DEPARTMENT OF ECONOMICS AND DEVELOPMENT STUDIES

P.O. Box 342-01000

Thika
Email: Info@mku.ac.ke
Web: www.mku.ac.ke

UNIT CODE: BED2206

UNIT NAME: INTERMEDIATE MICROECONOMICS

Instructional Material for Distance Learning

Compiled by Mr Forah Obebo, MSC (Fin Econ), B.A (Econ), CPA (K) (Part III)

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COURSE OUTLINE
Contact hours: 42

Pre-requisites: BBM 115, Introduction to Microeconomics

Purpose:
To understand and appreciate the importance of the various economics activities and equip
learners with skills that helps them actively play a practical role in economic analysis.

Expected Learning Outcomes:

By the end of the course unit the learners should be able to:-
i) Discuss economic problems faced by different types of economic systems
ii) Discuss intermediate welfare economics, economic efficiency, welfare efficiency
and compensation
iii) Explain causes and methods of dealing with externalities

Course Content
Consumer Behavior: Analyzing Economic Problems, Supply and Demand Analysis,
Consumer Preferences, Utility and the Concept of Utility, Indifference curves, Consumer
Surplus, Consumer Choice, the Theory of Demand Buying and selling and Inter-temporal
Choice.
Firms and Perfect Competition: Costs Minimization, Cost Curves, Inputs and Production
Functions, Perfectly Competitive Markets, Competitive Markets, Firm Supply, Profit
Maximization.
Imperfect Markets, General Equilibrium and Welfare: Market Structure and Imperfect
Competition, oligopoly and monopoly, Market Failures, Welfare and Elements of Public
Policy and Public Goods.
Elements of Game Theory and Strategic Behavior, General Equilibrium, Industry
Equilibrium,

Course Delivery Plan

WEEK 1 &2 TOPIC 1 Economic Models

INTRODUCTION Economic Problems
Economic Systems
Economic Theory

WEEK 3 &4 TOPIC 2 Supply and demand analysis

CONSUMER Consumer preferences.
THEORY

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WEEK 5 & 6 TOPIC 3 Concept of utility
CONSUMER Indifference curves
SURPLUS Consumer choice

WEEK 7 & 8 TOPIC 3 Cost minimization

INTERMEDIATE Cost curves
THEORY OF THE Perfectly competitive market
FIRM Monopolistic competition
Monopoly and oligopoly
WEEK 9 & 10 TOPIC 4 General equilibrium
ELEMENTS OF Industry equilibrium
GAME THEORY

WEEK 11& 12 Economic efficiency

TOPIC 5
INTERMEDIATE Welfare criteria and compensation test
WELFARE Public goods and externalities
ECONOMICS Methods of dealing with externalities
WEEK 13 &14 TOPIC 6 Theories and distribution
FACTOR MARKET A) Rent
B) interest
C) Profit

Teaching / Learning Methodologies: Lectures and tutorials; group discussion;

demonstration; Individual assignment; Case studies

Instructional Materials and Equipment: Projector; test books; design catalogues;

computer laboratory; design software; simulators

Course Assessment
Examination - 70%; Continuous Assessment Test (CATS) - 20%; Assignments - 10%;
Total - 100%

Recommended Text Books:

i. Alan Griffiths, Stuart Wall(Mar 2000), Intermediate Microeconomics: Theory and
Applications 2nd Ed.
ii. Miller, R. L. and D. Van Hoose, (2003). Macroeconomics: Theories, Policies, and
International Applications, South West College Publishing,
iii. Burda, M. and C. Wyplosz. (2001) Macroeconomics: A European Text 3rd Ed.
Oxford: Oxford University Press,

Text Books for further Reading:

i. Gordon, Robert (2001). Macroeconomics, 8th Ed., MA: Addison Wesley Longman.
ii. Bain, K. and P. Howells, (2003). Monetary Economics. Palgrave
iii. Handa, Jagdish , (2000). Monetary Economics. Routledge

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TABLE OF CONTENTS

CHAPTER ONE: INTRODUCTION…………………………………………. 6

1.1 Definition of economics…………………………………………………….... 7
1.2 Basic Economic Concepts …………………………………………………… 7
1.3 The Basic Analytical Framework of Modern Economic………....................... 11
1.4 Role of Economic Theory……………………………………………………. 13
1.5 Limitation of Economic Theory……………………………………………… 14
1.6 Review Questions…………………………………………………………….. 17

CHAPTER TWO: CONSUMER BEHAVIOUR THEORY………… 17

2.1 Approaches to measuring Utility……………………………………... 17
2.2 Indifference curves…………………………………………………………… 19
2.3 Budget Lines…………………………………………………………………. 27
2.4 The equilibrium under ordinal approach……………………………………... 28
2.5 Revealed Preference………………………………………………………….. 34
2.6 Mathematical Derivation of Consumer Equilibrium………………………….. 40
2.7 Review Questions…………………………………………………………….. 44

CHAPTER THREE: THEORY OF PRODUCTION………………………… 45

3.1 Production technology………………………………………… 45
3.2 Short run and long run cost……………………………………………………. 49
3.3 Returns to Scale……………………………………………………………….. 52
3.4 Economies of scale…………………………………………………………….. 56
3.5 Profit Maximization……………………………………………………………. 58
3.6 Cost Minimization……………………………………………………………… 61
3.7 Review Questions…………………………………………………………….... 64

CHAPTER FOUR: THE FIRM AND MARKET STRUCTURES………….. 64

4.1 Introduction……………………………………………………………………. 65
4.2 Perfectly competitive market…………………………………………………... 65
4.3 Monopoly market………………………………………………………………. 69
4.4 Monopolistic Competition……………………………………………………… 74
4.5 Effect of tax on monopoly …………………………………………………….. 77
4.6 Oligopoly Pricing Technique…………………………………………………… 78
4.7 Review Questions………………………………………………………………. 81

CHAPTER FIVE: ELEMENTS OF GAME THEORY………………………. 82

5.1 Introduction……………………………………………………………………. 82
5.2 Prisoners Dilemma:…………………………………………………………….. 83
5.3 Definition of Key terms in Game Theory……………………………………… 84
5.4 Characteristics of games ………………………………………………………. 86
5.5 Nash Equilibrium………………………………………………………………. 86
5.6 Oligopoly and Game Theory: …………………………………………………. 88
5.7 Review Questions……………………………………………………………… 91
CHAPTER 6: GENERAL EQUILIBRIUM…………………………………… 91

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6.1 Efficiency of exchange………………………………………………………… 91
6.2 The Edgeworth Box Diagram………………………………………………….. 92
6.3 Review Questions……………………………………………………………… 92

CHAPTER 7 : CHAPTER TWO: PUBLIC GOODS,MARKET FAILURE AND

EXTERNALITIES……………………………………………………………… 96
7.1 Characteristics of Public Goods…………………….………………………… 96
7.2 Market Failure: ……………………………………………………………….. 98
7.3 Review Questions……………………………………………………………... 98

SAMPLE QUESTION PAPERS

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CHAPTER ONE: INTRODUCTION

Learning Objectives

By the end of this chapter the learner should be able to:

i) Explain the nature of modern economics.

ii) Explain the relationship between mathematics and micro-economics.
iii) Outline Key Assumptions and Desired Properties Commonly Used Economics
iv) Explain The Basic Analytical Framework of Modern Economics
v) Understand Methodologies for Studying Modern Economics
vi) Understand the limitations of economy theory

1.1 Definition of economics

Economics is derived from a Greek word meaning “the management of household.” The
word Economics has its origin in the Greek word oikonomos meaning a steward.
The two parts of this word, oikos- house and nomos- manager show what economics is all
about. How do we manage our house, what kind of stewardship do we render to our
families, to the nation, to our descendants?

Economics is a social science that studies how individuals and society choose to allocate
their scarce resources to provide goods and services in order to satisfy their needs and
wants effectively. Economics as a discipline of study examines the allocation of a society’s
resources among alternative uses at a point in time, the changes in allocation, distribution
and production of total output over time and the efficiencies and inefficiencies of economic
systems.

1.1.1: The Economic problem

Human wants are unlimited but the means of satisfying them is limited. Even after
satisfaction of certain wants, new wants arise and the means of satisfying them may become
quite inadequate. The economic problem arises because the individuals’ wants are virtually
unlimited, whilst the resources to satisfy them are scarce.

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Due to scarcity of resources individuals have to make a choice on which needs/wants to
satisfy and which to sacrifice. Satisfaction of one thing implies sacrifice of another and
hence opportunity cost i.e. value of best forgone alternative. This choice relates to the
basic economic problems.

1.1.2 Basic economic problems

There are three basic economic questions:

 What to produce – which product and how much
 How to produce – the method/means/technology
 For whom to produce- the need/want/market/allocation
What to produce
This refers to the various goods and services that satisfy human wants. They include:
 Consumer goods – demanded in the form in which they are for consumption e.g.
soda, shoe brush
 Producer goods – for production of other goods e.g. cooking stick
 Intermediate goods – demanded for further processing e.g. garment for clothing
 Final goods – finished goods for final use
 Private goods – owned by private individuals for private use e.g. cloth
 Public goods – owned by government for public use
 Economic goods/resources – scarce and have monetary value and utility
 Free goods – with no price
 Homogeneous goods – uniform/similar goods
 Heterogeneous goods – different/dissimilar goods

How to produce
This is related to factors of production or production process. Production is creation of
utility for satisfaction. It is arranging inputs to realize outputs for final goods and services
to satisfy human wants.
There are four factors of production: land, labour, capital and entrepreneurship or
organization. Two main techniques or methods of production:

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  Labor Intensive: more units of labour are combined with few units of capital to
produce a given amount of output.
 Capital Intensive: more units of capital are combined with few units of labour to
produce a given amount of output.

For whom to produce

This depends on demand which also depends on returns to factors of production. The three
basic questions above form the basis of economic systems which deal with the decision
making.
 Free Market Economic System
 Central Planned Economic System
 Mixed Economies

1.2 Basic Economic Concepts

 Positive economics is concerned with the investigation of the ways in which
different economic agents in the society seek to achieve their goals. For instance
analysis of profit maximizing behavior of a firm. It is concerned with propositions
that can tested by reference to empirical evidence. It relates to statements of what is,
was or will be. For example, the statement: increased public expenditure will
increase employment but increase the rate of inflation.
 Normative economics is concerned with propositions that are based on value
judgments, that is statements which are expressions of opinions i.e. what ought to be
or what should be. It depends on our value judgments about what is good or bad
and is thus integrated with our philosophical, cultural and religious positions.
 Wants: Wants are related to human needs. Primary and secondary needs
 Scarcity: Situation where means (resources) to satisfy human wants are inadequate.
The demand is greater than the supply
 Choice: Allocation of resources to meet certain wants.
 Opportunity costs: The value of the best foregone alternative in satisfaction of
human wants. For example a person may decide to buy a car instead of land. In this
case the land is the opportunity cost.

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 Utility: satisfaction derived from consumption of particular goods and services.
Four dimensions of utility: form, time, place and possession utility.
 Marginal utility: Refers to the extra level of satisfaction derived by individuals
from consuming additional units of a commodity
 Wealth: A country’s stock of resources and goods that can be used to satisfy wants
 Welfare: The level of satisfaction that a person or group of persons derives from the
consumption of goods and services
 An economic model : Simplified description of reality that is used to understand
and predict an economic event. For example demand of a product can be said to
depend on its price and consumer’s income.
 Households: The consumers of goods and services produced and the suppliers of
productive resources.
 Firms: Decision making business units that decide what to produce and employ
productive resources. This includes sole proprietorship, partnership, government etc.
 Equity: Fairness of the treatment of different individuals or groups in society
 Pareto efficiency: A situation in which it is not possible to make someone better off
without making someone else worse off
 Welfare economics: The study of the impact of the pattern of resource allocation on
society’s well-being (welfare)
 Production possibility frontier (PPF): The PPF is a curve showing all the possible
combination of two goods which can be produced by the society’s resources when
they are fully utilized (full employment)

For example: Kenya produces Coffee and Tea as shown in the table:
Combination A B C D E F
Tea (‘000 T) 0 1 2 3 4 5
Coffee (‘000T) 19 18 16 13 8 0

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Production possibility frontier curve

Coffee

Tea

In the PPF combinations along the curve show maximum utilization of resources hence
efficiency. Points above it show unattainable combinations while points below it show
wastage of resources.
Production of a particular good/service implies sacrifice of another (opportunity cost) due to
scarcity of resources and hence the need to make a choice of what to produce and how
much. As more units of a product are produced, its opportunity costs per unit keep on
increasing and thus the law of increasing cost.

The Law of Increasing Opportunity Cost

States that the opportunity cost increases as production of one output expands. This causes
the PPC to display the bowed-out shape. This is because all workers are not equally suited
to producing one good, compared to producing another

Shifting the PPC

The production capacity is not permanently fixed. If either the resources base increases or
technology advances, the economy experiences economic growth, and the PPC shifts
upwards. Economic Growth is the ability of the economy to produce greater level of output,
represented by an outward shift of its PPC

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 PPC 2

PPC 1
A* B*

1.3 The Basic Analytical Framework of Modern Economics

The basic analytical framework for an economic theory consists of five aspects or steps:
1.3.1 Specification of Economic Environments
The first step for studying an economic issue is to specify the economic environment. The
specification on economic environment can be divided into two levels namely: description
of the economic environment, and Characterization of the economic environment.

To perform these well, the description is a job of science, and the characterization is a job
of art. The more clear and accurate the description of the economic environment is, the
higher the possibility is of the correctness of the theoretical conclusions. The more refined
the characterization of the economic environment is, the simpler and easier the arguments
and conclusions will obtain.

Modern economics provides various perspectives or angles to look at real world

economic issues. An economic phenomenon or issue may be very complicated and be
affected by many factors. The approach of characterizing the economic environment can
grasp the most essential factors of the issue and take our attention to the most key and
core characteristics of an issue so that we can avoid unimportant details. An economic
environment usually consists of
 A number of individuals,

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  The individuals' characteristics, such as preferences, technologies, endowment
 Informational structures, and
 Institutional economic environments that include fundamental rules for
establishing the basis for production, exchange, and distribution.

1.3.2 Imposition of Behavior Assumptions

The second step for studying an economic issue is to make assumptions on individuals'
behavior. Making appropriate assumptions is of fundamental importance for obtaining a
valuable economic theory or assessment. A key assumption modern economics makes
about an individual's behavior is that an individual is self-interested.

This is a main difference between individuals and other subjects. The self-
interested behavior assumption is not only reasonable and realistic, but also has a
minimum risk. Even this assumption is not suitable to an economic environment; it does
not cause a big trouble to the economy even if it is applied to the economy. A rule of a
game designed for self- interested individuals is likely also suitable for altruists, but the
reverse is likely not true.

1.3.3. Adoption of Economic Institutional Arrangement

The third step for studying an economic issue is to adopt the economic institutional
arrangements, which are also called economic mechanisms, which can be regarded as the
rules of the game. Depending on the problem under consideration, an economic
institutional arrangement could be exogenously given or endogenously determined. For
instance, when studying individuals' decisions in the theories of consumers and
producers, one implicitly assumes that the undertaken mechanism is a competitive market
mechanism takes it as given. However, when considering the choice of economic
institutions and arguing the optimality of the market mechanism, the market institution is
endogenously determined. The alternative mechanisms that are designed to solve the
problem of market failure are also endogenously determined. Economic arrangements
should be designed differently for different economic environments and behavior
assumptions.

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1.3.4 Determination of Equilibrium
The fourth step for studying an economic issue is to make trade-off choices and
determine the "best" one. Once given an economic environment, institutional
arrangement, and other constraints, such as technical, resource, and budget constraints,
individuals will react, based on their incentives and own behavior, and choose an
outcome from among the available or feasible outcomes. Such a state is called
equilibrium and the outcome an equilibrium outcome.

1.3.5. Evaluation
The fifth step in studying an economic issue is to evaluate outcomes resulting from the
undertaken institutional arrangement and to make value judgments of the chosen
equilibrium outcome and economic mechanism based on certain criterion.
The most important criterion adopted in modern economics is the notion of efficiency or
the \first best". If an outcome is not efficient, there is room for improvement. The other
criterions include equity, fairness, incentive-compatibility, informational efficiency, and
operation costs for running an economic mechanism. In summary, in studying an
economic issue, one should start by specifying economic environments and then study how
individuals interact under the self-interested motion of the individuals within an
exogenously given or endogenously determined mechanism.

Economists usually use \equilibrium," \efficiency", \information", and \incentive-

compatibility" as focal points, and investigate the effects of various economic
mechanisms on the behavior of agents and economic units, show how individuals reach
equilibria, and evaluate the status at equilibrium. Analyzing an economic problem using
such a basic analytical framework has not only consistence in methodology, but also in
getting surprising (but logically consistent) conclusions.

1.4 Role of Economic Theory

An economic theory has three important roles:
 It can be used to explain economic behavior and economic phenomena in the
real world.

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  It can make scientific predictions or deductions about possible outcomes and
consequences of adopted economic mechanisms when economic environments
and individuals' behavior are appropriately described.
 It can be used to refute faulty goals or projects before they are actually
undertaken. If a conclusion is not possible in theory, then it is not possible in a real
world setting, as long as the assumptions were approximated realistically.

1.5 Limitation of Economic Theory

When examining the generality of an economic theory, one should realize any theory or
assumption has a boundary, limitation, and applicable range of economic theory. Thus, two
common misunderstandings in economic theory should be avoided. One misunderstanding
is to over-evaluate the role of an economic theory. Every theory is based on some
imposed assumptions. Therefore, it is important to keep in mind that every theory is not
universal, cannot explain everything, but has its limitation and boundary of suitability.
When applying a theory to make an economic conclusion and discuss an economic
problem, it is important to notice the boundary, limitation, and applicable range of the
theory. It cannot be applied arbitrarily, or a wrong conclusion will be the result.

The other misunderstanding is to under-evaluate the role of an economic theory. Some

people consider an economic theory useless because they think assumptions imposed in the
theory are unrealistic. In fact, no theory, whether in economics, physics, or any other
science, is perfectly correct. The validity of a theory depends on whether or not it
succeeds in explaining and predicting the set of phenomena that it is intended to explain
and predict. Theories, therefore, are continually tested against observations.

The process of testing and refining theories is central to the development of modern
economics as a science. One example is the assumption of perfect competition. In reality,
no competition is perfect. Real world markets seldom achieve this ideal status. The
question is then not whether any particular market is perfectly competitive, almost no one
is. The appropriate question is to what degree models of perfect competition can generate
insights about real-world markets. We think this assumption is approximately correct in

14
certain situations.
Just like frictionless models in physics, such as in free falling body movement (no air
resistance), ideal gas (molecules do not collide), and ideal fluids, frictionless models
of perfect competition generate useful insights in the economic world. It is often heard
that someone is claiming they have toppled an existing theory or conclusion, or that
it has been overthrown, when some condition or assumption behind it is criticized. This is
usually needless claim, because any formal rigorous theory can be criticized at anytime
because no assumption can coincide fully with reality or cover everything. So, as long
as there are no logic errors or inconsistency in a theory, we cannot say that the theory is
wrong. We can only criticize it for being too limited or unrealistic.

What economists should do is to weaken or relax the assumptions, and obtain new
theories based on old theories. We cannot say though that the new theory topples the old
one, but instead that the new theory extends the old theory to cover more general
situations and different economic environments, boundary of a theory, we may get a
very bad consequence and hurt an economy seriously.

Some of the advantages of using mathematics are that (1)the \language" used and the
descriptions of assumptions are clearer, more accurate, and more precise, (2) the logical
process of analysis is more rigorous and clearly sets the boundaries and limitations of a
statement, (3) it can give a new result that may not be easily obtained through observation
alone, and (4) it can reduce unnecessary debates and improve or extend existing results.

It should be remarked that, although mathematics is of critical importance in modern

economics, economics is not mathematics. Economics uses mathematics as a tool in order
to model and analyze various economic problems. Statistics and econometrics are used to
test or measure the accuracy of our predication, and identify causalities among economic
variables.

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Review Questions
i) Define and explain different economic terms
ii) Describe the role of economic theory in studying economics
iii) Outline some of the shortcomings of economic theory
iv) Explain the role of mathematics in economic

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CHAPTER TWO: CONSUMER BEHAVIOUR THEORY

Learning Objectives

By the end of this chapter the learner should be able to:

i) Explain the concept of Budget Constraint
ii) Explain the concept of consumer Preferences
iii) Outline assumptions about preferences
iv) Define Indifference curves and illustrate the shapes of Indifferent Curves
v) Explain the concept of Marginal Rate of Substitution

2.1 Approaches to measuring Utility

In intermediate consumer behavior theory we are concerned with how consumers maximize
their total utility: Total Utility refers to the level of utility satisfaction derived from,
consuming a particular product. On the other hand marginal utility refers to the extra
satisfaction derived from the consumption of particular products.
Economists have two approaches to this:

2.1.1 Cardinal approach

This belongs to the Cardinalists who believed that utility is measurable in its own units
called utils. E.g. 10 crates of soda and 1 loaf of bread yields 1000 utils. The concept of
diminishing marginal utility was developed by the Cardinalists to justify their argument.
Equilibrium (cardinal approach): Lets assume a consumer has the option of choosing
between two goods x and y whose prices are Px and Py.
To maximize utility, (at equilibrium) the consumer will allocate his income such that the
utility he derives from an extra income on x equals the utility derived from an extra income
on y.

The equilibrium condition is stated as;

MUx = MUy
Px Py

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Example:
A consumer derives the following utilities by consuming several units of good x and y.
Prices for x and y are 2 and 3 per unit respectively. Based on the coordinal approach,
determine:

1. MUx, MUy, MUx/Px and MUy/Py

2. The equilibrium quantities of x and y which maximizes his or her utility.

Units Tux TUy MUx MUy MUX/Px Muy/Py

0 0 0 _ _ _ _
1 16 30 16 30 8 10
2 30 57 14 27 7 9
3 42 80 12 23 6 7.67
4 52 98 10 18 5 6
5 60 112 8 14 4 4.67
6 66 122 6 10 3 3.33
7 70 130 4 8 2 2.67
8 72 135 2 5 1 1.67
9 70 137 -2 2 -1 0.67
10 66 136 -4 -1 -2 -0.33

Solution
At maximum utility, MUx/Px = MUy/Py = 6
He or she will consume 3 units of x and 4 units of y.

2.1.2 Ordinal approach

This belongs to the ordinalists who argue that utility is not measurable objectively but rather
individuals rank the bundles of goods available to them in order of their preferences. E.g.
first, second, third etc.

Example: if Jane prefers goods A, B, C and D, in that order, then his preferences can be
expressed as A>B>C>D. The ordinalists use indifference curves and budget lines in
analyzing consumer demand.

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 2.2 Indifference curves
Refers to a curve which gives all the possible combinations of two goods which yield the
same level of utility to a consumer.

Good Y

15
A

B
10
C
5 Ux

0
4
Good X

The combinations along the curve give the same or equi-marginal utilities of A = B = C
because they are equally satisfying. A set of the above indifference curves gives an
indifference map.

Good
y
C

U3
B

A
U2

U1

Good x
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A<B<C because the indifference curves which are further away from the origin denote a
high level of satisfaction.

2.2.1: Consumer Preferences

The objects of consumer choice are consumption bundles. This is a complete list of the
goods and services that are involved in the choice problem faced by a consumer. Suppose
there are two consumption bundles (X 1 X 2 ) and (Y 1 Y 2 ).The consumer can rank them
as to their desirability. That is, the consumer can determine that one of the bundles is
strictly better than the other, or decide that she is indifferent between the two bundles.

2.2.2 Assumptions of consumer rationality

1. completeness
Consumers should be able to rank all their preferences over the entire field of
choice. It is assumed that any two bundles can be compared. That is, given any X
bundle and any Y bundle, then  X 1 X 2   Y1Y2  or Y1Y2    X 1 X 2  or both, in which
case the consumer is indifferent between the two bundles. This is to say that the
consumer can make a choice.
2. Transitivity
Consumer behavior should be transitive, if he has to rank good A, B and C, and that
A>B and B>C, then A>C. If  X 1 X 2   Y1Y2  and Y1Y2   Z1 Z 2  then we assume
that consumer thinks that X is at least as good as Y and that Y is at least as good as Z,
then the consumer thinks that X is at least as Z.
3. Non – satiation
The consumer will prefer more to less. That is he should prefer the highest possible
indifference curve.
4 Reflexive: We assume that any bundle is at least as good as itself
X 1 X 2   X 1 X 2 

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2.2.3 Shapes of Indifferent Curves

If no further assumptions about preferences are made, ICs can take very peculiar shapes.

1. Perfect Substitutes
Two goods are perfect substitutes if the consumer is willing to substitute one god for
the other at a constant rate. The simplest care of perfect substitutes occurs when the
consumer is willing to substitute the goods on a one to one basis. ICs for such a
consumer are all parallel straight lines.

X2

IC S
Linear ICs , perfect substitution

0 X1

2. Perfect Complements
Perfect complements are goods that are always consumed together in fixed
proportions, e.g. shoes (left and right). The ICs are L shaped, with the vertex of the
L occurring where the number of one good equals the number of the other good.

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 X2

0
X1

3. Bad Goods
A bad is a commodity that the consumer doesn’t like. Suppose that the two
commodities are meat and pepper, the consumer loves meat but dislikes pepper. But
suppose there is some trade off possible between meat and pepper i.e. there would
be some amount of meat in samosa that could compensate the consumer for having
to consume a given amount of pepper, if more pepper is given in the samosa, more
meat has to be given to compensate for having to put up with the pepper. Thus this
consumer will have indifference curves that slope up and to the right.

X2
Bad 

ICs

0 X1
Good 

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4. Neutral Goods
A good is a neutral good if the consumer doesn’t care about it one way or the other.
Suppose in the above case the consumer is just neutral about pepper  X 2  . The IC
would be vertical lines as depicted below. The consumer only cares about the
amount of X 1 and doesn’t care at all about how much of X 2 he/she has. The more

of X 1 the better but adding more X 2 doesn’t affect him.

X2

IC

Adding X 1

0 X1

5. Imperfect Substitutes
If the rate at which one good is substituted for another is not constant, but
diminishing, then the two goods are imperfect substitutes. As more and more of one
good is given up successively larger units of the other good are consumed to
compensate the consumer for the loss. Such goods will have indifference curves
that are rounded, i.e. the ICs are strictly convex.

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 X2

X1

2.2.4 The Magical Rate of Substitution

The slope of the indifference curve is known as the Marginal Rate of Substitution (MRS) . It
measures the rate at which the consumer is just willing to substitute one good for another.
Suppose that we take a little of good 1, X 1 away from the consumer. Then we give him
X 2 , an amount i.e. just sufficient to put him back on his/her IC, so that he is just as well
off after this substitution of X 2 for X 1 as he was before.

X 2
The ratio is thought as being the rate at which the consumer is willing to substitute
X 1
good 1 for good 2 and is called the MRS
Geometrically, we are offering the consumer an opportunity to move to any point along a
line with a slop E that passes through X 1 X 2 as depicted.

24
 IC
X2

X2

X 2
E
X 1

X1 X1

Moving up and to the left from X 1 to X 2 involves exchange of good 1 for good 2, and
moving down to the right involves exchanging good 2 for good 1. In either movement the
exchange rate is E. Since exchange always involves giving up one good in exchange for
another, the exchange rate E corresponds to slope at E.

2.2.5 Characteristics of indifference curves

1. Indifference curves should not intersect

2.
Y

A
Uo
B

U1 X
C

The above means that point A has two levels of utilities which is impossible. This violates
the assumption of transitivity because: A = B because they lie on the same line and
similarly A = C because they lie on same indifference curve therefore B = C which is not
correct.
25
 3. Indifference curves are downward sloping

As we substitute good x for good y, (moving from point A to B), more units of y are given
up as more units of x are obtained if the same level of utility is to be maintained.

A
Y

4. Indifference curves are convex to origin

If some units of y are to be given up, larger and larger amounts of x must be obtained to
compensate the consumer for the loss in utility and to live at the same level of satisfaction
therefore moving down the indifference curve the amount of y foregone keeps on declining
while the x units gained increases.
Convexity – defines the slope of indifference curve which is also referred to as the slope of
marginal rate of substitution

Good y

Good x

26
2.3 The budget line
This gives information about the consumers income and prices of goods x and y. The
Budget line refers to the curve giving all possible combinations of two goods a consumer
can buy from a given amount of money.
Example:
Suppose John has Kshs. 100 to spend on good x and y whose prices are Kshs 10 and 20.
Formulate an equation showing the various combinations.

10y + 20 x = 100 is the budget line

x 0 4
y 10 2

income exp. chart

12

10

8
good y

0
0 1 2 3 4 5
good x

Slope of curve = ∆ y/∆x = 8 /-4 = -2

The slope of the budget line is also given by the price ratios. To illustrate this, Let the
consumer’s consumption bundle be ( X1 X 2 ) where X 1 ,represents the number of units
the consumer chooses of good I and X 2 is the number of units of good to be chosen by the
consumer.
Let P 1 and P 2 represent the unit prices for the two goods respectively; and M to represent
the amount of money the consumer has to spend. The budget constraint of the consumer
can be written as:
27
 P1 X1 + P2 X2 = M

Where P 1 X 1 is expenditure for good I and P 2X 2 is expenditure on good 2 and M is the

income (assume perfect equality, where all the money is spent).

X2

M
P2 Budget line
P1
Slope  
P2

Budget set

M X1
P1

These are the bundles of goods that are affordable at the given prices and income. The
budget set consists of all bundles that are affordable at the given prices and income.

2.4. The equilibrium under ordinal approach

To derive consumer’s equilibrium under ordinal approach, we superimpose the indifference
curve on the budget line.

Good y

y E

Good x

28
At E the consumer can purchase the maximum units which will give him the maximum
utility. Equilibrium is given at E where the budget line is just tangent to an indifference
curve. Initially at E the indifference curve and the budget line are the same therefore the
equilibrium condition is therefore given as
MRSxy = Px / Py = Point E

2.4.1 Effects of change in income on consumer equilibrium

An increase in consumer income enables him or her to enjoy a higher level of utility. That
is the budget line shifts to the right but remains parallel to the original one.

I2
Income consumption curve

I • Increase in income

IC2

IC0

BL1 BL0
BL2

The line that joins together combinations of equilibriums of different incomes levels is call
the income consumption curve

2.4.3 Effects of change in price of good x on consumer equilibrium

The effect of this is to tilt or rotate the budget line inwards (for increases in prices) or
outwards (for decreases in prices)
For suppose the price of x is halved, reduced by 50% ceteris paribus. This tilts the budget
line from AB to AB1; a further reduction tilts it further to AB2. The locus of points of
consumer equilibrium (points of tangency between indifference curves and budget lines) is
known as price offer curve (ICC) i.e. E1, E2, E3, e

29
 A
Price offer curve

E3

E2

E1

B B1 B2
2.4.4 Separating income and substitution effects of a price change
(Case of a normal good)
A decrease in price of a commodity leads to an increase in quantity demanded due to:
1. Substitution effect 2. Income effect

Good y

E0
C
E1
E2

B`
O
Xo X2 B X1 Good x

Suppose the price of good X falls, this means that the budget line rotates around the
vertical intercept A and becomes flatter .The original budget line rotates from AB to AB`

30
The original budget line is AB, and the consumer is at equilibrium E0. The new equilibrium
is now at point E1
Eo – E1 represents the total effect of the price fall. This can be split into income and
substitution effect by assuming that we consume for the price fall by drawing a parallel
budget line C. This gives the equilibrium point E2.

1) Substitution effect (E0 – E2)

Suppose we hold purchasing power constant such that the consume will consume along the
original indifference curve, IC1. In order to compute it we ask what is the bundle that would
make the consumer just as happy as the price change, but if they had to make their choice
faced with the new prices. To find this point we consider a budget line characterized by the
new prices but with a level of income such that it is tangent to the initial indifference curve.
Since good X is cheaper, the consumer prefers to consume more of good X than Y. Hence
the increase of the quantity of X from X0 to X2 (or change of equilibrium from E0 to E2) is
known as the substitution effect Substitution effect is always negative for normal goods.
This is because if price of a commodity increases, its demand increases. Thus the
substitution effect keeps the utility level constant rather than keeping the purchasing power
constant
2) Income effect
This is the effect due to the change in real income. For example, when the price of X goes
down the consumer is able to buy as many bundles that she could purchase before and even
have extra income if he were to be on the same level of utility as before. This means that in
real terms he has become better off. To illustrate the income effect we introduce a dummy
budget line qp . The dummy budget line measures the real income if the consumer was to
remain on the original level of utility at IC1. This is known compensating variation ie the
amount of income neede to keep the consumer in his original level of satisfaction. Since the
consumer has extra income he can purchase more of the cheaper good to increase his level
of utility. The change of the equilibrium from E1 to E2 is known as Income effect.
Consequently the quantity of X increases from X1 to X2.

31
 Signs for Substitution and Income effect
The substitution effect always moves opposite to the price movement. it is said to be
always negative, since the change in demand due to the Substitution effect is opposite to
the change in price. If the price increases, the demand for the good due to the SE decreases.
Income effect is either positive or negative depending on the nature of the commodity. For
normal goods it is positive as rational consumers would find it optimal to spend more
money on the cheaper good However the case of inferior or giffen goods is different

Case for inferior good

Good y

A
E1

C Eo
X2
E2

O
Xo E1 B B1 Good x

When a good is inferior, the quantity demanded decreases with an increase in income. From
our case above the income effect shown by E2 – E1 is negative since the consumer will
purchase less of the good X hence. The SE is shown by E0 – E2 but the income effect
cancels some of the quantity by E2 – E1

32
2.5 Revealed Preference

We have seen how we can use information about the consumer’s preferences and the budget
constraints to determine his/her demand. However, in real life, preferences are not directly
observable. We discover people’s preferences from observing their behavior The revealed
preference theory shows how we can use information about the consumers demand to
discover information about his/her preferences. The theory adopts a maintained hypothesis
that the consumers preferences are stable over the time period for which his/her behaviour is
observed-whether they may be – are known to be strictly convex. Thus there will be a
unique demanded bundle at each budget.

Consider the figure below, where we have depicted a consumer’s demanded bundle  X 1 X 2 
and another arbitrary bundle Y1Y2  i.e. beneath the consumer’s budget line.

good 2

 X1 X 2

 Y1Y2

good 1

Bundle Y1Y2  is certainly an affordable purchase at the given budget. The consumer could
have bought it if he/she wanted to and even had money left over. Since  X 1 X 2  is the
optimal bundle it must be better than anything else that the consumer could afford. Hence it
must be better than Y1Y2  or any other bundle on or beneath the budget line.
Let  X 1 X 2  be the bundle purchased at prices P1 P1  when the consumer has income M.
Since Y1Y2  is affordable at these prices and income, then:
P1Y1  P2Y2  M

33
Since X1X2 is actually bought at the given budget, then

P1Y1  P2Y2  M
Putting these two equations together
P1Y1  P2Y2  P1Y1  P2Y2
If the above inequality is satisfied and Y1Y2  is actually a different bundle from  X 1 X 2  ,
then  X 1 X 2  is said to be directly revealed preferred to Y1Y2  . This revealed preference is
a relation that holds between the bundle that is actually demanded at some budget and the
bundles that could have been demanded at that budget. The principle of revealed preference
is therefore stated as:-
Let  X 1 X 2  be the chosen bundle when prices are P1 P1  and let Y1Y2  be some other
bundle such that:
P1Y1  P2Y2  P1Y1  P2Y2 . Then if the consumer is choosing the most preferred bundle, he
can afford, we must have  X 1 X 2   Y1Y2  .
Suppose further that Y1Y2  is a demanded bundle at prices q1 q 2  and that Y1Y2  is itself
revealed preferred to some other bundle Z1 Z 2 . That is:
q1 y1  q 2 y 2  q1 z1  q1 z 2 .
Then  X 1 X 2   Y1Y2  and Y1Y1   Z1 Z 2  . From the transitivity assumption, we can
conclude that  X 1 X 2   Z1 Z 2  .

This is illustrated:

good 2

 X1 X 2

Y1Y2 budgetlines

 Z1 Z 2
good 1

Revealed preference and transitivity assumption tell us that  X 1 X 2  must be better than
Z1 Z 2  for the consumer who made the illustrated choices. In this case  X 1 X 2  is said to

be indirectly revealed proffered to Z 1 Z 2  . The chain of direct comparisons can be of any

length such that if bundle A is directly revealed to B, and B to C, C to D… all the way to Z,
then bundle A is still indirectly revealed to Z.

34
If a bundle is either directly or indirectly revealed preferred to another bundle, we will say
that the first bundle is revealed preferred to the second.
From the figure below, since  X 1 X 2  is revealed preferred, either directly, to all of the
bundles below (shaded area) either budget lines,  X 1 X 2  is in fact preferred to those
bundles by the consumer. That is, the true indifference curve through  X 1 X 2  , whatever it
is, must lie above the shaded region. It therefore also follows that, the true indifference
curve through Y1Y2  must lie above the flatter budget line

2.5.1 The Weak Axiom of revealed preference

We have so far supposed that the consumer has preferences and that he/she is always
choosing the best bundle of goods affordable. If the consumer is not behaving this way, the
estimated of the indifference curves that we have constructed are meaningfulness.

Consider:

Good 2

X1 X2 Budget line

* Y1 Y2

Good 1

According to the logic of revealed preference, the diagram allows us to conclude two
things.

(i) (X 1 X 2 ) is preferred to (Y 1 Y 2 )

(ii) (Y 1 Y 2 ) is preferred to (X 1X 2 )

That is, the consumer has apparently chosen (X 1 X 2) when she /he could have (Y1Y 2)
Indicating that (X 1 X 2 ) was preferred to (Y 2 ) indicating that (X 1 X 2 ) was preferred to

35
 (Y 1 Y 2 ) but then he/she indicating the opposite. This situation absurd and violates
the weak Axiom of Revealed Preference.

Clearly this consumer cannot be a maximizing consumer. Either the consumer is not
choosing the best bundle he/she can afford or there is some other aspect of the choice
problem that has changed that we have not observed. If consumers are choosing the best
bundles that are affordable, but not chosen must be worse than what is choosen
Economics have therefore formulated this simple point in a basic axiom of consumer
theory referred to as the weak axiom of revealed preference (WARP) it states that if (X 1 X 2
) is directly revealed preferred to (Y 1 Y 2 ) and the two bundles are not the same, then it
cannot happen that (Y 1 Y 2 ) is directly revealed [referred to (X 1 X 2 ) .

In other words, if a bundle (X 1 X 2 ) is purchased at prices (P 1 P 2 ) and a different

bundle (Y 1 Y 2 ) is purchased at prices q 1 q 2 then if.
P1 X1 + P2 X2 > P1 Y 1 + P2 Y 2
It must not be the case that
q1 Y 1 + q2 Y2 > q1 X1 + q2 X2

That is, if the Y bundle is affordable when the x – bundle is purchased, then when the Y –
bundle is purchased the X bundle must not be affordable.
The consumer is (immediate diagram) has violated the WARP and therefore this
consumers behavior could not have been maximizing behavior. There is no set of
indifference curves that could make both bundles maximizing bundles.
On the other hand, a consumer who satisfies WARP is said to have a maximizing or
optimal behavior and for such, it is possible to find indifference curves for which his/her
behavior is optimal. One possible choice of indifference curves is illustrated below.

36
 Good 2

Budget line

*X 1 X 2

*X 1 X 2

Good 1

2.5.2 The Strong axiom of revealed Preference

The weak axiom of revealed preference requires that if X is directly revealed to Y,

then we should never observe Y being directly revealed to X. The strong Axiom of
revealed preference requires that the same sort of condition hold for indirect revealed
preference.. The strong Axiom of revealed Preference (SARP) states that:

If (X 1 X 2 ) is revealed preferred to (Y 1 Y 2) either directly or indirectly and (Y 1 Y 2 )

is different from (X 1 X 2 ) is revealed preferred to (Y 1 Y 2 ).

It is therefore clear that if the observed behavior is optimizing behaviour, then it must
satisfy the strong axiom. For if the consumer optimizing and (X 1 X 2 ) is revealed preferred
to, either directly or indirectly, then it must be case that (X 1 X 2 ) > (Y 1 Y 2 ) and (Y 1 Y 2 )
> (X 1 X 2 ),which is a contradiction . We can conclude that either the consumer must not
be optimizing or some other aspect of the consumer’s environment such as tastes,
other prices e.t.c must have changed.

While WARP is a necessary condition for optimizing behavior .SARP is both necessary
and sufficient in the sense that, if the observed choices satisfy SARP, we can always find
37
well behaved preferences that could have generated the observed choices. It ensures both
consistency and transitivity of consumer preferences.

2.6 Mathematical Derivation of Consumer Equilibrium

To solve for constrained problem such as the Consumer utility functions, we employ the
Langragian multiplier method to solve for the equilibrium values of the consumer.

Procedure
1. Augmented function – Combination the objective and constrained through use of a
multiplier.
L = f (x, y) + λ G (x, y) where λ is the lagrangian multiplier.

2. Get the first order condition / first derivative of L or A with respect to x, y and λ.

3. Solve for x, y and λ.

4. Confirm whether it’s maxima or minima (2nd order derivative).

For a maxima: 2gxgyLxy – (g2xLyy + g2yLxx) >0

For a minima: 2gxgyLxy – (g2xLyy + g2yLxx) <0

Example
Find the critical values of Z given that:
Z = x + 2xy +y (objective function)
subject to x + y = 4 (constraints)
Solution
Augmented objective functions
x+y–4=0
L = x + 2xy + y + λ(x + y + 4)
L = x + 2xy + y + λx + λy + λ4
First order condition,
Lx = δ L / δ x = 1 + 2y + λ
Ly = δ L / δ y = 2x + 1 + λ
Lλ=x+y+4=0

39
Solve for x , y, λ and z
If λ = 1 + 2y and – λ = 2x + 1
then 1 + 2y = 2x + 1
hence y = x
and if x + y = 4
then x = 2 and y = 2
Second order condition,
gx = ∂G/ ∂X = 1
gy = ∂G/ ∂y = 1`
gx2 = 1 and gy2 = 1
Lx = ∂L/ ∂X = 1 + 2Y + λ
Lxy = ∂Lx/∂y = 2
Lxx = ∂Lx / ∂x = ∂2L/∂2X = 0
Ly = 2x + 1 + λ
Lyy = ∂Ly/ ∂y = ∂2L/ ∂2Y = 0
And
2gxgyLxy – (g2xLyy + g2yLxx)
= 2(1)(1)(2) – [(1)(0) + (1)(0)] = 4- 0 = 4 >0 : It’s a maxima.
Critical value z
Z = x + 2xy + y=
Z = 2 + (2x2x2) + 2
=12.
Since the Lagrangian function incorporates the constraint set equal to Zero, it can also be
treated as an unconstrained optimization problem, and its solution will always be identical
to the original constrained optimization problem.

Budget line and Utility maximization.

It shows the various combinations of 2 commodities that can be bought with the same
income. Eg
An increase in a consumer’s income can lead to an increase in the quantity consumed of a
commodity (normal good) or a decrease (giffen good).
40
A change in the price of a commodity has 2 effects:
(i) The substitution effect: if the price rises ceteris paribus, the consumer will try to
shift to a substitute
(ii) The income effect: the rise of a price reduces the real income of a consumer thus
reducing the quantity consumed of the commodity.
The objective of a consumer is to maximize his utility so that:
( )

The consumer maximizes his/her utility at the point of intersection of the indifference curve
and the budget line.

Using the Lagrangian multiplier method,

( ) ( )
The first-order conditions are:
…………………………….(1)
…………………………….(2)
……………………..(3)

Solving the 3 equations simultaneously yields the following condition for utility
maximization:

Example:
⁄ ⁄
The utility function for a consumer is . If the price per unit of is Ksh 10
and Ksh 5 per unit of , determine amount of and that the consumer should buy so
as to maximize his utility given that the consumer has a Ksh 300 budget.

Solution to the Example

42
 ⁄ ⁄

The augmented objective function is:

⁄ ⁄
( )
The first-order conditions are:
⁄ ⁄

⁄ ⁄

For maximum utility,

So that,
⁄ ⁄

⁄ ⁄

it follows that , substituting this into equation (iii) we get

Solving the quadratic equation you get:

⁄
and and the maximum utility is ( )

Review Questions
i) Which the help of a well labeled diagram, explain the concepts of substitution effect
and income effect for rise in the price of a normal, giffen and inferior goods
ii) Use the langragian multiplier to obtain the equilibrium values of two goods
consumed a consumer
iii) Describe the theory of revealed preference
iv) Use graphs to illustrate different shapes of indifference curves.
v) Describe the assumptions of consumer rationality

43
CHAPTER THREE: THEORY OF PRODUCTION

Learning Objectives

By the end of this chapter the learner should be able to:

i) Identify and categorize the factors of production

ii) Analyze the relationship between the input of factors and the output of
goods and services in the short-run and in the long-run
iii) Define fixed and variable costs and show, that in the short-run, average
and marginal costs will eventually rise as ‘diminishing returns’ come into
operation
iv) Explain the role of economics and diseconomies of scale in determining the
shape of a firm’s long-run average cost curve

3.1 Production technology

We examine the constraints on a firm’s behaviour. When a firm makes choices it faces
many constraints Nature imposes the constraints that are only certain feasible ways to
produce outputs from the inputs; there are only certain kinds of technological choices that
are possible.
3.1.1 Inputs and outputs
Inputs to production are called factors of production (classified into broad categories such
as land, labour, capital and raw materials). Capital goods are those inputs to production that
are themselves produced goods. Basically capital goods are machines of one sort or
another. Money used up or maintain a business is called financial capital and capital goods
or physical capital used for produced factors of production

3.1.2 Describing Technological Constraints

Nature imposes technological constraints on firms, only certain combinations of inputs
are feasible was to produce a given amount of output and the firm must limit itself to
technologically feasible production plans.
The set of all combinations of inputs and outputs that comprise a technologically feasible
way to produce is called a production set.
For example, one input (x) and one output (y) the production set may have the shape

44
Y=output Y=f(x)

Production set

X= input

The production set shows the possible technological choices facing a firm. As long as the
inputs to the firm are costly it makes sense to limit ourselves to examining the maximum
possible output for a production set depicted. The function depicting the boundary set is
known as the production function. It measures the maximum possible output that you can
get from a given amount of input.

In a two input case f(x 1 x 2 ) a convenient way to depict production is by use of isoquant.
An isoquant is the set of all possible combinations of inputs 1 and 2 that are just
sufficient to produce a given amount of output. Isoquants are similar to indifferent
curves, but one difference is that isoquants are labeled with the amount of output they can
produce, not with a utility level. Thus the labeling of isoquants is fixed by the technology
and does not have the kind of arbitrary nature that the utility labeling has.

4.1.3 Properties of technology

1. Technologies are monotonic – if you increase the amount of at least one of the
inputs, it should be possible to produce at least as much output as you were
producing originally. This is sometimes referred to as the property of free disposal:
if the firm can costlessly dispose of any inputs, having extra inputs around cant hurt
it.

2. Technology is convex – this means that if you have two ways to produce y units of
output, x1 x 2  and  z1 z 2  , then their weighted average will produce at least units of
output. Two ways of producing output is called production techniques.
45
 X2

100a 2  100a1  100a2 

 25a1  75b1 ,25a1  75b2 

100b2 
100b2  100b1 Y  100

100a1 100b1 X1

Convexity, if you can operate production activities independently then weighted averages of
production plans will also be feasible. Thus the isoquant will have a convex shape.

3.1.4 The Marginal Product

Suppose that we are operating at some point, (x1x2) and that we consider using a little bit
more of factor 1 while keeping factor 2 fixed at the level x2. How much more output will
we get per additional unit of factor 1
y f x1  x1 , x2   f x1 , x2 

x1 x1

This is called the marginal product of factor 1. Marginal product is a rate; the extra amount
of output per unit of extra input.

3.1.5 The Technical Rate of Substitution

Suppose that we are operating at some point x1 x 2  and that we consider giving up a little
bit of factor 1 and using just enough more of factor to produce the same amount of output y.
How much extra of factor 2, x 2 , do we need if we are going to give up a little bit of factor

1, x1 ? This is just the slope of the isoquant referred to as the technical rate of substitution

(TRS) denominated by TRS x1 x 2  .

46
TRS measures the trade off between two inputs in production. It measures the rate at which
the firm will have to substitute one input for another in order to keep output constant.
Consider a change in our use of factors 1 and 2 that keeps output fixed. Then:
y  MP1 x1 x2 x1  MP2 x1 x2 x2  0

Which we can solve to get:

x MP1 x1 x2 
TRS x1 x2   2  
x1 MP2 x1 x2 

3.1.6 Diminishing Technical Rate of Substitution (DTRS)

This assumption says that as we increase the amount of factor 1, and adjust factor 2. so as
to stay on the same isoquant, the technical rate of substitution declines. Thus assumption of
diminishing TRS means that the slope of an isoquant must decrease in absolute value as we
move along the isoquant in the direction of increasing x1 . (convex isoquant).

3.1.7 Diminishing Marginal Product

As long as we have a monotonic technology, we know that the total output will go up as we
increase the amount of factor one. But it is natural to expect that it will go up at a
decreasing rate. We would typically expect that the marginal product of a factor that will
diminish as we get more and more of that factor. This is called the law of diminishing
marginal product. It only holds when other inputs are fixed

3.1.8 Isocost line

It refers to a curve showing the combinations of two factors which can be bought from
given amount of income.

47
 isocost line

25

20
capital (k)

15

10

0
0 2 4 6 8 10 12
labor (l)

3.1 9. Combination of isoquants and isocosts

Suppose the cost outlay of the firms keeps on increasing, the isocost line keeps on shifting
to the right and new equilibrium points are generated

The firm’s long run

expansion path

3.2 Short run and long run costs

Short run refers to that period of production time in which at least one factor input is fixed
(cannot be varied). On the other hand long run refers to that period of production time in
which the input of all factors of production can be varied. The actual length of production
time does not correspond precisely to any particular period but varies from industry to
industry.
48
3.2.1 Short run costs in production
Short run costs can be classified as follows:
a) Fixed costs (FC): This refers costs which do not change with changes in the out put.
For example land.
b) Variable costs (VC): Refers to costs s which change with change in output.

Total Costs (TC) = Fixed Costs (FC) + Variable Costs (VC)

c) Average Fixed Cost (AFC): Refers to average fixed cost per unit of output.
AFC = TFV / Q
d) Average Variable Cost (AVC) Refers to total variable cost per unit of out put.
AVC = TVC / Q
e) Average Total Costs (ATC) = TC / Q or AFC + AVC
f) Marginal Costs (MC)
Refer to change in total cost due to change in output.

Illustration
A firm produces good x using labor as the only variable factor. It’s fixed cost is five dollars.
The table below therefore shows the firms total cost at the corresponding output levels.
Calculate: TVC, AFC, AVC, ATC and MC

Output
TC (Q) TVC AFC AVC ATC MC
5 0 _ _ _ _ _
9 1 4 5 4 9 4
12.5 2 7.5 2.5 3.75 6.25 3.5
15.8 3 10.8 1.7 3.6 5.27 3.3
18.8 4 13.8 1.25 3.45 4.7 3
22 5 17 1 3.4 4.4 3.2
25.5 6 20.5 0.83 3.42 4.25 3.5
29.3 7 24.5 0.71 3.5 4.19 3.8
33.6 8 28.6 0.63 3.56 4.2 4.3
38.5 9 33.5 0.56 3.72 4.27 4.9
44 10 39 0.5 3.9 4.4 5.5

49
The above data plotted to scale would give:

Costs MC

ATC

AVC

AFC

Q1 Q2
Output

NB: MC cuts the ATC and AVC at their minimum point. AVC reaches the lowest point at a
lower level of output Q1 compared with ATC. This is because ATC includes both AFC and
AVC. Q2 is the equilibrium output that minimizes costs. The equilibrium point is given by
the point where MC cuts ATC at its minimum point.

3.2.2 Long run costs

In the long run, the firm varies its output as well as is plant capacity to expand therefore all
costs is variable. Therefore the firms long run average cost curve can be derived assuming
that the firm can build an infinite number of plants of different sizes. This curve shows the
lowest possible costs of producing different output levels given the firm production and
factor prices.

50
 SAC9
Costs
SAC1

LAC

Qe Q
O
Economies of scale Diseconomies of scale

Qty
3.3 Returns To Scale
This is a long term analysis of production. It shows by how much output will change as a
result of change in factor inputs. Laws of return to scale refer to the effects of scale
relationships. In the long run output may be changed by changing all factors by the same
proportion or by different proportion.
Suppose the initial level of output and inputs is Q0  f ( K , L) . If we increase all factors by
the same proportion t we obtain a new output level Q*  f (tK , tL) which is higher than the
initial Q0 .
If Q is increases by the same proportion t as the inputs, we say that there are constant
returns to scale. If Q rises less proportionally with the increase in the factors we have
decreasing returns to scale. And if Q increases more than proportionally with increase in
the factors, we have increasing returns to scale.
Graphical representation of returns to scale can be shown by the distance between
successive multiple levels of output Isoquants that show levels of output that are multiples
of same base level of output e.g. X, 2X, 3X etc.
51
 a) Constant returns to scale

Oa = ab = bc
K

c
3X=300

b
2X=200
a
X=100

0 L

The liner joining points a, b, and c from the origin is called an isocline. An isocline is a
locus of points along which MRTS is constant. In CRS, doubling the factor inputs
achieves double the level of initial output.

52
 (b) Decreasing returns to scale

-by doubling inputs, the distance

between consecutive multiple
Isoquant increases by less than twice
its original level

-That is Oa <ab <bc

L
0

(c) Increasing returns to scale

-When inputs are doubled,

output increases by more
than double. The distance
between consecutive
Isoquants decreases.

Returns to Scale and Homogeneity of the Production Function

A homogenous function is a function such that if each of the inputs is multiplied by k, then
k can completely be factored out of the function raised to any power v.

53
Example
Take initial production function as Q0  f ( K , L) . If the both factor inputs are increased by
same proportion k, then the new level of output will be
Q*  f (kK, kL) . If k can bred out of this new expression of the production function so that
Q*  k v f ( K , L) , we say that the function is homogenous of degree v. that is the power v of
k is called the degree of homogeneity of the function and is a measure of the returns to scale

A production function is said to be homogenous of degree n, if when inputs are multiplied

by some constant say k, the resulting output is a multiple of k n times the original output.
E.g. if X 0  b0 Lb1 K b 2 , multiplying both K and L by a constant k gives
X *  b0 (kL) b1 (kK ) b 2
 b0 k b1 k b 2 ( Lb1 K b 2 )
 k b1b 2 b0 Lb1 K b 2
 k b1b 2 X o
Here the returns to scale are measured by the power of k which is ( b1  b2 ) . b1 and b2 ) are
powers of factor inputs too.
 If ( b1  b2 ) = 1 we have constant returns to scale. This production function is
sometimes referred to as linear homogeneity.
 If ( b1  b2 ) < 1 then we have decreasing returns to scale and
 If b1  b2 ) >1 then increasing returns to scale.
Alternatively:
Instead of increasing the amount of one input while holding the other input fixed, input
fixed, let us scale the amount of all inputs up by some constant factors if we twice as
much output, its referred to as constant returns to scale.

2f(x 1 x 1 ) = f(2x 1 2x 2 )

In general, if we scale all of the inputs by some amount tg, constant returns to scale
implies that we should get t times as much output;

Tf(x 1 x 2 )=f(tx 1 ,tx 2 )

Returns to scale describes what happens when you increase all inputs, while diminishing
marginal product describes what happens when you increase one of the inputs and hold
the others fixed (explained)
If we scale up both inputs by some factor t we get more than t times as much as output.
This is called increasing returns to scale i.e.
54
 f(tx 1 ,tx 2 ) >tf(x 1 x 1 ) for all t>1 in some instances , we get less than twice as much
output from having twice as much of each input. This is called decreasing returns to scale.
f(tx 1 ,tx 2 )<tf(x 1 ,x 2 )for all t>1

3.4 Economies of scale

These are the benefits / advantages that accrue to affirm by virtue of its large size.
Economies are either internal or external.

3.4.1 Internal economies

These are advantages which come from within and reduce the cost of operation.
They include:
1. Technical economies.
2. Managerial / administrative economies.
3. Marketing economies of scale.
4. Financial economies of scale.
5. Research and developmental economies.
6. Welfare economies.
7. Risk bearing economies.

External economies
These are savings that come from without because a firm is located near others.
They include:
1. Ready markets.
2. Development of good transport and communication.
3. Development of financial institutions.
4. Development of training institutions.
5. Research through pool of capital resources.
6. Development of trading associations

55
3.4.2. Diseconomies of scale
These are disadvantages / problems that accrue to a large firm as it expands in size. It can
be both internal and external.

Internal diseconomies
1. Managerial diseconomies
2. Selling / marking diseconomies
3. Labors diseconomies

External diseconomies
They accrue due to concentration of firms in the same place / area and they increase the cost
of production.
1. Traffic congestion.
2. Shortage of accommodation.
3. Air, water pollutions.
4. Increased price on land.
5. Increase in crime.
6. Development of slums.
7. Shortage of food

56
 Economies
Diseconomies of
of scale.
scale.

Po
Optimum
point.
Qo

3.5 Profit Maximization

Lets consider the short run profit maximization problem when input 2 is fixed at some level
x 2 . Let f  x1 x 2  be the production function for the firm, let p be the price of output, and let
w1 and w 2 be the prices of the two inputs. Then the profit maximization problem facing the
firm can be written as:
Max p. f x1 x2   w1 x1  w2 x2
x1

If x1* is the profit maximizing choice of factor 1 then the output price times the marginal
product of factor 1 should equal the price of factor 1.
 
pMP1 x1* x2  w1
MP  w
i.e. the value of the marginal product of a factor should equal its price.

The same condition can be described graphically (PTO). The curved line represents the
production function holding factor 2 fixed at x 2 . Using y to denote the output of the firm,
profits are given by:

57
  py  w1 x1  w2 x2
This expression can be solved for y to express output as a function of x1 .
 w w
y   2 x 2  1 x1 isoprofit line equation
p p p
 
int ercept slope

This equation describes isoprofit lines (combinations of the input goods and the output good
that give a constant level of profit,  ). As  varies, a family of parallel straight lines each
 w2 x 2
with a slope of w1/p and each having a vertical intercept of  , which measures the
p p
profit plus the fixed costs of the firm.

Output

W1
Isoprofit line scope 
P

Y* Y  f X 1 , X 2 
Pr oduction function

 W2 X 2

P p

X 1* X1

The firm chooses the input and output combination that lies on the highest isoprofit line.

In this care the profit –maximizing points is x1* y * 
The profit maximization problem is then to find the point on the production function that
has the highest associated isoprofit line. As usual it is characterised by a tangency

58
condition: the slope of the production function should equal the slope of the isoprofit line.
Since the slope of the production function is the marginal product, and the slope of the
w1
isoprofit line is this condition can also be written as:
p1
w1
MP1 
p
pMP1  w1

Inverse Factor Demand Curves

The factor demand curves of a firm measure the relationship between the price of a factor
and the profit – maximizing choices: for any prices,  p, w1 , w2  we just find those factor

 
demands x1* x2* , such that the value of the marginal product of each factor equals its price.
The inverse factor demand curve measures what the factor prices must be for some given
quantity of inputs to be demanded.

The profit – maximization problem of the firm is:

Max pf x1 x2   w1 x1  w2 x2
x1 x2

Which has FOC


pf x1* x2* 
 w1  0
x1

pf x1* x2*   w2  0
x2
Suppose the CD function is given by f x1 x2   x1a x2b
then the two foc become.
pax1a 1 x 2b  w1 x1  0
pbx1a x2b  w2 x 2  0
Multiply the first equation by x1 and the second by x 2 to get.
pax1a x 2b  w1 x1  0
pbx1a x 2b  w2 x 2  0
Using y  x1a x2b to denote the level of output of this firm we can rewrite these expression
as:

59
pay  w1 x1
pby  w2 x 2
Solving for x1 and x 2
apy 
x1* 
w1 
 gives demand for the factors as a function of the optimal output choice
bpy 
x2 
*

w1 

Inserting the optimal to obtain optimal choice of output factor demands into the (i)
production function, we have:
a b
 pay   pby 
     y
 w1   w2 
Factoring out the y gives
a b
 pa   pb  a b
    y  y
 1
w  w2 
a b

 pa  1 a b  pb  1 a b 
y      Supply function of the CD firm
 w1   w2  

This gives a complete solution to the profit maximization problem.

3.6 Cost Minimization

Suppose that we have two factors of production that have prices w1 and w 2 and that we

want to figure out the cheapest way to produce a given level of output., y. If we let x1 and
x 2 measure the amount used of the two factors and let f  x1 x 2  be the production function
for the firm, the problem can be written as:
Min w1 x1  w2 x 2
x1 x2

st
y  f  x1 x 2 
Minimum cost will depend on w1, w2 and y i.e. C  w1 , w2 , y  – cost function which
measures the minimal costs of producing y units of output when factor prices are w1 w2 

60
X2

Optimal choice
iso cos t line
W
X 2* slope   1
W2

Isoquant Y  f  X 1 X 2 technolog ical constraint 

X 1* X1
C  w1 x1  w2 x 2
Rearranging
C w1
x2   x1
w2 w2
NB: If the optimal solution involves using some of each factor, and if the isoquant is a nice
smooth curve, then the cost minimizing point will be characterised by a tangency condition,
the slope of the isoquant must be equal to the slope of the isocost curve. i.e. TRS must
equal the factor price ratio.

 
 MP1 x1* x 2*
  w
 TRS x1* x 2*   1
* *
MP2 x1 x 2  w2

The algebra that lies behind equation above

   
MP1 x1* x2* x1  MP2 x1* x2* x2  0

x1 and x 2 must be of opposite signs, if we are at the cost minimum, then this change
cannot lower costs, so we have
w1 x1  w2 x2  0
Now consider the change  x1 ,x2  . This also produces a constant level of output, and
it too cannot lower costs. This implies that
 w1x1  w2 x2  0
Putting the above two expressions together gives:
w1 x1  w2 x2  0

61
The choices of inputs that yield minimal costs for the firm will in general depend on the
input prices and the level of output that the firm wants to produce written as x1 w1 , w2 , y 

and x 2 w1 , w2 , y  .
These are called the conditional factor demand functions or derived factor demands. They
measure the relationship between the prices and output and the optimal factor choice of the
firm, conditional on the firm producing a given level of output y.
Note difference between conditional factor demands and profit maximization factor
demands. Conditional factor demand tells us how much of each factor would the firm use if
it wanted to produce a given level of output in the cheapest way.

For example
MinC  w1 x1  w2 x 2
st
y  x1a x 2b

L  w1 x1  w2 x2   x1a x2b  y 
L
 w1  ax1a 1 x 2b  0
x1
L
 w2  bx1a x 2b 1  0
x1
w1 ax1a 1 x 2b

w2 bx1a x 2b 1
w1 a a 1a b b 1
x1 x 2
w2 b
w1 a x2

w2 b x1
a
w1 x1    w2 x 2
b
a w2 x 2
x1 
b w1
a w1 x1
x2 
b w2

62
 a
 a w2 x 2  b
  x 2  y
 b w1 
a
a  w2  a b
  x  y
b  w1 
a
bw 
x a b
2   2  y
a  w1 
1

b  w2  
a a b

x 2    y 
a  w1  
 
a
bw  a b 1
  2  y a b
a  w1 

Review Questions
i) Describe the concepts of short-run cost and long-run costs in production
ii) Explain the concepts of isocosts and isoquants
iii) Explain the profit maximizing condition for a firm
iv) Describe the perspectives of returns to scale
v) Diagramatically explain the quantity that minimizes cost

CHAPTER FOUR: THE FIRM AND MARKET STRUCTURES

Learning Objectives

By the end of this chapter the learner should be able to:

i) Explain the types of market structures

ii) Describe the equilibriums of different market structures
iii) Illustrate the concept of profit maximization under different markets
iv) Understand the concept of price discrimination

63
4.1 Introduction
The traditional economic theory assumes that the typical firm has a single objective to
maximize profits. The modern theme of economics however does acknowledge firms may
have other objectives such as sales revenue maximization or the maximization of
managerial utility. Typically the owners of a large public company, the owners / share
holders delegate their authority to a board of directors who in turn place the effective
control of the company in the hands of professional managers. The interest of shareholder
and managers may diverge. The share holders are presumably interested in obtaining the
maximum dividends possible over a reasonable time period, which implies that the firm
should aim to maximize long run profits. The managers who do not necessarily share the
profits do not have profit maximization as their primary objective instead may aim for an
increased market share or great sales revenue which they feel will bring them more profits,
greater security or higher salary.

4.2 Perfectly competitive market

It’s a market having many buyers and sellers selling homogeneous/ identical products. Its
common in the agricultural sector e.g. maize, eggs
Characteristics
1. It’s a market which has many buyers and sellers such that no single person can
influence the market price and output.
2. Products sold are homogeneous.
3. There are no barriers to entry and exit of market.
4. No government control e.g. no price control.
5. Demand curve facing the firm is perfectly elastic. For example a small price
increase in one firm causes a big decrease in demand.
6. Both buyers and sellers are price takers- no one can influence the market.
7. Both buyers and sellers have perfect knowledge about the market. They know
product price and quantity.
8. There is perfect mobility of factors of production. Factors of production are free to
move from none profitable activities to profitable activities.

64
4.2.1 Equilibrium of a perfect competitive firm
A firm maximizes profits or is at equilibrium when it produces the level of output at a point
where MR = MC and as long as MC cuts MR from below. It is possible for a PC firm to
make losses, abnormal profits or normal profits in the short run depending on the position
of the AC curve. Firms in this market make normal profits in the long run.
Case 1: Supernormal profits (P>AC)
Categories all those firms which are earning a return which exceeds the minimum
necessary to induce them to remain the industry they currently occupy

Revenue MC AC
D
P
C AR
E
 Q2 Output X axis

From the figure above when the level of output is Q2 the cost for unit is EQ2 and the
price DQ2 supernormal profit is equal to CPDE which is represented by the
scheduled area.

Case 2: Normal profits (P=AC)

This refers to the minimum level of profit which a firm must make in order to induce it to
remain in operation. The level of normal profit varies from one industry to the other. This
because of different level of risk and nature of the production process involved in different
industries. Normal profits may be considered be just past cost of production line since
production will not continue unless at least this level of profit is attained.

MC
Revenue
cost price AC

AR=MR

Q1
Case 3: Losses (P AC)
MC

AC
M
C
losses

Pe MR = AR = D
E1
Losses

\ Output
O
Qe
Long Run Equilibrium For The Firm

Since there is freedom of entry into the industry the surplus profits will attract new firms
into the industry. As a result the supply of the product will increase and the price will
fall. The individual firm will face a falling perfectly elastic demand curve, and the
surplus profits will be reduced.
Firms in this market at first make abnormal profits attracting many firms since entry is free.
Supply increases and prices start decreasing and now firms start making losses.
Losses force some firms to exit the market since exit is also free. This consequently reduces
supply and prices start increasing such that in the long run firms are at equilibrium when
they make normal profits.
Normal profits are experienced when TR = TC meaning TR - TC = 0 (normal profits). At
this point existing firms cannot quit the market and new firms cannot enter the market.

Example
A perfect competitive firm sells its products at Kshs 60 per unit. If it faces the cost function
given: C = 30 + 2.5 Q2
Determine:
1. AFC, AVC, MC and MR.
2. Calculate the level of output the firm should produce in order to maximize profits.
3. Level of profits / losses made.

Solution AFC = FC / Q = 30/Q

AVC = VC / Q = 2.5Q

MC = ∆C / ∆Q = 5Q2-1 = 5Q

MR = P = MR and P = 60 Kshs

MR = MQ
60 / 5 = 5Q / 5
= 12
P X Q = TR
TR = 60 X 12 = 720
TR= 30 + 2.5 X 122 = 390
67
4.3 Monopolistic market
This is a market having many buyers and one seller selling a product which has no close
substitute and there are barriers to entry preventing other firms from entering the market.
Characteristics
1. Has many buyers and one seller.
2. There are barriers to entry. For example trade licenses.
3. There is no direct competition from sellers since there is only one seller.
4. Total control of essential resources or strategic resources.
5. The government confers exclusive rights through issuance of ownership rights and
especially through innovation / discovery.
6. The firm experiences economies of scale.
7. The government can grant one firm the exclusive right to operate - legal monopoly.

Sources of monopolistic power

1. Absolute ownership of raw material.
2. Control over the marketing channel.
3. Economies of scale.
4. Government licensing to only some firms to supply some commodities KPLC
5. High initial costs of starting the firm / industry. SAFARICOM
6. Patent rights issued as a result of innovations.MICROSOFT
8. Ownership of the rights of a well known brand.OMO BLUEBAND
9. Elasticity of market demand – Inelastic demand promotes monopoly
10. Number of firms - monopoly decreases as no of firms increase
11. Interaction among firms – Aggressive interactions promotes monopoly for some
firms

4.3.1 Monopoly pricing

He sets the price hence the amount he sells depend on price, i.e. the demand is a decreasing
function of price. i.e.
Q  f  p  f ' 0

68
Specifically:
Q  b0  b1 p
The demand curve is assumed to be linear with changing elastics at every one point.

p 
B

 p 1
A

p 0
0 C Q

OQ
 b1
OP
OQ P
p  
OP Q
P
At point B,  p  b1  
O
0
At point C,  p  b1   0
O
At point A,  p  1

Now
TR  P  Q
But Q  b0  b1 p
b b
P 0  Q
b1 b1
TR  P  Q
b 1 
  0  Q Q
 b1 b1 
b 1
 0 Q  Q2
b1 b1
69
 b0 1
AR   Q
b1 b1
b0 2
MR   Q
b1 b1

The MR is a straight line with the same interrupt as the demand curve but twice as steep as

MR AR  D Q

the AR is the demand curve for a monopolist

Equilibrium requires that MR=MC and slope of MC scope of MC slope of slope of

MR at intersection.

70
 P

SATC
SMC

QM MR AR  D Q

 Q   TR Q   TC Q 
 TR TC
  0
Q Q Q
MR  MC
 2  2TR  2TC
  0
Q 2 Q 2 Q 2
slope of MR  slope of MC
e.g.
Q  50  0.5P , C  50  40Q
P  100  2Q
TR  PQ  100  2Q Q
 100Q  2Q 2
TR
MR   100  4Q
Q
FOC MR=MC
100 – 4Q = 40
60 = 4Q
Q = 15
P = 100 – 2Q
= 100 – 2(15) = 70 units
4.3.2 Monopoly Short run equilibrium
The aim of the monopolistic is to maximize profits and this will be achieved when his
71
 MC = MR .During the short run period, the market demand and costs of production will
dictate how much a monopolistic will produce. At equilibrium a monopolistic will produce
at a point where the short run marginal cost equals marginal revenue.
The monopolist misallocates resources because he adheres to the principle of MR = MC.
but restricts output and charges more price than a perfectly competitive market. He also
does not produce at the lowest point of ATC therefore does not gain productive efficiency.
Also the monopolistic does not have a supply curve because the same quantity is sold at
market sat different prices.
MC
Price /
revenue

AC
C
P

D = AR = P
MR

O Quantity
qm

4.3.3 The long run equilibrium

In the long run, the monopolistic has enough time to adjust output with change price. He
can do this by building another plant or a smaller one depending on price and demand.
At the long run a monopolistic will produce at a point where long run marginal cost is
equal to long run marginal revenue. If the total demand fro the product does not change, the
demand for any product of the firm will fall. This shifts the demand curve shifts to the left
until the abnormal profits are eliminated and this point there are no incentives for new firms
to enter the market.

72
4.3.4 Price discrimination under monopoly
A monopoly might charge different prices to different customer of similar goods and
services in different markets in order to increase his profit levels and where price
differences are not justified by cost differences.

Conditions for price discrimination

1. The seller must posses some degree of power in ability to control out put and price.
2. The monopoly must segment the market into distinct classes and charge different
prices to each class.
3. The monopolistic must be aware of the willingness of the customers to pay for the
products.
4. The monopolistic must be able to protect resale of the product by buyers.

The price to charge in each market is dependent on the price elasticity of demand. In the
first market where demand is price inelastic, he charges a higher price while selling lower
quantity. In the second market where demand is price elastic, the price is lower and the
quantity sold is higher.
4.4 Monopolistic Competition
Most markets have neither the single seller required to meet the definition of a pure
monopolist nor the large number of small sellers and undifferentiated product necessary to
qualify as perfectly competitive.
73
Monopolistic competition is a market where there are many firms producing similar but
differentiated products with each firm having a limited degree of price control.
Monopolistic competition is a form of market in which there are many sellers of a
heterogeneous or differentiated product and entry into and exit from the industry are rather
eas’;y in the long run. Because of the differences among their products, firms in this market
have some control over their price but it is usually small, because the products are close
substitutes. The demand curve of a monopolistic competitive firm is highly elastic, but not
perfectly elastic as in the case of perfect competition.

Monopolistic competition is most common in the retail and service sectors of an economy.
Clothing, hair dressing, detergents and food processing are some of the industries that come
close to monopolistic competition at the national level. At local level we can think of fast
food outlets, beauty salons all located in close proximity to one another.

4.4.1 Short run price and output determination under monopolistic competition
The figure below shows the price and output determination under monopolistic competition.
Since a monopolistically competitive firm produces a differentiated product that has close
substitutes, the demand curve it faces is negatively sloped but highly price elastic. As in the
case of monopoly, since the demand curve facing a monopolistic competitor is negatively
sloped and linear, the corresponding marginal revenue curve is below it. The best level of
output of the monopolistically competitive firm in the short run is given by the one at which
MR=MC. This is shown by point E1 on figure a. The optimal output is Q1 while optimal
price is P1. The monopolistically competitive firm earns an economic profit presented by
P1CVA in the figure below
Long run price and output determination under monopolistic competition

If firms in a monopolistic competition earn economic profits in the short run, more firms
will enter the market in the long run. This shifts the demand curve facing each monopolistic
competitor to the left (as its market share decreases) until it becomes tangent to the firm’s
LAC curve. Thus in the long run all monopolistically competitive firms break even (earn
normal profit) and produce on the negatively sloped portion of their LAC curve (rather than
74
 at the lowest point, as in the case of perfect competition). This is shown in figure b above.
The condition to be satisfied for profit maximization in the long run is MR=MC and P=AC.

Price Price LMC

MC
LAC

AC
C
P1 P2
V
A
E1
E0 AR1
AR = D

MR1
MR

0
Q1 Quantity Q2 Quantity

a) Short Run Equilibrium b) Long Run Equilibrium

4.5 Effect of tax on monopoly

price

MC

Pm em
Pc A B ec
C

AR  P

Ym Yc Output

MR

Suppose that we could somehow costlessly force this firm to behave as a competitor and
take the market price as being set exogenously. Then we would have PcYc for the
competitive price and output.
Alternatively, if the firm recognized its influence on the market price and chose its level of
output so as to maximize profits, we would see the monopoly price and output PmYm .
Recall that an economic arrangement is pareto efficient if there is no way to make anyone
better off without making somebody worse off.
Therefore is the monopoly level of output pareto efficient?

Recall the inverse dd curve P(Y) measures how much people are willing to pay for an
additional unit of the good. Since (Y) is greater than MC(Y) for all the output levels
between Ym and Yc , there is a whole range of output where people are willing to pay more
for a unit of output than it costs to produce it. Clearly there is a potential for pareto
improvement here. Hence a monopoly would be inefficient.
76
Measuring Monopoly inefficiency
But just how inefficient is the monopoly? Can we measure the total loss in efficiency due
to monopoly?
The consumers surplus in the monopoly structure is Are Pm em A which would go up by area
A + B if the monopolist behaved competitively.
On the other hand, the area A would just be a transfer from the monopolist to the consumer.
Under competition, the producer surplus would include area C. However due to the
monopoly charging the price Pm, he denies the consumer surplus (A+B). Out of this
surplus, only A benefits the producer while B is lost. Area C is also lost since the producer
sells Ym instead of Yc .
The Area B + C is know as the dead weight loss due to the monopoly. It provides a
measure of how much worse off people are paying the monopoly price than paying the
competitive price
It measures the value of the lost output by valuing each unit of lost output at the price that
people are willing to pay for that unit.

4.6 Oligopoly Pricing Technique

A market which has few firms selling standardized or differentiated products so that each
firm is able to take into account actions of competitor firms into its market operations. The
firms are oligopolically interdependent such that if one firm changes its price the other does
the same. The theory of oligopoly is usually associated with the view of reaction of one firm
to price changes by rival firm. Because of this several models of oligopoly have been
developed.
Where Oligopoly exists each firm knows that its profit depends on its rivals’ action. The
unique characteristic with respect to oligopoly market structure is that one firms action will
produce a reaction to its competitors. This is unlike in the case of perfect and monopolistic
competitive markets, which are too small to have a significant impact on other firms.
Take an example of a three firm oligopoly market. If one firm reduces the price in order to
increase its market share and earn more profit, the other two firms will not ignore it since
their market share or profit will be adversely affected. They will react to protect their
77
 interest. This way the three firms will be interdependent in the market therefore if one
taking unilateral decision regarding price or quantity or anything else will take into account
the possible reactions of its rivals in mind. In most cases the market concentration ratio for
largest for firms in the industry is between 50% and 100% of the total output from the
industry.
Examples of oligopolistic industries include aluminum processing, motor vehicle
assembling, glass manufacturing, petroleum industry, etc. in each of these industries a small
number of firms produce all or very large percentage of output.

4.6.1 Price quantity relationship under oligopoly

Under oligopoly market structure if firm A changes the price of its product, all other firms
in the industry will react by changing their prices. Change in prices by competitors will lead
to shift in demand of firm A, so that instead of moving along the same demand curve, the
firm moves to an entirely new curve as follows.

Oligopoly firms kinked demand

V
Price

P2 A

P1

B C

D2 D1

P2  In the above diagram, firm A’s initial demand curve is D1 and initial price and
quantity is P1, Q1, respectively. This is the firm’s initial demand assuming that other
0 firms do not changeQtheir
1 prices. Q3 Q2 Quantity
  Under this assumption, a fall in price by the firm from P1 to P2 would result to
increase in quantity demanded from Q1 to Q2 if other competing firms do not
respond to changing their prices.
 However, since only a few firms operate in the market, if one of the firms reduce its
price and secure part of the market of other firms, the competing firms would
quickly know exactly why their sales have declined and would react by reducing
their prices.
 From economic theory, a change in price of substitute leads to a shift in demand of
the competing product. So, if competing firms reduce their price also, firm A’s
demand curve will have to shift downwards to D2. The reaction of competing firms
of reducing prices result to firm A’s quantity demanded to reduce from Q2 to Q3
 The movement from point A to B represents the downwards shift from initial
demand curve D1 to new demand curve D2.
 Line VABD2 is the new kinked demand curve for firm A. it is a reaction based
demand curve. It shows how quantity demanded would be affected by price
reduction after competitive reaction has been taken into account. Kinked demand
curve assumes that rival sellers follow a price cut policy but not a price increase one.
That is whenever the seller reduces the price increase one. That is whenever the
seller reduces the price, all others will also do so.

4.6.2 Oligopoly kinked equilibrium

Early students of oligopoly noted that prices in such markets sometimes remained
unchanged for long periods of time. The apparent price rigidity led Paul Sweezy (1939) to
suggest that oligopolists behave as if dancing a kinked demand curve such as shown in
figure below.

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 Oligopoly Kinked Equilibrium

Price
MR1 MC1
X
PE
MC2

MR2

0 QE Quantity

 The kink in the demand curve stems from an asymmetry in the response of other
firms to one firms price change. Suppose that the price initially is at Pe, the point
of the kink of the demand curve. If the firm increases the price beyond Pe, other
firms might not follow the increase. The result would be that the firm would lose a
significant amount of sales. This is shown in the figure above as a relatively elastic
demand curve (DX) above the existing price Pe.
 In contrast, if the firm reduces its price below Pe, it is likely that the other firms
will follow suit in an attempt to maintain their market shares. As a result, the price
cut by the original firm will not add much to its sales. The figure depicts this
outcome as a relatively inelastic demand curve (XV) below Pe.
 Associated with the demand curve is a marginal revenue curve. For the demand
curve (DX) above the kink, the marginal revenue is given by MR1. For the demand
curve (XV) below the kink it is MR2.
 At the point of the kink, the marginal revenue curve is a line that connects the two
segments of the marginal revenue.

79
  As with previous models, the profit maximizing output is determined by equating
marginal cost and marginal revenue. Thus the output rate is Qe and the price is Pe
 Note that even though the marginal cost curve shifted upward or downward within
the vertical section of the marginal revenue curve (RS), there is no change in the
profit maximizing price and quantity. For price and quantity to change, the
marginal cost curve must shift enough to cause it to intersect the marginal revenue
either above point R or below point S.

Review Questions
i) Describe the different markets structures
ii) Discuss the concept of kinked equilibrium under an oligopoly
iii) Explain the inefficiency of a monopoly when a tax is imposed on it?
iv) Explain why the perfectly competitive markets produces normal profits in the long
run

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CHAPTER FIVE: ELEMENTS OF GAME THEORY

Learning Objectives

By the end of this chapter the learner should be able to:

i) Explain the meaning of game theory

ii) Understand the importance of game theory in economics
iii) Explain the concept of Nash Equilibrium
iv) Apply the game theory principles in the oligopoly market

5.1 Introduction
Game theory is a slightly oddly defined subject matter. A game is any decision problem
where the outcome depends on the actions of more than one agent, as well as perhaps on
other facts about the world. Game Theory is the study of what rational agents do in such
situations. You might think that the way to figure that out would be to come up with a
theory of how rational agents solve decision problems, i.e., figure out Decision Theory, and
then apply it to the special case where the decision problem involves uncertainty about the
behaviour of other rational agents. Indeed, that is really what I think. But historically the
theory of games has diverged a little from the theory of decisions. And in any case, games
are an interesting enough class of decision problems that they are worthy of attention
because of their practical significance, even if they don’t obviously form a natural kind.

Let’s start with a very simple example of a game. Each player in the game is to choose a
letter, A or B. After they make the choice, the player will be paired with a randomly chosen
individual who has been faced with the very same choice. They will then get rewarded
according to the following table.
 If they both choose A, they will both get £1
 If they both choose B, they will both get £3
 If one chooses A, and the other B, the one who chose A will get £5, and the
one who chose B will get £0.

81
We can represent this information in a small table, as follows. (Where possible, we’ll use
uppercase letters for the choices on the rows, and lowercase letters for choices on the
columns.)

Choose a Choose b

Choose A £1, £1 £5, £0

Choose B £0, £5 £3, £3

5.2 Prisoners Dilemma:

One way to describe a game is by listing the players (or individuals) participating in the
game, and for each player, listing the alternative choices (called actions or strategies)
available to that player. In the case of a two-player game, the actions of the first player form
the rows, and the actions of the second player the columns, of a matrix. The entries in the
matrix are two numbers representing the utility or payoff to the first and second player
respectively. A very famous game is the Prisoner's Dilemma game. In this game the two
players are partners in a crime who have been captured by the police. Each suspect is placed
in a separate cell, and offered the opportunity to confess to the crime. The game can be
represented by the following matrix of payoffs

not confess Confess

not confess 5,5 -4,10

Confess 10,-4 1,1

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Note that higher numbers are better (more utility). If neither suspect confesses, they go free,
and split the proceeds of their crime which we represent by 5 units of utility for each
suspect. However, if one prisoner confesses and the other does not, the prisoner who
confesses testifies against the other in exchange for going free and gets the entire 10 units of
utility, while the prisoner who did not confess goes to prison and which results in the low
utility of -4. If both prisoners confess, then both are given a reduced term, but both are
convicted, which we represent by giving each 1 unit of utility: better than having the other
prisoner confess, but not so good as going free.

5.3 Definition of Key terms in Game Theory

 Game: Any set of circumstances that has a result dependent on the actions of two of
more decision makers ("players")
 Players: A strategic decision maker within the context of the game
 Strategy: A complete plan of action a player will take given the set of circumstances
that might arise within the game
 Payoff: The payout a player receives from arriving at a particular outcome. The
payout can be in any quantifiable form, from dollars to utility.
 Information Set: The information available at a given point in the game. The term
information set is most usually applied when the game has a sequential component.
 Equilibrium: The point in a game where both players have made their decisions
and an outcome is reached.
 Backward induction is a technique to solve a game of perfect information. It first
considers the moves that are the last in the game, and determines the best move for
the player in each case. Then, taking these as given future actions, it proceeds
backwards in time, again determining the best move for the respective player, until
the beginning of the game is reached.
 Dominating strategy A strategy dominates another strategy of a player if it always
gives a better payoff to that player, regardless of what the other players are doing. It
weakly dominates the other strategy if it is always at least as good

83
 Extensive game An extensive game (or extensive form game) describes with a tree
how a game is played.It depicts the order in which players make moves, and the
information each player has at each decision point.
 Mixed strategy A mixed strategy is an active randomization, with given
probabilities, that determines the player’s decision. As a special case, a mixed
strategy can be the deterministic choice of one of the given pure strategies.
 Nash equilibrium A Nash equilibrium, also called strategic equilibrium, is a list of
strategies, one for each player, which has the property that no player can unilaterally
change his strategy and get a better payoff.
 Perfect information A game has perfect information when at any point in time only
one player makes a move, and knows all the actions that have been made until then
 Rationality A player is said to be rational if he seeks to play in a manner which
maximizes his own payoff. It is often assumed that the rationality of all players is
common knowledge.
 Strategy In a game in strategic form, a strategy is one of the given possible actions
of a player. In an extensive game, a strategy is a complete plan of choices, one for
each decision point of the player.
 Strategic form A game in strategic form, also called normal form, is a compact
representation of a game in which players simultaneously choose their strategies.
The resulting payoffs are presented in a table with a cell for each strategy
combination
 Extensive form, also called a game tree, is more detailed than the strategic form of
a game. It is a complete description of how the game is played over time. This
includes the order in which players take actions, the information that players have at
the time they must take those actions, and the times at which any uncertainty in the
situation is resolved. A game in extensive form may be analyzed directly, or can be
converted into an equivalent strategic form.
 Zero-sum game A game is said to be zero-sum if for any outcome, the sum of the
payoffs to all players is zero. In a two-player zero-sum game, one player’s gain is
the other player’s loss, so their interests are diametrically opposed.

84
5.4 Characteristics of games
 There are two or more players involved.
 One or more players make decisions from a certain number of options.
 One decision creates different situations which can affect who makes the next
decision and the options available.
 The decisions made by each player may or may not be known by the other
players.
 There is an ending point, i.e. the game does not continue forever.
 Each combination of decisions determines a payoff to each player.

5.5 Nash Equilibrium

A concept of game theory where the optimal outcome of a game is one where no player has
an incentive to deviate from his or her chosen strategy after considering an opponent's
choice. Overall, an individual can receive no incremental benefit from changing actions,
assuming other players remain constant in their strategies. A game may have multiple Nash
equilibria or none at all.

Example One
Two firms are merging into two divisions of a large firm, and have to choose the computer
system to use. In the past the firms have used different systems, I and A; each prefers the
system it has used in the past. They will both be better off if they use the same system then
if they continue to use different systems.

We can model this situation by the following two-player strategic game.

Player 2
I A
I
2,1 0,0
Player 1
A 0,0 1,2

To find the Nash equilibria, we examine each action profile in turn.

85
(I,I)
Neither player can increase her payoff by choosing an action different from her current one.
Thus this action profile is a Nash equilibrium.
(I,A)
By choosing A rather than I, player 1 obtains a payoff of 1 rather than 0, given player 2's
action. Thus this action profile is not a Nash equilibrium. [Also, player 2 can increase her
payoff by choosing I rather than A.]

(A,I)
By choosing I rather than A, player 1 obtains a payoff of 2 rather than 0, given player 2's
action. Thus this action profile is not a Nash equilibrium. [Also, player 2 can increase her
payoff by choosing A rather than I.]
(A,A)
Neither player can increase her payoff by choosing an action different from her current one.
Thus this action profile is a Nash equilibrium.

We conclude that the game has two Nash equilibria, (I,I) and (A,A).

Example Two

Consider a market comprising of two competing firms, Nation and Standard, and a choice
of two strategies for each: advertise and don’t advertise. The possible outcomes and payoffs
are presented in the payoff matrix below.

Standard
Advertise Don’t Advertise
Nation Advertise (5,4) (6,2)
Don’t Advertise (3,6) (4,3)

Determine the equilibrium strategy for each of the firms and the equilibrium of this
advertising game.
Nation:
If Standard chooses to advertise, then:
If Nation advertises, the payoff = 6
If Nation doesn’t advertise, the payoff = 4
86
Nation will choose to advertise
If Standard chooses not to advertise, then:
If Nation advertises, the payoff = 5
If Nation doesn’t advertise, the payoff = 4
Nation will choose to advertise
Equilibrium strategy for Nation is to advertise
Standard:
If Nation chooses to advertise, then:
If Standard advertises, the payoff = 4
If Standard doesn’t advertise, the payoff = 2
Standard will choose to advertise
If Nation chooses not to advertise, then:
If Standard advertises, the payoff = 6
If Standard doesn’t advertise, the payoff = 3
Standard will choose to advertise
Equilibrium strategy for Standard is to advertise
Conclusion: Equilibrium of the game is advertise, advertise.

5.6 Oligopoly and Game Theory: (Single period or static games).

Firms or players “meet only once” in a single period model. The market then clears one
and for all. There is no repetition of the interaction and hence, no opportunity for the firms
to learn about each other over time. Such models are appropriate for markets that last only a
brief period of time.
There are three main types of static oligopoly models.

 Cournot

 Bertrand

 Stackelberg

87
5.6.1 THE COURNOT MODEL
Augustin Cournot was a French mathematician. His original model was published in 1838.
He started with a duopoly model. His idea was that there was one incumbent firm
producing at constant unit cost of production and there was one rival firm considering
entering the market. Since the incumbent was a monopolist, p > MC, and there was
potential for a rival to enter and to make a profit.
Cournot postulated that the rival firm would take into account the output of the
incumbent in choosing a level of production. Similarly he postulated that the monopolist
would consider the potential output of the rival in choosing output.

General assumptions of the Cournot model.

 Two firms with no additional entry.

 Homogeneous product such that q1 + q2 = Q where Q is industry output and qi is
the output of the ith firm.
 Single period of production and sales (consider a perishable crop such as
cantaloupe or zucchini).
 Market and inverse market demand is a linear function of price.
 Each firm has constant and equal marginal cost equal to c. With constant
marginal cost, average cost is also constant and equal to c.
 The decision variable in the quantity of output to produce and market. Example
Model

Equilibrium of the Cournot Model:

Both firms to take into consideration the Best Response functions and produce the same
output at the point where P=MC.

5.6.2 THE BERTRAND MODEL

In the Cournot model each firm independently chooses its output. The price then adjusts so
that the market clears and the total output produced is bought. Yet, upon reflection, this
phrase “the price adjusts so that the market clears” appears either vague or incomplete.

88
What exactly does it mean? In the context of perfectly competitive markets, the issue of
price adjustment is perhaps less pressing. A perfectly competitive firm is so small that its
output has no effect on the industry price. From the standpoint of the individual
competitive firm, prices are given i.e., it is a “price- taker.”

Hence, for analyzing competitive firm behavior, the price adjustment issue does not arise.
The issue of price adjustment does arise, however, from the perspective of an entire
competitive industry. That is, we are obliged to say something about where the price,
which each individual firm takes as given, comes from.

The Cournot duopoly model, recast in terms of price strategies rather than quantity
strategies, is referred to as the Bertrand model. Joseph Bertrand was a French
mathematician who reviewed and critiqued Cournot’s work nearly fifty years after its
publication in 1883, in an article in the Journal des Savants. Acentral point in Bertrand’s
review was that the change from quantity to price competition in the Cournot duopoly
model led to dramatically different results.
Assumptions of the Basic Bertrand Model.

 Two firms with no additional entry.

 Homogeneous product such that q1 + q2 = Q where Q is industry output and qi is
the output of the ith firm.
 Single period of production and sales
 Market and inverse market demand is a linear function of price. p = A − BQ = A − B
(q1 + q2) Q = AB −pB= A – pB
 Each firm has constant and equal marginal cost equal to c. With constant marginal
cost, average cost is also constant and equal to c.
 The decision variable is the price to charge for the product.

Equilibrium of the Betrand Model

The Nash Equilibrium of the Betrand game will be : P1 = P2 = C. Where P1, P2, C are the
price of firm 1, price of firm 2 and marginal cost of both firms respectively.
89
Any deviation from this condition is not optimal
Suppose firm 1 raises the price such that: P1 P2 = C. It means that firm will take the
whole market .If firm 2 increases the price, same thing will happen to it.
Suppose that: P1 = P2 C. Both firms can continue to share the demand in the market
.However if any of the firms decide to deviate it will take the whole market.

Review Questions
i) Describe the elements of game theory
ii) Explain the stages involved in establishing a Nash equilibrium
iii) Explain the equilibrium under the Betrrand Model
iv) Explain the prisoners dilemma

CHAPTER 6: GENERAL EQUILIBRIUM

Learning Objectives

By the end of this chapter the learner should be able to:

i) Illustrate the concept of efficiency of exchange
ii) Explain the concept of general equilibrium
iii) Illustrate the concept of Edgeworth Box Diagram and its
application

6.1 Efficiency of exchange

The state of efficiency in exchange/consumption i.e. how we can exchange one good for
another but maintaining the same level of utility.

We shall assume two people A & B two goods 1 and 2.

MRS12A  MRS12B Efficiency in exchange

Efficiency in production where we assume two goods 1 and 2 and two inputs L and K, such
that.
90
MRTS 12L  MRTS 12K Efficiency in production

6.2 The Edgeworth Box Diagram

This is a convenient graphical tool known as the edgeworth box that can be used to analyze
the exchange of two goods between two people. It allows us to depict the endowments and
preferences of two individuals in one convenient diagram.
Let us assume two people involved A & B and two goods 1 & 2.
 
Let person A’s consumption bundle be X A  X 1A X A2 where X 1A represents to A’s
consumption of good 1 and X A2 represents As consumption of good 2.

B’s consumption bundle of the two goods is X B  X B1 X B2 .
A pair of consumption bundles X A and X B is called an allocation. An allocation is a
specific allocation if the total amount of each good consumed is equal to the total amount
available.

i.e.
X 1A  X B1  W A1  WB1
X A2  X B2  W A2  WB2

where W A1 for instance is the total availability of good 1 to person A and W B1 WB is the
availability of good to person B.

Good 2
w1B x1B
Person B

x A2 M x B2

Endowment
2 W
w A wB2

Person A

x1A w1A
Good 1
The width of the box measures the total amount of good 1 in the economy and the height
measures. The total amount of good 2. Persons A’s consumption choices are measured
from the lower left hand corner while person B’s choices are measured from the upper
right.

The bundles in this box indicate the amount of goods that each person can hold. If for
example there are 10 units of good 1 and 20 units of good 2, then if A holds (7,12), then B
must be holding (3,8).

For instance at point M, if person A holds X 1A if good 1, then B holds X B1 of good 1. if A

holds X A2 of good 2, then B holds X B2 of good 2.

Consider Point W
Movement from point W to point M for example puts person A to a higher 1C I MA from I WA
. Hence making person A better off without necessarily making person B worse off. To
move to point M person A have to forego WA1  X 1A   amount of good 1 and have

X 2
A  
 WA2 amount more of good 2. on the other hand person B has to forego WB1  X B1 

amount of good 2 in oder to have more of good 1 i.e. X B1  WB1 .
All the same, this movement makes person A better off by putting him on a higher IC.
Similarly, movement from point W to point N will make person B better off without
making person A worse off.

At a pareto efficient allocation each person is on his highest possible IC given the IC of the
other person. A pareto optimal state is therefore a state such that changing the state will at
least make one person better off at the expense of the other. One is made better off while
the other is made worse off.

A line connecting all such points in consumption contract curve. It is a locus off all
efficient allocation in consumption.

92
A long the c.c.c. the MRS for both persons is the same. When this condition is met, then
the first condition for social welfare maximization has been achieved i.e.

MRS12A  MRS12B

Generally:

MRS12A  MRS12B  MRS12C  ...  MRS12n

By definition, a pareto efficient allocation makes each agent as well-off as possible given
the utility of the other agent. Let u be the utility level for agent B, so how can agent A be
made as well-off as possible?
The maximization problem is:


MaxUA X 1A , X A2 
st
 
UB X B1 , X B2  U
X  X W1
1
A
1
B

X Z2  X B2  W 2

Where.

W 1  WA1  WB1 is the total amount of good 1 available and W 2  WA2  WB2 is the total
availability of good 2.

 
We then seek to find X 1A X A2 X B1 X B2 i.e. X A and X B that makes person B’s utility, and
given that the total amount of each good used is equal to the amounts available.

We can write the langrangian for this problem as:

        
L  UA X 1A X A2   UB X B1 X B2  U  1 X 1A  X B1  W 1   2 X A2  X B2  W 2 
 is the language multiplier on the utility constraint and  ' s are the language multipliers
of the resource constraints.

Getting the FOC’s.

93
 L UA
  1  0.......... .......... .......... ....... I 
X A X 1A
1

L UA
  1  0.......... .......... .......... ....... II 
X A X 1A
1

L UB
  1  0.......... .......... .......... ....... III 
X B X B1
1

L UB
   2  0.......... .......... .......... ....... IV 
X B X B2
2

If we divide the first equation by the second and the third equation by the fourth we have:
UA UA 1 1
  MRS 12 A 
X A X A  2
1 2
2
UB UB 1 
  MRS B12  1
X B X B  2
1 2
2
At a pareto efficient allocation the MRS between the two goods must be the same.

Review Questions
i) Explain the concept of efficiency of exchange
ii) Describe the concept of pareto efficiency
iii) Use the edgeworth box to explain the concept of general equilibrium

94
CHAPTER 7 : CHAPTER TWO: PUBLIC GOODS,MARKET FAILURE AND
EXTERNALITIES

Learning Objectives

By the end of this chapter the learner should be able to:

i) Describe the characteristics of public goods

ii) Explain the causes of market failure
iii) Describe the causes and solutions to externalities
iv) Outline the possible solutions to market failure
v)

7.1 Characteristics of Public Goods

We now need to consider how the characteristic of pure public goods relate to the concept
of market failure. There are some goods that either will not be supplied by the market or if
supplied would be supplied in insufficient quality e.g. defence, street lighting etc. These
are called public goods. If a pure public good is to be available for consumption then it
must be provided collectively either through private voluntary arrangements or public via
the budget.

Pure public goods have 2 properties

(1) Non-excludability
(2) Non-rival in consumption.

Non-excludability characteristics of public goods

In the case of pure private good a set of property rights define the ownership of the good.
The individual who possess the property right has the sole claim to enjoy the benefits of the
good and can therefore exclude others from doing so. In the case of a pure public good
technical feature of excludability begin to breakdown. First, it is generally difficult to
exclude individuals from enjoyment of public good. If for example a geographical area is
provided with defence services which diverts and attack from abroad it becomes extremely
difficult to exclude anyone who lives in the country from being defended. Similar example
is found in street lighting.

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For pure public good the degree of exclusion depends upon the technical characteristics of
the good and the resources available to the producer to enforce the exclusion.
In general, however, there is no perfect exclusion. So an optimal amount of exclusion is a
decision to be made by a producer.

Second reason why the exclusion principle breakdowns is that, while it may be technically
feasible to exclude, the application of exclusion device may be very expensive. That is, the
cost of exclusion can outweigh any advantages to be obtained from its application. A pure
public good is the one for which exclusion is either technically not feasible and if feasible,
the cost of enforcing the exclusive device is too prohibitive to apply.

With non-excludability, there is no incentive for a profit maximizing producer to supply the
public good because once he produces it he cannot exclude individuals from consuming it
and hence he is unable to charge a price. Individuals wishing to consume the benefits of a
pure public good could, however, form a private co-operative. They could agree to
contribute to the cost of supplying the public good. Such an arrangement might be feasible
for a small group of individuals, but as the group grows in size the possibility of individuals
becoming free riders increases and the private voluntarily arrangement fails.

Non-rivalness in consumption
Definition of a pure public good implies that it is non-rival in consumption. It means that it
does not cost anything for an additional individual to enjoy the benefit of public goods.
Non-rivalness arises from the indivisibility of public goods. That is, adding one or more
persons (up to a capacity constraint) does not add to the marginal cost.

Formally there is zero marginal cost for an additional individual to enjoy a good. Non-
rivalness thus implies, one individual access to the commodity does not reduce another
individual’s benefit because these benefits are available to all without interference. A
perfect solution in this case would require a zero price because marginal cost equals zero.

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This will mean that revenues will not cover losses and so a private profit maximizing
producer will not supply such a commodity. The market, in other words, will not allocate
such goods efficiently thus the market failure.

CLASSIFICATION OF PUBLIC GOODS

Therefore goods can be classified into four cases according to their consumption and
excludability characteristic.
Exclusion
Consumption Feasible Not Feasible
Rival 1 2
Non-Rival 3 4
Characteristic
Case 1: This is a private goods that is rival in consumption and excludable e.g. a loaf of
bread, clothing. You only consume the goods after paying for it. Whoever does not pay is
excluded. Benefits are internalized.
Case 2: This represents a good that is rival in consumption but non-excludable. In this case
there is market failure due to non-excludability or high cost of exclusion. Example, travel
on a crowded street, traffic jam due rush hours.
Case 3: This is a good that is non-rival in consumption but excludable. Examples are clubs,
watching a movie, swimming, education, crossing a bridge that is not crowded.
Case 4: This is a good that is non-rival in consumption and non-excludable. This is a pure
public good. Examples are, air purification, national defence, street lights e.t.c.

7.2 MARKET FAILURE:

Where the market is efficient, consumers have freedom to choose what they want to
consume freely, and they reveal their preferences to producers. Producers, in trying to
maximize their profits will produce what consumers want to buy and will do so at least cost.
Competition will not only ensure that the mix of goods and services produced corresponds
to consumers preferences, but would ensure that resources are allocated efficiently. The
main assumption here is markets are efficient and competition.
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Under normal circumstances, however, this may not be the case. Market may fail to
achieve an efficient allocation of resources, leaving open the possibilities that government
provision of certain commodities might enhance efficiency. Given the presence of market
failure, one possible role for government would be to intervene in allocation function of the
market to correctly the market failure or introduce policies that would compensate its effect.
This gives rise to the allocation function of the government.

Market failure will also bring about the question of equity of social justice in the
distribution of income and welfare where market failure produces a socially unjust
distribution of welfare, government intervene to bring about a distribution that is considered
to be socially just and fair. This is referred to as distributional role of government.

Market failures could also produce macro-economic instability such instability as

inflation, unemployment, BOP disequilibrium, etc. In these circumstances, a stabilization
role exist for government to intervene in the economy using monetary and fiscal policies to
bring about desired level of inflation and unemployment, thereby improving the welfare of
society.
Further, there is a regulative function which government performs. As part of its allocative
role government enact and enforce laws of contracts. It also administers the more general
system of laws, order and justice which regulates individuals or firms behavior.
7.2 1 Causes of Market failure.
a) Imperfect competition as a cause of market failure
When some agents have the ability to affect price, the allocation of resources generally is
inefficient. An extreme form of such market power is monopoly, which comprises of one
seller in the market for a given commodity. Conditions that bring about monopoly
includes:-
 Where transportation costs are large the relevant market may be limited a
geographically if there is only one firm in such a locality, there may be no or very
limited competition.

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 In case where cost of production per unit of output declines (decreasing cost of
production or increasing returns to scale) entry into industry becomes very difficult,
thereby permitting the firms already established to exercise natural monopoly.
 Some monopolies are created by the government or run by the government. The
Kenyan government, for example, has given the Kenya Power and Lighting Company
the exclusive right to generate and distribute electricity in the country. Patent rights
given to some investors grant them monopoly over their invention over specified period
of time.
If monopoly has some possible aspects then why is it generally viewed as bad? The reason
is that, if not regulated and if allowed to trade freely, they would restrict output to attain
higher prices. The design of optimal government policy is therefore one of the weighing out
the distortions and inefficiencies introduced by interventions, compared with the
inefficiencies that the policies are designed to reduce.

b) Imperfect/ Costly information

The competitive model assumes that information on existing prices is somehow spread
around at no cost, so that everyone can find the best price. In reality, this is not the case.
Shopping around to find the lowest price requires time which is a valuable commodity.

Moreover, once information is obtained, it may be asymmetric. Thus, it is possible that

because individuals do not have the necessary information to make the right economic
decision, inefficient patterns of resource allocation emerge. Asymmetric information
refers to situations in which the parties on the opposite sides of transaction have differing
amounts of relevant information. For instance, doctors have more knowledge and
information about medicine than patients /consumers, the individual may not be the best
judge of his/her own interests, the doctor acts as an agent of the patients demand.
There are two main forms of asymmetric information
i) Adverse selection: A situation often resulting from asymmetric information in
which individuals are able to purchase insurance at the rates that are below

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 actuarially fair rates plus loading costs. An event in healthcare whereby one
party decides not to reveal the full extent of their risk profile to the other party
(i.e. insurance model). A company selling health care insurance has to estimate
the level of risk accurately. This is difficult because they will not have complete
information on the risk status of the person they are insuring. One solution is to
set the premium at an average risk level. But this makes the policy expensive for
low risk customers who therefore may choose not to buy the insurance. The
process whereby the best risks select themselves out of the insured group is
called adverse selection. Insurance companies know that this is likely to happen
so they offer different premiums according to the level of risk and the person’s
experience of ill health. This is why most companies will offer non-smokers a
lower premium than smokers. Offering low insurance premiums to low risk
groups, often called ‘cream skimming’ or ‘cherry picking’, means high
premiums have to be charged to high risk groups such as the elderly or
chronically sick. Therefore, in a free market, health care insurance is likely to be
too expensive for many people, and especially for those most in need of health
care.

ii) Moral hazard: the possibility of consumers or providers exploiting a benefit

system unduly to the disadvantages of other consumers, providers or the
financing community as a whole. It refers to an insurance term that represents
the disincentives created by insurance for individual to take measures that would
reduce the amount of care demanded. In the health services literature, it is more
commonly used to express the additional quantity of health care demanded,
resulting from a decrease in the net price of care attributable to insurance. Moral
hazard can affect any insurance market, but is a particularly serious problem for
health care insurance. Consumers who are insured have an incentive to over-
consume health care - to demand operations and treatments, which they would
not choose if they were directly paying for them. They may also not bother to

100
 iii) follow a healthy lifestyle or to get preventative checkups. As a result, when they
do fall ill, the cost of treatment is higher than it would otherwise have been.

c) Externalities
Where provision of certain products result to “externalities”, market cannot function
effectively. In this basic competitive model, people interact solely by trading with each
other in the market. There are situations, however, in which economic agents affect each
other in ways outside the market. According to Harvey S. Roser, “the activity of one person
affecting the welfare of another in a way that is outside the market is termed and
externality.”

Musgrave and Musgrave define externality as, ‘a situation where the benefit of
consumption of a given good or service cannot be paid by producer who causes them
to result into external costs to others.
For example, a particular technology used in the production of a private good producers
smoke as a by-product (i.e. the externality of spill-over) which is involuntarily consumed by
people living near the factory, thus lowering their utility. Despite the producer causing
pollution, he does not include such external costs as eradicating air pollution in his
production costs. So that, his private costs (costs of living inputs) is less than the overall
social cost (private costs and external costs). This external diseconomy will result in the
overall production of the good associated with the diseconomy, and the allocations would
differ from those that would have been produced by perfectly competitive markets. The
existence of externalities results in outcomes that are not pave to efficient.

In the presence of externalities and public goods competitive market equilibria cannot be
expected to yield socially efficient resource allocations. This is due to "special"
characteristics of externalities and public goods called "non-excludability" and/market
thinness," or what is more commonly called the "free rider problem."

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Free-rider problem
The free rider problem exits when people enjoy the benefits of government provided goods
i.e. public goods, independent of whether they pay for them. Free riders are actors who take
more than their fair share of the benefits or do not shoulder their fair share of the costs of
their use of resource. The actual "Free rider problem" can therefore be defined as the
question of how to prevent free riding from taking place or at least limit its effect. Since the
notion of "fairness" is highly subjective, free riding is only considered/to be an economic
problem when it leads under or non-production of a public good thus Pareto inefficiency.
Examples of free riding:
i) National defense-one is protected whether or not he pays for the services
rendered
ii) An employee who pays no union dues but benefits from union representation as
dues-payers since the union owe a duty fo fair presentation to all employees.
iii) 25 people living in a street each prepared to pay $100 for installation of a CCTV
costing $2500. Since if the system is installed everyone will benefit from it, its
very possible that some people will refuse to pay, and instead hope that others
will pay for the system anyway, and receive benefits for no personal expense.
This will result in no system installed, an example of market failure. This is
despite the fact that allocative efficiency would be improved.

Forms of Externalities:
There are two forms of externalities:
(i) Positive Externalities
(ii) Negative Externalities
(iii) Fiscal Externalities

(i) Positive Externalities:

A positive externality is something that benefits society, but in such a way that the producer
cannot fully profit from the gains made. A few examples of positive externalities are
environmental clean-up and research. A cleaner environment certainly benefits society,
102
but does not increase profits for the company responsible for it. Likewise, research and new
technological developments create gains on which the company responsible for them cannot
fully capitalize.

(ii) Negative Externalities:

A negative externality is something that costs the producer nothing, but is costly to society
in general. Unfortunately these externalities are much more common. Let's take an example
of pollution. This is a very common negative externality. A company that pollutes loses no
money in doing so, but society must pay heavily to take care of the problem pollution
caused. The problem this creates is that companies do not fully measure the economic costs
of their actions. They do not have to subtract these costs from their revenues; hence profits
inaccurately portray the company's actions as positive. This can lead to inefficiency in the
allocation of resources.

iii) Fiscal Externalities:

This is whereby the behavior of people affects the cost of some subsidy or alters the
revenues from some tax as externalities. Fiscal externalities do not necessarily imply any
inefficiency, and when there is inefficiency, it is the result of the pre-existing policy. An
example is smoking; this imposes costs on taxpayers due to the existence of subsidized
medical care. In this case the medical care subsidy creates the fiscal externality.
However, when there is inefficiency, the nature and magnitude of the fiscal externality is
not a reliable guide to the appropriate corrective policy. Like in the above example, it will
usually be best to modify the pre-existing policy (the medical care subsidy) rather than tax
smoking.

Implications of Externalities for allocative efficiency:

The prevalence of externalities in the market based economy suggests that the optimality
rules normally assumed to lead to allocative efficiency may not in fact lead to the most
socially efficient outcome. The presence, of externalities thus represents an example of
market failure to achieve allocative efficiency.
103
This is because in the presence of externalities the market price of a good may not reflect
the true societal cost or benefit and hence may be under or over produced. Figure EE1
illustrate the implication of negative externalities for allocative efficiency.

Figure : Effects of Negative Externality on allocative efficiency

Dollars SMC = (PMC + d)
per year
S (PMC)
P*

D
d

X* Xp Tons of output per year

In a free market where the optimality rules have been followed the quantity produced will
occur at quantity Xp and price Pm, the point where demand (D) equals the private marginal
cost (PMC). However where a negative externality exists the market fails to produce the
socially optimal level of production. This is because the marginal damage (d), generated by
the negative externality, is a cost not taken in to account in the market. When a social
marginal cost (SMC) curve is generated it is possible to see that socially optimal level of
production is in fat X* and that the product should be sold at a higher price P* to reflect the
fact that the true social cost of the product is higher than the private cost.

Positive externalities also have their own special implications for the achievement of
allocative efficiency. Figure EE2 illustrates the implications for the optimality rules of a
positive externality. The market equilibrium in this situation occurs at quantity' Q* and
price Pm where the private marginal benefit (PMB) of the item equals its marginal cost.

104
However this item produces an external benefit (b) which is not taken in to account by the
market. The socially optimal quantity of this item actually occurs where the social marginal
benefit (SMB) curve derived by summing the private marginal benefit and the external
benefit, equals the marginal cost of producing the item. This analysis suggests that the
allocatively efficient situation occurs at quantity Q* and price p*.
Figure : Effect of positive externality

Dollars Per
year MC

P*

b
SMB (PMB + b)
PMB

QP Q* Units of outputs per year

The conclusion which can be drawn from this is that true allocative efficiency will not be
achieved unless the external benefits and costs associated with externalities are taken in to
account when making economic analysis.

Solutions to Externalities:
i) Internalize Externalities:
Economists recognize that negative externalities are a major problem. To combat this
problem, the government might try to force companies to internalize externality' costs. In
any type of production and economy, some negative externalities of production are
inevitable. The real problem created by negative externalities in the free-market economy
is that because they are not a cost to the company, the company will see only what is
profitable to itself, not to society as a whole; this will create inefficiency in the economy.

105
The famous economist Milton Friedman says that the government should require companies
to pay for the costs of cleaning up the problems they create.

This can be accomplished through taxes and fees, making companies pay for the amount of
harm they do to society as a whole. This solves the inefficiency problem. If companies
have to pay the costs of pollution, they can accurately compare the total costs and revenues
of production and determine if it is profitable to produce. However the government still has
to struggle with the question of placing a monetary value on such things as death,
extinction, the destruction of forests, and many other social costs and it is not always easy
to put this policy into practice. Regulations are not always enforced, and governments may
simply choose to relax their standards in order to avoid hurting businesses.

ii) Social Conventions;

This deals with negative externalities through social conventions and tradition. The
argument here is that "certain social conventions can be viewed as attempts to force people
to take in to account the externalities that they generate." and through tradition "recognition
of signals and appropriate responses are instilled as part of the culture." The example
associated with this is impressing on people from a young age that even though one bears a
cost by holding on to litter until a bin is found that one should do so because of the
externality which litter creates. However its overall usefulness may be limited to low cost
externalities generated by individuals.

iii) Property Rights:

The establishment and enforcement of private property rights provide an alternate
framework for the solving of externalities. "A private property right is a legally established
title to the sole ownership of a scarce resource that is enforceable in the courts." Private
property rights offer a number of solutions to the problems posed by externalities. Firstly,
the establishment and enforcement of greater private property rights by the legal system
would allow victims of negative externalities to sue the offending party for compensation
106
for the damage caused. For example, if property rights to a section of river are assigned to a
particular fishing club, then that club will be able to sue the chemical firm/upstream which
pollutes the river and kills the fish stock in the fishing clubs section of the river.

iv) Coase Theorem & Bargaining:

The other way in which property rights can assist in achieving allocative efficiency is by
providing a framework in which bargaining may take place. Consider the situation
illustrated in Figure below which builds on the fishing club example.

Figure : Property rights and. bargaining

Dollars per SMC = (PMC + d)

Years

PMC

MR

X* XP Tons of chemical per year

The Coase Theorem suggests that " the efficient solution will-'be achieved independently of
who is assigned the ownership rights , so long as someone is assigned those rights" The
reasoning for this is that if the chemical firm is assigned the property rights , the fishing
club will be prepared to pay the chemical firm an amount up to the value of the damage
being caused, to have the chemical firm reduce its output and that at any point past X* the
damage being caused exceeds the firms profits from doing so. Hence the firm is willing to
accept the payment to reduce its output to X*. Similarly if the fishing club has the rights, it
will not allow the firm to produce past X* as the damage caused to the fishing club is
greater than any payment the firm would be willing to make.

107
The establishment of property rights thus creates a framework which allows bargaining and
the achievement of the socially optimal outcome.

v) Mergers:
Another possible solution to the problem of externalities may be for the parties involved to
merge. For example if a fishing companies profits are being harmed by the pollution
produced by a steel mill then the problem of this externality can be solved by merging the
parties involved and internalizing the effects. "For instance, if the steel manufacturer
purchased the fishery, he would willingly produce less steel than before, because at the
margin doing so would increase the profits of the fishing subsidiary more than it decreased
the profits from his steel industry.” This suggestion too however may be seen as having a
number of problems in its practical implantation.

vi) Tradable Pollution Permits:

Tradable pollution (or emission) permits are a free-market solution to the problems caused
by negative externalities. The difficulty is that companies that pollute create a cost to
society but not a cost to themselves. Because the company does not have an accurate view
of its costs of production, it cannot set its production at the level that maximizes efficiency
in the economy. One method of stopping this economic problem is to impose emission (or
pollution) taxes. This would mean that companies have to pay a certain amount for the
pollution they produce. While this system would solve the externalities problem, it would
make it difficult for the government to set absolute pollution limits if it felt the need to do
so.

Tradable emission permits allow the government to give companies licenses to pollute at a
certain level. Companies can buy, sell, and trade these permits on the market. Therefore it
is in the interests of companies to pollute as little, as possible. If they pollute at a level
higher than their permit allows, they have to buy permits from another company. If they
pollute less than they are allowed to, they can sell their permit.

108
Conclusion:
In conclusion then it can thus be said that the existence of externalities and the failing of the
market to adequately deal with them has serious implications for the achievement of true
allocative efficiency within the economy.
Whilst there are a number of possible approaches to correcting the problems caused by
externalities, each of the suggested solutions entails its own problems which must be
overcome before society will have an effective means of dealings with the problems caused
by externalities.

Review Questions
i) Explain of market failure
ii) Describe two characteristics of public goods
iii) Explain the causes of market failure
iv) Explain the possible solutions of externalities

109
 SAMPLE QUESTION PAPER 1
MOUNT KENYA UNIVERSITY
UNIVERSITY EXAMINATIONS 2012/2013
SCHOOL OF SOCIAL SCIENCES
DEPARTMENT OF ECONOMICS AND DEVELOPMENT STUDIES
BED2206: INTERMEDIATE MICRO ECONOMICS TIME: 2 HOURS
Instructions: Answer any Question ONE and any other TWO Questions.

Question 1

a) Describe any three solutions to the problem of externalities (6 marks)

b) Suppose that the demand equation for Delmonte, a monopolist. is given by P = 400 –
20Q cost equation is given by TC = 500 + 20Q2 and. Find the profit-maximizing price
and output for the monopolist. (6 marks)
c) With the help of indifference curves differentiate between perfect substitute goods and
bads (6 marks)
d) Explain four elements of game theory (4 marks)
e) Write short note on
i) Kinked Oligopoly demand curve ( 5 marks)
ii) Public good ( 3 marks)

Question 2
a) Consider a consumer who consumes two normal goods X1 and X2. Suppose the
price of X1 reduces, Use an appropriate diagram to illustrate the effect of this price
changes, while separating the income and substitution effects
(7 marks)
b) Suppose now good X1 is either (i) an inferior good or (ii) giffen good , explain with
a diagram the effect of the price change in each of the cases (7 marks)
c) Explain any four sources of monopoly power (6 marks)

Question 3
a) With the help of diagrams , use the concepts of total product, marginal product and
average product to describe the characteristics of three stages of production and
explain why a firm may not operate in the first and third stage of production ( 8
marks)
b) Explain three assumptions of consumer rationality (6 marks)
c) A Jua Kali artisan produces specially designed leather belts. The demand
curve for the belts is as follows:-

Price Sh Quantity of belts (units)

1500 200
2000 100

i) Calculate the arc elasticity of demand and interpret it (3 marks)

ii) Highlight three uses of elasticity (3 marks)
Question 4
a) Consider the cost function of Bamburi Cement Ltd given by Total cost (TC) = 4q2 +
16. Find the variable cost, fixed cost, average cost, average variable cost, average
fixed cost and the marginal cost for Bamburi Cement Ltd. ( 10 marks)

b) Demonstrate how the quantity demanded for both substitutes and complements for a
commodity will each shift, due to an increase in the price of the commodity (6
marks

c) A monopoly might charge different prices to different customers of similar goods

and services in different markets in order to increase his profit levels and where
price differences are not justified by cost differences. Highlight any four conditions
for price discrimination (4 marks)

Question 5
a) Consider a market comprising of two competing firms, Nation and Standard, and a
choice of two strategies for each: advertise and don’t advertise. The possible outcomes
and payoffs are presented in the payoff matrix below.

Standard
Advertise Don’t Advertise
Nation Advertise (7,6) (8,4)
Don’t Advertise (5,8) (6,5)

Determine the equilibrium strategy for each of the firms and the equilibrium of this
advertising game. (10 marks)
b) Discuss any five sources of market failure (10 marks)
 SAMPLE QUESTION PAPER 2
MOUNT KENYA UNIVERSITY
UNIVERSITY EXAMINATIONS 2012/2013
SCHOOL OF SOCIAL SCIENCES
DEPARTMENT OF ECONOMICS AND DEVELOPMENT STUDIES
BED2206: INTERMEDIATE MICRO ECONOMICS TIME: 2 HOURS
Instructions: Answer any Question ONE and any other TWO Questions.

Question One
a) With the help of relevant economic tools/methodologies where possible, briefly explain
the meaning of the following terms. (10 marks)
i. Pareto efficiency
ii. Consumer equilibrium
iii. Price elasticity of demand
iv. Necessary condition
v. Marginal Rate of Substitution

b) Graphically show and explain the substitution effect and income effect for a fall in price
for a normal good and an inferior good. (10 marks)
c) Explain the concept of the deadweight loss in a case of a monopoly and show that the
perfectly competitive market is more efficient (10 marks)

Question Two
a) Given the following equation U = √ , decompose the total effect of a price change
when the price of good one reduces by 10% from Ksh. 20. The income of the
consumer is Ksh.5000 per month while the price of good two is Ksh. 30
(10 marks)
b) Describe the causes of market failure (10 marks)

Question Three
a) Explain in detail the axioms of consumer preferences (8 marks)
b) With the help of well labeled diagrams, explain the differences in indifference curves
for the neutral goods, perfect substitutes, bad goods and perfect complements.
(12 marks)
Question Four
a) Explain in details the properties of technology (6 marks)
b) If firm uses only two inputs X1 and X2 to produce output Y, assuming short-run profit
maximization, show graphically the firm’s optimal level of output and input. Derive
the optimality condition in this case.
(10 marks)
c) State and explain the condition for efficiency in exchange (4 marks)
 Question Five
a) Differentiate between cardinal and ordinal utility (4 marks)
b) Explain two characteristics of public goods (4 marks)
c) Describe the equilibrium in the Bertrand Model of oligopoly (8 marks)
d) Outline the key characteristics of game theory (4 mark