NATIONAL UNIVERSITY OF SCIENCE

AND TECHNOLOGY

FACULTY OF COMMERCE

GRADUATE SCHOOL OF BUSINESS

MANAGERIAL ECONOMICS (5163)

Lecturer: Mr. F. Chinjova

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CHAPTER ONE
DEFINITION AND SCOPE OF MANAGERIAL ECONOMICS
What this unit is about
This Unit introduces you to the basic concepts of managerial economics. The unit
begins by outlining the definition, origins and methods of managerial economics
analysis. The subsequent sections of this unit give a detailed discussion on the
link between managerial economics and other disciplines as well as the basic
features of the firm and its environment.

Unit Objectives
By the end of this unit, you should be able to:
• Define managerial economics.
• Understand the origins and methods of managerial economics analysis.
• Explain the link between managerial economics and other disciplines.
• Describe basic features of different forms of business organizations.

1.1 A Definition of Managerial economics

According to V. Sibanda managerial economics is defined as the application of
economic analysis to business problems. Managerial economics is viewed as a
special branch of economics bridging the gap between pure economic theory and
managerial practice. Managerial Economics involves the application of economic
theory and methodology to decision making process by the management of the
business firms. According to McNair and Marrian, managerial economics
consists of use the economic models of thought to analyze business situations.
Spencer and Seigelman define managerial economics as the integration of
economic theory with business practices for the purpose of facilitating decision
making and forward planning by the management.

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The Origins and Methods of Managerial Economic Analysis
Most of economic analysis to be found in managerial economics has its origins in
theoretical microeconomics. Topics like the theory of demand and supply, the
profit maximization model of the firm, optional prices and advertising
expenditures and the impact of the market structure on firms’ behaviour are all
approached using the economist’s standard intellectual ‘ tool- kit’, which consists
of building and testing models. The following aspects are to be taken into
account.

1) Cost analysis
Cost analysis is helpful in understanding the cost of a particular product. It
takes into account all costs incurred while producing a particular product.
Under costs anal, we will take into account determinants of costs, method of
estimating costs, the relationship between costs and output, the forecast of
costs and profits.

2) Production function
Conversion of inputs into output is known as production function. Factors of
production are combined in a particular way to get maximum output.

3) Demand Analysis
Demand analysis helps in analyzing the various types of demand which
enables the manager to arrive at reasonable estimates of demand for a
product of his company. Managers not only assess current demand, but have
to take into account the future demand also.

4) Advertising
Advertising is a promotional activity. The problem of cost, the methods of
determing the total cost of advertisement, measuring of economic effects of
advertising are the problems of the manager. Advertising forms the integral
part of decision making and forward planning.

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 5) Pricing System
The pricing system as a concept was developed by economists and is widely
used in managerial economics. Pricing is also one of the central functions of
an enterprise. While pricing a commodity, the cost of production has to be
taken into account, but complete knowledge of the pricing system is essential
to determine the price.

6) Resource allocation
Resources are allocated according to the needs only to achieve the level of
optimization. Since we have scarce resources and unlimited needs, we have
to make the best alternative use of the available resources.

1.2 The link between managerial economics and other

disciplines
1.2.1 The link between managerial economics and industrial
economics
In managerial economics, the emphasis is upon the firm, the environment in
which the firm finds itself and the decisions which individual firms have to take. In
industrial economics, the emphasis is upon the behaviour of the whole industries,
in which the firm is a component. The most common approach adopted by
industrial economists is known as the structure – conduct – performance
approach, in which the structure of an industry is seen as an important
determinant of its conduct and performance. The structure of an industry has a
number of different dimensions, including most notably:
• The height of barriers to entry.
• The level of concentration.
• The degree of product differentiation.
• The extent of vertical integration.
• The extent of diversification.

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The conduct of an industry refers to the type of behaviour engaged in by its
component firms taking into account,
• Company objectives
• Collusive vs competitive behaviour
• Pricing policies
• Advertising policies
• Competitive strategies
The performance of an industry refers to its results, the most common features
of performance being:
• Profitability
• Growth
• Productivity increases
• Expert performance and international competitiveness
In the simplest applications of the structure – conduct – performance
approach, the structure of an industry is treated as exogenous and structure is
seen as the cause of conduct or performance.

1.2.2 The links between managerial economics and management

Science

Management science is essentially concerned with techniques for the

improvement of decision making and is therefore almost entirely normative.
Techniques used in operation research, like linear programming and forecasting
are all aspects of management science, which tends to have a quantitative bias.
In so far as managerial economics is concerned with finding optional solutions to
decision problems, the boundaries between the two subjects are not clearly
defined.

1.3 Basic Features of the Firm and its Environment

1.3.1 Sole Trader

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This is a business carried out by an individual on his / her own accord.
Advantages
a) It is easy to start.
b) It is not registered nor controlled by statute law.
c) It does not need a great capital outlay to start operations.
d) There is no need legally to take the interests of outsiders into
consideration when running the business.
e) No meetings are required to be held nor the need to make any formal
appointments of any officials such as directors, secretaries or auditors.
Disadvantages
a) No separate legal personality expert from its members.
b) The owner has no limited liability. The owners properly may be sold to
meet the debt of the business.
c) The business cannot own property separate from the property of the
owner.
d) The sole trading business is risky to the owner. He has less security
against financial ruin to himself.
e) This business, because of its nature is difficult to expand as raising capital
is difficult.
1.3.2 Partnership
This business is a result of agreement between two or more people. The number
should not be more than twenty. A partnership may also be formed by conduct of
the parties.
Advantages
a) The business is easy to start because only agreement is required. The
agreement may be oral or written.
b) It is easier to raise capital for a partnership as capital does not have to be
money.
c) The partners have a legal right to manage their business.
d) Partners owe each other a duty of care. Their relationship is one of good
faith towards each other.

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Disadvantages
a) This business cannot have more than twenty members unless the
members belong to a designated profession such as lawyers or
accountants. This may limit those contributing to capital.
b) A partnership has no separate legal personality from its members.
c) Members of a partnership are liable jointly and severally for the
partnership
d) Insolvency of the partnership may detrimentally affect the estate of the
partners. This is because partners do not enjoy limited liability.
e) Death or resignation of a partner affects the legal nature of the partnership
in the death or resignation would terminate the partnership. Admission of a
new partner would also have the same effect.
1.3.3 Co-operative Society

This enterprise is governed by the Co-operative Societies Act. The Act requires
the Registrar of Co-operatives to assist and promote the interest and welfare of
members.
Advantages
a) Promote the interests and welfare of members
b) Co-operatives are governed by principles of democracy in that each
member would have one vote when making decisions despite the number
of shares the member may have.
c) Co-operatives have separate legal personality from members.
d) Co-operatives officers are obliged to assist in the running of the co-
operative societies for the benefit of members.
Disadvantages
a) The application form for registration must be signed by at least ten
people who intend to be members.
b) The Registrar of Co-operatives has to check and agree with the
objectives of the enterprise.

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 c) There is greater involvement of officers from the Registrar’s Office in
the affairs of the Co-operative.
d) It is difficult to raise capital for co-operative.

1.3.4 Private Business Corporation

This is governed by the Private Business Corporation Act Chapter 24:11.

Characteristics
a) It allows one or more people associated for a lawful purpose to form a
private business corporation.
b) The business is a separate legal person apart from its members. Thus, the
members also enjoy limited liability in that they will not be liable for the
debts or obligation of the business.
c) Members are not obliged to contribute money as capital of the business.
Their contribution may be in the form of services or goods.
d) The members are allowed to manage the business as its agents.
e) Only natural persons can be members of the Private Business
Corporation.
f) The private business corporation is simple to manage. It is not required to
hold any meetings or to appoint any officers such as directors or
secretaries.

1.3.5 Companies
These are regulated both by common and statute law. The statute which
regulates them is the Companies Act Chapter 24:03.
Characteristics
a) Companies are separate legal persons apart from the shareholders.
b) A person who intends to form a company has to closely follow and comply
with the requirements of the Companies Act as to registration.

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 c) The members have limited liability in that they are only liable for the
amount which would have been paid on the shares.
d) Members do not become directors or members of the company merely
due to the fact that they are members. They have to be appointed.
e) Shares in companies are transferable. A shareholder may sell his shares
to another and as a result, the death or resignation of a shareholder does
not end the existence of companies.
f) There are private companies and public companies.

Self Test Questions

1. Describe the characteristics of sole traders, partnership, private business
Corporation and Companies.
2. Compare and contrast the following business organizations
a) Sole trader and partnership
b) Private business corporation and companies

CHAPTER TWO

Business Objectives and Models of the Firm

What this unit is about:
This Unit looks a variety of different models of the firm, based upon different
assumptions about the firm’s basic objective. The neo-classical economic model
of the firm is developed first and then the unit goes on to examine some of the
criticisms which have been directed at that model, and some of the alternatives
which have been put forward in its place.

Unit objectives
After reading this unit, you should be able to:
• Describe the Neo – Classical economic Model of the firm.
• Explain the assumptions, advantages and disadvantages of the neo-
classical economic model.

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 • Describe the Alternative Models i.e. Sales Maximization, Utility
Maximization, Profit Maximization, Rate of Growth, Behavioral Models as
well as X- Inefficiency.
• Explain the assumptions, advantages and disadvantages of the
alternative models.
• Explain the concept of x- inefficiency.

2.1 The Neo- Classical Economic model of the firm

The neo- classical economic model assumes that profit maximization is the only
objective of the firm. Profit is defined as the difference between firm’s revenues

and its costs i.e. ╥ =TR-TC. Where ╥= Profits

TR = Total Revenue
TC = Total costs

Assumptions
i. The objective of the firm is to maximize profits
ii. No matter how large or complex a firm is, it is a single entity capable of
having its own objective and making its own decisions.
iii. The firm seeks to optimize i.e. seek the best possible performance
amongst given alternative
iv. The firm produces a single perfectly divisible, standardized product.
v. The costs of production are known with certainty and in the short run
some costs are fixed and others are variable.
vi. The average cost curve is U- shaped in the short run.
vii. Demand for a product is a function of consumer behavior, structure of the
industry and behavior of competitors, but the demand curve takes the
normal shape i.e. downward sloping from left to right.

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viii. The firm does not practice discrimination, so that its product demand
curve is also its average revenue curve.

Basing on the assumptions above, profit maximizing condition is as illustrated

below:
Profit Maximization

MC
Price AC
Revenue
Cost

Po

PC
Eo
AR=D

MR

Fig 2.1 qo
Output Level

In fig 2.1, Eo is the equilibrium point i.e. the point at which marginal revenue
(MR) is equal to marginal cost (MC). Thus, Po is the equilibrium price and Pc is
the cost per unit. The shaded regions are the abnormal profits which are earned
by a firm.
Defence for profit maximization model
i. Firms that survive in the long run in a competitive market are those which
make a reasonable profit. Once they are able to make profit, they would
always try to make it as large as possible. All other objectives are subject
to this profit maximazation.
ii. Profit maximization assumption has been found to be extremely accurate
in predicting certain aspects of firm’s behavior. Friedman argues that the
validity of profit maximization hypothesis cannot be judged by logic or

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 asking the business executives. The ultimate test is its ability to predict the
business behavior and trends.
iii. Profit maximization assumption is time – honored objective of a business
firm and evidence against this objective is not conclusive or unambiguous.
iv. Profit maximization is the most efficient and reliable measure of efficiency
of a firm.
Criticism of the profit maximization Model
i. Profit maximization assumption is too simple to explain the business
phenomenon in the real world. In fact most businessmen are themselves
not aware of this objective attributed to them.
ii. It is argued that firms do not have the necessary knowledge and
appropriate data to equalize marginal revenue and marginal cost. Hence
firms cannot attempt to maximize their profits in the manner suggested in
the model.
iii. It is unrealistic to assume that firms aim for maximization profits in a
modern economy where ownership and control of firms lies with different
groups of individuals.
2.2 Sales Maximization Model – Baumol (1958)
Baumol suggested that firms seek to maximize revenue, subject to making a
minimum profit which was defined as that level of profit needed to retain the
support of the firm’s shareholders and the financial markets. According to
Baumol, the firm will be more competitive when it grows large in terms of
revenue.
An illustration of sales maximization model is as follows:
Sales Maximisation

Total Cost

E
Total Revenue

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+

C
Output
- O
D A
Profit

Fig 2.2

In the diagram above, the firm will choose to produce level of output A, giving
total revenue B and profit C. Note that this implies a higher level of output, and
therefore a lower price, that the equivalent profit maximizer, which would produce
output D and earn revenue E.
Why should firms Maximize Sales?
Sales maximization seems the most plausible goal for managers for the following
reasons.
i. There is evidence that salaries and other slack earnings of top managers
are correlated more closely with sales than with profits.
ii. Banks and other financial institutions keep a close eye on the sales of the
firm and are more willing to finance firms with large and growing sales.
iii. Sales revenue maximization is an acid test for success as profits are
calculated at the end of the financial year while changes in sales can be
identified at more regular intervals during the year prompting appropriate
action where deemed necessary.
iv. Personnel problems are handled more satisfactory when sales are
growing. Employees at all levels can be given higher earnings and better
terms of work in general.
v. Large sales growth overtime gives job security and prestige to the
managers.
vi. Large sales growth ensure growth and survival of the firm.
vii. Managers prefer a steady performance with satisfactory profits to
spectacular profits maximization projects. If they realize maximum high

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 profits in a period, they might find themselves in trouble with shareholders
in other periods when profits are less than maximum.
viii. Sales maximization is associated with lower prices for the products than
when profit maximization is the objective. This acceptable from the
consumer’s point of view, as consumers prefer a lower price.
ix. Large growing sales strengthen the power to adopt competitive tactics
while a low or declining share of the market weakens the competitive
position of the firm and its bargaining.
Criticism of Baumol’s Sales Maximization Model
i. The sales maximization model does not show how equilibrium in an
industry in which all firms are sales maximizers will be attained. The model
does not establish the relationship between the firm and the industry.
ii. Baumol’s model is based on the implicit assumption that the firm has
market power i.e. can control its price and expansionary policies hence
can take policies without being affected by competitors’ reactions. Thus
Baumol rules out inter dependence and hence this theory cannot explain
the core problem of uncertainty in non-collusive oligopoly markets.
iii. The theory cannot explain observed market situations in which price is
kept for considerable time periods in the range of inelastic demand.
iv. The theory ignores actual and potential competition. It fails too see that if a
firm encroaches on the share of firms in the same industry or other
industries , reactions are bound to set limits to its discretion in expanding
sales.
v. Baumol claims that the sales maximization hypothesis implies lower
degree of misallocation of resources and hence an increase in the welfare
of the society. This claim is not true. This whole argument rests on the
shape of the demand and costs curves as well as on the way by which
one measures the society’s optimal welfare.
vi. Sales maximization is not compatible with the goal of long run profit
maximization. The firm may be willing to keep sales at a high level, even
though they are unprofitable in the short run in the hope that eventually, in

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 the long run, the product will become profitable once established in the
market.

2.3 Managerial Utility Maximization Model – Williamson (1963)

Williamson’s model takes account of wider range of variables by introducing the
concept of expense preferences. The model is based on the assumption that
managers want to maximize their own utility. Expense preferences means
managers get satisfaction from using the firm’s potential profits for unnecessary
spending on item from which they personally benefit. Williamson identified three
major types of expense from which they personally benefit. Williamson identified
three major types of expense from which managers derive utility. These are as
follows:
1. The amount which managers can spend on staff, over and above those
needed to run the firm’s operation (s). This variable captures the power,
prestige, status and satisfaction which managers experience from having
control over large numbers of people.
2. Additions to manager’s salaries and benefits in the form of perks’ (M).
These include unnecessarily luxurious company cars, extravagant
entrainment and clothing allowances.
3. Discretionary profits (P). These are after-tax profits over and above the
minimum required to satisfy the shareholders.

The basic form of the model is summarized as follows:

U = ƒ (S, M, D)

This is interpreted as managerial utility is a function of S, M and D i.e.

managerial utility depends upon the level of S, M and D available to the

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 managers. In common with the utility theory of consumer behavior, it is also
assumed that the principle of diminishing marginal utility applies, so that
additional incremental to each of S, M and D yield smaller increments of utility
to the management.

While the model may be easy to understand, it has some complexities which
made it difficult to grasp every detail of it but its practical application comes in
the explaining high profits usually reported by take-overs or mergers. New
managers may have different ideas regarding S and M. They will seek to
prune these in line with what they believe is good for the organization. This
however depends on management’s decision and preparedness to earn less
than maximum profits. The model also fails to deal with the problem of
oligopolistic interdependencies. It is said to hold only where rivalry, profit
maximization is claimed to be more appropriate hypothesis.

2.4 Profit Maximizing Rate of Growth Model:- Marries (1964)

The Marris model is a dynamic model in that it concerns growth rates. It shares
the same basic assumption of the Managerial Utility Maximization Model i.e.
maximization of managerial utility. However in this model the utility is derived
from:

1) Managers seeing reasonable growth of the firm.

2) Job security which depends on satisfaction of the satisfaction of the
shareholders interest.

Growth and profitability of the firm are therefore key in this model. Growth in this
model is characterized by diversification into new products, rather than increase
in output perse.
Dimension of relationship between profits and growth in the
model

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 1. Supply growth which results from the profits generated and ploughed back
as additional investment into the firm or obtaining funds from capital market.
2. Demand growth relationship which operates in the other direction with
growth determining profits. This is more complex. As growth consists of
diversification into new products the links between profits and growth are
seen as different at different levels of growth. At low levels of growth it is
argued that the relationship is a positive one, with more growth providing
more profits. At these levels it is argued that the firm will be introducing
more profitable new products from those which are possible and
managers will be motivated to be more effective by more growth.
However, as the growth rate increases, with ever greater diversification,
the relationship changes and becomes negative. The management team
has to cope with increasing burdens, including the development of a larger
management team. Thus, higher growth leads to lower profitability.
The resulting relationship is show below:
Profit maximizing rate of growth
SG1

A Supply Growth
Profit B
Rate
x

Demand Curve

Fig 2.3 C

Growth Rate

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If the retention ratio is very low, so that nearly all profits are distributed to the
shareholders, then at every level of profitability, growth will be low as there is
limited finance for expansion. The supply – growth curve will be low as there is
limited finance for expansion. The supply – growth curve will be very steep, as
shown by SG1. The equilibrium point will be at point A, where less than
maximum profit is earned and growth is relatively low. As the retention ratio rises,
the supply – growth curve becomes flatter as more growth can be financed from
retained earnings at each level of profitability. As a result, as the retention ratio
rises, so does the equilibrium combination of growth and profitability until it
reaches point B where the profits are maximized. Up to this point managers have
no fear for their job security as the combination of higher profits and higher
growth rate will meet the approval of the shareholders. However, if the managers
wish to adopt even higher retention ratios, giving higher growth then they need to
pay attention to the impact on the wealth of shareholders. A further increase in
retentions will reduce dividends because profits will be lower and the proportion
those distributed in dividends will be lower. In so far as share prices are
determined by both dividends and the firm’s growth rate it will probably be
possible to go some way beyond point B without the firms share price beginning
to fall. However, at some point the effect of still higher retentions, creating an
even flatter supply – growth curve and yet lower profits and dividends will be to
reduce the share price and the value of the shareholder’s wealth, rendering the
firm vulnerable to takeover and threatening the job security of the managers.
Therefore, as both the ‘supply – growth’ and ‘demand – growth’ relationship must
be satisfied, the combination of growth and profitability which the firm achieves
must be where the two curves interest, at point X.
2.5 Defence of the profit – maximizing rate of growth model
1) If the purpose of the model is to predict, the model is able to yield
predictions quite clearly.
2) The predictions should be testable against the data, which is the test the
model also passes.

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 3) The predictions should be supported by the data, which its supporters
claim is the case.

2.6 Behavioral Model of the Firm.-Cyert and March (1963)

In this model, the firm is seen as a coalition between shareholders, managers
and customers, all of whose support is needed to hold the coalition together. To
do so, the firm has to pursue multiple objectives, such as profit, sales growth,
customers as well as the needs of production managers, but no one objective
can be pursued to the exclusion of the others. The firm has to develop a set of
behavioral principles to enable it to hold the behavioral principles to enable it to
hold the coalition together and guide managerial decision making. The key
elements of this model are that the firm hardly exists as a single entity, but
consists of a group of people who form coalitions and alliances amongst
themselves based on common group and individual interests. Each individual will
have own objectives based on their historical background, preferences, and
position within the firm. Decision – making therefore acknowledges a score or
average that allows group and individual interests to be considered and taken
care of. Decision makers exhibit satisfactory behavior, rather than an optimizing
one. There is no minimization or maximization of anything in this firm, the
incentive is just not there to do so. If one of the multiple organizational objectives
is not met there will be problem oriented search using rule of thump to ensure
that this is not.
Critique of the model
1) Model does not offer insights into how organizations responds to changes
in the environment because it is too in ward looking.
2) Model does not fully address the question on what firms should do to meet
their objectives.
3) Decision – making takes time if all suggestions of this model are followed.
For this reason it is of limited use in managerial economics.
4) Does not reveal how the firm reaches its equilibrium
5) Does not analyse how the firm reaches its equilibrium.

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 6) Does not deal with interdependence in the case of oligopoly
Defence of Behavioral Model
1) It is a very realistic model which depicts a lot of common in terms of how
organizations are run. Therefore, it is descriptively more realistic.
2) If all the stakeholders share a common objective, the process of
organizational learning may lead the firm towards profit maximization.
3) The model offers an alternative way that fosters democratization in
organizations that allows participation by all and if properly applied, this
may yield positive benefits to the firm.
2.7 The concept of X - inefficiency
A useful concept which links the behavioral model, and the managerial utility
model, is that of ‘X – inefficiency’ .In the standard, neo- classical, profit-
maximizing model, it is assumed that the firm incurs the minimum cost
achievable for the level of output being produced, given the set of output being
produced, given the set of plant and equipment which has been installed. In
terms of the diagram, the firm is on its cost curve. Such a firm may be described
as being ‘x – efficient’ or ‘operationally – efficient’. However, this may not be the
case. If a firm which is maximizing managerial utility will tend to spend more on
staff and on ‘perks’ for management than is necessary. Thus cost per unit will be
above the average cost curve. In this case, the firm is said to be X- inefficient.

This is illustrated by the diagram below:

X- Inefficiency
SAC

x
a

qo

Fig 2.4
Output

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If the firm is producing output q o at point X, the cost per unit is (a) instead of “b’.
Thus, the average cost per unit is higher than what it should be indicating that the
firm is x- inefficient.

Causes of x- inefficiency
1) Factors, internal to the firm e.g. if contracts between the principals and
agents, (owners, managers and workers) are not so efficient managers
will not be motivated to keep costs down.
2) Factors external to the firm e.g. if the management has the discretion to
avoid profit- maximization, it will allow its costs to rise above the level
which is strictly necessary.

Self – test questions

1(a) Describe the Neo – classical profit maximization model

(b) Explain the advantages and disadvantages of the neo- classical model

2(a) How realistic is Baumol’s sales maximization model from your experience
with business objectives as pursued by Zimbabwean firms
(b) What are the criticisms of Baumol’s sales Maximization model?

3 (a) Compare and contrast Baumol’s Sales maximization model with Marris’
Model of Profit Maximizing rate of Growth Model.
(b) What are the weaknesses of the Marris Model?

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CHAPTER THREE
THEORY OF CONSUMER BEHAVIOUR AND MARKET DEMAND
What this Unit is about?

This unit looks at what lies behind the demand. The amount of sales enjoyed by
individual firms depends on how consumers make choices. In this unit, we model
rational consumers who seek to maximize utility given their budget constraints.
We attempt to analyze consumer behavior and how consumer equilibrium is
attained. Inaddition, concepts of elasticity of demand are introduced. Elasticity is
concerned with the extent to which a dependant variable responds to changes in
the independent variables.

Unit Objectives
After reading this unit, you should be able to:

• Explain the behavior of the consumer.

• Present the consumer’s equilibrium point.
• Explain the substitution on and income effects of a price change.
• Explain the variables than influence market demand.
• Explain the difference between change in demand and change in quantity
demanded.
• Define the elasticity concept for demand.
• Explain the principal applications of the elasticity of demand.

3.1 Consumer Preferences and Choice

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The history of demand has seen two major breakthroughs. The first was the
marginal utility theory, which assumed that the utility that people got from
consuming products could be measured quantitatively. The second
breakthroughs came with indifference theory, which allowed demand theory to
dispense with the dubious assumption of quantitatively measurable utility on
which marginal utility theory was based.

3.1.1 Utility analysis

3.1.1.1 Meaning of Utility

Utility is defined as the satisfaction that a household receives from consumption

of a product.

3.1.1.2 Assumptions of Utility theory

1. The consumer is rational. This means the consumer aims at the

maximization of his utility subject to the constraint of his given income.
2. Utility is measurable in cardinal numbers.
3. The marginal utility of a commodity diminishes as the consumer acquires
larger quantities of it.
4. The utility of money is constant.
5. Utility is addictive i.e. the total utility of a “basket of goods” depend on the
quantities of the individual commodities and can be added together

3.1.1.3 Total Utility

This is the total satisfaction derived from consuming some amount of a
commodity. This is illustrated by the diagram below:

Total Utility
Utility

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 Total Utility

qo
Fig 3.1
Quantity

The total utility curve is positively sloped up to quantity q o. This shows that total
utility increases as quantity consumed increases. At quantity q o, total utility is
maximized. This is known as the point of satiation; marginal utility=0. Beyond
quantity qo, the total utility curve is negatively sloped, indicating that total
satisfaction decrease as quantity consumed increases. This indicates that the
consumer is getting dissatisfied.

3.1.1.4 Marginal Utility (MU)

Marginal utility refers to the change in satisfaction resulting from consuming one
unit more or one unit less of a commodity. This is calculated using the formula
below:
MU = change in total utility
change in quantity

The diagrammatic representation of the marginal utility curve is shown below:

Marginal utility curve

+
Utility

o Quantity
Q
-
MU
Fig 3.2

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The marginal utility curve is negatively sloped. This shows that marginal utility
decreases as quantity increases. At quantity below Q, marginal is positive
showing that total utility is increasing as quantity consumed increases. At
quantity Q, marginal utility is zero showing that total utility has reached the
maximum point. Thus, the consumer has reached the point of satiation. Beyond
quantity Q, the marginal utility curve is now negative. Thus, total utility would be
decreasing as quantity consumed increases. In this case, the consumer would be
getting dissatisfied
3.1.1.5 Maximizing Utility
Equilibrium for one product

The consumer maximizes utility when the price of the product is equal to the
marginal utility of the product. This is illustrated by the equation below:

MUx = Px where MUx = Marginal Utility of Product X

Px = Price of product X

When the consumer is maximizing utility, there is no tendency for change i.e the
consumer will be at equilibrium point.

Consumer maximizes satisfaction subject to income; consumer does not change

consumption.
Equilibrium when MU(x) = P(x); MU-marginal utility of good x;P(x) price of good x
Equilibrium is a state where there is no tendency for change.
IF MU(x) > P(x) it means good x is cheap that a rational consumer will react by
increasing consumption of good x.
This is a state of disequilibrium.
If MU(x)<P(x), good x is expensive thus a rational consumer would react by
reducing consumption of the product resulting in a state of disequilibrium.

25
 Equilibrium for many products

The consumer maximizing his or her utility will allocate expenditure among
products so that the utility derived from the last unit of money spent on each is
equal. This is illustrated by the equation below:

MUx = MUy where MUx = marginal utility of product x

Px Py
Px = Price of Product x
MUy = Marginal Utility of Product Y
Py = Price of Product Y
Equilibrium for many goods
If the consumer is consuming more than one product, equilibrium exists when
the ratio of the marginal utility to price of the goods being considered are equal.

MU(x)/P(x)=MU(y)/P(y)=MU(z)/P(z)
If MU(x)/P(x)<MU(y)/P(y )then good x is cheaper than good y so a rational
consumer increases consumption of good x and decreases consumption of good
y; it’s a state of disequilibrium.
3.1.1.6 Derivation of the demand curve

The derivation of demand is based on the assumption of diminishing marginal

utility as well as maximization of utility given the price of the product. If the
marginal utility is measured in monetary units, the demand curve for the product
is identical to the positive segment of the marginal utility curve. This is illustrated
by the diagram below:
Marginal Utility Demand Curve
(a) (b)
D

P1
MU1
MUx =Px
Price
Utility

MUx = Px P2
MU2
MUx = Px

26
 P3
MU3
D
MU
X1 x2 x3 x1 x2 x3
Quantity Quantity
Fig 3.3
At quantity X¹, the marginal utility is MU, in diagram (a). This is equal to P ¹ and the
consumer demands quantity X¹ in diagram (b). Similarly, at X², the marginal utility
is MU² which is equal to P². Hence at P², the consumer will buy quantity X², and so
on. The negative section of the marginal utility curve does not form part of the
demand curve since they have quantities that do not make any economic sense.
Since the consumer is maximization satisfaction, price = marginal utility,
corresponding points showing price and quantity are plotted, i.e. x1, x2, x3.
By joining the corresponding points, a demand curve is derived.
Evaluation of the Theory

3.1.1.7 Limitations of the Utility Theory

1. It is based on the unrealistic assumption of cordinal measurement of
utility.
2. Utility is a psychological term which cannot be measured numerically and
in units
3. It is applicable only for one product.
4. It does not explain the impact of complimentary and substitute goods on
the demand.
5. It cannot explain the impact of changes in the income on demand.
Self Test Questions
1) Distinguish between Total Utility and Marginal Utility. What is the
role of equi- marginal utility?
2) Describe the limitations of the Utility Theory.
3) Explain the basic assumptions of the theory.
4) Show the derivation of the demand curve using the Utility Theory.

27
3.1.2 Indifference curve Analysis
In order to overcome the limitations of the utility approach, Hicks gave a new
treatment to the theory of demand. According to the Indifference curve Theory,
a consumer can rank the commodities according to their preferences.

3.1.2.1 What is an Indifference Curve?

An indifference curve is a locus of all possible combinations of two goods or two
groups of goods which provide the same level of total utility for an individual,
group of people or community. It is called an indifference curve because there is
no preference for one combination over any of the others. All offer the same
amount of utility or satisfaction, so that people are indifferent as to which
combination they have. This is illustrated below:

6 A

Good
Y
(Unit)
4 B

C
2
1o

1 2 3

Fig 3.4 Good x (Units)

The figures given here for units of Good X and y are purely hypothetical. From
the curve, we see that the person whose curve this is would have the same utility
from 3 units of good X and 2 units of Y as from 2 units of X and 4 units of Y or
from 1 unit of X and 6 units of Y. Although these figures are, to some extent, just
“plucked out of the air”, they are also chosen to illustrate the general shape which
we can expect all indifference curves to take.

28
 Properties of Indifference curves
1) Indifference curves are space filling i.e. they pass through every point
in the commodity space.
2) Indifference curves are convex to the origin and have declining
marginal rate of substitution (MRS). Marginal rate of substitution is
the indifference curve. Marginal Rate of Substitution is the amount of
one more unit of another commodity while leaving the level of
satisfaction unchanged.
3) Indifference curves can never intersect. This property is explained by
the transitivity assumptions. If indifference curves were to intersect,
then all points on the crossing curves are indifferent to one another,
contradicting the transitivity assumption.
4) The further away from the origin an indifference curve lies, the higher
the level of utility it denotes. Bundles of goods on a higher indifferent
curve are preferred by the rational consumer.
3.1.2.3 Indifference map

An indifference map is a series of indifference curves. This is illustrated below:

Indifference Map

Good Y

L2

L1

Lo

29
 Good X
Fig 3.5

Combinations on Good X indifference curve L² yield a higher utility as compared

to combinations on indifference curves L¹ and Lo. The higher the indifference
curve from the origin, the higher the total utility.

3.1.3 Consumer Income and Price Constraints

The consumer has a given income or budget (B) which sets limits to the
consumer’s maximizing behavior. The income constraint, in the case of two
commodities may be written as:
B= Px X + Py Y where B = Income or budget
Px = Price of Good X
Py = Price of Good Y
X = Quantity of Good X
Y = quantity of Good Y

The budget can be represented graphically by a budget line below:

Budget line
B
6
Good Y (Units)

Q
3

B
2 4

Good X (Units)
Fig 3.6
A budget line is a locus of all possible combinations of good X and good Y that
fully utilize the consumer‘s income. Combinations on the budget line exhaust the
consumer‘s income. Assuming that good x is priced at $ 3 per unit and y at 4 per

30
unit, the amount available for spending is $ 12. The budget line joining 6Y and 4X
shows all the combinations of y and x that can be bought for $12.
Holding all other factors a combination inside the budget line does not exhaust
the consumer’s income.
Combinations outside the budget line are unattainable as long as the prices and
consumer’s income remains constant.
Shift of the Budget Line
A budget line is drawn based on the subject that prices of the goods and income
of the consumer remain constant.
Therefore a change in prices or consumer’s income will cause the budget line to
shift.
3.1.4 Consumer Equilibrium

The consumer is in equilibrium when maximizes his utility, given his income and
market prices. For the consumer to be in equilibrium, two conditions must be
satisfied.
• Tangency condition, i.e. the budget line should be tangential to the highest
possible indifference curve.
• The sufficient condition is that the indifference curve must be convex to
the origin.
This is demonstrated in the diagram below:
Consumer equilibrium

Units
A

Eo
Good Y

3
Lo

2 B Units

31
 Good X
Fig 3.7
In Fig 3.7 AB is the budget line Lo is the indifference curve. Eo is the
equilibrium point. Thus, 3Y and 2X are equilibrium quantities of Good Y and
Good X respectively. Had there been less than $12 to spend the budget line
would not have reached this indifference curve and only a lower level of utility
would have been available

3.2 Consumer Behavior

3.2.1 Changes in Income
A change in consumer’s income shifts the position of the budget line parallel to
the initial budget line.
Effects of changes in consumer’s income
An increase in consumer’s income shifts the budget line outwards thereby
causing an increase in the consumption of the product.
A decrease in consumer’s income shifts the budget line inwards thereby causing
a decrease in the consumption of the product.
3.2.1.1 Increase in Income
Consider what would if the person had it, not $12 to spend. The budget line
changes as shown in the diagram below.
Increase in income

A
E1
Good Y

4 EO
3 L1

LO

2 3 B D
Good X

32
AB is the initial budget line where E0 is the initial equilibrium point. An increase
in consumer income shifts the budget line to CD where E1 is the new equilibrium
point. This increases the consumption of good X to 3 units and Y to 4
Fig 3.8
If the amount available for spending in increased from $12 to $16, the consumer
can move to a higher indifference curve where 4 units of Y and 3 units of X can
be bought. Note the further the indifference curve is from the origin of the graph,
the greater the level of utility it presents as more of both Y and X can be
obtained.
3.2.1.2 Decrease in Income
Consider now what would happen if the person had $12, not $16 to spend. The
budget line would shift inwards or to the left as shown below:
Decrease in income

A
E1
Good Y

4 EO
3 L1

LO

2 3 B D
Fig 3.9
Good X

CD is the initial budget line where E, is the initial equilibrium point. Thus, the
consumer is buying 4 units of Good y and 3 units Good X. A decrease in
consumer’s income from $16 to $12 shifts the budget line to AB. This decreases
the consumption of Good y to 3 units and consumption of good X to 2 units.

3.2.2 Changes in Price

33
A change in price of one product, with the price of the other product remaining
constant causes a change on the gradient of the budget line. However, if the
prices for the two products changes by the same magnitude in the same direction
e.g. if both increase by $10, the gradient of the budget line would not change. In
this analysis, the price of one product is assumed to be changing.

3.2.2.1 Increase in price of Good X

An increase in price X with the price of good Y remaining constant shifts the
budget line inwards thereby decreasing the consumption of good X and vice-
versa.
Increase on P(x) shifts the budget line to AC where E1 is the new equilibrium
point thus the consumption of good x decreases.
Let us say that the price of x is increased to $4 per unit but that of y stays the
same at $2. This is illustrated below
Increase in price of good x

5
Good Y

4
Eo
3 E1
2 Lo
1 L1
C B
0
1 2 3 4
(Units)

Fig 3.10 Good X

The two extreme possibilities for a total amount of spending of $12 now 6 units of
Y (no X) and 3 units of x (noY). The line between these two points on the graph
shows all possible combinations of X + Y that can be bought for $12. This budget

34
line no longer meets our original indifference curve Lo. The old combinations of
3X + 4½ Y now costs more. The lower indifference curve L¹ touches the budget
line AC at point E¹ to give a package of rather less X and Y.
3.2.2.2 Decrease in price of Good X

A reduction in the price of x allows more of good X be bought from a given level
of income. This is illustrated below:
AB is the initial budget line with E0 equilibrium point.
A decrease in price of good x with P(Y) constant shifts the budget line to L1
where E1 is equilibrium point. This increases the consumption to x2.
Decrease in price of good x

A
Good Y

E1
Eo
L1

Lo
X1 X2 B C
(Units)

Fig 3.11 Good X

In Fig. 3.11, AB is the initial budget line where Eo is the initial equilibrium point on
indifference curve Lo. A decrease in price of good X with the price with the price
of good y remaining constant shifts the budget line to AC where E ¹ is the new
equilibrium point on higher indifference curve L ¹. Thus the quantity of good X
bought increases from X¹ to X².
3.2.3 Substitution and income effects of a price change

35
The substitution effect refers to the change in quantity demanded of a good
resulting from a change in the commodity‘s relative price, eliminating the effect of
the price change on real income.

Income effect refers to the effect on quantity demanded of a change in real

income, relative prices held constant. The diagram below illustrates the
substitution and income effects.
Substitution and income effect of a price change

Substitution Effect
a
E2 Income
Good Y

Effect
a1 E1
L1

L2
-
qo q1 q2 B J1 J

Good X
Fig. 3.12
The original budget line is at A B and a fall in the price of good X takes it at A j.
The original equilibrium is at Eo with qo of good X consumed, and the final
equilibrium is at E² with q² of good x consumed. To remove the income effect,
imagine reducing the consumer’s income until he is just able to attain his original
by shifting the budget line a j to a parallel line nearer the origin until it just
touches the indifference curve that passes through Eo. The intermediate point E¹
divides the quantity change into substitution effect q ¹ -q˚ and an income effect
q² - q¹. This point can also be obtained by sliding the original budget line a b
around the indifference curve until its slope reflects the new relative prices.
3.2.4 Application of indifference curve Analysis: Derivation of
the consumer’s demand curve

36
The demand curve is derived from the price consumption line. This is illustrated
below
Price consumption line

a
Good Y

E2
E1
E0 L1

L1
LO
60 120 220 C
(i)
Good X

Demand Curve
Price of Good X

xo Y1
$75
$50 E2

Demand Curve
$25

60 120 220

Quantity of Good X
(ii)
Fig 3.13
In part (i) the consumer has a given income per month, and alternatively faces
prices of $75, $50, and $25 per unit of good X, choosing positions E o, E¹, and E².

37
The information for quantity of good X at each price in then plotted in past (ii) to
yield the consumer’s demand curve. The three points X, Y and Z in (ii)
correspond to the three equilibrium positions E o, E¹, and E² in (i) further application
of Indifference analysis.
3.2.5 Normal, Inferior and Giffen Good

3.2.5.1 Normal Good

A product with a positive relationship between income and consumption.

A normal good is a commodity whose demand increases when income
increases. The income and substitution effects of a price change reinforce each
other i.e. act in the same direction. The demand curve for normal good slopes
downwards from left to right.
****If asked for the effect of price decrease for a normal good, illustrate this using
a diagram********
3.2.5.2 Inferior Good
A commodity whose demand decreases when the consumer‘s income
increases. (negative relationship between consumption and income of the
consumer i.e. an increase in income for the consumer decreases the
consumption of the product.) Its income elasticity is negative. The substitution
and income effect of a price change oppose each i.e. they act in different
directions. The substitution effect outweighs the income effect.

*************Find out how this is illustrated diagrammatically****************

3.2.5.3 Giffen Good

Special type of an inferior good because the substitution effect and income effect
of a price change oppose each other.
A Giffen good is a good with a positively sloped demand curve. Thus, an
increase in price of the product increases the quantity demanded of the product.

38
The substitution and income effect of a price change oppose each other.
However, the income effect is greater than the substitution effect.

*************Find out how this is illustrated diagrammatically****************

3.2.5.4 Evaluation of Indifference Curve Analysis

1) The indifference curve analysis has been a major advance in the field of
consumers demand. The assumption of this theory is less stringent than
for the utility approach. Only ordinality of preference is required and the
assumption of constraint utility is dropped.
2) The indifference approach established a better criteria for the classification
of goods into normal, inferior and giffen goods.
3) The main weaknesses of this theory is the convexity of indifference
curves. The theory does not establish either the existence or the shape of
the indifference curves. It assumes that they exist and have the required
shape of convexity.
4) Further, it is questionable whether the consumer is able to order his
preference as precisely and rational as the theory implies.

Self test Questions

1) Explain why economic analysis assumes that demand curves slope

downwards, using either indifference analysis or marginal utility theory in
support of your argument.
2) Draw indifference maps for beer and cigarettes for consumers with the
following preferences:
a) Likes both beer and cigarettes
b) Gets no enjoyment or discomfort from cigarettes but likes beer.
c) Gets no enjoyment or discomfort from beer but likes cigarettes
d) Is made ill by both beer and cigarettes

39
 3.) Discuss the prediction of indifference curve analysis to the behavior of
rational consumers.
4.) What are the properties of indifference curves and what role do they play in
consumer analysis.

3.3 Market demand Analysis under perfect Competition

3.3.1 Demand

Demand in economics is not just a matter of desire for a good. It refers

specifically to how much of a good person would actually be willing to buy at a
given price over a given period of time. Demand is want backed by money. In
practice, the quantity demanded depends on (i) the price of the good, (ii) the
conditions of demand.

3.3.1.1 Law of Demand

This is the law which states that holding all other factors constant, at a higher
price, consumers demand lesser quantities than they do at lower prices and vice
versa. Thus, the law of demand postitulates an inverse relationship between
price and quantity demanded of any commodity.

3.3.1.2 Demand Schedule

This is a table which shows the law of demand. This is illustrated below:

Price per unit Quantity demanded

10 1000
15 700
20 400
30 100

The table shows an inverse relationship between price and quantity demanded.

40
3.3.1.3 Demand Curve

This is a graphical representation of the law of demand. The law of demand

implies that normal demand curve are downward sloping. This is illustrated
below;
Demand curve

D
Price

Po

P1
D

qo q1
Fig. 3.14

Quantity

The demand curve slopes downwards from left to right showing that decrease in
price from Po to P¹ increases quantity demanded from qo to q¹.

3.3.1.4 Determinants of Demand

a) Price: Normally, a person will demand more of a good, the lower its price
and vice versa.
b) Income: An increase in consumer’s disposable income allows greater
consumption of the product and vice versa.
c) Prices of related goods: Substitutes are goods that’ satisfy similar
consumer wants e.g. butter and margarine. Compliments are commodities
which are jointly used e.g. tennis rackets and tennis balls.

41
An increase in price of a substitute makes the production question relatively
cheaper than the substitute. This will lead to an increase in demand for the good
in question and vice versa.

An increase in price of a compliment will lead to a decline in the quantity

demanded of the complimentary good. Such a cut in the quantity demanded of
the complimentary good will result in a decrease in the demand for the good in
question and vice versa.

d) Consumer expectations: If consumers expect price of the product to

increase, they buy now in order to take advantage of the relatively lower
price prevailing now and vice versa.
e) A change in tastes and fashion: an advertising campaign would
increase demand.
f) A change in population: additional people would increase the price of
the product. This would decrease demand for the product .A rebate paid to
the consumers would increase demand for the product.
g) Government policy: a tax on a product would increase the price of the
product. This would decrease the demand for the product. A rebate paid to
the consumers would increase demand for the product.

3.3.1.5 Changes in Demand

A change in demand refers to the shifts of demand curves. An increase in
demand shifts the demand curve to the right. A decrease in demand shifts the
demand curve to the left. This is illustrated below:

42
 Shifts of demand curves

Price

D1
Do
D2

Quantity
Fig. 3.15
Do is the initial demand curve. An increase in demand shifts the demand curve to
D¹. A decrease in demand shifts the demand curve to D ².

3.3.1.6 Exceptional Demand Curves

Exceptional demand curves are demand curves which slopes upwards from left
to right. This are illustrated below:
Upward sloping demand curve

P1
Price

Po

qo q1

Quantity
Fig.3.16

43
The demand curve shows that an increase in price increases in price from P o to
P¹ increases quantity demanded from qo to q¹.
3.3.1.7 Causes of exceptional demand curves
1) Veblen goods; these are prestige goods e.g. diamonds. The consumer
would like to hold it only when they are costly and rare.
2) Spectacular Market: in this case the higher the price, the higher will be
the demand. It happens because of expectations of an increase in price
in future e.g shares, lotteries, etc.
3) Giffen goods; this is a special type of an inferior good where the
increase in the price results in increase in the quantity demanded.

Self test Questions

1) Explain the factors affecting demand.
2) Distinguish between a change in demand and a change in quantity
demanded.
3) What are exceptional demand curves?
4) Describe the causes of exceptional demand curves.

3.3.2 Price elasticity of demand

Price elasticity of demand is the degree of responsiveness or sensitivity of
demand to changes in the price of the commodity in question.
Price elasticity = Percentage change in quantity demanded of demand
Percentage change in own price
In some cases, a marked change in price causes comparatively little fluctuation
in demand, whereas in other cases, demand changes considerably with a
comparatively small variation in price. Three broad cases of elasticity may be
distinguished:

• If demand has changed to a greater extent than the price, then the result
price elasticity of demand will be greater than unit. Demand is said to be
elastic.

44
 • If demand has changed by a lesser extent than price, then the result is
less than unit. Demand is said to be inelastic.
• If the proportionate change in demand is equal to the proportionate
change in price, then the result ids equal to unit. Demand is said to be
unitary elastic.

3.3.2.1 The sign of the measure

The cause of the negative slope of the demand curve, the price and quantity will
always changes in opposite directions. One change will be positive and the
other negative, making the measured elasticity negative. However, the negative
sign is dropped and elasticity is reported as a positive number.

3.3.2.2 Three Constant elasticity demand curves

Each of the demand curves have a constant elasticity

Perfectly Inelastic Demand Curve

D1
Price

Fig. 3.17 Quantity

D¹ has zero elasticity. The quantity demanded does not change at all when price
changes.

45
 Perfectly Elastic Demand Curve

Price Po D2

Quantity
Fig. 3.18

D² has infinite elasticity at the price Po. A small price increase from Po decreases
quantity demanded from an indefinitely large quantity to zero.

Unitary Elastic Demand Curve

Price

D3

Quantity
Fig.3.19

D³ has unit elasticity. A given percentage increase in price brings an equal

percentage decrease in quantity demanded at all points on the curve. It is
rectangular hyperbola for which price time’s quantity is a constant.

46
3.3.2.3 Determinants of Price Elasticity of Demand
1) Availability of substitutes: The existence of substitutes increases the
elasticity of demand for the commodity.
2) Nature of the product: Demand for luxuries tends to be elastic while that
for necessities is inelastic.
3) The importance of the consumption item In the general plan of
expenditure: A rise of 30% in the price of matches would not appreciably
affect the demand for matches, but a rise of even 5% in the price of meat
would lead to a considerable contraction of demand.
4) Habits: Once we have cultivated certain tastes, we cannot readily change
our habits. The demand thus, becomes inelastic.

3.3.2.3 Application of Price Elasticity of Demand

1) Pricing Decisions
Any seller who is in a monopolistic position, in that he can fix his own
prices must take into account the price elastic of demand for his product.
The question he must ask himself is “How much will my sales fall off if I
raise my price by so much?”. If demand is inelastic at the ruling price, if he
raises his price his revenue will increase. It will therefore pay him to go an
increasing his price until demand becomes elastic.

2) Government Policy
Any government wishing to raise revenue by imposing indirect taxes needs to
know something about the elasticities of demand for the goods in question.
Government policy can also cover exchange rate policy, i.e. devaluation.
3) Price Discrimination

Any price discriminating monopolist must take into account elasticity of demand.
Thus, a monopolist is likely to charge a higher price in the market where demand
is relatively inelastic, and a lower price in that market where demand is relatively
elastic.

47
Self Test Questions

1. (a) Define price elasticity of demand.

(b) Explain the factors affecting price elasticity of demand.

2. As a Manager of a retail shop, explain how understanding of price

elasticity of demand could be helpful to your organization.

3.3.3 Income and Gross Elasticity of demand

3.3.3.1 Income Elasticity of demand

Income elasticity of demand can be defined as the relative responsiveness of
quantity demanded to changes in the consumer’s income. In other words, it is
given by:
Income Elasticity of Demand = Percentage change in quantity demanded
Percentage change in Income

Increase income will generally lead to an increase in demand, but the demand for
some goods is more responsive to changes in income than others.
The sign of the measure

The sign of income elasticity of demand is very important; as a result it is not

disregarded.
A negative sign shows that the product in question is an inferior good i.e. an
increase in consumers’ income brings about a decrease in demand of the
product.
A positive sign shows that the product in question is a normal good i.e. an
increase in income brings about an increase in demand of the product.
Main Determinants of Income Elasticity of Demand
1) The nature of the need that the community covers.
2) The initial level of income of a country.
3) The time period.

48
Importance of Income Elasticity of Demand
Income elasticity is useful in assessing actual and potential opportunities in the
market place. Income elasticity of demand is important when forecasting the
pattern of consumer behavior as the economy grows or contracts. As real income
increases or decreases, the demand for most products increases or decreases
respectively.

3.3.3.2 Cross- Price Elasticity of Demand

Cross price elasticity of demand measures the relative responsiveness of the

quantity demanded of a given commodity to changes in the price of a related
commodity.

Cross Price Elasticity = Percentage Change in Quantity demanded of Good X

Percentage change in price of Good Y

The responsiveness of quantity demanded of one commodity to changes in the

prices of other commodities often of considerable interest.
The sign of the measure

The sign of cross price elasticity of demand is very important. A positive sign
shows that the products in question are substitutes. For example producers of
beans and other meat substitutes find the demand for their products rising when
cattle shortages force the price of beef up. A negative sign shows that the
products in question are complements. For example, sellers of large cars find
their revenues falling off when OPEC forces up the prices of oil. If the cross
elasticity of demand is zero, it means the two goods are not related at all.

Importance of Cross elasticity of Demand

Cross elasticity of demand is important to the business community as they

provide a useful measure of the relationship between goods.

49
Self Test Questions

i. There are various kinds of elasticities of demand discussed

in this course. Discuss why it is important for managers to
have a clear understanding of the elasticity of demand. You
should be very clear in your answer on which elasticity
concept you are discussing.
ii. Discuss why understaning of the concept of elasticity of
demand for a commodity is important in managerial decision
making.

CHAPTER FOUR

Production and determination of costs

What this unit is about
This chapter begins by setting out the basic relationships between inputs and
outputs, as represented by the production function. Isoquants are then used to
identify the cost minimizing combinations of inputs in both the short-run and the
long-run, and this analysis is linked to the concept of the cost curve. The sources
of scale economics and diseconomies are then analyzed.

Unit Objectives
By the end of this unit, you should be able to:

• Define production function.

• Distinguish between the short run and long-run in production.
• Explain the behavior of output curves in the short run.
• Describe cost curve in the short and long run periods.
• Describe the long run average cost curve.
• Explain the difference sources of economies and diseconomies of scale.
Factors of production
Economic resources used in the production process.
• Categories

50
 • 1. Land-provided by nature ground sunlight
• 2. Capital- manmade resources: machinery, equipment etc
• 3. Labour- physical and mental effort of human beings towards production
• 4. Entrepreneurship- risk bearer who combines the other 3 factors of
production so that production can take place.
Production Periods
1. Short run period- at least one factor of production is fixed
Output can only be changed by changing the variable factors of production
2.Long-run period- all the factors of production are variable
4.1 Production Function

The starting point for the economic analysis of function. A production function is a
mathematical statement of the relationship between inputs and outputs. In its
simplest and most general form, the production function is usually written as
follows:
Q = F (K, L) where Q = level of output
K = a measure of the capital output
L = a measure of the labour input.
F = functional notation
A firm’s decision about what level of outcome it is most profitable to produce
depends partly on demand and partly on costs.

4.2 Factor productivity

Factor productivity is the ability of a factor input to produce output. Factor inputs
are classified into four major categories i.e. land, labour, capital and
entrepreneurship. Land are factors inputs provided by nature. Labour refers to
the physical and mental effort of human beings towards production. Capital refers
to man-made resources. Entrepreneurship refers to combining the other three
factors of production so that production can take place.

51
To allow for different speeds with which different inputs can be varied, we think of
the firm as making decisions within two time periods the short run and the long
run. Short run is the period of time when at least one factor of production is fixed.
The long run is the period long enough for all factors of production to be varied
within confines of given technology. The long run is the period that is relevant
when a firm is either planning to go into business or change its entire scale of
operations.
4.3 Short- Run Output
In the short run, output changes as a result of changes in the employment of a
variable factor e.g. labour. Below is a review of output concepts in the short run.

4.3.1 Total Product (Q)

This represents the total volume of output changes in the employment of all
factors of production. Two factors of production are assumed namely labour (L)
and capital (K). Thus, total product can be presented functionally as follows:

Q = f (L, K) where L = labour

K = capital
Graphically Q can be shown as follows:

Total product curve

Q
Output

Fig. 4.1
Quantity of Labour

52
The total product curve shows the total product steadily rising, first at an
increasing rate, then a decreasing rate.

4.3.2 Average product (AP)

This shows output per unit of the variable factor (L) as:

AP =Q/L

4.3.3 Marginal product (MP)

This represents the change in total output resulting from a unit change in the
employment of the variable factor input.

MP = Change in output
Change in labour
Average and Marginal Product Curves

Marginal and average products curves rise at first to reach their respective peaks
at first and then decline due to the law of diminishing returns. This is illustrated
below:
Average and Marginal product curves
Output

AP
MP

30 41

Labour
Fig 4.2

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The marginal product curve reaches the maximum point after employing the 3 rd
worker. The average product curves reach the maximum point after employing
the fourth worker. The marginal product curve cuts the average product curve at
its highest point.

The relationship between marginal and average product curves

The MP cuts the AP curve at the latter is maximum point. It is important to

understand why? The key is that the average product curve slopes upwards as
long as the marginal product curve is above it. It makes no difference whether
the marginal curve is itself sloping upwards or downwards. The common sense
of this relation is that, if an additional worker is to raise the average product of all
workers, the worker’s output must be greater than the average output of all
existing workers. It is immaterial whether his contribution to output is greater or
less than the contribution of the worker hired immediately before him, all that
matters is that his contribution to output exceeds the average of all the workers
hired before him. Since AP slopes upwards or downwards depending on whether
MP is above or below AP it follows that MP must equal AP at the highest point on
the AP curve.

4.3.4 Law of Diminishing Returns

The law of diminishing returns states that, if increases in quantities of a variable

factor are applied to a given quantity of a fixed factor, the marginal product, and
the average product, of the variable factor will eventually decrease. The law of
diminishing returns is also called the “law of variable proportions”, because it
predicts the consequences of varying the proportions in which factors of
production are used.

4.4 Production in the long run

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The law of variable proportions deals with what are essentially short run
situations. In the short run, at least one of the factor inputs is fixed. However in
the long run, all factor inputs are variable, i.e. there are no fixed factors. In the
long run, it is possible for a firm to vary the amounts of all factors of production
employed e.g. acquiring more land, more buildings erected and more machinery
installed. Thus, it is possible to change the scale of its activities. Strictly speaking
a change of scale takes place when the quantities of all factor inputs are
changed by the same percentage so that the proportions in which they are
combined are not changed.
4.4.1 An alternative analysis of the firm’s long run input
Decisions
1. Isoquant Curve
An isoquant refers to a curve showing all technology efficient factor combinations
for producing a specified output. This is illustrated below.
Isoquant curve

a
Quantity of Capital

b
c

Quantity of Labour
Fig 4.3
An isoquant is negatively sloped and convex to the origin. The convex shape of
the isoquant reflects a diminishing marginal rate of substitution i.e. moving along
the isoquant to the right, its slope becomes flatter. All combinations on the
isoquant show all technological efficient factor combinations e.g. (a) (b) and (c).

55
 2. Isoquant Map
An isoquant shows a set of isoquants, one for each level of output. This is
illustrated by the diagram below:
Isoquant Map
Quantity of Capital

Is2 q = 8

Is1 q = 6

Iso q= 4

Fig 4.4
Quantity of Labour

The diagram shows three isoquants drawn from the production function and
corresponding to 4, 6 and 8 units of production. The higher the level of output,
the further is the isoquant from the origin.

3. Isocost Lines
An isocost line shows alternative factor combinations that can be purchased for a
given outlay. This is illustrated below:
Isocost lines
C
8
Quantity of Capital

Fig 4.5 B D
10 12
Quantity of Labour
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Fig 4.5 shows two isocost lines AB and CD when expenditure is $ 100 where
labour cost is $6, capital cost $ 8 and total expenditure of $200 where labour is
$10, capital $10 respectively. AB represents all combinations of factors of
production (labour, capital) that the firm could buy for $100. Line CD represents
combinations off factors of production which the firm could buy with $200.

4. Isoquants and the conditions for cost minimization

The least cost method of producing any given output is shown graphically by the
tangency between the relevant isoquant and an isocost line. This is illustrated
below:
Equilibrium point for cost minimization
C

A
Quantity of capital

k1 D

ko C

Ls1

Lso

Lo L1 B D

Quantity of Labour
Fig 4.6
The isoquant map and isocost map are brought together. Points C and D are the
tangency points of isoquant curves and isocost lines. These are points where
costs can be minimized by each firm projected cost.

4.5 Theory of Costs

Cost theory is concerned with the transaction of productivity into costs by
bringing in the prices that have to be paid to factor inputs. Costs are translated in

57
monetary terms. Traditional theory of costs had identified two broad classes of
costs: fixed and variable costs.

4.5.1 Costs in the Short Run

1. Fixed Costs (FC)

These are costs of employing fixed factor inputs. Thus, fixed costs refer to costs
that do not change with the level of economic activity. Production or no
production, fixed costs are incurred e.g. rent, depreciation, administration
overheads.
2. Variable Costs (VC)
These are costs that move in the same direction with economic activity or output.
Variable costs increases as output increases and decline as output declines.
Variable costs are only incurred when production takes place. Thus, if there is no
production, no variable costs will be incurred.
3. Total Cost (TC)
This is the aggregate of fixed and variable costs i.e. TC = FC + VC

Total Cost, total variable Cost and fixed Cost Curves

TC
FC
Cost ($)

FC

Fig 4.7 Output

Total fixed cost does not vary with output. Total variable cost (VC) and the total
of all costs (TC) rise with output, first at a decreasing rate, then at an increasing
rate.

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Average and marginal Costs

1. Average Fixed Cost (AFC)

Average fixed cost represents fixed cost per unit of output. Average fixed costs
can be computed using the following equation:
AFC = FC where FC = Fixed costs
Q Q = output

Average fixed cost declines continuously as output increases, but does not
become zero. An average fixed cost curve is a rectangular hyperbola i.e. it is
asymptotic to both the vertical and horizontal axes. Average fixed cost will not
cross either of the axes.
2. Average Variable Cost (AVC)
Average variable Cost represents variable cost per unit of output. Average
Variable Cost can be computed using the following equation:
AVC = VC where VC = variable costs
Q Q = output
The average variable cost curve is U- shaped, reflecting the law of variable
proportions.
3. Marginal Cost (MC)

Marginal Cost may be defined as the change in total cost resulting from unit
change in the level of output. Marginal cost can be computed as follows:
MC = DTC DTC= Change in total cost
DQ DQ = Change in output

The marginal cost curve is U- shaped reflecting the law of variable proportions.

59
Average Fixed Cost, Average Variable Cost, Average total cost and
Marginal Cost Curves

MC

ATC

AVC
Cost

AFC

qo

Fig 4.8 Output

Average fixed cost declines as output increases. Average variable cost and
average total cost fall and then rise as output increases. Marginal Cost (MC)
does the same, intersecting the average total cost and average variable cost
curves at their minimum points. Capacity output is at the minimum point of the
average total cost curve (ATC) i.e. at output q o.
4.5.2 Long- run Cost Curves

In the long run the firm is free to choose whichever combination of inputs it
expects to be most profitable, and in the long run the firm is essentially
concerned with investment decisions. The behavior of costs in this period
depends fundamentally upon the extent to which there are economies of scale
to be enjoyed from the construction of larger sets of plant and equipment.

60
Long run cost curves can be constructed from a set of short-run total cost curves.
This is illustrated below
Long run average costs curve

SRC1
SRC2
SRC5
SRC3 SRC4 LRAC
Cost

Economies of scale Diseconomies of scale

qo
Fig 4.9

Output

The long run average cost curve is U shaped. However the U shaped nature of
the long run average cost curve is explained by returns to scale i.e. increasing,
constant, and decreasing returns to scale.
Increasing returns to scale are also known as the economies of scale. Thus the
firm is enjoying economies of scale up to output qo. Decreasing returns are also
known as diseconomies of scale when producing output greater than qo.

Sources of Economies of Scale

Economies of scale are those aspects of increasing size (scale of production)

that are responsible for declining average costs. Sources of economies of scale
are as follows:
1. Specialization and the division of labour: Specialization on the part
of workers and machines can improve the efficiency of production as
they focus on a narrower task.

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 2. Stochastic economies of scale: This is associated in particular with
levels of inventory held and with amounts of ‘back up “failure. If a firm
has a production process which would involve very heavy costs in the
event of breakdown, it will need to have a second set of equipment on
standby.
3. One-time costs: these are costs which are incurred only once for each
product, and hence are independent of the scale at which the product is
subsequently produced.
4. Technology of large-scale production: Large scale production can
use more specialized and highly efficient machinery than smaller –scale
production. It can also lead to specialization of human tasks with a
resulting increase in human efficiency.
5. Discounts on bulk purchases

Sources of economies of scale

Diseconomies of scale are those aspects of increasing size that are responsible
for rising average costs. The sources of diseconomies of scale are as follows:
1. Cost of communication: as the organization grows, communication
channels increase. This increases costs of communication.
2. Duplication of effort: When firms grow to thousands of workers, it is
inevitable that someone, or even a team, will take on a project that is
already being handled by another.
3. To - heavy companies: The more employees a firm has, the larger the
percentage of workforce will be managed.
4. Office politics: This is defined as management behavior which the
manager knows is counter to the best interest of the company, but is in his
personal best interest.
5. Isolation of decision makers from results of their decisions : A person
at a huge company may not know the effect of his decision. This lack of
consequences can lead to poor decisions.

62
 6. Slow response to time: A large company is slow to react to changes
which may cause costs to increase.
7. Unwillingness to change: refusal to consider change is toxic to any
company, as inevitably changes in the industry and market conditions will
demand changes in the firm, in order to remain successful.

Different shapes of long run average cost curves

There are a number of different shapes which the long run cost curve might take.
The diagram below shows some of the shapes.

Different long run average cost curves

b)
a)
Cost

Cost

LRAC

A
Output
Output

c) d)
LRAC
Cost

Cost

Output Output
Fig 4.10

63
In fig 4.10, diagram (a) shows a U- shaped long run average cost curve
exhibiting diseconomies beyond level A. Diagram (b) shows a curve where
economies of scale are never exhausted, so that the curve always has a
downward slope. Diagram (c) exhibits a downward slope to a point known as the
‘minimum efficient scale’, beyond which no further scale of economies are known
to exist. In diagram (d), the firm suffers diseconomies of scale continuously.

Self test Questions

1) Explain the relationship between
(i) Average total cost and average variable cost
(ii) Marginal cost and Average total cost and
(iii) Marginal cost and average variable cost

2) With the aid of diagrams illustrate the relationship between product curves
(Average product and marginal product) and per Unit Cost Curves (AC and
MC).
3) Explain briefly the relationship between the marginal product and average
product.
4) Describe the cost minimization condition in the long run.
5) Explain the different sources of economies of scale and diseconomies of
scale.
6) Discuss the concept of returns to scale and how it explains the behavior of
output functions in the long run.

CHAPTER FIVE

THE IMPORTANCE OF RISK AND UNCERTAINTY

What this Unit Is About

This unit introduces the problem of imperfect information. Techniques for
decision making in presence of risk and uncertainty are outlined and the chapter
then goes on to consider the broader implications of uncertainty for the analysis
of the firm.

64
Unit objectives
After reading this unit, you should be able to:
• Explain the alternative states of information
• Describe techniques for decision making in risk conditions.
• Describe techniques for coping with uncertainty.

5.1 Alternative States of information

Three alternative ‘states of Information’ may be identified. These areas follows:
5.1.1 Certainty
Under certainty, the decision maker is perfectly informed in advance about the
outcome of his decisions. For each decision, there is only one possible outcome,
which is known to the decision maker. For example, the neo- classical economic
model of the firm is based on the assumption that the firm has certain knowledge
of its costs and demand conditions.
5.1.2 Risk
In this situation, a decision may have more than one possible outcome, so that
certainty no longer exists. However, the decision maker is aware of all possible
outcomes and knows the probability of each one occurring.
5.1.3 Uncertainty
In this situation, a decision may have more than one outcome and the decision
maker does not know the precise nature of these outcomes, nor can he
objectively assign a probability to the outcomes.

5.2 Techniques for Decision making in risky conditions.

The techniques for decision making in risky conditions are expected monetary
value and decision trees. These are explained below:

5.2.1 Expected Monetary values

A decision maker knows the possible outcomes which may result from a
decision, and can assign probabilities to each of those outcomes, then expected

65
monetary values may be substituted for certain values in choosing between
alternative courses of action. This is calculated using the formula below:

Expected Monetary Value (EMV) = ∑ pivi

Where Pi = the probability of the ith outcome
Vi = the value of the ith outcome
Example
A soft drinks shop’s takings vary with weather. These are shown below
Weather conditions Probability Sales
$
Sunny conditions 0,2 300
Cloudy 0,3 400
Raining 0,4 100

What is the expected monetary value?

Solution
Expected monetary value = ∑ pivi
= 0, 2 * 300 +0.3 *400+ 0, 4*100
= $20
Decision Rule
A rational decision maker deciding between two alternatives will always choose
the course of action which yields the highest expected monetary value.
5.2.2 Decision trees (DTS)
These are diagrammatic representations of problems done in a sequential way.
Decision trees are excellent tools for helping the decision maker to choose
between several courses of action. They provide a highly effective structure
within which you can lay out options and investigate the possible outcomes of
choosing those options. They also help the decision maker to form a balanced
picture of the risks and rewards associated with each possible course of action.
They are usually used in decision making under conditions of risk.

We need to take into account three things:

66
 • The decision maker must make a choice among alternatives course of
action
• The choice must lead to some consequences except that the decision
maker cannot tell in advance the exact nature of the consequence
because the latter depends on some unpredictable events or on the
course of itself.
• Decisions must be made at different stages.

Managers using Decision Trees for decision making will use the following
process:
1. Identify the courses of action available
2. Identify the possible outcomes of the action.
3. Determine the probabilities of each outcome.
4. Calculate the expected value of each outcome.
5. Select the course of action worth the highest value.
Advantages
Decision trees provide a form of analysis that gives managers:
1) A way of structuring complex multiphase decisions by mapping decisions
from present to future i.e. simple to understand and interpret.
2) A direct way of dealing with uncertain events.
3) An objective way to determine the relative value of each decision
alternative
4) Aids decision making by illustrating possible alternative courses of action
and their economic consequences.
5) Require little data preparation.

Disadvantages

1) Difficult to organize because they contain multiphase decision.

67
 2) Coming up with probabilities can be a difficult process because most
managers do not assign probabilities for projects events.
3) It may prove difficult to calculate.

5.3 Techniques for coping with uncertainty

If the probabilities are not known, the situation is one of uncertainty, rather than
risk. The techniques outlined above cannot be applied i.e. decision trees and
expected monetary value.
5.3.1 The Maximin Criterion

A firm making a decision may be characterized as choosing between alternative

courses of action, whose outcomes depend upon which ‘stage of nature’
happens to be in force at the time of the action. This is illustrated below:

A pay-off Matrix

Action States of nature

A B C
$ $ $

1 10 30 100
2 5 90 110
3 20 39 120

Each cell in the matrix shows the pay – off. If the maximin criterion is adopted,
the decision- maker examines the worst pay- off for each action and the chooses
the action with worst pay - off for each action and then chooses the action with
worst pay off is highest.
Thus Action 1 10
Action 2 5

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 Action 3 20

Therefore action 3 is selected, guaranteeing that the lowest pay- off which will be
received is 20. The rule ensures that the worst possible outcomes are avoided.
This may be described as highly risk averse strategy.

5.3.2 The Mini regret criterion

In the case of the minimum regret criterion, the decision maker considers the
extent of the sacrifice made if a particular state of nature occurred but the best
action for that state of nature was not chosen.
This is illustrated below:
Payoff matrix
Action States of nature
A B C
$ $ $
1 10 30 100
2 5 90 110
3 20 39 120

Solution
Choosing the maximum regrets

Action regret
$
1 100
2 110
3 120

Having set out the regret matrix, the action is chosen for which the largest regret
is a minimum, leading to the choice of Action 1, where the regret is $100

69
5.3.3 The Maximax Criterion
This criterion is the opposite of the maximum criterion in that the best outcomes
of each action are identified, and then the action is selected for which the best
outcome is largest. This is illustrated below:
Payoff matrix

States of nature
Action A B C
$ $ $
1 10 30 100
2 5 90 110
3 20 39 120

Choosing the maximum regrets, the results are as follows:

Action Maximum
$
1 100
2 110
3 120

Therefore, the action chosen is action 3 since it produces the highest regrets of
$120. This is clearly an ‘optimistic’ criterion to use in that it selects the action
which provides a possibility of making the highest possible return.

5.3.4 The Hurwicz ‘ alpha’ criterion

the Hurwicz approach is an attempt to use more of the information available by
constructing an index ( the ‘alpha index) for each action, which takes into account
both the best and worst outcomes and the extend to which the decision maker
wishes to adopt a pessimistic or optimistic posture.
The index is defined in the following way for each action

70
1i = a1i + (1-a) Li where = the index for action i
a = an optimism/pessimism index
Ii = the lowest pay off for action i
Li = the highest pay- off for action i

The action which has largest alpha index is the one selected. The optimism/
pessimism index may vary from between zero and one.

5.3.5 Combinations of different strategies

Firms may adopt different strategies on different occasions or may consciously

combine different strategies in order to ‘spread the risk’ associated with any
single approach.

Self test Questions

1) How does the understanding of risk and uncertainty help the manger
make optional management decisions? (You should demonstrate a clear
understanding of various techniques to decision making under insufficient
information).
2) The study of managerial economics helps managers make informed
decisions under different types of situations, including risk and uncertainty.
Give a detailed description of any three approaches that you know. What
are the weaknesses of the identified approaches?
3) Distinguish between certainty, risk and uncertainty, and explain how utility
theory might be used to assist decision –making in the presence of risk.
4) Discuss using illustrations, how the following are used dealing with risk
and uncertainty in practical business decision- making:
a) The maximin approach
b) The min-max regret approach
c) The max-max approach

71
 d) The expected value approach
e) The mean- variance approach.

CHAPTER SIX
FORMAL MODELS OF COMPETITIVE STRUCTURE
What this Unit is about

This chapter examines a number of formal economic models of market structure,

covering the cases of perfect competition, monopoly, monopolistic competition
and oligopoly.
Unit Objectives
By the end of this unit, you will be able to:
• Explain the salient features of different market structures.
• Demonstrate the short run and long run equilibrium for firms operate under
different market regimes.
• Evaluate the equilibrium outcome for different market structures.

6.1 Perfect Competition

The perfect competition is an economic state which is rarely found in the real
world. Why the notion of perfect competition is important in economics is that it
provides a bench mark against which to analyze and judge other types of
markets.
6.1.1 Characteristics of perfectly competitive market
1) Free entry and exit: Any firm wishing to enter the market can gain access to
finance, factors of production in this market. Firms wishing to leave the market
face no obstacles either.
2) All firms produce an identical product: there are no brand names that can
distinguish the product of any other. Consumers will therefore choose between
the products of the various firms solely on the basics of price.

72
3) There are many producers and consumers: this means that any single
market participant is too small to influence prices and quantities prevailing in the
market in any way no one has any market power.
4) All producers and consumers have perfect knowledge: Consumers have
perfect information about the prices charged by different firms and producers
have perfect knowledge about technology and consumer preferences.
The requirements for a perfectly competitive market are clearly very stringent, but
at least the model does not assume that the earth is flat. The perfect competitive
model does provide a useful standard against which to compare other market
forms, since it is most efficient functioning market structure.
6.1.2 Market demand and the firm’s demand curve
Figure 6.1 (a) shows the down sloping market demand curve and the upward
sloping market supply curve as well as the equilibrium price Pe. We have
assumed that no producer can affect market price, because of its insignificant
size relative to the market as a whole. Therefore the demand curve for the
individual firm’s output is horizontal or perfectly elastic as shown in figured6.1 (b)

S Price
Price

Pe Eo Pe d

D
a) b)
Fig 6.1
Perfectly elasticity of the firm’s demand curve occurs for two reasons:
1. Its product is identical to that of its competitors. Thus, if the firm were to
raise its price above Pe, it would sell nothing because consumers could
get exactly the same good from any other firm at price Pe.

73
 2. Since the firms output is extremely small compared to that of the entire
industry, it can sell all that it wishes at price Pe, the market equilibrium
price
6.1.3 The perfectly competitive in the short run
The perfectly competitive firm’s plant size is fixed in the short run. Thus, it can
only change its output level by changing its variable inputs: the amount of raw
materials, labour, and energy inputs.
The firm is at equilibrium when it is maximizing profits. This occurs where the
marginal Revenue is equal to the Marginal cost i.e. MR= MC
If MR< MC, the firm would cut back its output level because it is making a loss on
the production of the marginal unit. This adjustment process continues until MR
equals MC, which will ensure that profit is maximized.
If MR> MC, the marginal unit adds less to total cost that it does to total revenue.
Thus it makes sense to produce this unit. The excess of marginal revenue over
marginal cost adds to profit and so the firm should increase its production as long
as marginal revenue exceeds marginal cost. Figure 6.2 illustrates the different
equilibrium positions in the short run.
Short run equilibrium
MC

MC ATC
ATC
Price
Abnormal
Eo loss
Eo AR=P=MR
Po Po

Abnormal
a) profits b)

qo qo
Fig 6.2
In both diagrams, Eo is the equilibrium point i.e. the point at which MR=MC. In
diagram (a), the firm is making abnormal profits as shown by the shaded region.

74
In diagram (b), the firm is making abnormal losses as shown by the shaded
region.

6.1.4 Shut- down position

If price exceeds average variable cost, the perfectly competitive firm should
produce that output level where MR= MC=P in order to maximize profit or
minimize losses. If price is less than average variable cost, it will minimize its loss
by producing no output. Therefore the shutdown position is where price is equal
to average variable cost.

6.1.5 The Short run supply curve

As long as price is equal to or greater than an average variable cost, the perfectly
competitive firm adjusts its output by moving along that part of its marginal cost
curve that lies above its variable cost curve. This part of the MC curve coincides
exactly with the definition of a supply curve: the supply curve indicates the
amount of a good that the producer is willing and able to provide to the market at
different prices.
The relationship between the supply curve and the marginal cost curve for the
perfectly competitive firm is illustrated in fig 6.3

Derivation of supply curve

MC
ATC
S
AVC MR3=P3 P3
P3
MR2= P2 P2
P2
MR=P1 P1
P1

q1 q2 q3 q1 q2 q3

Fig 6.3 Output Output

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At price P¹, the diagram is just able to cover its average variable cost; this marks
the starting point of the firm’s supply curve. With higher prices (such as P ² and
P³) larger quantities of output would be produced. Thus, that part of the perfectly
competitive firm’s curve that lies above its average variable cost is that its short
run supply curve.
6.1.6 The Perfectly Competitive Firm and Industry in the long run
In the long run, the firm has enough time to adjust to its plant size, and
consequently all factor inputs are variable. This is explained below:
1. New firms enter the industry
The existence of abnormal profits in the short run attracts new firms in the
industry as they attempt to capture some of the economic profits. So resources
will be reallocated away from less profitable industries to this one. As long as
abnormal profits are made, new firms will continue to enter the industry, since in
the long run all factors of production are variable.
2. Firms leave the industry
The existence of abnormal losses in the short run causes firms to leave the
industry in the long run. As firms leave the industry, the short run industry supply
curve will shift to the left. As long as abnormal losses are existing, firms will
continue to leave the industry.
3. Long run equilibrium
In the long run equilibrium, the individual firm will be earning normal profits. This
is illustrated below:

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 Long run equilibrium

MC

ATC

Price
Po EO MR=AP=P

qo
Output
Fig 6.4
In the diagram above, Eo is the equilibrium point. Thus Po and qo are equilibrium
price and output respectively. In this case, the firm is earning normal profits i.e.
breaking –even.

6.1.7 Criticism of Perfect competition

1. In a perfectly competitive structure, information about technology is readily

available to all. As a result, a firm cannot expect to gain much competitive
advantage over other firms by developing new technology. Therefore,
there is no incentive to develop new technologies.
2. Because all firms in a perfectly competitive market produce identical
products, a perfectly competitive would be very dull.
3. Perfectly competitive provides for an efficient allocation of resources,
given the existing distribution of wealth and income among members of
society. What society regards as an equitable distribution of income may
not be necessarily the same as that associated with a perfectly
competitive world.

77
 4. Market values are based on the private costs and benefits associated
with actions individual consumers and producers. They thus fail to capture
the external costs and benefits of production and consumption.

6.2 Pure Monopoly

Monopoly is a market structure in which a single seller supplies the entire market
for a good or service. This complete dominance of the market means that the
firm is not subject to combination from rival firms and it is said to have market
power. Monopoly is therefore at the very opposite extreme from perfect
competition where intense competition between firms exists.
6.2.1 Reasons for Monopoly

There are basically three sets of circumstances which can give rise to a situation
where a firm has total control of an entire industry i.e. where it supplies the entire
market.

1. Exclusive control of a factor of production

When a firm owns and controls one of its crucial inputs it will also have
monopolistic control over the market for its output. DeBeers in South Africa
controls almost all diamond production in the country while the Aluminium
Company of America has monopoly position in the aluminium market
because it controls most of the reserves of bauxite , a key input in the
production of aluminum.

2. Economies of scale

Where a particular production technology gives rise to economies of scale,

the long run average cost curve may exhibit decreasing unit cost over the
entire range of industry demand. The lower cost per unit at higher levels of

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 output allows it to charge a price lower than the average cost pertaining at
lower levels of output. This firm can therefore meet the entire market demand
at prices below those of new rival firms entering the market.

3. Government created monopoly

The government can grant the exclusive right to production to a particular firm
and in this way create a secure monopoly. It can do this by issuing patents,
copyrights, or exclusive franchises.
6.2.2 Profit maximization by a monopolist
The distinguishing characteristic of a monopoly is its potential earns economic
profit almost indefinitely. We examine how the monopolist decides what quantity
to produce and what price to charge. First, let’s look at trade –off between price
and output in Fig 6.5
Revenue curves

Price

MR AR= D

Fig 6.5
Output
A monopolist can either fix price and allow demand to determine output; or fix
the output and allow demand to determine price. The monopolist cannot fix
both quantity and price. Thus, there is a trade –off between fixing price and
quantity. Because of this trade-off, the monopolist faces a downward sloping
demand curves as shown above in Fig 6.4. The salient feature of downward
sloping demand curves is that AR is always greater than MR. This is so
because for the monopolist to expand its sales, it has to reduce its price.

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 6.2.3 Short Run Equilibrium
Recall the necessary and sufficient conditions for profit maximization
• Marginal Cost (MC)= Marginal Revenue (MR)
• Slope of MC> MR at the point of intersection of the two curves.
Fig 6.6 shows the short run equilibrium conditions for a profit maximizing
monopoly.
Equilibrium condition

MC
MC

ATC ATC
Price Price
Po
Abnormal
profit Abnormal
Eo Loss
Po
Eo AR
AR

MR
(i) qo qo
(ii)
Output
Output
Fig 6.6

Point Eo is the equilibrium point in both diagrams i.e. the point at which MR= MC.
Thus Po and qo are equilibrium price and output respectively. In diagram (i) the
firm is making abnormal profits while in (ii) the firm is making abnormal losses.

6.2.4 Long run Equilibrium

In the long run, the monopolist has time to expand his plant or to use his existing
plant at any level that will maximize profit. With entry blocked, however, it is not

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necessary for the monopolist to reach an optimal scale (i.e. to build up his plant
until it reaches the minimum point of the of the long-run average cost curve).
The monopolist will not stay in business, if he makes losses in the long run. He
will probably continue to earn abnormal profits even in the long run, given that
entry is barred.

6.2.5 Price Discrimination

Price discrimination refers to charging different prices to different groups of

customers for reasons not associated with difference in cost of production. The
necessary conditions which must be fulfilled for the implementation of price
discrimination are:
• The market must be divided into sub-markets with different elasticities of
demand.
• There should be no arbitrage. Thus, there must be effective separation of
the sub-markets so that no reselling can take place from low price to high-
price market.
• The good or service in question should not be resaleable

6.2.6 Monopoly Vs Perfect Competition

• Under conditions of monopoly consumers pay a higher price for a smaller

quantity of the product than under perfect competition.
• Formation of a monopoly can cause technological efficiencies to be
realized such that costs incurred decreases as compared to perfect
competition.
• The incentive for a perfectly competitive firm to innovate is slight because
the prospect of reaping super profits from such activity for any length of
time is small. For a monopoly, the situation is different. With innovation the

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 monopolist faces the prospect of making abnormal profits for a prolonged,
indefinite, period of time.

6.2.7 Regulation of natural monopolies

• The government may regulate the price of the monopoly to enable
consumers to benefit from the economies of scale associated with
increased output.

6.3 Monopolistic Competition

Monopolistic Competition arises when every seller enjoys a partial monopoly
which gives him a degree of security of customer, but does not enable market
being invaded by one or more of his competitors.

6.3.1 Characteristics

1. A large number of firms

There are many firms in a monopolistically competitive industry, but not as many
as in a perfectly competitive industry, but not as many as in a perfectly
competitive industry. Thus, no firm is large enough to dominate the market.

2. Product differentiation

Each firm’s product in a monopolistically competitive market is slightly different

from those of other firms, in terms of product characteristics, service, and
packaging and advertising.

3. Freedom of entry and exit

As in perfect competition, monopolistically competitive firms have the freedom to

enter or leave the industry. Freedom of entry and exit means that there are no
barriers to competition in a monopolistically competitive industry.

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4. Non-price competition

Since each firm produces a similar yet differentiated product, it will attempt to
emphasize the differences in its product in order to increase demand. We refer to
this as non-price competition and it can take many forms of which advertising
and offer sales service are two examples.

6.3.2 Short run equilibrium

The short run equilibrium of the monopolistically competitive firm looks like that of
the monopolist except that the former’s demand curve is more elastic. Figure
6.7shows a profit making situation for monopolistically competitive firm.

Short run equilibrium

MC MC

ATC ATC
Price Price
Po

Eo
P1
Eo AR
AR

MR

(a) Qo Q1
(b)
Output
Output
Fig 6.7
The firm will always adjust its price and output level so that MR equals MC. In
part (a), the firm’s demand curve is such that it produces Qo, at price Po.the
resulting profit is the shaded area. In part (b), the demand for the firm’s product is
weak; the entire demand curve lies below its ATC curve. Assuming that it can
cover its AVC, the best, the firm can do is to produce Q¹ and charge P¹. In this
way it minimizes its losses, which are represented by the shaded area.

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6.3.3 Long run equilibrium
For the monopolistically competitive firm in figure 6.6 (a) can only represent a
short run situation, since there are no barriers to entry and new firms will enter
the market attracted by the prospect brands into the industry, the market has to
be shared by more and more firms, and thus, each firm’s market share id
reduced. This implies that the individual firm’s demand curve and associated
marginal revenue will shift leftward. New firms will continue to enter the market
as long as abnormal profits exist shifting the demand curves of firms leftward
until the abnormal profits of each have been eliminated.

Alternatively, each of the many firms could be making a loss, as shown in Figure
6.7 (b). If, in the long run, a firm continues to make a loss, it will leave the
industry and the share of the market of the remaining firms will grow. Their
demand curves and associated marginal revenue curves will this shift to the right.
This process will continue until enough firms have left the industry so that the
remaining are just able to cover costs.
The monopolistically competitive firm will finally be in long run equilibrium in the
situation depicted in figure 6.8 below:
Long run equilibrium

MC
ATC

Po
EO
AR

MR
Fig 6.8 qo
The firm is at equilibrium when producingOutput
output qo, as determined by the
intersection of MR and MC. The price Po is just equal to the average total cost at
this point. Therefore the firm’s revenue is equal to its total cost. There is no more
incentive or new firm to enter or leave industry.

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6.3.4 Economic evaluation of monopolistic competition

1) Monopolistic competition is wasteful because too many firms operate at

excess capacity means that the firm is producing less output than is
required to attain minimum ATC.
2) Unlike perfect competition, monopolistically competitive markets offer
consumers a choice of products on the basics of quality, service, product
image, and other aspects of non-price competition.
3) Advertising can provide the consumer with information about differences
among products.
4) Monopolistic firm offer little incentive to invest in the long run

6.4 Oligopoly

An oligopoly is an industry of a few large sellers. Some oligopoly produces

homogenous or undifferentiated products. Examples of these are cement and
steel producers. Other oligopolies produce differentiated products. Examples of
these are producers of automobiles and electrical appliances.

Perhaps the most important distinguishing characteristic of an oligopoly is the

recognized interdependence among firms. This interdependence leads to a
range of behavior patterns on the part of firms. An oligopoly market may consist
of only two firms (a duopoly), or of many small firms dominated by a few large
firms, or several large firms.

6.4.1 Non- Collusive Oligopolies

Unless they form cartels, oligopolistic firms must compete against each other.
Because of strategic interdependence, the outcome is uncertain. Thus, one of
the major problems faced by an oligopolist is of pricing.

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Assuming a two firm case- duopoly - firms A and B if A increases its price, there
is risk that B may not follow suit. Given such situation, A is likely to lose its
market to B. Conversely, if A lowers its price, B is very likely to follow and as
such there will be no significant gain in sales or market share that will be
forthcoming to A. Such a situation, if it exists, produces a kinked demand curve.

This is illustrated in figure 6.9 below:

k
Price Elastic

Eo
Po
Inelastic

AR=D
MR
R
Fig 6.9 Qo
Output

The following generalizations can be drawn from Figure 6.9

• Demand is relatively price elastic for price increases. If A increases its
price, B is unlikely to follow suit as it will hope to gain market share at
A’s expense (curve Eo K).
• If A cuts its price it might expect B to make a corresponding cut to
prevent A gaining market share. Thus, for a price reduction, A will face
a relatively less elastic demand curve (EF).
• The demand curve perceived by A is a kinked demand curve (E o KF)

Because of the problems associated with using price as a strategic variable,

there is likely to be a relatively stability or stickness of prices in some oligopolies.
Uncertainty about competitors’ reactions may lead firms to presume the worst

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outcome and make them reluctant to engage in price competition. The logical
question that then follow is “what is the optional strategy for an oligolist firm?

• Form cartels with other firms. However , this is illegal

• Engaging in non- price competition such as advertising
• Development of leadership models i.e. price and quantity leadership
models. A market leader is a form that adjusts its key decisions variable
hoping other players will follow suit. Thus, a market leader faces the risk of
losing its market to a competitor, if the competitor does not follow suit.

6.4.2 Explicit Collusion: the Cartel

A cartel is a combination of firms whose aim is to limit the scope of competitive

forces within a market. The firms usually enter into an agreement pertaining to
price and output levels. In most countries, however, cartels are now illegal.

Suppose that a group of firms, producing a homogenous product, forms a cartel.

A central management body is applied and its function is to determine the
uniform cartel price. Its first is to determine the uniform cartel price. Its first task is
to determine the market demand for the product. Once it has determined this
demand curve, it can derive the associated marginal revenue curve. Therefore,
the costs and revenue curves would resemble those of a monopolist.
6.4.3 Factors that make a cartel prone to instability
1. The management body has to estimate the market demand curve: This in itself
is a difficult task, but is further complicated by the fact that negotiations within the
cartel may take a long time.
2. Cost of estimates have to be submitted by the member firms: These are likely
to change over the duration of the agreement and high cost firms, which could
distant cartel costs, may be asked to shut down in return for a share of profit.

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3. There is an incentive to cheat: Firms could increase their market share beyond
that allocated to them by the cartel e.g. by undercutting the cartel price.
6.4.4 Price Leadership
A fairly common form of implicit collusion is price leadership. Consider a situation
where one firm is recognized as the dominant firm in the market. It may be a
large firm or have been in the market for some time. It will set its own price so as
to maximize profit, the followers, will adopt this price and adjust their output
accordingly.

The price leader effectively behaves like a monopolist. The leader firm begins by
estimating the market demand for the product. It then estimates how much the
group of follower or minor firms would supply at different prices. The dominant
firm then determines its demand curve for the product by deducting the quantity
that the group or minor firms would supply each price.
6.4.5 Economic evaluation of oligopoly
1) An oligopoly firm cannot produce at the point where average total cost
curve is at a minimum. By this criterion oligopoly in not efficient.
2) An oligopoly can experience significant economies of scale.
3) It may be argued that technological change and innovation are fostered
in an oligopoly environment which brings together elements of competition
and monopoly.
4) Advertising may contribute to abnormal profits because it encourages
product differentiation and proliferation.

6.5 Game Theory

Game theory examines the strategies of individuals or organizations with
conflicting objectives. We will examine an oligopoly with two firms (a duopoly)
using the principles of game theory. The game is therefore played in a market
and the players are the firms, Firm I and Firm II. Their strategies describe their
decisions to change their price or output levels. The payoffs are the resulting
profits.

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Each firm considers two alternative strategies: raising price by 10 per cent or
keeping price constant. Each considers two possible reactions on the part of its
rival: the rival raises its price by 10 per cent or does not raise its price. The profit
increase or decrease from each possible reaction by the rival is shown in the
payoff matrix in table below.
Payoffs for duopolists from price changes (R million)

Firm II’s strategies

Firm I’s Raise price by I’s profit down I’s profit up R6 R9

strategies 10% R9
II’s profit II’s profit down
down R9 R15

Keep price I’s profit down I’s profit no R15

constant R15 change
II’s profit up II’s profit no
R6 change

Firm II’s R9 R15

maximum loss

Each firm will take into account the reaction of its rival when deciding on a pricing
strategy. If Firm I raises its price, it could increase its profits by R6 million, or
decrease them by R9 million, depending on the reaction of Firm II. If it keeps its
price constant it could potentially lose R15 million! Since Firm I cannot control the
actions of Firm II, it would be prudent to adopt the strategy that potentially incurs
the minimum loss, rather than leaving the fate of the firm to chance by wagering
on compliant behavior from firm II.

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Hence it makes sense to select the strategy that results in the minimum loss of
profit, i.e raise price by 10%. Similarly, if Firm II raises its price it could lose R15
million if Firm I raises its price by 10%. Firm II therefore chooses to raise its price
by 10% and suffers a decrease in profit of R9 million as opposed to the
alternative of a R15 million decrease.
Each firm will select that strategy which yields the ‘better’ of the bad outcomes.
Firm I chooses to raise its price by 10% as does firm II. The table corresponds to
examining Firm I’s maximum loss, and choosing the strategy which minimizes
this loss. For Firm II the final row indicating its possible maximum loss is
examined, and the strategy which minimizes this loss is selected. This is known
as the maximin strategy.

Self - Test Question

1 (a) What conditions are favorable to the formation maintenance of a cartel?
(b) Why are price fixing cartels inherently unstable?
(c) Why may it be detrimental for a cartel to charge exorbitantly high profits?

2. What is price discrimination and under what conditions is it successful?

3. Giving relevant examples from Zimbabwe, distinguish between the perfectly

competitive and oligopolistic market structures.

CHAPTER SEVEN

INVESTMENT DECISIONS AND THE COST OF CAPITAL

What this unit is about

This chapter examines the major issues raised by long term decisions
concerning the firm’s investment in capital goods and equipment. The first part
examines the techniques which are available for the appraisal of investment
projects and the second part addresses the cost of capital for a firm.

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Unit objectives
Unit studying this unit, you should be able:
• Explain project cash flows.
• Analyze project cash flows using different investment appraisal
techniques.
• Make long term decisions.
• Calculate weighted average cost of capital

7.1 ANALYSIS OF CAPITAL PROJECTS

Capital budgeting is the analysis of capital projects.
• A project is an investment that is made by a firm in hope of a future
return.
• A capital budgeting project requires the allocation of current funds to
capital assets in anticipation of future benefits from cash flows over a
number of years.
• Capital budgeting analysis is not required for every investment but is
necessary for investment that;
- generate cash flows for more than one year,
- have an initial outlay,
- and are capital in nature.

In order to analyze a project it is necessary to;

• have project cash flows,
• and use method of analysis to analyze the project cash flows.

7.1.1 Project cash flows

Project cash flows are made up of the initial investment, annual cash flows
and the terminal cash flow. The cash flows used in financial analysis of projects
must be:

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1. Incremental cash flows. An incremental cash flow is the net financial effect of
implementing a project.
2. After tax cash flows. Project cash flows should always be on an after tax
basis. The cash flows must take into account the tax payable, the timing of
tax payments and any capital allowances.
3. Include opportunity costs. An opportunity cost is a loss of revenue that
results from accepting investment. This must be taken into account in capital
budgeting analysis.
4. Exclude sunk costs. Sunk costs are those outlays that the company has
already made, or is already committed to, which are not affected by the
decision to accept or reject an investment.
5. Exclude interest payments. Any interest expense must be excluded in cash
flow calculations because the cost of funds is incorporated into the discount
rate.

The initial Investment

The initial investment is the net cash outlay on implementation of a project. The
initial investment takes place in year zero.
New investment: A new investment is when totally new project is being
analyzed or the implementation of the project does not have any effect on the
present cash flows of the firm. If a new investment is being analyzed the initial
investment can be made up of the following factors:

1) The cost of the assets + installation costs. This is an outflow (-).

2) Change in working capital caused by implementation of the project. This
is usually an outflow (-) since there is usually an increase in working
capital.

Replacement Project: in a replacement project there is replacement of assets

which results in:

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 • The firm no longer deriving any cash flows from the replaced assets
but from the new assets.
• The loss of the revenue that was previously being generated by the
firm must be taken into account in the analysis of replacements
projects.

The following make up the initial investment in replacement decision;

1. The cost of new project + installation costs + changes in working capital.
This is an outflow of money (-).

2. The disposal value of the old asset. A replacement decision is a mutually

exclusive decision. The implementation of the new project results in the old
asset being disposed. The funds that are received at disposal of old asset
are an inflow (+).
3. Scraping allowance or recoupment. Selling a fixed asset can result in
scrapping allowance or recoupment. The tax savings or the tax payable as a
result of disposal of the old asset must be incorporated in the initial
investment calculation.
Annual cash flows
Annual cash flows are made up of:
• Incremental revenue less incremental costs,
• Or incremental cost savings which are treated as inflows,
• Plus any tax savings from tax deductible allowances such as special
initial allowance or wear and tear allowance.
• Depreciation is not a tax deductible expense in Zimbabwe and should
not be used as a tax shield unless the problem expressly states that
depreciation is a recognized tax shield.
• Unless other information is provided, annual cash flows are assumed
to occur at the end of the year.
The terminal cash flow

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The terminal flow is the net after tax amount received by the firm when a project
is terminated. For a new investment the estimated terminal cash flow might
include the following:
1. The estimated salvage value of the new asset. This is the amount that is
expected to be received when the assets are sold at termination of the project.
This is an inflow (+)
2. Scrapping allowance or recoupment. Any scrapping allowance or recoupment
due to the disposal of the asset.
3. Change in net working capital. If there is a change in net working capital when
the project is implemented it is expected that an opposite change will occur at
termination of the project. The change is usually an inflow.
In a replacement investment it is necessary to take into account the salvage
value of the old asset and any changes in working capital that would have
occurred on termination of the project if it has not been disposed of.
Analyzing Project Cash Flows
There are four important methods of analyzing capital projects; the net present
value, the internal rate of return, the payback and the accounting rate of return.
The net present value method
The net present value (NVP) is calculated by deducting the initial investment
from the sum of the present values of future cash flows. The formula for
calculating the NVP is as follows;
NVP = -1o + CF1 x PVIF (k%, 1 year) +CF2 x PVIF (k%, 2years) +… CFn x PVIF
(k% ,n years)
Where:
CFt = is the cash flow in year t
K = is the cost of capital or discount rate
N = is the period of investment
1o = is the initial investment
If the future cash flows are an annuity the net present value will be equal to:
Net Present Value = CF x PVIFA (k%, n years) - 1o
Where: CF is the annual cash flow
Decision Criteria

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If projects are independent;
• Accept all projects with a positive NPV.
• Reject all projects with a negative NPV.
• Indifferent to all projects which have an NPV equal to zero.
If projects are mutually exclusive, accept the alternative with the highest positive
NPV.
The Profitability Index. The profitability index (PI) is a ratio between the net
present value and the initial investment. The difference between the Pi and the
NPV is the PI is a relative measure while NPV method is an absolute measure.
Profitability index = Net Present Value
Initial investment
Decision Criteria
If projects are independent;
• Accept all projects with a positive profitability index.
• Reject all projects with a negative profitability index.
• Indifferent to projects with a profitability index of zero.
If the projects are mutually exclusive accept the alternative with the highest
positive profitability index.
The internal rate of return
The internal rate of return (IRR) is the yield or the rate of return generated by a
project’s cash flows. The internal rate of return is also the discount rate that
results in a net present value of zero.
Decision Criteria
When using the IRR I, the cost of capital is the hurdle rate which must be met
by a project in order to be accepted. The decision rule is;
• Accept projects which have an IRR higher than the cost of capital.
• Reject projects with an IRR lower than the cost of capital.
• Indifferent to projects with an IRR equal to the cost of capital.
If the projects are mutually exclusive accept the alternative with the highest IRR
given that this exceeds the firm’s cost of capital.
The internal rate of return can be calculated using interpolation as follows:

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 Ai
IRR = i+ A- B (r- i)

Where:
i is the discount rate which results in a positive NVP
r is the discount rate which results in a negative NVP
A is the positive net present value using i
B is the negative net present value using r
The denominator in the formula becomes A- -B which is A + B.

The pay back method

A payback method is the period that it takes for the project’s cash flows to
recover the initial outlay.

Decision criteria
An acceptable payback period, which is the maximum period acceptable for the
recovery of the initial investment, must first be decided upon by the company.
The acceptable payback period is then used to decide on whether to accept or
reject projects. The criteria for acceptance or rejection when projects are
independent is:
• Accept a project that has a payback period within the acceptable payback
period.
• Reject a project that has a payback period longer than the acceptable
payback period
If the project are mutually exclusive the investment with the lowest payback
period will be accepted as long as the period is within the acceptable period.
The payback period is calculated differently for annuities and unequal cash
flows
When project cash flows are an annuity. If cash flows are an annuity the
payback period can be calculated using the following formula:

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 Payback period = Initial Investment
Annual cash flows
Unequal project cash flows. If the cash flows are not an annuity the
payback period will be equal to:
Io - Ct
Payback period = t + CFt + 1
Where:
Io = the initial investment
t = is the last full year in which the cumulative cash flows are than 1o.
CFt + 1 = the cash flow in year t + 1
Ct = the cumulative cash flows in year t

A payback period can be also calculated by using discounted instead of non-

discounted cash flows.
The decision criteria for discounted cash flows is the same as that for non-
discounted cash flows.

The average rate of return (ARR) is a non-discounted method of determining the

rate of return of a project. An important difference between the average rate of
return and other methods of investment appraisal is that the method uses profits
instead of cash flows.
Average annual profits
Average rate of return = _________________
Average Investment

Average investment = (Initial Outlay + Scrap value) /2

Decision criteria
To make decisions on the acceptability of a project the firm has to come up with
an acceptable accounting rate of return.

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If projects are independent:
• Accept projects with an ARR higher than the acceptable ARR.
• Reject projects with an AAR lower than the acceptable ARR.
• Indifferent to projects with ARRs equal to the acceptable ARR.

If investments are mutually exclusive, accept the project with the highest ARR.
This ARR should be higher than the acceptable ARR.

7.2 The Cost of Capital

The cost of capital is the cost of funds that have been used to finance the firm.
• Given that the firm usually uses different sources of financing the cost of
capital of a firm is a weighted average of the costs of the different sources
of financing.
• If a firm is financed by debt, preference stock and common stock the
weighted average cost of capital (WACC) or (k) will be equal to:

K = WdKd + Wps Kps + WeKe

Where
Kps is the cost of preference stock
Ke is the cost of common stock or equity
K is the weighted average cost of capital (WACC)
W is the weight of each of the source of capital
Kd is the after tax cost of debt
Short tern financing should also be included in the calculation of the WACC.
Short term financing is however sometimes excluded because:
(a) it is difficult to determine the precise value of short term financing
because the amounts change frequently with business activity.
(b) The cost of short term financing also changes frequently as money
market rates change.

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 (c) It is difficult to come up with an explicit cost of trade credit making it
difficult to determine the overall cost of short term financing.
7.2.1 Component Costs
To calculate the WACC it is necessary to calculate the cost of each source of
capital.
The cost of debt
The cost of debt is the after tax yield of debt. If debt financing is raised from an
institution the cost of debt will be the after tax on the debt. The yield or interest on
debt is adjusted for tax because debt interest is tax deductible.
Kd = rd (1-T)
Where
Kd the required rate of return on debt
rd is the yield of the debt
T is the corporate tax rate
The yield of a debenture can be calculated using a financial calculator or
estimated using the following formula:
1 + (Fd –Vd) / n
Approximate yield to maturity = ______________
(Fd + 2vd)/3
Where:

Fd the face value of the debenture

1d the annual interest paid by the debenture
Vd the value (current price of the debenture)
N number of years to maturity
Example 1
A firm has debentures with a face value of $100.00. A market value of $108 a
coupon rate of 28% and 15 years to maturity. If the tax rate is 40% the yield on
the debentures would be:
($28 + ($100-$108)/15
Yield on debentures = ___________________

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 ($100 +2(108)/3
= 26%
Cost of debt ( kd ) = 26% (1- 40)
= 15.6%

Cost of preference shares

• The cost of preference shares is the yield or the required return on
preference shares.
• If the preference shares are issued in perpetuity and have a have fixed
return then the yield (kps) can be calculated as follows:
Annual preference share divided
Kps = ______________________________
Price of preference shares on the market
Example 2
Suppose preference shares trading at 108 cents and pay a yearly dividend of 20
cents. The yield on the preference share is:
20
Kps = _____
108
= 18.5%
Preference share dividends are not tax deductible therefore no tax adjustment
needs to be made on the dividend yield.
The cost of equity
In addition to the discussed in the last Chapter the methods of determining the
required rate of return on equity are divided based models. Dividend based
models are based on the evaluation models discussed in chapter 2. The formulas
for calculating the required rate of return are a restatement of the valuation
formulas.
No growth assumption
If an assumption is made that the same dividend will be paid in perpetuity the
required rate of return on common stock will be equal to:

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 Annual dividend
Ke = _______________________
Price of shares (Ex-dividends)

Example 3
A firm has shares that are trading at 75 cents ex-dividend and expects to pay a
dividend of 18 cents forever. The required rate of return by equity shareholders
would be:
18 cents
Ke = 75 cents
= 24%
Earnings instead of dividends are sometimes used in the no growth cost of
capital calculation:

Ke = Earnings per share

Price of shares (Ex-dividend)

Constant growth
If constant growth is expected then the required rate of return (ke) formula
becomes:
D1
Ke = +g
Po
D1 Next dividend expected to be paid by firm
Po ex dividend market value of shares
G annual growth rate
Example 4
A firm which has a cum dividend price of 280 cents is about to pay a dividend of
30 cents. The dividends are expected to grow at a rate of 12 % annually forever.
D1 = Do (1+g)

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 = 30 cents (1.12)
= 33.60 cents
Ex dividend price = 280 cents – 30 cents
= 250 cents

33.60
Cost of equity = _____ + .12
250 cents
= 25.44%
Cost of retained earnings
There usually a temptation to look at retained earnings as free financing.
Retained earnings are however funds that have been reinvested by the firm on
behalf of the shareholders.
• If retained earnings are shareholders funds, shareholders will require the
same rate of return on these funds as they require on their direct equity
investment.
• The cost of retained earnings is therefore the same as the equity of the
firm.
Cost of raising new equity funds
When new equity is raised from the financial markets there are substantial costs
that are incurred.
• These costs incurred in raising funds need to be incorporated into the cost
of funds by adjusting the cost of equity to reflect floatation costs.
• This will result in an increase in the cost of equity.
• When the dividend growth model is being used to calculate the effective
cost of equity the following formula can be used:
D1
Effective cost = _____ +g
Po (1-f)

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ƒ is equal to (floatation cost/prices)

Example 5
The next dividend expected to be paid by a firm is 24 cents, the present price is
200 cents, the growth rate is 10% and the floatation costs are 5% of the price of
share. The effective cost is:
24
Effective cost = _____ + 10
200 (1-.05)
= 22.6%

7.2.2 Calculating the WACC

To calculate the cost of capital it is then important to have relevant weights.
These weights can be calculated using;
• Book values
• Market values
• Or target weight
• When using book values and market values it is necessary to calculate the
total value of each source of financing and divide by total financing to find
the proportion of financing from each source.
Value of source of financing
Proportion of financing (w) = ___________________________
Total capital employed
Targets weights are the term financing proportions required by a firm therefore
they are already in weight form.

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Self - Test Question
Faye Pvt is investigating three alternative investment projects, each involving an
initial cost $10m at a discount rate of 10% per annum. The pattern of net returns
on the investment is shown in the table below:

Project A B C
$m $m $m
Year 1 4 6 8
2 4 1 6
3 8 8 4
4 8 26 4
5 8 20 4
Residual value 2 3 1
after year 5

The Managing Director insists on a 3 year payback rule as an initial screening device.
Thereafter, the Net Present (NVP) is used in project appraisal.
a) Which project should Faye Ltd choose?
b) (i) Assuming that the payback period had not been used, which project would
you choose base on the NPV method only.
(ii) What is the internal rate of Return of the project chosen, based on the NPV in
(b) (i) above.
b) What are the major disadvantages of the payback rule in project appraisal?

Q2 (a) Give three uses of the measure of cost of capital to a financial manager.
(b) Calculate the effective cost of debt for a company which borrows $1
million which pays 40% p.a and has a corporate tax rate of 43%.

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c) Tantavantu Holdings plans to issue new shares at $2 per share, thereby
incurring flotation costs of 10% per annum. The firm is expected to earn a
dividend of 10 cents in the next year and thereafter dividends are expected to
grow at a constant rate of 5% per annum. Calculate the cost of the new
external equity.

APPENDIX: CASES

CASE 1: The OPEC cartel

OPEC was formed in 1960.In 1973 members of the cartel cut output and prices
of crude oil tripled. By the mid 1980s, however, there was a surplus of oil on the
market and prices fell. Why was OPEC unable to keep prices high?

1. OPEC never established a barrier to entry. When prices rose, non – cartel
members increased production, and put downward pressure on prices.
2. Since 1970 demand for oil became more elastic as substitutes were
developed for petroleum products. In response to OPEC’s initial production
cutbacks, consumers developed more energy – efficient technologies.

In the 1980s OPEC tried to raise prices by reducing production and met with
short term success. The price increases may have been caused by other
factors, such as an increased demand resulting from the Iran – Iraq war.
Members of OPEC were also in disagreement over quotas. By 1989 cheating
among member nations was rampant, and production exceeded the total quota,
putting pressure downward on prices. The disagreement over quotas and
subsequent cheating destroys the cartel’s ability to maintain high prices.

CASE 2: The Zambian copper mines

Copper mining is the mainstay of the Zambian economy, accounting for

approximately 90 per cent of Zambia’s foreign exchange earnings. The mines
were nationalized by President Kaunda in 1969. In the 1980s two government

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mining companies merged to form the Zambian Consolidated Copper Mines
(ZCCM) – effectively becoming a monopoly. By controlling the mines, the
government controlled the entire copper industry. During the 1980s production
fell owing to mismanagement, the use of expensive equipment, poor
maintenance and equipment breakdowns. The Chiluba administration has now
undertaken to privatize the industry to improve performance.

CASE 3: South African Competition policy

The Maintenance and Promotion of Competition Act number 96 of 1979
prescribes South Africa’s competition policy. This policy is currently under
review, and although discussion documents have been drafted, the Act of 1979
is still in force as is the institutional framework which gives effect to the policy.
Following the enactment of this legislation the Competition Board was
established. It, together with the Directorate of Investigation, is responsible for
initiating investigations into firm behaviour and making recommendations to the
Minister of trade and industry. The Competition Board has no power to
implement the recommendations that it makes it being the responsibility of the
Minister.

The basic areas of importance with regard to South Africa’s competition policy
are:

1. Public interest. This is the criterion which is used to judge firm behaviour.
The act does not, however define the public interest. This criterion has to
be interpreted by the Competition Board may recommend that the firm be
forced to cease that activity, and this recommendation may be
implemented by the Minister. The fact that the public interest is not defined
means that there is some flexibility and discretion involved in decisions by
the Competition Board. However, it also brings the possibility of
inconsistencies.

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 2. Restrictive practices. These are any act or mission that may restrict the
free operation of market forces. While some restrictive practices, such as
resale price maintenance are specifically outlawed, the act does not
contain a comprehensive list and description of such practices.
3. Competition. The virtues of competition are lauded in the Act, yet
competition is not clearly defined. It appears that competition refers to the
day to day interactions among firms as they attempt to get an edge on
other firms in the same market.
4. The role of the market. The Competition Act appears to favour market
forces over intervention, yet the specific role of the market and that of
government are not clearly delineated.

Current discussions on competition policy suggest that the institutional

framework is likely to be enhanced, and perhaps a competition Court
established. The independence and power of the competition Board is likely to be
extended too. The proposed legislation will perhaps focus more clearly on the
impact of market dominance by a firm, and define more closely restrictive
practices.

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READING LIST
Chiang A. C (1984): Fundamental Methods of Mathematical Economics, 3rd Edition,
Clarke Roger (1993): Industrial Economics, Blackwell, Oxford, UK
Davies h. (1991): Managerial Economics for Business and Management
Accounting Pitman, London, UK
Hill S. (1989): Managerial Economics: The Analysis of Business Decision,
Macmillan, and London, UK.
Kutsoyannis A (1979): Modern Microeconomics, 2nd Edition, Macmillan, London, UK
Kutsoyannis A (1994): Modern Microeconomics, 2nd Edition, Macmillan, London, UK
Sydsaeter Knut & Hammond Peter (1994): Mathematics for Economics, Baobab
Books, Harare, Zimbabwe
Webb S. C (1976) Managerial Economics, Houghton Mifflin Company, Boston, USA
Davies J. R and Hughes (1990) Managerial Economics, Macdonald and Evans Ltd
ivision of Longman UK

Douglas E (1992) Managerial Economics Analysis and Strategy 4th Edition, Prentice
Hall, New Jersey.
Keat P. G and young P (1996): Managerial Economics, Economic Tools for Today’s
Decision Makers, 2nd Edition, Prentice hall, Upper saddle River, New Jersey.

Keating B and Wilson J. H. (1992): Managerial Economics, 2nd Edition, Dryden Press,
Orlando, Florida, USA.

Salvatore Dominic P Managerial Economics, McGraw Hill, Book Company, New York,
USA

Salvatore Dominic P: Microeconomics, Harper Collins, New York, USA

Varian Hal (1996): Intermediate Microeconomics: A Modern Approach, 4th Edition,

W.W. Norton and Company, and New York

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