RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS
Micro 1

Chapter – One
The Subject Matter of Economics
1.1. Definition and Nature of Economics
Economics is one of the most exciting disciplines in social sciences. Different economists
define economics in different ways. Although there are different definitions of economics the
most agreed up on one is:
Definition: Economics is the study of the efficient allocation of scarce resources (which
often do have alternative uses) in the production, distribution &consumption of goods and
services, so as to attain the maximum fulfillment of unlimited human wants or needs.
The above definition of economics clearly indicates that there are two fundamental facts
which are the foundation for the field of economics.
 The first fact is: human wants (needs) are unlimited
 The second fact is: economic resources -the means of producing goods and
services are limited in supply or scarce.
The need to balance unlimited wants with limited resources has raised the question of
efficient utilization of scarce resources by minimizing loss or wastage.
Labor: - refers to the physical as well as mental efforts of human beings in the production
and distribution of goods and services.
- The reward for labor is called wages.
Land: refers to the natural resources or all the free gifts of nature usable in the production of
goods and services.
- The reward for the services of land is known as rent.
Capital: - refers to all the manufactured inputs that can be used to produce other goods &
services. Example: equipment, machinery, transport and communication facilities,
etc.
- The reward for the services of capital is called interest.
Entrepreneurship:-refers to a special type of human talent that helps to organize and
manage other factors of production to produce goods and services and
takes risk of making loses.
Scarcity: The fundamental economic problem that any human society faces is the problem of
scarcity. Scarcity refers to the fact that all economic resources that a
society needs to produce goods and services are finite or limited in
supply. But their being limited should be expressed in relation to human
wants
 WHY WE STUDY ECONOMICS?
The knowledge of economics is important in;
 Wisely allocating scarce resources to satisfy the unlimited human wants
 Efficiently managing your business , since it deals about
price ,cost ,profit ,market, production, saving ,investment etc

Introduction to Economics By: Chernet A.

 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

 A better understanding of the economic problems of societies ,such as rising

unemployment, inflation, budget deficit, external debt, economic growth etc
 Formulating different policies. Presidents and prime ministers seek the help of
economists during the formulation of economic policies.
1.2. Scope of Economics (Branches of Economics)
Generally, economics can be analyzed at micro and macro level.
A) Micro-economics:- is concerned with the economic behavior of individual decision
making units such as households, firms, markets and industries
Some of the issues that are studied in microeconomics are:-
i) The behavior of consumers in maximizing satisfaction.
ii) How business firms make decision as to what, how, and for whom to produce
outputs so as to maximize profits.
iii) How prices of products and inputs are determined in product and factor markets.
iv) The different types of markets and how each type of markets affects the efficiency
of producers and the welfare of consumers, etc.
B) Macro-economics: - is a branch of economics which studies (analyses) the
economy as a whole and sub-aggregates.
Example: -Total output level (GDP/GNP) of an economy
- Total employment (Unemployment) level.
- General Price level, etc.
1.3. Scarcity, Choice and Opportunity Cost
1.3.1. Scarcity: The fundamental economic problem that any human society faces is the
problem of scarcity. Scarcity refers to the fact that all economic resources
that a society needs to produce goods and services are finite or limited in
supply. But their being limited should be expressed in relation to human
wants. Thus the term scarcity reflects the imbalance between our wants and
the means to satisfy those wants.
Resources Free resources: - A resource is said to be free if the amount available to
a society is greater than the amount people desire at
zero price. E.g. sunshine, air etc.
Scarce (economic) resources: - A resource is said to be scarce or

Introduction to Economics By: Chernet A.

 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

Economic resource when the amount available to a society is less than what people want to
have at zero prices. Example, labor, land, capital, entrepreneur, etc.
Labor: - refers to the physical as well as mental efforts of human beings in the production
and distribution of goods and services.
- The reward for labor is called wages.
Land: refers to the natural resources or all the free gifts of nature usable in the production of
goods and services.
- The reward for the services of land is known as rent.
Capital: - refers to all the manufactured inputs that can be used to produce other goods &
services. Example: equipment, machinery, transport and communication facilities,
etc.
- The reward for the services of capital is called interest.
Entrepreneurship: -refers to a special type of human talent that helps to organize and
manage other factors of production to produce goods and services and
takes risk of making loses.
Entrepreneurs are peopling who:
a) Organize factors of production to produce goods & services.
b) Make basic business policy decisions.
c) Introduce new inventions and technologies into business practice.
d) Look for new business opportunities.
e) Take risks of making losses.
 The reward for entrepreneurship is called profit.
Note: - Scarcity does not mean shortage. We have already said that a good is said to be
scarce if the amount available is less than the amount people wish to have at zero price. But
we say that there is shortage of goods and services when people cannot get the amount they
want at the prevailing or on going price. Shortage is a specific and short term problem but
scarcity is a universal and everlasting problem.
1.3.2. Choice
If resources are scarce, then output would be limited. If output is limited, then we can not
satisfy all of our wants Thus, choice must be made. Due to the problem of scarcity,
individuals, firms and government are forced to choose as to what output to produce, in what
quantity, and what output not to produce. In short, scarcity implies choice.

Introduction to Economics By: Chernet A.

 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

Choice, in turn, implies cost. That means whenever choice is made, an alternative opportunity
is sacrificed. This cost is known as opportunity cost.
1.3.3. Opportunity Cost
In a world of scarcity, a decision to have more of one thing, at the same time, means a
decision to have less of another thing. The value of the next best alternative that must be
sacrificed is, therefore, the opportunity cost of the decision.
Definition: Opportunity cost is the amount or value of the next best alternative that must be
sacrificed (forgone) in order to obtain one more unit of a product.
1.3.4. The Production Possibilities Frontier or Curve (PPF/ PPC)
The production possibilities frontier (PPF) is a curve that shows the various possible
combinations of goods and services that the society can produce given its resources and
technology.
To draw the PPF we need the following assumptions.
a. The quantity as well as quality of economic resource available for use during
the year is fixed.
b. There are two broad classes of output to be produced over the year.
c. The economy is operating at full employment and is achieving full production
(efficiency).
d. Technology does not change during the year.
e. Some inputs are better adapted to the production of one good than to the
production of the other (specialization).
Example: Consider the following hypothetical data stated in table 1.1.to draw PPF/PPC
graphically;
Table 1.1. Alternative production possibilities of a certain nation.
Types of Unit Production alternatives
products A B C D E
Food In metric 500 420 320 180 0
tons
Computer In no, 0 500 1000 1500 2000

Introduction to Economics By: Chernet A.

 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

Food A
500
B .R - All points on the
420 PPF are attainable
and efficient
320 Q C - Point Q is
attainable but
180 D inefficient
- Point R is
unattainable

E
500 Frontier
Fig. 1.1 Production possibilities 1000 1500 2000 Computer

 A society is said to be efficient when it cannot produce more of one good without
producing less of another
 The PPF describes three important concepts:
i) The concepts of scarcity: - The society cannot have unlimited amount of
outputs even if it employs all of its resources and utilizes them in the best
possible way.
ii) The concept of choice: - any movement on the curve indicates the change
in choice.
iii) The concept of opportunity cost: - when the economy produces on the
PPF, production of more of one good requires sacrificing some of another
product. It is reflected by the downward sloping of the PPF.
The Law of Increasing Opportunity Cost
This law states that as we produce more and more of a product, the opportunity cost per unit
of the additional output increases. This makes the shape of the PPF concave to the origin.
The reason why opportunity cost increases when we produce more of one good is that
economic resources are not completely adaptable to alternative uses (specialization effect)
Opportunity cost of a good = the amount of the next best alternative sacrificed
The amount of another good gained
Example: - Referring to table 1:1 above;

Introduction to Economics By: Chernet A.

 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

Suppose currently the economy is operating at point B, what is the opportunity cost of
producing one more unit of computer?
Solution: Moving from production alternative B to C we have:
320−420 −100
OC= =| |=0.2
1000−500 500 (Scarifying 0.2 metric tons of food per computer)
1.4. Basic Economic Questions and the Alternative Economic Systems
1.4.1. Basic Economic Questions
In connection with the problem of scarcity, any human society should answer the following
three basic questions.
1. What to produce and in what quantities: - Given the problem of scarcity, any human
society should decide on what outputs to produce and what not to produce.
2. How to produce: - this is a question of technological choice. That is, does a country
use labor-intensive or capital-intensive technology?
3. For whom to produce: - This is a question of distribution.
1.4.2. Alternative Economic systems
The way a society tries to answer the above fundamental questions is summarized by a
concept known as economic system. An economic system is a set of organizational and
institutional arrangements established to answer the basic economic questions.
Customarily, we can identify three types of economic system.
A. Pure capitalism
B. Command economy
C. Mixed economy
A) Pure capitalism: - also known as market economy or laissez- faire.
In pure capitalism, the three basic economic questions are answered as follows.
 Firms address the “what to produce” question by producing those goods and
services that give them the maximum possible profit.
 The “how to produce” question is answered by choosing the technique of
production which are least costly.
 The “for whom to produce” question is addressed depending on peoples decision as
to how they spend their income.
In pure capitalism, economic activities are coordinated and directed through market
mechanisms.

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

Advantages of pure capitalism- It promotes economic efficiency

Disadvantage: - It leads to market failure.
Some sources of market failure are:
 - becauseof the presence of externalities
 - public goods
 - Monopoly power
 - Asymmetric information, etc.
B) Command Economy: unlike pure capitalism, command economy is characterized by:
- Public ownership of property / resources.
- Economic activities are co-ordinate and directed by the government through a
central planning committee.
- In such a system, the three basic questions are addressed by the government.
Advantage: - Fair distribution of income
- Absence of private monopolistic power
Disadvantage: - economic inefficiency.
C) Mixed Economy: - the mixed economy system takes the strong elements of pure
capitalism and command economy. In such a system, both the government and the market
decide on the questions of what, how and for whom to produces
1.5. Decision making units and the circular flow of economic activities
1.5.1. Decision making units
Generally, there are three decision making units in a closed economy. They are households,
firms, and the government.
i) Household: - A household can be one person or more who live under one roof and
make joint financial decisions.
Households make two decisions
a) Selling of their resources, and
b) Buying of goods and services.
ii) Firm: - A firm is a production unit that uses economic resources to produce goods
and services. Firms also make two decisions:
a) Buying of economic resources
b) Selling of their products.

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

iii) Government: - A government is a set of organizations that have legal and political
power to control or influence households, firms and markets. Government also
provides some types of goods and services known as public goods and services in a
society.
1.5.2. The circular flow of economic activities
The above mentioned economic agents interact in two markets:
i) Resource markets where resources are bought and sold.
ii) Product markets where final products are bought and sold
iii)
Look at the following three – sector circular flow model

Resource Money income

Markets
costs
Labor,land,capital
for factors
Demand

Payme
nt

resources
Income Households
Firms Government
Subsidies support

Taxes taxes
G&S Payment

Goods&services Goods and services

Product
markets
Revenue Consumption exp.

Fig 1.3 Three sector circular flow of resources

In order to produce goods and services, firms require resources .To acquire the resources they
need, they go to the resource market and buy the required resources. Firms pay money to the
resource suppliers- households. What firms pay is considered as cost of production. Households
receive income in the form of wages, rent, interest and profit.

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

Once firms buy those resources, they combine them and produce goods and services and supply
to the market. Households, on the other hand, require those goods and services in order to satisfy
their material wants. Now, firms as suppliers of goods and services, and households as demanders
of those goods and services interact in the product market.
As mentioned earlier, a government produces and supplies some goods and services such as
public education, public health services, defense services, street light etc. To produce those goods
and services, it needs resources. It can get resources from the resource markets where households
supply them. Once it acquires the necessary inputs, then the government would produce and
supply those goods and services to firms and households. But to provide those goods and
services, the government needs finance. It will get the money from households and firms in the
form of taxes.

Introduction to Economics By: Chernet A.

 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

Chapter Two
The Theory of Consumer Behavior
Introduction
In our day to day life, we buy different goods and services for consumption. As
consumers ,we act to drive satisfaction by consuming goods and services. But have you ever
thought of our decision or the decision made by our parents to buy those consumption goods
and services? This is what we are going to discuss in this chapter.
2.1. The Meaning of utility
Before discussing the concept of utility, let us first point out some of the assumptions that
economists make about the average consumer.
1. An average consumer is rational. That means:
a) A consumer has a clear-cut preference,i.e, the consumer is able to compare
any two bundles X and Y and decide which one he/she prefers.
b) A consumer has a persistent (transitive) preference.Forexample , given three
consumption bundles X, Y and Z, if X> Y, and Y>Z, then he/she prefers X to
Z (X>Z).
2. The consumer is not free in his/her choice. This means the consumer’s choice is
constrained by his/her income level and the prices of goods and services.
Definitions:
 Utility is defined as the power of a product to satisfy human wants. In other
words “Utility is the quality of good to satisfy a want.”
 According to Mrs. Robinson, “Utility is the quality in commodities that
makesindividuals wants to buy them”
 Utility is the word used to describe the pleasure or satisfaction or benefit derived
by a person from consuming goods.
Important Points to note:
1. Utility is Subjective: as it deals with the mental satisfaction of a man. A thing may have
different utility to different persons.
E.g. Liquor has uti lity for drunkard but for person who is teetotaler, it has no utility.
2. Utility is Relative: As a utility of a commodity never remains the same. It varies with time
and place.
E.g. Cooler has utility in summer not during winter season.

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

3. Utility is not essentially Useful: A commodity having utility need not be useful.
E.g. Liquor and cigarette are not useful, but if these things satisfy the want of addict then they
have utility for him.
4. Utility is independent of Morality: It has nothing to do with morality. Use of opium
liquor may not be proper from moral point of view, but as these intoxicants satisfy wants of
the opium – eaters, drunkards, they have utility.
2.2. Theories of Utility
There are two approaches to measure or compare consumer’s utility derived from
consumption of goods and services.
2.2.1. The Cardinal Utility Theory
According to the cardinalist approach, utility is measurable using arbitrary unit of
measurement called ‘util’ in the form of 1util, 2utils, 3utils,etc.
For example, consumption of an orange gives Almaz 10 utils,and a banana gives her 7
utils From this we can say that an orange gives Almaz more utility than that of a banana.
According to the cardinal utility approach, there fore, utility is measurable and
comparable.
A. Total Utility (TU): is the total satisfaction or pleasure a consumer derives from
consuming a specific quantity of a commodity at a particular time.
B. Marginal Utility (MU): refers to the extra satisfaction or pleasure a consumer derives
from consuming one more unit of a commodity.
Mathematically:
MU= ΔTU Where, ΔTU = change in total utility
ΔQΔQ = change in the amount of the product consumed

Marginal utility can be:

a) Positive Marginal Utility: If by consuming additional units of commodity, total
utility goes on increasing, then marginal utility of these units will be positive.
b) Zero Marginal Utility: If the consumption of additional unit of commodity
causes no change in the total utility, it means the marginal utility of additional unit
is zero.
c) Negative Marginal Utility: If the consumption of an additional unit of a

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

commodity causes fall in total utility, it means the marginal utility is negative.
For N commodities case
MUnth = TUn – TUn-1; Where
MUnth = Marginal utility of nth unit.
TUn = Total utility of n units.
TUn-1 = Total utility of n-1 unit
Example : Table 3.1 , Total and Marginal utility
Banana consumed per hour Total utility in utils Marginal utility
0 0 -
1 11 11
2 19 8
3 25 6
4 29 4
5 31 2
6 31 0
7 28 -3

Graphically, the above data can be represented as follows.

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

70-

60-
Total

50- TU curve
utility

40-

30-

20-

10-
0 2 3 4 5 6 7 8 Quantity

70-

60-

50-

40-

30- MU
Marginal

20-
utility

10-

0 1 2 3 4 5 6 7 8 Quantity
Fig.3.1 Total and marginal utility.

The law of diminishing marginal utility

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
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This law states that other things remaining constant, consuming successive units of a
product gives a consumer less and less extra satisfaction (utility). This law is based on the
assumptions that:
 The consumer is rational
 The consumer consumes identical or homogenous product.
 There is no time gap in the consumption of the good.
 The consumer taste/preference remain unchanged.

Consumer Equilibrium:- cardinal utility approach

Consumer Equilibrium: is the point where a rational consumer maximize his/her total
utility given his/her income and prices of the commoditiesAs mentioned earlier, a consumer
is assumed to be a utility maximize.Analyzing consumer’s equilibrium requires answering the
question as to how a consumer allocates his money income among the various goods and
services he/she consumes.

Consumer equilibrium:- One commodity case

We begin with a simple model of one commoditycase (say X). The consumer can either buy
X or retain his money income M. Under these conditions the consumer is in equilibrium
when the marginal utility of X is equated to its market price (PX). Symbolically we have:

MUX= PX

If MUX>PX, the consumer can increase his welfare by purchasing more units of X.(Which
result in decrease in MU of X)

Similarly if MUX< PX, the consumer can increase his total satisfaction by cutting down the
quantity of X and keeping more of his income unspent.

Therefore, he/she attains maximum utility when:

MUX= PX

A case of more than one commodity:

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

If there are more commodities, the condition for the equilibrium of the consumer is
the equality of the ratio of the marginal utilities of the individual commodities to
their prices. i.e.

MU X MU Y MU N
i) P X = P Y …………… P N , and

ii) PXX + PYY +-----------------+ PNN =M , where M is money income.

Example: Given a utility function of the form:

U(x,y) = 4x2 + 3xy +6y2: maximize utility subject to the budget constraint:

x + y = 56

Solution: The equilibrium condition is given by:

MU X MU Y
PX = PY

Thus, MUX = 8x + 3y, and px = 1

MUY = 12y + 3x, and py = 1

Applying the equilibrium condition, we have:

X = 36, and Y = 20. Therefore, the consumer purchases 20 units of good Y and 36
units of good X.

2.2.2. The Ordinal Theory of Utility (The Indifference Curve Approach)

Unlike the cardinal utility theory, the ordinal utility theory says that utility is not
measurable rather, the consumer can rank or order the utility he/she derives from
consuming different goods & services.

For example, if a consumer is subjected to three consumption bundles X, Y and Z,

he/she can rank or order his/her preference as :

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

1st preference = Y 1st = X

2nd preference =Z or 2nd = Z

3rd preference =X 3rd = Y, or any other ordering.

The ordinal utility theory provides another method of studying the consumer
behavior. Since it uses indifference curves to study consumer’s behavior, this theory
is also known as the indifference curve approach.

Indifference Set, Curve and Map

The indifference curve approach is based on the following assumptions;

1. The consumer is rational (utility maximize )

2. The consumer can simply order /rank his/her performances.

3. There is diminishing marginal rate of substitution.

4. The consumer’s preference is transitive.

A) Indifference set: An indifference set is a combination of goods for which the

consumer is indifferent.

Eg. Combination Qx Qy

A 10 2

B 6 4

C 3 6

D 2 8

Note:-Each combination gives the consumer equal level of total utility.

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
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B). Indifference Curve: - An indifference curve is a line (curve) that

connects all possible combinations of goods and services which gives the
consumerequal total utility.

Fig 3.2 An indifference curve

C. Indifference Map:- is a set of indifference curve

Qy

U3
U2

U1

Qx

Fig: 3.1 An indifference curve and map.

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
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Properties of an indifference curve:

i). An indifference curve is downward slopping.
ii). It is convex to the origin (reflects diminishing marginal rate of substitution).
iii). Indifference curves never cross each other. If they do, the consumer is not consistent in
his/her choice.

Marginal Rate of Substitution (MRS)

The MRS is the rate by which the consumer is willing to give up (scarify) a good so as to
obtain more of another good holding total utility constant. Consider the following figure.
Y

X
In the above figure, in moving from point ‘a’ to ‘b’ the consumer is willing to scarify good
good Y. to get more ofX

In short, for two goods X&Y, the MRS of good X for Y shows the amount of good Y the
consumer is willing to give up so as to get more units of good X, holding total utility
constant. Mathematically:
MRS xy =Δy = The amount of good Ysacrificed = The slope of the
Δx The amount of good X gained Indifference curve

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

Budget constraint of the consumer

The consumer has a given income, which set limits to his maximizing behavior. Income acts
as a constraint in the attempt for maximizing utility. The income constraint, in the case of two
commodities, may be written as:
M= PXQX+PYQY
Where, M= money income
PX = price of good X

PY = Price of good Y

We may represent the income constraint graphically using the budget line; whose
equation is derived from the budget equation by solving for QY.
M
−PXQX
QY= PY ,if QX=0, i.e ,if the
Consumer spends all his income on Y, he/she can buy
QY=M/PY units of Y. similarly
M −PYQY
QX= PX , If the consumer spends all his income on X) i.e at QY =0
M
QX= PX

This assumption shows that the commodities can substitute one another,
Y

=A

−PX
Slope= PY

0 X

B=

Mathematically, the slope of the budget line is the derivative

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
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∂QY PX M / PY PX
= = =
∂Qx PY M / PX PY
Equilibrium of the consumer (The indifference curve Analysis)
A consumer gets the maximum possible total utility when he buys that combination of goods
or services at which the budget line is tangent to the highest attainable indifference curve.
That is: MRS must be equal to the ratio of commodity prices. Considering the earlier two
commodity model, we have;
MRSX,Y= MUX/MUY = PX/PY
(Slope of IC) (Slope of the budget line)

Y PX
At point E, MRSX,Y = PY ,
equilibrium is at the point of
M/PY
tangency of IC2 with the budget
line. Question: Can point R and S be
R U unattainable
utility maximizing points? If yes
E
explain it If No why?
AttainableIC3
S IC2
T IC1

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
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Chapter Three
Theory of production
3.1 Theories of production

Introduction:- As we have discussed in chapter one “how to produce” is one of the basic
economic problem common to every economic system. The theory of production is
concerned to deal with this question.

The objective of this chapter is to enable the student achieve in-depth knowledge
about the following concepts of theory of production:

 production and production function

 Iso-quant curves and their properties

 The short run and long run laws of production

 optimum combination of inputs

3.1.1Definition of concepts:
Production:- is a process by which resources are transformed in to final goods and services.
Inputs to production: - are factors of production that go into the production of goods and
services.
Fixed inputs:- are inputs whose supply can not be varied over the time period under
consideration.
Variable inputs:- are those the supply of which can be varied in the short run.
Short –run period :- is a time period over which at least one input is fixed.
Long – run period :- is a period of time in which all inputs are variable.
Note that:- short – run doesn’t refer to relatively short period of time like a year or less, and
long- run doesn’t refer to a period of time greater than a year. They rather refer to the nature
of economic adjustment in the firm to changing economic environment.
Production function:-describes the technological relationship between inputs & outputs.
Example: Q = f( L, K, Ld, R…..)
Where; Q= Output

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L= Labor
K= Capital
Ld= land
R= Raw materials
3.1.2Production in the Short – Run
consider that a farmer wants to produce wheat on one hectar of land. To produce wheat, he
needs land, labour, fertilizer, water and some equipment. Assume that all of the inputs except
labour are fixed at a certain quantity. Look at the following hypothetical data with labor the
variable input, and land a fixed input.

Given Q = f (L, L̄a )

Table-4.1: Short run production
Land Number of Out put Average Marginal Stage of
workers (Q) product product production
(APL) (MPL)
1 hectare 0 0 - 0
“ 1 2 2 2
“ 2 5 2.5 3 Stage – I
“ 3 9 3 4
“ 4 12 3 3
“ 5 14 2.8 2
“ 6 15 2.5 1 Stage – II
“ 7 15 2.14 0
“ 8 14 1.75 -1 Stage – III

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Micro 1

Graphically:

TP Stage

Stage – I II Stage –III

TP, ( Q= f(L, L̄a ))

7 Labour

MPL
APL

AP
MP
Fig 3.1 Total, average and marginal products

Total output ( total product):- describes the total amount of output produced during some
period of time
Average product ( AP) :- is the total product per unit of the variable input.
TP L Q
=
APL = L L
Marginal product (MP):- is a change in total product resulting from one unit change in the
variable input.
ΔTPL ΔQ
=
MPL= ΔL ΔL
Stage of production: The short run production function can generally be classified into three
stages of production.

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Stage – I :- It goes from the origin up to the point where average product is maximum (i.e.
AP = MP).
- In this stage total product increases at an increasing rate.
- In stage – I each additional unit of labour contributes more than the average (i.e.
MP > AP).
- In this stage the fixed input is underutilized.
Stage – II :- It goes from the point where the AP is maximum to the point where MP is zero (
i.e. TP is maximum).
- In this stage TP increases at a decreasing rate.
- In stage – II, AP> MP.
Stage – III: - It covers the range over which the marginal product is zero.
- In this stage TP diminishes.
- In stage – II, the additional unit of labor contributes negatively to total product.
- Since there is over employment of the variable input, the fixed input is over
utilized.
- In this stage, AP > MP.
Note: -A rational producer should produce in stage – II where marginal product of the
variable input is positive but diminishing (why?)
The law of diminishing Marginal Returns
The law states that as an increasing amount of a variable input is combined with fixed inputs,
eventually the contribution of each additional amount of the variable input to the total product
declines. This is due to the fact that the amount of the fixed input per unit of the variable
input declines. The law starts to operate after the marginal product curve reaches its
maximum.4.1.3Production with Two Variable Inputs: Isoquants

Definition – An iso-quant is a firm’s counter part of the consumer’s indifference curve. An

iso –quant is a curve that shows all the combinations of inputs that yield the same level of
output. In this context, “iso” means equal and “quant” means quantity, thus an iso-quant
represents a constant quantity of output.

The concept of iso-quant schedule can be easily explained with the help of the table given
below.

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DEPARTMENT OF ECONOMICS
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Table 3.2: Iso-quant schedule showing different combination of labor and capital

Combination of Units of Units of capital Out put of cloth

Labor& capital labor (L) (K) (meters)
A 5 9 100
B 10 6 100
C 15 4 100
D 20 3 100

Combinations A, B, C and D show the possibility of producing 100 meters of cloth by

applying various combinations of labor and capital.

Iso-quant map – is a set of iso-quants that show the maximum attainable output from any
given combination of inputs.

Capital Capital A

IQ3 = 300 8 B

IQ2= 200 6 C D Q=100

IQ1= 100 4

Labor 5 10 15 20 Lab

B) An iso-quant map A) An iso-quant curve

Fig 4.2 the Iso-quant curve and map

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DEPARTMENT OF ECONOMICS
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3.1.3.1 Properties of iso-quants

1. An Iso-quants slopes down ward. As the use of one variable in put increase, the quantity
of the other variable input should decreases so as to produce the same level of total
product.

2. Iso-quants are convex to the origin: convexity of is-quants implies not only the negative
shape but also a diminishing rate of Marginal Rate of Technical Substitution.

3. Iso- quants can not intersect or be tangent to each other. Intersection or tangency of two
iso-quants implies that a certain combination of L and K can produce two different
quantities.

4. Upper iso-quants represent higher level of output. An upper iso-quant always means a
higher level of output because any point on it (with in the economic region) indicates a
larger input combination than a lower iso-quant, with either higher level of capital or
labor or both.

3.1.3.2Marginal Rate of Technical Substitution (MRTS)

Marginal Rate of Technical Substitution is the rate at which one input can be substituted for
another with out changing the level of output. In other words the MRTS of labor for capital
may be defined as the number of capital, which can be replaced by one unit of labor,keeping
the level of out put constant. In mathematical terms;
MRTS L,K = - K = slope of iso-quant
L

The concept of MRTSLK can be easily understood from the table below

Table 3.3:Marginal Rate of Technical Substitution

Combination of Units of Units of out put of MRTSLK
L and K Labor (L) capital (K) cloth (meters) -
A 5 9 100
B 10 6 100 3:5
C 15 4 100 2:5
D 20 3 100 1:5

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DEPARTMENT OF ECONOMICS
Micro 1

In the above table all the four factor combinations A, B, C and D produce the same level of
out put.i.e,100 meters of cloth. They are all iso –product combinations. As we move from
combination A to combination B, it is clear that 3 units of capital can be replaced by 5 units
of labor, hence MRTSLK is 3:5. similarly, when we move from combination B to C, 2 units of
capital is replaced by 5 units of labour, and so on.

MRTS and Marginal Products:

MRTSLK = MPL
MPK
To prove this, according to the definition; output remains constant on the iso– quant curve.
More over the loss in physical output from a small reduction in capital will be equal to the
gain in physical output from a small increment in labor.
Thus;

The loss in output due to reduction in capital is given as (-) MPK(K)

The gain in output due to increase in labor is given as (+) MPL (L)

To maintain same level of output the above two conditions should be equal

(-) MPKK = (+) MPLL, Rearranging these we find;

- K = MPL
L MPK
But ,MRTSL,K = - K
L
Hence, MRTSL,K = MPL
MPK

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DEPARTMENT OF ECONOMICS
Micro 1

The Law of Diminishing MRTS – along an iso-quant curve, MRTS continuously declines,
hence making the curve convex to the origin. The reason is that along the iso-quant, as the
quantity of labor is increased and the quantity of capital is reduced, the marginal productivity
of labor diminishes and the marginal productivity of capital increases. Therefore, less and
less of capital is required to be substituted by an additional unit of labor to maintain the same
level of output and hence a diminishing marginal rate of technical substitution.

3.1.3.3 Economic Region of Production

The whole iso-quant map or production plane is not technically efficient nor is every point on
an iso-quant.

Capital A

b c B

a g Q2

e f Q2

0 Q1

Labor

Fig 3.3 Economic region of production

On the above figure one can notice that above the line OA and below the line OB the slope of the iso-
quant is positive, which means that more units of labor and capital is needed to produce a given fixed
output. As a result the production technique in these two regions is technically inefficient.

The lines OA and OB are called ridgelines, which bound a region in which marginal products of the
two factors are positive. The ridge line OA connects those points with MP K =O, and ridge lineOB
connects those points of the iso quant where MPL = O

The range of diminishing marginal products of a factor but non-negative imply that production
concentrates on the range of iso- quant over which their slope is negative and convex to the origin.
This is the area in figure 4.3 between the ridge lines and is called economic region or technically
efficient region of production.

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
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Chapter Four
4.1 Theory of costs
To produce goods and services ,producers need factors of production. To acquire most of
these factors of production,producers have to incur costs.
4.2.1 Definition of concepts
Cost :- is the monetary value of inputs used in the production process.

Cost Private cost

Social cost
Private cost :- is the cost of producing an item to the individual producer.

Social cost :- is the cost of producing an item to the society.

Social cost = Private cost + External cost

Private Cost Accounting cost

Economic cost
Accounting cost: is the cost of purchased input only ( explicitly cost of production )

Economic cost Explicit cost  is an actual ( out – of – pockt expenditure to

purchase inputs )
Implicit cost  is the estimated cost of non – purchased inputs.
2 Short – Run cost of production
Short run costs are divided into two: Fixed costs and variable costs.
Fixed costs ( over head costs): - are costs that do not vary ( changes ) as the firm
changes its output level.
Example: – salaries of a administrative staff
- Depreciation costs
- Rents on leased properties
- Interests on borrowed funds , etc.
Variable costs(running costs ):- are costs that change ( vary ) as the firm change s it
output level.

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e.g. – wage for workers

- cost of raw materials
- running costs such as fuol, etc.
Total costs(TC):- is the sum of fixed costs and variable costs.
Thus , TC ( Q) = TVC ( Q) +TFC
Look at the following hypothetical data
Table:4.3, TC,TFC,TVC,AC,AFC,AVC and MC
Out put
(Q) TFC TVC TC AFC AVC AC MC
0 100 0 100 - - - -
1 100 90 190 100 90 190 90
2 100 170 270 50 135 185 80
3 100 240 340 33.3 80 113.3 70
4 100 300 400 25 75 100 60
5 100 370 470 20 74 94 70
6 100 450 550 16.7 75 91.7 80
7 100 540 640 14.3 77.1 91.4 90
8 100 650 750 12.5 81.25 93.7 100
9 100 780 880 11.1 86.7 97.8 130
10. 100 930 1030 10 93 103 150

TFC
Average fixed cost ( AFC) = Q
TVC
Average variable cost ( AVC) = Q
TC TFC + TVC
= =AFC + AVC
Average cost ( AC or ATC) = Q Q
dTC d (TFC+TVC ) d (TFC ) d (TVC ) d (TV )
= = + =
Marginal cost ( MC) = dA dQ dQ dQ dQ

A numerical example

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Given a cost function as:

3 2
Q −12Q +60Q 100
C(Q )= +
, where Q is the level of output
3 2
TC Q −12Q +60 Q+100 100
AC= = =Q2 −12Q+60+
Q Q Q
3 2
TVC Q −12 Q +60Q
AVC= = =Q 2 −12 Q+60
Q Q
TFC 100
AFC= =
Q Q
dTC
MC= =3 Q2 −24 Q+60
dQ
Graphical representation of costs

TC TC
TVC Note that :- total
TVC variable cost and
total cost have an
TFC inverse – s shape
which reflects the
law of diminishing
returns ( the law of
100 TFC variable proportion).

Fig 4.2 Total cost, Total variable cost, and Total fixed cost curves.
AC
AVC MC
AFC
MC
AC
AVC

AFC
Q

Fig 4.3 AC, AVC,AFC and MC curves

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Relationship between AC & AVC curves

a) They are U- shaped.
b) The AC is above the AVC since AC = AVC +AFC
c) The gap between AC & AVC is getting smaller and smaller as
output level increases because of the effect of AFC.

Relationship between AC &MC

a) Wherever MC <AC, AC declines
b) Wherever MC >AC, AC rises
c) Whenever MC = AC, AC reaches minimum.
The short – run link between production and cost functions
i) Average product and Average Variable cost

APL
APL Mathematically :
L TP L Q
AVC AVC =
a) APL= L L
TVC W . L
=
b) AVC = Q Q
Q 1 W
⇒ AVC=WX =
AP L APl

ii) Marginal Product and Marginal Cost

MPL Mathematically
L
MPL ΔTPL ΔQ
MC MC =
a) MPL= ΔL ΔL
b) MC=
Δ(TC ) Δ(TVC ) Δ(W . L )
= =
ΔQ ΔQ ΔQ
ΔL
,
MC=W. ΔQ since wage is
Q
constant

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DEPARTMENT OF ECONOMICS
Micro 1

1 W
W. =
MC = MPL MPL

Bringing case i) and case ii) together:

MPL
APL

APL Note:- you can

observe from the
L figure as well as
MPL from the
MC mathematical
AVC MC illustrate that AP and
AVC AVC are inversely
related. The same is
true for MP and MC
functions.

4.2.3 The Least Cost Rule

To produce a product at the least cost, the firm should spend its money in such a way
that the last birr spent on each factor of production brings equal marginal products.
Mathematically it is stated as:

MPL =MPK
PL PK
Where, PL = price of labor
PK = price of capital
4.2.4 Long – run costs of production
In the short – run, a firm is handicapped by the fact that some of the inputs may be
fixed . In the long-run, however, the firm does not face such a problem because all
inputs are variable. This means that, in the long-run, the producer can make necessary
changes in the size of his plant.
( long-run costs will be treated in detail in micro-economics – I)

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Micro 1

CHAPTER FIVE

5. MARKET STRUCTURES

5.1. Definition of concepts

Market is a mechanism that brings buyers and sellers to buy or sale their goods and
services.The most important factor that determines firm’s choice of price and output is the
market structure. The term market structure refers to the organizational features of an
industry that influence the firm’s behavior in its choice of price and output.

5.2Types of market structure

Economists have found it useful to classify markets in to four general types. This
classification is based largely on the numbers of firms in the industry, the nature of products
and the nature of entrance of new firms. In this unit, we investigate how price and output are
determined in perfectly competitive markets in the short as well as long run periods.

Generally there are two types of market structure.

I. Perfect Market structure  perfectly competitive market

II. Imperfect market structure Monopoly market

Monopolistically competitive market.

 Oligopoly Market

5.2.1. Perfectly competitive market

Definition and assumptions of perfect competition

Perfect competition is a market structure characterized by a complete absence of rivalry

among the individual firms, because there are so many firms in the industry so that no
personal recognition among individual firms in a market. Perfect competition is characterized
by the following assumptions. It is a type of market structure in which there are many buyers
and sellers of homogeneous products.

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DEPARTMENT OF ECONOMICS
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Characteristics of perfect competition

1. Large number of sellers and buyers

Under perfect competition the number of sellers is assumed to be too large that the share of
each seller in the total supply of a product is very small. There, fore no single seller can
influence the market price by changing the quantity supply. similarly, the number of buyers is
so large that the share of each buyer in the total demand is very small and that no single buyer
or a group of buyers can influence the market price by changing their individual or group
demand for a product there fore in such a market structure, seller & buyers are not price
market rather they are price takers i. e the price is determined by the interaction of the market
supply and demand forces.

price DD SS Price

P0 P0
d

0 Quantity O Quantity

a) The market b) the firm

Fig 6.2 Market equilibrium and the firm’s demand curve

2. Homogeneous product: - homogeneity of the product implies that buyers do not

distinguish between products supplied by the various firms of an industry. Product of each
firm is regarded as a perfect substitute for the products of other firms. Therefore no firm can
gain any competitive advantage over the other firm.

3. Perfect mobility of factors of production: - factors of production are free to move from
one firm to another throughout the economy. This means that labor can move from one job to

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another and from one region to another. capital, raw Materials, and other factors are not
monopolized

4. Free entry and exit; there is no restriction or market barrier on entry of new firms to the
industry, and no restrictionon exit of firms from the industry. A firm may enter the industry
or quit it on its accord.

5. Perfect knowledge: - there is perfect knowledge about the market conditions. All the
buyers and sellers have full information regarding the prevailing and future prices and
availability of the commodity.

6. No government interference: - government does not interfere in any way with the
functioning of the market. There are no discriminator taxes or subsidies, no licensing, no
allocation of inputs by the procurement, or any kind of direct or indirect control. That is, the
government follows the free enterprise policy. Where there is intervention by the government
it is intended to correct the market imperfection.

5.2.1.1. Profit maximization under perfect competitive market.

The objective of a consumer is maximization of utility; likewise the firms produce goods and
service and sell the product to consumers. Consumer demand for goods and services
determines the revenue side of a business operation. Production theory has been used to
derive the cost conditions faced by firms .Brought together, revenue and cost determines the
behavior of a profit maximizing business firm. There are two approaches of profit
maximization

i) The total approach

ii) The marginal approach

i) The total approach According to this approach profit is maximized when the
vertical difference between total revenue(TR) and total cost(TC) is the
largest .symbolically;

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∏= TR-TC and TR=P x Q Where ∏ =profit TR=Total revenue, TC= Total

cost , P= price of output ,Q=quantity of output show this graphically by assuming
linear total revenue function as follows ;

TR , TC TC

TR

Xa Xe Xb
Fig 5.1 The total approach of profit maximization

In the above figure the firm maximizes its profit at the output Xe, where the vertical distance
between TR and TC curves is the widest. At output levels less than Xa and greater than Xb
the firm incurs loss.

ii) The marginal approach:

i. Graphical presentation

P MC AC

PoC AR = MR = d

a b

O Qo Qo

Firm maximize its profit

a. MR = MC

b. MC is rising

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TR= PQ

TR= OPo X OQo TR = OPoCQo

TC =AC X Q b/c AC = TC/Q

TC = Qob X OQo TC = OabQo

Profit = TR –TC  π = OPoCQo - OabQo

Π = aPocb

ii. Algebraic Presentation

According to this approach, the firm will maximize profit or minimizes loss by
producing that level of output where the following two conditions are fulfilled;

 The first order condition (F.O.C); MR is equal to MC

Symbolically MR=MC, but MR=dTR /dQ
Mc=dT /dQ

 The second order condition (S.O.C); MC should be increasing in a higher

rate than MR.
2 2
d TC d TR
Symbolically; >
d2Q d2 Q

Numerical example: Find the profit maximizing output given the following revenue and cost
functions;

TR=1000Q-2Q2

TC=Q3-59Q2+1315Q+2000

Solution: FOC MR=MC

MR=dTR/dQ=1000-4Q

MC=dTC/dQ=3Q2-118Q+1315

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 RIFT VALLEY UNIVERSITY FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
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Solving for Q we get, Q=35 or Q=3 to determine which output maximizes profit check
for second order condition

d 2 TC d 2 TR
S.O.C , 2
> 2
d Q d Q

2 2
d TC d TR
2 = 6Q-118 and 2 =-4
d Q d Q

at Q=3 6(3) -118<-4 , 18 – 118 < -4 , -100 <-4 ……do not fulfill the
condition

at Q=35 6(35)-118>-4 , 210 – 118 > -4 , 92> -4 ……fulfills the SOC for
profit maximization .

5.2.2. Monopoly market

Definition, monopoly is amarket structure where there is only one firm that produces and
sells aparticular commodity or service and there are no close substitutes available. Since the
monopoly is the seller in the market, the industry is asingle firm industry and it has no direct
competitors.

It is a type of market structure in which there is only one firm that producers a distinctive
products.

5.2.2.1. Sources of monopoly

The emergence and survival of monopoly is attributed to the factors which prevent the entry
of other firms in to the industry. The barriers to entry are therefore the sourcesof monopoly
power. The reason for the presence of a monopoly
i. Absence of close substitute
ii. Economic of scale ( cost advantage)
iii. legal restrictions
iv. sole control over the supply of key raw materials
v. efficiency
vi. patent right

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I. Absence of close substitute – the products that is produced by a monopoly is distinctive

(unique) and has no close substitute.
II. Economic of scale – If one producer has cost advantage than other firms he can produce
with list cost which helps him/her to reduce the price of their product to push out other firms
from the industry and become a monopoly.

III. Legal restriction: Some monopolies are created by law in public interest such monopoly
may be created in both public and private sectors. Most of the state monopolies in the public
utility sector, including postal service, telegraph, telephone services, radio and TV services,
generation and distribution of electricity, rail ways, airlines etc… are public monopolies.

IV. Control over key raw materials: Some firms acquire monopoly power from their
traditional control over certain scarce and key raw materials that are essential for the
production of certain other goods. E.g. Bauxite, graphite, diamond, etc…..for example
Aluminum Company of America had monopolized the aluminum industry because it had
acquired control over almost all sources of bauxite supply; such monopolies are often called
raw material monopolies.

V. Efficiency: a primary and technical reason for growth of monopolies is economies of

scale, the most efficient plant (probably large size firm, which can produce at minimum cost,
could eliminate the produce at minimum cost, could eliminate the competitors by curbing
down its price for a short period and can acquire monopoly power. Monopolies created
through efficiency are known as natural monopolies.

VI. Patent rights: another source of monopoly is the patent right if afirm for aproduct or for
aproduction process. Patent rights are granted by the government to a firm to produce
commodity of specified quality and character or to use a specified rights to produce the
specified commodity or to use the specified technique of production, such monopolies are
called to patent monopolies.

5.2.2.2. Characteristics of monopoly

Monopoly markets are characterized by:

 There are only one supplier (seller) and many buyers of the product

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 The product has no close substitute.

 There is a considerable entry barrier for new firms.

 The firm is a price setter or maker.

5.2.2.3. Kind of monopoly.

A. Natural monopoly– a monopoly in which the supply of the product is available in small
or single place. Example: Diamonds in South Africa

B. Legal monopoly – any legal right which is given to a firms to produce a unique product.

Example: If the right of manufacturing a medicine with the brand name is given by the law
to a company.

C. Public monopoly – a public agency (monopoly) which supply or provide and control the
utility service for the society. Example: Tele, EEPC

D. Artificial monopoly – the individual producer of the same product come together and
forms into a single organization. Such types of amalgamation of firms in to a single
organization is known as Artificial monopoly or Private monopoly.

5.2.3. Monopolistically Competitive market

Monopolistic competition – it is atype of market structure in which there are many
buyers and sellers of differentiated products. This market structure is characterized
by the existence of:
A, Many buyers and sellers: there many buyers and sellers of the products, but
their number is not as large as that of perfectly competitive market.
B, Differentiated products: the product produced and supplied by many sellers in
the market is similar but not identical.
C, Free entry and exit – like perfectly competitive market, there is no barrier on
new firms to enter to the market.
D, The existence of non price competition – Seller compete not only in price but
also through advertisement, brand name, etc. A firm spends money in advertisement
to inform the consumers about the relative l unique character of their product.

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5.2.4. Oligopoly market

Oligopoly refers to the market structure in which there are few sellers and many
buyers of particular product in the market. Oligopoly differs from monopoly where
there is only one seller and from perfectly competitive and monopolistic
competition where there are many sellers in that there are a few sellers in this
market.
Characteristic of Oligopoly market
1. Very few sellers of the product
2. Interdependence
3. Differentiated or identical product
4. Entry barriers
5. Existence of price rigidity
6. Excessive expenditure on advertising
7. Presence of monopoly power.

Introduction to Economics By: Chernet A.