Zica Economics PDF

ZICA
ZICA ACCOUNTANCY PROGRAMME
PAPER T4
MICRO-ECONOMICS
TEXTBOOK
MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

MICROECONOMICS

CHAPTER 1
INTRODUCTION TO ECONOMICS
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After studying this chapter, the students should be able to:
 Appreciate the subject matter of Economics

 Explain how Economists derive their theories
 Identify the nature of factors of production
 Explain the law of diminishing Returns
 Explain the relationship that exists between Scarcity, Opportunity Cost and Choice
 Understand the basic Economic tables, graphs and models
 Explain the Economic systems, their merits and demerits
____________________________________________________________________________
1.0 INTRODUCTION – THE SUBJECT MATTER OF ECONOMICS
Economics comes from the verb „to economise‟, and this means making ends meet. This is a study
of how society makes decisions, regarding the allocation of scarce resources. Economics as a
subject is divided into two parts;
(a) Microeconomics, which deals with individual economic decision makers or

agents, namely households, firms etc. Households as resource owners supply factors of
production to firms, and earn an income. In return households demand goods and
services produced by firms, and spend their income.
Firm in general demand and pay for factors of production from households and in
return, supply goods and services at a price, to households.
The interaction between the individual decision makers is known as the circular flow
of income, it is dealt with in detail at a later chapter.
Economics assumes that these individual economic units behave rationally:

- Firms or producers always try to maximise their profits.
- Households or consumers always try to maximise the satisfaction or utility they
- derive from their income.
- Governments always attempt to maximise the welfare of society
(b) Macroeconomics looks at the total (aggregate) picture, the practical effects of
decisions of the Economic units.
Economics as a subject makes use of normative statements of Economic and social

value judgments of what society thinks ought to happen in an ideal scenario, such as
Zambia winning the world cup!
Economics is also concerned with positive statements and objective explanations of what

has happened in the past, and based on that, what is likely to happen in the future.
Economics is a social science subject; it deals with human behaviour, which is diverse. Therefore,
it is difficult to come up with blanket conclusions. The assumption, ceteris paribus “all things
remain equal”, usually applies.
The subject matter of Economics is concerned with human beings “trying to make ends meet with
what they have”, the basic Economic problem is that:-
 Human wants are unlimited or insatiable. Maybe because goods wear out and have to be
replaced, or, new and improved products become available on the market, or people are just
tired of what they own and want a change.
 Economic resources, which are required for the production of goods and services to satisfy
human wants, are limited.
The above are the two pillars on which the whole subject matter of Economics rests, the scarcity
of resources and the choices that have to be made to try to make ends meet, since not all of our
unlimited wants can be satisfied!
The scarce economic resources are commonly known, as factors of production and these have to
be examined in relation to how they limit production.
1.1 Factors of production
The factors of production are the resources that are necessary for production, and if these were in
plentiful supply, there would be no need to economise, and society would have free goods! What
affects the rate of Economic growth that an economy can manage is the quantity and the quality of
the factors of production they have.
The following are the four different groups into which factors of production are usually classified:
Land
This refers to all natural resources such as farmlands, mineral wealth, fishing grounds provision of
site where production can take place, and so on.
Land differs from other factors of production in three main ways as follows:
1) It is a “gift of nature”, man has done nothing to bring it about.

2) It is limited in supply but man through schemes such as fertilizers, irrigation, better quality
seeds etc can improve it.
3) Since land is in limited supply, Diminishing returns tend to set in early.
The Law of Diminishing Returns.
Diminishing returns refers to a situation where a firm is trying to expand by using more of its
variable factors, but finds that the extra output they get each time they add one more variable

factor to a fixed factor of production such as land, gets progressively less and less. This usually
arises because the capacity of land for example, is limited in the short-run and the combination
of the fixed and variable factors becomes less than optimal.
The law, with reference to land, states, “after a certain point, successive application of
equal amounts of resources to a given area of land produces less than proportionate
return”.
If, for example, a farmer has one hectare of land (fixed factor) and produces the following bags
of maize by employing more workers (variable factor).
Number of workers Output per year Addition to Output

1 100 100
2 210 110
3 300 90
4 250 -50
Fig: 1 The law of Diminishing Returns
Output 300
per
year 250
200
150
100
50
0 1 2 3 4
Number of workers
Note that diminishing returns start after the second worker is employed, when the additions

to output start to decline from 110 to 90, and eventually being negative. It is no longer
worthwhile to employ more workers on only one hectare of land, it costs more to employ
than the additional revenue from an additional worker. Additional workers can only be
employed when more land is acquired, but this can only be achieved in the long run.
Labour
This is a human resource, it is human effort employed in production.
Labour is considered as the most important economic resource, it is indispensable to all forms of
production. It is the end user of everything that is produced. It differs from other factors in that
ethical and moral consideration has to be taken into account when dealing with labour.
The quantity and quality of labour has to be considered as they both relate to production and
productivity. The supply of labour depends on:-
- Total population of a country

- Proportion of the population available for employment
- Number of hours worked per year
Quality, efficiency or productivity of labour varies, depending on a number of issues, such as
 The climate
 Nutrition and health of the worker
 Peace of mind
 Working conditions
 Education and training
Capital
This is composed of man-made aids to production, for example, factory, bridges, machinery, raw
materials, means of transportation etc.
Quantity of capital depends on the wealth accumulated from previous production by firms and
governments. „Wealthy‟ or rich firms and governments have a lot of the latest sophisticated
equipment, while poor countries have very little, depending on obsolete equipment and few
„handouts‟. The quality of capital is influenced by a nations Economic development and
technological progress.
Enterprise
This is another human resource, but entrepreneurial ability requires organising land, labour and
capital for production. It is concerned with decision-making. Therefore, there are two distinct
functions of the entrepreneur, uncertainty bearing by supplying risk capital and organizing for
production by making decisions on what to produce, how to produce and for whom to produce etc.
Such decisions or choices are necessary because factors of production are not only scarce but they
also have alternative, competing uses. Choices are made, to satisfy some wants and to forgo other
wants.
When a choice is made, an alternative has to be given up, this sacrifice is termed as the
opportunity cost. Opportunity cost explains the fact that „the cost of something is what you have
to give up in order to get what you want‟ a „trade off‟. It is the real cost of an action, which is
considered as the next best alternative forgone. It usually has a monetary value, but it can also be a
choice over the use of time, for example, choosing to watch a movie or to study Economics!
1.2 PRODUCTION POSSIBILITY CURVE
The relationship between scarcity, choice and the forgone alternative is exhibited by a production
possibilities curve or frontier, also known as the transformation curve, opportunity cost curve. It
helps to explain the important Economic concept of opportunity cost.
To simplify, assume that they are only two commodities, and if the society chooses more of one
thing it must necessarily choose less or sacrifice something else, such as more of good X means
less of good Y. The production possibility curve for any country is a graph showing the
combination of two goods that can be produced using all of its scarce Economic resources in the
most efficient manner, given a country‟s Economic development and technological progress.
Fig: 2 Production Possibility Curve
Good Y B
Good X
Any point along the PPF is the maximum of all possible combinations of the two products X and
Y. Society can choose a specific combination of output, a single point along the PPF such as point
A, B, C, and D.
At point A the existing resources are all being used to produce commodity Y and no X is being
produced. Alternatively, at point D the economy chooses to produce X without Y, or decide on
large quantities of Y and small quantities of X (at point B), or vice versa, at point C.
Any point inside the PPF (e.g. point E) or an inward shift to the left, is an indication that the
economy is producing beneath its full potential, and therefore operating inefficiently or some

resources are lying idle. An inward shift normally occurs when a country is at war and or the
economy is contracting. There is no Economic growth.
An outward shift to the right, as shown by the dotted lines, shows an increase in the productive
capacity of the economy, Economic growth. Economic growth can occur from either better use of
existing resources, increased productivity, or effective use of newly acquired inputs or resources,
that is increased production. Increased output may also be due to division of labour and
specialization.
It is important to note that the curve is normally drawn as being concave to the origin, a sign that
some resources are well suited to the production of one good rather than another good and vice
versa. Otherwise, the PPF would be a straight line slanting downwards from left to right, implying
that if production of X reduces by one unit, then the production of Y would increase by one unit, if
it reduces by two units, then the production of the other good would increase by two units, and so
on. However, that is not the case.
The existence of scarcity and choosing between competing ends creates decisions that must be
made regarding resource allocation.
 What to produce
 How to produce
 For whom to produce
 Where to produce
 How to distribute etc.
Note that factors of production are not only scarce with competing uses, but they can also be
specific, if they are of a specialized kind, and therefore cannot be easily used for any other purpose
other than that for which they are originally intended. Examples of specific factors are bridges,
factories, accountants, and economists, combine harvesters blast furnaces, etc.
Alternatively, factors can be non-specific, that is, if a factor can easily be transferred from one use
to another. For example, land used for animal grazing, growing maize, unskilled labour, raw
materials like cotton is used to make blankets, carpets clothes or small tools like a knife used to cut
meat, rope and so on.
1.3 ECONOMIC GROWTH AND ECONOMIC WELFARE
When a country‟s PPF shifts outwards, to the right, then Economic growth is judged to have taken
place. It is measured by a „real‟ increase in the national income figure. The national income is the
total value of goods and services produced in a country in a year. When production is increasing
then the economy is growing. Factors determining increases in output are both internal and
external. Internal factors include the quantity and quality of a country‟s factors of production, the
amount of scarce Economic resources available and their productivity. The external factors result
from a country‟s relationships with the rest of the world, including the terms of trade..
Economic growth is an important subject in that it affects the measurement of Economic welfare,
an improvement in the overall standard of living of the people in any country, more goods and

services are available. The quality of life in terms of, for example, the life expectancy in Zambia
improving to an average of eighty years or above instead of forty years or less!
The other advantages of economic growth are an improvement in the social sector, better
infrastructure, a lower doctor: patient, teacher: pupil ratio etc.
Economic growth maybe balanced or unbalanced, that is some sectors and some areas grow
faster than others. In Zambia, the mining, agriculture and tourism sectors as well as the some urban
areas are expanding faster than others.
Unfortunately, there are a number of disadvantages associated with economic growth. It is

associated with a cost, the opportunity cost of diverting resources from present consumption. It
also implies that there is faster use of natural resources, it gets depleted quickly. There is need to
continuously discover new natural resources to sustain Economic growth. Unfortunately, the
wealth is not equally distributed; there is a marked difference between the rich and the poor people
in the society.
Economic growth also leads to less desirable attitudes, people leading carefree and selfish
lifestyles, moving away from extended families to nuclear families in this era of H.I.V/A.I.D.S
orphans prevalent in poor countries like Zambia, extended families are needed to assist in looking
after orphans.
Another problem is social costs, the undesirable effects of modernisation and industrialization as
the economy grows. There is increased noise, traffic congestion, and loss of natural beauty, crime,
pollution etc. Social benefits may also arise. The social costs and benefits are jointly known as
externalities. Externalities are spillover effects, there are external to the transaction. An externality
occurs when a cost or benefit of an Economic action is borne or received by society as a whole,
and not just the cost to a firm or a benefit to the consumer, it is regarded as the difference between
private and social costs, as well as private and social benefits.
An example of the private cost and the private benefit to a person drinking a bottle of beer or
smoking cigarettes is the actual cost of the items and the enjoyment by the customer. However, this
transaction affects society in general through the social cost of drinking and drunkenness, fumes
and generally the increased health care provision by the government. The loud music played in
bars and enjoyed by the patrons is a private benefit, but, even passersby may enjoy the music. This
is a social benefit.
1.4 ECONOMIC SYSTEMS
The decisions to the central Economic problems of what to produce, how to produce and for whom
to produce depend on the Economic system prevailing in any particular country. To a large extent,
the Economic system depends on the political system and the manifesto of the political party that
has formed the government.
Society gives its mandate as to which political/Economic system they prefer by voting for a
particular political party during the general elections.
There are three (3) main Economic systems:

a) MARKET ECONOMY
Also known as the „capitalist system‟. This is the kind of Economic system generally characterized
by advanced Western countries such as Germany, France, the United Kingdom in the 19th and 20th
centuries. During the 20th century there has been rapid technological progress in many countries,
many of them becoming capitalists.
The features of this system is emphasis on the freedom of the individual or firm, both as a
consumer and as the owner of productive resources, to make their own Economic choices on what,
how and for whom to produce.
In its pure form, there is no government interference in Economic activity, resources are allocated
on the basis of price. Price signals facilitate change and show shifts in consumer wants, the concept
of consumer sovereignty. A consumer expresses his choice of goods through the price he is
willing to pay for the product. The system responds to consumer preferences. There is no or very
little wastage of resources.
The system is efficient and self-adjusting, there is an „invisible‟ hand in the market which helps in
the resource allocation. There is technical and Economic efficiency, and most importantly, it is
more practical than the socialist system since there is a clear incentive by producers, this is self-
interest!
DISADVANTAGES
- Marked inequalities in income and wealth distribution.

- It „suffers‟ from market failure, that is failure to produce a satisfactory allocation of
resources
- using the market forces of demand and supply for some commodities such as defence,
street lights etc, known as public goods.
- Lack of adequate provision of goods considered worth providing in great volumes,
such as education providing in great volumes, such as education and health knowns merit
goods.
- There are monopolies instead of competition
- There is no guarantee that demand will match supply, there is usually a time lag.
b) PLANNED (COMMAND) ECONOMY
This is a „socialist‟ political system advocated by „idealists‟, or anyone uncomfortable with the
marked inequalities in income, which is a common characteristic of capitalism. In the planned
Economic
system, the government makes production decisions on what how and for whom to produce on
behalf of the community, for the benefit of everyone. An attempt is made to create a new social
order, where everyone is happy, and „utopianism‟.
The disadvantages of the market economy correspond closely to the merits of the centrally planned
economy.
The central planning authority can ensure that

- Adequate resources are devoted to community goods and merit goods.
- An attempt is made to distribute resources equally.
- There is full utilization of resource, no unemployment of resources. Sometimes, workers are
employed simply to keep them occupied.
- Monopoly powers are used in the interest of the community, no self-interest.
- There is certainty into production and improving mobility by directing resources, including
labour.
- Inefficiencies, which result from competition, are eliminated
- Weaker members of the society are well taken care of; their basic needs such as food, clothing
and shelter are met by the government.
- Adequate resources are devoted to community
DISADVANTAGES
- Lack of sensitivity and initiative, and even if the resources are fully employed, they are used
inefficiently.
- There is too much bureaucracy.
- Errors are easy to make so there are either surpluses (wastage) or shortages, resulting in black
markets.
c) MIXED ECONOMIC SYSTEM
There are few countries that follow entirely the market or the planned Economic system. Examples of
socialist countries are Cuba and North Korea. In practice, most economies in the world make decisions
and choices regarding resource allocation by adopting both free market and planned Economic policies.
They do not make a complete choice between the two extremes, in order to enjoy the best of both
„worlds‟, thus following the „middle of the road‟.
Economic wealth is divided between the private and the public sectors. The major difference is the
extent to which an economy is „leaning‟ towards a market or a planned Economic system. A good
example is Zambia, just after independence from Britain, the country was following a mixed system
although the proportion of centrally planned decision making was more than that of the free market.
Under the Movement for Multi party Democracy (MMD), the country is more towards capitalism than
socialism. Yet it is still maintains a mixed Economic system.
A government can have three-quarters of production carried out by private enterprises through the
market, while the government is directly responsible for the other quarter. Government involvement is
necessary because there is need for public provision of merit goods such as education and health, which

are deemed to be worthwhile for everyone. The market forces cannot provide for public goods, such as
defence, police, justice and national parks. Government involvement may also be in the form of public
deterrence of commodities considered being harmful to society like beer and cigarettes.

1.5 CHAPTER SUMMARY
The subject matter of Economics is on allocation of scarce resources, how to make ends meet by:-
 Explaining the number of theories, models that make up the principles of Economics;
 Emphasizing that human wants are unlimited, while resources required to satisfy these
wants are limited;
 Looking at the problem of scarcity of resources (factors of production) which have
competing uses and the related problem of making choices that involve sacrificing
alternatives, called opportunity costs;
 Identifying the relationship between resources and Economic growth and Economic
welfare;
 Allocating resources using the market system or the planned Economic system, the
advantages and the disadvantages of each system;
 Looking at the real world, most economies have a the mixed Economic system;
REVIEW QUESTIONS
1. What is the basic Economic problem facing all economies?

2. How would you describe positive and normative Economics?
3. What are the main production decisions that have to be made?
4. What are the four factors of production?
5. What is opportunity cost?
6. What does a production possibilities curve show?
7. How are the decisions and choices on the allocation of resources made in a planned
Economic system?
8. What is an externality?
9. How is actual Economic growth measured?
10. What is unbalanced Economic growth?
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EXAM TYPE QUESTION 1.1
(a)
i) Explain the term “opportunity cost”. (4 Marks)
ii) Illustrate with examples the practical importance of this concept with reference to the
individual, the firm and the state (6 Marks)
(b)
i) What is the opportunity cost of a non Economic (free) good? (2 Marks)
ii) Which of the following are non-Economic goods and why?
- beer
- hedge trimmings

- a worn out suit case
- a second hand car
- a NATech Certificate
- sand in the Sahara
- sand in a builders‟ yard (8 Marks)
(Total: 20 Marks)
a) What is meant by the law of diminishing returns (6 Marks)
b) How might the concept of Diminishing Returns be applied in the following cases:
i) Motor car production (2 Marks)

ii) Wheat production (2 Marks)
iii) Listening to lectures? (2 Marks)
c) How does the market system answer the key Economic questions relating
to the problem of the allocation of resources?
(8 Marks)
(Total: 20 Marks)

CHAPTER TWO
SUPPLY AND DEMAND

_______________________________________________________________________________________________
 Explain how decisions are made on what to produce, how to produce and for whom to
produce, how prices act to allocate resources within an economy
 Explain Consumer behaviour and demand
 Draw standard demand and supply curves
 Explain Price determination
 Explain why prices change from time to time, the main influences of demand and supply
 Distinguish between a change in demand or supply, and a change in the quantity demanded
and supplied
 Explain why and how the government intervenes
 Explain the effects of government intervention
_______________________________________________________________________________
1.0 INTRODUCTION
This chapter deals with how the free market Economic systems deals with the allocation of scarce
resources, making choices on what, how and for whom to produce. This emphasis is on the market
for goods and services. However, the factor market, which is the market for factors of production,
land, labour, capital and enterprise, with the corresponding rewards, rent, wages, interest and profit
respectively, works in almost a similar way.
A market is where buyers and sellers meet, it does not necessarily mean a geographical location.
What determines what and how much of anything to produce is the price, and price results from
the operation of demand by buyers and supply from sellers.
In a free market, prices, which are basically determined by demand and supply, combine to solve
the problem of resource allocation. Prices act as a signal of what people want to buy, indicating to
producers where their scarce factors will most profitably be utilized.
1.1 DEMAND
Individual demand must be differentiated from wants or desires. Demand refers to the willingness
by consumers to own goods, and it must be backed by money, it is therefore, qualified as effective
demand. This is the quantity of a product or service that consumers are willing and able to buy at a
given price. Emphasis is not only willingness, but this must be supported by the ability to pay.
Market demand is the total quantity, which all customers are willing and able to buy at a
particular price.

1.2 THE DEMAND SCHEDULE
There is an inverse relationship between the quantity demanded and price, the amounts that a
consumer is willing and able to purchase at various prices at any given time tends to be high at low
prices, and low at high prices.
Below is Mr Banda‟s demand schedule for mangoes in the month of November.
Price (K) Quantity demanded (units)
1 000 0
800 3
500 4
300 6
200 10
1.3 DEMAND CURVE
When the data above is plotted into a line graph, a demand curve is produced.
FIG 3: DEMAND CURVE
Price
D
Quantity
A „normal‟ demand curve slopes downwards from left to right, due to changes in price. A change
in price never shifts the demand curve for any good, it results in a movement along a demand
curve. This is a change in the quantity demanded.
An increase in price from OP to OP1 causes a contraction in demand from OQ to OQ1.

Alternatively, a reduction in price from OP1 to OP results in an extension in the quantity
demanded from OQ1 to OQ.

Contraction in demand Extension in demand
1.4 UTILITY THEORY
The standard shape of a demand curve, downward sloping, explains consumer behaviour with
reference to utility theory. Utility is the satisfaction or the benefit derived from consuming a good
or a service, and total utility is the total satisfaction. The utility theory assumes that consumers
want to maximize the total utility they gain when they buy goods and services, a sign that they are
behaving rationally.
In general, when a consumer buys more of a product, the total utility rises, but the marginal
utility, which is the satisfaction gained from consuming one additional unit of a product, reduces.
For example, if a very thirsty person drinks a glass of water, she will derive a lot of satisfaction
from that, but the second glass of water will be less satisfying, by the time she drinks the third and
fourth glasses of water, there is very little satisfaction derived from drinking water. This signifies
that successive increases in consumption raise total utility but at a diminishing rate, known as
diminishing marginal utility. A person is only prepared to pay less for an extra unit bought, more
demand is at a lower price! This explains the shape of the demand curve, it slants downwards from
left to right, signifying that the lower the price, the higher the quantity demanded and the higher
the price the lower the quantity demanded.
The normal demand curve is also partly explained by the substitution effect, which occurs due to
relative price changes. Changes in the price of goods and services cause consumers to adjust their
demand schedules. If the price of a good falls, there is a substitution effect, consumers buy more of
that good and less of the other goods because of relative price changes. However, there is also an
income effect, as the fall in price increases a consumer‟s real income. The consumer is better off,
and can buy more of a product, hence increasing demand as price falls.
A consumer‟s spending of a good is in equilibrium where the marginal utility is equal to price.
Therefore the equilibrium for a combination of goods is
Marginal utility of good A = MUB = MUC

Price of good A PB PC

Note that the utility theory has a number of limitations, the important one being that it is
subjective, an individual who does not smoke cannot derive any satisfaction from cigarette
smoking. For some products such as beer, there is no diminishing marginal utility for some people!
In addition, a poor person who is starving can pay dearly for basic foodstuffs, while a rich person
will find this negligible in terms of price and utility.
1.5 A CHANGE IN DEMAND
Demand curves shift only if there is a change in the conditions of demand other than price.
The following are the main influences on demand:
 Household income
An increase in income leads to an increase in the demand for goods and services, known as
„normal‟ goods. These are expensive, luxurious products. Demand falls when there is a
reduction in income, indicating a positive relationship between household income and most
goods and services.
 For some products, there is an inverse relationship between household income and demand.
Demand is high only when household income is low. Goods, whose demand decreases
when income is high, are known as „inferior‟ goods. Examples are black and white
television sets, cheap wine, some vegetables etc.
 The price of other goods

`This can either be substitute or competitive goods, those goods that are interchangeable,
are competing with each other. Examples are margarine is a substitute for butter, and tea is
a substitute for coffee. Different brands of tea, coffee and different cellular phone service
providers like Celtel, Telecel and Zamtel are very close substitutes of each other!
 For substitute goods, a change in the price of one good causes a change in the demand for
the other good. Suppose there is an increase in the price of butter, the demand for
margarine is likely to increase as consumers will switch to margarine, which will appear
relatively cheaper.
 The other goods can also be complementary goods or those goods that are jointly
demanded such as cars and fuel, or cell phones and sim cards.
 For complementary goods, a change in the price of one good also causes a change in the
demand for the other good, however, an increase in the price of motor vehicles causes a
reduction in the demand for fuel.
 There is an increase in demand for herbal medicines because of the complexities of the
H.I.V A.I.D.S. scourge.

 Population
An increase in population creates a larger market for goods and services, demand increases
and vice versa.
 Price expectations
Expectations of future price increases in a commodity results in an increase in demand, the
idea is to purchase a lot of goods at the current „low‟ price and „beat‟ future price increases.
 A change in demand is a shift in the whole demand curve either to the right or to the left,
indicating an increase or a decrease in demand respectively.
Price D2
D1 D
Quantity
In the diagram above, a decrease in demand shifts the demand curve to the left from DD to D1D1
and an increase in demand would shift the demand curve to the right from DD to D2D2
2.0 SUPPLY
Supply must be differentiated from production, which is the total value of goods in stock. Supply
is the amounts of a good producer are willing and able to sell at a given price.
2.1 THE SUPPLY SCHEDULE
There is a positive relationship between the quantity supplied and price. The amounts that
producers or sellers are willing and able to sell at various prices at any given time tend to be high
at high prices, and low at low prices.
Below is Ms Chanda‟s supply schedule in the month of November.
Price (K) Quantity supplied (units)

1 000 0
800 3
500 4
300 6
200 10

2.2 SUPPLY CURVE
When the data above is plotted into a line graph, a supply curve is produced.
Price S
Quantity
A „normal‟ supply curve slopes upwards from left to right, an indication that at high prices, supply
is high, while at low prices, supply is also low. A change in price never shifts the supply curve for
any good, it results in a movement along a supply curve. This is a change in the quantity
supplied.
An increase in price from OP to OP1 results in an extension in supply from OQ to OQ1.

Alternatively, a reduction in price from OP1 to OP results in a contraction in the quantity supplied
from OQ1 to OQ.
Price
P1
P
P P1
0
Q Q1 Quantity Q1 Q
2.3 A CHANGE IN SUPPLY
The supply curve shifts only if there is a change in the conditions of supply either than price. If
supply conditions change, a different supply curve must be drawn, unlike a change in the quantity
supplied due to price changes,

The following are the main influences on supply:
- Cost of production
A rise in costs generally decreases the amount of a commodity being supplied to the
market, since firms cannot continue in business for long if they are failing to cover the
costs of production. Low costs encourage production and therefore increases the supply of
goods and services.
- Technological changes
Improvements in technology lead to more efficient production a method that reduce
production cost per unit and therefore increases supply. Obsolete technological has the
opposite effect.
- Weather conditions
For agricultural goods, natural disasters like floods, droughts or favorable weather
conditions can reduce or increase the supply respectively.
- Prices of other goods

The goods can be either substitute goods or those that are jointly supplied.
- Suppose it is easy to shift resources into the production of other goods, then an increase in
the producer price of one maize would lead to an increase in the production and supply of
maize, and a decrease in the production and supply of groundnuts.
- An increase in the price of a good such as beef, would lead to an increase in its supply. In
addition, the supply of leather would also increase.
- Government policy, such as taxes and subsidies

Taxes are treated as costs, subsidies are benefits to a firm. An increase in taxes reduces
supply, while a reduction in taxes tends to increase the supply.
A subsidy is when the government pays part of the costs in order to encourage the
production of goods. Increased production increases supply.
- Other factors
Industrial and political unrest in the form of work stoppage, strikes, fire, wars, riots etc, can
lead to a reduction in supply.
- A change in supply is a shift in the whole supply curve either to the right or to the left, an
indication of an increase or a decrease in supply respectively.

In the diagram below, a decrease in supply shifts the supply curve to the left from SS to S1S1 and
an increase in supply shifts the supply curve to the right from SS to S2S2.
Price S1
S
S2
S1
S
S2
Quantity
4.0 PRICE DETERMINATION
The equilibrium market price is the price at which consumers want to buy equals the price at which
producers want to sell.
Consumers and producers both act rationally. Consumers want to maximize their utility and
therefore want to purchase goods as cheaply as possible, while producers also act rationally and
aim at profit maximization, they charge high prices. The equilibrium market price therefore is
determined by the interaction of the market forces of demand and supply. The point where the
demand and supply curves intersect is the compromise price, both consumers and producers are
satisfied at this point.
Consumers are willing and able to purchase OQ quantities at price OP, while Producers are also
willing and able to supply OQ quantities at price OP, as shown in the diagram below.
Price D S
S D
O
Q Quantity

At the equilibrium price, there are neither surpluses nor shortages. The price is stable unless there
are changes in either supply or demand conditions listed above under changes in demand and
supply.
Note that the marginal utility of consumers vary, with some consumers willing and able to pay for
a product than the prevailing market price, since they are paying less, there is a consumer surplus.
A producer surplus also arises when some suppliers are willing to sale at less than the prevailing
market price, since they are selling at a higher price there is a producer surplus.
Price
Consumer
surplus
Producer
surplus
Quantity
4.1 PRICE CHANGES
Shifts in the supply or demand curves will change the equilibrium price and quantity traded.
If for example, there is a large increase in consumer‟s income, the demand curve will shift to the
right from DD to D1D1 signifying an increase in the demand for goods and services. The new
equilibrium price is OP1 and the quantity traded also increases to OQ1.
Price D1
S
D
P1
D1
S
D
O Q Q1 Quantity

4.2 DISEQUILIBRIUM IN THE MARKET
The market system is considered to be the best way of allocating scarce Economic resources,
because prices act as signals to producers. An increase in the price of product X, is a signal to
producers to transfer resources to the production of product X and vice versa.
The objective of maximizing profits provides the incentive for firms to respond to changes in
price.
The system is self-adjusting. If the price is above the equilibrium at OP1, there is excess supply,
surpluses. At this high price, producers are encouraged to supply more, but the quantity demanded
at this high price is less. This causes a downward pressure of cutting down production to eliminate
the surplus and reducing the price to encourage demand.
At prices below the equilibrium at OP2, there is excess demand, shortages. Producers supply few
quantities at low prices while more consumers are willing and able to purchase products at low
prices. Excess demand causes an upward pressure on price resulting in a rise in price and output.
Price D S
Excess supply
P1
P2
Excess demand
S D
O
Q Quantity
4.3 GOVERNMENT INTERVENTION
Price regulation and government policy of taxation and subsidy interfere with the working of the
free market system.
MAXIMUM PRICE (PRICE CEILING)
If the government thinks that the price determined by the market forces of supply and demand for a
product or service is high, the government might decide to set a maximum price, that is the price
should not go beyond the amount stipulated by the government.
Maximum prices are normally set to encourage the consumption of goods and services, considered

to be essential, and therefore should be affordable to everyone.
This has the same effect as the price being below the equilibrium, at OP2 in the diagram above.
The result is excess demand, shortages. There is no self-adjustment as this is government policy;
queues, black markets and tie in sales become common whenever there are shortages.
The government may attempt to ration the few commodities, or subsidize consumers.
Price D S
S D
O
Q1 Q Q2
Quantity
Maximum price OM, at this price OQ, quantities are supplied while OQ2 quantities are demanded,
the result is a shortage.
MINIMUM PRICE (PRICE FLOOR)
This is set in order to protect producers. If the government feels that the price set by the market
forces of supply and demand is too low for producers to earn a decent standard of living them a
minimum price is set. This meaning that the goods should not be sold below the amount stipulated
by the government.
This has the same effect as the price being above the equilibrium at OP.

Price D S
D
O
Q1 Q Q2 Quantity
Minimum price is OM, quantity supplied is OQ2 while the quantity demanded at this high price is
only OQ1. The result is excess supply, surplus amounts that have to be sold at low prices “dumped”
in poor countries.
The surplus can also be stored away, but this is at a cost.
Government intervention in relation to taxation and subsidy is explained in detail in the next
chapter.
5.0 CHAPTER SUMMARY
In a free market economy prices act as a means for consumers to signal to the market what they
wish to buy, and for producers where their scarce Economic would most profitably be utilized. The
price for any good or service is determined by the demand for and the supply of that good or
service.
Changes in demand or supply cause changes in the equilibrium price and quantity
Government intervention, such as the setting of maximum and minimum prices, as well as taxation
and subsidy also disturbs the equilibrium price and quantity.
If maximum prices are imposed, there are shortages or excess demand, and if minimum prices are
imposed, there are surpluses or excess supply.
Indirect taxes lead to an increase in price, while subsidies cause prices to reduce.

REVIEW QUESTIONS
1. Describe the shape of a typical demand curve

2. What is the difference between a shift in demand and an expansion of demand?
3. If a cabinet minister urged people in Zambia to cut down on the high cost of living
4. by buying only „cheap‟ products, is that Economically sound?
5. How does a consumer surplus arise?
6. List some factors which can cause a change in supply
7. What are substitute and complementary goods? Give two examples of each.
8. What is the shape of a typical supply curve?
9. When the price of a good is set above the equilibrium price, what is the result?
10. Illustrating graphically and specifying the assumptions upon which your reasoning is based,
describe briefly
i) The effect on the price and output of fresh maize of adverse weather conditions.
ii) The effects on the price and output of oranges of an increase in consumer‟s income.
---------------------------------------------------------------------------------------
a) Explain the difference between „a change in supply‟ and a „change in the quantity supplied‟
(12marks)
b) Zim Police warns dubious traders.
HARARE–“The Zimbabwean police warned last Monday unscrupulous traders selling

commodities at above the government stipulated prices that they risked being arrested if
caught doing the unlawful act.
Police spokesperson Inspector, Cecilia Churu, said that police would not hesitate to arrest any
retailer caught flouting the gazetted price.
The warning comes in the wake of unjustified price increases of Mealie Meal in the past two
weeks by millers without the approval of the government.”
Zambia Daily Mail, 24th July, 2003.
You are required to:
Explain, with the aid of a diagram, the effect of this form of government intervention on the price
mechanism.
(8 Marks)
(Total: 20 marks)

CHAPTER 3
ELASTICITY
______________________________________________________________________________________________
 Explain why demand or supply may not change in spite of price changes
 Explain and measure the price elasticity of demand and supply.
 Explain the determinants of price elasticity of demand and supply.
 Assess the relationship between price elasticity of demand and total revenue
 Explain why demand may change when income changes.
 Explain why demand for one product changes when there is a change in the price of
another product
 Appreciate the use of elasticity in pricing of goods, taxation and subsidy of certain goods
_______________________________________________________________________________
1.0 INTRODUCTION
The law of demand states that an increase in price causes a decrease in the quantity demanded,
while a decrease in price causes an increase in the quantity demanded.
Elasticity measures the degree of responsiveness or sensitivity of demand to a change in price.
If a small change in price causes a big change in the quantity demanded then demand is elastic.
However, if a big change in price causes only a small change in the quantity demanded, then it is
inelastic.
2.0 PRICE ELASTICITY OF DEMAND (PED)
It is measured by the formula: % change in quantity demanded

% change in price
There is an inverse relationship between price and quantity, as such the sign is negative.
Note that the sign is always ignored when interpreting the elasticity value.
2.1 CATEGORIES OF PRICE ELASTICITY OF DEMAND
There are five categories of PED, namely:-
Perfectly or completely inelastic demand
When a change in price has no effect at all on the quantity demanded, PED when measured is
equal to zero. This is an extreme situation, the closest it can be liked to is medicines. Consumers

purchase exactly the same quantities whatever the price is, whether it is high at OP or low at OP1,
the quantity remains OQ.
Price D
P1
O
Q Quantity
Inelastic demand
This is when elastic is relatively or fairly inelastic, a big change in price results in only a small
change in the quantity demanded and the conclusion is that demand is inelastic. Price changes by a
big margin, from OP to OP1, but the demand reduces by a very small amount, from OQ to OQ1.
PED when measured is greater than zero, but less than one.
Inelastic demand applies to necessities such as mealie meal, sugar, salt, and addictive products
such as cigarettes, beer, drugs.
Price
D
P1
D
O Q1 Q Quantity
Unitary elasticity of demand
This is a hypothetical scenario, based on the assumption that if demand changes by a certain
percentage, then the quantity demanded should also change by exactly the same percentage. When
measured, elasticity is equal to one exactly.

Price D
P1
D
O Q1 Q Quantity
Perfectly or completely elastic demand
This is another theoretical structure, it is important because a perfectly competitive market

structure model is based on it.
At the compromise price of OP, demand is infinite, but a small change in price would cause
demand to reduce to zero.
PRICE
P D
QUANTITY

Elastic demand
Demand is relatively or fairly elastic when a small change in price results in a big change in the
quantity demanded, a sign that consumers are able to respond to changes in prices.
Therefore goods and services that can easily be substituted, those that are mere luxuries and are
expensive (normal) goods are the ones which have an elastic demand.
When measured, the value would be greater than one but less than infinity.
Price
D
P1
P
D
O Q1 Q Quantity
2.2 CALCULATING PRICE ELASTICITY OF DEMAND
The calculation is done in two ways
(a) Point Elasticity of Demand
Under point elasticity, the elasticity is calculated at a certain point on the demand curve.
Example1
The price of a product was K4000 and the annual demand was 2000 units when the price was
reduced to k3000, the annual demand increased to 4000 units.
Calculate the price elasticity of demand for the price changes given.
PED Formula = % change in quantity demanded = Q2 - Q1 ÷ P2 –P1

% change in price Q1 P1
= Q2 - Q1 × P1
Q1 P2 –P1
where Q2 = 4000
Q1 = 2000
P2 = 3000
P1 = 4000
= 4000 – 2000 x 100
2000
___________________
3000 – 4000 x 100
4000
= 2000 x 4000 = -4_

2000 -1000 Demand is elastic
Example 2
The price of a commodity was initially K10, 000 and 150 units were bought per day. When the
price fell to K5, 000 the units being bought increased to 200 per day. What is the price elasticity of
demand for the price changes given?
PED Formula = % change in quantity demanded = Q2 - Q1 ÷ P2 –P1

% change in price Q1 P1
= Q2 - Q1 × P1
Q1 P2 –P1
where Q2 = 200
Q1 = 150
P2 = 5000
P1 = 10000
200 - 150 x 100 50

150 150
= _____ = 50 x 10 000 = 10
150 -5 000 -15
5 000 – 10 000 x 100 -5000

10,000 10000
= -2 = - 0.67
3
Demand is inelastic

Example 3
From the following data
Price quantity bought

(K’000) ( units)
1.75 125
2.0 100
Calculate PED
At price K1.75
% Change in quantity 25 x 100 = 20%
125
% Change in Price -0.25 x 100 = -14.2857%

1.75
PED Formula = % change in quantity demanded

% change in price
= 20% = -1.4 Demand is elastic

-14.2857%
(b) Arc elasticity of demand
The elasticity is calculated over a range of values or an arc.
Example 1
The annual demand for a product is 1,800,000 at K2, 600 per unit and demand reduces to
1,500,000 when the price increases to K3, 000 per unit. What is the elasticity of demand over this
price range?
PED Formula = Percentage change in quantity demanded

Percentage change in price

Q2 - Q1 x 100 Where Q2 = 1 800 00
Q1 + Q2 Q1 = 150 0000
___ 2______________ P2 = 2600
___ _______________________ P1 = 3000
P2 - P1 x 100
P1 + P2
2
18 00000 – 15 00 000 x100

1500000 + 18 00 000
2 600 – 3 000
3 000 +2 600 x 100

2
300,000
1650 000
= 300,000 x 2800 = -1.27

-400 1650 000 -400 demand is elastic
2800
Example 2
From the following data
Price Quantity bought

K’000 000 units
10 15
5 20
Calculate PED
Change in quantity -5 x 100 = -28.57%

17.5
Change in price -5 x 100 = 66.67%

7.5
PED = -28.57% = - 0.43

66.67% demand is inelastic

2.3 PRICE ELASTICITY ALONG THE DEMAND CURVE
The five categories of price elasticity of demand can be shown on one demand curve. Demand
curves generally slope downwards from left to right, and elasticity varies along the length of a
demand curve. The ranges of price elasticity of demand at different points along a demand curve
are illustrated below.
Price
PED = ∞
PED>1
PED = 1 (mid-point of
the line)
PED<1
PED = 0
Quantity
0
Along the top half of the line, PED is greater than 1. We say that demand is elastic. Along the
bottom half of the line, PED is less than 1 and we say that demand is inelastic. Exactly halfway
along the line, PED = 1; demand is of „unitary elasticity‟.
The arithmetic accuracy can be examined by studying the demand schedule for beans shown
below:
Price Quantity
(K‟000) (kilograms)
10 0
9 10
8 20
7 30
6 40
5 50
4 60
3 70
2 80
1 90
0 100

If the price is lowered from 8 to 7, PED is 10/20  1/8 = 10/20 x 8/1 = 4.
Demand is therefore, elastic.
If price is lowered from 4 to 3, PED is 10/60  ¼ = 10/60 x 4/1 = 2/3 = 0.66.

Demand is therefore, inelastic
At higher price ranges, demand is elastic. At lower price ranges, demand is inelastic.
At the point where demand is changing from elastic to inelastic demand, demand is unitary. If
price is lowered from 5 to 4, PED is 10/50  1/5 = 10/50 x 5/1 = 1.
Note that it is wrongly assumed that when calculating elasticity values, either an increase or a
decrease in price calculations, given the same values, have the same elasticity coefficient. It is also
wrongly assumed that two demand curves with the same shape will have the same elasticity
coefficient, and yet the slope and position of the demand curve determine the numerical value of
elasticity. In general, a big change in price causes only a small change in the quantity demanded,
resulting in an inelastic demand curve if the demand curve is steep, further from the origin, and
vice versa.
2.4 POSITIVE PRICE ELASTICITIES OF DEMAND OR EXCEPTIONAL

DEMANDCURVES
If the quantity demanded of certain goods falls as an individual‟s income reduces, then the goods
are said to be inferior goods. It is assumed that a person substitutes better quality alternatives, for
example substituting a black and white television for a colour, flat plasma television set, from
buying mixed cut beef to a high quality expensive steak.
The quantity demanded for a good may also increase when the price increases if the product is a
status maxi miser! Ostentatious goods such as gold and diamond jewels, private jets, etc., are
more desirable to some consumers when the price is high, when the price falls, the products
become common and are no longer desirable to those people.
If consumers anticipate future price increases whenever the price of a product increases, they are
likely to buy more to „beat‟ inflation in the short term.
2.5 FACTORS DETERMINING PRICE ELASTICITY OF DEMAND
Elasticity of demand depends on the consumer‟s ability to increase or reduce the quantities being
purchased when there is a change in price. This depends on the following:
 Availability of substitutes
Substitutes have a very big impact on elasticity, if there are close substitutes available, then
an increase in the price of a good, will enable consumers to react, and demand will be
elastic. However, the demand for a unique product is likely to have an inelastic demand.

 Income
This is when a commodity constitutes a small proportion of an individual‟s income, a cheap
product such as a razor blade, a rubber and pencil or a box of matches, items costing K100
or so would still be affordable even if there is a 100% percent increase in price. In contrast, the
demand for luxurious expensive products is likely to be elastic. A 10% increase in the price
of a product costing K2 million would make consumers responsive to changes in demand.
 Necessities
The demand for commodities such as mealie meal, salt, sugar, milk etc is likely to be stable
and inelastic.
 Additive or habit forming products

Consumers who are addicted to products such as beer, cigarettes, drugs etc feel that they
cannot function properly without them. To them, the products are „necessities‟, and
therefore their demand is stable and inelastic.
 Time period
It takes time to adapt to changes in price. Consumers are likely to cling to a certain lifestyle
until reality sets in and they are forced to adjust their spending habits. As such demand is
more likely to be elastic in the long run rather than in the short run.
3.0 PRICE ELASTICITY OF SUPPLY (PES)
Price elasticity of supply is analogous to price elasticity of demand, it measures the responsiveness
of supply to changes in price. That is the extent to which producers increase production and
therefore the quantity which they take to the market as a result of a rise in price.
PES is measured by the formula: % change in quantity supplied
% Change in price
There is a direct relationship between price and quantity supplied.
3.1 CATEGORIES OF PRICE ELASTICITY OF SUPPLY
As with elasticity of demand, there are five categories of elasticity of supply.
Perfectly or completely inelastic supply
A change in price has no effect at all on the quantity supplied to the market. The same quantity is
supplied regardless of a price change, from 0P to 0P1 or vice versa.

Elasticity is equal to zero.
Price S
P1
O Q Quantity
Inelastic supply
This is when elastic is relatively or fairly inelastic, a big change in price results in only a small
change in the quantity supplied. A large increase in price results in only a small increase in the
quantity produced and therefore supplied to the market. The conclusion is that supply is inelastic.
Price changes by a big margin, from OP to OP1, but supply increases by a very small amount,
from OQ to OQ1. PES when measured is greater than zero, but less than one.
Price S
P1
O Q Q1 Quantity

Unitary elasticity of supply
This is a hypothetical, it is based on the assumption that if price changes by a certain percentage,
then the quantity supplied should also change by exactly the same percentage. When measured,
elasticity is equal to one exactly.
Price S
P1
O Q Q1 Quantity
Perfectly or completely elastic supply
This is another theoretical structure. At price OP, supply is infinite, producer will supply any
amount, but a small change (reduction) in price would cause supply to reduce to zero. Absolutely
nothing is supplied to the market even at the smallest decrease in price

Price
P S
O Quantity
Elastic supply
Supply is relatively or fairly elastic when a small change in price results in a big change in the
quantity supplied, a sign that producers are able to respond to changes in prices. A small increase
in price is able to induce a large increase in the quantity produced and supplied to the market and
vice versa.
When measured, the value would be greater than one but less than infinity.
Price
S
P1
P
S
O Q1 Q1 Quantity
3.2 FACTORS INFLUENCING PRICE ELASTICITY OF SUPPLY
Elasticity of supply depends on the producer‟s ability to increase or reduce the quantities being
supplied to the market when there is a change in price. This depends on the following:
 Time period
This is one of the major factors affecting PES. Supply is likely to be more inelastic in the
short run than in the long run generally because existing stock levels may be low, or it may
take some time for producers to purchase more capital equipment in order to increase
production, if they are already operating at full capacity.
 Availability of factors of production

In order to respond to an increase in price, a firm should consider the existing stock levels,
do they have enough to increase supply? What is the shelf life of what is in stock, etc? Are
the necessary raw materials and labour easily available in order to increase production?

What about the existence of other factors of production like fixed capital equipment if the
firm is already operating at full capacity?
 Number of firms and entry barriers can also affect the price elasticity of supply.
4.0.0 THE SIGNIFICANCE OF PRICE ELASTICITY
4.0.1. WHEN DEMAND OR SUPPLY CHANGES
In the previous chapter, the explanation on why prices change is given as due to a change in either
supply or demand conditions. In practice, while any change in demand or supply alters the
equilibrium price and output, the effects will vary due to the differences in the elasticities
involved!
If demand is inelastic, a shift in supply will cause a large change in the price but only a small
change in the quantity traded, and vice versa.
a) INELASTIC DEMAND
S
Price
S1
D
P
P1 D1
0 Q Q1 Quantity
b) ELASTIC DEMAND
S
Price
S1
D
P
P1 D1
0 Q Q1 Quantity

In the same general way, the effects of a shift in demand depend on the elasticities of the supply
involved. Where supply is inelastic, a shift in demand causes a large change in the equilibrium
price but only a small change in the equilibrium output, and vice versa.
a) INELASTIC SUPPLY b) ELASTIC SUPPLY
Price D1 Price D1
D D
P1 P1
P
P
0 Q Q1 Quantity 0 Q Q1 Quantity
In extreme cases, where demand or supply is perfectly inelastic or elastic, a change in supply or
demand does not change the equilibrium position at all.
a) PERFECTLY INELASTIC DEMAND b) PERFECTLY ELASTIC SUPPLY

Price
S1 Price
D1
D
P1 S
0 Q Quantity 0 Q Q1 Quantity
Under a), a change in supply causes the equilibrium price to change but the equilibrium output
does not change. Under b) a change in demand causes the equilibrium output to change but the
price does not change.
Note that an understanding of this first section is very crucial as sections 2, 3 and 4 below are
more or less a repetition and an extension of this concept.
4.0.2. WHEN THERE IS A CHANGE IN TOTAL REVENUE
The calculation of PED is very useful to the business community, as well as the amount being
spent by consumers. If the demand for a good is elastic, then a reduction in price increases total
revenue, and the total amount being spent by consumers. A business selling products that are very

competitive on the market, those with close substitutes, luxuries etc., can advertise small
reductions in prices and discounts in order to woo customers and increase the company‟s total
revenue.
Price
D
P
P1 D1
0 Q Q1 Quantity
Total revenue is price x quantity, the price reduction results in a more than proportionate increase
in the quantity demanded, this offsets the price reduction. Area 0PDQ is „given up‟, while area
0P1D1Q1 is what is „gained‟ when the price is reduced, total revenue increases.
Alternatively, if total revenue falls after a price rise then demand is elastic.
If the demand for a good is inelastic, then an increase in price increases total revenue. A business
selling products that are necessities and addictive products like beer and cigarettes, can afford to
increase prices, and the reduction in the quantity demanded is negligible, as shown below.
Area 0P1D1Q1 is „given up‟, while area 0PDQ is what is „gained‟ when the price is increased,
therefore, total revenue increases.
Price
D
P
P1 D1
0 Q Q1 Quantity
Alternatively, if total revenue falls after a price cut then demand is inelastic.

If total revenue or total expenditure by households remains unchanged whether there is an
increase or reduction in price, then the elasticity of demand is unitary. The areas are equal!
Price
D
P
P1 D1
0 Q Q1 Quantity
4.0..3 WHEN AN INDIRECT TAX IS IMPOSED ON A PRODUCT
Imposing an indirect tax on a product is a form of government intervention, like the setting of
maximum and minimum prices. An indirect tax is a tax on expenditure. Such taxes reduce output,
maybe harmful to the domestic industry if it is in a competitive environment and some foreign
firms are not subject to the same tax. Taxes however, can assist in the allocation of resources when
there is a lot of pollution and only polluters are pay through heavy taxes.
The significance of elasticity is in determining how the burden of the tax is to be shared between
the producer and the consumer.
Suppose, a product has unitary elasticities of demand and supply, the market forces determine the
equilibrium price and output. Following the imposition of a tax, some producers transfer their
resources to another product, as this one would be deemed unattractive. Supply reduces, and the
supply curve shifts to the left, to S1. The price paid by consumer‟s increases to P1, but the net
amount received by the producer is lower than previously, since he must pay to the government
part of the earning and there is a reduction in output to Q1, due to the tax.
Price D S1
S
P1
P2
0 Q1 Q Quantity

In the diagram above, the burden of the tax is shared equally between the producer and the
consumer.
In practice, such an equal distribution of the tax burden is unlikely. The burden of the tax depends
on the elasticities of demand and supply involved! If the demand for a good is inelastic, a firm
producing necessities and addictive products like beer and cigarettes can afford to pass the major
burden of the tax on to consumers, price increases to P1 from P. Producers bear a small portion of
the burden, return falls toP2.
a) INELASTIC DEMAND
S
Price
S1
P1
P2
0 Q Q1 Quantity
b) ELASTIC DEMAND
S
Price
S1
P1
P
P2
0 Q Q1 Quantity
If the demand for a good is elastic, then a firm dealing in products that are competitive on the
market by having close substitutes, luxuries etc., the burden of the tax is borne mainly by
producers. The price paid by consumers rises slightly to P1, the return received by suppliers falls
by a big margin, to P2.

c) INELASTIC SUPPLY
S1
Price S
P1
P
P2
0 Q Q1 Quantity
The conclusion as to how the burden is shared is self explanatory from the diagram, the price paid
by consumers rises slightly to P1, the return received by suppliers falls by a big margin, to P2.
4.0.4 WHEN A SUBSIDY IS GIVEN
A subsidy is the exact opposite of an indirect tax. It is another form of government intervention, it
is when the government makes a payment to producers, and it can bring about artificially low
prices.
Suppose, a product has unitary elasticities of demand and supply, the market forces determine the
equilibrium price and output. When a subsidy is given, production is encouraged. Supply
increases, and the supply curve shifts to the right, to S1. The price paid by consumers reduces to P2,
and this is a benefit to them. There is an increase in output to Q1, and the amount received by the
producer increases.
Price D S
S1
P1
P2
0 Q Q1 Quantity
The significance of elasticity is in determining how the benefit of the subsidy is to shared between
the producer and the consumer, the benefit will fall more on the consumers if the product has an
inelastic demand and vice versa.

5.0 OTHER ELASTICITY MEASURES
5.1 INCOME ELASTICITY OF DEMAND (YED)
The elasticity measures are alike, the definition of income elasticity of demand is similar to that of
price elasticity of demand, but price is replaced by income.
Income elasticity of demand measures the degree of responsiveness or sensitivity of demand to

changes in income.
The formula = percentage change in quantity demanded

percentage change in income
5.2 Categories of income elasticity of demand

Positive Income Elasticity
This is when an increase in income leads to an increase in demand, YED > 0. It applies to „normal‟
goods such as colour television sets, motor vehicles etc. Most goods have a positive income
elasticity of demand.
Quantity
Income
Negative Income Elasticity

For some goods, an increase in income causes a reduction in demand, YED < 0. Inferior goods,
such as black and white television set, have a negative income elasticity of demand.
Quantity
Income
Zero income Elasticity

A change in income may have no effect on the quantity demanded, demand remains the same,
YED = 0. Consumers purchase only what they require, this applies to Giffen goods, „necessities‟
like mealie meal, potatoes etc. Note that with Giffen goods, less is demanded when price falls
because the negative income effect overcomes the positive substitution effect.
Quantity
Income
5.3 Factors affecting income elasticity of demand
The size of income elasticity of demand depends on the current standard of living. For example,
the developed countries have a high standard of living, so that when income expands, sales of
consumer durables such as washing machines and cars will rise; sales of basic commodities (Food,
etc) are unlikely to respond significantly to the rise in income (zero income elasticity). In contrast,
developing economies such as Zambia, when income rises, the income elasticity of demand for
basic goods will be higher as a large percentage of the population is unable to afford basic
commodities at its current level of income.
5.4 Practical uses of income elasticity of demand
Producers may wish to know the income elasticity of demand for their product, it has an effect on
their businesses. The planned future production may depend on whether incomes are rising or
falling. Income increases during Economic prosperity (Economic boom), businesses sell normal
goods. While during a recession, basic inferior goods are more profitable.
6.0 CROSS ELASTICITY OF DEMAND

Cross elasticity of demand measures the sensitivity of demand for one good to changes in the price
of another good. The formula for cross elasticity of demand (XED) is given below.
The formula for cross elasticity of demand
XED = percentage change in quantity demanded of Good A

percentage change in price of Good B

6.1 Categories of cross elasticity of demand
Positive cross elasticity of demand

The XED between butter and margarine is positive, this is because butter and margarine are
substitutes. When the price of butter goes up, demand for margarine rises and demand for butter
falls. In other words, the price of margarine and demand for butter move in the same direction,
therefore XED is positive.
Negative cross elasticity of demand

The XED between complements (goods that are jointly demanded) is negative. Consider cars and
fuel, if the price of cars increases, demand for fuel would fall. Cars and fuel are complementary
goods, so demand for cars is also likely to fall. The price of cars and demand for fuel move in
opposite directions, so the XED of complements is negative.
Zero cross elasticity of demand
This applies to unrelated goods. A change in the price of one good has no effect on the quantity
demanded of the other good.

7.0 CHAPTER SUMMARY
Price elasticity of demand and supply measure how much the quantity demanded and supplied
responds to changes in price.
PED/PES are calculated as the percentage change in quantity demanded/supplied divided by the
percentage change in price.
PED/PES are very important in determining the effects of changes in demand and supply,
increases and reductions in total revenue given changes in the prices of goods and services. In
addition, PED/PES are important in determining the effects of changes in government policy such
as taxation and subsidies.
If total revenue increases following a price cut, then demand is elastic. If total revenue falls after
a price cut, then demand is inelastic, and vice versa. If total revenue remains unchanged, then
demand is unitary.
There are a number of factors, which determine the ability of consumers and producers to respond
to changes in price, such as the availability of substitutes, whether a product is a necessity or it is
addictive, as well as the income of consumers.
In most markets, supply is more elastic in the long run than in the short run, it takes time to
transfer resources following a price rise, it also depends on the availability of factors of production
especially raw materials and labour, as well as the ease of entry of new firms into the market.
Income elasticity of demand measures how much the quantity demanded responds to changes in
income.
Cross-elasticity of demand measures how the quantity demanded of one good responds to changes
in the price of another good.
REVIEW QUESTIONS
1. What is the price elasticity of demand?

2. The price of a good falls by K10, 000, but the quantity demanded increases from 100 to 120
units. Calculate the price elasticity of demand?
3. List any four factors, which influence price elasticity of demand.
4. What is an inferior good?
5. Demand is said to be……, when the price of a good rises, the quantity demanded falls and the
total expenditure on the good decreases.
6. How would you classify a good with a positive income elasticity of demand?
7. How would you classify goods with a negative cross-elasticity of demand?
8. List the commodities that has a positive price elasticity of demand
9. Draw a perfectly or completely elastic supply curve.
10. Show how the burden of a tax will be shared between the producer and the consumer when
demand for a product is perfectly elastic.

EXAMINATION TYPE QUESTIONS 3.1
a) The following table is a demand schedule for a particular commodity, between which price
range is demand elastic? Explain your answer. Hint: At least three calculations, a reduction
from K8, 000 to K7, 000, K5, 000 to K4, 000 and from K4, 000 to K3, 000.
Price (K‟000s) Quantity Demanded

10 0
9 10
8 20
7 30
6 40
5 50
4 60
3 70
2 80
1 90
0 100
(10 Marks)
b)
i) What do you understand by the term “income elasticity of demand” (6 Marks)
ii) Why should a firm pursuing long term growth be interested in the income elasticity of
demand of its products? (4 Marks)
(Total: 20 Marks)

CHAPTER 4
PRODUCTION AND COSTS

______________________________________________________________________________________________
 Differentiate legal forms of business units, the advantages and disadvantages of each
 Name the three classes of production
 Explain how production costs are determined
 Discuss Division of labour, its merits and demerits
 Explain the differences between fixed, variable and marginal costs
 Explain on the rewards of factors of production
_______________________________________________________________________________
1.0 Introduction
Production takes place in firms. A firm is an independently administered business unit. In practice,
there are different types of firms, known as sole traders, partnerships etc.
1.1 Sole traders
Individuals who set up businesses of their own are sole traders. It can be someone with a good
business idea, an own invention or finding something to do after restructuring or simply being his
or her own boss after several years as someone else‟s employee.
An example of a sole trader is a corner shop, a fish trader, a marketeer etc.
Advantages
- It requires little capital to set up.

- Self-interest acts as an incentive to work.
- Regular customers and suppliers are known.
- Owner can make quick business decisions.
Disadvantages
- It does not have a separate legal personality, if a person mortgages the house to raise
capital. If the business fails, then the house is lost.
- Thus, there is unlimited liability.
- Difficult to raise capital.
- Holidays or illnesses cause problems.
- Lack of continuity after the death of the owner.

1.2 Partnership
Business company owned by partners: a company set up by two or more people who put money
into the business and share the financial risks and profits. An example of a partnership is a firm of
doctors, lawyers etc. The activities of partnerships are regulated by a legal document, a
partnership deed.
Most of the advantages and disadvantages of sole traders are transferred to partnerships, as it is
only slightly better than a sole trader. Partners contribute the capital, and as owners, share the
profits, they can specialize and they have regular known customers.
However, partnerships also have unlimited liability, and one partner‟s mistake affects all partners.
Lack of continuity if partners disagree, or if one partner dies.
1.3 Private limited Company
This is a company with limited stockholder liability, a registered company in which the
stockholders' liability for any debts or losses is restricted, regulated by the Companies Act. Two or
more shareholders own the company. An example is a small family firm. Shareholders contribute
capital of the company. Shares are not sold to the general public. Like sole traders and
partnerships, there is limited capital for expansion, and therefore limited economies of scale.
The advantage of private limited companies is that if the company goes bankrupt, owners have
limited liability for the company‟s debt. They only lose the capital they have invested in the
company, nothing more.
1.4 Public limited Company
Public limited companies identify themselves by putting the word „PLC‟ after their name. These
are companies whose share can be bought and sold on the stock market, unlike private limited
companies, they are allowed to sell shares to the general public. Shareholders are subject to
restricted liability for any debts or losses. An example is Chilanga Cement PLC Large amounts of
capital can be raised, as such they are usually very large, enjoying economies of scale.
Professional managers normally run the companies, and the company can be remote from
customers and there are potential diseconomies of scale.
1.5 Co-operatives
These are formed when people join together to carry on an Economic activity for mutual benefit. It
is owned or managed jointly by those who use its facilities. An example is a consumer cooperative,
which is for the wholesale or retail distribution usually of agricultural goods. Membership is open,
and goods are sold to the general public as well as to its members.

The major disadvantage of cooperatives is lack of business or management experience by members
to carry out an Economic activity.
2.0 Industry- the three classes of production
Production is divided into three categories
a) Primary production
The producers of natural goods such as farmers, oil drillers, copper miners etc, are all engaged
in primary production.
b) Secondary production
The producers of sophisticated goods, manufactured goods such as carpenters, tailors, car
manufacturers, are in secondary production.
c) Tertiary
These are providers of services like bankers, retailers, stockbrokers, accountants, teachers,
doctors and entertainers.
3.0 Specialisation
Specialization happens when one individual, region or country concentrates in making one good.
Division of Labour
The division of labour is a particular type of specialization where the production of a good is
broken up into many separate tasks each performed by one person. An early economist, Adam
Smith, suggested that without any division of labour and specialization, one worker could produce
only ten pins in one day. However, in a pin factory where each worker performs only one task, ten
workers using the division of labour principle, could produce a daily total of 48 000 pins. Output
per person (productivity) can rise from 10 to 4800 when the division of labour principle was used.
3.1 Advantages of the division of labour
The division of labour raises output, thereby reducing costs per unit, for the following reasons:
- Workers become more practiced at the task

- Workers can be trained more precisely for the task
- Specialization enables more efficient organization of production with a series of distinct
tasks
3.2 Disadvantages of the Division of Labour
Eventually the division of labour may reduce productivity and increase unit costs of the following
reasons:

- Continually repeating a task may become monotonous and boring
- Workers begin to take less pride in their work
- If one machine breaks down then the entire factory stops.
- Some workers receive a very narrow training and may not be able to find alternative
jobs.
- Mass produced goods lack variety.
3.3 Limits to the Division of labour
- Mass production requires mass demand.

- The transport system must be good enough to reach a large number of consumers
(mass market)
- Barter is the direct exchange of goods for other goods. Each worker creates only part of the
finished goods; -therefore the division of labour cannot be used in a barter society.
4.0 COSTS OF PRODUCTION
It is important to first divide the costs of production into time period of short run and long run
costs, depending on variable or fixed factors of production.
The short run is defined as a period when at least one factor of production is in fixed supply, a
combination of both variable and fixed factors. The short run is the time period that is too brief for
a firm to alter its plant capacity. The plant size is fixed in the short run. Short run costs, then, are
the wages, raw materials, etc., used for production in a fixed plant.
A firm will undertake production in the short run, if the price at which their product is sold is at
least equal to the average variable cost of production. Therefore, a firm will continue in business in
the short run as long as it is able to cover the variable costs of production.
The long run is a period when all factors of production can be varied. All the factors of production
are considered to be variable. The long run is a time period long enough for a firm to change the
quantities of all resources employed, including the plant size. Long run costs are all costs,
including the cost of varying the size of the production plant.
4.1 Total Costs

The amount spent of producing a given amount of a good by a firm is called total cost, TC, and is
found by adding together variable and fixed costs.
4.2 Variable Costs

Variable costs, VC, depend on how many (the output) goods are being made. If just one more unit
is made then total variable costs rise. Variables costs are costs that vary with output. Examples
include the following:-

- Wages paid to casual workers
- The cost of buying raw materials and components.
- The cost of electricity and charcoal.
4.3 Fixed Costs
Fixed costs, FC, are independent of output. Fixed costs have to be paid out even if the factory stops
production. Fixed costs are costs that do not vary with output. Examples include the following:
- Monthly salaries paid to managers

- Rent paid for the use of premises
- Rates paid to the council
- Any interest paid on loans
- Depreciation, that is money put aside to replace worn-out machines and vehicles sometime
in the future
The short run cost schedule of an individual firm shows the behaviour of costs when output is
varied. Table 1 below presents the cost structure of a hypothetical firm, to illustrate the general
principles covered under 4.1, 4.2 and 4.3, total costs remain the same at different levels of output.
The total costs are made up of fixed and variable costs. The output and the costs are in thousand
units and thousands of kwacha respectively.
Output Total fixed Total variable Total Costs

units costs costs
0 50 0 50
1 50 50 100
2 50 90 140
3 50 120 170
4 50 160 210
5 50 210 260
6 50 270 320
7 50 340 390
8 50 420 470
9 50 510 560
10 50 610 660
After plotting the above information, the following diagrams are obtained:

Costs TC
660
TVC
50 TFC
0 10 Output
4.4 Average cost, AC or average total cost (ATC) is the cost of producing one item, it is
sometimes called per unit cost. It is calculated by dividing total costs by total output
(ATC = TC/Q).
Note: ATC also equals AFC + AVC.
4.5 Marginal cost, MC is the cost of producing one extra unit of output, and is calculated by
dividing the change in total costs by the change in output. Marginal decisions are very
important in determining profit levels. Marginal revenue and marginal cost are compared.
4.6 Average fixed cost is the total fixed cost divided by the level of output (TFC/Q). It will
decline as output rises.
Average variable cost is the total variable cost divided by the level of output
(AVC = TVC/Q).
Note that in Economics, for practical purposes, the average cost data is used more than the total
aggregate figures. The table 2 below presents the cost structure of a hypothetical firm, a
continuation of table 1 above. It illustrates the general principles covered under 4.4,4.5, 4.6 and 4.7
Output Average variable Average fixed Average total Marginal

units costs costs costs costs
0 - - - -
1 50 50 100 50
2 45 25 70 40
3 40 16.6 56.6 30
4 40 12.5 52.5 40
5 42 10 52 50
6 45 8.3 53.3 60
7 48.6 7.1 55.7 70
8 52.5 6.3 58.8 80
9 56.6 5.5 62.1 90
10 61 5 66 100

After plotting the above information, the following diagrams are obtained, where 1 is the marginal
cost curve, 2 is the average total cost curve, 3 is the average variable cost curve and 4 is the
average fixed cost curve respectively.
4.8 Explicit costs are those costs that are clearly stated and recorded.
4.9 Implicit costs are those costs that are implied, unstated but understood as a necessary
component in the economist‟s view. These are opportunity costs, benefits forgone by
not using the factor of production in the next most profitable way.
This is important because it explains the difference in the calculation of profit
between the Accountant and the Economist.
Accounting profits are sales revenue minus explicit costs of a business.
Economic profits consist of sales revenue minus explicit and implicit costs!
For example, assuming that Mabvuto runs a business and sells goods worth K10 million, the cost
of sales is K4.5 million. If the premises used for the business could be put to alternative use, it can
earn a rent of K1million. The capital invested in the business could have earned K1.5 million in
interest if deposited in a bank. Suppose Mabvuto was employed elsewhere, he would have been
earning an income of K2.5 million. The accounting gross profit and the Economic profit or loss
earned is as follows:
Accounting profit K’M K’M
Sales 10
Less cost of sales 4.5
___
Gross Profit 5.5

Economic profit
Sales 10
Less cost of sales 4.5
___
Gross Profit 5.5
Less opportunity costs

Rent 1
Interest 1.5
Salary 2.5
Opportunity costs total 5.0
Economic profit 0.5
4.10 SHAPE OF THE SHORT RUN COST CURVES
Short run production reflects the law of diminishing returns that states, “as successive units of a
variable resource are added to a fixed resource, beyond some point the product attributable to each
additional resource unit will decline”.
The law of diminishing returns is explained as an essential concept for understanding average and
marginal cost curves. The general shape of each cost curve is a “U”.
The AFC and the AVC both influence the AC. As output increases, both the AVC and the ATC
curves will first slope downward and then slope upward due to diminishing returns. The same
volume of fixed costs are divided by increasing levels of output, therefore the AFC is constantly
decreasing.
Marginal cost is a reflection of marginal product and diminishing returns. When diminishing
returns begin, the marginal cost will begin its rise. The marginal cost is related to AVC and ATC.
It is the variable cost component in the total cost that changes as output levels increase.
These average costs will fall as long as the marginal cost is less than either average cost. As soon
as the marginal cost rises above the average, the average will begin to rise. The relationship
between AC and MC is summarised as
 At low levels of output, the MC curve lies below the AVC and the ATC curves
These curves will slope downward
 At higher levels of output, the MC curve will rise above the AVC and the ATC curves
These curves will slope upward
 As output increases, the average curves will first slope downward and then slope upward
Will have a “U” shape
 The MC curve will intersect the minimum points of the AVC and the ATC curves.

5.0 FACTOR MARKETS
The four factors of production explained in chapter one, land, labour, capital and enterprise are
used by firms in any productive service that people perform. Each factor receives a reward.
Labour performs work and is paid by wages and salaries.
Capital is a man made resource, and the owners of capital receive interest.
Land consists of natural resources for which rent is paid.
Entrepreneurs establish business firms and receive profit.
The important question is „what determines the rate at which each factor is paid?‟ In other words,
what determines the level of wages and salaries, rent, interest and profit? Factor rewards are prices
paid for each factor of production, and just like any price, it is determined by the market forces of
demand and supply.
The demand for factors of production differs from the demand for consumer goods and services.
The demand for factors is said to be a derived demand, the demand is derived from the demand for
the final product, which they help to produce. Factors of production are not demanded for their
own sake, but they are demanded because firms want to produce consumer goods and services.
The market demand curve for a factor resembles that of a consumer good, a typical demand curve
slopes downwards from left to right. The higher the „price‟ of a factor, the lower the demand for it,
and vice versa.
The demand for factors of production also introduces the diminishing marginal productivity
theory that is each additional unit of any factor employed tends to add progressively less to total
output (other factors being held constant).

An individual firm will increase its employment of any factor as long as the value of the extra
output achieved exceeds the additional cost involved.
The supply of a factor represents the different quantities that are offered at various possible
„prices‟. For example the higher the wage rate, the higher the supply of labour, and vice versa.
Therefore, a typical supply curve for a factor resembles that of a consumer good, it slopes upward
from left to right.
A change in factor „prices‟, such as wage rates, maybe due to changes in the demand and supply
conditions of labour, just like in the product market.
Note that the above is generalized, in practice, there are other factors that should be considered in
the factor market, including elasticity.
6.0 CHAPTER SUMMARY
There are various types of organizations in mixed Economic systems. Business organizations are
categorized as sole traders, partnerships, limited companies and cooperatives.
The economy can be divided into primary, secondary and tertiary sectors.
A firm‟s output decisions can be examined both in the short run, when at least one factor of
production is in fixed supply, or in the long run, when all factors of production are considered to
be variable.
A firm‟s total cost of production is made up of fixed and variable costs.
Average fixed cost declines as output increases, average variable costs initially falls as output
increases, then after a certain point, when diminishing returns set, the average variable costs begin
to rise.
When average fixed cost and average variable cost are added, the resulting average total costs fall,
and then rises as output increases.
The marginal costs also falls briefly, then rises, cutting the average costs at their minimum points.
Economic costs are different from accounting costs. Economic costs include the opportunity costs
of factors of production that are used.
The factor market is similar to the market for goods and services. The demand for factors of
production is derived from the demand for the final goods and services, which that factor helps to
produce.

REVIEW QUESTIONS
1. What is the distinction between long run and short run in Economics?
2. Distinguish between fixed costs and variable costs.
3. What costs should be covered in the long run?
4. What is meant by the term marginal costs?
5. What is derived demand?
6. From the following cost schedule of a hypothetical firm:
Output Fixed costs Variable costs

(units) K‟000 K‟000
100 100 700

101 100 706
102 100 709
103 100 710
You are required to calculate
a) The total cost of production

b) The average total cost
c) The marginal cost
7. From the following cost schedule of a hypothetical firm:
Output Total costs

(units) K‟000
20 270
30 330
40 400
50 500
60 630
70 840
You are required to calculate
a) The average total cost

b) The marginal cost and to construct
c) The average total cost curve
-----------------------------------------------------------------------------------------------

EXAMINATION TYPE QUESTION 4.1
(a) The table below is given as follows:-
Variable factor (in units) 1 2 3 4

Marginal physical product 6 10 15 12
You are required to calculate the:
(i) Total physical product (4 Marks)

(ii) Average physical product (4 Marks)
(b) Distinguish between fixed and variable costs, and give two examples of each.
(4 Marks)
c) Construct the following curves on one graph:
i) The marginal cost curve (2 Marks)

ii) The average total cost curve (2 Marks)
iii) The average variable cost curve (2 Marks)
iv) The average fixed cost curve (2 Marks)
(TOTAL: 20 MARKS)

CHAPTER 5
LONG RUN COSTS

______________________________________________________________________________________________
 Explain how the shapes of the long run cost curves are determined
 Draw long run and short run cost curves
 Discuss internal and the external economies and diseconomies of scale
 Appreciate small firms and their survival despite the advantages of large-scale production
 Explain how the location of industries is determined
 Explain the integration of firms to form large undertakings
 Describe the revenue structure of firms and the profit maximizing position
_______________________________________________________________________________
1.0 Introduction
The long run is when all factors of production are variable, and as such all the costs must be
covered. The firm is assumed to be a profit maximiser. It can plan ahead on long run
improvements, which involve changing factors of production that are currently fixed. Therefore if
a firm is to continue in business in the long run, the price must at least equal average total cost of
production.
In the long run, firms have combinations of factors of production that result in low average costs.
The factors that cause average costs to decline in the long run as output increases are known as
economies of large-scale production, commonly known as economies of scale.
The shape of the long run average cost (LRAC) curve however, depends on whether
- Output increases more in proportion to inputs, when there are economies of scale and
the LRAC decline to show increasing returns to scale.
- Output increase in the same proportion as inputs indicating constant returns to scale.

Costs
Output
- The arrow is pointing to the minimum efficiency scale (MES), which is that level
of output on the LRAC curve at which average costs first reach their minimum
point. At output levels below this point, the firm will experience higher average
costs, otherwise, the LRAC remain unchanged at whatever the level of output, and
the curve is flat.
- Output increases less than in proportion to inputs, due to diseconomies of scale, LRAC
increases as output increases. As output continues to increase, most firms reach a point
where bigness begins to cause problems. When LRAC rise more than in proportion to
output, there are diseconomies of scale, and the curve slopes upward.
The behaviour of LRAC can be summarised as:
- Economies of scale (decreasing LRAC) at low levels of output

- Constant returns to scale (constant LRAC) at intermediate levels of output
- Diseconomies of scale (increasing LRAC) at high levels of output
Therefore, the LRAC curves are typically “U” shaped as shown below
Cost
Output
Economies Constant Diseconomies

of scale returns of scale
to scale

2.0 ECONOMIES OF SCALE
These indicate that as the output or plant size increases, the average costs per unit decreases or
falls, they are reductions in long run average total costs achieved when the whole scale of
production is expanded.
Not all the factors are expanded proportionately with output. Average costs fall as output is
expanded, but not all fixed factors of production need to be increased in line with output. This
reduction in the long run average costs is due to economies of scale.
Economies of scale only occur in the long run, as they are associated with the alteration of some or
all of the firm‟s fixed factors. The economies of scale are either internal (within the firm) or
external (originating outside the firm).
2.1 INTERNAL ECONOMIES

These are advantage that accrue within an organization because of large-scale production which a
firm a can plan to achieve directly by increasing the size of its output. The benefits accrue to the
individual firm, some of them include the following:
 Financial Economies
When raising finance large firms, since they are household names, can easily borrow money from
commercial banks and negotiate for lower interest rates. In addition, they have more advantages
because they offer better security to bankers than a briefcase businessperson. Large firms can also
raise new capital at a lower cost through the issue of shares, company bonds or commercial paper.
Therefore, it is generally accepted that larger firms can raise funds more easily and cheaply than
small firms.
 Technical Economies
The advantages of division of labour and specialization can be achieved, as the plant grows in size
and output increases, it becomes more possible for labour to undertake more specialized activities.
This increases efficiency and reduces costs per unit.
The firm can also buy specialized sophisticated machinery, this is utilized more efficiently if
operation is on a large scale. There is greater use of advanced machinery. Some machines are
worth using beyond a minimum level of output, which maybe beyond the capacity of a small firm.
For example the use of combine harvesters by commercial farmers, compared to its use by small
subsistence farmers with less than an acre of land.
More resources are devoted to research and development because resources are borne over more
units of output in large firms, this leads to further technical improvements, more cost reductions.

 Managerial Economies
The division of labour can be introduced into the task of management. The function of
management is divided into production, sales, finance etc. A large firm can afford to hire
specialists in different fields, which is an efficient use of labour resources.
 Commercial or Trading Economies
The large firm achieves economies both in buying raw materials and other inputs, as well as in
selling finished products.
Favourable terms are granted to a large firm since it buys in bulk and may get discounts. It can
afford to employ specialist buyers.
The cost per unit of advertising on television may be expensive for a small firm, but far lower for a
firm with a high output. Therefore, there are reduced costs per unit in advertising, sales promotion
and distribution.
 Welfare
Large firms are in a position to increase production by improving the condition of service of their
employees through the provision of facilities such as transport, clinics, sport and other recreation
facilities.
2.2 EXTERNAL ECONOMIES
External economies are advantages of an increased scale possible to all firms in an industry. They
are influenced by the growth of the industry as a whole.
External economies occur when an industry is concentrated in one area, and the local economy
evolves around the industry. The industry is supplied with skilled labour force, specialist suppliers
etc. It is also associated with knowledge, new inventions and the discovery of new markets.
External economies are made outside the firm as a result of its location and occur when:
 A local skilled labour force is available

 Specialist local back up firms can supply raw materials, component parts or services.
They supply to a large market and achieve their own economies of scale, which are
passed on through lower input prices.
 An area has a good transport network
 An area has an excellent reputation for producing a particular good
 Firms in the industry may find a joint enterprise and share their research and development
facilities, to lower the overhead costs.

 As the industry grows in size, different firms within it specialize in different processes. A
good example of external economies of scale in Zambian is copper mining in the copper
belt province. A number of firms provide information, labour, machinery or component
parts that are required by the copper mining companies.
2.3 DISECONOMIES OF SCALE
These are problems of growth, unlimited expansion of scale of output may not necessarily result in
ever-decreasing costs per unit. There may be a point beyond which average costs begin to rise
again.
Cost
Output
Diseconomies of scale can be categorized in the same way as economies of scale.
2.4 INTERNAL DISECONOMIES OF SCALE
 Managerial diseconomies occur, as large firms are difficult to manage in relation to

effective control and coordination. The disadvantages of the division of labour, increasing
bureaucracy as the firm becomes too large and loss of control as management becomes
distanced from the shop floor.
 Labour relations affected, workers cease to feel that they belong: moral and motivation
fall.
 As the firm increases in size management may become complacent since it is less
vulnerable to competition from other firms. These complacency leads to inefficiency
termed “X” inefficiency.
 Decisions are not taken quickly
 Technical diseconomies occur, as the technical size of the plant may create large
administrative overheads.
 Trading diseconomies, which is mass standardized production verses individualism.

2.5 EXTERNAL DISECONOMIES OF SCALE
As the firm and industry grows it may be hampered by shortage of various types, for example,
- Local labour and raw materials become scarce and firms have to offer higher wages to
attract new workers or buy raw materials at high costs.
- Land, factories become scarce, and rents begin to rise. Roads become congested and so
transport costs begin to rise.
- Lack of markets for the firms‟ out put.
3.0 SMALL FIRMS
It is difficult to classify firms as small or large. This generally depends on whether one is residing
in a developed or in a developing country. Generally, small firms are classified by size relative to
other firms, for example
25 employees or less is a small firm

A turnover of K1 000 000 or less
Assets like 3 vehicles or less
A relatively small market share, and so on.
Small firms are largely found in retailing, financial and services like consultancies.
The number of small firms is high because the number of people being self-employed is growing
due to retrenchments. In addition, there is no formal sector growth to absorb the unemployed.
As the result, most governments have come up with a policy of advising and training people to
start small businesses.
Governments, mostly in developed countries, provide loans, loan guarantee schemes and working
capital as well as tax rebates.
Small firms compete with large firms and they owe their survival to the following:-
- They can adapt to customer needs quickly.

- They offer individualized service as opposed to mass production and standardized
products.
- There is personal involvement in the business by the owner.
- Flexible approach and personal relationship with customers and employees in addition,
- In addition, some products cannot be mass-produced, like spectacles, others have only a
limited demand for example custom made items, and some require little capital, like
window cleaning.

4.0 THE LOCATION OF INDUSTRY
A company will locate its factory and offices where it can achieve minimum costs and maximum
profits.
Principle influences on the location of industries are:-

- Nearness to raw materials especially where the raw materials are heavy and
bulky.
- Accessibility to the markets
- Nearness to the power supply
- Government policy
5.0 INTEGRATION OR AMALGAMATION OF FIRMS
This may be horizontal, vertical or lateral.
5.1 Horizontal Integration
Horizontal integration occurs when firms that are producing the same type of product, and are at
the same stage of the production process, join together. An example is if Kafue Textiles acquires
or combines with Mulungushi Textiles.
The reasons for horizontal integration would be for firms to:
- Obtain economies of scale

- Increase market share
- Fight off imports
- Pool technology
5.2 Vertical Integration
This is the amalgamation of firms engaged in different stages of production, it may be towards a
source of raw materials, known as backward vertical integration, an example is if Zambeef
acquires a cattle ranch. Alternatively, it may be near to the market known as forward vertical
integration. An example is when an oil exploration company takes over an oil marketing company
like Total or British Petroleum.
Reasons for vertical integration:
- To eliminate transaction cost of middlemen

- To increase entry barriers for new competitors
- To secure raw material supplies
- To improve distribution network

5.3 Lateral Integration
This occurs when firms increase the size of their products. Concentration on one product may
make a firm vulnerable, hence the need to diversify. A firm may be vulnerable to a change in
fashion, a „recession‟ or a change in government policy.
Reasons for diversification:
- To minimize risks
- To make use of expertise by seeking challenging situation
- To achieve economies of scale
6.0 DISTRIBUTION OF GOODS

An individual firm in most cases is only a single link in a larger supply chain and distribution
channel. A firm‟s success depends on how well it performs as well as how well its entire
distribution channel competes with competitors‟ channels.
Distribution of goods refer to the methods by which producers transfer goods and services to
consumers. A variety of functions are involved in distribution, including stock management to
ensure continuous production, transporting of goods to consumers, proximity to the local market
and knowledge of that market in order to pursuer economies of scale, as well as major promotional
campaigns and the display of goods for sale.
In setting up a channel of distribution, a producer has to take into account the following:-
 The number of potential customers, their buying habits and their geographical location.
 Product characteristics such as whether the product is perishable, and therefore speed of
delivery is essential, or whether the product is customized and has to be distributed directly etc.
 The location, performance promotion, pricing policies and other characteristics of the
distributor.
 The channel choice of competitors, which maybe exclusive.
 The supplier‟s own characteristics, for example, is the supplier a market leader, more
importantly, does the supplier have a strong financial base to operate own distribution channel?

6.1 WHOLESALING AND RETAILING
This consists of many organizations bringing goods and services from point of production to point
of use.
Wholesaling includes all the activities involved in selling goods or services to those who are
buying for the purpose of resale or for business use.
Wholesalers stock in a range of products from competing producers to sell to retailers. Many
wholesalers specialize in particular products and perform many functions such as selling,
promoting, warehousing, transporting, financing, supplying market information, providing
management services etc.
Retailing includes all the activities involved in selling goods or services directly to households or
final consumers for their personal non-business use. Retailers are traders operating outlets. In
practice, there are different types of retailers, the majority are classified as store retailers, while
others are non-store retailers, and this number is growing at a fast rate. A good example in
Zambia is street vending.
Store retailers are further classified as:-
- Self-service, limited service or full service, depending on the amount of service

they provide.
- Speciality stores, department stores, supermarket stores, convenience stores etc,
depending on the product line sold.
- Discount stores or price retailers, this depends on the relative prices.
- Corporate chains, retail cooperatives, merchandising conglomerates etc.,
depending on whether retailers have banded together in corporate and
contractual retail organizations.
6.2 DISTRIBUTION CHANNELS
Producers sometimes distribute goods directly to consumers, but in most cases, the distribution is
done indirectly through a wide range of intermediaries between the original producer and the
ultimate consumer. Each layer of intermediary that performs some work in bringing the product
and its ownership closer to the final consumer is a channel level. Both the producer and the
consumer perform some work and therefore, they are part of every channel as shown below.

NUMBER OF INTERMEDIARIES/CHANNEL LEVELS
Zero One Two Three

Producers Producer Producers Producers
Agent
Wholesaler
Wholesaler
Retailer
Retailer Retailer
Consumer Consumer Consumer Consumer
Direct distribution
channel Indirect distribution channels
Note that in practice, there are other intermediaries, such as-
- Distributors and dealers who contract to buy a producer‟s goods and sell them to
customers. Distributors often promote the products and offer after sales service.
- Agents sell goods on behalf of suppliers and earn a commission on their sales.
- Franchisees are independent organizations, who trade under the name of a parent
organization in exchange for an initial fee and a share of the sales revenue.
However, the two major channels of distribution are the retailers and the wholesalers.
7.0 TOTAL REVENUE (TR)
This is the money the firm gets back from selling goods and is found by multiplying the number
sold, Q, by the selling price, P.
TR = (Q x P)
Average revenue AR, is the amount received from selling one item and equals the selling price of
the good, the price per unit.

AR = TR
Q
Marginal Revenue MR is the change in total revenue from the sale of one more unit of output.
MR = ∆TR
∆Q
Profit
Firms are profit maximisers. Profit is calculated as the difference between total revenue and total
costs.
P = TR - TC
It is private costs not social costs that are taken into account. The private cost to a motorist of
driving from Chipata to Lusaka is the cost of petrol and oil and the wear and tear on the car.
However, other people have to put up with the externalities of the journey, for instance the noise,
smell, pollution and traffic congestion the motorist helps to cause along the way.
Total revenue and total cost both vary with output. Total revenue starts from zero and increases
gradually, then flattens out as output and sales increase.
Total costs do not start from zero due to the element of fixed costs, they accelerate and become
steep as output increases.
Profits are at a maximum where the vertical distance is greatest, as shown in the diagram below.
Revenue TC
and
Costs
TR
Quantity
7.1 Profit maximising position

If MC is lower than MR, then profit increases by making and selling one more unit of output.
However, if MC is higher than MR, profits fall if one more unit is made or sold.

If MC is equal to MR, then the profit maximizing position has been reached, as shown below.
Profits are maximized where MC = MR.
AN IMPERFECT MARKET A PERFECT MARKET
MC Revenue MC
Revenue MR and
and Costs
Costs
MR
Quantity
Quantity
8.0 CHAPTER SUMMARY

As some firms expand, whether by mergers, diversification or take-overs, the firms enjoy
economies of scale, whereby there is a reduction in average total costs as output expands.
Economies of scale are of two types, internal and external.
Unfortunately, the growth is sometimes accompanied by problems of diseconomies of scale, which

are also of two types, internal and external diseconomies of scale. This causes the average total
cost to rise as output increases.
Small-scale production is equally important and continues to grow partly due to some limitations
on large-scale production.
Producers have to deliver goods and services to customers, this maybe done directly or indirectly
using a wide range of intermediaries such as agents, franchisees, dealers etc. However, the two
major channels of distribution are the wholesalers and the retailers.
Firms expand because of the desire to make more profits, enjoy the economies of scale etc. One
form of expansion is through amalgamation of firms, and this maybe vertical, horizontal or lateral
integration.
In Economics, the stated objective of firms is profit maximization, and it is attained where MR =
MC.

8.1 Summary of equations
TC = VC + FC
VC = TC – FC
FC = TC – VC
AC = TC/Q
TR = P x Q
AR = TR/Q
MC = ∆TC/∆Q
MR = ∆TR/∆Q
Social Cost = Private costs + Externalities = Social Cost

(Cost to individual) + (Cost to other people) = (Cost to everyone)
REVIEW QUESTIONS
1. What is the difference between internal and external economies of scale?

2. Give a brief description of four categories of internal economies of scale
3. Why might there be internal diseconomies of scale?
4. Give a brief description of two external economies of scale
5. What is the importance of the minimum efficiency scale?
6. Suggest three reasons for vertical integration.
7. How do small firms benefit an economy?
8. At what point is a firms‟ profit maximized?
9. Why should the long run average cost curve for a business eventually rise?
------------------------------------------------------------------------------------------------

From the following data of a firm:
Output Total cost Price
0 40 9
10 70 8
20 100 7
30 140 6
40 180 5
50 200 4
i) You are required to calculate at each level of output

a) The firm‟s total revenue (3 marks)
b) The firm‟s marginal revenue and average revenue (3 marks)
c) The firm‟s fixed costs (1 mark)
d) The firm‟s marginal cost (3 marks)
e) The firm‟s average cost (3 marks)
f) The firm‟s profit levels (3 marks)
ii) State the type of market the firm is operating in

(1 mark)
iii) At what level of output will the firm aim to produce, state the reason.
(2 marks)
iv) State the relationship between average revenue and price (1 mark)
(Total: 20 marks)

CHAPTER 6
MARKET STUCTURES: PERFECT COMPETITION AND MONOPOLY

______________________________________________________________________________________________
 Explain what economists consider as perfectly competitive markets

 Draw and explain a perfectly competitive market
 Discuss the existence of one firm industries, a monopoly, the merits and demerits
 Draw a monopoly market structure
 Explain how pricing and output policies are determined under perfect competition and
monopoly
 Discuss the Economic assessment of normal and supernormal profits earned by firms
 Describe price discrimination
_______________________________________________________________________________________________
1.0 Markets
A “market” is not necessarily a geographical or physical location where people buy and sell like at
the city center market in Lusaka.
The modern usage of the word “market” is an exchange mechanism, an interpersonal institution
that brings together buyers and seller (both actual and potential) of particular products or services.
Markets are classified according to number and size of buyers and sellers, the type of product
bought and sold, the degree of mobility of resources, and the extent to which information is
accessible.
1.1 Market Structures
Markets are categorized into either perfect or imperfect based primarily on the degree of
competition, the number of firms supplying or selling the product, whether the product bought is
homogeneous (identical) or differentiated and whether firms can easily enter or exit the market.
The perfect market structure is composed of perfect competition, while the imperfect market
structure is made up of monopoly, monopolistic competition and oligopoly.
The continuum of market structures can be summarized as follows:

Very Perfect Very many firms in the
High competition market and a lot of product
is identical with no barriers
to entry.
Monopolistic Many firms in the market but

the product is not homogenous
However, there are no barriers
Degree of to entry.
competition
Oligopoly A few large firms, the capital

required acts as a natural barrier to entry. The product
may or may not be homogenous
Very Monopoly A single firm makes up the

Low industry. There are entry barriers.
2.0 Perfect Competition

Perfect competition has the following characteristics:
- There are many sellers and buyers in the market, both buyers and sellers are “small”, they
lack market power to influence the price of product. The price is determined by the market
forces of demand and supply. Individual producers and consumers are “price takers”.
- The product being traded is homogenous each firm‟s product is the same as what the
competitor is selling on the market.
- There are no barriers to entry, firms are free to enter and exit the market.
- There is perfect knowledge of market conditions. This perfect information is available to

every one, buyers and sellers at no extra cost.
Only the stock exchange and the foreign exchange markets are often cited as the closest examples
of this market structure.
2.1 Demand curve of a firm under perfect competition
No individual firm has market power, the market forces of demand and supply for the product
determine the price. Note that the price = average revenue = demand curve (P = AR = D)

D S Price
P P = AR = D
Quantity Quantity
The demand curve for the individual firm operating under a perfect market is a horizontal line. At
a given price of OP, the firm can sell as much as it can, whatever is taken to the market is bought,
and demand is infinite.
However, if an individual firm increases in price, even by a very small margin, demand reduces to
zero, since there is perfect market information, the product is homogenous and there are many
sellers.
2.2 Short run equilibrium position

The short run is defined as a period when at least one of the factors of production is fixed,
therefore it is possible in the short run for individual firms to make supernormal profits or losses.
Suppose the price determined by the market forces of demand and supply is high due to high
demand relative to supply.
Price Costs
D S and MC
Revenue
P MR
AC
0 Quantity 0 Q Quantity
The firm maximizes its profits when the price and output combination is such that the marginal
revenue of an additional unit of output is equal to the marginal cost of producing it. This is at
output OQ were MC = MR. At this level of output, the AR (representing TR) is much higher than
AC (representing TC). In short, the price charged is greater than the long run average costs

incurred, the difference are the supernormal profits made by the firm (represented by the shaded
area).
Alternatively, the firm can make losses if the price determined by the market forces of demand and
supply is low. This can happen when market demand is low while market supply is high.
Costs
Price and
Revenue MC
AC
D
S
0 Quantity 0 Q Quantity
The firm maximizes profits at output OQ where MC = MR, at this level of output, AC is much
higher than AR and the firm makes losses.
2.3 Long run equilibrium position

There are no barriers to entry, firms are free to enter and to exit. Profits and losses can only occur
in the short run. Where profits are made, they are competed away through the entry of new firms
and where losses are made, firms will leave.
AC
REVENUE AND
MC
COSTS
P= AR= MR
0
Q QUANTITY

The firm maximizes its profits at OQ where MC = MR. At this output level, AR is also equal to
AC. Individual firms earn normal profits only, in the long run.
In addition, at this level of output, AC is also equal to MC, the firm is operating at its most cost
effective point, where costs are at their lowest level, an indication that the firm is technically
efficient.
The firm is also allocatively (or economically) efficient since the price charged to the consumer
equals the marginal cost of its supply. The price is equal to the demand curve and the marginal
cost curve is in effect the individual firm‟s supply curve. Economic efficiency occurs where
demand equals supply.
The unique feature of the long run equilibrium position is that all firms in the industry have MR =
MC = AC = AR = P = D.
Perfect competition is a theoretical model, but it sets a benchmark for efficiency and firms should
strive to attain the desired benchmarks.
3.0 MONOPOLY
In this market structure, one firm is the sole supplier of a product or service that has no close
substitutes. The firm makes up the industry.
3.1 Characteristics
The following characteristics features must be met for a monopoly to exist.
- There is only one supplier of the product or services

- The product or service has no close substitutes
- There are barriers to entry
3.2 Demand curve
A monopolist being the sole supplier has market power and therefore the firm is a “price maker”.
However, the firm can only determine either the price or the quantity, but not both
at the same time. At high prices, few quantities are bought, while at low prices,
demand is high.
Therefore, the monopolist is faced with a downward sloping “normal” demand

curve.

Price
P = D = AR
Output
3.3 Equilibrium position

The firm maximizes its profit at OQ where MC = MR. The price charged, the average revenue is
greater than the average cost. This difference is the supernormal or Economic profits earned by the
monopolist, represented by the shaded area of the rectangle.
The monopolist is likely to earn supernormal profits in both the short run and the long run because
of the barriers to entry, the supernormal profits are not „competed away‟ by other firms.
The equilibrium position is illustrated in the diagram below.
AC
PRICE
MC
Economic
Profit
P
CO AR
LMR
0 Q* OUTPUT
3.4 Barriers to entry

Barriers limit competition in the market. Firms are prevented from increasing the supply, pushing
the supply curve to the right or pushing the demand curve to the left, which reduces the price, and
eliminates the supernormal profits.

Barriers to entry explain why monopolies continue to exist. Some of the entry barriers are as
follows:-
- Government legislation.
Governments may play a major role in the creation of monopolies. A good example is the
Zambia Electricity Supply Corporation (ZESCO), which is the sole supplier of electricity.
The government may also be more comfortable when one organization is marketing an
essential product like maize. Such as the former grain marketing boards (NAMBOARD) or
the Food Reserve Agency (FRA).
- Control of the source of supply for raw materials.
This gives the firm an advantage, as the other firms do not have access to the necessary raw
materials to produce a product.
- Legal barriers in terms of patent and copyrights
These grant a creative and innovative person or firm that has invented a product, written a
book, composed a song, the exclusive right to enjoy the benefits or profits from that work,
preventing others from exploiting that work.
- Immobility of factors of production.
Resources are not mobile, including labour. This is worsened by the formation of trade
unions and professional associations. In addition, a single firm may control a natural
resource such as copper, which is found in the copper belt, no close substitute, and no other
firm can set up a competing firm.
- Indivisibilities, the amount of fixed costs that a new firm would have to sustain would act
as a natural barrier to entry.
- The minimum efficiency scale, which is the level of output at which the average costs first
reach their minimum point, may be at a very high level. A new entrant might need to
spend a lot on advertising, and sales promotion in order to compete effectively with
existing companies and to increase the market share. The cost involved might again, act as
a natural barrier to entry.
3.5.0 Price discrimination

Price discrimination means charging different prices to different groups of consumers for the same
product or service. Price discrimination is the same product or service being sold at different prices
in different markets. A firm may increase its revenue by charging high prices in some markets
while lowering the price in other markets but the sales volume increases, given the fact that TR =
Quantity X Price. Either an increase in the quantity sold or an increase in the price leads to an
increase in the total revenue. A monopolist cannot control both the price and quantity even if the
firm is in an advantageous position and has market power.
3.5.1 Examples of price discrimination

- A car manufacturer who sells cars cheaply in export markets than on the local
market.
- Telephone charges during public holidays, weekends and at night are lower.
- Electricity and water charges are lower for domestic use than for commercial
use.
- The same electricity and water charges are lower in the high-density areas than

in the low-density areas.
- Rail fares and airfares practice price discrimination.
- A doctor or lawyer who varies fees depending on the wealth of the customer.
Generally, discrimination is by income, time, place or customer.
3.5.2 Basic conditions to practice price discrimination

For price discrimination to be possible, practicable and profitable, certain conditions must be
fulfilled.
- Control supply of product, which means imperfections in the market.

Discrimination is not possible under conditions of perfect competition.
- Consumers should be members of separate markets to prevent resale of the
product.
- Elasticities of demand must be different so that different prices may be charged.
- High prices are charged for inelastic markets and low prices for elastic markets,
and profits are maximized.
3.6 Regulations of monopolies
The barriers to entry explain the existence of monopolies, the question is whether monopolies are
harmful or beneficial. Monopolies operate against consumer interest and public policy. To this
end, governments regulate monopolies by forming monopoly regulation commissions to correct
the many inefficiencies resulting from lack of competition.
3.7 Arguments for monopolies
- To achieve economies of scale as a single firm supplies to the whole market. Large scale
production results in a reduction in average costs. The consumer is likely to benefit from
efficiencies through lower prices.
- The supernormal profits that monopolists make, enable the firm to be innovative and spend
on research and development. Society gains by having new products on the market.
- It is easier for a large firm to raise capital, again this enables the firm to be innovative and
spend on research and development.
- Through practicing price discrimination, monopolists ensure that the rich as well as the
poor benefit by enjoying the same or a similar product.
- Some monopolies are natural due to high ratio of fixed costs to variable costs there is less
contribution, which is less attractive, and as such, there are few competitors.
- Some governments feel that in some cases, production or distribution of, for example, gas,
electricity and water can be carried out more efficiently if it is in the hands of a monopolist.
Where there is competition, it would be wasteful and result in higher prices to consumers.

3.8 Arguments against monopolies
- At the profit maximizing level of output, prices are likely to be higher while output is less
than in a more competitive firm.
- The supernormal profits, which monopolies make, are naturally at the expense of
customers.
- Monopolies are not technically efficient. At the profit maximizing level, the costs
are not at their lowest level since the marginal cost is not equal to the average cost. This
also implies that monopolies are not allocatively or Economically efficient.
- Price discrimination is a restrictive practice carried out by monopolists.
- Monopolies are not threatened by competition, they tend to adopt a complacent Attitude
known as „x‟ inefficiency, and they may not be inclined to be innovative.
- The lower prices that monopolies charge once in a while because of lower costs are just
used to stifle competition.
- There may be diseconomies of large-scale production due to the size of the Monopoly firm.
The firm might become difficult to coordinate and control. Communication also becomes
difficult, the morale of workers is low etc.
4.0 CHAPTER SUMMARY
The market is an interpersonal institution that brings buyers and sellers together. A perfect market
consists of perfect competition, while the rest are considered to be imperfect. Many sellers and
buyers characterize a perfect market, the product is homogeneous, the information is perfect, and
there are no entry barriers in the market.
Firms operating in a perfect environment are price takers, in such an industry, market demand and
supply determine the price. Individual firms earn normal profits in the long run.
Monopoly is where there is only one firm in the market selling a product, which has no close
substitute. A monopolist creates barriers to entry, which maybe legal barriers to entry, or
otherwise, in order to enjoy supernormal profits.
Monopolists generally charge higher prices and produce lower output than firms operating under a
perfect market. Monopolies have a number of merits and demerits, one of which is price
discrimination.
Price discrimination is the charging of different prices to different customers for the same product
or service.

REVIEW QUESTIONS
1. What is a market?
2. What are the main assumptions of perfect competition?
3. What are the unique features of the long run equilibrium of a perfectly competitive firm?
4. What is allocative or Economic efficiency?
5. Explain the reasons for the existence of monopoly
6. In a monopoly, the firm fixes the price. What determines the quantity supplied?
7. Give two reasons to justify monopolies
8. What is price discrimination?
9. Mention the conditions necessary to practice price discrimination
10. What is the aim of price discrimination?
11. From the figures below
OUTPUT Total
(units) Revenue
50 500
60 600
70 700
80 800
90 900
100 1000
110 1100
120 1200
a) Calculate the average revenue

b) Calculate the marginal revenue
c) Draw the average revenue curve
d) Determine the market structure
12. From the figures below
OUTPUT Total
(units) Revenue
50 750
60 840
70 910
80 960
90 990
100 1000

a) Calculate the average revenue
b) Calculate the marginal revenue
c) Draw the average revenue (demand) curve
d) Determine the market structure
13. Mention some differences between perfect competition and monopoly
a) What are the main features of the perfectly competitive market? (6 marks)
b) With the help of well-labeled diagrams, compare the long run equilibrium of a firm under a
perfectly competitive market structure and a monopoly market structure. (14 marks)
(Total: 20 marks)

CHAPTER 7
MONOPOLISTIC COMPETITION AND OLIGOPOLY

______________________________________________________________________________________________
 Explain imperfect market structures – monopolistic competition and oligopoly

 Describe the main characteristics, pricing and output policies of monopolistic competition
 Explain the significance of product differentiation
 Draw and understand the standard graph relating to monopolistic competition
 Explain the implications of monopolistic competition
 Describe the main characteristics, pricing and output policies of oligopoly
 Draw and understand the standard graph relating to oligopoly markets
 Explain why some firms sometimes enter into agreements not to compete against each
other
_______________________________________________________________________________
1.0 MONOPOLISTIC COMPETITION
Monopolistic Competition combines features of perfect competition and monopoly.
1.1 Characteristics of monopolistic competition
- A large number of sellers or firms in the market

- A large number of buyers
- There are no barriers to entry, firms are free to enter and leave the market.
- The products are not homogeneous but are differentiated through product differentiation
and non-price competition, such as the use of brand names, attractive packaging, extensive
advertising, offering guarantees, good after sales services etc.
1.2 Demand curve
Firms under monopolistic competition attempt to monopolise the industry through product
differentiation, this gives firms some influence on price charged, as a sign that they are „price
makers‟. An individual firm is faced with a normal downward sloping demand curve, even if the
demand curve is more elastic due to competition from close substitutes.
Price
P = D = AR
Output

1.3 Short run equilibrium position
The pricing and output determination in the short run is similar to that of a monopolist since firms
have some market power because of product differentiation.
Individual firms under monopolistic competition maximise profits where MC = MR. At this level
of output, the AR is greater than the AC, therefore the firm makes supernormal profits just like
monopolies.
AC
REVENUE
AND MC
COSTS
Economic
Profit
P
AR
CO
MR
0 Q* OUTPUT
The supernormal profits attract new entrants into the market, since there are no entry barriers.
Rival firms produce products that are similar, but somewhat differentiated. This causes the short
run demand curve for an individual firm to be pushed to the left, as the supernormal profits are
competed away.
1.4 Long run equilibrium position
Individual firms as usual, maximize profits where MC = MR, in the long run the AR is also equal
to the AC and therefore the firm only makes normal profits, as shown below.

Revenue
and costs MC
AC
AR
MR
0 Q Quantity
IMPLICATIONS OF MONOPOLISTIC COMPETITION
- The long run equilibrium position is not at a point where AC is minimized, therefore, there
is no technical efficiency.
- A waste of resources like in a monopoly because prices are high while output is low
compared to a firm under perfect competition. Firms unable to expand output to the level
where AC is at a minimum, an indication that there is excess capacity.
- There is no allocative or Economic efficiency.
- It is considered wasteful to produce a wide variety of differentiated versions of the same
product.
- The extensive advertising is also considered wasteful.
It is also argued that monopolistic competition is not wasteful as it provides consumers with
choices, the differentiated versions of the same product is for the benefit of consumers, besides,
rational buyers should opt for the least cost good.
2.0 OLIGOPOLY
This is a market structure with a few large firms. The number of firms is few, but the capital
involved is large. The huge amounts of capital act as natural barriers to entry.

2.1 Introduction
The oligopoly market structure is based on a number of assumptions, which makes it rather
different from the market structures studied earlier. It maybe a perfect oligopoly, which means the
product is homogeneous, such as the oil marketing companies in Zambia, British Petroleum,
Caltex, Mobil, Agip, Total, Engen, etc. Alternatively, the product maybe differentiated, this is
known as imperfect oligopoly. An example is the Japanese motor vehicle manufacturers like
Nissan, Toyota, Honda, Mitsubishi, Isuzu.
2.2 Characteristics
- Interdependence between firms, this is because an individual firm is uncertain of the

behaviour of rival firms.
- Price stability
- Non-price competition between firms
2.3 Demand curve
The shape of the demand curve depends on the assumption of the pricing policy of an individual
firm. A firm operating under conditions of oligopoly might adopt a number of pricing strategies
such as
- Firms collude on pricing and or output policies, they may form cartels or price rings,
known as collusive oligopoly.
- A firm may become a price leader, initiating a price change, then the rival firms follow suit.
- A firm may decide simply to be a price follower, awaiting the pricing decisions of other
firms.
- The firm‟s demand curve is based on the assumption that an oligopoly firm, which is
competing, with rival oligopoly firms decide on its own price and output levels. Even
then, the firm‟s decisions are influenced by what the rival firms can do, hence the kinked
demand curve model.
Firms are few, and each firm has some market power, therefore the action of one firm affects the
market share of the rival firms. Suppose the firm increases the price above OP, and then if the rival
firms do not increase their prices, the result would be a reduction in sales and a fall in the market
share. This means that demand is elastic above OP, the price of the rival firms will be relatively
lower.
Price
D
Elastic demand curve
P
D
O
Quantity

Note that there is no explanation as to how the price is actually determined to be at OP.
If the firm lowers the price in an attempt to increase the sales and the market share, then the rival
firms are likely to follow suit, as they would not like to lose their market share. This implies that
the whole industry would suffer, the same quantities would be sold, but at reduced prices!
Demand is therefore inelastic below OP
Price
Inelastic demand curve

P
0 Q Quantity
An oligopolist‟s demand curve is a combination of the elastic and the inelastic demand curves,
where the two curves intersect, a kink is formed, hence the name kinked demand curve.
Price
D
Kink
D = AR = P
Quantity

A more detailed diagram
Revenue and
Costs
MC1
MC2
0 Q MR AR Q uantity
In the detailed diagram, the MR curve has a vertical discontinuity where the elastic demand curve
changes to inelastic demand curve (where there is a kink) on the AR/demand curve. The
discontinuity is explained by the fact that at prices higher than OP the MR curve corresponds to the
inelastic demand curve while at prices below OP the MR curve corresponds with an elastic
demand or AR curve.
The kinked demand curve reemphasizes why an oligopolist might have to accept price stability in
the market. An individual firm cannot afford either to reduce or to increase the price, as this leads
to a change in the market share.
3.0 CHAPTER SUMMARY
Monopolistic competition combines the features of perfect competition and monopoly. Like
perfect competition, there are a number of buyers and sellers with no barriers to entry. However,
the products are differentiated. Differentiated products are similar but not identical; the products
are close substitutes to each other.
Product differentiation gives firms operating under monopolistic competition some form of market
power, just like under monopoly. Therefore, the firms are able to earn supernormal profits.
Lack of entry barriers causes the supernormal profits to be competed away in the long-run, and the
firms operating under monopoly can only earn normal profits in the long run, just like firms under
perfect competition.

However, there are some implications of firms operating under monopolistic competition
compared to firms under perfect competition, in the long-run, where there are normal profits for
both firms. Prices are high, output is lower, and resources are wasted under monopolistic
competition.
Oligopoly is defined as where there are a few large firms in the market. Oligopolistic markets do
not have a standard analysis. The main characteristic feature is that an individual firm‟s production
decisions in such markets are interdependent, as they affect rival firms. This major feature of
oligopoly markets is what leads to the kinked demand curve model.
When groups of oligopoly firms agree on the price, and or output policies, then a cartel has been
formed.
REVIEW QUESTIONS
1. Write two ways in which a firm operating under monopolistic competition can practice
product differentiation
2. What is the importance of product differentiation in monopolistic competition?
3. What is a cartel?
4. How is the oligopoly market structure different from other market structures?
5. What is meant by non-price competition?
6. Mention the implication of the kinked demand curve model for price and output by an
oligopoly firm?
7. Draw a kinked demand curve
---------------------------------------------------------------------------
a) In what ways does monopolistic competition differ from perfect competition? (12 Marks)
b) Is it correct to describe monopolistic competition as wasteful? (4 Marks)
c) What is product differentiation? (4 Marks)
(TOTAL: 20 MARKS)


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ZICA

ZICA ACCOUNTANCY PROGRAMME

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

After studying this chapter, the students should be able to:

 Appreciate the subject matter of Economics

1.0 INTRODUCTION – THE SUBJECT MATTER OF ECONOMICS

(a) Microeconomics, which deals with individual economic decision makers or

Economics assumes that these individual economic units behave rationally:

Economics as a subject makes use of normative statements of Economic and social

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

1.1 Factors of production

1) It is a “gift of nature”, man has done nothing to bring it about.

The Law of Diminishing Returns.

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

Number of workers Output per year Addition to Output

Fig: 1 The law of Diminishing Returns

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

- Total population of a country

Quality, efficiency or productivity of labour varies, depending on a number of issues, such as

1.2 PRODUCTION POSSIBILITY CURVE

Fig: 2 Production Possibility Curve

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

1.3 ECONOMIC GROWTH AND ECONOMIC WELFARE

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

Unfortunately, there are a number of disadvantages associated with economic growth. It is

1.4 ECONOMIC SYSTEMS

There are three (3) main Economic systems:

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

- Marked inequalities in income and wealth distribution.

b) PLANNED (COMMAND) ECONOMY

The central planning authority can ensure that

c) MIXED ECONOMIC SYSTEM

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

1. What is the basic Economic problem facing all economies?

EXAM TYPE QUESTION 1.1

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

EXAM TYPE QUESTION 1.2

a) What is meant by the law of diminishing returns (6 Marks)

i) Motor car production (2 Marks)

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

SUPPLY AND DEMAND

After studying this chapter, the students should be able to:

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

Below is Mr Banda‟s demand schedule for mangoes in the month of November.

Price (K) Quantity demanded (units)

1.3 DEMAND CURVE

FIG 3: DEMAND CURVE

An increase in price from OP to OP1 causes a contraction in demand from OQ to OQ1.

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

1.4 UTILITY THEORY

Marginal utility of good A = MUB = MUC

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME

1.5 A CHANGE IN DEMAND

The following are the main influences on demand:

 The price of other goods

MICRO-ECONOMICS (ZICA) ACCOUNTING PROGRAMME