greatly affects the amount that people are
willing to buy.
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Elastic demand
O Another example of goods that are generally
considered to have elastic demand are luxury
items. Luxury items are things people might
want but do not really need to survive.
Expensive cars, high-end electronic items,
and exotic vacations are all examples of
luxury items. Some foods, especially
expensive foods such as steak and lobster,
are also considered luxury items. Because
people do not need these things to survive,
the demand for them is usually elastic.
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Inelastic Demand
O If a price change does not result in a
substantial change in the quantity demanded,
then demand for that particular good is
considered inelastic. This means that
consumers are usually not flexible with these
items and will purchase some of the items no
matter what they cost.
O In general, goods that are considered
necessities, such as staple foods, spices like
salt and pepper, and certain types of
medicine, normally have inelastic demand.
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Inelastic Demand
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Unitary elasticity of
demand
O This is a hypothetical scenario, based on
the assumption that if demand changes by
a certain percentage, then the quantity
demanded should also change by exactly
the same percentage. When measured,
elasticity is equal to one exactly.
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Perfectly or completely
elastic demand
O This is another theoretical structure, it is
important because a perfectly competitive
market structure model is based on it.
O At the compromise price of OP, demand is
infinite, but a small change in price would
cause demand to reduce to zero.
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Elastic demand
O Example1
O The price of a product was K4000 and the
annual demand was 2000 units when the
price was reduced to k3000, the annual
demand increased to 4000 units.
O Calculate the price elasticity of demand
for the price changes given.
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Arc elasticity of demand
O The elasticity is calculated over a range
of values or an arc.
O Example 1
O The annual demand for a product is
1,800,000 at K2, 600 per unit and demand
reduces to 1,500,000 when the price
increases to K3, 000 per unit. What is the
elasticity of demand over this price range?
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Arc elasticity of demand
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PRICE ELASTICITY ALONG
THE DEMAND CURVE
O The five categories of price elasticity of
demand can be shown on one demand
curve. Demand curves generally slope
downwards from left to right, and elasticity
varies along the length of a demand
curve. The ranges of price elasticity of
demand at different points along a
demand curve are illustrated below.
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THE DEMAND CURVE
O P
O QTY
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THE DEMAND CURVE
O Along the top half of the line, PED is
greater than 1. We say that demand is
elastic. Along the bottom half of the line,
PED is less than 1 and we say that
demand is inelastic. Exactly halfway along
the line, PED = 1; demand is of ‘unitary
elasticity’.
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What Determines Price Elasticity
of Demand
O Availability of substitutes
O the percentage of a person’s total budget
devoted to the purchase of that good
(income).
O time consumers are given to adjust to a
change in price.
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PRICE ELASTICITY OF
SUPPLY
O That is the extent to which producers
increase production and therefore the
quantity which they take to the market as
a result of a rise in price.
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CATEGORIES OF PRICE
ELASTICITY OF SUPPLY
O Perfectly or completely inelastic supply
O Inelastic supply
O Unitary elasticity of supply
O Perfectly or completely elastic supply
O Elastic supply
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FACTORS INFLUENCING
PRICE ELASTICITY OF
SUPPLY
O Time period
O Availability of factors of production
O Number of firms and entry barriers can
also affect the price elasticity of supply
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WHEN THERE IS A CHANGE
IN TOTAL REVENUE
O The calculation of PED is very useful to the
business community, as well as the amount
being spent by consumers. If the demand
for a good is elastic, then a reduction in
price increases total revenue, and the total
amount being spent by consumers. A
business selling products that are very
competitive on the market, those with close
substitutes, luxuries etc., can advertise small
reductions in prices and discounts in order to
woo customers and increase the company’s
total revenue.
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O if total revenue falls after a price rise
then demand is elastic.
O If the demand for a good is inelastic,
then an increase in price increases
total revenue. A business selling
products that are necessities and
addictive products like beer and
cigarettes, can afford to increase prices,
and the reduction in the quantity
demanded is negligible.
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O Alternatively, if total revenue falls after a
price cut then demand is inelastic.
O If total revenue or total expenditure by
households remains unchanged
whether there is an increase or reduction
in price, then the elasticity of demand is
unitary.
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INCOME ELASTICITY OF
DEMAND
O Income elasticity of demand measures the
degree of responsiveness or sensitivity of
demand to changes in income.
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Categories of income
elasticity of demand
O Positive Income Elasticity - This is when
an increase in income leads to an
increase in demand, YED > 0. It applies to
‘normal’ goods such as colour television
sets, motor vehicles etc. Most goods have
a positive income elasticity of demand.
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O Negative Income Elasticity - For some
goods, an increase in income causes a
reduction in demand, YED < 0. Inferior
goods, such as black and white television
set, have a negative income elasticity of
demand.
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O Zero income Elasticity - A change in
income may have no effect on the quantity
demanded, demand remains the same,
YED = 0. Consumers purchase only what
they require, this applies to Giffen goods
‘necessities’ like mealie meal, potatoes
etc. Note that with Giffen goods, less is
demanded when price falls because the
negative income effect overcomes the
positive substitution effect.
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Factors affecting income
elasticity of demand
O current standard of living
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CROSS ELASTICITY OF
DEMAND
O Cross elasticity of demand measures the
sensitivity of demand for one good to
changes in the price of another good. The
formula for cross elasticity of demand
(XED) is given below.
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Categories of cross elasticity
of demand
O Positive cross elasticity of demand -
The XED between butter and margarine is
positive, this is because butter and
margarine are substitutes. When the price
of butter goes up, demand for margarine
rises and demand for butter falls. In other
words, the price of margarine and demand
for butter move in the same direction,
therefore XED is positive.
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O Negative cross elasticity of demand -
The XED between complements (goods
that are jointly demanded) is negative.
Consider cars and fuel, if the price of cars
increases, demand for fuel would fall.
Cars and fuel are complementary goods,
so demand for cars is also likely to fall.
The price of cars and demand for fuel
move in opposite directions, so the XED
of complements is negative.
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O Zero cross elasticity of demand - This
applies to unrelated goods. A change in
the price of one good has no effect on the
quantity demanded of the other good.
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PRODUCTION AND
COSTS
TYPES OF FIRMS/BUSINESS
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Sole Proprietorships
O A sole proprietorship is a business
owned and operated by one person.
O proprietor: owner of a business
O ADV & DISADV
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Partnerships
O A partnership is a business owned and
operated by two or more individuals.
O ADVA & DISAD
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Corporations
O Stock represents ownership rights to a
certain portion of a corporation’s
profits and assets.
O ADVA & DISADVA
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Industry- the three classes
of production
O Primary production - The producers of
natural goods such as farmers, oil drillers,
copper miners etc, are all engaged in
primary production.
O Secondary production - The producers
of sophisticated goods, manufactured
goods such as carpenters, tailors, car
manufacturers, are in secondary
production.
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O Tertiary - These are providers of services
like bankers, retailers, stockbrokers,
accountants, teachers, doctors and
entertainers.
O Specialisation; Division of Labour
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COSTS OF PRODUCTION
O It is important to first divide the costs of
production into time period of short run
and long run costs, depending on variable
or fixed factors of production.
O short run - at least one factor of
production is in fixed supply
O long run - all factors of production can be
varied
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Types of cost
O Total Costs - The amount spent of
producing a given amount of a good by a
firm.
O TC = VC + FC
O Variable Costs - costs that vary with
output e.g cost of electricity and charcoal.
O Fixed Costs - costs that do not vary with
output e.g Rent paid for the use of
premises
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O Average cost - cost of producing one
item,
O ATC = TC/Q
O ATC = AVC + AFC
O Marginal cost - cost of producing one
extra unit of output,
O MC = change in TC/ change in Q
O Average fixed cost - total fixed cost
divided by the level of output, AFC =
TFC/QMUKONDA - ICU

O Average variable cost - total variable
cost divided by the level of output.
O AVC = TVC/Q
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O 1 is the marginal cost curve,
O 2 is the average total cost curve,
O 3 is the average variable cost curve and
O 4 is the average fixed cost curve
respectively.
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O Explicit costs are those costs that are
clearly stated and recorded.
O Implicit costs are those costs that are
implied, unstated but understood as a
necessary component in the economist’s
view, E.G opportunity costs.
O This is important because it explains
the difference in the calculation of
profit between the Accountant and the
Economist.
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O Accounting profits are sales revenue
minus explicit costs of a business.
O Economic profits consist of sales
revenue minus explicit and implicit
costs!
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O The relationship between AC and MC is
summarised as
O · At low levels of output, the MC curve lies below
the AVC and the ATC curves. These curves will
slope downward
O At higher levels of output, the MC curve will rise
above the AVC and the ATC curves.These curves
will slope upward
O As output increases, the average curves will first
slope downward and then slope upward Will have
a “U” shape.
O The MC curve will intersect the minimum points of
the AVC and the ATC curves.
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FACTOR MARKETS
O Each factor receives a reward.
O Labour performs work and is paid by
wages and salaries.
O Capital is a man made resource, and
the owners of capital receive interest.
O Land consists of natural resources for
which rent is paid.
O Entrepreneurs establish business firms
and receive profit.
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O Factor rewards are prices paid for each
factor of production, and just like any
price, it is determined by the market
forces of demand and supply.
O The demand for factors of production also
introduces the diminishing marginal
productivity theory that is each
additional unit of any factor employed
tends to add progressively less to total
output (other factors being held constant).
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LONG RUN COSTS
O In the long run, firms have combinations
of factors of production that result in low
average costs.
O The factors that cause average costs to
decline in the long run as output increases
are known as economies of large-scale
production, commonly known as
economies of scale.
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O The shape of the long run average cost
(LRAC) curve however, depends on
whether
O - Output increases more in proportion to
inputs, when there are economies of scale
and the LRAC decline to show increasing
returns to scale.
O - Output increase in the same proportion
as inputs indicating constant returns to
scale.
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O The arrow is pointing to the minimum efficiency
scale (MES), which is that level of output on the
LRAC curve at which average costs first reach their
minimum point. At output levels below this point, the
firm will experience higher average costs, otherwise,
the LRAC remain unchanged at whatever the level of
output, and the curve is flat.
O - Output increases less than in proportion to inputs,
due to diseconomies of scale, LRAC increases as
output increases. As output continues to increase,
most firms reach a point where bigness begins to
cause problems. When LRAC rise more than in
proportion to output, there are diseconomies of
scale, and the curve slopes upward.
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O The behaviour of LRAC can be
summarised as:
O - Economies of scale (decreasing LRAC)
at low levels of output
O - Constant returns to scale (constant
LRAC) at intermediate levels of output
O - Diseconomies of scale (increasing
LRAC) at high levels of output
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O Therefore, the LRAC curves are typically
“U” shaped as shown below
O Eco of Scale diseconomies
of scale
O constant returns to scale
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ECONOMIES OF SCALE
O These indicate that as the output or plant
size increases, the average costs per unit
decreases or falls, they are reductions in
long run average total costs achieved
when the whole scale of production is
expanded.
MUKONDA - ICU

INTERNAL ECONOMIES
O These are advantage that accrue within
an organization because of large-scale
production which a firm a can plan to
achieve directly by increasing the size of
its output. The benefits accrue to the
individual firm, some of them include the
following:
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O Financial Economies - can easily borrow
money from commercial banks and
negotiate for lower interest rates & offfer
better security.
O Technical Economies - as the plant
grows in size and output increases, it
becomes more possible for labour to
undertake more specialized activities.
O This increases efficiency and reduces
costs per unit.
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O Managerial Economies - A large firm can
afford to hire specialists in different fields,
which is an efficient use of labour resources.
O Commercial or Trading Economies -
Favourable terms are granted to a large firm
since it buys in bulk and may get discounts. It
can afford to employ specialist buyers.
O Welfare - Large firms are in a position to
increase production by improving the
condition of service of their employees
through the provision of facilities such as
transport, clinics, sport and other recreation
facilities.
MUKONDA - ICU

EXTERNAL ECONOMIES
O External economies are advantages of an increased scale possible
to all firms in an industry. They are influenced by the growth of the
industry as a whole.
O External economies are made outside the firm as a result of its
location and occur when:
O A local skilled labour force is available
O Specialist local back up firms can supply raw materials, component
parts or services.
O They supply to a large market and achieve their own economies of
scale, which are
O passed on through lower input prices.
O An area has a good transport network
O An area has an excellent reputation for producing a particular good
O Firms in the industry may find a joint enterprise and share their
research and development
O facilities, to lower the overhead costs.
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O As the industry grows in size, different
firms within it specialize in different
processes. A good example of external
economies of scale in Zambian is copper
mining in the copper belt province. A
number of firms provide information,
labour, machinery or component parts that
are required by the copper mining
companies.
MUKONDA - ICU

DISECONOMIES OF SCALE
O These are problems of growth, unlimited
expansion of scale of output may not
necessarily result in ever-decreasing
costs per unit. There may be a point
beyond which average costs begin to rise
again.
O As economies of scale
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Principle influences on the
location of industries are:-
O - Nearness to raw materials especially
where the raw materials are heavy and
bulky.
O - Accessibility to the markets
O - Nearness to the power supply
O - Government policy
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INTEGRATION OR
AMALGAMATION OF
FIRMS
O This may be horizontal, vertical or lateral.
O Horizontal Integration - firms that are
producing the same type of product, and
are at the same stage of the production
process, join together. An example is if
Kafue Textiles acquires or combines with
Mulungushi Textiles.
MUKONDA - ICU

O Vertical Integration - firms engaged in
different stages of production. E.g if
Zambeef acquires a cattle ranch.
O Lateral Integration - This occurs when
firms increase the size of their products.
Concentration on one product may make
a firm vulnerable, hence the need to
diversify.
MUKONDA - ICU

DISTRIBUTION OF GOODS
O Look at it , that is straight forward
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TOTAL REVENUE (TR)
O This is the money the firm gets back from
selling goods and is found by multiplying
the number sold, Q, by the selling price, P.
O TR = P *Q
O Average revenue AR, is the amount
received from selling one item and
equals the selling price of the good, the
price per unit.
O AR = TR/Q
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O Marginal Revenue MR is the change in
total revenue from the sale of one more
unit of output.
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O Profit
O Firms are profit maximisers. Profit is
calculated as the difference between total
revenue and total costs.
O P = TR - TC
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TR & TC
O TC
O
TR
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O Profits are at a maximum where the
vertical distance is greatest, as shown in
the diagram below.
O If MC is lower than MR, then profit
increases by making and selling one more
unit of output.
O However, if MC is higher than MR, profits
fall if one more unit is made or sold.
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O If MC is equal to MR, then the profit
maximizing position has been reached, as
shown below.
O Profits are maximized where MC = MR.
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IMPERFECT MARKET
O MC
O MR
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PERFECT MARKET
O MC
O MR
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MARKET STUCTURES:
O Market structure refers to the extent of
competition within particular markets.
O perfect competition: market situation in
which there are numerous buyers and
sellers, and no single buyer or seller can
affect price.
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XSTICS OF PERFECT
COMPETITION
O (1) A Large Market Numerous buyers
and sellers must exist for the product.
O (2) A Nearly Identical Product The
goods or services being sold must be
nearly the same.
O (3) Easy Entry and Exit Sellers already
in the market cannot prevent competition,
or entrance into the market. In addition,
the initial costs of investment are small,
and the good or service is easy to learn to
produce.
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O (4) Easily Obtainable Information
O Information about prices, quality, and
sources of supply is easy for both buyers
and sellers to obtain.
O (5) Independence The possibility of
sellers or buyers working together to
control the price is almost nonexistent.
MUKONDA - ICU

Demand curve of a firm under
perfect competition
O No individual firm has market power, the
market forces of demand and supply for
the product determine the price. Note that
the price = average revenue = demand
curve (P = AR = D)
MUKONDA - ICU

REFERENCE
O D S p
O P …………………..
P=AR=D
Q
Q
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O The demand curve for the individual firm
operating under a perfect market is a
horizontal line. At a given price of OP, the firm
can sell as much as it can, whatever is taken
to the market is bought, and demand is
infinite.
O However, if an individual firm increases in
price, even by a very small margin, demand
reduces to zero, since there is perfect market
information, the product is homogenous and
there are many sellers.
MUKONDA - ICU

Short run equilibrium
position
O The firm maximizes profits at output OQ
where MC = MR, at this level of output,
AC is much higher than AR and the firm
makes losses.
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Long run equilibrium
position
O There are no barriers to entry, firms are
free to enter and to exit. Profits and losses
can only occur in the short run. Where
profits are made, they are competed away
through the entry of new firms and where
losses are made, firms will leave.
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O The firm maximizes its profits at OQ
where MC = MR. At this output level, AR is
also equal to AC. Individual firms earn
normal profits only, in the long run.
O The unique feature of the long run
equilibrium position is that all firms in the
industry have MR = MC = AC = AR = P =
D.
MUKONDA - ICU

O Economic efficiency occurs where
demand equals supply.
O Perfect competition is a theoretical model,
but it sets a benchmark for efficiency and
firms should strive to attain the desired
benchmarks.
MUKONDA - ICU

MONOPOLY
O A monopoly exists when a single seller
controls the supply of a good or
service and largely determines its
price.
O market situation in which a single supplier
makes up an entire industry for a good or
service with no close substitutes.
MUKONDA - ICU

Types of Monopolies
O natural monopolies, where the
government grants exclusive rights to
companies that provide things like utilities,
bus service, and cable TV.
O A geographic monopoly is - A country
store in a rural setting is an example of
this. Because the setting of the business
is isolated and the potential for profits is
so small, other businesses choose not to
enter the market.
MUKONDA - ICU

O technological monopoly - A government
patent gives you the exclusive right to
manufacture, rent, or sell your invention
for a specified number of years—usually
20.
O government monopolies - In a
government monopoly, local, state, and
national governments themselves hold
exclusive rights to contract out work like
highway and bridge construction.
MUKONDA - ICU

Characteristics
O There is only one supplier of the product
or services
O - The product or service has no close
substitutes
O - There are barriers to entry
MUKONDA - ICU

Demand curve
O A monopolist being the sole supplier has
market power and therefore the firm is a
“price maker”.
O However, the firm can only determine
either the price or the quantity, but not
both at the same time. At high prices, few
quantities are bought, while at low prices,
demand is high.
O Therefore, the monopolist is faced with a
downward sloping “normal” demand
curve.
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O Price
O
P=AR=D
O
Q
MUKONDA - ICU

Equilibrium position
O The firm maximizes its profit at OQ where MC
= MR. The price charged, the average
revenue is greater than the average cost. This
difference is the supernormal or Economic
profits earned by the monopolist, represented
by the shaded area of the rectangle.
O The monopolist is likely to earn supernormal
profits in both the short run and the long run
because of the barriers to entry, the
supernormal profits are not ‘competed away’
by other firms.
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Barriers to entry
O barriers to entry: obstacles to
competition that prevent others from
entering a market.
O Barriers limit competition in the market.
Firms are prevented from increasing the
supply, pushing the supply curve to the
right or pushing the demand curve to the
left, which reduces the price, and
eliminates the supernormal profits.
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Price discrimination
O Price discrimination means charging different
prices to different groups of consumers for the
same product or service. Price discrimination is the
same product or service being sold at different
prices in different markets. A firm may increase its
revenue by charging high prices in some markets
O while lowering the price in other markets but the
sales volume increases, given the fact that TR
=Quantity X Price. Either an increase in the
quantity sold or an increase in the price leads to an
increase in the total revenue. A monopolist cannot
control both the price and quantity even if the firm
is in an advantageous position and has market
power.
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Basic conditions to practice
price discrimination
O Control supply of product, which means
imperfections in the market.
O Discrimination is not possible under conditions of
perfect competition.
O - Consumers should be members of separate
markets to prevent resale of the
O product.
O - Elasticities of demand must be different so that
different prices may be charged.
O - High prices are charged for inelastic markets and
low prices for elastic markets, and profits are
maximized.
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Regulations of monopolies
O The aim of government regulatory
agencies is to promote efficiency,
competition, fairness, and safety.
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Arguments for monopolies
O To achieve economies of scale as a single
firm supplies to the whole market. Large scale
production results in a reduction in average
costs. The consumer is likely to benefit from
efficiencies through lower prices.
O - The supernormal profits that monopolists
make, enable the firm to be innovative and
spend on research and development. Society
gains by having new products on the market.
O - It is easier for a large firm to raise capital,
again this enables the firm to be innovative
and spend on research and development.
MUKONDA - ICU

Arguments against
monopolies
O At the profit maximizing level of output, prices are likely to be higher
while output is less than in a more competitive firm.
O - The supernormal profits, which monopolies make, are naturally at
the expense of customers.
O - Monopolies are not technically efficient. At the profit maximizing
level, the costs are not at their lowest level since the marginal cost
is not equal to the average cost. This also implies that monopolies
are not allocatively or Economically efficient.
O - Price discrimination is a restrictive practice carried out by
monopolists.
O - Monopolies are not threatened by competition, they tend to adopt
a complacent
MUKONDA - ICU

MONOPOLISTIC
COMPETITION
O Monopolistic competition exists when
a large number of sellers offer similar
but slightly different products, and
each firm has some control over price.
MUKONDA - ICU

CHARACTERISTICS
OF MONOPOLISTIC
COMPETITION.O A large number of sellers or firms in the
market
O - A large number of buyers
O - There are no barriers to entry, firms are free
to enter and leave the market.
O - The products are not homogeneous but are
differentiated through product differentiation
and non-price competition, such as the use of
brand names, attractive packaging, extensive
advertising, offering guarantees, good after
sales services etc
MUKONDA - ICU

IMPLICATIONS OF
MONOPOLISTIC
COMPETITIONO The long run equilibrium position is not at a point
where AC is minimized, therefore, there is no
technical efficiency.
O - A waste of resources like in a monopoly because
prices are high while output is low compared to a
firm under perfect competition. Firms unable to
expand output to the level where AC is at a
minimum, an indication that there is excess
capacity.
O - There is no allocative or Economic efficiency.
O - It is considered wasteful to produce a wide
variety of differentiated versions of the same
product.
O - The extensive advertising is also considered
wasteful.MUKONDA - ICU

O It is also argued that monopolistic
competition is not wasteful as it provides
consumers with choices, the differentiated
versions of the same product is for the
benefit of consumers, besides, rational
buyers should opt for the least cost good.
MUKONDA - ICU

OLIGOPOLY
O An oligopoly exists when an industry is
dominated by a few suppliers that
exercise some control over price.
O product differentiation: manufacturers’
use of minor differences in quality and
features to try to differentiate between
similar goods and services
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O cartel: arrangement among groups of
industrial businesses to reduce international
competition by controlling the price,
production, and distribution of goods.
O Characteristics
O Interdependence between firms, this is
because an individual firm is uncertain of the
behaviour of rival firms.
O - Price stability
O - Non-price competition between firms
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Demand curve
O The shape of the demand curve depends on the
assumption of the pricing policy of an individual firm. A
firm operating under conditions of oligopoly might adopt
a number of pricing strategies such as
O Firms collude on pricing and or output policies, they may
form cartels or price rings, known as collusive
oligopoly.
O - A firm may become a price leader, initiating a price
change, then the rival firms follow suit.
O - A firm may decide simply to be a price follower,
awaiting the pricing decisions of other firms.
O - The firm’s demand curve is based on the assumption
that an oligopoly firm, which is competing, with rival
oligopoly firms decide on its own price and output
levels. Even then, the firm’s decisions are influenced by
what the rival firms can do, hence the kinked demand
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O Firms are few, and each firm has some
market power, therefore the action of one
firm affects the market share of the rival
firms. Suppose the firm increases the
price above OP, and then if the rival firms
do not increase their prices, the result
would be a reduction in sales and a fall in
the market share. This means that
demand is elastic above OP, the price of
the rival firms will be relatively lower.
MUKONDA - ICU

Introduction to microeconomics - Mukonda F

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