This document is the introduction chapter of a textbook on microeconomics. It defines key economic concepts such as scarcity, choice, opportunity cost, and production possibility frontier. Scarcity means that resources are limited in supply relative to human wants. Because of scarcity, choices must be made about how to allocate resources. Opportunity cost refers to the next best alternative forgone when making a choice. The production possibility frontier illustrates the concept of scarcity and tradeoffs, showing the maximum possible output combinations of two goods an economy can produce with full employment of its resources.

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FIRST EDITION
INTRODUCTION TO MICROECONOMICS
WITH POLICY APPLICATIONS
WARREN M. MASAVIRU
B.A Econ, MA; M.A Econ, MU;
PhD Econ, UoN
SEPTEMBER 2015

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Table of Contents
PREFACE.................................................................................................................................................................6
1.0 NATURE AND SCOPE OF ECONOMICS ....................................................................................................7
1.1 Meaning of Economics.........................................................................................................................7
1.2 Basic economic concepts.....................................................................................................................7
1.3 Methodology of Economics ..............................................................................................................14
1.4 Microeconomics versus Macroeconomics........................................................................................17
1.5 Economic Systems .............................................................................................................................18
1.6 Consumer Sovereignty.......................................................................................................................32
Exercises 1 ........................................................................................................................................................34
CHAPTER TWO: DEMAND SUPPLY AND EQUILIBRIUM ....................................................................................35
2. DEMAND ......................................................................................................................................................35
2.1 Meaning of demand...........................................................................................................................35
2.2 Determinants of demand...................................................................................................................35
2.3 Individual demand..............................................................................................................................35
2.4 Other determinants of demand ........................................................................................................42
2.5 Market demand..................................................................................................................................43
2.6 Determinants of market demand......................................................................................................44
2.7 Movements along and shifts of the demand curve .........................................................................44
2.8 Movements along the demand curve...............................................................................................44
2.9 Shifts of the demand curve ...............................................................................................................45
Exercises 2........................................................................................................................................................46
3. SUPPLY.........................................................................................................................................................48
3.1 Meaning of supply..............................................................................................................................48
3.2 Determinants of supply .....................................................................................................................48
3.3 Market supply and individual supply.................................................................................................51
3.4 Movements along and shifts in the supply curve.............................................................................52
3.5 Movements along the supply curve..................................................................................................52
3.6 Shifts of the supply curve ..................................................................................................................53
4.1 Meaning of equilibrium......................................................................................................................55
4.2 Excess demand...................................................................................................................................56
4.3 Excess supply .....................................................................................................................................57
4.4 Stable and unstable equilibria ...........................................................................................................58
4.5 Demand and supply equations..........................................................................................................62
4.6 Applications of the concept of equilibrium ......................................................................................63
4.7 Maximum price control......................................................................................................................64
4.8 Minimum price controls.....................................................................................................................65
4.9 The case for price controls ................................................................................................................66
4.10 The case against price control...........................................................................................................67
4.11 Price decontrol or price liberalization...............................................................................................67

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CHAPTER THREE: ELASTICITIES OF DEMAND AND SUPPLY .............................................................................69
5. ELASTICITIES OF DEMAND..........................................................................................................................69
5.1 Price elasticity of demand..................................................................................................................69
5.2 Measurement of price elasticity of demand.....................................................................................71
5.3 Point elasticity of demand.................................................................................................................71
5.4 Arc elasticity of demand ....................................................................................................................76
5.5 Price elasticity of demand and the demand curve ...........................................................................78
5.6 Determinants of price elasticity of demand .....................................................................................80
5.7 Price elasticity of demand and revenue............................................................................................82
5.8 Income elasticity of demand .............................................................................................................83
5.9 Determinants of income elasticity of demand .................................................................................84
5.10 Cross elasticity of demand.................................................................................................................85
5.11 Applications of elasticities of demand..............................................................................................85
5.12 Advertisement or promotional elasticity of sales. ...........................................................................88
5.13 Determinants of advertisement elasticity ........................................................................................89
6. ELASTICITIES OF SUPPLY ............................................................................................................................90
6.1 Price elasticity of supply ....................................................................................................................90
6.2 Types of price elasticities of supply...................................................................................................91
6.3 Factors determining price elasticity of supply..................................................................................94
6.4 Applications of price elasticity of supply ..........................................................................................95
6.5 Why agricultural prices fluctuate ......................................................................................................97
6.6 Cobweb theorem: ............................................................................................................................100
CHAPTER FOUR: CONSUMER THEORY ............................................................................................................103
7. Introduction...............................................................................................................................................103
7.1 Cardinal utility theory or Marginal utility theory ............................................................................103
7.2 Consumers’ equilibrium ...................................................................................................................106
7.3 Deriving demand curve under the cardinal utility theory ..............................................................108
7.4 Graphical derivation of the demand curve for the consumer........................................................109
7.5 Critique of the cardinal utility theory ..............................................................................................110
7.6 Ordinal utility theory or indifference curve approach....................................................................111
7.7 Consumer’s equilibrium ...................................................................................................................112
7.8 Indifference curves ..........................................................................................................................112
7.9 Characteristics of indifference curves.............................................................................................114
7.10 Types of indifference curves ...........................................................................................................117
7.11 Perfect substitutes...........................................................................................................................117
7.12 Perfect complements ......................................................................................................................117
7.13 Budget line .......................................................................................................................................118
7.14 Consumer equilibrium point............................................................................................................119
7.15 Changes in consumers’ income and equilibrium ............................................................................121
7.16 Changes in price on consumers’ equilibrium ..................................................................................122

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7.17 Applications of indifference curve analysis ....................................................................................123
7.18 Other applications of indifference curve analysis ..........................................................................126
7.19 Consumer surplus ............................................................................................................................127
Exercises 3......................................................................................................................................................127
12. CHAPTER FIVE: THEORY OF PRODUCTION .........................................................................................129
8. Introduction .....................................................................................................................................129
8.1 Basic concepts..................................................................................................................................129
8.2 Short-run changes in production.....................................................................................................130
8.3 Stages of production .......................................................................................................................133
8.4 Long - run changes in production....................................................................................................135
8.5 Isoquants..........................................................................................................................................135
8.6 Properties of Isoquants ...................................................................................................................136
8.7 Isocost lines......................................................................................................................................138
8.8 Least cost factor combination.........................................................................................................139
8.9 Firm’s expansion path......................................................................................................................140
8.10 The law of decreasing returns to scale ...........................................................................................140
Exercises 5......................................................................................................................................................142
1. CHAPTER SIX: THEORY OF COST...............................................................................................................144
9. Introduction...............................................................................................................................................144
9.1 Basic cost concepts..........................................................................................................................144
9.2 Short run and long run.....................................................................................................................145
9.3 Short run cost functions ..................................................................................................................145
9.4 Relationship between the short run cost curves ...........................................................................153
9.5 Long run cost functions...................................................................................................................154
9.6 Economies of scale...........................................................................................................................158
9.7 Internal economies of scale.............................................................................................................158
9.8 External economies of scale............................................................................................................160
9.9 Diseconomies of scale......................................................................................................................161
Exercises 6 .....................................................................................................................................................161
CHAPTER SEVEN: MARKET STRUCTURES ........................................................................................................163
10. Introduction..........................................................................................................................................163
10.1 Perfect Competition.........................................................................................................................164
10.2 Characteristics of perfect competition ...........................................................................................164
10.3 Short –run equilibrium.....................................................................................................................166
10.4 Long – run.........................................................................................................................................167
10.5 Monopoly .........................................................................................................................................169
10.6 Sources of monopoly power ...........................................................................................................169
10.7 Monopolist demand curve ..............................................................................................................169
10.8 Short run equilibrium.......................................................................................................................170
10.9 Long run equilibrium........................................................................................................................171

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10.10 Criticisms of monopoly ....................................................................................................................171
10.11 Price discriminating monopolist......................................................................................................171
10.12 Monopolistic Competition...............................................................................................................171
10.13 Characteristics of monopolistic competition..................................................................................172
10.14 Monopolistic demand curve............................................................................................................172
10.15 Short run/long run............................................................................................................................173
10.16 Oligopoly ..........................................................................................................................................174
10.17 Meaning............................................................................................................................................174
10.18 Characteristics of oligopoly .............................................................................................................174
10.19 Kinked demand curve model...........................................................................................................174
10.20 Cartels...............................................................................................................................................177
10.21 Dominant firm model.......................................................................................................................177
10.22 Oligopoly and Game theory.............................................................................................................177
10.23 Nash Equilibrium ..............................................................................................................................177
10.24 The Prisoner’s dilemma....................................................................................................................177
Exercises 7......................................................................................................................................................177
CHAPTER EIGHT: THEORY OF DISTRIBUTION..................................................................................................179
11. Theory of Distribution ..........................................................................................................................179
11.1 Introduction .....................................................................................................................................179
11.2 Demand for factors of production ..................................................................................................179
11.3 Supply of factors of production ......................................................................................................179
11.4 Pricing of factors of production ......................................................................................................179
11.5 Reward to factors of Production ....................................................................................................179
11.6 Rent-The reward on land .................................................................................................................179
11.7 Interest or Profit-The reward to capital..........................................................................................179
11.8 Impact of trade unions and collective bargaining on wages and jobs ..........................................179
Exercises 8 .....................................................................................................................................................179
REFERENCES......................................................................................................................................................181

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PREFACE
In my experience teaching economics to undergraduate students in Kenya, I have been shocked
by the inability of universities to stock their library with textbooks despite charging exorbitant
fees for the same. Someone must be chewing students’ textbooks. I have also discovered that
most available readings in economics are not local. The available books are not only expensive
but also lack localized examples and exercises. Where are the textbooks written by our local
Professors of economics? I have come across a countable number. Maybe our Professors are
busy making money in constitutional commissions, public service, consultancy and politics and
have no time to publish and teach.
It is on this backdrop that this book is inspired. There is an urgent need to fill these gaps in the
market and restore some love for economics among these folks. I should also mention that I have
learnt that for the majority of these folks there is no love lost between them and economics. The
aim of this textbook is to localise the content and exercises and also provide an affordable yet
competitive reading in Microeconomics for the many underprivileged university students in
developing countries.

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CHAPTER ONE: INTRODUCTION
1.0 NATURE AND SCOPE OF ECONOMICS
1.1 Meaning of Economics
The term economics comes from the Greek for oikos (house) and nomos (custom or
law), hence "rules of the house (hold)."
Economics is a study of the ways in which mankind provides for his material well-
being. That is, how people apply their knowledge, skills and efforts, to the gifts of
nature in order to satisfy their material wants. In this sense economics is as old as
mankind.
Economics is also defined as a social science, which studies the allocation of scarce
resources that have potentially alternative uses among competing and virtually
limitless wants of consumers in a society. It is therefore the science that studies
human behaviour as a relationship between ends and scarce means which have
alternative uses.
It can also be defined as a branch of social science that deals with the production,
distribution, consumption and management of goods and services.
1.2 Basic Economic Concepts
1.2.1 Human Wants
Human wants are peoples’ desires for goods, services and circumstances that
enhance their material well-being. Human wants are assumed to be limitless in the
sense that they can never be satisfied to the point of satiety. Satiety refers to the
feeling of fullness.
Human wants in this case does not refer to the desire for a specific commodity or set
of commodities, rather it is to commodities in general. Human wants are different
from human needs. Economic activity (productive activity) is generally directed
towards the satisfaction of these human wants.
1.2.1 Resources

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Resources are the means or ingredients available for producing goods and services.
They can be broadly classified into land, labour, capital and entrepreneurial ability.
These resources are combined by the entrepreneur in various ways to produce goods
and services. Thus resources are also referred to as factors of production or the
inputs in production process.
1.2.2 Scarcity and Choice
Scarcity is defined as the inability of resources to satisfy all human wants to the point
of satiety. In other words, it means that available resources are insufficient to satisfy
all wants and needs. Therefore resources available to people are said to be scarce
because they are insufficient to satisfy all their wants. The problem of scarcity is
known as the economic problem. If resources were not scarce and did not have
alternative uses, there would be no economic problem. The next paragraph presents
discusses the notion of scarcity.
Scarcity is a relative concept that relates the extent of peoples wants to the means
available to satisfy them. (Scarcity is not absolute i.e. not just a question of fewer or
more). Scares resources are called economic resources, and goods produced using
such resources are economic goods. Economic goods/resources command a non-zero
price. Abundant resources are not economic resources; consequently they do not
have a price. Scarcity implies also that resources have competing alternative uses.
Scarcity is a feature of all societies both affluent and the poor, it is what is called the
economic problem.
1.2.3 Choice
Because of scarcity choices have to be made. Since human wants are unlimited and
resources to satisfy these wants are scarce, individuals and society as a whole cannot
have all the things that they want. Choices then have to be made as to which need to
satisfy and which to forego. The choice to have X may imply forgoing Y, or the choice
to have more of X means having less of Y and vice versa.
1.2.4 Rationale for Choice
What considerations do economic agents make when making these choices?
Consumers aim to maximise utility, producers aim to maximise profits and resource

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owners aim at maximising factor incomes (They want the best from the available
resources). Choices are made by individuals as well as the society.
Consumers choose how to spend their limited income so as to maximise utility or the
satisfaction derived from consumption of goods and services. Producers choose how
to combine resources to minimize costs and maximise profits. Resource owners
choose where to hire their factors to maximise factor incomes.
1.2.5 Opportunity Cost
Opportunity cost of an action refers to the value of the benefit expected from the
next best-forgone alternative. Or the benefits you could have received by taking an
alternative action. It is based on the fact that resources are scarce and have
competing alternative uses. Not all the potential uses can be realized thus choices
have to be made. The choice to satisfy one alternative implies that another
alternative is foregone. The value of the foregone alternative is called opportunity
cost. Examples of opportunity costs are discussed in the paragraph that follows:
The opportunity cost of going to college is the money you would have earned if you
worked instead. On the one hand, you lose four years of salary while getting your
degree; on the other hand, you hope to earn more during your career, thanks to your
education, to offset the lost wages.
Also a gardener decides to grow carrots; his or her opportunity cost is the alternative
crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.)
In both cases, a choice between two options must be made. It would be an easy
decision if you knew the end outcome; however, the risk that you could achieve
greater "benefits" (be they monetary or otherwise) with another option is the
opportunity cost.
If a consumer with a fixed amount of money, Ksh.150, has to choose between buying
a textbook and going for a movie, the opportunity cost of going for a movie is the
textbook forgone.

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It is not only the choices of consumers, which will involve opportunity cost but also
those of producers and resource owners. There would be no opportunity cost if first,
resources were unlimited as no action would be at the expense of the other since all
could be undertaken, and the opportunity cost of any action would be zero. Second,
resources were to have only one use, because there would be no foregone action or
alternative.
1.2.6 Production Possibility Frontier (PPF)
OR Production Possibility Curve (PPC)
The problem of scarcity and choice can be illustrated by making use of the production
possibility curve. The Production Possibility Curve (PPC) is defined as a locus of points
representing combinations of commodities that can be produced in a country if all
available resources and the most efficient techniques of production are utilised in a
given period of time.
PPC represents the point at which an economy is most efficiently producing its goods
and services and, therefore, allocating its resources in the best way possible. If the
economy is not producing the quantities indicated by the PPF, resources are being
managed inefficiently and the production of society will drop. The production
possibility frontier shows there are limits to production, so an economy, to achieve
efficiency, must decide what combination of goods and services can be produced
As an illustration, imagine an economy that can produce only wine and cotton.
According to the PPF, points A, B and C - all appearing on the curve - represent the
most efficient use of resources by the economy. Point X represents an inefficient use
of resources, while point Y represents the goals that the economy cannot attain with
its present levels of resources.

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Figure 1.1: The Production Possibility Curve/Frontier
Since the PPC is downwards sloping, producing more of one of the commodities
implies producing less of the other by reallocating resources. Thus, producing more
of cotton will only be possible if there is a reduction in the amount wine produced.
As we can see, in order for this economy to produce more wine, it must give up some
of the resources it uses to produce cotton (point A). If the economy starts producing
more cotton (represented by points B and C), it would have to divert resources from
making wine and, consequently, it will produce less wine than it is producing at point
A. As the chart shows, by moving production from point A to B, the economy must
decrease wine production by a small amount in comparison to the increase in cotton
output. However, if the economy moves from point B to C, wine output will be
significantly reduced while the increase in cotton will be quite small.
This illustrates the concavity of the PPF, (i.e. the absolute value of the slope of the
curve increases moving downwards from left to right), hence opportunity cost of
producing wine increases with its production. The same can be said of cotton. This is
because resources are not equally efficient in manufacture and agricultural
production. (Some resources are more efficient in food production while others in
manufactured production).The amounts of wine given up to produce one more unit

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of cotton measures the opportunity cost of producing cotton. This is measured by the
absolute slope of the PPC at any given point.
The absolute value of the slope of the PPC is sometimes called the Marginal Rate of
Transformation (MRT) that is, the rate at which the output of one commodity is
being transformed to that of another by re-locating resources. Marginal Rate of
Transformation (MRT) is defined as the amount of output of one product given up to
produce an extra unit of another. Because of the concave shape of the PPC the MRT
will also increase as more and more of either commodity is produced.
Absolute slope PPC = Marginal Rate of Transformation = Opportunity cost
Keep in mind that A, B, and C all represents the most efficient allocation of resources
for the economy; the nation must decide how to achieve the PPF and which
combination to use. If more wine is in demand, the cost of increasing its output is
proportional to the cost of decreasing cotton production.
Point X means that the country's resources are not being used efficiently or, more
specifically, that the country is not producing enough cotton or wine given the
potential of its resources. Point Y, as we mentioned above, represents an output level
that is currently unreachable by this economy. However, if there was a change in
technology whiles the level of land, labour and capital remained the same, the time
required to pick cotton and grapes would be reduced, output would increase, and the
PPF would be pushed outwards. A new curve, on which Y would appear, would
represent the new efficient allocation of resources. A country’s productive capacity
will increase if there is an increase in the labour force, stock of capital goods or
improvement in technical knowledge as shown by the outwards shifting of the PPC.

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Figure 1.2: Outward Shift of the PPF/PPC
When the PPF shifts outwards, it means that there is growth in an economy.
Alternatively, when the PPF shifts inwards it means that the economy is shrinking as a
result of a decline in its most efficient allocation of resources and optimal production
capability. A shrinking economy could be a result of a decrease in supplies or a
deficiency in technology.
An economy can be producing on the PPF curve only in theory. In reality, economies
constantly struggle to reach an optimal production capacity. And because scarcity
forces an economy to forgo one choice for another, the slope of the PPF will always
be negative; if production of product A increases then production of product B will
have to decrease accordingly.
There are two extreme possibilities. The economy may devote all its resources to
cotton production and produces no wine. Or, all resources are put to work in the
manufacturing industry (wine) and none to agriculture (cotton). These two extremes
are very unlikely; the economy will most likely choose to produce a combination of
both commodities.
To illustrate this, suppose that the country is using all its resources in the production
of manufactured goods. If the country now decides to produce agricultural
commodities, it is expected that the opportunity cost of the first few tonnes of

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agricultural products to be relatively small as those recourses, which are relatively
more efficient in agricultural production, move from manufactured goods production
to agricultural production. As more and more of agricultural products are produced,
however, it becomes necessary to move into agriculture production those factors
which are more efficient in the production of manufactured goods. As this happens
the opportunity cost of the extra tonnes of agricultural products produced will get
larger and larger.
1.3 Methodology of Economics
Economic methodology refers to the way in which economists go about the study of
their subject matter.
1.3.1 Positive Economics
A useful insight can be gained by distinguishing between positive economics and
normative economics. This will enable one to appreciate the limitation and scope of
economics.
Positive economics is concerned with propositions that can be tested with reference to
empirical evidence. Positive economics is sometimes defined as the economics of
"what is." It is the branch of economics that concerns the description and explanation
of economic phenomena. It focuses on facts and cause-and-effect relationships and
includes the development and testing of economics theories. For example “if prices
rise, demand will fall”.
Positive economics is concerned with describing and analysing the economy as it is. It is
in principle independent of any particular ethical position or normative judgments. As
Keynes says, it deals with “what is,” not with “what ought to be.” Its task is to provide
a system of generalizations that can be used to make correct predictions about the
consequences of any change in circumstances. Its performance is to be judged by the
precision, scope, and conformity with experience of the predictions it yields. In short,
positive economics is, or can be, an “objective” science, in precisely the same sense as
any of the physical sciences. Of course, the fact that economics deals with the
interrelations of human beings, and that the investigator is himself part of the subject

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matter being investigated in a more intimate sense than in the physical sciences, raises
special difficulties in achieving objectivity at the same time that it provides the social
scientist with a class of data not available to the physical scientist.
1.3.2 Normative Economics
Normative economics discusses "what ought to be". Normative economics is the
branch of economics that incorporates value judgments about what the economy
should be like or what particular policy actions should be recommended to achieve a
desirable goal. Normative economics looks at the desirability of certain aspects of the
economy. It underlies expressions of support for particular economic policies. For
example “The rich should be taxed more”. It is common to distinguish normative
economics ("what ought to be"(in economic matters) from positive economics
("what is"). But many normative (value) judgments are held conditionally, to be given
up if facts or knowledge of facts changes, so that a change of values may be purely
scientific (Sen, 1970, p, 61). This undermines the common distinction (Wong, 1987, p.
923). But Sen distinguishes basic (normative) judgments, which do not depend on
such knowledge, from non-basic judgments, which do. He finds it interesting to note
that "no judgments are demonstrably basic" while some value judgments may be
shown to be non-basic. This leaves open the possibility of fruitful scientific discussion
of value judgments (Sen, 1970, pp. 63-64).
Hence it is important to note that normative economics is based on positive
economics, for example “Industries in Kenya should be more concentrated in rural
areas”. This statement rests on a positive assertion of existing industrial
concentration. Thus at times there is no clear-cut line in between positive economics
and normative economics. Unlike positive economics, normative economics is not
subject to empirical verification (Disputes settled by voting).
1.3.3 The Scientific Method
The scientific method is confined to positive questions, those that can be verified or
falsified by looking at facts. The economic way of thinking focuses on positive, as
opposed to normative, analysis, and applies the five-step scientific method: (1)
recognize the problem, (2) cut away unnecessary detail by making assumptions, (3)
develop a model or story, (4) make predictions, and (5) test the model. One major

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objective of science is to develop theories. Theories are general statements or
unifying principles, which explain and describe the relationship between things
observed in the world around us. They try to answer the question why? The search
for a theory begins when some definite pattern is observed between two or more
things and one asks why? In trying to come up with a theory, scientific enquiry makes
use of procedures that are common to all sciences; these procedures are called the
scientific method.
They consist of the following;
1. To define the concepts to be used in such a way that they can be measured. This
is necessary if the theory is to be tested against facts; for example if a relationship
is observed between income and consumption, these terms must be defined in a
clear way.
2. To formulate a hypothesis. A hypothesis is a tentative untested statement, which
tries to explain how one thing is related to another. It will be based on
observations and assumptions about the way the world behaves. These
assumptions are in turn based on theories that have proved to have a high degree
of reliability. With these assumptions and observations, a process of logical
reasoning leads to a hypothesis.
3. To use the hypothesis to make predictions. i.e., if the hypothesis is correct, then if
certain things happen then certain consequences will follow.
4. To test the hypothesis. This is to see if the predictions of the hypothesis are
supported by facts. In the natural sciences the tests are done through controlled
experiments, but this is not possible in the social sciences. If the hypothesis is
correct, then we have a successful theory- a scientific law.
A successful theory is useful because it helps to predict with a high degree of
probability the out-come of certain events.
1.3.4 Economics as a Social Science
Economic analysis is based on above described procedure, and in so far as economists
make use of the scientific method, economics may be considered a science. The
subject matter of economics is the behaviour of human beings, therefore it is

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considered as a social science. There are certain difficulties encountered in
considering economics as a science
First, Economists cannot test their hypothesis in controlled experiment as they are
dealing with human behaviour. Predictions of economic theory must be tested
against developments in the real world. Economic activities are recorded and the
results of mass statistical data subjected to statistical analysis. Second, the subject
matter of economics is human behaviour and thus difficult to predict than reactions
of inanimate matter. The fact that all human beings are different is not a major
handicap to economists. They are able to make predictions about group behaviour
with reasonable certainty [Why]. What economists are interested in is not individual
but group behaviour. Human beings are assumed to be rational beings who want to
maximise their well-being. Third, the complexity of the world they are studying. There
are numerous factors influencing economic behaviour of people, which are
simultaneous and constantly changing. Natural scientists in their labs can hold other
things constant (controlled experiments) while studying the effects, which changes
in X have on Y.
Economists cannot do this so they assume that other things remain constant. Thus
many economic statements begin with the phrase "if other things remain constant”
which is also written as "ceteris paribus" in Latin (Principles rather than statements).
1.4 Microeconomics versus Macroeconomics
The overall study of economics is divided into two, microeconomics and
macroeconomics.
Microeconomics: “Micro” is Greek word meaning small. Microeconomics
concentrates on decisions of individual economic units; the factors influencing such
decisions. (Economic units such as the consumer, producer, government, resource
owners). It thus gives a worm’s view to the economy. Microeconomics (or price
theory) is a branch of economics that studies how individuals, households, and firms
make decisions to allocate limited resources, typically in markets where goods or
services are being bought and sold. Microeconomics examines how these decisions

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and behaviours affect the supply and demand for goods and services, which
determines prices, and how prices, in turn, determine the supply and demand of
goods and services.[2] [3]
Macroeconomics: “Macro” is also a Greek word, which means large. It is a branch of
economics that deals with the performance, structure, and behaviour of a national
economy as a whole.[1] Macroeconomists seek to understand the determinants of
aggregate trends in an economy with particular focus on national income,
unemployment, inflation, investment, and international trade.
In contrast, microeconomics is primarily focused on the determination of prices and
the role of prices in allocating scarce resources.[1]
Much of modern macroeconomic theory has been built upon 'micro foundations' —
i.e. based upon basic assumptions about micro-level behaviour. Macroeconomics
concentrates on how decisions of individual economic units influence the
macroeconomic aggregates. It thus gives a bird view of the economy.
1.5 Economic Systems
1.5.1 Basic economic choices
Because of scarcity choices have to be made. The problem of choice is essentially one
of allocation. People must decide how to allocate resources to different uses and
then how to allocate goods and services produced to different individual members of
society. Three fundamental choices that have to be made by any society are as
follows.
What to produce (which goods to produce and in what quantities). The problem in
this case concerns the composition of the final output, i.e, how much of each good
should be produced?
N/B. The choices of society are not of “all or nothing”. They take the form of more of
one thing and less of another.

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How to produce. (How should the various goods and service be produced). Most
goods and services can be produced by a variety of methods. Different methods of
production can be distinguished from each other by the quantities of different
resources used in producing them. Economists use the terms capital and labour
intensive to distinguish the various methods of production.
For whom to produce. (How should the goods and services be distributed). This third
choice involves the relative shares of all the total output going to the households.
Should everyone get an equal share? Should distribution be based on everyone's
contribution to production? Should distribution be based on the people's ability to
pay a price? Should the relative shares be determined according to traditions and
customs?
While the nature of these three choices is the same for all societies, it is possible to
adopt different methods, which jointly are referred to as economic systems. An
economic system is defined as “a set of institutional arrangements whose function is
to employ most efficiently scarce resources to meet the ends of society”. [United
Nations Dictionary of social sciences, 1932]
An economic system is a particular set of social institutions which deals with the
production, distribution and consumption of goods and services in a particular
society. The economic system is composed of people and institutions, including their
relationships to productive resources, such as through the convention of property. It
addresses the problems of economics, such as the allocation of scarce resources in a
given economy. Economic systems are concerned with the ownership and control of
resource.
Economic systems can be broadly be categorized into three groups: Market
economies, Command economies, Mixed economies
1.5.2 Market Economy
A market economy (also called a free market economy or a free enterprise economy)
is an economic system in which the production and distribution of goods and services
take place through the mechanism of free markets guided by a free price system.[1][2]

20. 20
This is an economic system in which the decisions of what, how and for whom to
produce are undertaken by millions of separate individual (consumers, producers and
resource owners) acting through the price mechanism. (Both in the factor and
product markets)
In a market economy, businesses and consumers decide what they will purchase and
produce. Technically, this means that the producer gets to decide what to produce,
how much to produce, what to charge customers for those goods, what to pay
employees, etc., and not the government. These decisions in a free-market economy
are influenced by the pressures of competition, supply, and demand
A free price system or free price mechanism (informally called the price system or
the price mechanism) is an economic system where prices are set by the interchange
of supply and demand, with the resulting prices being understood as signals that are
communicated between producers and consumers which serve to guide the
production and distribution of resources. Through the free price system, supplies are
rationed, income is distributed, and resources are allocated. A free price system
contrasts with a controlled or fixed price system where prices are set by government,
within a controlled market or planned economy. The state plays no part in economic
activities or if it does, it is only very minimal.
NB: This is not to be confused with a perfect market where individuals have perfect
information and there is perfect competition.
What to produce is determined by consumers acting through the price mechanism,
i.e. any economic activity is directed towards the satisfaction of human wants, thus
the free market gives rise to a situation where the consumers are the ultimate
dictators of the kind and quantity of the goods to be produced. This situation is
referred to as consumer sovereignty.
In effect the consumers make their preferences known to producers through money
votes, in other words those goods which are in greatest demand, will be the ones
that producers are keen to supply following their motivation to maximize profits.

21. 21
Consumers exercises this power by bidding up the prices of those goods they want
most .The suppliers follow the lure (entice) of higher prices and profits, and produce
more of those goods.
How to produce (whether capital intensive of labour intensive) will depend on the
relative factor prices. Factor price will be determined in the factor market by demand
and supply of a factor. (That is the working of the price mechanism in the factor
market). Profit maximising firms will attempt to keep the cost of production to a
minimum and will seek to use the most efficient methods of production. If for
example there is a high demand for labour, the price of labour (wages) will increase
forcing most firms to adopt capital-intensive production methods. Thus the question
of how to produce is determined by competition among firms for factors of
production through the price mechanism.
For whom to produce is determined by the ability to pay the price which in turn is
determined by the households’ incomes. Households' income distribution will depend
on ownership of factor inputs and the prices of the factors. For a given distribution of
factors, household incomes will depend on the prices of factors of production, which
are dependent on the working of the price mechanism in the factor market.
The greater the level of income received, the greater the ability to purchase goods
and services. The distribution of goods and services is therefore determined by the
purchasing power of individuals, which in turn depends on their factor incomes.
1.5.3 Features of a Free Market
The framework of a capitalist or market economy contains six essential features:
private property, freedom of choice and enterprise, self-interest as a dominative
motive, competition, reliance on the price system and limited government role.
Private Ownership of the resources means that individuals are free to own, control
and dispose, the means of production that is land, capital etc. and enjoy the incomes
from them. Resources can be held in the form of money which is a claim to resources
held by others. Private property also confers to the right to the income from that

22. 22
property in the form of interest, rent profit and wages. The rights to own property
only apply to nonhuman resources in the absence of slave trade. Owners of capital
and land purchase services of labour in order to operate their firms.
Freedom of choice and enterprise means that individuals are free to buy or hire
economic resources, organise these resources for production and sell their products
in the market of their choice. Freedom of choice means that owners of land and
capital may use these resources as they see fit. Workers are free to sell their labour in
any occupation and industries of their choice. Consumers are free to buy any product
of their choice. It is this consumer’s freedom of choice that is considered most
important of economic freedoms. The consumer is regarded as being sovereign since
it is the way in which he chooses to spend his income which determines the way in
which society uses its economic resources.
Self-interest as the dominating motive in a capitalist economy, each unit tries to do
what is best for itself. Firms aim to maximise profits, workers to maximise their
wages, landowners to maximise the returns from their land and consumers at
maximising their satisfaction/utility.
Competition envisages a situation where for a given commodity there are a large
number of buyers and sellers. Thus an individual buyer and seller accounts very little
share of business transacted thus no influence on market demand and supply. It is the
market forces of demand and supply that determines the market price and each
participant whether the buyer or seller must take this price as given as it is beyond
their influence.
Reliance on price mechanism the most basic feature of a capitalist economy is the
use of price mechanism to allocate resources. With a freely operating price
mechanism, both prices and output levels are determined by the interaction of forces
of demand and supply. Changes in demand and supply cause changes in the market
price, and it is these price movements which bring about the changes in the way
society uses its resources.

23. 23
Limited role of the government means that the government has a very limited role in
the economic profit making activities i.e. no price control, subsidies, taxation etc. It is
only involved in defence, police service, facilitating roads for public transport and
others as such.
1.5.4 Functions of Price
It rations out scarce goods. At any one time the supply of a good is relatively fixed.
This good has to apportioned among many people who want it, this is achieved by
adjusting the prices price raises demand contracts as it falls demand expands .At the
equilibrium price, demand just equals supply should supply increase the total quantity
can just be disposed by lowering the price. And should supply decrease, price would
have to be raised.
It indicates changes in wants. Prices in a community are signals that indicate the
extent to which different goods are wanted and changes in those wants. The price
induces supply to respond to changes of demand. When demand increases prices
increase and supply expands, when demand falls prices fall and supply contracts.
Indicates changes in conditions upon which goods can be supplied and rewards
factors of production. When prices rise, producers can afford to offer a higher reward
to the factors they use in order to attract them from other users such give the
owners of resources spending power.
1.5.5 Planned Economy
This is also known as centrally planned economy, command economy or controlled
economy. This is an economic system in which decisions of what, how and for who to
produce are undertaken by a Central Planning Authority. (CPA) Hence the CPA on
behalf of the state determines resource allocation.
The CPA is made up of large administrative machinery responsible for issuing
commands and directives to all households and producers in the society. Producers
are directed about what to produce, where to get the supply of resources, what
techniques of production to use and where to dispose the finished product.

24. 24
Consumers are issued with ration cards telling them to which commodities they are
entitled to and which distribution centres they could obtain them.
Labour would also be directed to occupations and industries decided upon by the
CPA. In a pure command economy there would be no place for money and prices.
Effectively, the CPA assumes the role of the price mechanism in relation to a capitalist
economy. Because of the restrictions on individual decision making implied, this
system can only work within a rigid and probably totalitarian political framework.
Strictly, a pure command economy could not exist in reality, the command economies
that existed until early 1990s in communist countries of central and eastern Europe
depended on money for resource allocation, i.e. to mirror consumers choices more
accurately, thus they could better be described as planned economies with some
degree of household choice.
(It has been calculated that for an economy the size of the soviet union, the CPA would
have to issue 200 billion orders to determine exactly how much each house hold and
each firm should consume and produce respectively with respect to a single
commodity.)
In this system the CPA made production decisions of what and how to produce,
allocation resources to industries and productive units that were then required to
meet production targets of a master plan. The planners would in some cases set the
prices of essential goods, but allow factory managers to set prices of less essential
goods.The households and individual consumers were free to choose the final goods
they wished to buy subject to their availability.
1.5.6 Features of a Planned Economy
All important means of production are publicly owned, i.e. all land, housing, power
stations, transport system and so on, are owned by the state. The rationale for public
ownership is based on the following reasons, equitable income distribution & Greater
government control in order to carry out government plans. Since the property is
publicly owned, there is no personal income derived from resources.

25. 25
Generally, there is no private enterprise. Production is initiated and conducted by the
state, which may pay wages and other costs retaining resultant profits. Interest and
rent goes to the state, as it is the owner of capital and land.
The allocation of the country’s productive resources will be determined according to
the direction or plans of the CPA. Thus the CPA is entrusted with two fold duties,
laying down the objectives of planning and to settle the targets and priorities of the
plan. The effectiveness of implementing such plans lies in the fact that the state owns
and controls strategic means of production.
Other features include: Fixing of prices and wages which are not the equilibrium rates
as well as rationing of some commodities, occasional existence of a conscripted
labour market in which workers take jobs assigned to them, existence of production
targets in different sectors of the economy which are achievable as resources are
owned and controlled by the state and provision of free basic services to all. These
goods include: education, health service.
1.5.7 Advantages of a Free Market
A capitalist economy works automatically and so does not require any CPA for it to
function. It functions automatically through the price mechanism, i.e. any disturbance
in the economy will rectify by price changes. In a command economy, which functions
through active state intervention, changes in demand will have to be adopted
through the CPA. Thus allocation of resources through the use of price mechanism
means that no resources are wasted in the planning process. It is costless to allocate
resources.
Demand matches supply since all production takes place in response to demand,
there is a balance between the goods produced and those required by the
consumers. Resources are thus used efficiently and there are no gluts due to over
production or Shortages due to under production.

26. 26
The free market is flexible to respond to changes in the demand or supply
conditions. The economy reacts quickly to changing economic conditions in the world
markets than do planned economies; this is because in a command/planned economy,
changes in production have to be planned and hence takes a lot of time between
planning and implementing.
There is consumer sovereignty meaning that competition among the firms gives rise
to a large number of goods and services being offered for sale. This means that
consumers have a wider variety of goods and services to choose from.
There is higher efficiency and incentive to hard work under a capitalist system,
workers and entrepreneurs are encouraged to improve their efficiency and work hard
for higher wages and profits respectively. This in turn will entail higher rates of
economic growth.
The market is characterized by higher rates of capital formation. In a market
economy, people have a right to own property and consequently a right to the
income proceeding from it. This provides a motive for people to save and invest their
incomes. Investment will increase the stock of capital goods needed to increase the
efficiency of the production processes.
There is optimum resource utilization since a market economy leads to an
economical use of resources. This is because of keen competition among producers in
the production of commodities. An Uneconomical use of resources will lead to losses
and eventually exist from the industry.
1.5.8 Disadvantages of the Free Market
Wasteful competition since competition is one of the cardinal/fundamental features
of a capitalist economy it leads to wastage in various forms:
First, Advertising and salesmanship expenditure; such and expenditure will not be
undertaken in a command economy. These sales campaigns may be in turn aimed at
defeating a rival firm, thus resources employed in such a firm will go to waste.

27. 27
Second, wastage will be seen in the production of many varieties which make it
difficult for firms to operate economically. (to obtain economies of scale)
Income Inequalities since people receive their incomes from the factors of
production owned and controlled. However such resources are not equally
distributed, thus not everyone has the same capacity to accumulate wealth and
income. Coupled with the fact of inheritance, income inequalities are likely to develop
and become wider.
Misallocation of resources since in a market economy, production responds to
consumers demand. With large income inequalities, the rich who have more money
hence greater purchasing power are able to exert a greater pull in the allocation of
resources. Scarce resources in response to price levels can be diverted to the
production of luxuries for the wealthy before adequate outputs of necessities for the
poor can be produced. In this sense, the price mechanism allocates economic
resources to the production of nonessential goods that benefits a few individuals and
leaves out the production of essential goods which could benefit many more people.
The free market leads to the emergence of monopolies. A monopoly is a market
structure with only one seller and many buyers of a commodity. Monopoly power is
the ability of a firm to control prices of its products. It can be achieved through
collusion or mergers, which give a firm a substantial market share and can be
maintained by making it difficult for new rival firms to enter the industry. Given the
motive of profit maximization, a firm with monopoly power can exploit consumers by
setting prices above competitive levels thus earn supernormal profits. Also the lack of
competition many lead to inefficiency.
Externalities in economics, is an impact (positive or negative) on any party not
involved in a given economic transaction. An externality occurs when a decision
causes costs or benefits to third party stakeholders, often, although not necessarily,
from the use of a public good. In other words, the participants in an economic
transaction do not necessarily bear all of the costs or reap all of the benefits of the
transaction. For example, manufacturing activities that cause air pollution imposes

28. 28
costs on others when making use of public air. In a competitive market, this means
too much or too little of the good may be produced and consumed in terms of overall
cost or benefit to society, depending on incentives at the margin and strategic
behaviour.
The economic organisation of every human society is characterised by certain social
costs (pollution) and certain social benefits, which are not taken into account by firms
in determining their price and output levels. Such social costs and benefits are called
externalities, and their existents means that the price mechanism fails to reflect the
true opportunity cost of resources, thus these goods are under produced or
overproduced as the market fails to compensate the third party or reward the
businessman.
The free market economy will not allocate resources towards the production of
public goods or collective consumption goods.
These are goods possessing the following two characteristics: Non-Rivalry in
consumption - benefits from these goods are not confined to one individual or house
hold; consumers are not in competition with each other as the consumption of the
good by one household does not affect the consumption of the same good by
another household or individual; Non-excludability in consumption - once the good
has been provided it is not possible to prevent anybody else from getting the benefit
as a penalty for non-contribution towards the cost of providing them.
It thus leads to the problem of free riders as a rational consumer may choose to
refuse to meet his share of the production cost in the knowledge that he cannot be
punished for so doing. An example of this is defence.
Reading exercise: Read on impure public goods
It leads to Instability and unemployment. It leads to phenomena characterised by
trade cycles, which exhibits periods of prosperity recession depression and recovery.

29. 29
During periods of recession and depression there is a slowing down of economic
activity resulting to unemployment.
There is an inability to cope with rapid structural changes. For example in the case of
a war price mechanism cannot mobilise enough resources for the war efforts as an
overriding aim. In a free market undesirable drugs and drinks may be produced.
1.5.9 Advantages of a Planned Economy
First, a planned economy facilitates shift of resources in pursuit of grand schemes
such as rapid industrialisation. Second, this economy avoids the instability which
characterises the free market system economies i.e. booms and depressions. Third, it
ensures greater equality in income distribution that might otherwise occur as in the
case of the free market economy. This is because wealth is owned by the state and
any one should accumulate it, the state would distribute their incomes to the poor.
Fourth, it ensures that negative externalities or social costs are minimised. This is
done by putting restrictions such as; industries may not be established in certain
areas as they may pose high social costs.
Fifth, a planned economy makes adequate provision for public goods such as defence
law and order and merit goods such as education and health care. Sixth, it guarantees
the provision of essential goods such as education and health by the state regardless
of whether the consumer can be able to pay for them. Seventh, a planned economy
puts a check to monopoly power, and those industries, which can easily develop into
a monopoly such as Electricity and railways, are controlled in the form of public
monopolies. Finally, the CPA enables a command economy to achieve full
employment of resources by directing labour to production activities even if those
activities are not profitable.
1.5.10 Disadvantages of a Planned Economy
On the other hand, without the price mechanism, it is very difficult to estimate the
existing and future pattern of demand for commodities. Consequently, shortages and
gluts have been recurring features of command economies. Second, even when the
required information about allocation decisions is collected, the pattern of

30. 30
consumer’s preferences and society’s composition of resources might well change
before production and distribution plans are implemented. In other words there is a
time lag between collection of information and the formulation of production plans
based on that information. Also there is a further time lag between the
implementation of production plans and the realization of production targets.
Third, the cost of gathering information on what to produce how to produce and for
whom to produce is likely to be high requiring the expertise of professionals like
statisticians, economists etc. In the free market economy, price mechanism provides
a costless source of information. Fourth, the absence of the profit motive prevalent in
planned economies means that there is no incentive for innovation and hard work
which gives raise to inefficiency in terms of low output per worker. Fifth, in the
planned economies, the power of consumer sovereignty does not operate because
demand is manipulated to match the limited range of goods available, thus the goods
produced tend to be standardised with no regard for individual tastes.
1.5.11 Mixed Economic System
This is an economic system in which the solutions to the 3 basic economic questions,
(problem of resource allocation) are determined by both state planning and the
working of the price mechanism. Features of both free market and command
economies are found in this system.
In practice the mixed economy exists in two forms. First, where the means of
production are privately owned, but the state through the fiscal, monetary and price
policies influences the working of the price mechanism towards the desired direction.
(according to its plan). Second, where the state does not only regulate the working of
the price mechanism, but also owns and controls strategic resources thereby
undertaking part of the economy’s production. The former leans towards a capitalist
system while the latter towards the socialist system.
History has witnessed a gradual shift from a capitalist form of economy, one where the
state plays no part or plays a minimal role, to a mixed economy in which the state has a
greater role in resource allocation.

31. 31
Some of the reasons for government intervention in the economy Include: First is to
create a framework of rules and regulation. There is need for rules and regulations to
ensure fair play in competition between producers, and in transactions between
consumers and producers. Such rules will cover areas of property rights, contracts,
fraud, standards of hygiene, restrictive practices, working conditions, etc. the creation
and enforcement of such rules and regulations is only possible through a central
governing authority.
Second is to maintain competition. The evolution of market economies (from
experience) more often than not results in the development of monopolies and
oligopolies which undermine the efficient allocation of resources between competing
uses. Thus the government has found it necessary to intervene in the economy to
maintain competition. This intervention may be in two ways.
First, in the case of natural monopolies; those in which technological and economic
realities, rule out the possibility of competition, the government either provides the
service itself or sets up regulatory bodies to control prices and standards.
Second, the state could pass anti-monopoly legislation that seeks to limit any supplier
from developing monopoly control of any particular product or service.
Third is the case of public goods. A public good is one possessing the characteristics of
non-rivalry in consumption and non-excludability. Because of these characteristics it is
not possible to charge a price for the provision of public goods thus the operation of
the price mechanism cannot be suitable in providing public goods. One possibility is for
the government to provide these goods financing them through taxation. (Other
organizations could also provide these of course financed by the state).
Fourth is the case of merit goods. A merit good is a good or service from which the
social benefits of consumption to the whole community exceeds the private benefits
to the consumer. (e.g. education and health care). If provided only through the market
system, the amount consumed will be less than optimal as it will reflect only the

32. 32
private benefit. Thus the state needs to put in places subsidies or regulations
[reflecting the social befit] thus increasing consumption to the socially optimal level.
Fifth is the case of demerit goods. A demerit good is a good or service from which the
social cost of consumption to the whole community exceeds the private cost to the
consumer. (e.g tobacco and alcohol). If provided through the market the, amounts
consumed will be more than optimal as it will reflect only the private cost. The state
needs to put in place taxes or regulations [to reflect the social costs] thus reducing
consumption to the socially optimal level.
Sixth is redistribution of income. One of the major objectives of the government is to
promote the general economic welfare of the citizens. A means towards this is to
ensure an equitable distribution of income and wealth. This can be achieved through a
system of taxation that bares more on the wealthier member of society [progressive
tax system] together with the provision of benefits in kind or cash to needier groups,
financed from taxation.
Seventh is stabilizing the economy. A trade cycle, i.e. Periods of recession, Depression,
Recovery & Prosperity, characterizes the market economy. During Recession &
Depression, the levels of economic activity, incomes & employment are falling or low.
During recovery, the level of economic activity, incomes & employment are raising or
high, but there is the possibility of high inflation rates. The government, through the
various polices at hand can ensure that the level of economic activity & income
remains high and stable.
1.6 Consumer Sovereignty
To be sovereign is to have sole power, and applying it to the consumer, the concept
of consumer sovereignty regards the consumer as having power to determine how
resources are to be allocated. (The consumer is free to decide for himself what they
want to buy). Only those things that the consumers want and have the ability for will
be produced. Quantities produced will also depend on the demand for them.

33. 33
The consumers exercise this power through the price mechanism. If there is an
increase in effective demand of consumers for a product, prices will be pushed up
because of competition. Profit motivated firms will take this increase in price as a
signal that it pays them to relocate the productive resources to begin or increase
production of that commodity, and vice versa.
Although firms make decisions as to what to produce, and how much, it is only in
response to consumers demand, and thus the consumer is still sovereign. Consumer
sovereignty is limited by the following factors
Nature of the economic system; in general the consumer is more sovereign in a free
market economy where commodities are produced in line with consumers’
preferences. In a command economy, very little regard is given to consumers’
preferences.
Size of consumer’s income; the most important check on consumer’s sovereignty is
the size of his income. Only effective demand of the consumer can determine
resource allocation. Thus the larger the income the more his sovereign power is.
Goods actually available; the satisfaction of the consumer depends on the goods
actually available in the market. Due to the level of technology, it is possible for actual
production to lag behind consumers’ desires.
High pressure salesmanship; together with advertising, high pressure salesmanship
tends to modify the real desires of the consumers. The consumers are induced to
purchase something different from what they would have bought otherwise.
Government control; the government, for the sake of the common good, prohibits
the consumption of certain articles and consequently their production. Also the
government being one of the largest consumers in the economy can determine how
resources are to be allocated through its purchases.

34. 34
Consumers own habits; these bind the consumer and he is reluctant to make any
departure from his set scale of preferences.
Conventions of the society; society’s conventions exercise a restraining influence on
the consumer’s choice.
Production of standardized goods; it is often cheaper for manufacturers to produce
standardized goods, but in the processes of doing so consumer’s sovereignty is
inevitably limited.
Exercises 1
1. Explain the importance of studying microeconomics
2. Distinguish between the following terms:
(a) Positive Economics and Normative Economics
(b) Microeconomics and Macroeconomics
3. Define the term theory and explain whether economic theories are necessary in
understanding the economic behaviour of human beings
4. Some people consider economics to be a science while others consider it to be an
art. Explain why this is so.
5. Explain how the basic economic problems of every society are solved under each
of the three economic systems.
6. Using the Production Possibility Frontier (PPF), explain how full utilisation of
resources, attaining economic efficiency and growth are interrelated aspects of
an economy.
7. Discuss the performance of capitalism and socialism in solving the allocation
problem in the contemporary world.
8. Explain how a mixed economic system may solve the basic economic problem of
developing countries.
9. Explain how in a free market system, the price mechanism brings about
equilibrium in the entire economic system. Explain the likely effect of controlling
prices on the market equilibrium.
10. Explain the sources of limitations on consumer sovereignty.

35. 35
CHAPTER TWO: DEMAND SUPPLY AND EQUILIBRIUM
By the end of the lecture, the learner should be able to:
1. Explain the meaning of demand
2. Explain the factors affecting demand
3. State the law of demand
4. Distinguish between movement along a demand curve and shift in demand
2. DEMAND
2.1 Meaning of demand
Demand refers to the quantity of a commodity1
that consumers are willing and able to
purchase at any given price over some given period of time. The quantity demanded
is the amount of a product people are willing to buy at a certain price; the relationship
between price and quantity demanded is known as the demand relationship. Three
important aspects that must be mentioned in the definition of demand are: Quantity,
Price and Time period.
Demand is not the same thing as need, want or desire, only when want is supported
by ability and willingness to pay the price, dose it become effective demand and have
influence the market prices hence resource allocation2
. (Hence in economics demand
always means effective demand).
2.2 Determinants of Demand
The demand for a commodity can be considered from two points of view: Individual
demand and Market demand.
2.3 Individual Demand
Individual demand for a commodity is the amount an individual is willing and able to
buy at any given price over a given period of time. This demand is influenced by
several factors. The factors influencing the demand (dx ) for good x over a given
period are: Price of the good (Px), price (s) of other goods related to the good (PR),
1
Commodity refers to a good or a service.
2
Hence resource allocation

36. 36
consumers’ income (Y), consumers’ taste and preferences for good x (T), consumers’
expectations about future prices (E,), advertising (A), any other factors (O).
As a functional notation, demand for commodity x can be expressed as follows: dx = f
( Px, PR ,Y ,T ,E ,A,O). This means that an individual’s demand for commodity x is a
function of all factors listed in the brackets. Each of these determinants of demand is
discussed below:
The first determinant of demand is the price of the good. The price of a commodity
is the most important influencing factor or determinant of an individual’s demand for
the commodity. All other determinants of demand other than price are called
conditions for demand. When analysing the relationship between an individual’s
demand for commodity x and the price of commodity x, Economist assume that all
other influencing factors remain unchanged, ceteris paribus. Thus demand for x can
be written as: dx = f(Px) , ceteris paribus.
This means that an individual’s demand for commodity x is a function of, or is
determined by the price of x, assuming that all other influencing factors are held
constant.
Demand for x can also be expressed as a schedule i.e. a demand schedule. A demand
schedule shows the different possible prices of commodity x, listed together with
consumers’ demand for commodity x over a given period of time (Ceteris paribus). A
demand schedule for commodity x is illustrated in table 2.1 below.
Table 2.1: Demand Schedule
Price of X
(Kes Per Unit)
Consumers
Demand (Weekly)
6 65
5 70
4 80
3 90

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In Table 2.1 above, it is shown that 65 units of commodity x were demanded weekly
when the price was Kes. 6 per unit, 70 unit when the price fell to Kes. 5 per unit and
so on.
Demand can also be represented using a demand curve. A demand curve is defined as
the relationship between the price of the good and the amount or quantity the
consumer is willing and able to purchase in a specified time period, ceteris paribus.
This can be done by representing the information in the demand schedule in a graph
whose vertical axis represent the unit price of the commodity while the horizontal
axis represent the quantity demanded in a given time. This is shown below in figure
2.1 below.
Figure 2.1: Downward sloping demand curve
The curve labelled DD is the individual demand curve for commodity x. It shows the
relationship between quantity demanded of x by an individual and the price of the
good, ceteris paribus. It is basically a graphical representation of the information
contained in the demand schedule. The demand curve has a negative slope, i.e., it
slopes downwards from left to right3
. The negative slope shows an inverse
relationship between quantity demanded for commodity x (dx) and its price, Px,
ceteris paribus.
3
The curve needs not be a straight line.

38. 38
There are two effects that explain this inverse relationship. First, is a substitution
effect; as the price of x falls it becomes cheaper than its substitute y thus more of x is
and less of the substitute y is bought. (The consumer is said to substituting x for y.
Second, is an income effect; with the fall in price of x, the consumer experiences an
increase in real income with which he can now buy more of x. The inverse relationship
between quantity demanded of commodity x and its price, Px leads us to the law of
demand, which states that;
“If all other factors remain equal, a rise in price of goods leads to a fall in the total
quantity demanded. A fall in the price of goods leads to an increase in the total quantity
of the goods demanded for normal goods”.
There are three exceptions to this law. The first exception is the case of Veblen goods
or goods of ostentation. Commodities are Veblen goods if peoples' preference for
buying them increases as a direct function of their price. It is claimed that some types
of high-status goods, such as expensive wines or perfumes, are Veblen goods. A
decrease in the prices of Veblen goods decreases people's preference for buying
them because they are no longer perceived as exclusive or high status products.
Similarly, an increase in price may increase that high status and perception of
exclusivity, thereby making the good further preferable. The Veblen effect was
named after the economist Thorstein Veblen. He was the first to point out the
concept of conspicuous consumption and status-seeking. The Veblen effect is also
known as the snob effect.
Second is the case of Giffen goods. These are goods named after Professor Robert
Giffen, a nineteenth century economist cum statisticians. A giffen good is a very
inferior good that also forms a substantial part of the household’s budget. An
increase in the price of a giffen good will lead to an increase in its demand. Similarly, a
decrease in the demand of a giffen good will lead to a decrease in its demand. This is
because as prices of a giffen good falls, more of the households’ money is released
and such a household can now afford to buy more superior goods, thus less of the
inferior good is needed. On the other hand, as the price of giffen good increases,
households have to reduce their consumption of normal goods and redirect more

39. 39
money to the consumption of these giffen goods. Therefore, more of giffen goods
will be demanded, as the households cannot now afford the normal goods.
The classic example of giffen goods was given by Sir Alfred Marshall. He gave the
example of inferior quality staple foods. Demand for these inferior quality staple
foods is driven by poverty that makes their purchasers unable to afford superior
foodstuffs. As the price of the cheap staple rises, they can no longer afford to
supplement their diet with better foods, and must consume more of the staple food.
There are three necessary preconditions for this situation to arise: the good in
question must be an inferior good, there must be a lack of close substitute goods,
and the good must constitute a substantial percentage of the buyer's income, but not
such a substantial percentage of the buyer's income that none of the associated
normal goods are consumed.
Second, are expectations consumers make of future changes in prices. This is a
situation where consumers believe that a change in price implies that further changes
in price will occur. A good example is the stock exchange where a fall in share price
leads to a fall in quantity demanded of the shares. This is because potential buyers
expect the trend to continue. The demand curve for these three exceptions is shown
in figure 2.3 below.
Figure 2.3: An Abnormal (Exceptional, regressive) demand curve
Price of x
Quantity of x
P1
P2
Q1
Q2
0

40. 40
The curve has a positive slope, indicating a direct relationship between price and
quantity demanded. As price increases from P1 to P2, quantity demanded increases
from Q1 to Q2.
The third key determinant of demand is/are the price (s) of other related goods. The
demand for all goods is related in the sense that they all compete for the consumer’s
limited income. Two particular relationships of demand may be quantified: where
goods are substitutes for one another and where goods are complimentary to one
another.
Two goods x and y are substitutes if they satisfy the same consumer need. A rise in
price of one commodity says y leads to a rise in demand for another say x. Common
cited examples of substitutes are tea and coffee, or beef and pork, butter and
margarine. If the price of tea increases, then demand for coffee increases as the
consumer finds that coffee is relatively cheaper to buy tea. He therefore substitutes
coffee for tea.
On the other hand, two goods x and y are said to be compliments if they are
consumed jointly to satisfy a particular need of the consumer. An increase in the price
of say good x leads to a fall in demand of another good say y. Good examples of
complimentary goods include: cars and petrol; printers and ink cartridges, shoes and
shoe polish. If the price of cars decreases, the demand for petrol increases because
more cars would be demanded.
Figure 2.4a below depicts the effect of an increase in the price of a chicken on the
demand for beef, its substitute good,. On the other hand Figure 2.4b shows the effect
of an increase in the price of fuel on the demand for motor vehicles, its complement.

41. 41
Figure 2.4: Demand for Substitutes and Complements
The fourth key determinant of demand is the consumer’s income. In order for
demand for a commodity to be effective, it must be backed by the ability to buy it.
Hence the demand for a commodity is related in some way to the consumer’s income.
This relationship (represented by an income demand curve) depends on the type of
good and on the level of consumers’ income. The three types of goods are; Normal
goods, necessities and inferior goods.
Figure 2.1 Consumer’s income demand curve
Under normal circumstances, if the demand for a commodity increases as income
rises, then that commodity is said to be a normal good, ceteris paribus. This is
D
D
D’
D’
(a) Substitutes (b) Complements
Price of
Beef
Price of Chicken rises
Quantity of Beef
per period
Price of
Vehicle
Quantity of
vehicles per period
0 0
Fuel price rises
D
D
D’
D’
Income
Quantity a
b
c

42. 42
represented in the graph above by line a. This is the income demand curve for a
normal good. This demand curve for normal goods rises continuously with income
and tends to flatten out at higher levels of income as people reach their desired level
of consumption
For necessities such as salt, milk.., the income demand curve tends to remain
constant other than at the lowest levels of income. This demand is represented by
line c.
If an increase in income is followed by a decrease in an individual’s demand for a
good, it is said to be an inferior good. This is represented by line b. At low levels of
income people will tend to consume large amounts of this product but, as their
income rises they will buy other more superior foods and thus require less of the
inferior goods. Note that at lower levels of income, inferior goods behave as normal
goods, only to become inferior as income continues to rise. For instance, cotton
sheets may be considered inferior if as one becomes wealthy, he replaces them with
silk sheets. In other words, the goods are not intrinsically inferior; it is the
commodity’s relationship with income that is inferior.
The fifth determinant of demand is consumers’ tastes and habits. A change in the
tastes for a particular commodity of the consumers will affect the quantity demanded
of the product. A change in taste in favour of a commodity will increase its demand.
For instance, if it becomes fashionable for middle class households to drink wine
during meals, expenditure on wine will go up.
Sixth is advertising. In very competitive markets, a successful advertising campaign
will increase the Individual’s demand for a particular product while at the same time
decreasing the demand of the competing product. The effect of an increase in
advertising expenditure on a particular good is to shift the demand curve to the right.
This means that more units of the product can be sold at each and every price.
2.4 Other Factors influencing Demand

43. 43
Seasonal factors also matter for demand. The demand for many products such as
clothing, food and power is influenced by seasons. During the rainy season the
demand for warm clothing and umbrellas goes up.
Government can also influence demand through the policies it enacts. For instance
through its legislation, it can make it compulsory to fit seat belts in cars. Thus the
demand for seat belts will increase. Conversely it can prohibit the purchase of some
goods for example firearms. It can also influence demand through taxes and
subsidies.
2.5 Market demand
Market demand for a commodity refers to the total quantity of that commodity
demanded by all individuals at any given price over a given period of time. It is the
summation of individual demands hence all factors affecting individual demand will
also affect market demand. Market demand can be derived from individual demands
as follows;
Figure 2.7: Market demand
Suppose that in the market for a given commodity, there are n consumers whose
individual demand curves are D1D1, D2D2 … DnDn as shown above. The market demand
of the commodity can be derived by summing up the individual demands at given
prices. At price P1, consumers 1, 2, 3 …n demand Q1, Q2, Q3 …Qn units respectively of
the commodity. Thus the market demand for the commodity at price P1 is the sum of
the individual demands at that price. i.e.
D
D
D1
D1
0
Dn
D
nP1
P2
q Q q1 Q1 qn Qn
Qn
Price
Quantity

44. 44
Market Demand at price P1 = Qm = Q1 + Q2 + Q3 + …+ Qn
At price = P2, market demand = qm = q1 + q2 + q3 + …+ qn
It follows that the market demand will have a much gentler slope than the individual
demand. The greater the number of individual consumers, the gentler the slope of
the market demand curve, ceteris paribus
2.6 Determinants of Market Demand
Since it is the summation of the individual demands in the market, all factors affecting
individual demand, will also affect market demand. However there are some factors
that affect only the market demand of the commodity. These include: changes in
population. Demand is influenced by overall size of the population, structure of the
population in terms of gender and age, and geographical distribution. The
distribution of income also influences the level of demand. A more even distribution
of income, for example might increase the demand for shoes and lower the demand
for expensive models of Volvos.
2.7 Movements along and shifts of the demand curve
Demand is a multivariate function, in the sense that it is determined by many
variables; price of the commodity, prices of substitutes and compliments, consumers
incomes etc. The price of the commodity is the most important determinant, and its
relationship with quantity demanded is what yields a price demand curve.
2.8 Movements along the demand curve
A movement refers to a change along a curve. On the demand curve, a movement
denotes a change in both price and quantity demanded from one point to another on
the curve. The movement implies that the demand relationship remains consistent.
Therefore, a movement along the demand curve will occur when the price of the
good changes and the quantity demanded changes in accordance to the original
demand relationship. In other words, a movement occurs when a change in the
quantity demanded is caused only by a change in price, and vice versa.

45. 45
Figure 2.8: Movement along the demand curve
The result of a change in price of commodity x from P2 to P1 is shown by a movement
along the demand curve. This movement indicates a change in quantity demanded.
This change can be an increase or a decrease in quantity demanded.
2.9 Shifts of the Demand Curve
A change in any other factor of demand other than price will cause a shift of the price
demand curve. Thus these factors are also known as shifting factors or conditions of
demand. Assume there is an increase in consumers’ income, shifting can be
illustrated as follows.
Figure 2.10: Backward and Forward shift of the demand curve
The consumer now demands more of the commodity at all prices, such that there is
now a new demand curve that is to the right of the original one. The demand is said
D
D1
0
Dn
D
n
P2
Price
Decrease
D
D
D1
0
P2
Q Q1
Qn Quantity
Increase
D
D
0
P1
P2
Q2 Q1
Price
Quantity
A
B

46. 46
to have increased shown by the rightward shifting of the demand curve.4
If the
consumers’ income instead falls, less of the commodity will be demanded at all
prices, such that the new demand curve is to the left of the original one. The demand
is said to have fallen shown by the leftward shifting of the curve. The same will be
observed if there is a change in the other conditions of demand.
Exercises 2
1. Explain why the demand curve slopes downward
2. Explain the determinants of demand
3. Using a suitable diagram, show the relationship between the quantity and price
for each of the following type of good
i. Normal good
ii. Inferior good
iii. Giffen good
4. The demand function for a commodity is given as Q=8/P, where Q is quantity
demanded and P is price of the commodity, ceteris paribus.
i. Draw the demand curve given by this function
ii. Also, compute the price elasticity of demand at points Q=1, P=8; and Q=4,
P=2
5. The demand schedules for two consumers for a commodity are given as:
Q1= 10 - P;
Q2= 6 - 0.5P
The market price for the commodity is Kes 4.00/=
i. Determine the quantities consumed by each consumer
ii. Compute the price elasticities of demand for each consumer
6. Suppose the market demand and market for apartments in a city given by the
following functions:
4
In this case good X is a normal good, if it was an inferior good, it would shift to the left.

47. 47
Qd =5000 - 3P
Qs= 1000 + P
i. Compute the price at which the market for apartments in the city clears. How
many apartments are rented at this price?
ii. Suppose the city sets a maximum rent at Kes 1200/=. Show the rent control in
a supply and demand diagram. Compute the resultant excess demand.
iii. Suppose that there is a binding rent control law. Explain the condition that
must hold for the maximum rent imposed by the city to be binding. Will there
be an excess demand or supply of apartments at this price?
iv. Suppose that in response to the rent control law, some, but not know,
landlords decide to convert their apartments to condominiums, which are not
subject to rent control. Explain the effect of this action on the rental market
for apartments. Show in a diagram.
7. There are 100 consumers in the economy. Half of them belong to tribe A and
demand oranges according to the inverse demand function: P=10-2Q. The other
half belong to tribe B and demand oranges according to the individual inverse
demand function: P=16-4Q.Suppose that the market clearing price for oranges is
Kes 4/+
i. Compute the number of oranges bought by each member of tribe A and B
respectively
ii. Compute the price elasticity of demand for each member of tribe A and B
respectively at this point
iii. Compute the Market demand for oranges in this economy. Is the Market
demand linear? If not where is the kink?
iv. Using the market demand function derived in part ii, compute the total
quantity of oranges demanded in this economy and the corresponding
price elasticity of demand at the market clearing price.
v. If the price increases from kes 4/= to Kes 10/=, compute the resultant
change in consumer surplus and deadweight loss. Graph the demand curve
with the quantity on the horizontal axis and price on the vertical axis, and
show the change in consumer surplus and deadweight loss.

48. 48
3. SUPPLY
By the end of the lecture the learner should be able to:
1. Explain the meaning of supply
2. Explain the factors affecting supply
3. State the law of supply
4. Distinguish between movement along a supply curve and shift in supply
3.1 Meaning of supply
Supply can either be individual supply or market supply. Individual supply is defined as
the quantity of a commodity that an individual producer or firm is willing and able to
offer for sale at a given price over a given time period. Market supply refers to the
sum of the quantities of a good that individual firms are willing and able to offer for
sale over a given time period.
Supply differs from existing stock or amount available. It refers to the amounts
actually brought into the market. Supply is influenced by several factors discussed
below.
3.2 Determinants of supply
The quantity supplied of commodity of x (Qsx) is influenced by the following: price of
the good x (Px), prices of certain other goods (Pr), prices of factors of production (Pf),
state of technology (T), expectations (E), other factors (A). As a functional notation,
the supply of x can be written as follows.
Qsx = f (Px, Pr, Pf, T, E, A)
This means that the quantity supplied of x is a function of, or is determined by, all the
variables listed in the brackets.
The first determinant of supply is the price of the good. It is the most important
factor influencing supply. All other factors influencing supply are referred to as
conditions of supply. In analysing the effect of price changes on supply of a

49. 49
commodity, all other influencing factors are assumed to be constant. Thus as a
functional notation the supply of commodity x, can be written as follows.
Sx = f (Px), ceteris paribus
This means that the supply of commodity x is a function of its price, ceteris paribus.
Supply can also be represented using a supply schedule. This is a table listing
different quantities of a commodity supplied at different prices. The schedule is
shown below.
Table 2.2: Supply Schedule.
Price of x
( Kes per unit)
Quantity Supplied
(Weekly)
30 500
31 550
32 600
33 650
34 700
35 725
36 750
From the table 2.2 above, 500 units of x will be supplied weekly at the price of Kes.30
per unit, 600 units at a higher price of Kes.32 per unit and so on. Supply can be
represented using a supply curve as shown below.
Figure 2.11: The upward sloping supply curve
Price of x
Quantity of x
P1
P2
Q1
Q2
P3
Q3
S
S
0