An Introduction To A Level Economics

BRIAN ROPI ADVANCED LEVEL ECONOMICS
AN INTRODUCTION TO A LEVEL ECONOMICS

Human needs and wants are unlimited meaning people will never reach a point of maximum
satisfaction even if they are to be given all the resources of the world. People by nature always
demand more to less.
Resources of the world are not enough to satisfy human needs and wants. Economics is therefore
available to device different ways of allocating scarce resources to try to satisfy people needs and
wants.
Economics is defined in different ways by different authors’ but they all agree on the fact that
economics is all about finding ways of allocating scarce resources.
Economics is a social or human science that deals with the allocation of scarce resources
among the competing ends to satisfy human needs and wants.
Important elements in the definition

Scarcity-resources are scarce on the sense that they are not enough to fulfill everyone’s needs
and wants to the point of satiety. The economists’ job is to evaluate the choices that exist from
the use of these resources.
Economics is a social science
A social science is the scientific study of human behaviour. Other examples of social sciences
are psychology, politics and sociology.
It is different from a physical science, which involves the study of the physical world. Examples
of physical sciences are chemistry and physics.
The Scientific Method
Both physical and social sciences follow a scientific method of study. The method involves
forming a hypothesis, or idea, which can then be tested. In the physical sciences, the hypothesis
can be tested repeatedly in a laboratory until it is proved or disproved. It uses empirical data;
that is, factual information. A hypothesis in a social science can be tested through using methods
such as a survey or through observation. For example, if the idea to be tested is ‘the favourite
drink of students in this class is Coke’, I can test this by asking the students. However, the result
will not be as exact as a result in a physical test because it involves humans whose behaviour is
not always easy to measure. For example, they may not tell the truth and their answers may
THINK LIKE AN ECONOMIST 1

change from day to day. Social sciences often use models help them study complex ideas in
economics. A model is a simplification of reality. It often means that parts of the problem being
studied are kept the same (held constant) while one part is changed. This would show that the
result would be due solely to the part that was changed. Parts that change are called variables,
holding other things constant is called ‘ceteris paribus’.
Normative and Positive Statements
One of the basic tasks of all scientists is to separate facts from opinions (or value judgments).
Positive statements are statements of fact; they can be proved to be correct or incorrect by
looking at the facts. They can be tested empirically.
Statistics are available to help prove facts in Economics. For example, the inflation rate in a
country. This data is available to provide past facts and some information about the future; for
example, when the next set of inflation statistics will be available.
Normative statements are statements of opinion or value judgments. They cannot be tested
empirically.
For example the statement, ‘unemployment is a worse problem than inflation’ is both a matter of
opinion and involves a value judgment. A person’s opinion cannot be proved to be right or
wrong. The economist traditionally does not make value judgments while analysing problems.
Microeconomics and Macroeconomics
Microeconomics
Economists develop economic principles and models at two levels. Micro economics is the part
of economics concerned with individual units such as a person, a household, a firm, or an
industry. At this level of analysis, the economist observes the details of an economic unit, or very
small segment of the economy, under a figurative micro-scope. In micro economics we look at
decision making by individual customers, workers, households, and business firms. We measure
the price of a specific product, the number of workers employed by a single firm, the revenue or
income of a particular firm or household, or the expenditures of a specific firm, government
entity, or family. In microeconomics, we examine the sand, rock, and shells, not the beach.
Macroeconomics

Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates,
such as the government, household, and business sectors. An aggregate is a collection of specific
economic units treated as if they were one unit. Therefore, we might lump together the millions
of consumers in the economy and treat them as if they were one huge unit called “consumers.”In
using aggregates, macroeconomics seeks to obtain an overview, or general outline, of the
structure of the economy and the relationships of its major aggregates. Macroeconomics speaks
of such economic measures as total output, total employment, total income, aggregate
expenditures, and the general level of prices in analysing various economic problems. No or very
little attention is given to specific units making up the various aggregates. Figuratively,
macroeconomics looks at the beach, not the pieces of sand, the rocks, and the shells. The micro–
macro distinction does not mean that economics is so highly compartmentalized that every topic
can be readily labeled as either micro or macro; many topics and subdivisions of economics are
rooted in both. Example: While the problem of unemployment is usually treated as a
macroeconomic topic (because unemployment relates to aggregate production), economists
recognize that the decisions made by individual workers on how long to search for jobs and the
way specific labor markets encourage or impede hiring are also critical in determining the
unemployment rate.
Pitfalls to Sound Economic Reasoning

Here are some common pitfalls to avoid in successfully applying the economic perspective.
Biases- Most people bring a bundle of biases and preconceptions to the field of economics. For
example, some might think that corporate profits are excessive or that lending money is always
superior to borrowing money. Others might believe that government is necessarily less efficient
than businesses or that more government regulation is always better than less. Biases cloud
thinking and interfere with objective analysis. All of us must be willing to shed biases and
preconceptions that are not supported by facts.
Loaded Terminology- The economic terminology used in newspapers and broadcast media is
sometimes emotionally biased, or loaded. The writer or spokesperson may have a cause to
promote and may slant comments accordingly. High profits may be labeled “obscene,” low
wages may be called “exploitive,” or self-interested behavior may be “greed.” Government

workers may be referred to as “mindless bureaucrats” and those favoring stronger government
regulations may be called “socialists.”
To objectively analyze economic issues, you must be prepared to reject or discount such
terminology.
Fallacy of Composition- Another pitfall in economic thinking is the assumption that what is true
for one individual or part of a whole is necessarily true for a group of individuals or the whole.
This is a logical fallacy called the fallacy of composition; the assumption is not correct. A
statement that is valid for an individual or part is not necessarily valid for the larger group or
whole. You may see the action better if you leap to your feet to see an outstanding play at a
Football game. But if all the spectators leap to their feet at the same time, nobody—including
you—will have a better view than when all remained seated. Here are two economic examples:
An individual stockholder can sell shares of, say, Econet stock without affecting the price of the
stock. The individual’s sale will not noticeably reduce the share price because the sale is a
negligible fraction of the total shares of Econet being bought and sold. But if all the Econet
shareholders decide to sell their shares the same day, the market will be flooded with shares and
the stock price will fall precipitously. Similarly, a single cattle ranch can increase its revenue by
expanding the size of its livestock herd. The extra cattle will not affect the price of cattle when
they are brought to market. But if all ranchers as a group expand their herds, the total output of
cattle will increase so much that the price of cattle will decline when the cattle are sold. If the
price reduction is relatively large, ranchers as a group might find that their income has fallen
despite their having sold a greater number of cattle because the fall in price overwhelms the
increase in quantity.
Post Hoc Fallacy- You must think very carefully before concluding that because event A
precedes event B, A is the cause of B. This kind of faulty reasoning is known as the post hoc,
ergo propter hoc, or “after this, therefore because of this,” fallacy. Noneconomic example: A
professional football team hires a new coach and the team’s record improves. Is the new coach
the cause? Maybe. Perhaps the presence of more experienced and talented players or an easier
schedule is the true cause. The rooster crows before dawn but does not cause the sunrise.
Economic example: Many people blamed the Great Depression of the 1930s on the stock market
crash of 1929. But the crash did not cause the Great Depression. The same severe weaknesses in

the economy that caused the crash caused the Great Depression. The depression would have
occurred even without the preceding stock market crash. Correlation but Not Causation Do not
confuse correlation, or connection, with causation. Correlation between two events or two sets of
data indicates only that they are associated in some systematic and dependable way. For example,
we may find that when variable X increases, Y also increases. But this correlation does not
necessarily mean that there is causation—that increases in X cause increases in Y. The
relationship could be purely coincidental or dependent on some other factor, Z, not included in
the analysis. Here is an example: Economists have found a positive correlation between
education and income. In general, people with more education earn higher incomes than those
with less education. Common sense suggests education is the cause and higher incomes are the
effect; more education implies a more knowledgeable and productive worker, and such workers
receive larger salaries. But might the relationship be explainable in other ways? Are education
and income correlated because the characteristics required for succeeding in education—ability
and motivation—are the same ones required to be a productive and highly paid worker? If so,
then people with those traits will probably both obtain more education and earn higher incomes.
But greater education will not be the sole cause of the higher income.
The Central Problem of Economics

Needs and Wants
Needs are the things we can’t survive without. They are necessities of life e.g. food, clothing,
shelter, water, basic wealth and basic education.
Wants are the things we desire to have or own but we can survive without them e.g. cell phones,
TVs, radios, entertainment etc.
Our wants are unlimited and we never seem to be satisfied with what we have. It is people’s
wants rather than their needs which provide the motive for economic activity. The economic
resources that are available to satisfy our wants are limited. These resources are called factors of
production which are
Land (Natural Resources)

Land refer to natural resources over which people have power of disposal and of which may be
used to yield income/money e.g. farming and building land, forests, mineral deposits, air, seas,
oceans, vegetation, fisheries. The reward for land is rent.
Labour
Labour is human effort – physical or mental which is directed to the product of goods and
services.
Reward for labour is wages/salary.
Capital
Is money and all man-made assets used in the production of goods and services e.g. money,
machinery, factories, delivery vans etc. Reward for capital is interest.
Enterprise
Land, labour and capital on their own will not produce anything. There must be a person or
people who will organise the 3 factors of production so that production can take place. Whoever
takes these decisions and consequent risks is known as the entrepreneur. Reward for enterprise is
profit.
The basic economic problem
It is about unlimited wants versus limited resources. Our wants seem to be never ending because
if we satisfy one another develops. The resources are limited in supply – scarce. The basic
economic problem is of scarcity. Scarcity is said to be the basic economic problem as all other
economic problems are as a result of scarce resources, economic problems such as Inflation,
Unemployment, and Inequalities in income distribution. Economists try to explain how this basic
economic problem is solved by different economic systems. Economics is sometimes referred to
as a social science of scarcity. The 3 basic economic problems faced by all societies are: -
1. What to produce? – There are not enough resources to produce all the goods and services
wanted so a decision must be made to produce some and not others.
2. How to produce? – Refers to the method of production. Should mainly capital or mainly
labour be used? (i.e. capital intensive or labour intensive production); should electricity be
produced using mainly gas, oil or solar?

3. For Whom? Who should receive the goods and services produced? This is a problem of
distribution of economic goods. Should the goods and services go to those who can afford to
pay? Should resources be taken from the rich and given to the poor?
Scarcity, choice and opportunity cost

Scarcity means limited in supply. From our definition of economics, we can easily see why
economists view the world through the lens of scarcity. Scarce economic resources mean limited
goods and services. Scarcity restricts options and demands choices because we “can’t have it all,”
we must decide what we will have and what we must forgo. At the core of economics is the idea
that “there is no free lunch.” You may be treated to lunch, making it “free” from your
perspective, but someone bears a cost. Because all resources are either privately or collectively
owned by members of society, ultimately society bears the cost. Scarce inputs of land,
equipment, farm labour, the labour of cooks and waiters, and managerial talent are required.
Because society could have used these resources to produce something else, it sacrifices those
other goods and services in making the lunch available. Economists call such sacrifices
opportunity costs: To obtain more of one thing, society forgoes the opportunity of getting the
next best thing. That sacrifice is the opportunity cost of the choice.
Purposeful Behavior
Economics assumes that human behavior reflects “rational self-interest.” Individuals look for and
pursue opportunities to increase their utility— the pleasure, happiness, or satisfaction obtained
from consuming a good or service. They allocate their time, energy, and money to maximize
their satisfaction. Because they weigh costs and benefits, their economic decisions are
“purposeful” or “rational,” not “random” or “chaotic.” Consumers are purposeful in deciding
what goods and services to buy. Business firms are purposeful in deciding what products to
produce and how to produce them. Government entities are purposeful in deciding what public
services to provide and how to finance them. “Purposeful behavior” does not assume that people
and institutions are immune from faulty logic and therefore are perfect decision makers. They
sometimes make mistakes. Nor does it mean that people’s decisions are unaffected by emotion or
the decisions of those around them. “Purposeful behavior” simply means that people make
decisions with some desired outcome in mind. Rational self-interest is not the same as

selfishness. In the economy, increasing one’s own wage, rent, interest, or profit normally requires
identifying and satisfying somebody else’s wants! Also, people make personal sacrifices to
others.
They contribute time and money to charities because they derive pleasure from doing so. Parents
help pay for their children’s education for the same reason. These self interested, but unselfish,
acts help maximize the givers satisfaction as much as any personal purchase of goods or services.
Self-interested behavior is simply behavior designed to increase personal satisfaction, however it
may be derived.
Choice is the decision one makes because we can’t have all the goods and supplies we desire to
have – we have to choose since our resources are limited in supply. We can’t have more of one
product/good without having less of another. When we choose to buy one good, we do this at the
expense of another.
Marginal Analysis:
Benefits and Costs
The economic perspective focuses largely on marginal analysis—comparisons of marginal
benefits and marginal costs, usually for decision making. To economists, “marginal” means
“extra,” “additional,” or “a change in.” Most choices or decisions involve changes in the status
quo, meaning the existing state of affairs. Should you attend school for another year? Should you
study an extra hour for an exam? Should you supersize your fries? Similarly, should a business
expand or reduce its output? Should government increase or decrease its funding for a missile
defense system? Each option involves marginal benefits and, because of scarce resources,
marginal costs. In making choices rationally, the decision maker must compare those two
amounts. Example: You and your fiancée are shopping for an engagement ring.
Should you buy a half carat diamond, five eights carat diamond, a three quarters carat diamond, a
one carat diamond, or something even larger? The marginal cost of a larger-size diamond is the
added expense beyond the cost of the smaller-size diamond. The marginal benefit is the
perceived lifetime pleasure (utility) from the larger-size stone. If the marginal benefit of the
larger diamond exceeds its marginal cost (and you can afford it), buy the larger stone. But if the
marginal cost is more than the marginal benefit, buy the smaller diamond instead, even if you can

afford the larger stone. In a world of scarcity, the decision to obtain the marginal benefit
associated with some specific option always includes the marginal cost of forgoing something
else. The money spent on the larger-size diamond means forgoing some other product. An
opportunity cost—the value of the next best thing forgone—is always present whenever a choice
is made.
Opportunity cost is the value of the next best alternative foregone when one makes an economic
choice e.g. opportunity cost of coming to A Level is going to work and earning a salary. The
foregone alternative is also an illustration of the basic economic problem. We live in a world of
scarcity, in the sense that we can never have everything that we might like. As a result we must
make choices, for instance whether to buy this or that, whether to eat this or that, whether to walk
in the park or go to a movie, or whether to produce this or that. Every time we make a choice to
do something we automatically exclude something else that we did not do we have given it up.
We call this the “opportunity cost”.
“Opportunity cost is the best forgone alternative” i.e. it is what we gave up to get what we did.
The opportunity cost of buying new pair of shoes might be a lunch forgone.
· The opportunity cost of buying a new shirt might be not going to the cinema.
· The opportunity cost of taking a part-time job might be not being able to hang out in the mall
with your friends.
For a producer
The opportunity cost of buying plastic packaging material might be the cardboard he did not buy.
NB there can be many alternatives foregone, but only one will be the opportunity cost you cannot
add them up and say they are all the opportunity cost, because it must be a choice between them.
Opportunity cost can be thought of as:
1. The cost in dollars (represents a real thing given up); or
2. The cost in time.
Opportunity cost is important
1. We use it whenever we are deciding what to do, for example shall we hire a couple of videos
or buy a pizza instead.

2. It always arises with budget allocations. At some point in your life you may have to draw up a
budget and allocate money for different purposes. You will be forced to weigh up what is really
needed in yourtennis club, computer society, your country or whatever.
3. It lies behind the cost curves that we draw. How does this work?
Consider two producers, A and B. Producer A might have to pay $20 a ton to get the iron ore to
make into motor cars. Producer A sees the cost as $20, but we see it as the way of making sure he
gets the resources, rather than letting B get them! So the opportunity cost really does stand
behind the cost curves we draw.
Similarly in consumption: if something costs $10, you have to pay $10 to buy it. That $10 is not
only the price of the object, it is also the amount you have to pay to get the resources, raw
materials, labour etc. that went into making it. This prevented these resources from going into
making something else. After you buy the item it will be reordered by the shopkeeper and
replaced on the shelf. S/he orders from a wholesaler who in turn orders more from the producer.
The producer then buys the raw materials etc. to make another of whatever you bought! In this
way, resources keep on going into making whatever people demand.
4. This is how the price mechanism really works – that is, how it allocates resources to wherever
the demand is the greatest.
THE PRODUCTION POSSIBILITY CURVE (PPC)

The ppc is also called the Production Possibility Frontier (ppf) Curve or Opportunity Cost Curve
or
Transformation Curve or Production Possibility Boundary.
Assumptions of the ppc
• Full employment-The economy is employing all its available resources.
• Fixed resources-The quantity and quality of the factors of production are fixed.
• Fixed technology-The state of technology (the methods used to produce output) is constant.
• Two goods-The economy is producing only two goods: manufactured goods and agricultural
products.

PPC and opportunity cost
A PPC shows combinations of goods and supplies a country/society can produce with its existing
supplies of factors of production which are limited. A society has a wide variety of options as to
the quantities and varieties of goods and services it can produce.
Ceteris paribus, a country producing only two kinds of goods i.e. manufactured products and
agricultural products:-
Diagrammatically
Points inside the ppce.g X mean some resources are unemployed (underutilization of resources).

Points A, B, and C show the maximum possible combinations of outputs of the 2 goods. There is
maximum use of factors of production available.
Points outside the ppce.g Y are not attainable given the present country’s productive potential.
A ppc illustrates the following economic ideas:-

 Scarcity
 Choice
 Opportunity cost
 Efficiency
 The law of increasing costs
Using information on the ppc it is not possible for this economy to produce 4,5 units of
Agricultural products and 40, 5 units of manufactured goods (point Y).Again it cannot produce 6
units of agricultural products and 30 units of manufactured goods. If this economy is producing 6
units of Agricultural produce it means zero units of manufactured goods will be produced. If
30units of manufactured goods is to be produced, a choice should be made. The choice to be
madewill be of reducing production of agricultural goods by one unit. The opportunity cost of
producing 30 units of manufactured goods will be one unit of agricultural goods (forgone
output).
Shifts in the ppc

a) Parallel shifts
A country’s production potential is constantly changing. If the capacity to produce goods and
services increases, the ppc will shift outwards to the right as shown i.e. parallel shift.
A ppc can shift outwards due to the following reasons

 Increase in labour force
 Increase in the stock of capital goods
 Increase in technical knowledge
 Economic growth

 Discovery of new resources

 Improvement in technology.
The ppc can also shift inwards to the left if the country’s production potential declines as shown
below:-

A ppc can shift inwards due to the following reasons:-

 Wars
 Natural disasters which reduce the country’s productive potential e.g floods, droughts,
cyclones, hurricanes
 Brain drain
 Decrease in stock of capital goods
 Outbreak of diseases e.g. HIV-AIDS, TB, malaria, typhoid, dysentery, cholera, swine flu,
bird flu
 Technological decay
 Depletion of natural resources eg minerals.
Pivotal shifting of the ppc
A ppc pivot after a change in the level of resources which affect only one product,for example an
increase or decrease in the labour force which only affects one good for example manufactured
good only.

AGRIC
MANUFACTURED GOODS
The slope of the ppc/Types of ppc
a) Concave to the origin ppc - A common PPF: increasing opportunity cost and decreasing
returns.
b) A straight line PPF: constant opportunity cost and constant returns.
c) Convex to the origin ppc - An inverted PPF: decreasing opportunity cost and increasing
returns.

The Law of Increasing Costs

The law of increasing costs is a principle that states that once all factors of production (land,
labour, capital) are at maximum output and efficiency, producing more will cost more than
average.
 As production increases, the opportunity cost does as well. The best way to look at this is
to review an example of an economy that only produces two things - cars and oranges.
 If all the resources of the economy are put into producing only oranges, there will not be
any factors of production available to produce cars. So the result is an output of X number
of oranges but 0 cars.
 The reverse is also true - if all the factors of production are used for the production of
cars, 0 oranges will be produced. In between these two extremes are situations where
some oranges and some cars are produced. There are three assumptions that are made in
this possibility.
 The economy is experiencing full employment (everyone who wants to work has a job),
the best technology is being used and production efficiency is being maximized. So the
question becomes, what is the cost of producing more oranges or cars?
 If the economy is at the maximum for all inputs, then the cost of each unit will be more
expensive. The economy will have to incur more variable costs, such as overtime, to
produce the unit.
Resource Allocation
The ppc can be used to illustrate the idea of efficient resource allocation.
Economic efficiency requires that it must not be feasible to change the existing resource
allocation in such a way that someone is made better off and no one worse off, since, if this is
possible, the existing resource allocation must involve a “welfare waste”. Economic efficiency is
also called Pareto efficiency/pareto optimality
The PPF and Economic Efficiency
An efficient production point represents the maximum combination of outputs given resources
and technology – clearly the PPF is a useful way of illustrating this idea

Allocative efficiency
An economy achieves allocative efficiency if it manages to produce the combination of goods
and services that people actually want. For allocative efficiency to be achieved we need to be on
the PPF - because at points which lie within the frontier, it is possible to raise output of both
goods and improve total economic welfare. The definition of Pareto Efficiency is an allocation of
output where it is impossible to make one group of consumers better off without making another
group at least as worse off. There is only one point on the ppc which shows allocative efficiency
and it is usually the resources available fully satisfy the needs of people. This point can be
illustrated as follows;

CAPITAL GDS
JJOKLK;
[KKKKKKKKHVCCCCCJJJJJJJRR
R
I
..
N CCKKKKKKGGFF
0 CONSUMER GOODS
Productive efficiency
Productive efficiency is defined as the absence of waste in the production process. When the
production of the two goods lies on the frontier, anywhere on the frontier is deemed to be
production efficient eg A, B & C and production inside frontier is inefficient e.g. X. Productive
efficiency requires minimizing the opportunity cost for a given value of output. When there is an
outward shift of the PPF perhaps due to improvements in productivity or advances in the state of
technology, then the opportunity cost of production falls and society can now produce more from
given resources.
Distributive efficiency
We achieve distributive efficiency if we get the goods and services produced to those who
actually want or need them. Where we are on the production possibility frontier has little real
bearing on distributive efficiency, we tend to use the concept to make comment on allocative and
productive efficiency. But when an economy achieves economic growth leading to an outward
shift in the PPF, economists have concerns over the distribution of gains in output and whether or
not an improvement in average living standards has benefited the majority of consumers or
whether there has been an increase in inequality and relative poverty.

Economic efficiency
Is achieved when each good is produced at minimum cost and people and firms get the maximum
satisfaction from their resources. Economic efficiency is also called pareto efficiency.
Movement from point X towards the boundary i.e the ppc is called pareto improvement because
this results in more agricultural products and manufactured products. The welfare of the society
improves.
Economic Systems
These are different ways or means in which we try to answer the 3 fundamental economic
questions: i.e. “What?”, “How?” and “For whom?”. To look at 3 means of resource allocation
1. The market mechanism
2. The planned economy
3. The mixed economy
Market Economies
It’s also called free enterprise or laissez faire or capitalist system. The framework of a market
or capitalist system contains 6 essential features which are:
1. Private Property
Private ownership of means of production or factors of production. This means individuals are
free to own factors of production. Income from these factors of production goes to the owners.
2. Freedom of choice and enterprise by individuals – free to buy/hire economic resources.
Consumers are sovereign i.e. free to spend their income as they wish. Producers respond to
consumer preferences and produce what they did.
3. Self Interest as the dominating motive. Each unit in the economy will do what is best for
itself. Firms aim to maximize profits. Owners of land aim to obtain highest possible rewards.
Workers move to occupations/jobs with the highest wages. Consumers spend incomes on goods
and supplies which yield maximum satisfaction/utility.
4. Competition - There are many sellers and buyers. Market forces of did and supplies determine
price as given and can’t influence the price. There is survival of the fittest.
5. A reliance on the price system - Decisions of producers determine supply of a good.
Decisions of customers or buyers determine demand of a good. The interactions of demand and

supply determine prices. Changes in demand and supply cause changes in market prices and it is
these changes/movements in market prices which bring about changes in the ways in which
society allocates or uses economic resources. Prices act as a rationing device; prices give the
value of goods and supplies. Prices act as an allocation/ distribution device of goods and
supplies.
6. A very limited role of government-government only intervenes to correct market failure.
Advantages of market economy

 Efficiency-free market economies are very competitive, most of their industries are
assumed to beperfectly competitive and so productive and allocative efficiency will
occur. It makes sense thatthis economy allocates its resources more efficiently. Decisions
about what to produce are madeby people who will actually consume the goods.
 Choice-Firms will produce whatever consumers are prepared to buy. Due to the free
enterprise factor, there are no restrictions on what the firm can produce
 It allocates resources where people want them; we get maximum consumer satisfaction.
 It works automatically, is essentially costless, and requires no bureaucracy to run it.
 This means no wasted resources in providing a huge civil service, so that people are left
with more to spend rather than pay tax, which means a higher standard of living.
 It allows the maximum economic freedom to the people to spend their own money in
their own way.
 People have the freedom to choose for whom they will work and in what industry or
service.
 People have the freedom to set up their own businesses.
 There is a strong incentive effect. People are encouraged to work hard and get on in life
as they have the freedom to try anything they want.
 Competition forces out the inefficient firms, which means lower prices for consumers,
and it also releases resources needed by the more efficient firms.
 Forcing out the inefficient and releasing resources for better uses encourages faster
economic growth.

 There is a constant striving to improve production methods and distribution chains which
is a stimulus to technical progress. Technical progress is a major source of growth, and
the major source in developed countries.
 With a totally free market there is less for the government to do. This might help to
prevent the emergence of a powerful national government that spends money and behaves
in ways that the people do not want. Totally free markets also tend to go hand in hand
with some form of democracy. A free market cannot prevent but perhaps does lessen the
danger of a dictatorship.
THE DISADVANTAGES OF A TOTALLY FREE MARKET

 There is no guarantee that growth will be maximised under perfect resource allocation;
the macro-economic side, and aggregate supply and demand, are most important.
 The allocation of resources is determined by the distribution of income and incomes are
usually distributed unequally. The rich get more “economic votes” than the poor so the
economy produces a lot of luxury goods. One result can be that the poor and needy might
suffer and at the\ same time the dogs in rich areas, like Borrowdale, probably eat better
than some babies in the ghetto.
 The physically or mentally challenged people would suffer greatly and unless they have a
caring family or private charity help their life, in the words of the political philosopher
Thomas Hobbes, would be poor, nasty, brutish, and short.
 In similar fashion, the elderly would not do well. There would be no state pensions if the
market does everything. Not everyone can, or chooses to, accumulate enough wealth to
take care of their own old age. Those without families would be especially vulnerable and
the extended family has broken down and largely disappeared. The extended family used
to take care of its own vulnerable members.
 Economic growth may be slower, rather than faster, if the people choose to spend more,
save less, and investment levels are lower as a result.
 Public goods, such as defence, a police force, and a justice system will not be provided
unless the state does it. The safety of the nation and individuals cannot be guaranteed.
Street lighting would not exist, as whichever individuals paid for it could not prevent

others from using or benefiting from the free light. Similarly, a state education system or
national health system would not exist, only more limited private ones.
 Some economic endeavours, such as a nation-wide transport system or postal system,
may not be established by private enterprise, and where they are, they may favour only
the rich, well-populated areas.
 Abilities and resources are not equally distributed, so that rather than a host of perfectly
competitive firms we see a small number of firms in imperfect competition or monopolies
who cartels or raise prices and make monopoly profits. This distorts consumer choice,
resource allocation, and the distribution of income.
 Advertising wastes may occur, where virtually identical products are heavily advertised
as being different and better than rival products. The rival firms compete with their own
advertising and the total increases. Much advertising is “percussive” repeatedly hitting
consumers with statements to influence their purchases, rather than “informative” or
telling people the product exists and what it does.
 The rise of a few rich and powerful companies, and monopolies, results in the emergence
of a small number of very rich and powerful people. Power tends to corrupt and they get
the ear of the government, influencing what laws will be passed; these often help such
people, generally to the disadvantage of society as a whole.
 Lack of knowledge of what is available in other areas is common for decisions by
workers on what job to pursue, by producers on the actions of their rivals, and by
consumers or what good and services are available to buy.
 Factors of production (land, labour and capital) are not fully mobile, especially of
workers, who often will not move to where the jobs are for social or other reasons.
 Many of the “better” jobs in the professions, such as lawyers, doctors, or dentists may
require lengthy training during which time the young trainee is out of the workplace.
Socially, this frequently means the rich and middle class parents can support their
children through the training period. The children of the poor, and of the working classes,
while not excluded make up a smaller proportion of such professions than their innate
abilities suggest they should.

 Only private costs are considered when decisions are made to maximise profits; public
costs and benefits are totally ignored. As a result, there is too little production of “merit
goods” and too much of “demerit goods”.
 Externalities are ignored: when there are external benefits, too little is produced; when
there are external costs too much is produced.
 Economies of scale can result in one or a few large companies that develop monopoly
power and can misuse it.
 Economic cycles naturally occur, with booms and slumps or recessions. In a boom there
can be inflation and shortages of various goods and services. In a slump, people can be
suddenly laid off and become unemployed, with severe consequences, such as difficulty
in paying the rent or mortgage, feeding themselves and their family, and paying off things
bought on credit. These social problems are created but none of this is their fault.
Functions of the Price Mechanism

The invisible hand – the workings of the price mechanism
The price mechanism is simply the means by which the millions of decisions taken each day by
consumers and businesses interact to determine the allocation of scarce resources between
competing uses. This is the essence of economics; the price mechanism plays three important
functions in any market-based economy
The signalling function
Prices have a signalling function. Prices adjust to demonstrate where resources are required, and
where they are not. Prices rise and fall to reflect scarcities and surpluses. If market prices are
rising because of stronger demand from consumers, this is a signal to suppliers to expand output
to meet the higher demand. Consider the left hand diagram below. The demand for computer
games increases. Producers stand to earn higher revenues and profits from selling more games at
a higher average price. So an outward shift of demand leads to an expansion along the market
supply curve (ceteris paribus)
In the second example on the right, an increase in supply causes a fall in the relative prices of
digital cameras and prompts an expansion along the market demand curve

The transmission of preferences

Through the signaling function, consumers are able through their expression of preferences to
send information to producers about the changing nature of our needs and wants. When
demand is strong, higher market prices act as an incentive to raise output (production) because
the supplier stands to make a higher profit. When demand is weak market supply contracts.
The rationing function
Prices serve to ration scarce resources in situations when demand in a market outstrips supply.
When there is a shortage of a product, the price is bid up – leaving only those with sufficient
willingness and ability to buy with the effective demand necessary to purchase the product. Be it
the demand for cup final tickets or the demand for a rare antique the market price acts a rationing
device to equate demand with supply. The growing popularity of auctions as a means of
allocating resources is worth considering as a means of allocating resources and clearing a
market.

Adam Smith and the Invisible Hand

The 18th Century economist Adam Smith – one of the founding fathers of modern economics,
described how the invisible or hidden hand of the market operated in a competitive market
through the pursuit of self-interest to allocate resources in society’s best interest. This remains the
central view of all free market economists, i.e. those who believe in the virtues of a free-market
economy with minimal government intervention.
The price mechanism is the only allocative mechanism solving the economic problem in a free
market economy. However, most modern economies are mixed economies, comprising not only
a market sector, but also a non-market sector, where the government uses the planning
mechanism to provide goods and services such as police, roads and health.
In a command economy, the price mechanism plays little or no active role in the allocation of
resources.
Instead the main mechanism is state planning – directing resources to where the state thinks there
is greatest need. The reality is that state planning has more or less failed as a means of deciding
what to produce, how much to produce, how to produce and for whom. The market economy is
now the dominant economic system – even though we are increasingly aware of imperfections
in the operation of the market – i.e. the causes and consequences of market failure.
Prices and incentives
Incentives matter enormously in our study of microeconomics, markets and market failure. For
competitive markets to work efficiently all economic agents (i.e. consumers and producers) must
respond to appropriate price signals in the market.
Market failure occurs when the signalling and incentive function of the price mechanism fails to
operate optimally leading to a loss of economic and social welfare. For example, the market may
fail to take into account the external costs and benefits arising from production and
consumption. Consumer preferences for goods and services may be based on imperfect
information on the costs and benefits of a particular decision to buy and consume a product. Our
preferences may also be distorted by the effects of persuasive advertising and marketing to create
artificial wants and needs.

Government intervention in the market

Often the incentives that consumers and producers have can be changed by government
intervention in markets. For example a change in relative prices brought about by the
introduction of government subsidies and taxation.
Suppose for example that the government decides to introduce a new tax on aviation fuel in a bid
to reduce some of the externalities created by the air transport industry.
1. How will airlines respond?
a. Will they pass on the tax to consumers?
b. Can they absorb the tax and seek cost-savings elsewhere in their operations?
2. If the tax raises price for air travellers, will they change their behavior in the market?
3. Is an aviation tax the most effective way of controlling pollution? Or could incentives for
producers and behavior by consumers wanting to travel by air be changed through other more
effective and efficient means?
Agents may not always respond to incentives in the manner in which textbook economics
suggests.

The “law of unintended consequences” encapsulates the idea that government policy
interventions can often be misguided of have unintended consequences! See the revision focus
article on government failure.
The Planned Economies
 Also called the command economy or collectivism.
 Collectivism is the system whereby economic decisions are taken collectively by
planning committees and implemented through the direction of collectively owned
resources, either centrally or at local level.
 In a command economy planning committees are appointed and they provide the answers
to the
3 fundamental economic questions.
 What? Problem- committees decide on whether more cars or tractors should be produced.
 They solve the “How?” problem by directing labour and other resources into certain areas
of production.
 “For whom?” problem not by pricing but by allotting goods and supplies on the grounds
of social and political priorities.
All means of production is publicly owned. Logic for public ownership is the desire for a more
equitable distribution of income and wealth.
There is no private property.
Production is for use rather than for profit.
Advantages of planned economy

 Can ensure stability because it does not coincide with business cycles
 Serves people collectively instead of individuals; focus on equality
 Distributes wealth among all of society
 Products produces fulfil needs
Problems of planned economies
 Bureaucracy and apathy
 Corruption because planners get/are paid relatively small salaries compared to the huge
amount of planning, they find it easy to accept bribes.

 There is no incentive to save, invest/ to be innovative because of no profits.

 Encourages laziness
 Workers get same salaries despite your experience, educational qualifications etc
Examples of Planned Economies
Russia in 1917 after the 1st World War till 1989
Cuba
China
Mixed Economies
Mixed Economies come in to being as a result of increasing government intervention and control
in capitalist societies. Mixed economies are those where there is a significant component of both
collectivism and free enterprise. In mixed economies there is private property because it provides
an important incentive for people to work, save and invest. Despite the wave of private property
significant economic decisions are still taken collectively.
The reasons for increasing government intervention are because of the unacceptable features of
laissez faire/market failure. Sometimes market economies do not lead to economic efficiency.
Market failure arise when the free market forces of demand and supply fail to produce the
quantities of goods and services people want at prices which reflect their marginal utilities.
Market failure is as a result of:
1. Instability-i.e. booms and slumps in economic activity and this results in dissatisfaction to the
society as a whole.
2. Lack of competition-Lack of competition can be caused by markets where there are few large
sellers/single seller and many buyers. Firms which dominate the market will attempt to change
high/exorbitant prices leading to consumer exploitation for e.g monopolies, duopolies and
oligopoly. There is also allocative and productive inefficiency – justifying government
intervention.
3. Inequalities-The ability of some individuals and firms to acquire excessive market power
leading to great inequalities in the distribution of income and wealth. The rich become richer and

the poor get poorer – government has to intervene e.g. through taxation (progressive) or welfare
transfer payments or grants or unemployment benefits.
4. Economic Change-The market economy does not provide an equitable basis for sharing the
burdens of economic change e.g. technological advancement can lead to unemployment –
workers suffer and employers gain.
Demand for older goods declines and demand for new goods in fashion increases. Some firms
benefit and others suffer e.g. black and white TV, brick cell phones etc. The burdens of change
full entirely on the unlucky ones.
5. Externalities (Spill Over Effects)-Externalities in consumption exits when the level of
consumption of some goods or service by one consumer has a direct effect on the welfare of
another consumer, an effect which is not transmitted through the price mechanism consumption
externalities exist when consumption activities of an individual directly affect consumption of
another person. Production externalities exist when the production activities of one firm directly
affect production activities of another firm. Individual or firms affected are called third parties
e.g. good perfume sprayed by someone, good music played by someone next door, smoking.
a) Positive Externalities are external benefits/advantages
b) Negative Externalities are external costs or disadvantages or economic bads e.g. Secondary
smoking
c) Social Costs are the costs to the society as a whole. Consist of private costs plus negative
externalities (external costs).
d) Social Benefits are total benefits or advantages to the society as a whole. Consists of private
benefits plus positive externalities (external benefits)
6. Missing Markets-A free market economy fails to provide:
a) Public goods- these are goods which when made available to one person, they are equally
available to everyone else e.g. street lights, defence. Public goods have 4 major characteristics:
i) Non rivalry in consumption
ii) Non excludability
iii) Non rejectable
iv) Non exhaustible

Public goods are not provided at all in a free market system and if provided, they have the
problem of free riders.
b) Merit Goods will be under provided. Merit goods are those goods which the state wants to
maximize and increase their consumption because it considers them to be highly desirable for the
welfare of citizens e.g. education, health services, insurance, training
Public goods and merit goods involve positive externalities. The government provides these
goods either for free or highly subsidized.
7. Demerit Goods-Demerit goods are goods which the state wants to discourage their
consumption because it considers them to be undesirable for the welfare of citizens. These goods
are dangerous, hazardous to health e.g. cigarettes, certain forms of drugs, beer.
Demerit goods involve negative externalities. The government discourages their consumption
through regulation, complete bans or taxation
8. Information asymmetries/ lack of Information/ Information Failure/ Imperfect
information-This results in wrong choices being made
9. Factor Immobility-This means that it is difficult to transfer factors of production from one
use to another e.g. workers are immobile i.e. a teacher can’t start working as a doctor unless
he/she undergoes fresh training.
10. Inequality in the distribution of wealth and income-The rich get richer and the poor
poorer.
11. Short Termism-Private sector entrepreneurs often have short term objectives at the expense
of long term planning. Short Termism can result in the overproduction of consumer goods and
the underproduction of capital goods and the failure to develop new methods of production and
new products.
Policy options that the government may use to correct market failure
1. Creating a framework of rules
2. Supplementing and modifying the price system i.e. price controls (maximum price, minimum
price, buffer stock)
3. Redistribution of income e.g. unemployment benefits, grants, transfer payments
4. Stabilising the economy

5. Provision of public goods and merit goods

6. Taxation
7. Fixing prices. Price floor. Price ceiling. Buffer stock.
8. Subsidising the production or sale of various goods and supplies.
9. Competition policy
10. Nationalisation of firms
11. Privatisation of firms
12. Providing information
13. Subsidies
14. Encouraging long term planning – companies or businesses and a mission statement.
Note - If the government fails to correct market failure, this results in government failure.
The Theory of Demand

Demand is the quantity of a commodity/ good which people are willing and able to buy at any
given price over some given period of time. This is effective demand. Demand is not the same as
desire or wish. Demand must be backed by an ability to pay.
Ex-ante demand is the quantity which buyers wish or intend to buy at the going price – ex-ante
means intended, desired or planned, expected before the event.
Ex-post demand is the quantity which buyers finally buy i.e. the quantity which they actually
succeed in buying.
Price and Value
Price is the quantity of money which must be exchanged for a unit of good or service or price is
the cost of a good.
Value is the worthiness of a good or service. Price is not the same thing as value.
Markets
A market is any effective arrangement of bringing buyers and sellers into contact with one
another.
Sub-market is a small market within an umbrella market of a good e.g. in the market for
computers, there are keyboards, mice, screens, CPUs.

The price of any economic good under market conditions such as we find in the capitalist world
is determined by forces of supply and demand. The forces of demand acting through buyers and
the forces of supply acting through sellers determine the market price.
For the great majority of goods and services, experience shows that the quantity demanded will
increase as the price falls. This particular characteristic of demand is illustrated by a table
described as a demand schedule.
The law of demand states that more of a good is demanded when its price falls
Hence there is an inverse relationship between the quantity of a good demanded and its price
since as price goes down the quantity demanded goes up.

Market Demand
The demand curves of all consumers in the market can be aggregated to obtain the market
demand curve showing the total amount of a good which consumers wish to buy at each price
e.g.
The market demand curve is the horizontal summation of individual demand arrives at given
prices.
Why does the demand curve slope downwards form left to right?
1) Income Effect – when the price of a food falls consumers buy more because the purchasing
power of their money income has increased and vice versa. E.g if a consumer has an income of
$100.00 and the price of the good falls,

If price is plotted against quantity demanded, we get a downward sloping demand curve.
1. The substitution effect – A fall in the price of a good makes it relatively cheaper when
compared with competing goods. There will probably be some switching goods of purchases
away from the now relatively dearer substitute towards the good which has fallen in price.
2. The law of diminishing marginal utility - Utility is satisfaction derived from consumption of
good or service. A person buys a good because it yields him satisfaction. As he buys more of any
good, the total utility derived increases but the increase in total utility is not proportionate to the
increase in his consumption. The additional utility derived from the last unit purchased is called
marginal utility of a good and it is generally accepted that marginal utility diminishes as
consumption increases. A persononly buys more of a good as price falls. e.gDiminishing
marginal utility

The Demand Curve

The demand curve tells us what happens to quantity demanded when price changes and there is
no change to any of the factors affecting demand.

At price OP quantity demanded is OQ. If price falls to OP1 quantity demanded would be OQ1
and vice versa. The area of rectangles under the demand curve represents total revenue (TR)
forthcoming. TR is the amount of money a firm gets from its sales – TR = P x Q
Movements along the demand curve are referred to as extensions or expansions and contractions
of demand.
Movements down along the demand curve to the right – extension/ expansions of demand,
Movement along the demand curve to the left – contraction of demand.
Exceptional Demand Curves
1. The stock exchange market – speculative demand
2. Ostentatious snob appeal goods / Veblen goods
3. Giffen goods or staple foods
1-3 the demand curve will be upward sloping
4. Demand curve which is horizontal
5. Demand curve which is vertical
Shifts in Demand
A change in demand means that one or more of the factors which determine demand (other than
the priceof product/good) has changed. It means the whole demand curve shifts/moves to the left
or right. An increase in demand means that more is now demanded at each and every price. A fall
in demand means that less is demanded at each and every price.
Increase in demand
An increase in demand would mean that the demand curve has shifted from DD to D1D1 – at
price level
OP quantity demanded increases from OQ to OQ1. At price level OP1 quantity demanded
increases fromOQ2 to OQ3.
Decrease in demand
A fall decrease in demand would shift the demand curve from DD to D1D1 – at price level OP
quantity demanded would decrease from OQ to OQ1. At price level OP1 quantity demanded
would decrease fromOQ2 to OQ3.
Determinants of demand or Factors affecting demand

1. Changes in the price level cause the demand curve to expand or contract. The demand curve
does not shift.
2. Changes in disposable real income – If income increases, the demand for most
goodsincreases. These are called normal goods. Increasing incomes may cause the demand for
some goods to fall. These goods are called inferior goods e.g. second hand clothing, public
transport. Disposable income is the amount of money which an individual has available for
spending after taxes have been deducted. Real income is the purchasing power of money i.e.
what money can actually buy.
3. Changes in the price of other goods
Substitutes are goods which can be used in place of another e.g. butter and margarine, beef and
pork, tea and coffee, OMO washing powder and sunlight washing powder, colgatetoothpaste and
close-up toothpaste. An increase in price of butter results in an increase in the demand for
margarine.
Complements are goods which the use of one requires the use of another. Jointly demanded or
complementary demand e.g. car and petrol, tennis ball and tennis racquet, tea and sugar, cell
phone and airtime, toothbrush and tooth paste, trousers and belt, shoes and socks, shoes and
polish, nail polish and nail polish remover. An increase in the price of sugar reduces the demand
for tea.
4. Changes in tastes and fashion
When a good is in fashion demand increases. When out of fashion demand decreases e.g.
clothing, furniture, plasma TVs are in demand.
5. Advertising
Businesses become big because they advertise. They become small or close down because they
don’t advertise. A successful advertising campaign will move the product’s demand curve to the
right and at the same time move demand curves for competing goods to the left e.g. coca cola
bottling company advertises a lot – always keeps products in front of customer eyes – demand
increases.
6. The availability of hire purchase finance
The demand for many durable consumer goods e.g. cars, furniture, houses etc depend on the
provision of hire purchase facilities. Availability of hire purchase finance increases the demand

for goods because few people can purchase these goods for cash since they require large sums of
money.
7. Changes in population
Changes in population and changes in age distribution will affect both the total demand for goods
and supplies and the composition of that demand.
8. Expectations of future price changes
If people think that prices are going to rise in the future, they are likely to buy/demand more now
before the price goes up.
9. Changes in weather conditions
Demand for some goods is affected by changes in weather conditions e.g. winter clothing,
summer clothing, sun hats and ice cream e.g. for ice cream, demand increases in summer and
decreases during winter season.
10. Exogenous shocks e.g. natural disasters e.g. cyclones, floods, earthquakes affect demand
11. Outbreaks of wars
Factor number 1 i.e. the change in the price of the good will cause the demand curve to either
expand/extend or contract.
Factors 2 - 11 will cause the whole demand curve to shift. They are called conditions of
demand.
Simple Demand Curve Functions/Equations
A demand function is an equation which shows the mathematical relationship between the
quantity demanded of a good and the values of the various determinants of demand.
Demand equations are often used to relate quantity demanded to just one determinant. Thus an
equation relating quantity demanded to price could be in the form:
Qd = a – bP
Where: Qd = quantity demanded; a = price axes intercept; b = slope of the demand curve which
is negative in this case
For example the actual equation might be Qd = 10 000 -200P
From this can be calculated a complete demand schedule or demand curve. e.g. Demand
Schedule for the equation Qd = 10 000 – 200P

Diagrammatically
Theory of Supply
The supply schedule and supply curve show the relationship between market prices and
quantities which producer/suppliers/manufacturers are prepared to offer for sale at a given
priceover a given period of time.
The basic law of supply says “more will be supplied at a higher price than at a lower price”.
Thesupply curve will slope upwards form left to right.

Supply Schedule is a table showing the different quantities of a good that producers are
willing and able to supply at various prices over a given period of time.
Supply Curve – A graph showing the relationship between the price of a good and the
quantity of the good supplied over a given period of time.
Diagrammatically

An increase in price usually means that production will become more profitable and existing
producers are expected to expand their outputs in response to rising prices and hence more
profits.
In the long run an increase in price (and hence profits) would tend to encourage new firms to
enter the industry.
Exceptional Supply Curves
Regressive Supply Curve
Supply curves usually slope upwards from left to right, sometimes however they change direction
and are said to become regressive e.g. an individual supply curve for labour where there may be a
high leisure preference.
As wage rates increase workers have opted to work for shorter hours. This is because instead of
taking the increased wage rate in money workers take increased leisure and offer less hour of
labour.
A perfectly inelastic supply curve and a perfectly elastic supply curve

Market Supply
The supply curves of all producers in the market can be aggregated to obtain the market supply
curve showing the amount of a good which producers are willing to supply at each price e.g.

Movements along the supply curve

As was the case with the demand curve the supply curve is drawn on the assumption that when
the price of a good changes no other thing changes (ceteris paribus). Movements along the supply
curve are referred to as changes in quantity supplied. They are as a result of price of the good
change. They either cause an extension/expansion in supply or a contraction of supply.
The term change in supply means the whole supply curve has moved/shifted either to the left or
right. A rise in price from OP to OP1 causes an increase in quantity supplied from OQ to OQ1.
This is referred to as an extension/ expansion in supply as shown by the diagram below.
A fall in price from OP to OP1 causes a decrease in quantity supplied from OQ to OQ1. This is
referred to as a contraction in supply as shown by the diagram below.

Changes in supply
An increase in supply means that more is supplied at each and every price e.g SS to S1S1 from
the diagram below.
At price level OP quantity supplied has increased from OQ to OQ1.

A decrease in supply means that less is supplied at each and every price e.g SS toS1S1 from the
diagram below.

At price level OP1 quantity supplied has decreased from OQ to OQ1.

The determinants of supply / factors affecting supply
 Changes in the price of the good – supply curve does not shift. It only expands or
contracts.
 Changes in prices of factors of Production
 Changes in prices of other commodities e.g. if the price of barley increases but not of
wheat, this will tend to reduce the supply of wheat and increase the supply of barley.
 Changes in technology/ technical knowledge. Improvements in technology tend to
increase supply.
 Tastes of producers
 Organizational changes
 Nature, random shocks and other unpredictable events
 Government policy changes
 Taxes and subsidies
 Number of suppliers in the market e.g if new firms enter the industry, supply increases
 Aims of producers
 Exogenous Factors
 Expectations about future price changes
Price & Output Determination in Competitive Markets

The Market Price

For each economic good there is a supply schedule and a demand schedule. If the 2 are brought
together, we find that quantity demanded and quantity supplied will be equal at one and only one
market price.
This is called equilibrium price or the market price. The equilibrium price may be determined
from the demand and the supply schedules or as is more usually the case form the point at which
the demand curve and supply curve intersect e.g.
Equilibrium Price = $30

Equilibrium Quantity = $150

At prices higher than the market price e.g. $40 quantity supplied is greater than quantity
demanded and there is excess supply which would oblige sellers to lower their prices in order to
dispose of their output.
This situation is called or described as buyer’s market. At prices lower than the market price
e.g. $20 quantity demanded exceed quantity supplied giving rise to a shortage competition
between buyers will force, push up the price giving rise to conditions known as the seller’s
market. The equilibrium or market price is $30 because at any other price there are market
forces at work which tend to change the price.
The Rationing Function of Price
The rationing function of price means that price has the potential of eliminating excess supplies
or excess demand which might exist. This will continue until equilibrium is restored at point e
where equilibrium price is P* and equilibrium quantity traded is Q*. If demand is not equal to
supply it’s a situation of disequilibrium. Its either there is excess supplies or excess demand.
Changes in Market Price
Market prices are determined by the interaction of demand and supply and in competitive market
changes in market prices must be due to changes in demand and supply or both.
Effects of Changes in Demand
The effects of changes in demand may be stated in terms of economic laws
1. Other things being equal, an increase in demand will raise the price and increase the quantity
supplied.
2. Other things being equal, a decrease in demand will lower the price and reduce the quantity
supplied.

Assuming that DD is the original demand curve and supply is the original supply curve, the
equilibrium price is OP and the quantity OQ is demanded and supplied. Assume that demand
now increases from DD to D1D1. The immediate effect is to cause a shortage (shown by the
dotted line) at the ruling price OP.
This shortage will cause the price to bid upwards and quantity supplied will increase until a new
equilibrium price is established at OP1. The quantity demanded and supplied is now OQ1.
***Question: Use the same diagram to explain the effects of a fall in demand. ***
Effects of a shift in supply
The effects of changes in supply may also be summarized in the form of 2 economic laws:-
1. Other things being equal, an increase in supply will lower the price and increase the quantity
demanded.
2. Other things being equal, a decrease in supply will raise the price and reduce the quantity
demanded.

Assuming SS is the original supply curve and DD is the original demand curve – OP is the
equilibrium price and OQ is the equilibrium quantity demanded and supplied. An increase in
supply moves the supply curve from SS to S1S1. The immediate effect is as surplus (shown by
the dotted line) at the ruling priced
OP. This surplus will force the price downwards, quantity demanded will increase and eventually
a new equilibrium price OP1 will be established. The quantity demanded and supplied will be
OQ1.
***Question: Use the same diagram above to explain the effects of a fall in supply.***
Complex Shifts in Demand and Supply
This is because of the different magnitude of shifts in demand and supply.
Effects of Taxes
Taxation is the transfer of money from individuals, companies, institutions or groups to the
government.
Taxes may be levied upon wealth, income or capital gains. Taxation is one of the principal means
by which government finances its expenditure. When a tax is imposed on a good, this has the
effect of shifting the supply curve upwards by the amount of the tax. The tax may be regarded as
an increase in the cost of production.

XY = burden of tax borne by consumer

YZ = burden of tax borne by producer
P1P2XZ is the total tax revenue collected by the government
The amount of the tax is the vertical distance between the 2 supply curves i.e. XZ
The effect of the tax is to raise price and reduce quantity. The original equilibrium is at the point
is X where price is P and quantity Q is traded. After the imposition of a tax, the new equilibrium
is where price is P1 and quantity is Q1. Taxes can be specific (i.e. unit tax) or ad valorem (i.e. %
tax/ by value). The effect of tax depends on the elasticity of demand and supply of the product.
Effects of Subsidies
A subsidy is a negative tax. For e.g. the government sometimes subsidises a product by giving an
amount of money to the producer for each unit they sell. Subsidies normally take the form of
payments bygovernment producers and are particularly important in the case of agriculture
products (e.g. wheat, milk,meat etc). The effect of a subsidy is to increase supply – it will reduce
price and increase the quantity supplied.

YZ = subsidy benefit to consumers

XY = subsidy benefit to producers
XZ = the amount of the subsidy which is the vertical distance between the 2 supply curves
P1 P2 XZ = total amount of subsidy paid by the government
Initially the equilibrium price is OP and quantity OQ is demanded and supplied. A subsidy, to
producers has moved the supply curve from SS to S1S1, price has fallen to OP1 and quantity
demanded has increased to OQ1. The amount of the subsidy is XZ. Consumers have benefited by
a price fall equal to YZ. They consume more at a lower price. Producers have benefited from an
increase in the supply price YQ1 to XQ1. They now supply more and receive higher supply
price. The effect of a subsidy depends on the elasticities of demand and supply for the good.
Effects of Import Tariffs
Tariffs (import duty) are taxes imposed on commodity imports. They may be levied on an
advalorembasis i.e. as a certain % of value or on a specific basis i.e. as an amount per unit. Their
purpose may be solely for raising government revenue. A tariff acts in exactly the same way as a
tax by artificially raising the price of the foreign product as it enters the country.
Effects of export subsidies
An export subsidy is a payment to a firm or individual that ships or exports a good abroad. A
nation may decide to subsidize certain domestic industries as a means of protecting them from
the competition of lower priced foreign goods. Like a tariff an export subsidy can either be
specific (a fixed sum per unit) or advalorem (a proportion of the value exported). When the

government offers an export subsidy shippers will export the good up to the point where
domestic price exceeds the foreign price by the amount of the subsidy. The effects of an export
subsidy on prices are exactly the reverse of those of a tariff.
The subsidy will reduce the price of the domestic product and hence make it more difficult for
the foreign producer to sell a similar product in the home market. There will be a redistribution of
income towards producers and consumers of the subsidized good because the cost of the subsidy
will fall on the taxpayers.
Effects of Price and Wages Control
Maximum Price (Price Ceiling)
A government or another body may set a maximum price. This will only affect the market price
if the maximum price is set below the equilibrium price. A government may introduce a
maximum price in order to :-
 Promote equity or equitable distribution of Y and wealth
 Enable poorer members of the society to purchase necessities like food, housing and
public transport.
Initial market equilibrium price is OP and the quantity bought and sold is OQ. When a maximum
is imposed at OPX quantity demanded expands to OQD and quantity supplied contracts to OQs.
A shortage QS-QD arises. The problem of maximum price is that queues may emerge, there

could be rationing and the black market may develop. Maximum prices increase the welfare of
those who are able to purchase the product at that stipulated maximum price.
Minimum Price (Price Floor)

A minimum price will only affect a market if it is set above the equilibrium price. A government
or other body may impose a minimum price if it considers that the market price is too low. This
is because the government may wish to raise worker’s wages in the case of minimum wage
legislation or to increase and protect producer’s incomes.
Pushing the price up to OPM causes supply to extend, demand to contract and creates a surplus
QDQS. To maintain the minimum price, the government or some other official body will have to
buy up the surplus.
Buffer Stocks
A buffer stock makes use of both minimum and maximum prices. It is a scheme operated by a
central authority and its main aim is usually to stabilize prices and protect producers from sudden
shifts in demand and supply.

The diagram shows the effect of setting up a buffer stock for oil seed. If the boundaries set by the
central authority no action is taken. However if the market price starts to move outside the buffer
stock operators will intervene.
The diagram below shows the effect of a good harvest of oil seed rape. The supply curve shifts to
the right. This puts downward pressure on the price and to prevent the price falling below the
lower boundary the operators step in to increase demand.
If there was no intervention new equilibrium would have been point e (i.e.the price outside
boundary) but because of intervention it’s now e1 – price is now oscillating within the boundary.
Consumer surplus and Producer Surplus+

Consumer Surplus
Consumer Surplus is defined as the difference between the price a customer willing to pay for a
product and the price that he actually ends up paying. When a consumer gets to purchase a good
at a lower price than the price he is willing to pay, he gets more benefits creating a consumer
surplus. As an example, for a necessity like food consumer would be willing to pay a higher price
as it is a necessity. But at normal market conditions consumer can obtain food at a relatively
lower price than what he is willing to pay and it creates a consumer surplus. When the utility
(satisfaction) of a good falls the consumer surplus reduces as the consumer will not be willing to
pay higher price. The consumer surplus can be visually represented as follows:
Price 7
0 q1 qty
The consumer is willing to buy the good for $7 but he finally pays $4. The area of the consumer
surplus is the area under the demand curve and above the price line.It is shown by the shaded
area on the diagram above.
Imagine rummaging through a rack of clothes at Edgars. You come across a shirt, and
immediately a price pops into your head. You think to yourself, I would be willing to pay
$25 for this shirt. That means, $25 is your marginal benefit (or demand – the willingness
to pay). Then you look at the price and see a tag of $16. You are happy!! You have a
consumer surplus of $9.

Producer Surplus – occurs when the producer receives a price for a product he sells which is
more than what he was willing to sell the good for. The producer surplus is equal to the area
above the supply curve and below the price line. S price
Price s
P2
P1
0 q1 qty
The producer is willing to sell the good at price P1 but he finally sells it at price level P2. The
shaded area represent producer surplus.
Elasticity of Demand
Elasticity is concerned with the extent to which one variable, for example, demand, responds to a
change in another variable for example price
There are 3 types of elasticity of demand which measure how the quantity demanded responds to
changes in the key influences on demand i.e. price, price of related products and income and
therefore we have:-
1) Price elasticity of demand
2) Cross elasticity of demand
3) Income elasticity of demand
With elasticity of demand we will be concerned not only with the direction of change in demand
but also the size of the change (i.e. the magnitude of the change)
Price Elasticity of Demand (PED)
Price elasticity of demand

PED measures the responsiveness of demand for a product following a change in its own
price.

The formula for calculating the co-efficient of elasticity of demand is:
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy
falls from 10 to 8 cones then your elasticity of demand would be calculated as:
Since changes in price and quantity nearly always move in opposite directions, economists
usually do not bother to put in the minus sign. We are concerned with the co-efficient of
elasticity of demand.
Computing the Price Elasticity of Demand Using the Midpoint Formula

The midpoint formula is preferable when calculating the price elasticity of demand because it
gives the same answer regardless of the direction of the change.
Example: If the price of an ice cream cone increasesfrom $2.00 to $2.20 and the amount you buy
falls from10 to 8 cones the your elasticity of demand, using themidpoint formula, would be
calculated as:

Understanding values for price elasticity of demand
 If PED = 0 then demand is said to be perfectly inelastic. This means that demand does
not change at all when the price changes – the demand curve will be vertical. For example
if prices increase from $4 to $5 quantity demanded will remain at 100 units as illustrated
below.
 If PED is between 0 and 1 (i.e. the percentage change in demand is smaller than the
percentage change in price), then demand is inelastic. Producers know that the change in
demand will be proportionately smaller than the percentage change in price. The amount
consumed does not vary very much with price, this can be illustrated as follows.

Examples of goods/services with Inelastic Demand
1. Habit forming goods-e.g. drugs, cigarettes.
2. Goods/services that are considered necessary- e.g bread, potatoes, rice, electricity,
cooking oil.
3. Products that are used in conjunction with other, more expensive goods.
Complimentary goods/service- e.g. petrol/car, spare parts for vehicles, driving licenses,
motor vehicle registration, car insurance.
4. Goods/services that make-up a relatively small part of Y-.e.g. Matches, ballpoint pens.
5. Agricultural goods, exports of LDCs. Most important.
 If PED = 1 (i.e. the percentage change in demand is exactly the same as the percentage
change in price), then demand is said to unit elastic. Using a midpoint formula A 22%

rise in price would lead to a 22% contraction in demand leaving total spending by the
same at each price level. A change in price will lead to the same change in the amount
demanded.
 If PED > 1, then demand responds more than proportionately to a change in price i.e.
demand is elastic. For example using midpoint formula a 22% increase in the price of a
good might lead to a 67% drop in demand. The price elasticity of demand for this price
change is –3. Even small changes in prices lead to big changes in demand.

Examples of goods/services with Elastic Demand
1. Goods/services having close substitutes which buyers find acceptable- e.g. butter/margarine.
2. Goods/services that are durable- e.g. TV’s; cars; furniture.
3. Goods/services that take-up a higher proportion of Yd- e.g. luxuries, holidays.
Perfectly elastic demand— Exist when the quantity demanded changes by a very large
percentage in response to an almost zero percentage change in price as shown below.

What Determines Price Elasticity of Demand?
An example: Demand for transport services
At peak times, the demand for public transport becomes inelastic – and higher prices are charged
by public transport companies who can then achieve higher revenues and profits.
 The number of close substitutes for a good / uniqueness of the product – the more
close substitutes in the market, the more elastic is the demand for a product because
consumers can more easily switch their demand if the price of one product changes
relative to others in the market. People ‘have’ to get to work for example, a latter bus is

not a good substitute as you get there late, so the demand is inelastic. The huge range of
package holiday tours and destinations make this a highly competitive market in terms of
pricing – many holiday makers are price sensitive, so demand is elastic. You can always
go somewhere else on holiday
 The cost of switching between different products – there may be significant
transactions costs involved in switching between different goods and services. In this
case, from shifting from public transport you would need to buy a car for example, find a
parking space near work and so on, therefore demand tends to be relatively inelastic.
 The degree of necessity or whether the good is a luxury – goods and services deemed
by consumers to be necessities tend to have an inelastic demand whereas luxuries will
tend to have a more elastic demand because consumers can do without luxuries when
their budgets are stretched. I.e. in an economic recession we can cut back on discretionary
items of spending. Again, you ‘HAVE’ to get to work so ‘have’ to pay the higher price.
Transport companies know this and so put the price up without affecting the levels of
demand.
 The % of a consumer’s income allocated to spending on the good – goods and
services that take up a high proportion of a household’s income will tend to have a more
elastic demand than products where large price changes makes little or no difference to
someone’s ability to purchase the product.
 The time period allowed following a price change – demand tends to be more price
elastic, the longer that we allow consumers to respond to a price change by varying their
purchasing decisions. In the short run, the demand may be inelastic, because it takes time
for consumers both to notice and then to respond to price fluctuations. Back to the public
transport example, it takes time to buy a car and so on. Transport operators put their
prices up and over time people would drift to cars away from public transport.
 Whether the good is subject to habitual consumption – when this occurs, the consumer
becomes much less sensitive to the price of the good in question. Examples such as
cigarettes and alcohol and other drugs come into this category. This is also why firms
spend vast amounts on building brand images.

 Peak and off-peak demand - demand tends to be price inelastic at peak times – a feature
that suppliers can take advantage of when setting higher prices. Demand is more elastic at
off-peak times, leading to lower prices for consumers. Consider for example the charges
made by car rental firms during the course of a week, or the cheaper deals available at
hotels at weekends and away from the high-season. Bus fares are also high at peak times
during the day
 The breadth of definition of a good or service – if a good is broadly defined, i.e. the
demand for petrol or meat, demand is often fairly inelastic. But specific brands of petrol
or beef are likely to be more elastic following a price change.
 The durability of goods - Goods which can be used more than once are called durable
goods. They are likely to have more elastic demand. Non-durable goods are likely to have
inelastic demand.
Elasticity of demand and the gradient of the demand curve

Elasticity of demand is not measured by the slope or gradient of the demand curve.
Normally on any downward sloping demand curve, elasticity will be different at different prices.
There are only 3 exceptions which are:-
a) A perfectly elastic demand curve
b) A perfectly inelastic demand curve
c) A demand curve with unitary elasticity

Adapted from Beardshaw
Adapted from Beardshaw

The value of elasticity decreases from infinity at point A through unity at point F to zero at point
K.
PED and Total Revenue
A firm’s total revenue (TR) is the amount of money it makes from selling its goods – TR = P x Q
E.g. a firm that sells 100 units of a good at $10 each will have a TR = 100 x $10 = $1000

The effects of a change in good price on the total revenue of a firm depends on whether the
demand for the good is elastic or inelastic.
When demand is elastic an increase in the price of a good will cause a decrease in TR as
illustrated below and a decrease in price will cause an increase in TR.
When demand is inelastic e.g. necessities an increase in the price of a good will increase TR as
illustrated below and a decrease in price will decrease TR.
When a good has elasticity of demand which is unity, a decrease or increase in price of good
leaves TR unchanged.

As the price of a good/service changes up or down, how TR will change depends on the PED of
the good/service. This can be summarised in the table below:
Adapted from www.tutor2u.com

Income Elasticity of Demand (YED or Ey)

YED is the relationship between the % Δ in quantity demanded of a good due to a % Δ in
income.
YED measures the degree of responsiveness of the quantity demanded of good to changes in
income.
Ey = YED
For most goods, income and quantity demanded will move in the same direction i.e. an increase
in Y will lead to an increase in quantity demanded and vice versa. These goods are called normal
goods – YED is positive.
For some goods, income and quantity demanded will move in opposite directions. An increase in
income will lead to a decrease in quantity demanded and vice versa. YED is negative. These
goods are called inferior goods e.g. public transport, second hand clothing, cheap food stuffs etc.
When quantity demanded does not change as income changes YED = 0.
Types of income elasticity of demand
(a) Here the product is normal with the percentage increase in the quantity demanded
outweighing the percentage rise in income, so that a 10% rise in income results in a 15% increase
in quantity demanded, giving a YED of +1.5. This would suggest that the product could be a
consumer durable such as a CD player where the demand increases rapidly as income increases.
(b) Here the 10% rise in income leads to exactly the same 10% increase in quantity demanded,
giving a YED of +1.

(c) Here the percentage increase in the quantity demanded is smaller than the percentage rise in
income, so that a 10% rise in income results in a 5% increase in quantity demanded, giving a
YED of +0.5. Basic foodstuffs is a type of product which could result in this response since we
would not expect a substantial increase in the quantity of basic food purchased as income rises.
(d) Here the 10% rise in income has no effect on the quantity demanded, giving a zero income
elasticity of demand.
(e) Here the 10% rise in income leads to a 5% decrease in the quantity demanded, giving a YED
of −0.5. Clearly this is an inferior product or inferior good, with consumers switching away from
this product to a better quality alternative which they can now afford.
The relationship between the quantity demanded of a product and income can be understood
further by studying the diagram below
The figure illustrates three situations relating to income elasticity of demand. Up to an income
level Y1 the quantity demanded of the product increases as income rises, indicating a positive
income elasticity of demand and thus a normal good. As income rises between Y1 and Y2 the
quantity demanded of the product remains unchanged; the income elasticity of demand is thus
zero. Finally, as income rises above Y2 the quantity demanded decreases, thus illustrating
negative income elasticity of demand and an inferior good.
QUESTION: Use income elasticity of demand to explain the difference between a normal and
an inferior product or good.(12)

Factors Affecting YED

1. Current standard of living
2. Type of good (normal, inferior)
3. Level of consumer’s income
Cross Elasticity of Demand (XED/CED)

XED measures the degree of responsiveness of the quantity demanded of one good (A) to
changes in the price of another (B)
This can be rewritten as:
Where:
qA = the original quantity of product A
pB = the original price of product B
ΔqA = the change in the quantity of product A
ΔpB = the change in the price of product B
Three possible outcomes are shown in the diagram below, with the sign of XED telling us
something about the relationship between the two products. The size (or magnitude) of

XED tells us how close the two products are, whether as substitutes or complements in
consumption.
Line (1) illustrates a positive cross elasticity of demand with respect to a substitute in that as
the price of product B rises the demand for product A increases. Line (2) illustrates a negative
cross elasticity of demand with respect to a complement, in that as the price of product B rises
the demand for product A decreases. Finally, line (3) illustrates a situation where the cross
elasticity of demand is zero, in that as the price of product B rises there is no effect on the
demand for product A.
 In the case of substitute goods (i.e. goods which can be used in place of another), XED
will be i.e. an increase in the price of good A will lead to an increase in the quantity
demanded of good B (and vice versa) e.g. tea and coffee or beef and pork.
 In the case of complementary goods (i.e. goods which the use of one will require the use
of another). XED will be negative i.e. an increase in the price of good A will lead to a fall
in the quantity demanded of good B (and vice versa) e.g. cell phone and airtime, tea and
sugar.
 If 2 goods are very close substitutes XED will have a very high positive value.

 If CED is equal to zero – the goods are not related at all. They are independent goods
e.g. televisions and toilet paper & blankets and sweets.
QUESTION:
a) Use the sign of CED to distinguish between a substitute product and a complement product.
b) Suppose CED is +3 for two products, but −3 for another two products. Explain what these
results mean.
Usefulness of PED to a firm/business
 To calculate a firm’s revenue.
 For a firm to know pricing strategies to use/ embark on.
 For a firm to plan carefully its production levels or level of output to produce.
 For a firm to plan on which products to produce i.e. those which give maximum profits.
 For resource allocation.
Usefulness of YED
 For resource allocation.
 For production levels or level of output to produce.
Usefulness of CED
 For production levels or levels of output to produce.
 For planning on which products to produce i.e. those which yield maximum profits.

Adapted from www.tutors2u.com

NOTE
Take note of the following terms:-
 Joint demand/ Complementary demand i.e. demand for complements
 Competitive demand i.e. demand for substitutes
 Composite demand - A good is said to be in composite demand if it is demanded for
several uses/different uses e.g. wool would be demanded by the textile industry, blanket

manufacturers etc. The demand for such goods are the aggregates of the demands of the
various users.
 Joint supply – this means the production of one good automatically leads to the output of
another e.g. peanut butter and oil, beef and hides, mutton and wool, lead and zinc.
Adapted from www.tutors2u.com

Elasticity of Supply
Price elasticity of supply (PES) is the relationship between the proportionate change in quantity
supplied due to a proportionate change in price.
PES is the responsiveness of quantity supplied to a change in price.
PES is positive since the supply curve slopes upwards from left to right
Where PES is >1 → supply is elastic
Where PES is <1 →supply is inelastic
Where PES is = 1 → supply has unitary elasticity
Where PES is = 0 → supply is perfectly inelastic
Where PES is = ∞ → supply is perfectly elastic
Diagrammatically
1) Supply is elastic
% Δ Quantity supplied > %ΔP, the supply curve is gentle or almost flat.
2) Supply is inelastic
% Δ in quantity supplied < % ΔP. The supply curve is steep.

3) Elasticity of supply is unity

% Δ in Quantity supplied = % Δ P. The supply curve passes through the origin

4) A perfectly inelastic supply curve.

PES = 0. A change in price has no effect on quantity supplied. The supply curve is vertical in
shape.
5) A perfectly elastic supply curve.
Producers will supply any amount at the ruling price. PES = ∞. The supply curve is horizontal.

Time Period and Elasticity of Supply

PES increases with time as producers have a longer period to adjust to changes in demand. Alfred
Marshal maintained that there are 3 periods of supply.
1) The Momentary Period
This is a period of time during which supply is restricted to the quantities actually available to the
market.Supply is fixed (i.e. perfectly inelastic). Normally this period will be a very short one. In
the case of perishable goods e.g. fruits, vegetables, fish, supply for the day in local markets is
limited to quantities delivered in the morning. SUPPLY IS PERFECTLY INELASTIC IN
THE MOMENTARY PERIOD.
2) The Short Run Period
This is the interval which must elapse before more can be supplied with the existing capacity.
The SR period is the period of time which allows for changes to take place in the quantities of the
variable factors employed e.g. labour. Other factors of production are fixed. Changes in supply in
this period are shown as movements along the normal supply curve. SUPPLY IS INELASTIC
IN THE SHORT RUN
3) The Long Run Period

In the LR all factors of production are variable and firms may enter or leave the industry. This is
a period long enough for fundamental changes to take place in the scale of industry. SUPPLY IS
ELASTIC IN THE LONG RUN
Determinants of Price Elasticity of Supply

1) Time period– PES increases with time i.e. from momentary to short run and finally long run
period of time. Supply changes from being perfectly inelastic to inelastic, then elastic and finally
perfectly elastic.
2) Factor immobility – i.e. the easiness with which factors of production can be moved from one
use to another will affect PES. The high factor mobility, the greater will be elasticity.
3) Natural constraints restrict supply e.g. droughts, earthquakes, floods, cyclones. Supply
becomes inelastic.
4) Risk Taking – The more willing entrepreneurs are to take risks, the greater will be the PES
(supply becomes elastic)
5) Where an industry is operating below capacity and there are unemployed resources supply
will be elastic.

6) Where suppliers are holding large stocks supply will be elastic. An increase in demand can
bemet by running down stocks.
7) In a situation of full employment the supply of most goods and services will be inelastic.
Application of Elasticity Concepts
INCIDENCE OF INDIRECT TAXES AND SUBSIDIES
The concept of elasticity is important in determining who pays (consumer and/or producer and
what %) when the government imposes an indirect tax on a good/service; and who benefits
(consumer and/or producer and what %) when a good/service is subsidised.
Imposition of an indirect tax or and subsidies affect three areas
Incidence of tax - who pays the indirect tax, the buyer or the seller or both.
Revenue - how much tax revenue a government will raise or how much a subsidy will cost the
government.
Resource allocation - to what extent the behaviour of buyers are affected by a tax or a subsidy.
Types of Taxes
Direct tax is a tax upon income. Income includes wages, rent, interest and profits.
Indirect tax is a tax on goods or services. It is taken indirectly from income when spending
occurs.
Types of Indirect Taxes
A specific or flat rate tax is when a specific amount is imposed upon a good/service e.g. $1 per
litre of whisky.
A percentage or ad valorem tax is when the tax is a percentage of the selling price e.g. a sales
tax of 10% of the selling price of the good/service.
Effect of imposing a flat rate tax
The tax is collected by the seller for the government. However, not all the amount of the tax will
necessarily be passed on to the consumer.
The supply curve for the good or service will shift upwards by the amount of the tax.
However, because the demand curve is not vertical but sloping, then the price rises by less than
by the full amount of the tax as illustrated below:

Effect on:
1. Incidence – payment of the tax is shared between buyers and sellers. The price rise is not the
same as the tax, which means the full amount of the tax is not paid by the consumer, therefore
some must be paid by the producer. The only situation where the consumer pays the full amount
is when there is perfectly inelastic demand.
2. Government revenue – the government will receive the full amount of the tax. The
government’s revenue is equal to the amount of the tax multiplied by the quantity sold.
3. Resource allocation – there are fewer resources allocated to the production of this good. The
quantity demanded and the quantity supplied of the good will both have fallen (0Q1 to 0Q2).
There may be a loss of satisfaction to both consumers and producers. The government may wish
to reduce the demand for harmful goods (e.g. cigarettes) by imposing an indirect tax.
Taxation and Elasticity
The PED and PES are what determines the
1. The incidence of the tax.
2. The revenue a government receives from a particular tax.
3. The effect upon resource allocation.

Example # 1:
a) PED = 0 Perfect Inelastic Demand
b) PED = α Perfectly Elastic Demand

1. Incidence:
Diagram (a): 100% on consumer.
Diagram (b): 100% on producer.
2. Government Revenue:
Diagram (a): area P1abP2; there has been no fall in quantity bought.
Diagram (b) area tabP1, 2 is small; there has been large fall in quantity sold.
3. Resource Allocation:
Diagram (a): unaffected. Same quantity bought and produced.
Diagram (b): significantly affected. Major decline in production, from 0Q1 to 0Q2.
Example 2: PES = 0 Perfect Inelastic Supply & PES = α Perfectly Elastic Supply
a) Perfectly inelastic supply

a) Perfectly elastic supply
1. Incidence:
Diagram (a): 100% on producer.
Diagram (b): 100% on consumer.
2. Government Revenue:
Diagram (a): area tabp1 is relatively large; there is no fall in quantity.
Diagram (b) area p1abp2 is relatively small.
3. Resource Allocation:
Diagram (a): no change. Quantity sold remains the same.
Diagram (b): this is likely to change considerably.
Ad Valorem or Percentage Taxes
A percentage or Ad Valorem tax is when the tax is a percentage of the selling price e.g. a sales
tax of 10% of the selling price of the good/service.
This is when a tax is applied as a percentage, the supply schedule and curve will move up
proportionately at each price. Means the amount of tax paid will be higher at higher prices.
The supply curve will move away from the original supply curve as the quantity supplied
increases.

Subsidies on Goods and Services

Subsidies are money paid to producers by the government.
Whether producers share the subsidy with consumers will depend on PED and PES Curves.
Subsidies have the opposite effect to a tax.
A subsidy shifts the supply curve down by the amount of the subsidy.

Effects
1. Given the PED and PES Curves drawn above, the subsidy will be shared between the producer
and the consumer. The full amount of the subsidy is a vertical distance between the two supply
curves. This is more than the fall in price.
2. It costs the government the amount of the subsidy multiplied by the quantity produced.
3. Resource allocation has changed; an extra amount is consumed and produced (0Q1 to 0Q2).
Summary:
Three issues emerge when an indirect tax is imposed:
1. Incidence of the tax – who pay the tax, producers or consumers.
2. Government expenditure – what is the total revenue to the government.
3. Resource allocation – how is consumption and production of the good/service affected.
Three issues emerge when a subsidy is given:
1. Incidence of the subsidy – who benefits from the subsidy, producers or consumers.
2. Government expenditure – what is the total cost to the government.
3. Resource allocation – how is consumption and production of the good/service affected.

THEORY OF CONSUMER BEHAVIOUR

Utility is the level of happiness or satisfaction that a person receives from consumption of a good
or service. utility can be considered in terms of cardinal utility and ordinal utility.
MEASUREMENT OF UTILITY:-There are two approaches for measurement of utility.
Measurement of utility
Cardinal utility Ordinal utility
Cardinal Utility
It is the concept of utility which is based on the idea of a consumer quantifying the utility he
derives from consuming a particular commodity. In the 19th Century, many economists among
them Alfred Marshal believed that it was possible for utility to be quantified/measured in cardinal
numbers as opposed to ordinal numbers – these economists are termed cardinalists. A cardinal
measure of utility implies that we can quantify how much more utility one unit of a good gives
to a person than the next.
Assumptions of the cardinalists approach
1. Rationality
Consumers are assumed to be rational/sensible decision makers which mean they weigh the
costs and benefits of each decision they make. Rational decision involves the consumer choosing
those items that give him the best value for his money i.e. the greatest benefit relative to cost
or where they derive maximum utility.
2. Cardinal utility
Cardinal utility refers to the fact that the utility can be measured in monetary units. The monetary
unit is conceptualized in terms of the amount a consumer is prepared to pay for another unit of
the commodity.

3. Constant Marginal Utility of money

The measurement rod is a monetary unit and the marginal utility of money must not change as
income changes, otherwise the measurement will be useless.
This implies that for a rational consumer to purchase an extra unit of a commodity, his expected
satisfaction from the consumption of the extra unit must be greater than the utility of money
which he must spend in order to obtain it.
The maximum sum of money that a consumer is willing to spend in order to acquire an extra unit
of a good can – serve as an indication of the amount of utility that he expects to realize from the
consumption of that unit.
Therefore, whether there is an increase or a decrease in the income of a consumer, the marginal
utility of money must remain the same.
4. Diminishing Marginal Utility
The marginal utility derived from a commodity diminishes as its consumption increases. This
means that the more a particular good is consumed, the less the additional satisfaction derived.
5. Consumers possess perfect knowledge of the price in the market.
6. The choices of the goods are certain in the market.
7. The prices of various commodities are not influence by variations in their supply.
8. There are no substitutes and that the utilities are measurable in terms of money.
9. A consumer does not buy a commodity simply because its price is very low or very high.
10. The units of the commodity must be appropriate.
11. The tastes of consumer do not change.
12. Utility of different commodities are independent of each other.
Total utility is the overall satisfaction that an individual get from the consumption of all units of
a good or service over a given period of time.
Marginal utility is the additional satisfaction derived from the consumption of one more unit of
a particular good or service. Consumers are rational because they want to maximize satisfaction.
Rational consumers would not consume a product when the marginal utility falls to zero.
The law of diminishing marginal utility

The law states that “other things being equal, as more and more units of a commodity are
consumed, the additional satisfaction or utility derived from the consumption of each successive
unit will fall or decrease” e.g
The marginal utility decline as each successive unit is consumed. If a consumer goes on
consuming more and more units, eventually total utility actually decreases so that marginal utility
becomes negative. Negative utility is referred to as disutility or dissatisfaction.
Logical consumers would not consume a product when marginal utility falls to zero, the marginal
utility curve in practice would be downward sloping from left to right like the one below. This
curve may look familiar. It is the basis of the demand curve. Indeed people’s demand curve for a
product is the same as their marginal utility curve for that product measured in money terms.
Whilst utility is a subjective matter, and is so difficult to measure, it can be estimated. One way
of doing this is to look at what a person is prepared to sacrifice in order to obtain a commodity.
Price measures the sacrifice in the sense that it indicates what other things might have been
obtained with the money. Since marginal utility diminishes; consumers will be tempted to buy
more of a good only if its price is lowered. By assuming that the sacrifices a person is prepared
to make in order to obtain something gives an indication of the utility derived from that good, it
is possible to obtain the demand curve. Different individuals will derive different levels of
satisfaction, and so will have different demand curves. Therefore the market demand curve is the
horizontal summation of the individual demand curves at different prices.

The figure illustrates total and marginal utility. As the consumption of product x rises, as seen
in (a), then the total satisfaction (utility) obtained by the individual rises up to a certain point.
Marginal utility (b) relates to the extra satisfaction obtained from consuming one extra unit of
the product over a given period of time. The figure illustrates diminishing marginal utility.
Factors affecting the Law of Diminishing Marginal Utility
 The time period over which decisions are made e.g a person who has not had a meal/ food
for several hours will place a high value on food than a person who has just had a meal or
is full (therefore he will not place any value or will place very low value on food).

 Addiction e.g. smokers may find that the more they smoke the more they want to smoke –
they will always place very high value on cigarettes
 The level of consumer’s income.
 The price level of goods or services.
 The type of good e.g. inferior goods versus normal goods.
 Trends in fashion i.e. if in fashion consumers derive more additional utility.
 Advertising i.e. informative, persuasive and generic
The whole satisfaction derived from a basket of goods is a function of how many goods there are
in the basket e.g. if there are unknown (n) goods in a basket i.e. X1, X2, X3, X4, X5 ..., XN. The
total utility derived would be:
TU = f(X1, X2, X3, X4, X5 ..., XN)
With the above assumption, if a consumer consumes the above set of goods, then total
utility/satisfaction derived will be:-
TU = TU1(X1) + TU2(X2) + TU3(X3) + TU4(X4) + TU5(X5) + … + TUN(XN) OR U = U1(X1) +
U2(X2) + U3(X3) + … UN(XN)
Equilibrium of the consumer under the cardinalist approach/method

The ‘consumer equilibrium’ is the consumption bundle where total utility is a maximum.
In considering the consumer equilibrium a number of assumptions are made, namely that the
individual:
a) Has a limited income;
b) Acts in a rational manner;
c) Aims to maximise his or her total utility subject to the income constraint.
The individual consumer is said to be in equilibrium when it is not possible to switch a single
dollar worth of expenditure from product x to product y and obtain an increase in total utility,
given the individual’s income level and the prices that he or she faces. This occurs when the ratio
of marginal utility to price is equal for all the products consumed.
In other words when:
MUx = Px
If MUx>Pxthe consumer should buy more of X to derive additional satisfaction.

If MUx<Px, the consumer should reduce the consumption of X to increase satisfaction.

→ MUx = Px is the point of consumer equilibrium, though it is very difficult to attain but at this
point the consumer achieves maximum utility.
The above analysis is basically for only one commodity. When a consumer consumes more than
one good e.g good X, good Y and good N, the consumer will obtain his equilibrium when there is
equality between the ratios of the marginal utility of each good to its price.
This is referred to as the equi-marginal principle.

A change in the price of any of the goods will cause a change in a person’s spending patterns.
From the above principle, the value of the expression MUX/ PX will now fall as the price of x is
increased so the MUx per dollar spent will now be less than any other good. The consumer will
therefore increase TU by spending less on good x and more on all other goods. In other words the
consumer only maximizes TU by buying less of good x. The conclusion is that the demand curve
is downward sloping.
EXAMPLE OF HOW THE EQUILIBRIUM IS ESTABLISHED
Suppose there are two commodity x and y. Price of good X =$2 per unit and Price of
goodY=$3per unit.Consumers money income =$24
Marginal utility of x and y commodity are given in the table below.
Units Mux (utility) Muy (utility)

1 20 24
2 18 21
3 16 18
4 14 15
5 12 12
6 10 9
In order to maximize his satisfaction the consumer will not equate marginal utility of ‘x’ with the
marginal utility of y because prices of these two goods are different. He will equate (per $ Mux)
with (per $Muy)
So, reconstructing the above table by dividing marginal utilities (Mux) of x by $2 and marginal
utilities (Muy) of y by $3, we get the table below. Table marginal utility of money expenditure
Units Mux / Px Muy / Py
1 10 8
2 9 7
3 8 6
4 7 5
5 6 4
6 5 3
In order to have maximum utility consumer will purchase 6 units of x any 4 units of y because it
satisfies the following two conditions required for consumers equilibrium.
At 6 units of x

At 4 units of y =
Expenditure on x + expenditure on y = total income= (Qx × Px + Qy × Py)
= 6x2 +4x3
= $24
Therefore for the consumer to arrive at the equilibrium he should take 6 units of good x and 4
units of good y. at this level of consumption the consumer enjoys maximum level of satisfaction.
Criticisms of the Cardinalist approach
Even though the multi-commodity version of marginal utility theory is useful in
helping/demonstrating the underlying logic of consumer choice, it still has major weaknesses.
1. Utility is Subjective:
Utility is a subjective concept. It relates to man's psychology. It is not possible to be
objective about it. But the analysis of consumer's demand is objective.
2. Marginal Utility cannot be Estimated for all Commodities:
Utility analysis is based on the concept of marginal utility. Marginal utility of only those
commodities can be measured which are divisible But division of some commodities T.V
set, refrigerator, etc.,is not possible.
3. Marginal utility of money does not remain constant:
The other assumption of utility analysis is that marginal utility of money remains
constant. This assumption is also not realistic. As the quantity of money with a person
increases, its marginal utility diminishes and as his quantity of money decreases, its
marginal utility increases.
4. Consumer is regarded as Computer:
It considers consumer as a computer. According to this analysis, while spending his
money, a consumer always compares the amount of gain he will have by way of utility of
the commodity purchased with the loss that he will have to suffer by way of sacrifice of
the money spent. But in real life none of consumer is so calculating.
5. Does not explain Giffen Paradox:
Cardinal utility analysis does not explain Giffen paradox. It has no answer to explain as to
why the demand curve of many inferior goods slopes upwards (positive slope) from left

to right. In other words, why does demand extend with rise in price and why does demand
contract with fall in price.
6. Cardinal Measurement of Utility is not possible:
Utility cannot be measured in cardinal numbers like 1,2,3,4, etc. As such, utility derived
from different quantities of the goods can neither be added nor subtracted Marshall sought
to measure marginal utility indirectly in terms of money. But According to Pigou, it is not
possible to measure marginal utility indirectly in terms of money, because money can, at
the best, measure the intensity of demand for a good. It cannot measure the actual
satisfaction.
7. Every Commodity is not an independent commodity:
The analysis is based on the assumption that every commodity is an independent
commodity. In real life, utility of a commodity is very much dependent upon the utility of
other commodities. No commodity is an independent commodity. Consumer's behaviour
cannot therefore be precisely measured through utility analysis.
8. Theories based on utility place a great emphasis upon rationality and search for utility
maximization but many decisions made by people lack rational behavior.
9. Those who work in advertising i.e. persuasive and informative advertising are well
aware that it is often the emotional content of a product that is more important that the
rational.
Ordinal Utility
It is the concept of utility which is based on the idea of preference ordering and ranking rather
than the concept of measurable utility. It is assumed that a consumer is capable of comparing
any 2 alternative bundles of goods and deciding whether he prefers one bundle to the other or is
indifferent between them. Several assumptions are made about the nature of this preference
ordering which lead to the conclusion that all possible bundles of goods can be grouped into sets
in such a way that the consumer is indifferent between all bundles in one set and not indifferent
between sets. These indifferent sets can be arranged in increasing order of preference. It is often
convenient though not necessary to assign numbers to these sets adopting the convention that the
higher a set is in order of preference the higher its number should be.

The indifference curves (ordinal) Approach

An indifference curve is a curve that describes a combination of two goods that yield the same
level of satisfaction or utility to the consumer. It shows the various sets of goods that make a
consumer indifferent to the satisfaction derived from consuming them. Based on the same utility
derived from various baskets of goods, it becomes uneasy for a consumer to choose a particular
basket of goods because utilities derived from a series of combinations to another are indifferent.
Assumptions of Indifference Curves
 Rationality – the consumer always aims to maximize satisfaction from goods consumed.
 Ordinal Utility( assumption of completeness)- It is axiomatically believed that the
consumer can rank his preferences in accordance with the utility derived from various
baskets of goods, utility measurements can only be handled using the ordinal method and
not the cardinal method. The total satisfaction derived by a consumer is a function of the
total quantity of commodities consumed i.e.
TU = f(q1, q2, q3, …, qx, qy, …, qn)
 Non satiety- consumers always prefer more to less. They will never reach the point of
satiety ie the maximum level of satisfaction.
 Consistency and transitivity of choice- Since we assume that a consumer is rational, his
choice of goods has to be consistent. When he chooses a particular point in time, he is not
expected to choose B over A in another time A>B, then A must be preferred to B.
Similarly if A>B>C – A>C. Meaning that if a consumer preferred bundle A to bundle B
and bundle B to C, then bundle A must be preferred to bundle C.
 There must be two baskets of goods for the analysis to be complete. The indifference
curve analysis will not be complete if the bundles are used in isolation of the other basket.
Properties/Characteristics of Indifference Curves

Negative Slope

An indifference curve slopes down from left to right. This means that the consumption of the 2
goods along the indifference curve is negatively related to each other i.e. if the quantity of one
commodity (Y) consumed decreases the quantity of the other (X) must increase in order to
maintain the same level of satisfaction.
Non Intersection
Indifference curves must not intersect. If the 2 curves intersect, the point at which the intersection
occurs will represent 2 different levels of satisfaction, thereby violating the consistency
assumption.

In the above diagram, two indifference curves are showing cutting each other at point B. The
combinations represented by points B and F given equal satisfaction to the consumer because
both lie on the same indifference curve IC2. Similarly the combinations shows by points B and E
on indifference curve IC1 give equal satisfaction top the consumer. If combination F is equal to
combination B in terms of satisfaction and combination E is equal to combination B in
satisfaction. It follows that the combination F will be equivalent to E in terms of satisfaction.
This conclusion looks quite funny because combination F on IC2 contains more of good Y
(wheat) than combination which gives more satisfaction to the consumer. We, therefore,
conclude that indifference curves cannot cut each other.
Convexity
The indifference curve is convex to the origin. This means that the curve is inwardly curved from
left downwards to the right signifying diminishing marginal rate of substitution (DMRS)

In the above diagram, as the consumer moves from A to B to C to D, the willingness to substitute
good X for good Y diminishes. The slope of IC is negative. In the above diagram, diminishing
MRSxy is depicted as the consumer is giving AP>BQ>CR units of Y for PB=QC=RD units of X.
Thus indifference curve is steeper towards the Y axis and gradual towards the X axis. It is convex
to the origin. If the indifference curve is concave, MRSxy increases. It violets the fundamental
feature of consumer behaviour. If commodities are almost perfect substitutes then MRSxy
remains constant. In such cases the indifference curve is a straight line at an angle of45 degree
with either axis. If two commodities are perfect complements, the indifference curve will have a
right angle. In reality, commodities are not perfect substitutes or perfect complements to each
other. Therefore MRSxy usually diminishes
Higher Indifference Curve Represents Higher Level of Satisfaction:
Indifference curve that lies above and to the right of another indifference curve represents a
higher level of satisfaction. The combination of goods which lies on a higher indifference curve
will be preferred by a consumer to the combination which lies on a lower indifference curve.

The indifference map is a conglomeration of indifference curves. A higher curve than another
one signifies a higher level of satisfaction. The indifference map shows various indifference
curves that stand for different levels of satisfaction. It should be noted that bundles or basket of
goods found on the same indifference curve produce the same level of satisfaction. An
indifference map ranks the preferences of the consumer. The higher the indifference curve or the
farther away from the origin it is, the more preferable it is to a rational consumer. On the other
hand, the lower the indifference curve, or the closer the curve is to the origin, the less preferable
it is.
From the diagram IC3 > IC2 and IC2 > IC1.Though the level of satisfaction might not be
determined, the utility associated with I1 is less than that attached to IC2 and satisfaction attached
to I2 is less than that of IC3. Given that consumers are rational most purchases of goods and
services will like to consume along the highest indifference curve i.e. IC3.
Diminishing Marginal Rate of Substitution (DMRS)

The technical term for the negative slope of an indifference curve is marginal rate of substitution
(MRS). The MRS is the amount of one good a consumer is ready to sacrifice in order to obtain
an additional unit of another good. The act of increasing and decreasing the commodities eg good
X and Y i.e. the willingness to give up one good for the other along the indifference curve is
called Diminishing Marginal Rate of Substitution. The slope of the indifference curve = MRS =
MUx/ MUy
The Budget Constraint/Budget Line

A budget line shows combinations of two products which can be purchased with a given level of
income.
 The budget line slope shows the relative prices of the two goods i.e. Px/ Py
 A consumer’s ability to purchase goods and services is limited by his level of income and
the prices of goods and services.
 A budget constraint/budget line or consumption possibilities curve measures the relative
scarcity between two goods.
 The line shows the combination of goods a consumer can purchase given his/her income
at market prices.
 It also classifies attainable and unattainable regions.
 The budget constraint in the case of two goods x and y is formulated as follows
I = PxQx + PyQy
Where: I is the consumer’s income
Px is the price of the good x
Qx is the quantity of the good x
Pyis the price of the good y
Qy is the quantity of the good y
e.g. A budget of $100 and prices for y of $2 per unit and for x of $5 per unit.

0ption Good y($2) Good x($5)

1 50 0
2 0 20
Good y
50
.U .C .W
20
0 good x
The consumer can attain or consume any combination along the budget line e.g. C i.e.
consumers all income or inside the budget line e.g. u i.e. doesn’t exhaust all the income – points
along the budget line are attainable and points outside the budget line e.g. Wis not attainable i.e.
they are beyond the consumer’s income. A budget line measures marginal rate of transformation
(MRT).
Shifts in the Budget Line

These are a result of:
 An increase or decrease in thelevel of the consumer’s income.

Changes in prices affect the level of real income, if prices decreases real income increases and
the budget line shifts outwards. The reverse is true for increase in prices.eg if prices decrease by
50%, the effect will be as follows.

Good y 100
50
0 20 40 good x
 Changes in prices of one good
If price of good x decrease by 50% the effect will be as follows
Good y
50
0 20 40 good x
• If the price of the good increases or decreases the budget line will not shift. It will pivot inwards
or outwards depending on the circumstances.
The Consumer Equilibrium under Indifference Curves Analysis

Given the consumer income and the prices of goods or supplies in the market, the consumer
maximizes satisfaction at the point of equilibrium.
Graphically it is the point where the budget line is tangential to the highest possible indifference
curve.

Conditions of consumer’s equilibrium

The conditions of consumer equilibrium where he would maximize his satisfaction is as
follows:-
 At equilibrium point budget line or price line should be tangent to indifferent

curve.
 At equilibrium point slope of the indifference curve must be equal to the slope of
budget line.
 At equilibrium point = (Qx Px) + (Qy Py) = money
Good y
Px (MRTxy)
MRSxy(mux/muy)
Py
60
50
Consumers Px
40 M R Sxy =
Equilibrium Py
30 L E
Px
MRSxy
20 Py
IC
10 IC
IC
10 S 20 30good x
Indifference Analysis and Consumers equilibrium
Point e is the equilibrium point. The equilibrium quantities are x * and y*. The slope of the budget
line = Px/ Py( marginal rate of transformation for good x and y (MRT)) and the slope of the
indifference curve = MUx/ MUY ( marginal rate of substitution for good x and y( MRS xy))are
equal at their point of tangency. At this point marginal rate of substitution is equal to marginal
rate of transformation and satisfaction will be equal to income.

Applications of Indifference Curves Analysis/Changes in Consumer Equilibrium
1. Effects of Changes in Income
A rise in the level of the consumer’s income shifts from C to C1 to C2 as more of both x and y are
consumed. The line C, C1, C2 is income consumption line/ curve(ICC/ICL) or the Engel curve
(EC).
An income consumption curve is the line that traces the different equilibrium points of the
consumer arising from changes in his income.

If the increase in income leads to an increase in the quantity demanded of a good then this is a
normal good. In the diagram aboveincreases in the level of income positively affected the level
of quantityconsumed as shown on the Engel curve(EC).
If the increment in income results in a reduction in quantity purchased, the good is inferior as
shown on the diagram below

2. Effects of changes in prices

Changes in Px, while that of good y remains fixed.
As the price of good x falls, the budget line pivots outwards and the consumer equilibrium shifts
from a to b to c. TSRis the price consumption curve/line (ppc) .

A price consumption curve (ppc) is a line that traces or joins the new equilibrium points as
a result of continuous falling or increasing of the price of a commodity.
3. Derivation of the demand curve using the indifference curves approach
Indifference curves can be used to show how an individual demand curve is derived.
Distinguishing between income and substitution effects

Total Effect
Total price effect measures the impact on quantity of good as a result of changes in the price
of that commodity. The effect can be divided into two different components of substitution
and income effects.
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Income and substitution effect for a normal good

A normal good is a good such that when the constraints income increases people buy more of
the good. On the diagram below AB is the original budget line with the consumer in
equilibrium at point a. If the price of product x falls this will lead to a pivot in the budget line
to AC, allowing the consumer to reach a higher indifference curve (IC2) and a new
equilibrium of point c. The result of this is that the quantity of product x bought has risen
from X1 to X3.
Given a budget line of AB and an indifference curve of IC1 a consumer is in equilibrium

at point a. The price of product x falls, hence the budget line pivots to AC. The substitution
effect involves a move from point a to b, where the relative prices of products x and y have
changed but real income has remained constant. The income effect involves a move from b
to c, where real income increases while relative prices remain unchanged.
Income and substitution effect for an inferior good

When people’s incomes increase, they will buy less of inferior goods e.g. public transport,
second hand clothing, poor foodstuffs etc since they will now be able to afford better quality
goods (and vice versa). On the diagram below, if the price of product x falls it leads to a
substitution effect towards the product, i.e. a movement from a to b, with more being
consumed (X1 to X2). However, the income effect is negative, unlike that for a normal good,
and this means a movement from b to c with less being consumed, X2 to X3.
109
Although the income effect is negative, in this case it is not sufficient to outweigh the
substitution effect, which means that overall there is still more of the product demanded as
the consumer has moved from X1 to X3. In other words, the demand curve for product x is
still downward sloping. It is possible, however, for the negative income effect to be
sufficiently large to outweigh the substitution effect.
The figure relates to an inferior good with the income effect (represented by a move from b
to c) working in the opposite direction to the substitution effect (represented by a move
from a to b) following a fall in the price of product x. The substitution effect is greater than
the income effect and so the demand curve for the product is still downward sloping.
Critique of the Indifference Curves Approach

 In practice, it is virtually impossible to derive indifference curves since it would
involve the consumer having to imagine a whole series of different combinations of
goods and deciding in each case whether a given combination gave more, equal or
less satisfaction than other combinations.
 Consumers may not behave “rationally” and hence may not give careful consideration
to the satisfaction they believe they will gain from consuming goods. They may
behave impertuously (i.erashing or acting without considering) e.g impulsive buying.
110
 Consumers are not perfectly knowledgeable. Therefore the “optimum consumption”

point may not in practice give consumers maximum satisfaction for their money.
 The belief that consumers are rational may be influenced by advertising.
 Indifference curves are based on the assumption that marginal increases in one good
can be traded off against marginal decreases in another. This will not be the case with
consumer durables e,g cars, TVs, sofas. Houses etc since they are purchased only now
and again and then only one at a time.
Usefulness of Indifference Curves
 To demonstrate the logic of rational consumer choice.

 Derivation of individual’s demand curve
 Income and substitution effects of a price change.
 Price consumption curve (PCC) and income consumption curve (ICC).
111
THEORY OF PRODUCTION AND COSTS
• A plant/establishment is a unit of production in an industry. It can be a

factory, a shop, a farm, a hotel or any economic unit that carries its own business at
one geographical location.
• A firm is a unit of ownership and control. A firm may consist of just one pant
in which case it is referred to as single plant. However many large firms are likely to
comprise a number of plants – they are multiplant.
• An industry is all firms concerned with a particular line of production or all
firms producing similar products e.g. automobile industry, tourist industry, mining
industry and agricultural industry etc
• Going beyond the supply curve, we need to find how the rational producer (or
firm) will behave.
• We will be looking at the benefits and costs to the firm of producing various
quantities of goods or services and using various alternative methods of production.
Questions to answer:-
How much will be produced?
What combinations of inputs will be used?
How much profit will be made?
• The traditional theory of supply or theory of the firm assumes that firms aim to
maximize profits.
• Rational Producer behavior is when a firm weighs up the costs and the
benefits of alternative courses of action and then seeks to maximize its net benefit
The Short Run (SR) Period of Production
• It is the period of production when at least one factor of production is variable e.g. labour
and the rest are fixed (i.e. land, capital and entrepreneurship)
The Law of Diminishing Returns/The Law of variable proportions/The Law of Diminishing
MarginalProductivity
The law states that “as we add successive units of the variable factor of production to fixed
amounts of other factors of production, the increments to total output or total product (TP) or
total physical product
(TPP) will first increase and then decline.”
112
e.g. assume some particular crop is to be grown on a fixed price of land e.g. 2 acres. We shall
assume also that the amount of capital to be used is also fixed. Labour will be the only
variable factor of production.
Number of Workers Total Product (T.P) Average Product (AP) Marginal Product
(MP)
1 8 8 8
2 24 12 16
3 54 18 30
4 82 20.5 28
5 95 19 13
6 100 16.7 5
7 100 14.3 0
8 96 12 4
Assumptions
1. Labour is the only variable factor of production.
2. All units of the variable factor of production are equally efficient.
3. There are no changes in the techniques of production.
Total Product (TP) or Total Physical Product (TPP)
It is the total output of a product per period of time that is obtained from a given amount of
inputs
Average Product (AP) / Average Physical Product (APP)
It is output per worker
AP=
AP is also called efficiency / productivity

Marginal Product (MP) / Marginal Physical Product (MPP)
It describes changes in total output brought about by varying employment by one person.
∆
113
MP = TP of n workers – TP of … (n-1) workers =

∆
Returns to the variable factor
Since labour is the only variable factor of production, changes in output are related directly to
changes in employment – we speak of changes in the productivity of labour i.e. returns to the
TP
TP
0 3 4 7 QTY
The LDMR sets in MP/AP
AP
0 3 4 7 MP 8 QTY
variable factor of production which is labour. Diagrammatically:
1. Increasing Returns(0 to 3 units)
TP is increasing at an increasing rate. MP is increasing
2. Constant returns (not illustrated)

TP is increasing at a constant rate. MP is constant.
114
3. Diminishing Returns / Decreasing Returns(3 to 7 units) TP is increasing at a

decreasing rate. MP is falling.
4. Zero Returns(7 units)

Total product is constant. MP is zero.
5. Negative Returns(7 to 8 units)

NB Total product is falling. MP is negative.
Diminishing returns set in because too many cooks spoil the meal.
The law of diminishing returns deals essentially with SRPeriod situations. It is assumed that
some of the resources (factors of production) used in the production process are fixed in
supply.
LONG RUN PRODUCTION PERIOD
Returns to Scale
• The law of diminishing returns deals with essentially SR situations. It is
assumed that some of the resources used in production process are fixed in supply.
• In the LR period it is possible for a firm to vary all factors of production
employed.
• In the LR period it is possible for a firm to change the scale of its activities.
Units of Labour Units of Land Total Output Increase in size Increase in TP
(acres) (tons) of firm
4 20 100 100% 150%
8 40 250 50% 68%
12 60 420 33.3% 33.3%
16 80 560 25% 20%
20 100 672 22% 16%
24 120 780
• It is a feature of production that when the scale of production is changed,

output changes are usually proportionate.
115
• When a firm doubles its size, output will change by more than 100% or less
than 100%. The relationship changes of production and changes in output are
described as returns to scale.
Increasing Returns to Scale
Output increase more than proportionality e.g. as the firm increases its size from 4 people /
workers and 20 acres to 12 workers and 60 acres of land.
Constant Returns to Scale
Size of firm and output changes by the same % e.g. a change of scale from 12 people /
workers and 60 acres to 16 workers and 80 acres.
Decreasing Returns to scale
Output increases less than proportionality e.g. a change of scale from 20 workers and 100
acres to 24 workers and 120 acres.
Those features of increasing size which account for increasing returns to scale are generally
described as economies of scale.
The causes of falling efficiency as the size of the firm increase are described s diseconomies
of scale.
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In the LR period it is possible for a firm to change the scale of its activities. When an
increase in the scale of production results in a more than a proportionate increase in output,
the firm is said to be experiencing economies of scale (INCREASING RETURNS TO
SCALE). Economies of Scale are the benefits which accrue to a firm as it grows in size or
they are the advantages of expansion. They are seen as the LRAC decrease / fall.
Diseconomies of scale are the disadvantages of expansion (DECREASING RETURNS TO
SCALE). They are seen as the LRAC start to increase. Minimum Efficient Scale (MES)
(CONSTANT RETURNS TO SCALE) is seen by the constant part of the LRAC.MES exist
if the proportionate change in scale of production is the same as the change in output.This can
be illustrated by an envelope curve as INCREASING
RETURNS TO DECREASING RETURNS TO
SCALE SCALE
0 Q1 Q2 Q3 MES
QTY
The diagram illustrates the long run production of a firm. Firms always operate at the least
part of the average cost curve. This firm was currently operating at Q1at the least point of
SRAC1.Assuming that demand of the firm’s products increases and output Q2 is now
demanded. If this firm decides to continue operating in the short run (SRAC1) its costs
increases from A to B. To avoid this increase in cost this firm should alter all its factors of
follows;
AC SRAC1 SRAC5 LRAC
SRAC2
B SRAC3 SRAC4 SRAC5
ECONOMIES OF SCALE DISECONOMIES OF SCALE
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production and starts operating on SRAC2, producing the same output of Q2.This firm can
increase output until it reaches Q3.
Economies of Scale
Economies of Scale can be classified into 2 groups:-
1. Internal Economies of Scale
2. External Economies of Scale
Internal Economies of Scale
These are the benefits which accrue to a firm independent of what is happening to other firms
/ the industry. They arise simply from the increase in the scale of production in the firm itself.
External Economies of Scale
These are the advantages in the form of lower C which a firm gains from the growth of the
industry. These economies are available to all firms in the industry independent of changes in
the scales of their individual outputs.
Internal Economies of Scale can be divided into plant economies and firm Economies of
Scale.
Plant Economies of scale include:-
Increased specialization – concentration of firms in producing a good or service
Indivisibility – full utilization of massive machinery or highly qualified personnel.
Increase in output doubling or trebling employment.
Increased dimensions – of factors of production – output increases
Principle of multiples – full use of multiple machinery unlike for small firms where some
machinery lie idle.
By product economies – waste products being recycled e.g fabric cuttings to make rags or
manure from chicken
Stock economies – e.g. joint supply, banc assurance, banking services and estate agent
Economies of Tinked processes
Firm Economies of Scale include :-
Technical Economies
Marketing Economies –bulk buying – huge discounts
- Employment of specialist buyers
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- lower packaging costs

- massive advertising
Financial economies –creditworthy borrower
–special interest rates huge
–collateral or security of finance
–access to more sources of finance
Risk bearing – diversification eggs not put into one basket
Research and development economies
Managerial economies – specialist mergers
Staff facilities economies – staff canteens
–sports grounds
–medical care
Plant specialization economies –a firm may be large enough for individual plants to
specialize – advantage of specialization.
Internal Diseconomies of Scale
• These are the disadvantages experienced by a firm due to expansion.
They are normally seen as the AC of production begins to rise.
• The main problems which rise when a firm grows too large are thought
to be mainly attributable to management difficulties.
1. Management Problems
• As the size of the firm increases management becomes more complex.
It becomes increasingly difficult to carry out the management functions of
• Coordination – coordinating various debts becomes more and more
difficult.
• Control – taking decisions and seeing to it that these decisions are
carried out becomes difficult workers don’t do what they are supposed to be
doing.
• Communication – keeping everyone informed through vertical and
lateral combination becomes more difficult.
• Morale / industrial relations – latitude of workers to management is of
critical importance to the efficient operation of the organization. Workers end
up not cooperating.
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2. Increases in prices of inputs e.g. raw materials, rentals, labour, energy,

transport etc
• External economies of scale are the advantages which accrue to a firm
from the growth in the size of the industry.
• These advantages are gained by firms of any size.
• External economies of scale are especially significant when industries
are heavily localized / concentrated in industries clusters.
• In this particular case they are referred to as economies of
concentration e.g.
1. Labour
2. Ancillary Services Disintegration
3. Cooperation
4. Commercial Services
5. Specialized Markets
External Diseconomies of Scale
• A firm may also experience disadvantages as a result of the industry to which
it belongs becomes too large. These are referred to as external diseconomies of scale.
• This can be due to the following reasons:-
1. Shortage of Labour
2. Increasing demand for raw materials may also bid up prices and
cause costs to rise
3. If the industry is heavily localized land for expansion will
become scarce and hence more expensive to purchase or rent.
Costs of ProductionOpportunity Cost
• Opportunity cost is the next best alternative forgone when one
makes economic choice. Opportunity cost is what we have to
“sacrifice or give up” in order to gain something we value /
something of economic value.
• We are forced to make a choice since economic goods are not
free i.e. they are limited in supply
Sunk Costs
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• Sunk costs are costs which cannot be recouped or recovered

once a firm leaves an industry (e.g. by transforming assets to
other businesses, marketing costs like advertising).
• Sunk costs act as barriers to exit for incumbents given the large
capital outlays involved.
• They also represent barriers to entry for now firms, which may
be reluctant to enter an industry if faced with the prospect of
substantial sunk costs should they not be successful.
User Costs
• The economies term for the reduction in the value of a machine
or capital asset from its use.
• User cost is not incurred if the item is idle or cannot be used.
Shadow cost or implicit cost / imputed price / shadow price is a price which is imputed.
• As the true marginal value of a good or opportunity cost of a
resource and which may differ from the market price.
• External costs and benefits (negative and positive externalities)
are not easy to measure since by definition they do not have a
price attached to them.
• E.g. the possible external costs arising from an overhead
railway may include visual pollution, congestion near the stations
and some noise pollution.
• The external benefits are likely to be greater and may include
less air pollution, less overall road congestion, fewer road
accidents (thereby reducing the burden on the police, health
services etc), and savings in travel time.
• Shadow costs / imputed prices are used to estimate these.
Shadow prices / costs are imputed prices based on opportunity
cost.
Private Costs
• Private costs are also called internal costs.
• They are costs incurred by those who buy products and by
those who produce products e.g. if a person buys a bottle of
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whisky, the cost (in the form of price charged) may be $15, and if
a firm produces a car the cost (in terms of wages, parts, overheads
etc) may be $4 000.
Costs in the SR period
1. Fixed Costs
• These are costs of production which do not vary with the level of
output.
• Production or no production they have to be borne e.g. rent, interest
payments on loans, stock (depreciation).
• Fixed costs are also called overhead costs or indirect costs.
Diagrammatically :
cost
0 QTY
FC are only found in the SR period of production and not in the LR.
2. Variable Costs (VC)
• These are costs directly related to the level of output e.g. wages / salaries, costs of raw
materials, fuel, power, water bills etc. Variable
costs are also called direct costs or primecosts .
COST
VC
3. Total Costs
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• Total costs are the sum total of FC and VC i.e. TC = FC + VC.

• When output is zero total costs are equal to FC since VC are equal to
zero.
Output Total Fixed Variable Average Average Average Marginal

units per Costs Costs Costs VC Fixed Variable Total Costs MC
week Q TC FC Costs Costs Costs
AFC ATC
FC
0 QTY
AVERAGE COSTS OF PRODUCTION
• AC are costs per unit of production.
• As production or output of the firm increases average costs first
decrease and there will come a point when they will start to increase – the AC
curve is U-shaped.
• When a firm is producing at the minimum point of production.
• ATC = = /AFC+AVC
(’ ()’
AFC = = /ATC-AVC
*$ +’
AVC = = /ATC-AFC
4. Marginal Cost (MC)
• When production commences TC will begin to rise as VC increases.
COST TC
VC
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• Marginal cost tells us what happens to total costs when we vary /

change output by some small amount.
• MC is the extent to which TC changes when output is changed by one
unit.
• MC = TC of n units – TC of (n -1) units
• The MC curve is also u – shaped because of diminishing returns
experienced as output rises.
AVC
0 116 116 0 00 - 00 24
1 140 116 24 116 24 140 20
2 160 116 44 58 22 80 16
3 170 116 60 38.6 20 58.6 24
4 200 116 84 29 21 50 40
5 240 116 124 23.2 24.8 48 56
6 296 116 180 19.3 30 49.3 72
7 368 116 252 16.6 36 52.6 88
8 465 116 340 14.5 42.5 57
• As output increases both MC and AC and AVC begin to fall, reach

minimum and then begin to rise.
• When plotted graphically AC = MC when AC is at its minimum value
AVC = MC when AVC is at its minimum value.
• The ATC curve is elongated U-shape. This is always so in the SR
period.
• ATC always start at infinity and then fall rapidly as FC are spread over
more and more units. It continues to fall until the point of optimum
efficiency or optimum capacity is reached.
• AC then begins to rise as diminishing returns set in and the increase in
AVC outweighs the fall in AFC.
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• The best output is 5 because this output is produced at lowest unit

costs (i.e. there is productive efficiency)
Shut down conditions during the SR period
• The firm will / should continue to produce in the SR as long as price of
the product is above the AVC because the price of the AFC of production are
being covered.
• As long as price > AVC, the firm should shut or stop production.
Average Costs in the LR Period

• Every plant size or level of fixed input is represented by a SRAC
curve, each SRAC curve is tangent to the LRAC curve.
• The LRAC curve is always referred to as the envelope curve of all
SRAC curves.
• It shows the minimum attainable unit cost for each and every level of
output
• The LRAC curve therefore consists of a series of points of different
SRAC curves. These points represent the lowest costs attainable for the
production of any given output.
• If it is assumed that there are many such SRAC curves, the LRAC
curve will be an “envelope curve”.
• It is U-shaped because of economies of scale and diseconomies of
scale.
Note
In practice, evidence suggest that in these industries investigated economies of scale exist but
diseconomies of scale either do not or are outweighed by economies of scale. In other words
the LRAC curve is more “L-shaped” than “U-shaped”
Total Revenue
• Total revenue is the amount of money which a firm gets from selling
its units of output.
• TR = P x Q
Average Revenue
• Average Revenue is the other name for price if the good.
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• AR is the amount a firm gets from each unit sold.

, )
• AR = = =P
• AR = P (NB : only exception is when a firm sells its output at different
price) – AR will be the weighted average price.
Marginal Revenue
• Marginal Revenue is the extra / additional revenue obtained when sales
are increased by one unit.
Output AR = P TR MR
1 8 8 6
2 7 14 4
3 6 18 2
4 5 20 0
5 4 20 -2
6 3 18 -4
7 2 14
• MR of the nth unit = TR of n units = TR from sale of (n-1) units • MR

= ∆,
∆
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Market Structures
• Market structures are the various market conditions under which firms
operate in order to determine prices and output to be produced.
• Going to look at 4 types of market structures which are :-
Perfect competition
Monopoly/monopolist
Monopolistic competition
Oligopoly
1. Perfect Competition
• Perfect competition is a market structure where there are many
sellers and buyers selling homogeneous / identical products.
Assumptions / Features
1. All units of the commodity are identical / homogeneous
(i.e. one unit is exactly like the other)
2. There are many sellers and many buyers and their
behavior has no influence on the price.
3. Buyers and sellers have perfect knowledge of the
market conditions and market activities.
4. There are no barriers to movement of buyers form one
seller to another.
5. There are no restrictions on entry or exit of firms from
the market.
6. There will be one and only one market price and this
price is beyond the influence of any one buyer / seller.
7. There is no advertising.
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8. There is perfect mobility of resources that firms wishing

to expand their output can attract resources.
• Firms can’t change different prices because they are selling
identical / homogeneous products.
• Each of them is responsible for a tiny part of the total supply
and the buyers are fully aware of what is happening in the market.
The Individual Firm under Perfect Competition
• The individual firm under perfect competition is powerless to
exert any influence on price. It sees the price as “given” i.e. established
by market forces of demand and supply beyond its control.
• e.g. in most countries the individual farmer has no influence on
the price he sells his wheat, beef, milk or vegetables. Any changes in
the amounts of the products which he brings to the market will have
negligible effects on price.
• The firm under perfect competition is a “price taker”
• The demand curve for the product of the single firm must be a
horizontal line at the ruling price, in other words a perfectly elastic
demand curve. No matter how many units the firm sells, it can’t
change the price. It can sell its entire output at the ruling price. If it
tries to sell at a higher price, its demand will drop to zero and
obviously there will be no incentive to sell at lower prices.
PRICE D S PRICE
P*
S D
0 Q*
a) The industry b) The Firm
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• The diagrams above show the determination of the market price OP* by
market forces of demand and supply.
• DD is the demand curve facing the industry and supply SS is the total market
supply provided by all firms in that industry – equilibrium market price is OP* and
quantity OQ*.
• The market price OP* is externally determined and the firm sees the demand
curve for its product as being perfectly elastic. The firm can now supply any quantity
it wishes at the ruling price OP*. If it rises to reduce or increase price, demand for its
product falls to zero.
Average Revenue and Marginal Revenue
• The firm under perfect competition will determine output by looking at the
shape of its MR and AR curves as well as cost curves.
• A firm will continue to expand its output as long as the revenue it receives
form additional output exceeds the cost of producing that additional output.
a) Total Revenue (TR) is the total amount of money a firm receives from
output sold.
TR = P x Q
b) Average revenue (AR) is revenue per unit sold. AR is another name
for price.
, )
AR = = =P
c) Marginal Revenue (MR) is the additional revenue obtained when
sales are increased by one unit or more precisely it is the change in TR
when quantity sold is varied by one unit.
MR of the nth unit = TR from the sale of n units – TR from the sale of (n-1) units
The output of the firm under perfect competition in the SR period

• It is assumed that firms producing under conditions of perfect competition any
business are profit maximisers. As long as the price (AR) it receives for each unit
exceeds the AC of production, a firm will be making abnormal profits /
supernormal profits or economic rent.
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• The diagram below shows that when price is P, the firm will be making
supernormal -s in the range of output Q to Q3 because at all the outputs in this range
AR is greater than AC of production.
• From the diagram, at price OP the firm will be making -s in the range of
output OQ to OQ3 because at all outputs AR > AC.
• We have to determine which output level between OQ to OQ3 yields
maximum total -s. Output level OQ1 will yield the maximum - per unit but firms seek
to maximum total -s not profit per unit.
• As output increases form from OQ to OQ2 the firm’s total profits will be
increasing because for each additional unit produced, the increase in TR (i.e. MR) is
greater than the increase in TC (i.e.
MC)
• As output is expanded beyond OQ2 total -s will be decreasing because for each
additional unit produced MR < MC.
• Therefore since total -s are increasing up to OQ2 and falling beyond OQ2, -s
must be maximized when output is at OQ2 i.e. when MC=MR.
• This relationship which says that -s are maximized when output is at a point
where MC=MR applies to all firms whether they are operating under perfect
competition or monopolies etc.
• In the case of a perfectly competitive firm, TTs are maximized at the point
where MC=MR=AR=P=demand only during the SR period of production.
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Normal profit
If firms in the short run are making profits, there are incentives for new firms to enter the
market. This will increase market supply, causing market price to drop and the profit of
incumbent firms to be eroded. This can occur because there are no barriers to entry. The price
will drop to the point where productive efficiency is achieved.
The shutdown point

In the short run, a firm operating at a loss [R < TC (revenue less than total cost) or P < ATC
(price less than unit cost)] must decide whether to continue to operate or temporarily
shutdown. The shutdown rule states "in the short run a firm should continue to operate if
price exceeds average variable costs."
Restated, the rule is that for a firm to continue producing in the short run it must earn
sufficient revenue to cover its variable costs. The rationale for the rule is straightforward. By
shutting down a firm avoids all variable costs. However, the firm must still pay fixed costs.
Because fixed cost must be paid regardless of whether a firm operates they should not be
considered in deciding whether to produce or shutdown. Thus in determining whether to shut
down a firm should compare total revenue to total variable costs (VC) rather than total costs
(FC + VC). If the revenue the firm is receiving is greater than its total variable cost (R > VC)
then the firm is covering all variable cost plus there is additional revenue ("contribution"),
which can be applied to fixed costs. (The size of the fixed costs is irrelevant as it is a sunk
cost. The same consideration is used whether fixed costs are one dollar or one million
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dollars.) On the other hand if VC > R then the firm is not even covering its production costs
and it should immediately shut down. The rule is conventionally stated in terms of price
(average revenue) and average variable costs. The rules are equivalent (If you divide both
sides of inequality TR > TVC by Q gives P > AVC). If the firm decides to operate, the firm
will continue to produce where marginal revenue equals marginal costs because these
conditions insure not only profit maximization (loss minimization) but also maximum
contribution.
Another way to state the rule is that a firm should compare the profits from operating to those
realized if it shutdown and select the option that produces the greater profit.A firm that is
shutdown is generating zero revenue and incurring no variable costs. However, the firm still
has to pay fixed cost. So the firm's profit equals fixed costs or −FC. An operating firm is
generating revenue, incurring variable costs and paying fixed costs. The operating firm's
profit is R − VC − FC. The firm should continue to operate if R − VC − FC ≥ −FC, which
simplified is R ≥ VC. The difference between revenue, R, and variable costs, VC, is the
contribution to fixed costs and any contribution is better than none. Thus, if R ≥ VC then firm
should operate. If R < VC the firm should shut down.
A decision to shut down means that the firm is temporarily suspending production. It does not
mean that the firm is going out of business (exiting the industry).] If market conditions
improve, and prices increase, the firm can resume production. Shutting down is a short-run
decision. A firm that has shut down is not producing. The firm still retains its capital assets;
however, the firm cannot leave the industry or avoid its fixed costs in the short run. Exit is a
long-term decision. A firm that has exited an industry has avoided all commitments and freed
all capital for use in more profitable enterprises.
However, a firm cannot continue to incur losses indefinitely. In the long run, the firm will
have to earn sufficient revenue to cover all its expenses and must decide whether to continue
in business or to leave the industry and pursue profits elsewhere. The long-run decision is
based on the relationship of the price and long-run average costs. If P ≥ AC then the firm will
not exit the industry. If P < AC, then the firm will exit the industry. These comparisons will
be made after the firm has made the necessary and feasible long-term adjustments. In the long
run a firm operates where marginal revenue equals long-run marginal costs.The shutdown
position can be illustrated as follows;
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Efficiency in perfect competition 5 reasons why Perfect Competition is efficient:

1. Allocative Efficient: This is because P = MC.
2. Productive Efficient: Firms produce where MC=ATC.
3. X Efficient: Competition between firms will act as a spur to increase efficiency.
4. Resources will not be wasted through advertising because products are homogenous.
5. Normal profit means consumers are getting the lowest price. This also leads to greater
equality in society.
Evaluation
The benefits
It can be argued that perfect competition will yield the following benefits:
1. Because there is perfect knowledge, there is no information failure and
knowledge is shared evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive any monopoly
power.
3. Only normal profits made, so producers just cover their opportunity cost.
4. There is no need to spend money on advertising, because there is perfect
knowledge and firms can sell all they can produce. In addition, selling unbranded
goods makes it hard to construct an effective advertising campaign.
5. There is maximum possible:
• Consumer surplus
• Economic welfare
6. There is maximum allocative and productive efficiency:
• Equilibrium will occur where P = MC, hence allocative efficiency.
• In the long run equilibrium will occur at output where MC = ATC,
which is productive efficiency.
7. There is also maximum choice for consumers
The disadvantage of perfect (or pure) competition
It produces what is demanded under the given distribution of income. We can imagine a
scenario with a very few rich people with pet dogs or cats which dine extremely well on
chicken and the like, while the masses starve.
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Spillovers and externalities can exist. These are costs caused to others, e.g. the disposal of
nuclear waste or toxic chemicals by dumping them in streams.
No economies of scale possible - all the firms are too small.
Perfect competition is consistent with a limited choice of range of goods; monopolistic
competition may have a much wider range. An example is motorcars – there are an awful lot
of different models and competition is much less than perfect.
Little or no research and development is possible because there are no funds for it. Under
perfect competition there are no surplus profits (in the long run they are whittled away!)
R&D is possible under monopoly because of the surplus profits available
MONOPOLY
Definition: Technically it is a sole supplier, i.e., there is one firm in the industry. It is the
industry.
But there are degrees of monopoly - if one firm supplies, say, 80 per cent, it is close to a
monopoly and will usually act like one.
Types of Monopoly/causes of monopolies
Economies of scale. One firm grows large, its cost curves are lower than the others, so it is
able to sell more; in the end it grows to become the sole firm. This is the so-called natural
monopoly. An example of a natural monopoly is the distribution of water. To provide waterto
residents of a town, a firm must build a network of pipes throughout the town. If two or more
firms were to compete in the provision of this service, each firm would have to pay the fixed
cost of building a network. Thus, the average total cost of water is lowest if a single firm
serves the entire market.
The law. The government may restrict the industry to one nationalised firm.
Regulations. A trade union may have a monopoly over the supply of one kind of labour
Agreement between firms, so that they all act together and behave as one monopolist. This
is often illegal but it happen
Exclusive ownership of a unique resource- if there is only one well in town and it is
impossible to get water from anywhere else, then the owner of the well has a monopoly on
water. Not surprisingly, the monopolist has much greater market power than any single firm
in a competitive market. In the case of a necessity like water, the monopolist could command
quite a high price, even if the marginal cost is low. Although exclusive ownership of a key
resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason.
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Actual economies are large, and resources are owned by many people. Indeed, because many
goods are traded internationally, the natural scope of their markets is often worldwide. There
are, therefore, few examples of firms that own a resource for which there are no close
substitutes.
Copyrights, patents and licences are particular forms of this exclusive ownership. The
patent and copyright laws are two important examples of how the government creates a
monopoly to serve the public interest. When a pharmaceutical company discovers a new
drug, it can apply to the government for a patent. If the government deems the drug to be
truly original, it approves the patent, which gives the company the exclusive right to
manufacture and sell the drug for 20 years. Similarly, when a novelist finishes a book, she
can copyright it. The copyright is a government guarantee that no one can print and sell the
work without the author’s permission. The copyright makes the novelist a monopolist in the
sale of her novel. The effects of patent and copyright laws are easy to see. Because these laws
give one producer a monopoly, they lead to higher prices than would occur under
competition. But by allowing these monopoly producers to charge higher prices and earn
higher profits, the laws also encourage some desirable behavior. Drug companies are allowed
to be monopolists in the drugs they discover in order to encourage pharmaceutical research.
Authors are allowed to be monopolists in the sale of their books to encourage them to write
more and better books. Thus, the laws governing patents and copyrights have benefits and
costs. The benefits of the patent and copyright laws are the increased incentive for creative
activity.
Marginal revenue and monopoly
Marginal revenue is the addition to total revenue from the last unit sold.
A perfectly competitive firm can sell as much as it wants at an unchanged price. Its MR curve
is equal to the price – every time it sells one more item it receives, say, an additional 50
pence, which adds 50 pence to TR.
A monopolist is the industry, so it faces a normal downward sloping demand curve.
So if wants to sell more of the good or service it must lower the price.
And of course it must sell all its products at that lower price. This means it loses by selling
the items it used to sell earlier at a higher price at the new lower price.
So the price of the marginal product is not the MR – the firm’s total revenue increases by less
than this sale, because of the bit it lost on the price on all the other products.
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See the example in the table below.
AS INCREASE MUST LOWER TOTAL REVENUE MARGINAL

QUANTITY PRICE (£) ALTERS (PxQ) (£) REVENUE (£)
1 7 7 7
2 6 12 5 (12-7)
3 5 15 3 (15 -12)
4 4 16 1 (etc)
5 3 15 -1
6 2 12 -3
7 1 7 -5
Note that marginal revenue is less than price for all quantities after the first one.
PROFIT MAXIMIZATION FOR A MONOPOLY.
A monopolymaximizes profit by choosing thequantity at which marginalrevenue equals
marginal cost
(point A). It then uses thedemand curve to find the pricethat will induce consumers tobuy that
quantity
( point B).
Cost and revenue MC
P B
ATC
A
AR=D
MR
0 q1 qmax q2qty
Suppose, first, that the firm is producing at a low level of output, such as Q1. In this case,
marginal cost is less than marginal revenue. If the firm increased production by 1 unit, the
additional revenue would exceed the additional costs, and profit would rise. Thus, when
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marginal cost is less than marginal revenue, the firm can increase profit by producing more
units. A similar argument applies at high levels of output, such as Q2. In this case, marginal
cost is greater than marginal revenue. If the firm reduced production by 1 unit, the costs
saved would exceed the revenue lost. Thus, if marginal cost is greater than marginal revenue,
the firm can raise profit by reducing production. In the end, the firm adjusts its level of
production until the quantity reaches QMAX, at which marginal revenue equals marginal
cost. Thus, the monopolist’s profit maximizingquantity of output is determined by the
intersection of the marginalrevenuecurve and the marginal-cost curve.
A MONOPOLY’S PROFIT
How much profit does the monopoly make? To see the monopoly’s profit, recall that profit
equals total revenue (TR) minus total costs (TC): Profit = TR - TC. We can rewrite this as
Profit = (TR/Q -TC/Q) X Q.
TR/Q is average revenue, which equals the price P, and TC/Q is average total cost ATC.
Therefore, Profit = (P - ATC) X Q.
This equation for profit (which is the same as the profit equation for competitive firms)
allows us to measure the monopolist’s profit in our graph.
Consider the shaded box in diagram below The height of the box (the segment P1C1) is price
minus average total cost, P – ATC, which is the profit on the typical unit sold. The width of
the box (the segment C1K1) is the quantity sold Q1. Therefore, the area of this box is the
monopoly firm’s total profit.
Monopoly equilibrium
Equilibrium is where MC = MR, as usual. When you are drawing the diagram and answering
questions you should locate that point first and draw it in.
Seeing monopoly profits in the diagram below
Profits = total revenue minus total cost. Total revenue = price times quantity. Total cost =
average cost times quantity.
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Problems with monopoly, “what is wrong with monopoly” or "the welfare effects of
monopoly"
A monopoly limits output and keeps price high.
A monopoly redistributes income from all the consumers to this one firm or person (an
equity issue).
Monopolists may develop political and social power over others, which reduces the
efficiency of democracy and is inequitable. There are political dangers of a few very rich and
powerful people (Marx called them “monopoly capitalists” who misuse their position and
exploit people).
A monopoly may behave badly in an anti-social way. For instance it may force out a rival
firm by selling its product at give-away prices, well below cost and taking the short term loss.
After it has forced out the competitor, it will then put the price back up again. This behaviour
may or may not be legal. It depends on the country involved and its legislation but it is
always reprehensible.
The lack of competition tends to promote inefficiency, there is no need to try hard, and it
lacks dynamism. This is probably the main criticism .
The result is lazy managers and owners. This means that technical progress is reduced,
leading to slow economic growth of the country and a lower standard of living than we could
have.
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Resources are misallocated. Too many go to the monopolist and they are not fully used by
him. This is a waste for society and in addition, the price mechanism is prevented from
working properly.
A monopoly reduces consumer choice. There is no one else to buy from and no other
producer’s product.
A monopolist may ignore small market demands as he cannot be bothered to meet them.
The long run effect from the existence of monopolies is slightly slower growth; a lower
standard of living; higher unemployment (because the monopolist restricts output and so
requires fewer people); higher prices (which monopolies charge); a slightly poorer balance of
payments as a result of this; a less equal income distribution; and poorer resource allocation.
Benefits of monopoly
A monopolist can use monopoly profits for research and development, leading to product
improvement, faster growth, and lower costs, despite the argument above that they are
inherently lazy. Joseph Schumpeter argued that they are important for innovation; he felt that
big firms are the only ones that are able to afford the necessary laboratories, equipment and
research staff. Against this, research exists that shows many of the breakthroughs come from
small firms, for example Apple began making those computers in a garage.
Monopolists may be able to reap economies of scale. Economies of scale mean lower costs.
A state monopoly may be safer than a private one. A private monopoly may be more tempted
to cut corners and reduces necessary maintenance to lower costs, and this could be
particularly serious in some areas like the railways or air traffic control.
Monopolies creates employmet
The theory of monopolistic competition was developed by xdward Chamberlin (1899-1967),

an Americal economist. He was dissatislied with the two extreme theodes that existed at the
time, perfect
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competition and monopoly, so wanted to devise someth.ing more realistic that would sit
between the two existing theories. In simple terms, a monopolistically competitive market is
one with many competing firms where each firm has a little bit of market power. This is why
we have the term "monopolistic", as firms have some ability to set their o\ry'n prices.
The assumptions of monoPolisticcomPetition
The assumptions for monopolistic competition are as follows. o The industry is made up of a
fairly large number oI firms.
. The firms are small, relative to the size of the industry. This means that the actions of one
firm are unlikely to have a great effect on any of its competitors. The lirms assume that they
are able to act independendy of each other.
r The firms all produce slightly differentiated products. This means that it is possible for a
consumer to tell one firm's product from another.
o Firms are completely free to enter or leave the industry. That is, there are no barriers to
entry or exit.
The only difference lrom perfect competition is that in monopolistic competition there is
product differentiation. Product dilferentiation exists when a good or service is perceived to
be dil{erent from other
goods or services in some way. Products may be dilferentiatedbybrand name, colour,
appearance, packaging, design, quality of service,
skill levels, and many other methods. Examples of monopolistically competitive industdes
are nail (manicure) salons, car mechanics, plumbers, and jewellers.
Although it may appear to be a small difference from the assumptions of perfect competition,
this leads to a markedly different market structure. As the products are differentiated there
will be some extent of brand loyalty. This means that some of the consumers will be loyal to
the product and continue to buy it if the price goes up a little. For example, it may be that the
customers of a certain plumber will stay with that plumber when she raises her prices above
local rivals, because they believe that she is slightly more skilled than her competitors.
This brand loyalty means that producers have some element of independence when they are
deciding on price. They are, to an extent, price-makers, and so they face a downward sloping
demand curve. However, demand will be relatively elastic since there are many, only slightly
different, substitutes.
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Have you ever walked down a street in a tourist area and seen a lot of restaurants with similar
menus? Explain why they might be considered to be in monopolistic competition.
The demand curve facing a monopolistically competitive firm is shown in Figure 9.1.
The firm faces a downward sloping demand curve with a marginal
MC
revenue curve that is below it and produces so that it is maximizing profits where : MR.
This means that the firrn in Figure 9.I will produce an output of q and sell that output at
rhepdce of P
Possible short-run profit and loss situations in monopolistic competition

Just as in perlect competition, it is possible for firms in monopolistic competition to make
abnormal profits in the short run. This is shown in Fig]jJe 9.2.
.9 Eo o I
.9
Student workpoint 9.1
Be a thinker-considel and explain
Try to think of an example of a market in your area that is in monopolistic competition.
\A,4th reference to the assumptions of the model, explain your choice. lVtR Output
F Bure 9.1 lhe demand curve for a firm in monopolistic competition Figure 9.2 Short-run
abnormal profits in monopolistic competition o-c
Output
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In this case, the firm is maximizing profits by producing at the level of output where MC =
MR, and the cost per unit (AC) of C is less than the selling price of P. There is an abnormal
profi.t that is shown by the shaded area.
It is also possible that a firm in monopolistic competition may be making losses in the short
run and this is shown in Figure 9.3. Once again, the firm is producing where MC : MR, but this
time the cost per unit, C, is above the price, P, and the amount of losses is shown by the
shaded area.
The long-run equilibrium of the fitm in monopolistic competition
whetherfims are making abnormal profits or losses in the short run, because of the freedom of
entry and exit in the industry there will be a long-run equilibrium, where all of the firms in
the industry are making normal profits.
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II the fims are making short-run abnormal profits, then other firms will be attracted to the
industry. Since there are no barriers to entry it is possible for these other firms to join the
industry. As they enter, they will take business away from the exisdng firms, whose demand
curves will start to shift to rhe left. If firms are making short-run losses, then some of the
firms in the industry will start to leave. The firms that remain will Iind that their demand
curves start to shift to the right as they pick up trade from the leaving firms. This analysis
explains why it is not uncommon to see similar shops or services spring up in an area.
Imagine that a new sushi restaurant opens up in a district. Soon it is so popular that there is a
line outside
the door every evening. Other catering entrepreneurs will be attracted to the possibility of
doing so we11, and so it is likely that another sushi restaurant will open up in the area. It may
not happen immediately, but eventually this is likely to result in a fall in demand for the
original sushi restaurant as some of its customers will switch.
If demand continues to be strong, then even more restaurants will open. Each restaurant will
try to distinguish itself from the othersperhaps
by staying open longer, oflering a "Happy Hour", special theme nights, or free children's
meals to name just a few possibilities.
This product differentiation is also known as non-price competition.
Whatever the short-run situation, in the long run the firms will end up in the position shown
in Figure
9.4, with all making normal profits.
MC
T?re firms are maximizing profits by producing at the level of output where : MR and, at
that output, the cost per unit, C, is equal to the pdce per unit, P Each firm is exactly covering
its costs, including its opportunity costs, and so there is no incentive for firms to leave the
industry. Fims outside the industry will not enter, since they will be aware that their entrance
would lead to losses for everyone.
PERFECT COMPETITION, MONOPOLY, MONOPOLISTIC COMPETITION, AND

OLIGOPOLY: GRAPHING TIPS
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For all firms, the MC curve must intersect the ATC at the minimum of the ATC curve.
When a firm is making positive profits, the ATC curve must lie at least partially below the
demand curve.
When a firm is making negative profits (losses), the ATC curve must lie entirely above the
demand curve.
When a firm is making zero profits (breaking even), the ATC curve must be tangent to the
demand curve.
For perfect competition, the firm’s demand curve must be horizontal and the same as the
MR curve.
For monopolistic and monopolistically competitive firms, the firm’s demand curve slopes
down to the right. Theoretically, the monopolistic firm has a steeper demand curve than the
monopolistically competitive firm. For both the monopolistic and monopolistically
competitive firms, the MR curve is twice as steep as the demand curve (if the demand curve
is a straight line).
When a perfectly competitive firm is making zero profits, the ATC curve is tangent to the
demand curve at the minimum of the ATC curve. When the monopolistic or
monopolistically competitive firm is making zero profits, the ATC curve is tangent to the
demand curve at an output level that is lower than the output at the minimum of the ATC
curve. The tangency must be directly above the intersection of the MR and MC curves.
When the oligopolist (in the kinked demand curve model) is making zero profits, the ATC
curve is tangent to the demand curve at the kink in the demand curve. This occurs at an
output level that is lower than the output at the minimum of the ATC curve. The tangency
must be directly above the intersection of the MR and MC curves.
For the oligopolist (in the kinked demand curve model), the MC cost curve intersects the
MR curve in the vertical segment of the MR curve. Each of the downward-sloping segments
of the MR curve is twice as steep as the corresponding section of the demand curve (if the
demand curve segments are straight lines).
Market failure
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Market failure is a concept within economic theory describing when the allocation of goods
and services by free market is not efficient, that is there exist another conceivable outcome
where a market participant may be made better off without making someone worse off.
Market failures can be viewed as scenarios where individuals’ pursuit of pure self interest
leads to results that are not efficient. The existence of market failure is often used s a
justification for government intervention in a particular market.
What does market failure mean?-It means that we do not have full efficiency; we could
produce more with the resources we have; and we could satisfy consumer demands better
with the resources we have. There is waste in the system.
Types of efficiency in economics:
A.) Allocative efficiency. This means good resource allocation, when we cannot make any
consumer better off without making some other consumer worse off. This approach looks at
the given resources and tries to get the most output from them and it also means that firms
sell at a fair price to consumers that reflects the real resource use.(p=mc)
B.) Productive efficiency. This means that production is done at the lowest possible cost.
• We are at the bottom of the average cost curve (which is always U-shaped). In that
position we have what is called “X-efficiency”.
• And this means we are also on the production frontier, not somewhere inside it.
A.) Allocative efficiency
Allocative efficiency occurs when the value the consumer puts on a good or services is the
same as the cost of the resources used in producing it. This occurs when price= marginal cost.
In this position, total economic welfare is maximized. In the perfect competition diagram
below, where MC = MR for the firm, we have allocative efficiency because the firm’s price is
the marginal revenue (it can sell any amount at the unchanged price - each extra unit sold at
that price provides the marginal revenue), so MC = P. In fact, at that point we have more
equalities MC = P= MR = AR. “AR” is merely another word for price – it is “average
revenue” which we get by dividing total revenue by quantity. We know that quantity
multiplied by price gives us total revenue, so it follows that price actually is average revenue.
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B.) Productive efficiency

This exists when we are actually on the production frontier. That means we are using the least
resources we can. In turn, it says that we are at minimum average costs = the bottom of the
AC curve. Perfect competition is like this – so economists prefer this position and you will
recall that it is known as “Xefficiency” – it is where we are totally efficient.
Where market equilibrium is totally efficient, we cannot make someone better off without
making someone else worse off (this is sometimes called “the Pareto optimum position”).
The production possibility curve:
When we are below the production possibility curve (e.g., at “X” in the diagram below), we
can move north-east and get onto the curve, thus making everyone better off; only when we
are on it do we have proper productive efficiency.And only when we are on it does the
concept of opportunity cost arise. If we are below it, we do not have to give anything up to
get more of the other thing; we can have more of both simply by moving out to the curve.
Note: we can have allocative efficiency and productive efficiency but still have inequity in
the country, which can also stop us reaching “perfection”.
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Example 1. If you personally have all the income in your suburb, the other residents will be
poor and might even starve, which does not sound at all like perfect! The market system is
amoral i.e., it is not concerned with good or bad. Economics is not about ethics.
Example 2. Drug dealers could wait at the gates of primary schools, give away drugs for free
to six year old children and in this way build up a market as they become addicted. This
would create a demand, which the drug dealers could then supply later at a price. Most
people would regard this situation as totally wrong, exploitative, and immoral – but the
market would be working - and possibly very “efficiently” too.
Social efficiency matter not just private
We might produce too much or too little as a society, for our own good, even if have perfect
competition and an acceptable distribution of income and nothing illegal or immoral is
occurring. This can happen because of externalities. We move on to consider these next.
Sources of market failures
Monopoly elements or market dominance.
Externalities.
Public goods.
Merit goods.
De-merit goods.
Information failures.
Factor immobility.
Undesirable income and wealth distribution
EXTERNALITIES
Externalities, social cost and private costs
Externalities are said to exist when the actions of producers or consumers affect themselves
as well as third parties who are offered no compensation to the loss generated. Externalities
can be known as external diseconomies and economies as well as third party spill over
effects. They exist because the market cannot deal properly with the side effects of many
economic activities. Externalities involve an interdependence on utility and production
functions. An external benefit or a positive externality refers to the benefit from production or
consumption experienced by people other than the producers or consumers. This occurs when
an externality-generating activity raises the production or the utility of the externality-
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affected party. Hence, the economic activity provides incidental benefits to others for whom
they are not specifically intended.
A negative externality or external cost refers to the cost of production or consumption borne
by people other than the consumers or producers. The undesirable effects on the allocation of
resources by an externality can be explained by the Marginal Social Cost (MSC). The
Marginal Social Cost is a sum of the Marginal Private Cost (MPC) and the Marginal External
Cost (MEC). MPC is a share of marginal cost caused by an activity that is paid by the people
who carry out the activity and MEC is the share borne by others. When the firm’s activities
generate negative externalities, its MSC will be greater than MPC. Since, in equilibrium, the
market will yield an output at which consumers marginal benefit is equal to a firm’s MPC.
Thus, as shown in Figure 1, MPB is less than MPC, hence the costs that is incurred to society
outweighs the benefit derived from the good. Consider the soap industry which, in a free
market would discharge waste products into the air and into rivers. The owners of soap
factories being profit maximisers will only consider their private costs and ignore the wider
social costs of their activities. Thus, MSC is more than MPC.
An example of an activity which generates an external benefit in consumption is vaccination.
If an individual makes a decision to be inoculated against a particular disease, then he will
receive the private benefit of not being infected by that particular disease. However, there are
also other possible benefits to all others with whom he comes into contact as they will not
contract the disease from him. The vaccination protects not only the person who is vaccinated
but also the entire community that person lives in, by preventing the spread of contagious
diseases. Thus, MSB is greater than MPB. The individuals consider only private benefits and
costs in their consumption decisions. Hence, they will consume OQ1 units where
MPB=MPC. However, the socially efficient output occurs at OQ2, where MSB=MSC. There
is thus an under consumption of Q1Q2 of the good which results in a deadweight loss equal
to the area of E2BE1. Insufficient scarce resources are being devoted to the production of this
product. The market has failed to allocate resources efficiently.
Private costs are the costs incurred when producing something. Social costs are greater than
private costs. Social costs include things like pollution and congestion that are suffered by
society in general, not by any one producer.
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These problems are called “externalities” i.e., they are external to the firm producing them.
They can be negative externalities (which harm society) or positive externalities (which
help).
Social cost = private cost + externality (if any)
Cost-benefit analysis tries to measure all the costs to society of a project.
We have a diagram for social costs:
Equilibrium will be where private costs cut the demand curve at Qa, as firms try to maximise
profits and charge price OPa for quantity OQa. But because of negative externalities
(pollution maybe), the socially optimum position should be where social costs cut the demand
curve. These would mean producing at Qb, reading from the social costs curve, and selling at
the higher price OPb to cover these costs.
NEGATIVE EXTERNALITIES
Common types of negative externalities by producers:
• Air pollution, e.g., smoky factory chimneys.
• Soil pollution, especially by farm chemicals (closely related to the next type).
• Water pollution, e.g., rainwater run-off containing farming pesticides and fertilisers.
• Noise pollution. Do you live near an airport or by a building site?
Some types of negative externalities by consumers:
• Pollution of air and water.
• Soil pollution, e.g., lead pollution in soils from motorcar exhaust emissions.
• Litter on streets; decomposing rubbish in land-fill sites.
• Noise pollution, e.g., motorcycle noise in urban areas, especially when the baffles
have been deliberately removed from the silencer.
• Vandalism; graffiti on walls.
• Smoking and alcohol abuse, causing NHS expenditures to rise.
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We are unsure why the urban sparrow population has plummeted in recent decades but it
would seem to be the result of some externality.
POSITIVE EXTERNALITIES
When these exist, society would gain more than the producer – who therefore is producing
less than the optimal social amount.
Examples include:
• Labour training in firms; one firm may do little, as it knows that when a trained
worker leaves, someone else benefits - but the first firm paid for all the training!
• Education generally.
• Health generally, especially in poor Third World countries.
• The provision of playing fields at or near schools so that the health and sporting skills
of the children improves.
• Free museums and art galleries that can encourage the poor and uneducated to widen
their horizons, educate themselves, and generally improve.
To draw the diagram for positive externalities: just reverse the labeling of the curves of social
cost and private costs above. This is done in the diagram below where you can see that we
produce too little for society if firms profit maximize for them (as they do). They choose to
produce at OQa and sell for a price of OPa, but for the greatest good of society they should be
at OQb and selling at the lower price of OPb.
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Government intervention may be necessary to correct or offset market failure caused by

negative externalities – usually the government chooses to tax those producing too much, or
they may use the law to prosecute for water pollution or whatever externality the government
is tackling.
There are probably fewer cases of external benefits, but if we find any (such as private firms
training labour well) we can encourage this by tax breaks or subsidies.
Government action with external diseconomies
Government might try (and does):
1. Taxation.
2. Regulation.
3. Perhaps extending property rights.
Let’s think about polluters – what can the government do using the three points above? a)
Taxing polluters
The need is to try to stop the problem being “external” and try to “internalise” it, i.e., to make
the polluter pay for it via a tax. As economists, what we are really doing is trying to get the
firm to stop looking only at the private costs and benefits. In the diagram below, we do this
by putting a tax on, which shifts the supply curve up from “S Private costs” to “Private costs
+ tax”. If we get it right, this moves the equilibrium quantity produced from Qa to the smaller
output Qb.
But there are problems with taxing polluters:

• When it works, output is reduced and prices are higher – but this can reduce the
consumer surplus, which some feel is not a good thing (Unit 4 looks at this concept).
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• It is often hard to identify the particular firms that are causing the pollution, and then
determine how much each is responsible for the total pollution.
• Poor legislation can hurt the innocent, e.g. households who wish to get rid of large
items of waste may not be allowed to take them to the dump.
• It is not easy to put a monetary figure on the damage pollution is causing.
• Producers can pass on much of the tax to consumers if demand is inelastic and not pay
it themselves.
• Taxes on demerit goods (to limit their consumption) can be regressive, i.e., hit poor
households the hardest. The tax on cigarettes does this because the poor are statistically
more likely to smoke than the wealthier.
b) Regulating polluters approach (a second way that can be used in addition to tax)
• Banning cigarette advertising at sporting events, or in places like cinemas.
• Making workplaces no-smoking areas.
• Increasing the penalties for firms that break the regulations.
c) Extending property rights (a third way that can be used)
If a lorry crashes into your garden and destroys the wall and all your trees you can get
compensation – but if a polluting factory puts out acid smoke and destroys the same trees you
cannot.
If we extend property rights so you could sue for compensation, it would make the polluter
think again and perhaps install anti-smoke devices on factory chimneys!
Benefits
• The property owner knows the value of the property better than the government does,
so the figures will probably be more accurate (but owners can, and perhaps would, lie!).
• The polluter is forced to pay those suffering from his or her activities.
Disadvantages
• The damage may occur abroad.
• Global interests and national interests may conflict. The Zimbabwe cannot make
Zambia extend property rights over Zambians trees which are being killed off at a rapid rate.
Trading permits to pollute
Many believe that it is so difficult and expensive to stop companies polluting (identifying
who did it can be impossible e.g., with one stream and dozens of factories discharging into it)
that instead we should auction off the right to pollute. Only those firms that pay a high price
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for the limited number of licences would be allowed to pollute. The government could then
use the large sum of money raised to tackle the pollution itself. The end result could be much
better than we currently have.
If we allow a firm to sell its right to pollute (it may have used only 80 per cent of what it is
permitted, for example) then those with the greatest demand for their product, and hence the
most profitable, can buy the remaining 20 per cent. It means the things we most desire still
get produced but the government has the resources to tackle the resulting pollution.
Coase’s Theorem
Ronald Coase established that there is no need to tax or regulate polluters at all! He saw that
if polluters compensated those suffering, the market would solve it properly, with just enough
“acceptable” pollution occurring and still no one suffers without being compensated.
MONOPOLY
What is a monopoly?
Definition: Technically a monopolist is a sole supplier, that is to say, one firm is the industry.
But there are degrees of monopoly - if one firm supplies, say, eighty per cent of the market, it
is close to being a monopolist and will usually act like one.
If two (or more) firms supply most of the output, it pays them to work together, to act like a
monopoly, and to keep prices high (if there are two firms we call it “a duopoly”).
Types of monopoly, (sometimes called “causes of monopoly”; "sources of monopoly"; or
"conditions for monopoly"
• Economies of scale, i.e. one firm grow large, its costs fall as a result and become
lower than the others, so it can reduce its price and sell more produce. The others cannot
compete because they are small and higher cost. The firm grows to become the sole one,
which then supplies the entire market.
• The result of law – the government may restrict an industry to one huge nationalized
firm.
• An agreement between firms, so that all act together as one monopolist - often it is
illegal but it happens. We call this a cartel. This can happen under oligopoly conditions.
• Exclusive ownership of a unique resource: perhaps there is only one source of supply
of a raw material.
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• Copyrights, patents and licenses are particular forms of this exclusive ownership.
• So-called natural monopoly. This is often the result of economies of scale - e.g.,
electricity supply.
Problems with monopoly (what is wrong with monopoly or "the welfare effects of
monopoly")
• It limits output and keeps price high - as just said. Really this means that a monopolist
misallocates (and misuses) resources.
• This behavior of the monopolist redistributes income from all the consumers of the
product (they are paying more than they need) to one firm or person (the monopolist). This
is an equity issue.
• A monopolist may develop political and social power over others which reduces the
efficiency of democracy and the amount of equity.
• A monopolist may behave badly in an anti-social way. For instance, he or she may
force out a potential rival firm by selling at give-away prices (well below cost). After they
have forced out the honest competitor, they will put the price back up again.
• Lack of competition tends to encourage inefficiency in the firm. The monopolist tends
to rest on his laurels, has no need to try hard, and lacks dynamism – this is probably the
main criticism .
• As a result, we can get the emergence of lazy managers and owners.
• And it may mean that technical progress is slow, leading to slow growth of the
country as a whole, and a lower standard of living than we could enjoy.
• A monopoly breeds inefficiency which means that the cost curves will be higher than
they need be; this means that the intersection of MC and MR may be higher.
• Resources are misallocated - too many are going to the monopolist who does not fully
use them. This is a waste for society. It really means that the price mechanism is prevented
from working efficiently.
• A monopoly may reduce consumer choice. He may ignore small market demands as
he cannot be bothered to meet them. As Henry Ford is reputed to have said about his motor
cars “You can have any colour you want, as long as it’s black”.
Benefits of Monopoly
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There are few benefits really - economists are almost united in opposition to monopolies, and
many are against both public and private ones – those on the political left wing tend to prefer
public ones more than those on the right wing.
Economists usually favour reducing or ending monopolies and increasing competition.
BUT some defence is possible!
• The monopoly profits can be used for research and development, leading to product
improvement, faster growth, and lower costs.
Joseph Schumpeter's argument on innovation - that big firms are the only ones able to afford
the necessary laboratories and research staff – may apply.
Against this, research shows that many breakthroughs come from smaller firms, not the large
ones. For instance, Apple computers began in a garage.
• A monopolist may reap economies of scale.
• A redistribution of income is not too bad perhaps:
It is always happening in a dynamic economy anyway. If necessary, it can be corrected by
government action.
Monopolies can lead to underproduction and higher prices than would exist under conditions
of competition. In a free market economy, there is nothing to prevent the emergence of
oligopolies and a monopoly in various industries. The more successful firm acquires other
firms or puts them out of business. When these imperfect market structures occur, there will
be allocative inefficiency because they generate shortages in order to hike up prices and
increase profits.
Public goods
Economic goods can further be subdivided into public and private goods. A public good is
one that has two characteristics that private goods do not. Firstly, public goods are non-
exclusive. This means that a producer or seller cannot separate non payers from benefitting
from the good. As a result, the payer too, eventually does not want to pay. As a consequence,
the market will not produce a public good. This is market failure.
Using the concept of externality for public goods, there are no private benefits or revenue for
the producer at all but more benefit for the society. Examples of public goods are street
lighting, defence and radio broadcasts. The second characteristic is that public goods are non-
exhaustible. This means that the use by one person does not reduce the amount available to
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another. As a result, there is no rivalry in consumption. As a result, there is no additional

opportunity cost for the second and third person to use.
Public goods are collectively consumed and the market may simply not supply them; e.g.,
defence of the country (a police force and army), a fire brigade, street lighting, or lighthouses.
The market system does not work well in this area.
Some goods are “semi-public goods”, “quasi public goods” or “collective consumption
goods”, for instance roads. These are often supplied by the state, but in principle they can be
privately supplied, and sometimes are.
Public goods require
• The lack of ability to exclude (if I am defended, so are you, even if you do not pay)
• The consumption by one does not reduce the consumption available to the others (if
you walk down the street after dark you do not use up any of the street lighting.)
These two requirements may be called the “non-rivalry” and “non-excludability” features.
One of the jobs of government, both central and local, is to supply public goods or services
that are needed but otherwise would not be made available by the market.
Merit Goods
These are goods with extensive external benefits. These are provided by the market - but in
smaller amounts than are needed for the good of the state. Health and education are the most
obvious ones – there will be some privately-supplied health and education but the state as a
whole benefits if everyone has access to them, not just a few. For instance, in the health area,
the National Health Service tends to reduce mass epidemics; the health service also means
that fewer people will be off work sick. In the case of education, society would not function
as well if half the population could not read the instructions on the label.
Private consumers individually value merit goods less than the state does. The market system
fails to provide enough merit goods which is why the state steps in to make them more
widely available. It does this by subsidizing the production of some merit goods or services.
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Merit goods may be targeted at certain groups and rationed; for instance, we might limit
access to higher education to those passing A levels well.It is assumed that such people are
the most intelligent in society.
In the diagram below, a subsidy equal to AB is applied by the government – this shifts the
supply curve downward and to the right. The equilibrium position then moves from P1Q1 to
P2Q2. The result is that more is then consumed at the lower price i.e., the demand for merit
goods has extended.
Demerit goods
Demerit goods are exactly the opposite of merit goods in that they are over-consumed by
individual people and this causes problems for the nation as a whole.
Cigarettes are a clear example: they cause unpleasant smoke which is dangerous to people in
the area who are forced to become passive smokers. They also cause cancer and a whole
range of nasty diseases, including emphysema. They inflate the national health bill because
both the smokers and the passive smokers get sick and visit the doctor. But smokers will not
stop, perhaps are unable to stop, because they are addicted.
Too many demerit goods are demanded, so the government steps in and taxes cigarettes
highly in order to reduce consumption and to raise revenue which is needed anyway to spend
on treating smokers. The government also advertises heavily to try to persuade people to stop
smoking and the young not to start and is seriously considering banning smoking in all public
work places, as Ireland did in 2004. Some individual doctors are also refusing to treat
smokers for smoke-related diseases unless they stop smoking which adds to the pressure.
The effect of the government taxation is in the diagram below. The indirect tax EB is added
vertically to the supply curve, which shifts upward and to the left from S1 to S2.
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This reduces the consumption from OQ1 down to OQ2, (a move from the equilibrium point
A to B) as price rises from P1 to P2 and consumers contract up the unchanged demand curve.
Rather than simply relying on tax to decrease the supply curve and force up the price, the
government may also try to tackle the demand side. It can do this in the ways mentioned
above and the diagram is reproduced below.
You will observe that, if successful, the quantity smoked falls.
The government uses both methods, reducing demand and taxing heavily, to deal with
smoking as a demerit activity.
Information failures
Consumers lack information on things like:
• What goods are available and what new goods have recently come onto the market.
• What the quality of the different models or makes available is like.
• How long an item will last before breaking down.
Information lack is particularly common in both the health service and in education where
consumers do not know much - although we now know more than a few years ago.
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This lack of perfect knowledge means that we may choose badly through ignorance. The
demand curves would be different, and better, if we did know everything. This means of
course that the existing demand curves do not give us a perfect market solution.
Producers lack information on:
• What new demands are arising and how old ones are starting to change, so the
producers may produce more (or less) than they should.
• What their existing rivals, and any new ones about to emerge, are doing or might do.
Which means that the producers may produce the wrong type of goods or the wrong quantity
of goods?
We know that in the world in which we live, new firms start up and many die away within the
first two years – they usually got it wrong on the demand for their service or goods in that
particular place, although sometimes they simply were not good enough at the job. In the
process of being born and dying, the firms used up resources (including the labour of the
would-be entrepreneur) in a less than fruitful way. Workers lack information on:
• All the jobs available now. Many of these will be local but more particularly they are
usually ignorant of opportunities elsewhere in the country or in the EU for that matter. So
the workers may not move to where they are needed though simple lack of knowledge.
• Which industries will grow and which will wither away in the future. This means that
workers may join a firm that will disappear in a few years time, throwing them out of work
but not for any fault of their own. Technical change can render whole jobs out of date.
- A real problem is that those leaving school or college may join an industry and train in skills
that will shortly be no longer needed.
So here again the market does not reach the “correct” or optimal solution.
The response to information failures

Private firms gather information and try to sell it. For instance:
• Private job centres may open up to try to find a job for people. These are mostly in
large cities and for service workers, rather than for manufacturing. Such firms are trying to
improve the flow of information for profit.
• Magazines like “Which?” exist. They test and investigate the quality of goods and
services and publish the results.
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• Specialist magazines are produced for things like hi-fi, TV, motorcars, or computers –
such magazines also test and report the results.
• In order to help producers, various trade associations and chambers of commerce
gather information and inform their members about what is happening. They also organise
conferences and set up fact-finding trips abroad and the like.
The state tries to provide information by:
• Establishing job centres.
• Providing advice to careers advisers in schools.
• Issuing pamphlets and working papers to try to improve peoples’ knowledge. The
newspapers pick up this information and may publicise it.
Overall, as information improves, consumers adjust their demand patterns to favour what fits
their needs best. Producers chose the most suitable and cheapest sources for their inputs. This
of course means the market mechanism then works better to supply what people want and are
willing to pay for.
Factor immobility
The factors of production that we have are land, labour and capital plus a remainder term (L,
N, K, + R) – most economists and textbooks focus on labour immobility, but this is not
guaranteed for the exam
We can also have land immobility
• Some land is good for growing one or two particular crops and not very good at some
other crops. It is not easy to change rice (which needs wet soils) to wheat (which needs drier
conditions).
• It is not possible to move land from where it is to somewhere else.
• Climate change may be occurring and farmers are often traditional, growing what
they or their family have done for years or even generations. They may be unaware of, or
refuse to try growing, a now more suitable crop.
• Economic Union subsidies keep many farmers’ attention on producing the crops that
are highly subsidised (as it gains them a higher income) rather than what might be more
suitable for their land or sell better. Quite often the EU gets it wrong, so
we ending up with a lot of produce that is hard to sell. Dumping it on international markets
annoys other countries that produce such goods efficiently as it reduces their market.
Dumping it into the sea causes criticisms of waste in a world of poverty.
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And capital immobility

• Some capital is specific e.g., it makes light bulbs, and it cannot be transferred to
another use, like producing ball point pens.
• Some capital is very big and heavy, e.g., a steel mill, and it is difficult or impossible
to move it to another geographic areas.
• Some old decaying industries may be subsidised by government and continue to exist
for years, well beyond their shelf life. This keeps the capital (and the associated land and
labour) where it is so that it is not released for use where it is more wanted by society. That
is to say, government subsidises prevent factors of production moving to turn out what
people now demand. The fact that the industry is decaying shows that demand has changed
and people no longer want that good or service as much as they once did.
• Some (usually small) firms stay in business despite making poor profits because the
owner does not want to move or to cease production; or perhaps the owner is too old to
bother to make any major change. Labour immobility (the really interesting one – we
ourselves are people)
Geographic immobility of labour
• People are usually happy where they are: they have got relatives and friends, they
know the town and area, and they are members of various clubs and other social groupings.
They do not wish to move.
• They may not know about the money they could get if they were to move
(“information failure”). Information failure actually costs money to overcome: people must
pay to use the Internet, or have to buy newspapers and magazines.
• Moving house costs money: there are estate agents’ fees, lawyers’ fees, a government
stamp duty and the cost of transporting furniture and all the other household effects.
• Inertia: people often do not like a big move as they have a sort of fear about it, so they
just stay where they are.
Institutional immobility of labour
• Trade unions and government pass rules or laws that prevent people from entering a
new job easily.
• Pension schemes may tie people into a particular company – if a worker moves, he or
she will probably lose the amount paid in by the employer on their behalf (this can amount
to several thousand dollars).
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• Council houses (state subsidised housing) are let below market rents and can prevent
people moving; if they move it means they must give up their cheap house unless they are
able to arrange for a houseexchange with another council tenant.
• Foreign-trained doctors may not be allowed to work in the Zimbabwe unless they
spend several years retraining - and not always even then.
Sociological and economic differences causing immobility of labour
• Minority groups often get paid less. For instance, it may be harder for migrants who
do not naturally speak English to find work and to receive the same pay. If they are not
selected for a vacancy, it renders them less mobile. Even women, hardly a minority, find it
hard to get the same pay as men, despite the existence of long-standing legislation.
• We can think of this as a lower demand curve for them, because employers do not like
hiring them as much.
• Married or very close couples: one may not be able to take a better paid job offered
elsewhere because it would render the other partner unemployed, so total family income
would fall if they moved.
• The skills a person has may not fit the new demand for workers, so he or she would
find it hard to get another job. As demands in society change (taste + higher incomes + new
goods + new technology + fashion and trends…) it means new skills are needed and old
ones become redundant. How many chariot wheel makers do we now need?
• Age: once past fifty years, or even forty years of age, it is difficult to get a new job.
Employers often prefer younger people. If an applicant is old, the employer fears that they
will not learn new skills quickly; and if the applicant is older than the employer, he or she
may feel uncomfortable giving them orders and so simply refuse to hire them in the first
place; and old workers who join the firm will only pay into pension scheme for, say, ten years
until they retire, but will take out for perhaps another thirty years until they die. An ageing
population makes this scenario more common.
Such factors mean that wage differences (and unemployment) can permanently exist between
industries and between regions. The market does not work well enough to equalise wages and
long term wage differences persist.
Diagram: the wage of labourers in London and Cornwall: London has a greater supply but a
much greater demand so the curves are further to the right. And of course in London, the
level of wages and the quantity of workers are higher.
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What can be done? Government intervention may help produce a better market solution.
Government training and retraining for the new skills that society needs.
The government may improve or alter the educational system and encourage academic
courses to be more geared to the needs of a modern economy (although some intellectuals
disagree and think education should not do this).
We can retrain workers at government expense. The state can pay for retraining courses and
give generous tax breaks to those choosing to receive new skills.
The government may tackle the geographic problem
It may pay workers to move; or pay the costs of buying or selling the house; or end (or
reduce) the stamp duty for such people; or pay the unemployed to travel to look at job
opportunities in a new area.
It may subsidise firms to move to old decaying areas. This approach is generally inefficient,
as it means costs will be higher than they need be, as it is probably not a good location for the
firm (which we can assume or the firm would be there already or willing to go without a
subsidy). This would make the Zimbabwe less competitive with other countries.
The government may allow pension mobility, i.e. when a person leaves a firm he or she can
take their pension rights with them – the new stakeholder pensions do this. The push for
people to take out their own private pensions means that workers are more mobile than they
once were. There is a slight problem in that the rich who are usually already mobile are
taking out stakeholder pensions, but the poor, less mobile, are tending to avoid them.
The government could change the laws as needed
Example 1. The government could make all company pension schemes pay out the
employer’s contribution when worker leaves.
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Example 2. The government could make the Zimbabwe Medical Association (ZMA) allow
foreign doctors in to work more easily. The ZMA is rather restrictive and keeps some well-
trained foreign doctors from working in the Zimbabwe unless they requalify or take special
tests. This reduction in supply means there is a permanent shortage of doctors which helps the
ZMA to pressure the government for pay increases, better conditions, or whatever it wants.
Example 3. The government could pass “non ageist” legislation to try to stop older but good
being refused jobs or even fired (government is planning to do this - eventually).
Other areas of law no doubt could be similarly changed – watch the newspapers for articles
and examples that you could quote in the exam room.
COST BENEFIT ANALYSIS (CBA)
Cost-budget analysis (CBA) is a framework for evaluating the social costs and benefits of an
investment project. This involves identifying, measuring and comparing the private costs and
negative externalities of a scheme with its private benefits and positive externalities, using
money as a measure of value.
Step 1: identify all costs and benefits using the principle of opportunity cost
Step 2: measure the benefits and costs using money as a unit of account
Step 3: consider the likelihood of the cost or benefit occurring (i.e. sensitivity analysis)
Step 4: take account of the timing of the cost and benefit (i.e. discounting). A £1,000 benefit
now is worth more than £1,000 benefit in 10 years time
IDENTIFY ALL COSTS AND BENEFITS

A firm deciding on an investment project will only take account of its own private costs and
benefits e.g. total cost and total revenue. Firms ignore externalities. CBA will take account of
both private and external costs and benefits.
Consider a project to build a bridge over a river:

• Private Costs e.g. construction costs, operating costs and maintenance costs
• External Costs i.e. costs incurred by non owners (a) monetary e.g. loss of profits to
competitors e.g. to ferry owner and (b) non monetary e.g. noise, loss of countryside,
inconvenience
• Private benefits direct the amount consumers are prepared to pay e.g. the tolls paid
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• External benefits i.e. benefits to non owners e.g. consumer surplus of users; time
savings for travellers and fewer accidents.
MEASURE THE BENEFITS AND COSTS

Benefits and costs can be valued using money. Private costs and benefits are relatively easy
to measure in monetary terms
Total costs and total revenue.
Private costs Build the bridge: £5,000, 000 to operate it £200,000 a year, to repair and
maintain £ 50,000
Private benefits 1,000,000 users each paying £1 each = £1,000,000 a year Externalities are
more difficult to measure:
• Noise or loss of countryside. What value do people place on these? By how much do
those who suffer need to be compensated Ask them using a questionnaire! If 50,000
affected people value the annual loss of countryside at £5 then cost = £250,000
• Time savings. What value do we place on work time saved or leisure time saved? Is
the time saved worth the same to everyone? If 100,000 hours re saved and valued at £4 per
hour, benefit = £400,000
• Fewer accidents. Economists value human life using money. One life = £750,000. If
the bridge saves on life a year, annual benefit is £750,000
LIKELIHOOD OF THE COST OR BENEFIT

If there is a 50% chance that a life will be saved then the benefit is
£750,000 x 0.5 = £375,000
THE TIMING OF THE COST AND BENEFIT

The major cost of the project occurs straight away. The benefits occur over the life of the
project. The bridge may cost £5m to build but consumers benefit by £1m a year. If the
expected life of the bridge is 25 years then economists use discounting to value now the £1m
of benefit in 25 years time. Commonly the rate of interest or inflation is used to discount the
future earnings as the £1m in 25 years time will be worth substantially less today.
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IS A PROJECT WORTH UNDERTAKING?

Yes if discounted benefits outweigh discounted costs. If the government has to choose
between competing projects then the ones with the highest positive net present.
GENERAL POINTS REGARDING CBA

Here are some common examples that can be applied to many CBAs they will hopefully
assist you in answering any question.
The most common external costs arising from production are:
• Noise.
• Pollution of atmosphere, rivers etc..
• Danger to workers and public.
• Congestion.
The most common external costs arising from consumption are:
• Pollution from motor vehicles.
• Litter.
• Noise pollution.
• Externalities from smoking and drinking alcohol.
External benefits from production and consumption are often grouped together, the Following
are the most commonly used examples:
• Industrial training by firms.
• Education which leads to an increase in human capital.
• Healthcare.
• Knowledge.
• Employment created.
• Arts and sports.
• Neighborhood watch schemes.
A range of different projects often attract cost-benefit analysis, e.g., • The building of a new
road.
• The building of new airport/runway.
• The expansion of a factory.
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• The building of a supermarket.

• The provision of a public or merit good.
There are a number of problems with cost-benefit analysis:
• If the project leads to a time saving, it can often be difficult to place a value on the
time saved.
• Lives maybe saved, again what value do we place on a life?
• How do we place a monetary value on an eyesore, pollution or illness? These require
a level of judgment that may vary from person to person.
• Over time the value of the benefits will fall as inflation erodes the value of the pound.
Any future benefits would have to be discounted.
It is accepted that cost-benefit analysis can be an imprecise; however it is deemed to be better
than making no attempt to recognise the externalities at all. Due to the amount of judgment
involved when coming to the figures and discount rate the results should be viewed with
caution. All of the assumptions made in the cost-benefit analysis should be explicitly stated.
It is important to note who is carrying out the cost-benefit analysis and do they have a
particular agenda, i.e., do they want the project in question to be approved/turned down.
Depending upon their stance will affect what data they choose to include and their methods
of interpreting it.
THEORY OF CONSUMER BEHAVIOUR

Utility is the level of happiness or satisfaction that a person receives from consumption of a
good or service
Total utility is the overall satisfaction that an individual get from the consumption of all
units of a good or service over a given period of time.
Marginal utility is the additional satisfaction derived from the consumption of one more unit
of a particular good or service.
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Consumers are rational because they want to maximize satisfaction. Rational consumers
would not consume a product when the marginal utility falls to zero.
The law of diminishing marginal utility
The law states that “other things being equal, as more and more units of a commodity are
consumed, the additional satisfaction or utility derived from the consumption of each
successive unit will fall or decrease” e.g.
Number of cups of tea Total utility Marginal Utility
1 80 80
2 150 70
3 210 60
4 250 40
5 275 25
6 280 5
7 280 0
8 278 -2
The figure for marginal utility decline as each successive unit is consumed. If a consumer
goes on consuming more and more units, eventually that should the seventh unit be
consumed, total utility actually decreases so that marginal utility becomes negative. Negative
utility is referred to as disutility or
dissatisfaction.
Diagrammatically
Total Utility
utils
TU
0 qty
Marginal Utility
utils
0 qty
MU
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consumers would not consume a product when marginal utility falls to zero, the
marginal utility curve in practice would be downward sloping from left to right like the one
above.
. Indeed people’s
demand curve for a product is the same as their marginal utility curve for that product
measured in money terms.
it can be estimated.
One way of doing this is to look at what a person is prepared to sacrifice in order to obtain a
commodity. Pricemeasures the sacrifice in the sense that it indicates what other things might
have been obtained with the money. Sine marginal utility diminishes; consumers will be
tempted to buy more of a good only if its price is lowered.
givesan indication of the utility derived from that good, it is possible to obtain the demand
curve.
will derive different levels of satisfaction, and so will have different
demand curves.
of the individual demand
curves at different prices.
Factors affecting the Law of Diminishing Marginal Utility
1) The time period over which decisions are made e.g. a person who has not had a meal/ food
for several hours will place a high value on food than a person who has just had a meal or is
full (therefore he will not place any value or will place very low value on food).
2) Addiction e.g. smokers may find that the more they smoke the more they want to smoke –
they will always place very high value on cigarettes
3) The level of consumer’s income.
4) The price level of goods or services.
5) The type of good e.g. inferior goods versus normal goods.
6) Trends in fashion i.e. if in fashion consumers derive more additional utility.
7) Advertising i.e. informative, persuasive and generic
Ordinal Utility
of preference ordering and ranking
rather than the concept of measurable utility.
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lternative bundles of goods

and deciding whether he prefers one bundle to the other or is indifferent between them.
ence ordering which lead to
the conclusion that all possible bundles of goods can be grouped into sets in such a way that
the consumer is indifferent between all bundles in one set and not indifferent between sets.
ference. It is often
convenient though not necessary to assign numbers to these sets adopting the convention that
the higher a set is in order of preference the higher its number should be.
Cardinal Utility
umer quantifying the utility
he derives from consuming a particular commodity.
l believed that it was
possible for utility to be quantified/measured in cardinal numbers as opposed to ordinal
numbers – these economists are termed cardinalists.
A cardinal measure of utility implies that we can quantify how much more utility one
unit of a good gives to a person than the next.
Assumptions of the cardinalists approach
1. Rationality
rational/sensible decision makers which mean they weigh
the costs and benefits of each decision they make.
best
value for his money i.e. the greatest benefit relative to cost or where they derive maximum
utility.
2. Cardinal Utility
the utility can be measured in monetary units. The
monetary unit is conceptualized in terms of the amount a consumer is prepared to pay for
another unit of the commodity.
3. Constant Marginal Utility of money
he marginal utility of money must not
change as income changes, otherwise the measurement will be useless.
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it of a commodity, his
expected satisfaction from the consumption of thus extra unit must be greater than the utility
of money which he must spend in order to obtain it.
order to acquire an
extra unit of a good can – serve as an indication of the amount of utility that he expects to
realize from the consumption of that until.
ome of a consumer, the
marginal utility of money must remain the same.
4. Diminishing Marginal Utility
from a commodity diminishes as its consumption increases.
ess the additional
satisfaction derived.
Criticisms of the Cardinalist approach
Even though the multi-commodity version of marginal utility theory is useful in
helping/demonstrating the underlying logic of consumer choice, it still has major weaknesses.
say therefore how much
marginal utility of one good exceeds another.
ionality and search for utility
maximization but many decisions made by people lack rational behavior.
ising are well aware
that it is often the emotional content of a product that is more important that the rational.
approach.
on of how many goods
there are
in the basket e.g. if there are unknown (n) goods in a basket i.e. X1, X2, X3, X4, X5 ..., XN.
Thetotal utility derived would be:
TU = f(X1, X2, X3, X4, X5 ..., XN)
above set of goods, then total
utility/satisfaction derived will be:-
TU = TU1(X1) + TU2(X2) + TU3(X3) + TU4(X4) + TU5(X5) + … + TUN(XN) OR
U = U1(X1) + U2(X2) + U3(X3) + … UN(XN)
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Equilibrium of the consumer under the cardinalist approach/method

A consumer is in equilibrium when the marginal utility of the commodity purchased is equal
to its market price when only one commodity is consumed i.e.
MUx = Px
If MUx>Px the consumer should buy more of X to derive additional satisfaction.
If MUx<Px, the consumer should reduce the consumption of X to increase satisfaction.
→ MUx = Px is the point of consumer equilibrium, though it is very difficult to attain but at
this point the consumer achieves maximum utility.
The above analysis is basically for only one commodity. When a consumer consumes more
than one good e.g. good X and good Y, the consumer will obtain his equilibrium when there
is equality between the ratios of the marginal utility of each good to its price.
→ MUX/ PX = MUY/ PY = …. = MUN/ PN
This is referred to as the equi-marginal principle.
A change in the price of any of the goods will cause a change in a person’s spending patterns.
From the above principle, the value of the expression MUX/ PX will now fall as the price of
x is increased so the MUx per $ spent will now be less than any other good. The consumer
will therefore increase TU by spending less on good x and more on all other goods. In other
words the consumer only maximizes TU by buying less of good x. The conclusion is that the
demand curve is downward sloping.
The indifference curves (ordinal) Approach
indifference curve is a curve that describes a combination of two goods that yield the
same level of satisfaction or utility to the consumer.
ds that make a consumer indifferent
to the satisfaction derived from consuming them.
goods, it becomes uneasy for a
consumer to choose a particular basket of goods because utilities derived from a series of
combinations to another are indifferent.
GOOD X
B
X2
X1 A
I
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0 y2 y1 GOOD Y
the two
combinations is the same. Therefore the consumer can consume any of the combinations on
the curve because any of the combinations makes the consumer just happy as the other, be it
A or B.
r graph, the consumer
prefers more of x in exchange for fewer y, and moving downwards along the same curve, the
consumer prefers more of y in exchange of x.
Indifference Map
rve is to the
origin, the more the quantity of commodities, hence the higher the level of satisfaction it
yields.
indifference map is a conglomeration of indifference curves. A higher curve than
another one signifies a higher level of satisfaction. The indifference map shows various
indifference curves that stand for different levels of satisfaction.
same indifference curve
produce the same level of satisfaction.
ranks the preferences of the consumer. The higher the indifference
curve or the farther away from the origin it is, the more preferable it is to a rational consumer.
On the other hand, the lower the indifference curve, or the closer the curve is to the origin,
the less preferable it is.
GOOD X
I3
I2
I1
0 GOOD Y
is
less than that attached to I2 and satisfaction attached to I2 is less than that of I3.
d services will like to
consume along the highest indifference curve i.e. I3.
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Assumptions of Indifference Curves

1. Rationality – the consumer always aims to maximize satisfaction from goods consumed.
2. Ordinal Utility- It is axiomatically believed that the consumer can rank his preferences in
accordance with the utility derived from various baskets of goods, utility measurements can
only be handled using the ordinal method and not the cardinal method. The total satisfaction
derivedby a consumer is a function of the total quantity of commodities consumed i.e.
TU = f(q1, q2, q3, …, qx, qy, …, qn)
3. Consistency and transitivity of choice- Since we assume that a consumer is rational, his
choice of goods has to be consistent. When he chooses a particular point in time, he is not
expected to choose B over A in another time A>B, then A must be preferred to B. Similarly if
A>B>C –
A>C. Meaning that if a consumer preferred bundle A to bundle B and bundle B to C, then
bundle
A must be preferred to bundle C.
4. There must be two baskets of goods for the analysis to be complete. The indifference
curveanalysis will not be complete if the bundles are used in isolation of the other basket.
Characteristics of Indifference Curves
1. Negative Slope
An indifference curve slopes down from left to right. This means that the consumption of the
2 goods along the indifference curve is negatively related to each other i.e. if the quantity of
one commodity (Y) consumed decreases the quantity of the other (X) must increase in order
to maintain the same level of satisfaction.
2. Non Intersection
Indifference curves must not intersect. If the 2 curves intersect, the point at which the
intersection occurs will represent 2 different levels of satisfaction, thereby violating the
consistency assumption.
3. Convexity
The indifference curve is convex to the origin. This means that the curve is inwardly curved
from left downwards to the right signifying diminishing marginal rate of substitution
(DMRS)
4. An Indifference Map
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An indifference map shows various indifference curve that stand for different levels of
satisfaction. An indifference map is a conglomeration of indifference curves.
Diminishing Marginal Rate of Substitution (DMRS)
substitution.
MRS is the amount of one good a consumer is ready to sacrifice in order to obtain an
additional unit of another good.
Good y
0 Good x
ity y increases while that
of X decreases and vice versa.
ult of compensating the
changes caused by the consumer’s preferences.
up onegood for the other along the indifference curve is called DMRS.
The Budget Constraint/Budget Line

budget line shows combinations of two products which can be purchased with a given
level of income.
limited by his level of Y and the

prices of goods and services.
measures the relative
scarcity between two goods.
urchase given his/her income
at market prices.
I = PxQx + PyQy
Where: I is the consumer’s income
Px is the price of the good x
Qx is the quantity of the good x
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Py is the price of the good y

Qyis the quantity of the good y e.g. a budget of $100 and prices for y of $2 per unit and for x
of $5 per unit.
0ption Good y($2) Good x($5)
1 50 0
2 0 20
Good y
50
. U .C .W
20
0 good x
consumer can attain or consume any combination along the budget line e.g. C i.e.
consumers all income or inside the budget line e.g. u i.e. doesn’t exhaust all the income –
points along the budget line are attainable and points outside the budget line e.g. W is not
attainable i.e. they are beyond the consumer’s income.
Shifts in the Budget Line

These are a result of:
1. An increase or decrease in the level of the consumer’s income.
Changes in prices affect the level of real income, if prices decreases real income increases
and the budget line shifts outwards. The reverse is true for increase in prices.eg if prices
decrease by
50%, the effect will be as follows.
Good y 100
50
0 20 40 good x
2. Changes in prices of one good
If price of good x decrease by 50% the effect will be as follows
Good y
50
0 20 40 good x
175
ot shift. It will pivot

inwards or outwards depending on the circumstances.
The Consumer Equilibrium under Indifference Curves Analysis
Given the consumer income and the prices of goods or supplies in the market, the consumer
maximizes satisfaction at the point of equilibrium.
Graphically it is the point where the budget line is tangential to the highest possible
indifference curve.
Good y
Y* e
I
0 x* good x
Point e is the equilibrium point. The equilibrium quantities are x* and y*. The slope of the
budget line =
Px/ Py
And the slope of the indifference curve = MUx/ MUY are equal at their point of tangency
.Consumer equilibrium exist at a point where marginal rate of substitution is equal to
marginal rate of transformation.
At this point satisfaction will be equal to income.
Applications of Indifference Curves Analysis/Changes in Consumer Equilibrium
1. Effects of Changes in Income
A rise in the level of the consumer’s income shifts from C to C1 to C2 as more of both x and
y are consumed. The line C, C1, C2 is income consumption line/ curve.
Good y
C2 Income consumption line
C1
C
0 goodx
income consumption curve is the line that traces the different equilibrium points of
the consumer arising from changes in his income.
is a
Normal good.
176
good is
inferior.
2. Effects of changes in prices
vots outwards and the consumer

equilibrium shifts from C to C1 to C2.
price consumption curve/line (PCC).
Good y
Price consumption line or curve
C C1 C2
0 good x
price consumption curve (PCC) is a line that traces or joins the new equilibrium
points as a result of continuous falling or increasing of the price of a commodity.
3. Derivation of the demand curve using the indifference curves approach
Indifference curves can be used to show how an individual demand curve is derived.
Good y
OL OM ON good x
Price x
P1 x
p2 x
p3 x
e and we can see that
the price consumption line shows how the demand for x grows as the price of x falls relative
to y.
rice of x against the demand for it.
e demand curve with the
various prices on the demand curve, we can see that we derive a normal downward sloping
demand curve.
to Op2 to Op3, demand has expanded from OL to OM to
ON.
177
clude here, if we can

derive an individual’s demand curve, we can also derive a market demand curve by
aggregating all individual demand curves.
Distinguishing between income and substitution effects
Total Effect
sult of changes in the
price of that commodity.
substitution and income
effects.
ence U1 at A, being the
initial equilibrium of the consumer.
and
became tangential to the higher indifference curve U2 at B establishing a new equilibrium
position.
total
effect of a price change.
compensated budget line is created and it
is tangential to u1 at C
substitution effect and
income effect.
. The purpose of the
compensated budget line is to disallow variation in the original utility enjoyed by the
consumer and the resultant satisfaction when the price of x changes.
The Substitution Effect(X1 to X2)
e good and vice versa.
buys less of it, meaning
good y is substituted for good x. The price of good y is relatively higher.
d of a good x as the price of
another\ good y which is a substitute increase.
Good y
I
0 x1 x2 good x
178
The Income Effect (e1 to e2)

Good y C
A
E2
E1 I2
I1
0 x1 x2 B D good x
f normal goods. As the
price of good x falls, the real income of the consumer increases signifying an increase in
purchasing power of the consumer. The additional good x purchased due to the increase in
real income resulting from a fall in price (increase in quantity of good x from x1 to x2) is
called the income effect.
Income and substitution effect for a normal good
ncreases people buy
more of the good.
A decrease in price of good x causes the budget line to pivot outwards from AA to AA2 since
good x is now relatively cheaper compared to good y.
More of good x is purchased e1 to e3 = substitution effect
eases signifying an
increase in purchasing power of the consumer. Additional good X is purchased due to the
increase in real income
income effect. In the case
of a normal good, the income effect and the substitution effect reinforce each other. They are
both positive due to a reduction in the price of good X and vice versa
Income and substitution effect for an inferior good
inferior goods e.g. public
transport, second hand clothing, poor foodstuffs etc since they will now be able to afford
better quality goods (and vice versa).
The consumer’s real income
and purchasing power increases.
e substitute effect.
179
Income and Substitution Effects for a Geffen good

Geffen goods are those where an increase in price causes an increase in quantity
demanded and vice versa e.g. staple food stuffs.
but falls. This has come

about because as Geffen goods are inferior. There is a negative income effect as their price
falls and because they are such an important part of the household budget, the negative
income effect has been sufficient to outweigh / swamp/ offset the substitution effect.
Critique of the Indifference Curves Approach
1) In practice, it is virtually impossible to derive indifference curves since it would involve
the consumer having to imagine a whole series of different combinations of goods and
deciding in each case whether a given combination gave more, equal or less satisfaction than
other combinations.
2) Consumers may not behave “rationally” and hence may not give careful consideration to
the satisfaction they believe they will gain from consuming goods. They may behave
impetuously(i.e.rushing or acting without considering) e.g. impulsive buying.
3) Consumers are not perfectly knowledgeable. Therefore the “optimum consumption” point
may not in practice give consumers maximum satisfaction for their money.
4) The belief that consumers are rational may be influenced by advertising.
5) Indifference curves are based on the assumption that marginal increases in one good can
be traded off against marginal decreases in another. This will not be the case with consumer
durables e.g. cars, TVs, sofas. Houses etc. since they are purchased only now and again and
then only one at a time.
Usefulness of Indifference Curves
1. To demonstrate the logic of rational consumer choice.
2. Derivation of individual’s demand curve
3. Income and substitution effects of a price change.
4. Price consumption curve (PCC) and income consumption curve (ICC).
THEORY OF PRODUCTION AND COSTS
plant/establishment is a unit of production in an industry. It can be a factory, a shop, a
farm, a hotel or any economic unit that carries its own business at one geographical location.
180
firm is a unit of ownership and control. A firm may consist of just one pant in which
case it is referred to as single plant. However many large firms are likely to comprise a
number of plants – they are multiplant.
industry is all firms concerned with a particular line of production or all firms
producing similar products e.g. automobile industry, tourist industry, mining industry and
agricultural industry etc.
behave.
ing various quantities of
goods or services and using various alternative methods of production.
Questions to answer:-
profits.
behavior is when a firm weighs up the costs and the benefits of
alternative courses of action and then seeks to maximize its net benefit
The Short Run (SR) Period of Production
duction is variable e.g. labour
and the rest are fixed (i.e. land, capital and entrepreneurship)
The Law of Diminishing Returns/The Law of variable proportions/The Law of Diminishing
Marginal
Productivity
The law states that “as we add successive units of the variable factor of production to fixed
amounts of other factors of production, the increments to total output or total product (TP) or
total physical product
(TPP) will first increase and then decline.”
E.g. assume some particular crop is to be grown on a fixed price of land e.g. 2 acres. We shall
assume also that the amount of capital to be used is also fixed. Labour will be the only
variable factor of production.
Number of Workers Total Product (T.P) Average Product (AP) Marginal Product
181
(MP)
1888
2 24 12 16
3 54 18 30
4 82 20.5 28
5 95 19 13
6 100 16.7 5
7 100 14.3 0
8 96 12 4
Assumptions
1. Labour is the only variable factor of production.
2. All units of the variable factor of production are equally efficient.
3. There are no changes in the techniques of production.
Total Product (TP) or Total Physical Product (TPP)
It is the total output of a product per period of time that is obtained from a given amount of
inputs
Average Product (AP) / Average Physical Product (APP)
It is output per worker
AP= ____ _______ (______)
#__$__ __ %__&___
AP is also called efficiency / productivity
Marginal Product (MP) / Marginal Physical Product (MPP)
It describes changes in total output brought about by varying employment by one person.
MP = TP of n workers – TP of … (n-1) workers = Δ _
Δ_
Returns to the variable factor
Since labour is the only variable factor of production, changes in output are related directly to
changes in employment – we speak of changes in the productivity of labour i.e. returns to the
variable factor of production which is labour. Diagrammatically:
TP
TP
0 3 4 7 QTY
182
The LDMR sets in MP/AP

AP
0 3 4 7 MP 8 QTY
1. Increasing Returns (0 to 3 units)
TP is increasing at an increasing rate. MP is increasing
2. Constant returns (not illustrated)
TP is increasing at a constant rate. MP is constant.
3. Diminishing Returns / Decreasing Returns (3 to 7 units)
TP is increasing at a decreasing rate. MP is falling.
4. Zero Returns (7 units)
Total product is constant. MP is zero.
5. Negative Returns(7 to 8 units)
NB Total product is falling. MP is negative.
Diminishing returns set in because too many cooks spoil the meal.
The law of diminishing returns deals essentially with SR Period situations. It is assumed that
some of the resources (factors of production) used in the production process are fixed in
supply.
LONG RUN PRODUCTION PERIOD
Returns to Scale
It is assumed that
some of the resources used in production process are fixed in supply.
Units of Labour Units of Land

(Acres)
Total Output
(Tons)
Increase in size of firm
Increase in TP
4 20 100 100% 150%
8 40 250 50% 68%
12 60 420 33.3% 33.3%
183
16 80 560 25% 20%

20 100 672 22% 16%
24 120 780
is changed, output changes
are usually proportionate.
han 100% or less than 100%.
The relationship changes of production and changes in output are described as returns to
scale.
Increasing Returns to Scale
Output increase more than proportionality e.g. as the firm increases its size from 4 people /
workers and 20 acres to 12 workers and 60 acres of land.
Constant Returns to Scale
Size of firm and output changes by the same % e.g. a change of scale from 12 people /
workers and 60 acres to 16 workers and 80 acres.
Decreasing Returns to scale
Output increases less than proportionality e.g. a change of scale from 20 workers and 100
acres to
24 workers and 120 acres.
returns to scale are
generally described as economies of scale.
diseconomies of scale.
activities. When an
increase in the scale of production results in a more than a proportionate increase in output,
the firm is said to be experiencing economies of scale (INCREASING RETURNS TO
SCALE). Economies of
Scale are the benefits which accrue to a firm as it grows in size or they are the advantages of
expansion. They are seen as the LRAC decrease / fall. Diseconomies of scale are the
disadvantages of expansion (DECREASING RETURNS TO SCALE). They are seen as the
LRAC start to increase. Minimum Efficient Scale (MES) (CONSTANT RETURNS TO
SCALE) seen by the constant part of the LRAC.MES exist if the proportionate change in
184
scale of production is the same as the change in output. This can be illustrated by an envelope
curve as follows;
AC SRAC1 SRAC5 LRAC
SRAC2
B SRAC3 SRAC4 SRAC5
A
ECONOMIES OF SCALE DISECONOMIES OF SCALE
INCREASING RETURNS TO DECREASING RETURNS TO
SCALE
0 Q1 Q2 Q3 MES QTY
The diagram illustrates the long run production of a firm. Firms always operate at the least
part of the average cost curve. This firm was currently operating at Q1at the least point of
SRAC1.Assuming that demand of the firm’s products increases and output Q2 is now
demanded. If this firm decides to continue operating in the short run (SRAC1) its costs
increases from A to B. To avoid this increase in cost this firm should alter all its factors of
production and starts operating on SRAC2, producing the same output of
Q2.This firm can increase output until it reaches Q3.
Economies of Scale
Economies of Scale can be classified into 2 groups:-
1. Internal Economies of Scale
2. External Economies of Scale
Internal Economies of Scale
These are the benefits which accrue to a firm independent of what is happening to other firms
/ the industry. They arise simply from the increase in the scale of production in the firm itself.
These are the advantages in the form of lower C which a firm gains from the growth of the
industry. These economies are available to all firms in the industry independent of changes in
the scales of their individual outputs.
Internal Economies of Scale can be divided into plant economies and firm Economies of
Scale.
Plant Economies of scale include:-
– concentration of firms in producing a good or service
185
– full utilization of massive machinery or highly qualified personnel.

Increase in output doubling or trebling employment.
– of factors of production – output increases
– full use of multiple machinery unlike for small firms where some
machinery lie idle.
– waste products being recycled e.g.fabric cuttings to make rags or
manure from chicken
– e.g. joint supply, banc assurance, banking services and estate agent
processes
Firm Economies of Scaleinclude:-
–bulk buying – huge discounts

- Employment of specialist buyers
-Lower packaging costs
- Massive advertising
–creditworthy borrower
–special interest rates huge
–collateral or security of finance
–access to more sources of finance
– diversification eggs not put into one basket
– specialist mergers
omies – staff canteens
–sports grounds
–medical care
–a firm may be large enough for individual plants to
specialize- advantages of specialization.
Internal Diseconomies of Scale
a firm due to expansion. They are normally
seen as the AC of production begins to rise.
rge are thought to be mainly
attributable to management difficulties.
186
1. Management Problems
the firm increases management becomes more complex. It becomes
increasingly difficult to carry out the management functions of
– coordinating various debts becomes more and more difficult.
– taking decisions and seeing to it that these decisions are carried out becomes
difficult workers don’t do what they are supposed to be doing.
– keeping everyone informed through vertical and lateral combination
becomes more difficult.
– latitude of workers to management is of critical importance
to the efficient operation of the organization. Workers end up not cooperating.
2. Increases in prices of inputs e.g. raw materials, rentals, labour, energy, transport etc.
rnal economies of scale are the advantages which accrue to a firm from the growth in
the size of the industry.
ant when industries are heavily

localized / concentrated in industries clusters.
economies of concentration e.g.
1. Labour
2. Ancillary Services Disintegration
3. Cooperation
4. Commercial Services
5. Specialized Markets
External Diseconomies of Scale
try to which it belongs
becomes too large. These are referred to as external diseconomies of scale.
-
1. Shortage of Labour
2. Increasing demand for raw materials may also bid up prices and cause costs to rise
3. If the industry is heavily localized land for expansion will become scarce and hence more
expensive to purchase or rent.
Costs of Production
187
Opportunity Cost
t is the next best alternative forgone when one makes economic choice.
Opportunity cost is what we have to “sacrifice or give up” in order to gain something we
value / something of economic value.
not free i.e. they are limited in
supply
Sunk Costs
or recovered once a firm leaves an
industry (e.g. by transforming assets to other businesses, marketing costs like advertising).
to exit for incumbents given the large capital outlays involved.
irms, which may be reluctant to enter an
industry if faced with the prospect of substantial sunk costs should they not be successful.
User Costs
e value of a machine or capital asset from its
use.
Shadow cost or implicit cost / imputed price / shadow price is a price which is imputed.
opportunity cost of a resource and which may
differ from the market price.
positive externalities) are not easy to measure
since by definition they do not have a price attached to them.
ng from an overhead railway may include visual
pollution, congestion near the stations and some noise pollution.
reater and may include less air pollution, less
overall road congestion, fewer road accidents (thereby reducing the burden on the police,
health services etc), and savings in travel time.
used to estimate these. Shadow prices / costs are
imputed prices based on opportunity cost.
Private Costs
188
e who buy products and by those who produce products

e.g. if a person buys a bottle of whisky, the cost (in the form of price charged) may be $15,
and if a firm produces a car the cost (in terms of wages, parts, overheads etc.)
Maybe $4 000.
Costs in the SR period
1. Fixed Costs
production they have to be borne e.g. rent, interest payments on loans,

stock (depreciation).
erhead costs or indirect costs. Diagrammatically: cost
F
0 QTY
FC are only found in the SR period of production and not in the LR.
2. Variable Costs (VC)
wages / salaries, costs of raw
materials, fuel, power, water bills etc. Variable costs are also called direct costs or prime
costs .
COST VC
3. Total Costs
are the sum total of FC and VC i.e. TC = FC + VC.
COST TC
VC
FC
0 QTY
AVERAGE COSTS OF PRODUCTION
costs per unit of production.
s first decrease and there will
come a point when they will start to increase – the AC curve is U-shaped.
n.
189
______
= '
_
/AFC+AVC
AFC = ('
_
=( )__ '____
______
/ATC-AVC
AVC = *__ _$__ _____
______
= +'
_
/ATC-AFC
4. Marginal Cost (MC)
we vary / change output by some
small amount.
– TC of (n -1) units
– shaped because of diminishing returns experienced as output
rises.
Output units per week Q
Total
Costs TC
Fixed
Costs FC
Variable
Costs VC
Average
Fixed
Costs AFC
Average
190
Variable
Costs
Average
Total
Costs ATC
Marginal
Costs MC
nimum and then
begin to rise.
is at its minimum value AVC = MC when
AVC is at its minimum value.
-shape. This is always so in the SR period.
ad over more and more
units. It continues to fall until the point of optimum efficiency or optimum capacity is
reached.
the fall in
AFC.
lowest unit costs (i.e. there is
productiveefficiency)
Shut down conditions during the SR period
long as price of the product is
above the AVC because the price of the AFC of production are being covered.
price > AVC, the firm should shut or stop production.
AVC
0 116 116 0 00 - 00 24
1 140 116 24 116 24 140 20
2 160 116 44 58 22 80 16
3 170 116 60 38.6 20 58.6 24
4 200 116 84 29 21 50 40
5 240 116 124 23.2 24.8 48 56
6 296 116 180 19.3 30 49.3 72
191
7 368 116 252 16.6 36 52.6 88

8 465 116 340 14.5 42.5 57
Average Costs in the LR Period
nted by a SRAC curve, each SRAC
curve is tangent to the LRAC curve.
envelope curve of all SRAC curves.
These points represent the lowest costs attainable for the production of any given output.
rves, the LRAC curve will be an
“envelope curve”.
-shaped because of economies of scale and diseconomies of scale.
Note
In practice, evidence suggest that in these industries investigated economies of scale exist but
diseconomies of scale either do not or are outweighed by economies of scale. In other words
the LRAC curve is more “L-shaped” than “U-shaped”
Total Revenue
ch a firm gets from selling its units of output.
Average Revenue
=,
_
=_)_
_
=P
AR = P (NB: only exception is when a firm sells its output at different price) – AR will
be the weighted average price.
Marginal Revenue
nal revenue obtained when sales are increased by
one unit.
192
-1) units
Δ,
Δ_
Output AR = P TR MR
1886
2 7 14 4
3 6 18 2
4 5 20 0
5 4 20 -2
6 3 18 -4
7 2 14
Market Structures
o
determine prices and output to be produced.
of market structures which are:-
1. Perfect Competition
many sellers and buyers selling
homogeneous / identical products.
Assumptions / Features
1. All units of the commodity are identical / homogeneous (i.e. one unit is exactly like the
other)
2. There are many sellers and many buyers and their behavior has no influence on the price.
3. Buyers and sellers have perfect knowledge of the market conditions and market activities.
4. There are no barriers to movement of buyers form one seller to another.
5. There are no restrictions on entry or exit of firms from the market.
6. There will be one and only one market price and this price is beyond the influence ofany
one buyer / seller.
7. There is no advertising.
193
8. There is perfect mobility of resources that firms wishing to expand their output can attract
resources.
nt prices because they are selling identical / homogeneous
products.
supply and the buyers are fully
aware of what is happening in the market.
The Individual Firm under Perfect Competition
dividual firm under perfect competition is powerless to exert any influence on
price. It sees the price as “given” i.e. established by market forces of demand and supply
beyond its control.
influence on the price he sells his
wheat, beef, milk or vegetables. Any changes in the amounts of the products which he brings
to the market will have negligible effects on price.
uct of the single firm must be a horizontal line at the ruling

price, in other words a perfectly elastic demand curve. No matter how many units the firm
sells, it can’t change the price. It can sell its entire output at the ruling price. If it tries to sell
at a higher price, its demand will drop to zero and obviously there will be no incentive to sell
at lower prices.
PRICE D S PRICE
P*
SD
0 Q*
a) The industry b) The Firm
by market forces of
demand and supply.
total market supply
provided by all firms in that industry – equilibrium market price is OP* and quantity OQ*.
firm sees the demand curve for its
product as being perfectly elastic. The firm can now supply any quantity it wishes at the
ruling price OP*.
If it rises to reduce or increase price, demand for its product falls to zero.
194
Average Revenue and Marginal Revenue
MR and AR curves as well as cost curves.

as the revenue it receives form
additional output exceeds the cost of producing that additional output.
a) Total Revenue (TR) is the total amount of money a firm receives from output sold.
TR = P x Q
b) Average revenue (AR) is revenue per unit sold. AR is another name for price.
AR =,
_
=_)_
_
=P
C) Marginal Revenue (MR) is the additional revenue obtained when sales are increased by
one unit or more precisely it is the change in TR when quantity sold is varied by one unit.
MR of the nth unit = TR from the sale of n units – TR from the sale of (n-1) units
The output of the firm under perfect competition in the SR period
are profit
maximizers. As long as the price (AR) it receives for each unit exceeds the AC of production,
a firm will be making abnormal profits / supernormal profits or economic rent.
-s in
the range of output Q to Q3 because at all the outputs in this range AR is greater than AC of
production.
-s in the range of output OQ to
OQ3 because at all outputs AR > AC.
-s.
Output level OQ1 will yield the maximum - per unit but firms seek to maximum total -s not
profit per unit.
will be increasing
because for additional unit produced, the increase in TR (i.e. MR) is greater than the increase
in TC (i.e.
195
MC)
-s will be decreasing because for each additional
unit produced MR < MC.
-s are increasing up to OQ2 and falling beyond OQ2, -s must be
maximized when output is at OQ2 i.e. when MC=MR.
-s are maximized when output is at a point where
MC=MR applies to all firms whether they are operating under perfect competition or
monopolies etc.
Ts are maximized at the point where
MC=MR=AR=P=demand only during the SR period of production.
Normal profit
If firms in the short run are making profits, there are incentives for new firms to enter the
market. This will increase market supply, causing market price to drop and the profit of
incumbent firms to be eroded.
This can occur because there are no barriers to entry. The price will drop to the point where
productive efficiency is achieved.
The shutdown point
In the short run, a firm operating at a loss [R < TC (revenue less than total cost) or P < ATC
(price less than unit cost)] must decide whether to continue to operate or temporarily
shutdown. The shutdown rule states "in the short run a firm should continue to operate if
price exceeds average variable costs."
Restated, the rule is that for a firm to continue producing in the short run it must earn
sufficient revenue to cover its variable costs. The rationale for the rule is straightforward. By
shutting down a firm avoids all variable costs. However, the firm must still pay fixed costs.
Because fixed cost must be paid regardless of whether a firm operates they should not be
considered in deciding whether to produce or shutdown. Thus in determining whether to shut
down a firm should compare total revenue to total variable costs (VC) rather than total costs
(FC + VC). If the revenue the firm is receiving is greater than its total variable cost
(R > VC) then the firm is covering all variable cost plus there is additional revenue
("contribution"), which can be applied to fixed costs. (The size of the fixed costs is irrelevant
as it is a sunk cost. The same consideration is used whether fixed costs are one dollar or one
million dollars.) On the other hand if VC >
196
R then the firm is not even covering its production costs and it should immediately shut
down. The rule is conventionally stated in terms of price (average revenue) and average
variable costs. The rules are equivalent (If you divide both sides of inequality TR > TVC by
Q gives P> AVC). If the firm decides to operate, the firm will continue to produce where
marginal revenue equals marginal costs because these conditions insure not only profit
maximization (loss minimization) but also maximum contribution.
Another way to state the rule is that a firm should compare the profits from operating to those
realized if it shutdown and select the option that produces the greater profit. A firm that is
shutdown is generating zero revenue and incurring no variable costs. However, the firm still
has to pay fixed cost. So the firm's profit equals fixed costs or −FC. An operating firm is
generating revenue, incurring variable costs and paying fixed costs. The operating firm's
profit is R − VC − FC. The firm should continue to operate if R − VC −
FC ≥ −FC, which simplified is R ≥ VC. The difference between revenue, R, and variable
costs, VC, is the contribution to fixed costs and any contribution is better than none. Thus, if
R ≥ VC then firm should operate. If R < VC the firm should shut down.
A decision to shut down means that the firm is temporarily suspending production. It does not
mean that the firm is going out of business (exiting the industry).] If market conditions
improve, and prices increase, the firm can resume production. Shutting down is a short-run
decision. A firm that has shut down is not producing. The firm still retains its capital assets;
however, the firm cannot leave the industry or avoid its fixed costs in the short run. Exit is a
long-term decision. A firm that has exited an industry has avoided all commitments and freed
all capital for use in more profitable enterprises.
However, a firm cannot continue to incur losses indefinitely. In the long run, the firm will
have to earnsufficient revenue to cover all its expenses and must decide whether to continue
in business or to leave the industry and pursue profits elsewhere. The long-run decision is
based on the relationship of the price and long-run average costs. If P ≥ AC then the firm will
not exit the industry. If P < AC, then the firm will exit the industry. These comparisons will
be made after the firm has made the necessary and feasible long-term adjustments. In the long
run a firm operates where marginal revenue equals long-run marginal costs. The shutdown
position can be illustrated as follows;
Efficiency in perfect competition
5 reasons why Perfect Competition is efficient:
197
1. Allocative Efficient: This is because P = MC.

2. Productive Efficient: Firms produce where MC=ATC.
3. X Efficient: Competition between firms will act as a spur to increase efficiency.
4. Resources will not be wasted through advertising because products are homogenous.
5. Normal profit means consumers are getting the lowest price. This also leads to greater
equality in society.
Evaluation
The benefits
It can be argued that perfect competition will yield the following benefits:
1. Because there is perfect knowledge, there is no information failure and knowledge is
shared evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive any monopoly power.
3. Only normal profits made, so producers just cover their opportunity cost.
4. There is no need to spend money on advertising, because there is perfect knowledge and
firms can sell all they can produce. In addition, selling unbranded goods makes it hard to
construct an effective advertising campaign.
5. There is maximum possible:
6. There is maximum allocative and productive efficiency:

nce allocative efficiency.
e MC = ATC, which is productive
efficiency.
7. There is also maximum choice for consumers
The disadvantage of perfect (or pure) competition
under the given distribution of income. We can imagine a
scenario with a very few rich people with pet dogs or cats which dine extremely well on
chicken and the like, while the masses starve.
Spill overs and externalities can exist. These are costs caused to others, e.g. the disposal
of nuclear waste or toxic chemicals by dumping them in streams.
- all the firms are too small.
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of range of goods; monopolistic

competition may have a much wider range. An example is motorcars – there are an awful lot
of different models and competition is much less than perfect.
Little or no research and development is possible because there are no funds for it. Under
perfect competition there are no surplus profits (in the long run they are whittled away!)
R&D is possible under monopoly because of the surplus profits available
MONOPOLY
Definition: Technically it is a sole supplier, i.e., there is one firm in the industry. It is the
industry.
But there are degrees of monopoly - if one firm supplies, say, 80 per cent, it is close to a
monopoly and will usually act like one.
Types of Monopoly/causes of monopolies
Economies of scale. One firm grows large, its cost curves are lower than the others, so it
is able to sell more; in the end it grows to become the sole firm. This is the so-called natural
monopoly.
An example of a natural monopoly is the distribution of water. To provide water to residents
of a town, a firm must build a network of pipes throughout the town. If two or more firms
were to compete in the provision of this service, each firm would have to pay the fixed cost
of building a network. Thus, the average total cost of water is lowest if a single firm serves
the entire market.
The law. The government may restrict the industry to one nationalised firm.
Regulations. A trade union may have a monopoly over the supply of one kind of labour
Agreement between firms, so that they all act together and behave as one monopolist.
This is often illegal but it happen
Exclusive ownership of a unique resource- if there is only one well in town and it is
impossible to get water from anywhere else, then the owner of the well has a monopoly on
water. Not surprisingly, the monopolist has much greater market power than any single firm
in a competitive market. In the case of a necessity like water, the monopolist could command
quite a high price, even if the marginal cost is low. Although exclusive ownership of a key
resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason.
Actual economies are large, and resources are owned by many people. Indeed, because many
goods are traded internationally, the natural scope of their markets is often worldwide. There
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are, therefore, few examples of firms that own a resource for which there are no close
substitutes.
Copyrights, patents and licences are particular forms of this exclusive ownership.
The patent and copyright laws are two important examples of how the government creates a
monopoly to serve the public interest. When a pharmaceutical company discovers a new
drug, it can apply to the government for a patent. If the government deems the drug to be
truly original, it approves the patent, which gives the company the exclusive right to
manufacture and sell the drug for 20 years.
Similarly, when a novelist finishes a book, she can copyright it. The copyright is a
government guarantee that no one can print and sell the work without the author’s
permission. The copyrightmakes the novelist a monopolist in the sale of her novel. The
effects of patent and copyright laws are easy to see. Because these laws give one producer a
monopoly, they lead to higher prices than would occur under competition. But by allowing
these monopoly producers to charge higher prices and earn higher profits, the laws also
encourage some desirable behavior. Drug companies are allowed to be monopolists in the
drugs they discover in order to encourage pharmaceutical research. Authors are allowed to be
monopolists in the sale of their books to encourage them to write more and better books.
Thus, the laws governing patents and copyrights have benefits and costs. The benefits of the
patent and copyright laws are the increased incentive for creative activity.
Marginal revenue and monopoly
Marginal revenue is the addition to total revenue from the last unit sold.
A perfectly competitive firm can sell as much as it wants at an unchanged price. Its MR curve
is equal to the price – every time it sells one more item it receives, say, an additional 50
pence, which adds 50 pence to TR.
A monopolist is the industry, so it faces a normal downward sloping demand curve.
So if wants to sell more of the good or service it must lower the price.
And of course it must sell all its products at that lower price. This means it loses by selling
the items it used to sell earlier at a higher price at the new lower price.
So the price of the marginal product is not the MR – the firm’s total revenue increases by less
than this sale, because of the bit it lost on the price on all the other products.
See the example in the table below.
AS INCREASE
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QUANTITY
MUST LOWER
PRICE (£)
TOTAL REVENUE
ALTERS (PxQ) (£)
MARGINAL
REVENUE (£)
1777
2 6 12 5 (12-7)
3 5 15 3 (15 -12)
4 4 16 1 (etc.)
5 3 15 - 1
6 2 12 - 3
717-5
Note that marginal revenue is less than price for all quantities after the first one.
PROFIT MAXIMIZATION FOR A MONOPOLY.
A monopoly maximizes profit by choosing the quantity at which marginal revenue equals
marginal cost
(Point A). It then uses the demand curve to find the price that will induce consumers to buy
that quantity
(Point B).
Cost and revenue MC
PB
ATC
A
AR=D
MR
0 q1 qmax q2 qty
Suppose, first, that the firm is producing at a low level of output, such as Q1. In this case,
marginal cost is less than marginal revenue. If the firm increased production by 1 unit, the
additional revenue would exceed the additional costs, and profit would rise. Thus, when
marginal cost is less than marginal revenue, the firm can increase profit by producing more
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units. A similar argument applies at high levels of output, such as Q2. In this case, marginal
cost is greater than marginal revenue. If the firm reduced production by
1 unit, the costs saved would exceed the revenue lost. Thus, if marginal cost is greater than
marginal revenue, the firm can raise profit by reducing production. In the end, the firm
adjusts its level ofproduction until the quantity reaches QMAX, at which marginal revenue
equals marginal cost. Thus, themonopolist’s profit maximizing quantity of output is
determined by the intersection of the marginalrevenuecurve and the marginal-cost curve.
A MONOPOLY’S PROFIT
How much profit does the monopoly make? To see the monopoly’s profit, recall that profit
equals total revenue (TR) minus total costs (TC): Profit = TR - TC.
We can rewrite this as Profit = (TR/Q -TC/Q) X Q.
TR/Q is average revenue, which equals the price P, and TC/Q is average total cost ATC.
Therefore, Profit
= (P - ATC) X Q.
This equation for profit (which is the same as the profit equation for competitive firms)
allows us to measure the monopolist’s profit in our graph.
Consider the shaded box in diagram below the height of the box (the segment P1C1) is price
minus average total cost, P – ATC, which is the profit on the typical unit sold. The width of
the box (the segment
C1K1) is the quantity sold Q1. Therefore, the area of this box is the monopoly firm’s total
profit.
Monopoly equilibrium
Equilibrium is where MC = MR, as usual. When you are drawing the diagram and answering
questions you should locate that point first and draw it in.
Seeing monopoly profits in the diagram below
Profits = total revenue minus total cost. Total revenue = price times quantity. Total cost =
average cost times quantity.
Problems with monopoly, “what is wrong with monopoly” or "the welfare effects of
monopoly"
s one firm or person (an

equity issue).
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which reduces the

efficiency of democracy and is inequitable. There are political dangers of a few very rich and
powerful people
(Marx called them “monopoly capitalists” who misuse their position and exploit people).
-social way. For instance it may force out a rival
firm by selling its product at give-away prices, well below cost and taking the short term loss.
After it has forced out the competitor, it will then put the price back up again. This behaviour
may or may not be legal. It depends on the country involved and its legislation but it is
always reprehensible.
need to try hard, and it
lacks dynamism. This is probably the main criticism.
progress is reduced,
leading to slow economic growth of the country and a lower standard of living than we could
have.
by him.
This is a waste for society and in addition, the price mechanism is prevented from working
properly.
to buy from and no other
producer’s product.
lies is slightly slower growth; a lower

standard of living; higher unemployment (because the monopolist restricts output and so
requires fewer people); higher prices (which monopolies charge); a slightly poorer balance of
payments as a result of this; a less equal income distribution; and poorer resource allocation.
Benefits of monopoly
development, leading to product
improvement, faster growth, and lower costs, despite the argument above that they are
inherently lazy. Joseph Schumpeter argued that they are important for innovation; he felt that
big firms are the only ones that are able to afford the necessary laboratories, equipment and
research staff.
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Against this, research exists that shows many of the breakthroughs come from small firms,
for example Apple began making those computers in a garage.
costs.
monopoly may be more
tempted to cut corners and reduces necessary maintenance to lower costs, and this could be
particularlyin some areas like the railways or air traffic control.
employment
The theory of monopolistic competition was developed by xdward
Chamberlin (1899-1967), an American economist. He was dissatisliedwith the two extreme
theodes that existed at the time, perfectcompetition and monopoly, so wanted to devise
something more realistic that would sit between the two existing theories. In simple terms, a
monopolistically competitive market is one with manycompeting firms where each firm has a
little bit of market power. Thisis why we have the term "monopolistic", as firms have some
ability toset their o\ry'n prices.
The assumptions of monoPolisticcomPetition
The assumptions for monopolistic competition are as follows. o The industry is made up of a
fairly large number oI firms.
. The firms are small, relative to the size of the industry. This means that the actions of one
firm are unlikely to have a great effect onany of its competitors. The firms assume that they
are able to act independently of each other. The firms all produce slightly differentiated
products. This means that it is possible for a consumer to tell one firm's product from another
.o Firms are completely free to enter or leave the industry. That is,there are no barriers to
entry or exit.
The only difference lrom perfect competition is that in monopolistic competition there is
product differentiation. Product dilferentiationexists when a good or service is perceived to
be dil{erent from other goods or services in some way. Products may be
dilferentiatedbybrand name, colour, appearance,packaging, design, quality of service,skill
levels, and many other methods. Examples of monopolisticallycompetitiveindustdes are nail
(manicure) salons, car mechanics,plumbers, and jewellers.
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Although it may appear to be a small difference from the`assumptions of perfect competition,

this leads to a markedly different marketstructure. As the products are differentiated there
will be some extentof brand loyalty. This means that some of the consumers will be loyalto
the product and continue to buy it if the price goes up a little. Forexample, it may be that the
customers of a certain plumber will staywith that plumber when she raises her prices above
local rivals, because they believe that she is slightly more skilled than hercompetitors.
This brand loyalty means that producers have some element of independence when they are
deciding on price. They are, to anextent, price-makers, and so they face a downward sloping
demandcurve. However, demand will be relatively elastic since there aremany, only slightly
different, substitutes.
Have you ever walked down a street in a tourist area and seen a lot of restaurantswith similar
menus? Explain why they might be considered to be in monopolisticcompetition.
The demand curve facing a monopolistically competitive firm is shown in Figure 9.1.
The firm faces a downward sloping demand curve with a marginal revenue curve that is
below it and produces so that it is maximizing profits where MC : MR. This means that the
firrn in Figure 9.I willproduce an output of q and sell that output at rhepdce of P
Possible short-run profit and loss situations in monopolistic competition
Just as in perlect competition, it is possible for firms in monopolistic competition to make
abnormal profits in the short run. This is shown in Fig]jJe 9.2.
.9
Eo
o
I
.9
Student workpoint 9.1
Be a thinker-consideland explain
Try to think of an example of a market in your area that is in monopolistic competition.
\A,4threference to the assumptions ofthe model, explain your choice.
lVtR Output
F Bure 9.1 lhe demand curve for a firm in monopolistic competition
Figure 9.2 Short-run abnormal profits in monopolistic competitiono-c
Output
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122
In this case, the firm is maximizing profits by producing at the level of output where MC =
MR, and the cost per unit (AC) of C is lessthan the selling price of P. There is an abnormal
profi.t that is shown by the shaded area.
It is also possible that a firm in monopolistic competition may be making losses in the short
run and this is shown in Figure 9.3. Onceagain, the firm is producing where MC: MR, but
this time the costper unit, C, is above the price, P, and the amount of losses is shownby the
shaded area.
The long-run equilibrium of the firm in monopolistic competition whether firms are making
abnormal profits or losses in the short run,because of the freedom of entry and exit in the
industry there will bea long-run equilibrium, where all of the firms in the industry aremaking
normal profits.
II the firms are making short-run abnormal profits, then other firms will be attracted to the
industry. Since there are no barriers to entry it is possible for these other firms to join the
industry. Asthey enter, they will take business away from the exisdngfirms, whose demand
curves will start to shift to rhe left. If firms are making short-run losses, then some of the
firms in the industry will start to leave. The firms that remain will Iind that their demand
curves startto shift to the right as they pick up trade from the leaving firms.
This analysis explains why it is not uncommon to see similar shops or services spring up in
an area. Imagine that a new sushi restaurant opens up in a district. Soon it is so popular that
there is a line outsidethe door every evening. Other catering entrepreneurs will be attracted to
the possibility of doing so
we11, and so it is likely that another sushi restaurant will open up in the area. It may not
happen immediately, but eventually this is likely to result in a fall in demand for the original
sushi restaurant assome of its customers will switch.
If demand continues to be strong, then even more restaurants will open. Each restaurant will
try to distinguish itself from the othersperhapsby staying open longer, oflering a "Happy
Hour", special theme nights, or free children's meals to namejust a few possibilities.
This product differentiation is also known as non-price competition.
Whatever the short-run situation, in the long run the firms will end up in the position shown
in Figure
9.4, with all making normal profits.
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T?re firms are maximizing profits by producing at the level of output where MC : MR and, at
that output, the cost per unit, C, is equal to the pdce per unit, P Each firm is exactly covering
its costs, including itsopportunity costs, and so there is no incentive for firms to leave the
industry. Firms outside the industry will not enter, since they will be aware that their entrance
would lead to losses for everyone.
PERFECT COMPETITION, MONOPOLY, MONOPOLISTIC COMPETITION, AND
OLIGOPOLY: GRAPHING TIPS
lie at least partially below

the demand curve.
rve must lie entirely above
the demand curve.
TC curve must be tangent to
the demand curve.
the
MR curve.
firm’s demand curve slopes
down to the right. Theoretically, the monopolistic firm has a steeper demand curve than the
monopolistically competitive firm. For both the monopolistic and monopolistically
competitive firms, the MR curve is twice as steep as the demand curve (if the demand curve
is a straight line).
irm is making zero profits, the ATC curve is tangent to
thedemand curve at the minimum of the ATC curve. When the monopolistic or
monopolistically competitive firm is making zero profits, the ATC curve is tangent to the
demand curve at an output level that is lower than the output at the minimum of the ATC
curve. The tangency must be directly above the intersection of the MR and MC curves.
ing zero profits, the
ATC curve is tangent to the demand curve at the kink in the demand curve. This occurs at an
output level that is lower than the output at the minimum of the ATC curve. The tangency
must be directly above the intersection of the MR and MC curves.
207
emand curve model), the MC cost curve intersects the

MR curve in the vertical segment of the MR curve. Each of the downward-sloping segments
of the
MR curve is twice as steep as the corresponding section of the demand curve (if the demand
curve segments are straight lines).
Market failure
Market failure is a concept within economic theory describing when the allocation of goods
and services by free market is not efficient, that is there exist another conceivable outcome
where a market participant may be made better off without making someone worse off.
Market failures can be viewed as scenarios where individuals’ pursuit of pure self-interest
leads to results that are not efficient. The existence of market failure is often used as a
justification for government intervention in a particular market.
What does market failure mean?-It means that we do not have full efficiency; we could
produce more with the resources we have; and we could satisfy consumer demands better
with the resources we have.
There is waste in the system.
Types of efficiency in economics:
A.) Allocative efficiency. This means good resource allocation, when we cannot make any
consumer better off without making some other consumer worse off. This approach looks at
the given resources and tries to get the most output from them and it also means that firms
sell at a fair price to consumers that reflects the real resource use.(p=mc)
B.) Productive efficiency. This means that production is done at the lowest possible cost.
• We are at the bottom of the average cost curve (which is always U-shaped). In that position
we have what is called “X-efficiency”.
• And this means we are also on the production frontier, not somewhere inside it.
A.) Allocative efficiency
Allocative efficiency occurs when the value the consumer puts on a good or services is the
same as the cost of the resources used in producing it. This occurs when price= marginal cost.
In this position, total economic welfare is maximized. In the perfect competition diagram
below, where MC = MR for the firm,we have allocative efficiency because the firm’s price is
the marginal revenue (it can sell any amount at the unchanged price - each extra unit sold at
that price provides the marginal revenue), so MC = P. In fact, at that point we have more
208
equalities MC = P= MR = AR. “AR” is merely another word for price – it is “average

revenue” which we get by dividing total revenue by quantity. We know that quantity
multiplied by price gives us total revenue, so it follows that price actually is average revenue.
B.) Productive efficiency
This exists when we are actually on the production frontier. That means we are using the least
resources we can. In turn, it says that we are at minimum average costs = the bottom of the
AC curve. Perfect competition is like this – so economists prefer this position and you will
recall that it is known as “Xefficiency”
– It is where we are totally efficient.
Where market equilibrium is totally efficient, we cannot make someone better off without
making someone else worse off (this is sometimes called “the Pareto optimum position”).
The production possibility curve:
When we are below the production possibility curve (e.g., at “X” in the diagram below), we
can move north-east and get onto the curve, thus making everyone better off; only when we
are on it do we have proper productive efficiency.And only when we are on it does the
concept of opportunity cost arise. If we are below it, we do not have to give anything up to
get more of the other thing; we can have more of both simply by moving out to the curve.
Note: we can have allocative efficiency and productive efficiency but still have inequity in
the country, which can also stop us reaching “perfection”.
Example 1. If you personally have all the income in your suburb, the other residents will be
poor and might even starve, which does not sound at all like perfect! The market system is
amoral i.e., it is not concerned with good or bad. Economics is not about ethics.
Example 2. Drug dealers could wait at the gates of primary schools, give away drugs for free
to six year old children and in this way build up a market as they become addicted. This
would create a demand, which the drug dealers could then supply later at a price. Most people
would regard this situation as totally wrong, exploitative, and immoral – but the market
would be working - and possibly very “efficiently” too.
Social efficiency matter not just private
We might produce too much or too little as a society, for our own good, even if have perfect
competition and an acceptable distribution of income and nothing illegal or immoral is
occurring. This can happen because of externalities. We move on to consider these next.
Sources of market failures
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goods.
-merit goods.
EXTERNALITIES
Externalities, social cost and private costs
Externalities are said to exist when the actions of producers or consumers affect themselves
as well as third parties who are offered no compensation to the loss generated. Externalities
can be known as external diseconomies and economies as well as third party spill over
effects. They exist because the market cannot deal properly with the side effects of many
economic activities. Externalities involve an interdependence on utility and production
functions. An external benefit or a positive externality refers to the benefit from production or
consumption experienced by people other than the producers or consumers. This occurs when
an externality-generating activity raises the production or the utility of the externality-
affected party. Hence, the economic activity provides incidental benefits to others for whom
they are not specifically intended.
A negative externality or external cost refers to the cost of production or consumption borne
by people other than the consumers or producers. The undesirable effects on the allocation of
resources by an externality can be explained by the Marginal Social Cost (MSC). The
Marginal Social Cost is a sum of the Marginal Private Cost (MPC) and the Marginal External
Cost (MEC). MPC is a share of marginal cost caused by an activity that is paid by the people
who carry out the activity and MEC is the share borne by others. When the firm’s activities
generate negative externalities, its MSC will be greater than MPC.
Since, in equilibrium, the market will yield an output at which consumers marginal benefit is
equal to a firm’s MPC. Thus, as shown in Figure 1, MPB is less than MPC, hence the costs
that is incurred to society outweighs the benefit derived from the good. Consider the soap
industry which, in a free market would discharge waste products into the air and into rivers.
The owners of soap factories being profit
210
maximisers will only consider their private costs and ignore the wider social costs of their
activities. Thus,
MSC is more than MPC.
An example of an activity which generates an external benefit in consumption is vaccination.
If an individual makes a decision to be inoculated against a particular disease, then he will
receive the private benefit of not being infected by that particular disease. However, there are
also other possible benefits to all others with whom he comes into contact as they will not
contract the disease from him. The vaccination protects not only the person who is vaccinated
but also the entire community that person lives in, by preventing the spread of contagious
diseases. Thus, MSB is greater than MPB. The individualsconsider only private benefits and
costs in their consumption decisions. Hence, they will consume OQ1 units where
MPB=MPC. However, the socially efficient output occurs at OQ2, where MSB=MSC. There
is thus an under consumption of Q1Q2 of the good which results in a deadweight loss equal
to the area of
E2BE1. Insufficient scarce resources are being devoted to the production of this product. The
market has failed to allocate resources efficiently.
Private costs are the costs incurred when producing something. Social costs are greater than
private costs.
Social costs include things like pollution and congestion that are suffered by society in
general, not by any one producer.
These problems are called “externalities” i.e., they are external to the firm producing them.
They can be negative externalities (which harm society) or positive externalities (which
help).
Social cost = private cost + externality (if any)
Cost-benefit analysis tries to measure all the costs to society of a project.
We have a diagram for social costs:
Equilibrium will be where private costs cut the demand curve at Qa, as firms try to maximise
profits and charge price OPa for quantity OQa. But because of negative externalities
(pollution maybe), the socially optimum position should be where social costs cut the demand
curve. These would mean producing at
Qb, reading from the social costs curve, and selling at the higher price OPb to cover these
costs.
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NEGATIVE EXTERNALITIES
Common types of negative externalities by producers:
• Air pollution, e.g., smoky factory chimneys.
• Soil pollution, especially by farm chemicals (closely related to the next type).
• Water pollution, e.g., rainwater run-off containing farming pesticides and fertilisers.
• Noise pollution. Do you live near an airport or by a building site?
Some types of negative externalities by consumers:
• Pollution of air and water.
• Soil pollution, e.g., lead pollution in soils from motorcar exhaust emissions.
• Litter on streets; decomposing rubbish in land-fill sites.
• Noise pollution, e.g., motorcycle noise in urban areas, especially when the baffles have been
deliberately removed from the silencer.
• Vandalism; graffiti on walls.
• Smoking and alcohol abuse, causing NHS expenditures to rise.
We are unsure why the urban sparrow population has plummeted in recent decades but it
would seem to be the result of some externality.
POSITIVE EXTERNALITIES
When these exist, society would gain more than the producer – who therefore is producing
less than theoptimal social amount.
Examples include:
• Labour training in firms; one firm may do little, as it knows that when a trained worker
leaves, someone else benefits - but the first firm paid for all the training!
• Education generally.
• Health generally, especially in poor Third World countries.
• The provision of playing fields at or near schools so that the health and sporting skills of the
children improves.
• Free museums and art galleries that can encourage the poor and uneducated to widen their
horizons, educate themselves, and generally improve.
To draw the diagram for positive externalities: just reverse the labeling of the curves of social
cost and private costs above. This is done in the diagram below where you can see that we
produce too little for society if firms profit maximize for them (as they do). They choose to
212
produce at OQa and sell for a price of OPa, but for the greatest good of society they should be
at OQb and selling at the lower price of OPb.
Government intervention may be necessary to correct or offset market failure caused by
negative externalities – usually the government chooses to tax those producing too much, or
they may use the law to prosecute for water pollution or whatever externality the government
is tackling.
There are probably fewer cases of external benefits, but if we find any (such as private firms
training labour well) we can encourage this by tax breaks or subsidies.
Government action with external diseconomies
Government might try (and does):
1. Taxation.
2. Regulation.
3. Perhaps extending property rights.
Let’s think about polluters – what can the government do using the three points above?
a) Taxing polluters
The need is to try to stop the problem being “external” and try to “internalise” it, i.e., to make
the polluter pay for it via a tax. As economists, what we are really doing is trying to get the
firm to stop looking only at the private costs and benefits. In the diagram below, we do this
by putting a tax on, which shifts the supply curve up from “S Private costs” to “Private costs
+ tax”. If we get it right, this moves the equilibrium quantity produced from Qa to the smaller
output Qb.
But there are problems with taxing polluters:
• When it works, output is reduced and prices are higher – but this can reduce the consumer
surplus, which some feel is not a good thing (Unit 4 looks at this concept).
• It is often hard to identify the particular firms that are causing the pollution, and then
determine howmuch each is responsible for the total pollution.
• Poor legislation can hurt the innocent, e.g. households who wish to get rid of large items of
waste may not be allowed to take them to the dump.
• It is not easy to put a monetary figure on the damage pollution is causing.
• Producers can pass on much of the tax to consumers if demand is inelastic and not pay it
themselves.
213
• Taxes on demerit goods (to limit their consumption) can be regressive, i.e., hit poor
households the hardest. The tax on cigarettes does this because the poor are statistically more
likely to smoke than the wealthier.
b) Regulating polluters approach (a second way that can be used in addition to tax)
• Banning cigarette advertising at sporting events, or in places like cinemas.
• Making workplaces no-smoking areas.
• Increasing the penalties for firms that break the regulations.
c) Extending property rights (a third way that can be used)
If a lorry crashes into your garden and destroys the wall and all your trees you can get
compensation – but if a polluting factory puts out acid smoke and destroys the same trees you
cannot.
If we extend property rights so you could sue for compensation, it would make the polluter
think again and perhaps install anti-smoke devices on factory chimneys!
Benefits
• The property owner knows the value of the property better than the government does, so the
figures will probably be more accurate (but owners can, and perhaps would, lie!).
• The polluter is forced to pay those suffering from his or her activities.
Disadvantages
• The damage may occur abroad.
• Global interests and national interests may conflict. The Zimbabwe cannot make Zambia
extend property rights over Zambians trees which are being killed off at a rapid rate.
Trading permits to pollute
Many believe that it is so difficult and expensive to stop companies polluting (identifying
who did it can be impossible e.g., with one stream and dozens of factories discharging into it)
that instead we should auction off the right to pollute. Only those firms that pay a high price
for the limited number of licences would be allowed to pollute. The government could then
use the large sum of money raised to tackle the pollution itself. The end result could be much
better than we currently have.
If we allow a firm to sell its right to pollute (it may have used only 80 per cent of what it is
permitted, for example) then those with the greatest demand for their product, and hence the
most profitable, can buy the remaining 20 per cent. It means the things we most desire still
get produced but the government has the resources to tackle the resulting pollution.
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Coase’s Theorem
Ronald Coase established that there is no need to tax or regulate polluters at all! He saw that
if polluters compensated those suffering, the market would solve it properly, with just enough
“acceptable” pollution occurring and still no one suffers without being compensated.
MONOPOLY
What is a monopoly?
Definition: Technically a monopolist is a sole supplier, that is to say, one firm is the industry.
But there are degrees of monopoly - if one firm supplies, say, eighty per cent of the market, it
is close to being a monopolist and will usually act like one.
If two (or more) firms supply most of the output, it pays them to work together, to act like a
monopoly, and to keep prices high (if there are two firms we call it “a duopoly”).
Types of monopoly, (sometimes called “causes of monopoly”; "sources of monopoly"; or
"conditions for monopoly"
• Economies of scale, i.e. one firm grow large, its costs fall as a result and become lower than
the others, so it can reduce its price and sell more produce. The others cannot compete
because they are small and higher cost. The firm grows to become the sole one, which then
supplies the entire market.
• The result of law – the government may restrict an industry to one huge nationalized firm.
• An agreement between firms, so that all act together as one monopolist - often it is illegal
but it happens.
We call this a cartel. This can happen under oligopoly conditions.
• Exclusive ownership of a unique resource: perhaps there is only one source of supply of a
raw material.
• Copyrights, patents and licenses are particular forms of this exclusive ownership.
• So-called natural monopoly. This is often the result of economies of scale - e.g., electricity
supply.
Problems with monopoly (what is wrong with monopoly or "the welfare effects of
monopoly")
• It limits output and keeps price high - as just said. Really this means that a monopolist
misallocates (and misuses) resources.
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• This behavior of the monopolist redistributes income from all the consumers of the product
(they are paying more than they need) to one firm or person (the monopolist). This is an
equity issue.
• A monopolist may develop political and social power over others which reduces the
efficiency of democracy and the amount of equity.
• A monopolist may behave badly in an anti-social way. For instance, he or she may force out
a potential rival firm by selling at give-away prices (well below cost). After they have forced
out the honest competitor, they will put the price back up again.
• Lack of competition tends to encourage inefficiency in the firm. The monopolist tends to
rest on his laurels, has no need to try hard, and lacks dynamism – this is probably the main
criticism .
• As a result, we can get the emergence of lazy managers and owners.
• And it may mean that technical progress is slow, leading to slow growth of the country as a
whole, and a lower standard of living than we could enjoy.
• A monopoly breeds inefficiency which means that the cost curves will be higher than they
need be; this means that the intersection of MC and MR may be higher.
• Resources are misallocated - too many are going to the monopolist who does not fully use
them. This is a waste for society. It really means that the price mechanism is prevented from
working efficiently.
• A monopoly may reduce consumer choice. He may ignore small market demands as he
cannot be bothered to meet them. As Henry Ford is reputed to have said about his motor cars
“You can have any colour you want, as long as it’s black”.
Benefits of Monopoly
There are few benefits really - economists are almost united in opposition to monopolies, and
many are against both public and private ones – those on the political left wing tend to prefer
public ones more than those on the right wing.
Economists usually favour reducing or ending monopolies and increasing competition.
BUT some defence is possible!
• The monopoly profits can be used for research and development, leading to product
improvement, faster growth, and lower costs.
Joseph Schumpeter's argument on innovation - that big firms are the only ones able to afford
the necessary laboratories and research staff – may apply.
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Against this, research shows that many breakthroughs come from smaller firms, not the large
ones. For instance, Apple computers began in a garage.
• A monopolist may reap economies of scale.
• A redistribution of income is not too bad perhaps:
It is always happening in a dynamic economy anyway. If necessary, it can be corrected by
government action.
Monopolies can lead to underproduction and higher prices than would exist under conditions
of competition. In a free market economy, there is nothing to prevent the emergence of
oligopolies and amonopoly in various industries. The more successful firm acquires other
firms or puts them out ofbusiness. When these imperfect market structures occur, there will
be allocative inefficiency because theygenerate shortages in order to hike up prices and
increase profits.
Public goods
Economic goods can further be subdivided into public and private goods. A public good is
one that has two characteristics that private goods do not. Firstly, public goods are non-
exclusive. This means that a producer or seller cannot separate non payers from benefitting
from the good. As a result, the payer too, eventually does not want to pay. As a consequence,
the market will not produce a public good. This is market failure.
Using the concept of externality for public goods, there are no private benefits or revenue for
the producer at all but more benefit for the society. Examples of public goods are street
lighting, defence and radio broadcasts. The second characteristic is that public goods are non-
exhaustible. This means that the use by one person does not reduce the amount available to
another. As a result, there is no rivalry in consumption. As a result, there is no additional
opportunity cost for the second and third person to use.
Public goods are collectively consumed and the market may simply not supply them; e.g.,
defence of the country (a police force and army), a fire brigade, street lighting, or lighthouses.
The market system does not work well in this area.
Some goods are “semi-public goods”, “quasi-public goods” or “collective consumption
goods”, for instance roads. These are often supplied by the state, but in principle they can be
privately supplied, and sometimes are.
Public goods require
• The lack of ability to exclude (if I am defended, so are you, even if you do not pay)
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• The consumption by one does not reduce the consumption available to the others (if you
walk down the street after dark you do not use up any of the street lighting.)
These two requirements may be called the “non-rivalry” and “non-excludability” features.
One of the jobs of government, both central and local, is to supply public goods or services
that are needed but otherwise would not be made available by the market.
Merit Goods
These are goods with extensive external benefits. These are provided by the market - but in
smaller amounts than are needed for the good of the state. Health and education are the most
obvious ones – there will be some privately-supplied health and education but the state as a
whole benefits if everyone has access to them, not just a few. For instance, in the health area,
the National Health Service tends to reduce mass epidemics; the health service also means
that fewer people will be off work sick. In the case of education, society would not function
as well if half the population could not read the instructions on the label.
Private consumers individually value merit goods less than the state does. The market system
fails to provide enough merit goods which is why the state steps in to make them more
widely available. It does this by subsidizing the production of some merit goods or services.
Merit goods may be targeted at certain groups and rationed; for instance, we might limit
access to higher education to those passing A levels well.It is assumed that such people are
the most intelligent in society.
In the diagram below, a subsidy equal to AB is applied by the government – this shifts the
supply curve downward and to the right. The equilibrium position then moves from P1Q1 to
P2Q2. The result is that more is then consumed at the lower price i.e., the demand for merit
goods has extended.
Demerit goods
Demerit goods are exactly the opposite of merit goods in that they are over-consumed by
individualpeople and this causes problems for the nation as a whole.
Cigarettes are a clear example: they cause unpleasant smoke which is dangerous to people in
the area who are forced to become passive smokers. They also cause cancer and a whole
range of nasty diseases, including emphysema. They inflate the national health bill because
both the smokers and the passive smokers get sick and visit the doctor. But smokers will not
stop, perhaps are unable to stop, because they are addicted.
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Too many demerit goods are demanded, so the government steps in and taxes cigarettes
highly in order to reduce consumption and to raise revenue which is needed anyway to spend
on treating smokers. The government also advertises heavily to try to persuade people to stop
smoking and the young not to start and is seriously considering banning smoking in all public
work places, as Ireland did in 2004. Some individual doctors are also refusing to treat
smokers for smoke-related diseases unless they stop smoking which adds to the pressure.
The effect of the government taxation is in the diagram below. The indirect tax EB is added
vertically to the supply curve, which shifts upward and to the left from S1 to S2.
This reduces the consumption from OQ1 down to OQ2, (a move from the equilibrium point
A to B) as price rises from P1 to P2 and consumers contract up the unchanged demand curve.
Rather than simply relying on tax to decrease the supply curve and force up the price, the
government may also try to tackle the demand side. It can do this in the ways mentioned
above and the diagram is reproduced below.
You will observe that, if successful, the quantity smoked falls.
The government uses both methods, reducing demand and taxing heavily, to deal with
smoking as a demerit activity.
Information failures
Consumers lack information on things like:
• What goods are available and what new goods have recently come onto the market.
• What the quality of the different models or makes available is like.
• How long an item will last before breaking down?
Information lack is particularly common in both the health service and in education where
consumers do not know much - although we now know more than a few years ago.
This lack of perfect knowledge means that we may choose badly through ignorance. The
demand curves would be different, and better, if we did know everything. This means of
course that the existing demand curves do not give us a perfect market solution.
Producers lack information on:
• What new demands are arising and how old ones are starting to change, so the producers
may produce more (or less) than they should.
• What their existing rivals, and any new ones about to emerge, are doing or might do.
Which means that the producers may produce the wrong type of goods or the wrong quantity
of goods?
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We know that in the world in which we live, new firms start up and many die away within the
first two years – they usually got it wrong on the demand for their service or goods in that
particular place, although sometimes they simply were not good enough at the job. In the
process of being born and dying, the firms used up resources (including the labour of the
would-be entrepreneur) in a less than fruitful way.
Workers lack information on:
• All the jobs available now. Many of these will be local but more particularly they are
usually ignorant of opportunities elsewhere in the country or in the EU for that matter. So the
workers may not move to where they are needed though simple lack of knowledge.
• Which industries will grow and which will wither away in the future. This means that
workers may join a firm that will disappear in a few years’ time, throwing them out of work
but not for any fault of their own. Technical change can render whole jobs out of date.
- A real problem is that those leaving school or college may join an industry and train in skills
that will shortly be no longer needed.
So here again the market does not reach the “correct” or optimal solution.
The response to information failures
Private firms gather information and try to sell it. For instance:
• Private Job centres may open up to try to find a job for people. These are mostly in large
cities and for service workers, rather than for manufacturing. Such firms are trying to
improve the flow of information for profit.
• Magazines like “Which?” exist. They test and investigate the quality of goods and services
and publish the results.
• Specialist magazines are produced for things like hi-fi, TV, motorcars, or computers – such
magazines also test and report the results.
• In order to help producers, various trade associations and chambers of commerce gather
information and inform their members about what is happening. They also organise
conferences and set up fact-finding trips abroad and the like.
The state tries to provide information by:
• Establishing job centres.
• Providing advice to careers advisers in schools.
• Issuing pamphlets and working papers to try to improve peoples’ knowledge. The
newspapers pick up this information and may publicise it.
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Overall, as information improves, consumers adjust their demand patterns to favour what fits
their needs best. Producers chose the most suitable and cheapest sources for their inputs. This
of course means the market mechanism then works better to supply what people want and are
willing to pay for.
Factor immobility
The factors of production that we have are land, labour and capital plus a remainder term (L,
N, K, + R) – most economists and textbooks focus on labour immobility, but this is not
guaranteed for the exam
We can also have land immobility
• Some land is good for growing one or two particular crops and not very good at some other
crops. It is not easy to change rice (which needs wet soils) to wheat (which needs drier
conditions).
• It is not possible to move land from where it is to somewhere else.
• Climate change may be occurring and farmers are often traditional, growing what they or
their family have done for years or even generations. They may be unaware of, or refuse to
try growing, a now more suitable crop.
• Economic Union subsidies keep many farmers’ attention on producing the crops that are
highly subsidised (as it gains them a higher income) rather than what might be more suitable
for their land or sell better. Quite often the EU gets it wrong, so we ending up with a lot of
produce that is hard to sell. Dumping it on international markets annoys other countries that
produce such goods efficiently as it reduces their market. Dumping it into the sea causes
criticisms of waste in a world of poverty.
And capital immobility
• Some capital is specific e.g., it makes light bulbs, and it cannot be transferred to another
use, like producing ball point pens.
• Some capital is very big and heavy, e.g., a steel mill, and it is difficult or impossible to
move it to another geographic areas.
• Some old decaying industries may be subsidised by government and continue to exist for
years, well beyond their shelf life. This keeps the capital (and the associated land and labour)
where it is so that it is not released for use where it is more wanted by society. That is to say,
government subsidises prevent factors of production moving to turn out what people now
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demand. The fact that the industry is decaying shows that demand has changed and people no
longer want that good or service as much as they once did.
• Some (usually small) firms stay in business despite making poor profits because the owner
does not want to move or to cease production; or perhaps the owner is too old to bother to
make any major change.
Labour immobility (the really interesting one – we ourselves are people)
Geographic immobility of labour
• People are usually happy where they are: they have got relatives and friends, they know the
town and area, and they are members of various clubs and other social groupings. They do
not wish to move.
• They may not know about the money they could get if they were to move (“information
failure”).
Information failure actually costs money to overcome: people must pay to use the Internet, or
have to buy newspapers and magazines.
• Moving house costs money: there are estate agents’ fees, lawyers’ fees, a government stamp
duty and the cost of transporting furniture and all the other household effects.
• Inertia: people often do not like a big move as they have a sort of fear about it, so they just
stay where they are.
Institutional immobility of labour
• Trade unions and government pass rules or laws that prevent people from entering a new
job easily.
• Pension schemes may tie people into a particular company – if a worker moves, he or she
will probably lose the amount paid in by the employer on their behalf (this can amount to
several thousand dollars).
• Council houses (state subsidised housing) are let below market rents and can prevent people
moving; if they move it means they must give up their cheap house unless they are able to
arrange for a house exchange with another council tenant.
• Foreign-trained doctors may not be allowed to work in the Zimbabwe unless they spend
several years retraining - and not always even then.
Sociological and economic differences causing immobility of labour
• Minority groups often get paid less. For instance, it may be harder for migrants who do not
naturally speak English to find work and to receive the same pay. If they are not selected for
222
avacancy, it renders them less mobile. Even women, hardly a minority, find it hard to get the
same pay as men, despite the existence of long-standing legislation.
• We can think of this as a lower demand curve for them, because employers do not like
hiring them as much.
• Married or very close couples: one may not be able to take a better paid job offered
elsewhere because it would render the other partner unemployed, so total family income
would fall if they moved.
• The skills a person has may not fit the new demand for workers, so he or she would find it
hard to get another job. As demands in society change (taste + higher incomes + new goods +
new technology +\ fashion and trends…) it means new skills are needed and old ones become
redundant. How many chariot wheel makers do we now need?
• Age: once past fifty years, or even forty years of age, it is difficult to get a new job.
Employers often prefer younger people. If an applicant is old, the employer fears that they
will not learn new skills quickly; and if the applicant is older than the employer, he or she
may feel uncomfortable giving them orders and so simply refuse to hire them in the first
place; and old workers who join the firm
will only pay into pension scheme for, say, ten years until they retire, but will take out for
perhaps another thirty years until they die. An ageing population makes this scenario more
common.
Such factors mean that wage differences (and unemployment) can permanently exist between
industries and between regions. The market does not work well enough to equalise wages and
long term wagedifferences persist.
Diagram: the wage of labourers in London and Cornwall: London has a greater supply but a
much greater demand so the curves are further to the right. And of course in London, the
level of wages and thequantity of workers are higher.
What can be done? Government intervention may help produce a better market solution.
Government training and retraining for the new skills that society needs.
The government may improve or alter the educational system and encourage academic
courses to be more geared to the needs of a modern economy (although some intellectuals
disagree and think education should not do this).
We can retrain workers at government expense. The state can pay for retraining courses and
give generous tax breaks to those choosing to receive new skills.
223
The government may tackle the geographic problem

It may pay workers to move; or pay the costs of buying or selling the house; or end (or
reduce) the stamp duty for such people; or pay the unemployed to travel to look at job
opportunities in a new area.
It may subsidise firms to move to old decaying areas. This approach is generally inefficient,
as it means costs will be higher than they need be, as it is probably not a good location for the
firm (which we can assume or the firm would be there already or willing to go without a
subsidy). This would make the
Zimbabwe less competitive with other countries.
The government may allow pension mobility, i.e. when a person leaves a firm he or she can
take their pension rights with them – the new stakeholder pensions do this. The push for
people to take out their own private pensions means that workers are more mobile than they
once were. There is a slight problem in that the rich who are usually already mobile are
taking out stakeholder pensions, but the poor, less mobile, are tending to avoid them.
The government could change the laws as needed
Example 1. The government could make all company pension schemes pay out the
employer’s contribution when worker leaves.
Example 2. The government could make the Zimbabwe Medical Association (ZMA) allow
foreign doctors in to work more easily. The ZMA is rather restrictive and keeps some well-
trained foreign doctors from working in the Zimbabwe unless they requalify or take special
tests. This reduction in supply means there is a permanent shortage of doctors which helps the
ZMA to pressure the government for pay increases, better conditions, or whatever it wants.
Example 3. The government could pass “non ageist” legislation to try to stop older but good
being refused jobs or even fired (government is planning to do this - eventually).
Other areas of law no doubt could be similarly changed – watch the newspapers for articles
and examples that you could quote in the exam room.
COST BENEFIT ANALYSIS (CBA)
Cost-budget analysis (CBA) is a framework for evaluating the social costs and benefits of an
investment project. This involves identifying, measuring and comparing the private costs and
negative externalities of a scheme with its private benefits and positive externalities, using
money as a measure of value.
Step 1: identify all costs and benefits using the principle of opportunity cost
224
Step 2: measure the benefits and costs using money as a unit of account
Step 3: consider the likelihood of the cost or benefit occurring (i.e. sensitivity analysis)
Step 4: take account of the timing of the cost and benefit (i.e. discounting). A £1,000 benefit
now is worth more than £1,000 benefit in 10 years’ time
IDENTIFY ALL COSTS AND BENEFITS
A firm deciding on an investment project will only take account of its own private costs and
benefits e.g. total cost and total revenue. Firms ignore externalities. CBA will take account of
both private and external costs and benefits.
Consider a project to build a bridge over a river:
• Private Costs e.g. construction costs, operating costs and maintenance costs
• External Costs i.e. costs incurred by non-owners (a) monetary e.g. loss of profits to
competitors e.g. to ferry owner and (b) non-monetary e.g. noise, loss of countryside,
inconvenience
• Private benefits direct the amount consumers are prepared to pay e.g. the tolls paid
• External benefits i.e. benefits to non-owners e.g. consumer surplus of users; time savings
for travellers and fewer accidents.
MEASURE THE BENEFITS AND COSTS
Benefits and costs can be valued using money. Private costs and benefits are relatively easy
to measure in monetary terms
Total costs and total revenue.
Private costs build the bridge: £5,000, 000 to operate it £200,000 a year, to repair and
maintain £ 50,000
Private benefits 1,000,000 users each paying £1 each = £1,000,000 a year
Externalities are more difficult to measure:
• Noise or loss of countryside. What value do people place on these? By how much do those
who suffer need to be compensated Ask them using a questionnaire! If 50,000 affected
people value the annual loss of countryside at
£5 then cost = £250,000
• Time savings. What value do we place on work time saved or leisure time saved? Is the
time saved worth the same to everyone? If 100,000 hours re saved and valued at £4 per hour,
benefit = £400,000
225
• Fewer accidents. Economists value human life using money. One life = £750,000. If the
bridge saves on life a year, annual benefit is £750,000
LIKELIHOOD OF THE COST OR BENEFIT
If there is a 50% chance that a life will be saved then the benefit is
£750,000 x 0.5 = £375,000
THE TIMING OF THE COST AND BENEFIT
The major cost of the project occurs straight away. The benefits occur over the life of the
project. The bridge may cost £5m to build but consumers benefit by £1m a year. If the
expected life of the bridge is 25 years then economists use discounting to value now the £1m
of benefit in 25 years’ time. Commonly therate of interest or inflation is used to discount the
future earnings as the £1m in 25 years’ time will be worth substantially less today.
IS A PROJECT WORTH UNDERTAKING?
Yes if discounted benefits outweigh discounted costs. If the government has to choose
between competing projects then the ones with the highest positive net present.
GENERAL POINTS REGARDING CBA
Here are some common examples that can be applied to many CBAs they will hopefully
assist you in answering any question.
The most common external costs arising from production are:
• Noise.
• Pollution of atmosphere, rivers etc...
• Danger to workers and public.
• Congestion.
The most common external costs arising from consumption are:
• Pollution from motor vehicles.
• Litter.
• Noise pollution.
• Externalities from smoking and drinking alcohol.
External benefits from production and consumption are often grouped together, the
Following are the most commonly used examples:
• Industrial training by firms.
• Education which leads to an increase in human capital.
• Healthcare.
226
• Knowledge.
• Employment created.
• Arts and sports.
• Neighborhood watch schemes.
A range of different projects often attract cost-benefit analysis, e.g.
• The building of a new road.
• The building of new airport/runway.
• The expansion of a factory.
• The building of a supermarket.
• The provision of a public or merit good.
There are a number of problems with cost-benefit analysis:
• If the project leads to a time saving, it can often be difficult to place a value on the time
saved.
• Lives maybe saved, again what value do we place on a life?
• How do we place a monetary value on an eyesore, pollution or illness? These require a level
ofjudgment that may vary from person to person.
• Over time the value of the benefits will fall as inflation erodes the value of the pound.
Any future benefits would have to be discounted.
It is accepted that cost-benefit analysis can be an imprecise; however it is deemed to be better
than making no attempt to recognise the externalities at all. Due to the amount of judgment
involved when coming to the figures and discount rate the results should be viewed with
caution. All of the assumptions made in the cost-benefit analysis should be explicitly stated.
It is important to note who is carrying out the cost-benefit analysis and do they have a
particular agenda,
i.e., do they want the project in question to be approved/turn down?
Depending upon their stance will affect what data they choose to include and their methods
of interpreting it.
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An Introduction To A Level Economics

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BRIAN ROPI ADVANCED LEVEL ECONOMICS

AN INTRODUCTION TO A LEVEL ECONOMICS

Important elements in the definition

THINK LIKE AN ECONOMIST 1

THINK LIKE AN ECONOMIST 2

Pitfalls to Sound Economic Reasoning

THINK LIKE AN ECONOMIST 3

THINK LIKE AN ECONOMIST 4

The Central Problem of Economics

THINK LIKE AN ECONOMIST 5

THINK LIKE AN ECONOMIST 6

Scarcity, choice and opportunity cost

THINK LIKE AN ECONOMIST 7

THINK LIKE AN ECONOMIST 8

THINK LIKE AN ECONOMIST 9

THE PRODUCTION POSSIBILITY CURVE (PPC)

THINK LIKE AN ECONOMIST 10

PPC and opportunity cost

THINK LIKE AN ECONOMIST 11

A ppc illustrates the following economic ideas:-

Shifts in the ppc

A ppc can shift outwards due to the following reasons

THINK LIKE AN ECONOMIST 12

 Discovery of new resources

THINK LIKE AN ECONOMIST 13

A ppc can shift inwards due to the following reasons:-

THINK LIKE AN ECONOMIST 14

The slope of the ppc/Types of ppc

THINK LIKE AN ECONOMIST 15

The Law of Increasing Costs

THINK LIKE AN ECONOMIST 16

THINK LIKE AN ECONOMIST 17

THINK LIKE AN ECONOMIST 18

THINK LIKE AN ECONOMIST 19

Advantages of market economy

THINK LIKE AN ECONOMIST 20

THE DISADVANTAGES OF A TOTALLY FREE MARKET

THINK LIKE AN ECONOMIST 21

THINK LIKE AN ECONOMIST 22

Functions of the Price Mechanism

THINK LIKE AN ECONOMIST 23

The transmission of preferences

THINK LIKE AN ECONOMIST 24

Adam Smith and the Invisible Hand

THINK LIKE AN ECONOMIST 25

Government intervention in the market

THINK LIKE AN ECONOMIST 26

Advantages of planned economy

THINK LIKE AN ECONOMIST 27

 There is no incentive to save, invest/ to be innovative because of no profits.

THINK LIKE AN ECONOMIST 28

THINK LIKE AN ECONOMIST 29

THINK LIKE AN ECONOMIST 30

5. Provision of public goods and merit goods

The Theory of Demand

THINK LIKE AN ECONOMIST 31

THINK LIKE AN ECONOMIST 32

THINK LIKE AN ECONOMIST 33

THINK LIKE AN ECONOMIST 34

The Demand Curve

THINK LIKE AN ECONOMIST 35

THINK LIKE AN ECONOMIST 36