ECO 431 ADVANCED MICROECONOMICS

NATIONAL OPEN UNIVERSITY OF NIGERIA

SCHOOL OF ARTS AND SOCIAL SCIENCES

COURSE CODE: ECO 431

COURSE TITLE: ADVANCED MICRO-ECONOMICS

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ECO 431 ADVANCED MICROECONOMICS

COURSE
GUIDE

ECO 431
ADVANCED MICROECONOMICS

Course Team Dr. S. O. Akinleye (Course Developer) – UNILAG

Dr. (Mrs.) G. A. Adesina-Uthman (Course Editor) -
NOUN

NATIONAL OPEN UNIVERSITY OF NIGERIA

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ECO 431 ADVANCED MICROECONOMICS

National Open University of Nigeria

Headquarters
14/16 Ahmadu Bello Way
Victoria Island, Lagos

Abuja Office
5 Dar es Salaam Street
Off Aminu Kano Crescent
Wuse II, Abuja

e-mail: [email protected]
URL: www.nou.edu.ng

Published by
National Open University of Nigeria

Printed 2014

ISBN: 978-058-855-9

All Rights Reserved

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CONTENTS PAGE

Introduction………………………………………………. iv
Course Content…………………………………………… iv
Course Aims……………………………………………… iv
Course Objectives………………………………………… v
Working through this Course……………………………... v
Course Materials………………………………………….. v
Study Units……………………………………………….. v
Textbooks and References……………………………….. vi
Assignment File…………………………………………... vi
Presentation Schedule……………………………………. vi
Assessment……………………………………………….. vi
Tutor-Marked Assignments (TMAs)……………………... vii
Final Examination and Grading…………………………... vii
Course Marking Scheme…………………………………. vii
Course Overview………………………………………… viii
How to Get the Most from this Course…………………... viii
Tutors and Tutorials……………………………………… x
Summary………………………………………………… xi

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INTRODUCTION

ECO 431-Advanced Microeconomics is a core course, which carries

two credit units for final year students of Economics in the School of
Arts and Social Sciences at the National Open University of Nigeria.
ECO 431 is a very useful course to you in your academic pursuit as it
would help you to gain an in-depth understanding on how the economy
is operated from the individual angle. This course guide tells you what
principles of economics (microeconomic theory) entails, what course
materials you will be using and how you can work your way through
these materials. It suggests some general guidelines for the amount of
time required of you on each unit in order to achieve the course aims
and objectives successfully. It also provides you some guidance on your
Tutor-Marked Assignments (TMAs) as contained herein.

WHAT YOU WILL LEARN IN THIS COURSE

You will be taught the introduction to the discipline of economics and

be provided a basic understanding of how individual unit of the
economy work together to determine the economic activity of a nation.

COURSE CONTENT

This course builds on the foundation of elementary economics on

studying the effect of individual unit behaviour on the economy. Topics
covered include: Market Structure, Comparative Static and Dynamic
Analysis, Theory of Demand, Consumer Behaviour, Optimisation,
Utility Maximisation, Welfare Economics, General Equilibrium, Linear
Programming, etc.

COURSE AIMS

There are 16 study units in this course and each unit has its objectives.
You should read the objectives of each unit and bear them in mind as
you go through the unit. In addition to the objectives of each unit, the
overall aims of this course include, to:

 introduce you to the basic analysis viz:comparative static and

dynamic analysis
 teach you the concept of linear programming
 expose you to the analysis of utility maximisation
 expose you extensively to market structure
 enlighten you on the theory of cost and production.

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COURSE OBJECTIVES

On successful completion of the course, you should be able to:

 define both functions of the economy and the power and breadth
of economics
 explain consumer utility and consumer surplus
 describe the concept of linear programming and welfare
economics.

WORKING THROUGH THIS COURSE

To successfully complete this course, you are required to read the study
units, referenced books and other materials on the course. Each unit
contains Self-Assessment Exercise (SAE). At some points in the course,
you may be required to submit assignments for assessment purposes. At
the end of the course, there is a final examination.

COURSE MATERIALS

The major components of the course, what you have to do and how you
should allocate your time to each unit in order to complete the course
successfully on time are listed as follows:

1. Course Guide
2. Study Unit
3. Textbook and References
4. Assignment File
5. Presentation Schedule

STUDY UNITS

There are five modules in this course broken into16 study units as
follows:

Module 1 Introductory Microeconomics

Unit 1 Introduction to Microeconomics

Unit 2 Economic Systems and Decision Making
Unit 3 Comparative Static and Dynamic Analysis

Module 2 Theory of Demand, Consumer Behaviour and

Optimisation

Unit 1 Theory of Demand

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Unit 2 Elasticities of Demand

Unit 3 Budget Constraint
Unit 4 Theory of Utility Maximisation

Module 3 Theory of Production and Cost

Unit 1 Theory of Production

Unit 2 Theory of Cost
Unit 3 Labour-Leisure Trade-Off

Module 4 Market Structure

Unit 1 Perfect Competition, Monopolistic Competition and

Monopoly
Unit 2 Price Discrimination, Bilateral Monopoly and Monopsony
Unit 3 Collusive Oligopoly and Non-Collusive Oligopoly

Module 5 Linear Programming and General Equilibrium and

Social Welfare

Unit 1 Linear Programming

Unit 2 General Equilibrium
Unit 3 Social Welfare

TEXTBOOKS AND REFERENCES

Each unit contains a list of materials for further reading. Try to get as
many as possible of those textbooks. They are meant to deepen your
knowledge of the course.

ASSIGNMENT FILE

In this file, you will find all the details of the work you must submit to
your tutor for marking. The marks you obtain from these assignments
will count towards the final mark you obtain for this course. Further
information on assignments will be found in the Assignment File itself
and later in this Course Guidein the section on assessment.

PRESENTATION SCHEDULE

The Presentation Schedule included in your course materials gives you

the important dates for the completion of TMAs and attending tutorials.
Remember, you are required to submit all your assignments by the due
date. You should guard against falling behind in your work.

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ASSESSMENT

Your assessment will be based on TMAs and a final examination which

you will write at the end of the course.

TUTOR-MARKED ASSIGNMENT (TMA)

There is one Tutor-Marked Assignment in each unit of this course. You

will submit all the assignments. You are encouraged to work all the
questions thoroughly. The TMAs constitute 30% of the total score.

You will be able to complete your assignments from the information and
materials contained in your text books and study units. However, it is
desirable that you demonstrate that you have read and researched more
widely than the required minimum. You should use other references to
have a broad viewpoint of the subject and also to give you a deeper
understanding of the subject.

When you have completed each assignment, send it, together with a
TMA form, to your tutor. Make sure that each assignment reaches your
tutor on or before the deadline given in the Presentation File. If for any
reason, you cannot complete your work on time, contact your tutor
before the assignment is due to discuss the possibility of an extension.
Extensions will not be granted after the due date unless there are
exceptional circumstances.

FINAL EXAMINATION AND GRADING

The final examination for ECO 431 will be of three hours' duration and
have a value of 70% of the total course grade. The examination will
consist of questions which reflect the types of Self-Assessment
Exercises and Tutor-Marked Assignments you have previously
encountered. All areas of the course will be assessed.

Use the time; between finishing the last unit and sitting for the
examination to revise the entire course material. You might find it useful
to review your Self-Assessment Exercises, TMAs and comment on them
before the examination. The final examination covers information from
all parts of the course.

COURSE MARKING SCHEME

The presented below indicates the total marks (100%) allocation.

Assessment Marks

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Assignment 30%
Final Examination 70%

Total 100%

HOW TO GET THE MOST FROM THIS COURSE

In distance learning, the study units replace the university lecturer. This
is one of the great advantages of distance learning; you can read and
work through specially designed study materials at your own pace and at
a time and place that suit you best. Think of it as reading the lecture
instead of listening to a lecturer. In the same way that a lecturer might
set you some reading to do, the study units tell you when to read your
books or other materials, and when to embark on discussion with your
colleagues. Just as a lecturer might give you an in-class exercise, your
study units provide exercises for you to do at appropriate points.

Each of the study units follows a common format. The first item is an
introduction to the subject matter of the unit and how a particular unit is
integrated with the other units and the course as a whole. Next is a set of
learning objectives. These objectives let you know what you should be
able to do by the time you have completed the unit.

You should use these objectives to guide your study. When you have
finished the unit, you should go back and check whether you have
achieved the objectives. If you make a habit of doing this you will
significantly improve your chances of passing the course and getting the
best grade.

The main body of the unit guides you through the required reading from
other sources. This will usually be either from your text books or from a
reading section. Some units require you to undertake practical overview
of historical events. You will be directed when you need to embark on
discussion and guided through the tasks you must do.

The purpose of the practical overview of some certain historical

economic issues are in two folds. First, it will enhance your
understanding of the material in the unit. Second, it will give you
practical experience and skills to evaluate economic arguments, and
understand the roles of history in guiding current economic policies and
debates outside your studies. In any event, most of the critical thinking
skills you will develop during studying are applicable in normal working
practice, so it is important that you encounter them during your studies.

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Self-Assessment Exercises are interspersed throughout the units, and

ways to answers them are already integrated in the units. Working
through these tests will help you to achieve the objectives of the unit and
prepare you for the assignments and the examination. You should do
each Self-Assessment Exercise as you come into the study unit. Also,
ensure to master some major historical dates and events during the
course of studying the material.

The following is a practical strategy for working through the course. If

you run into any trouble, consult your tutor. Remember that your tutor's
job is to help you. When you need help, donot hesitate to call and ask
your tutor to provide it.

READ THIS COURSE GUIDE THOROUGHLY

Organise a study schedule. Refer to the `Course Overview' for more

details. Note the time you are expected to spend on each unit and how
the assignments relate to the units. Important information, e.g. details of
your tutorials, and the date of the first day of the semester is available
from the study centre. You need to gather together all this information in
one place, such as your diary or a wall calendar. Whatever method you
choose to use, you should decide on and write in your own dates for
working each unit.

Once you have created your own study schedule, do everything you can
to stick to it. The major reason that students fail is that they get behind
in their course work. If you get into difficulties with your schedule,
please let your tutor know before it is too late for help.

Turn to Unit 1 and read the introduction and the objectives for the unit.

Assemble the study materials. Information about what you need for a
unit is given in the `introduction' at the beginning of each unit. You will
also need both the study unit you are working on and one of your set
books on your desk at the same time.

Work through the unit. The content of the unit itself has been arranged
to provide a sequence for you to follow. As you work through the unit,
you will be instructed to read sections from your set books or other
articles. Use the unit to guide your reading.

Up-to-date course information will be continuously delivered to you at

the study centre.

Work before the relevant due date (about 4 weeks before due dates), get
the Assignment File for the next required assignment. Keep in mind that

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you will learn a lot by doing the assignments carefully. They have been
designed to help you meet the objectives of the course and, therefore,
will help you pass the examination. Submit all assignments no later than
the due date.

Review the objectives for each study unit to confirm that you have
achieved them. If you feel unsure about any of the objectives, review the
study material or consult your tutor.

When you are confident that you have achieved a unit's objectives, you
can then start on the next unit. Proceed unit by unit through the course
and try to pace your study so that you keep yourself on schedule.

When you have submitted an assignment to your tutor for marking do

not wait for its return before starting work on the next unit. Keep to your
schedule. When the assignment is returned, pay particular attention to
your tutor's comments, both on the Tutor-Marked Assignment form and
also the written assignment. Consult your tutor as soon as possible if
you have any questions or problems.

After completing the last unit, review the course and prepare yourself
for the final examination. Check that you have achieved the unit
objectives (listed at the beginning of each unit) and the course objectives
(listed in this Course Guide).

TUTORS AND TUTORIALS

There are some hours of tutorials (2-hour sessions) provided in support

of this course. You will be notified of the dates, times and location of
these tutorials. Together with the name and phone number of your tutor,
as soon as you are allocated a tutorial group.

Your tutor will mark and comment on your assignments, keep a close
watch on your progress and on any difficulties you might encounter, and
provide assistance to you during the course. You should mail your
Tutor-Marked Assignments to your tutor well before the due date (at
least two working days are required). They will be marked by your tutor
and returned to you as soon as possible.

Do not hesitate to contact your tutor by telephone, e-mail, or discussion

board if you need help. The following might be circumstances in which
you would find help necessary.

Contact your tutor ifyou:

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• do not understand any part of the study units or the assigned

readings
• have difficulty with the self-assessment exercises
• have a question or problem with an assignment, with your tutor's
comments on anassignment or with the grading of an assignment.

You should try your best to attend the tutorials. This is the only chance
to have face to face contact with your tutor and to ask questions which
are answered instantly. You can raise any problem encountered in the
course of your study. To gain the maximum benefit from course
tutorials, prepare a question list before attending them. You will learn a
lot from participating in discussions actively.

SUMMARY

On successful completion of the course, you would have developed

critical thinking skills with the material necessary for efficient and
effective discussion of economic issues and integration of past events
with the present. However, to gain a lot from the course please try to
apply anything you learn in the course to term papers writing in other
economic development courses. We wish you success with the course
and hope that you will find it both interesting and useful.

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MAIN
COURSE

CONTENTS PAGE

Module 1 Introductory Microeconomics……………… 1

Unit 1 Introduction to Microeconomics……………... 1

Unit 2 Economic Systems and Decision Making……. 13
Unit 3 Comparative Static and Dynamic Analysis…... 25

Module 2 Theory of Demand, Consumer Behaviour

and Optimisation…………………………….. 32

Unit 1 Theory of Demand……………………………. 32

Unit 2 Elasticities of Demand………………………… 40
Unit 3 Budget Constraint……………………………... 50
Unit 4 Theory of Utility Maximisation………………. 61

Module 3 Theory of Production and Cost…………….. 82

Unit 1 Theory of Production………………………….. 82

Unit 2 Theory of Cost………………………………… 92
Unit 3 Labour-Leisure Trade-Off…………………….. 101

Module 4 Market Structure…………………………….. 110

Unit 1 Perfect Competition, Monopolistic

Competition and Monopoly………………… 110
Unit 2 Price Discrimination, Bilateral Monopoly and
Monopsony……………………………………. 118
Unit 3 Collusive Oligopoly and Non-Collusive
Oligopoly……………………………………… 127

Module 5 Linear Programming and General

Equilibrium and Social Welfare…………….. 137

Unit 1 Linear Programming…………………………… 137

Unit 2 General Equilibrium…………………………… 146
Unit 3 Social Welfare………………………………….. 158

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MODULE 1 INTRODUCTORY MICROECONOMICS

Unit 1 Introduction to Microeconomics

Unit 2 Economic Systems and Decision Making
Unit 3 Comparative Static and Dynamic Analysis

UNIT 1 INTRODUCTION TO MICROECONOMICS

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Positive versus Normative Economics
3.2 What is a Market?
3.3 Competitive versus Noncompetitive Markets
3.4 Real versus Nominal Prices
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Economics is divided into two main branches: microeconomics and

macroeconomics. Microeconomics deals with the behaviour of
individual economic units. These units include consumers, workers, and
investors, owners of land and business firms. Microeconomics explains
how and why these units make economic decisions e.g. it explains how
consumers make purchasing decisions and how their choices are
affected by changing prices and incomes. It also explains how firms
decide how many workers to hire and how workers decide where to
work and how much work to do. Another important concern of
microeconomics is how economic units interact to form larger units.

Macroeconomics deals with aggregate economic quantities, such as the

level and growth rate of national output, interest rate, unemployment
and inflation. Much of macroeconomics is about limits that is, the
limited incomes that consumers can spend on goods and services, the
limited budgets and technical know-how that firms can use to produce
things, and the limited number of hours in a week the workers can
allocate to labour or leisure.

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2.0 OBJECTIVES

At the end of this unit, you should be able to:

 differentiate between microeconomics and macroeconomics

 differentiate between positive and normative economics
 explain the difference between nominal and real prices
 have broad understanding of the market concept.

3.0 MAIN CONTENT

3.1 Positive versus Normative Economics

Microeconomics is concerned with both positive and normative

questions. Positive questions deal with explanation and prediction, while
normative questions deal with “what ought to be”. In a situation where
the Nigerian government imposes a quota on the importation of foreign
cars; what will happen to the price, production and sales of cars? What
impact will this policy change have on Nigerian consumers and on
workers in the automobile industry? These questions belong to the realm
of positive analysis; statements that describes relationships of cause and
effect.

Positive analysis is central to microeconomics, as theories are developed

to explain phenomena, tested against observations, and used to construct
models from which predictions are made, all of which are vital to firms’
prediction ability. For example, assuming the federal government is
considering raising the tax on petroleum. The change would affect the
price of petroleum, consumers’ purchasing choices for small or large
cars, the amounts of driving that people do, and so on. To plan sensibly,
oil companies, automobile companies, producers of automobile parts,
and firms in the tourism industry would all need to estimate the impact
of the change. Government policy makers will also need quantitative
estimate of the effects. They would want the costs imposed on
consumers, the effects on profits, and employment in the oil,
automobile, and the tourism industries; and the amount of tax revenue
likely to be collected each year.

However, sometimes we want to go beyond explanation and prediction

to ask such important questions as “what is best”. This involves
normative analysis, which is also important for both managers of firms
and those making public policy. Similarly, consider a new tax on
petroleum. Automobile companies would want to determine the best
(profit-maximising) mix of large and small cars to produce once the tax
is in place. Specifically, how much money should be invested to make
cars more fuel-efficient? For policy makers, the primary issue is likely

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to be whether the tax is in the public interest. The same policy objectives
(say, an increase in tax revenues and a decrease in dependence on
imported oil) might be met more cheaply with a different kind of tax,
such as tariff on imported oil.

SELF-ASSESSMENT EXERCISE

Define and differentiate between positive and normative economics’.

3.2 What is a Market?

Individual economic units can be divided into two according to their

function; buyers and sellers. Buyers include the consumers, who
purchase goods and services, and the firm, which buys labour, capital,
and raw materials that they use to produce goods and services. Sellers
include the firms, which sell their goods and services; workers, who sell
their labour services; and resources owners, who rent land or sell
mineral resources to firms.

The combination of buyers and sellers forms the market. A market is the
collection of buyers and sellers that, through their actual or potential
interactions, determine the price of a product or set of products. Also,
the term market refers to economic institutions for the
commercialisation of goods and services. It does not basically imply a
location where goods and services are physically exchanged. It implies
the summation of all transactions involving a specific good or service.

In the market for personal computers, for example, the buyers and
business firms, households and students; the sellers are Hawlett-Packard
(HP), Lenovo, Dell, Apple, and a number of other firms. Note that a
market includes more than an industry. An industry is a collection of
firms that sell the same or closely related products. In effect, an industry
is the supply side of the market.

The motivating force that makes the market mechanism to work is the
conflicting interests of selfish buyers and sellers and competition.
Conflicts stems from the fact that the two basic sides of the market have
conflicting interests. Suppliers want to sell at the highest possible prices.
Buyers on the other hand, want to purchase at the lowest possible price.
In a market, all participants want to buy cheap and sell dear. As the
sellers push for the highest possible price and buyers lobby for the
lowest; the resulting conflict between the basic sides of the market is
resolved by competition. In general, prices tends to rise when goods
become scarce, and when they are in abundance, prices tends to fall
because competition will beat the price down. The twin forces of
competition and self-interest make the market to operate effectively.

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Sellers will always strive to obtain the highest possible prices for their
products, bearing in mind that if the price is too high, competitors will
make all the sales. Buyers lobby for the lowest possible price while
noting that goods will in the end go to the highest bidder. The prices in
most markets are determined in this manner by these market forces.

3.2.1 Supply, Demand and Market Equilibrium

All markets are characterised by market participants making decisions to

improve their own self-interest. Buyers are assumed to be motivated
primarily by the desire to increase their personal satisfaction in life.
Sellers are assumed to be motivated by the desire to make the largest
profits possible. This interaction between buyers and sellers results in
equilibrium in the market.

Equilibrium is defined to be the point at which:

Qs = Q d

Where Qs = quantity supplied,

Qd = quantity demanded.

If the market price is not at equilibrium, market forces drive the market
toward equilibrium. If the market price is at equilibrium, there exists no
market pressure to move to some other level. To better understand this
concept, consider the Figure 1.1.

S1
Qs > Qd1 Surplus
P2

P1 E

P3

Qd > Qs1 Shortage

S2

Q2 Q1 Q3

Fig. 1.1: Supply-Demand (Market) Equilibrium

The market represented in Figure 1.1 is in equilibrium at point E

because Qs = Qd at the common price of P1. To better understand the
concept of equilibrium, it is useful to examine the market at other prices.
First, consider a market price above the equilibrium value. At P2, the
quantity supplied, Q3, is larger than the quantity demanded, Q2. At this

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price, sellers are willing to provide more to the market than consumers
are willing to buy. This situation is defined as a surplus. To combat their
rising inventories, sellers begin to lower their prices, attempting to
entice consumers to buy more. In addition, because of the lower price,
sellers decrease the amount they offer for sale. As this process unfolds,
there is an increase in Qd and a decrease in Qs as the market moves to
the equilibrium at point E.

Now consider a market price below the equilibrium value. At the price
P3, the quantity demanded, Q3, exceeds the quantity supplied, Q2,
resulting in a shortage in the market. In response to the shortage,
consumers begin to beat up the price. To understand this process,
consider the process of an auction. An auction usually begins with the
number of willing and able buyers exceeding the amount of product
available. The role of the auctioneer is to bid the price up until Qs = Qd.
As the price increases, consumers begin to drop out of the bidding
process. In the market represented above, consumers begin bidding the
price up and, as a result, some consumers begin to drop out of the
market and Qd begins to fall. As the price begins to increase, sellers who
are willing and able respond by increasing the amount they provide to
the market, and Qs begins to increase. These changes in Qs and Qd
continue until the market reaches equilibrium at a price of P1 and a
quantity of Q1.

Ultimately, markets tend to move toward equilibrium. When market

prices are too high, surpluses exist, and market forces drive the prices
down to the equilibrium level. When market prices are too low,
shortages exist, and market forces drive up the prices to the equilibrium
price. At equilibrium, there exists no market pressure for change, and
thus the price tends to stay at the equilibrium until something in the
economy changes, resulting in a change in either supply or demand.

Quantitative approach to market equilibrium

The law of demand suggests that an inverse mathematical relationship

exists between price and quantity demanded. The law of supply suggests
that a similar but positive relationship exists between price and quantity
supplied. An example of these relationships is expressed below.

(i) The case of a single product (X)

Given a simple linear demand and supply function

Qd= 6 – 0.5p (1)

Qs= -4 + 1.5p (2)

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At equilibrium, Qs = Qd =>Qe= Qd – Qs
Equating (1) and (2),

6 – 0.5p =-4 + 1.5p

p=5

Substituting value of p into (1) or (2)

Qe= 3.5

Thus, equilibrium price and quantity are Pe = 5 and Qe = 3.5

(ii) The case of two related goods (x and y)

Given two substitute goods (X and Y) with Demand and Supply

functions,

Qdx= 41 - 1.5px + 0.5px (3)

Qsx = -2.5 + 7.5px (4)

Qdy = 46 + px – 2py (5)

Qsy= -3 + 16py (6)

At equilibrium,

Qdx – Qsx = Qex

Qdy – Qsy = Qey

Equating (3) and (4)

41 – 1.5px + 0.5py = -2.5 + 7.5px

9px – 0.5py = 43.5 (7)

Equating (5) and (6)

46 + px – 2py = -3 + 16py
-px + 18py = 49 (8)

Equating (7) and (8) gives us a simultaneous equation system. Solving

simultaneously,

Px = 5 and py = 3

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Substituting value of px into (3) or (4),

Qex = 35

Substituting value of py into (5) or (6)

Qey = 45

Thus, equilibrium price and quantity for each product is

Px = 5, Qex = 35
Py = 3, Qey = 45.

3.2.2 Market Failure

Microeconomic theory is founded on the premise of a smooth

functioning market. The market (price) system allocates resources by
providing information to resources owners on the relative price of
individual goods and services. The price mechanism is a system
whereby the information provided by the relative prices of goods and
services determines freely what the society is to produce, how and for
whom it is to be produced. The price system is assumed to allocate
resources effectively, bringing maximum benefits to the society and
resources owners.

There are three main arguments proffered in support of the price system
as a means of resource allocation. They are:

(i) Its ability to achieve optimality in the allocation of societal

resources.
(ii) Its built-in flexibility which negates the need for conscious
government planning and intervention.
(iii) Its guarantee of economic freedom to all and sundry.

Market failure is a phrase that is usually employed to describe one or

both of two things:

(i) The failure of the price mechanism, at any point in time, to

achieve optimal resource allocation.
(ii) The inability of the price system to achieve other desirable
societal goals associated with the distribution and utilisation
of resources.

In relation to optimal resource allocation and utilisation, the price

mechanism does not, by itself, accommodate externalities in economic
transactions. Finally, the price mechanism breaks down whenever and

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wherever there are inefficient transportation and communication

systems. With market imperfections, there is bound to be resource
unemployment and imbalances within the economy.

SELF-ASSESSMENT EXERCISE

Explain the concept of market, market equilibrium and market failure.

3.3 Competitive versus Non-Competitive Markets

3.3.1 Competitive Market

A perfectly competitive market has many buyers and sellers, so that no

single buyers or seller has a significant impact on price. Most
agricultural markets are close to being perfectly competitive. For
example, thousands of farmers produce maize, which thousands of
buyers purchase to produce food and other products. As a result, no
single farmer and no single buyer can significantly affect the price of
maize. Equilibrium occurs in a competitive market when MR = MC = P
(MR = marginal revenue, MC = marginal cost, P = price), which can
lead to Pareto’s optimum. Firms in a competitive market are price takers
because they produce such a small share of their industries output, and
their production decisions have little impact on the total quantity of
output sold.

Marginal Revenue (MR) and Marginal Cost (MC)

Marginal revenue indicates how much extra revenue is received for

selling an extra unit of output. Marginal revenue plays a key role in the
profit maximising decision of a perfectly competitive firm relative to
marginal cost (MC). A perfectly competitive firm maximises profit by
equating marginal revenue, the extra revenue generated from
production, with marginal cost (MC) which is the cost incurred in the
production extra output. If these two marginal’s are not equal, then
profit can be increased by producing more or less output.

3.3.2 Non-Competitive Market

What if the industry has only one firm? How does the firm behave when it
is a monopolist that differs from its behaviour in a competitive industry?
Because the industry has only one firm, that firm must consider the effect
of its production decisions on the price of its output. The problem is that
when the monopolist produces an additional unit of output it cannot sell
that output at the prevailing price because the prevailing price corresponds
to some point on the demand curve for the product. At that price, the most
consumers are willing to buy some amount, say q0. To sell an addition unit

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of output, the monopolist must cut its price by an amount P for all q0units
of output. This behaviour implies that the marginal revenue associated
with selling an additional unit of output is less than the price that this unit
of output is sold for in the market:

MR = P +P *q0< P, becauseP < 0

Intuitively, the monopolist will maximise profits by raising prices. But to

do so, it must reduce output. This is the same problem that OPEC faces
when trying to control oil prices. In order for a $90 per barrel price to
prevail on world markets each producer must agree to cut back production.
The reason that OPEC is relatively ineffective is because it cannot
discipline itself to keep production within preset limits.

SELF-ASSESSMENT EXERCISE

Define and differentiate between competitive and non-competitive

market, and give an example of both.

3.4 Real versus Nominal

We often want to compare the price of goods today with what it was in
the past or is likely to be in the future. To make such a comparison
meaningful, we need to measure prices relative to an overall price level.
In absolute terms, the price of a dozen of oranges is many times higher
today than it was 50 years ago. We need to correct for inflation when
comparing prices across time. This means measuring prices in real rather
than nominal terms. For example, the nominal value of a pen is its
money values in different years. Real values adjust for differences in the
price level in those years i.e. Gross Domestic Product (GDP) and
income. For a series of nominal values in successive years, different
values could be because of differences in general price level. Nominal
value does not specify how much of the differences are from changes in
price level. Real values remove this ambiguity.

Real values convert the nominal values as if prices were held constant in
each year of the series. Any differences in real values are then attributed
to differences in quantities of the good that the money income could buy
in each year. For example, suppose the inflation rate in Nigeria is 3% in
2020. We can buy a basket of onion today (2020) and it will cost 100
naira, or we can buy that basket next year (2021) and it will cost 103
naira. If we buy a bond with a 6% nominal interest rate for 100 naira in
2020, sell it after a year (2021) and get 106 naira, buy a basket of onion
for 103 naira in 2021 from the proceed of the bond, we will have 3 naira
left over. So after factoring in inflation, our 100 naira bond will earn us
3 naira in income in 2021.

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3.4.1 Nominal and Real Values

The nominal value of a commodity bundle in a given year depends on

both quantities and then current prices.

Nominal value/ Real value =

Here, P is a price index, and Q is a quantity index of real value. P is

constructed to be equal to 100 in the base year. Alternatively, P can be
constructed to equal 100 in the base year.

Consider a simple case of one commodity. Here, output and

consumption may be measured either in terms of money value (nominal)
or physical quantity (real). Let us denote that commodity and let:

Pi = the unit price of i, say #5

Qi = the quantity of good i, say 10 units.

The nominal value of the good would then be price * quantity.

Nominal value of good i = Pi * Qi = #5 * 10 = #50.

Given only the nominal value and price, derivation of a real value is
immediate.

Real value of good i = = 50/5 = 10.

The price “deflates” (divide) the nominal value to derive a real value.

3.4.2 Nominal and Real Price

Economic decisions are mostly based on relative prices, not absolute

prices. In other words, if all prices and income doubled, there would be
no effect on purchasing decisions because relative prices would not have
changed. Similarly, planting decisions of farmers are largely determined
by the relative prices of different crops.

Inflation describes a general increase in all prices, although the rate of

increase varies across products. Inflation is usually measured by the
consumer price index (CPI), which describes the prices in a given month
as a percentage of prices in a base period. If the CPI has a base month of
January 2000, then by definition the CPI for that month is 100. If the
CPI is 150 in January 2002, this means that prices were 50 per cent
higher in January 2002 than they were two years before. This implies
that the annual inflation rate over this period is (1.5)1/2 = 1.225 or
22.5%.
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Real price in month t =

Real prices are defined as prices that have been adjusted for inflation.
The real price in a given month is calculated by dividing the nominal
price (the price observed in the market) by the CPI of that month, where
the CPI is expressed as a ratio and not a percentage. In other words, a
CPI of 150 is expressed as 1.5. Usually, we are most interested in the
changes in real prices over time rather than the level of real prices at one
time. For example, it is not very useful to know that the real price of
maize in June 2008 was say #40 per unit. It is more interesting to know
that, although nominal prices of maize in 2008 increased by 80%, the
real prices of maize increased by only 45%. This implies that, relative to
other prices in the economy, the price of maize rose by 45% over the
year.

SELF-ASSESSMENT EXERCISE

In what way is nominal price different from real price?

4.0 CONCLUSION

In this unit, we differentiated between microeconomics and

macroeconomics. Microeconomics was said to focus on individual unit
while macroeconomics deals with aggregates. Positive and Normative
economics both answers the question of “what is” and “what ought to
be”, as positive economics deals with explanation and predictions, while
normative economics answer the question of what ought to be and
provision of alternative options. Market comprises of both the buyers
and sellers, and through their interactions, prices of products are
determined. When the quantity demanded by the consumer is equal to
the quantity supplied by the seller, the market is in equilibrium. We
concluded that market failure is likely to occur when the price system is
unable to achieve optimal resource allocation through information
asymmetry.

5.0 SUMMARY

This unit treats the fundamentals of microeconomics by looking into the

concept of positive and normative economics as well as markets. Market
equilibrium was analysed using both algebra and graphically
presentation and finally, market failure. We realised that it is necessary
for students to be refreshed on these basic topics and terms before
moving ahead to other units and modules in order to facilitate easy
understanding of the concepts and terms used.

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6.0 TUTOR-MARKED ASSIGNMENT

1. Calculate the real price of an apple in 1980 naira.

a. Has the real price increased, decreased or stayed the same

from 1980 to 2010?
2. Explain the concept positive and normative economics.
3. Explain the concept of real and nominal price.
4. a. What do you understand by market equilibrium?
b. What do you understand by market failure?
5. a. What is competitive and non-competitive market?
b. Give examples of each.
6. Analyse the competitive market equilibrium using figures.
7. Given the demand and supply functions
Qdx = 25 – 10p and Qsx = -5 + 3p
Determine the equilibrium price and quantity.

7.0 REFERENCES/FURTHER READING

Krugman, P. & Robin, W. (2012). Economics. (3rd ed.). New York:

Worth Publishers.

Lipsey, R. et al. (2008). Economics. (13th ed.). New Jersey: Pearson.

Mankiw, N. G. (2009). Principles of Economics. (7th ed.). Mason, OH:

South-Western Cengage Learning.

Robert, S. P. & Daniel, L. R. (2009). Microeconomics. (7th ed.).

Pearson Education International.

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UNIT 2 ECONOMIC SYSTEMS AND DECISION

MAKING

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Economic Systems
3.2 Evaluating Economic Performance
3.3 Capitalism and Economic Freedom
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

An economic system is a set of rules that governs what goods and

services to produce, how to produce them, and for whom they are
produced. In order to analyse this concept, economic systems such as the
traditional, command and the free market will be discussed.
Furthermore, evaluation of economic performance will be analysed
using some economic and social objectives.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 describe the characteristics of the traditional, command, and

market economies
 explain the advantages and disadvantages of the traditional,
command, and market economies
 describe the basic economic and social goals used to evaluate
economic performance
 evaluate the trade-offs among economic and social goals
 explore the characteristics of a free enterprise system
 describe the role of the entrepreneur, the consumer, and
government in a free enterprise economy.

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3.0 MAIN CONTENT

3.1 Economic Systems
The survival of any society depends on its ability to provide food,
clothing, and shelter for its people. Because these societies face scarcity
and decisions concerning What, How, and For Whom to produce must
be made. All societies have something else in common. They have an
economy, or economic system which is an organised way of providing
for the wants and needs of their people. The way in which these
provisions are made determines the type of economic system they have.

Three major kinds of economic systems exist; the traditional, command,

and market system. Most countries in the world can be identified with
one of these systems.

3.1.1 Traditional Economies

Many of our actions spring from habit and custom. Why, for example,
do so many Nigerians eat chicken at Christmas? Why does the bride toss
the bouquet at a wedding? Why do most people shake hands when they
first meet, or leave tips in restaurants? For the most part, these practices
have been handed down from one generation to the next and have
become tradition - they are parts of our culture. In a society with a
traditional economy, the allocation of scarce resources, and nearly all
other economic activities, stems from ritual, habit, or custom. Habit and
custom also dictate most social behaviour. Individuals are not free to
make decisions based on what they want or would like to have. Instead,
their roles are defined by the customs of their elders and ancestors.
Many societies, such as the Central African Republic pygmies, the
Australian Aborigines, and other indigenous peoples around the world
are good example of traditional economies.

Advantages
The main strength of a traditional economy is that everyone knows
which role to play. Little uncertainty exists over what to produce. If you
are born into a family of hunters, you hunt. If you are born into a family
of farmers, you farm. Likewise, little uncertainty exists over how to
produce, because you do everything the same way your parents did.
Finally, for whom question is determined by the customs and traditions
of the society. Life is generally stable, predictable, and continuous.

Disadvantages

On the other hand, the main drawback of the traditional economy is that
it tends to discourage new ideas and new ways of doing things. The

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strict rules in a traditional society have the effect of punishing people

who act differently or break rules. The lack of progress leads to a lower
standard of living than in other types of economic societies.

SELF-ASSESSMENT EXERCISE

How are the questions of what, how and for whom answered in the
traditional economic system?

3.1.2 Command Economies

Other societies have a command economy, one in which a central

authority makes most of the what, How, and for whom decisions.
Economic decisions are made by the government, and the people have
little, if any, influence over how the basic economic questions are
answered. There are a few command economies left in the world today,
but they still can be found in North Korea and Cuba. Until recently, the
People’s Republic of China, the communist bloc countries of Eastern
Europe, and the former Soviet Union all had command economies. In
the former Soviet Union, the State Planning Commission directed nearly
every aspect of the Soviet economy. It determined needs, decided goals,
and set production quotas for major industries.

If the State Planning Commission wanted growth in heavy

manufacturing, it shifted resources from consumer goods to that sector.
If it wanted to strengthen national defense, it directed resources to the
production of military equipment and supplies.

Advantages

The main strength of a command system is that it can change direction

drastically in a relatively short time. The former Soviet Union went from
a rural (or primitive) agricultural society to a leading industrial nation in
just a few decades. It did so by emphasising heavy industry and
industrial growth rather than the production of consumer goods. During
this period, the central planning agency shifted resources around on a
massive scale. Consumer goods were virtually ignored, and when the
country faced a shortage of male workers on construction projects, the
government put women to work with picks and shovels. Another
advantage is that there is little uncertainty in this type of economy.

People do not have to worry about what they will study, or where they
will work, or if they might lose their job because these decisions are
made for them. Most command economies tend to provide minimum
levels of education, health, and other public services at little or no cost
to its people.

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Disadvantages

One disadvantage of a command system is that it is not designed to meet

the wants of consumers, even though many basic needs are provided. In
the case of Soviet industrial development, generations were forced to do
without consumer goods as cars, home appliances, and adequate
housing. People often were told to sacrifice for the good of the state and
the benefit of future generations. A second disadvantage is that the
system does not give people the incentive to work hard. In most
command economies, workers with different skills and responsibilities
receive similar wages. In addition, people seldom lose their jobs,
regardless of the quality of their work. As a result, many people work
just hard enough to fill the production quotas set by planners. A third
weakness is that the command economy requires a large decision-
making bureaucracy. Many clerks, planners, and other administrators are
needed to operate the system. Most decisions cannot be made until after
consulting a number of people and processing a large amount of
paperwork. These procedures slow decision making and raise the costs
of production.

Yet a fourth weakness of a command economy is that it does not have

the flexibility to deal with minor, day-to-day problems. Even when some
change is needed, the sheer size of the bureaucracy discourages even the
smallest adjustments. As a result, command economies tend to lurch
from one crisis to the next or collapse completely as in the case of the
former Soviet Union.

Finally, people with new or unique ideas find it difficult to get ahead in
a command economy. Rewards for individual initiative are rare. Each
person is expected to perform a job in a factory, in the bureaucracy, or
on a farm, according to the economic decisions made by central
planners.

SELF-ASSESSMENT EXERCISE

What are the disadvantages of Command Economy?

3.1.3 Market Economies

In a market economy, people and firms act in their own best interests to
answer the what, how, and for whom questions. In economic terms, a
market is an arrangement that allows buyers and sellers to come together
in order to exchange goods and services. A market might be in a specific
location, or not. As long as a mechanism exists for buyers and sellers to
get together, a market can exist. In a market economy, people’s
decisions act as votes. When consumers buy a particular product, they

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are casting their naira “votes” for that product. After the “votes” are
counted, producers know what people want. Because producers are
always looking for goods and services that consumers will buy, the
consumer plays a key role in determining what to produce. For example,
many of the largest and most prosperous economies in the world, such
as the United States, Canada, Japan, South Korea, Singapore, Germany,
France, Great Britain, and other parts of Western Europe, are based on
the concept of a market economy. While there are also many significant
differences among these countries, the common thread of the market
binds them together.

Advantages

One advantage of a market economy is that, over time, it can adjust to

change unlike the traditional economy; change is neither prohibited nor
discouraged. Similarly, in command economy, changes is neither
delayed because of bureaucracy, nor suddenly forced on people by
others.

A second major strength of the market economy is its high degree of

individual freedom. Producers may make whatever they think will sell.
They also decide the how question by producing their products in the
most efficient manner. Consumers, on the other hand, spend their money
on the goods and services they prefer. Meanwhile, individuals are free to
choose where and when they want to work.

A third strength is the relatively small degree of government

interference. Except for certain important concerns, such as national
defense and environmental protection, the government tries to stay out
of the way so that buyers and sellers can go about their business. As
long as competition exists, the market economy tends to take care of
itself.

A fourth advantage is that decision making is decentralised, or not

concentrated in the hands of a few. Literally billions, if not trillions of
individual economic decisions are made daily. Collectively, these
decisions direct scarce resources into uses that consumers favor.
Because individuals make these decisions, everyone has a voice in the
way the economy runs.

A fifth strength of the market economy is the incredible variety of goods

and services available to consumers. Almost any product can and will be
produced if a buyer for it exists. In short, if a product can be imagined, it
can be produced in hopes that people are willing to buy it.

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A sixth strength is the high degree of consumer satisfaction. In a market

economy, almost everyone can satisfy his or her wants because the
choice one group makes does not mean that another group cannot have
what it wants.

Disadvantages

One of the disadvantages of the market economy is that it does not

provide for the basic needs of everyone in the society; some members of
the society may be too young, too old, or too weak to care for
themselves. These people would have difficulty surviving in a market
economy without assistance from government or private groups.

Another disadvantage of a market economy is that it does not provide

enough of the services that people value highly. For example, private
markets cannot adequately supply a system of justice, national defense,
universal education, or comprehensive health care. This is because
private producers concentrate on providing products they can sell.
Therefore, government must provide these services.

A third disadvantage of a market economy is the relatively high degree

of uncertainty that workers and businesses face as the result of change.
Workers, for example, worry that their company will move to another
city or country in order to lower the cost of production. Employers
worry that another company will produce a better and less expensive
product, thereby taking their customers.

Finally, market economies can fail if three conditions are not met.
First, markets must be reasonably competitive, allowing producers to
compete with one another to offer the best value for the price. Second,
resources must be reasonably free to move from one activity to another.
Workers, for example, need the freedom to change jobs if they have a
better opportunity elsewhere. Producers need the freedom to produce
goods and services in the best way they know how. Third, consumers
need access to adequate information so that they can weigh the
alternatives and make wise choices. When markets fail, some businesses
become too powerful and some individuals receive incomes much larger
than that justified by their productivity. Because of this, we often have
to rely on government to ensure that sufficient competition, freedom of
resource movement, and adequate information exist.

SELF-ASSESSMENT EXERCISE

Explain the concept of Market Economy.

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3.2 Evaluating Economic Performance

Every economic system has goals such as financial security and freedom
to carry out economic choices. Goals are important because they serve
as benchmarks that help us to determine if the system meets most if not
all of our needs. If the system falls short, then we may demand laws to
change the system until the needs are met.

Economic and Social Goals

People share many broad social and economic goals. While it might be
difficult to find them listed in any one place, they are repeated many
times in the statements that friends, relatives, community leaders, and
elected officials make. We can categorise those statements into seven
major economic and social goals.

Economic Freedom

In Nigeria and mostly the United States, people place a high value on
the freedom to make their own economic decisions. People like to
choose their own occupations, employers, and uses for their money.
Business owners like the freedom to choose where and how they
produce. The belief in economic freedom, like political freedom, is one
of the cornerstones of American society.

Economic Efficiency

Most people recognise that resources are scarce and that factors of
production must be used wisely. If resources are wasted, fewer goods
and services will be produced and fewer wants and needs can be
satisfied. Economic decision making must be efficient so that benefits
gained are greater than costs incurred.

Economic Equity

Many people, for example, believe in equal pay for equal work. As a
result, it is illegal to discriminate on the basis of age, sex, race, religion,
or disability in employment. When it comes to selling products, most
people feel that advertisers should not be allowed to make false claims
about their products.

Economic Security

Everyone desires protection from such adverse economic events as

layoffs and illnesses. States have set up funds to help workers who lose
their jobs. On the national level, Congress has set up Social Security - a

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federal program of disability and retirement benefits that covers most

working people.

Full Employment

When people work, they earn income for themselves while they produce
goods and services for others. If people do not have jobs, however, they
cannot support themselves or their families, nor can they produce output
for others. As a result, people want their economic system to provide as
many jobs as possible.

Price Stability

Another goal is to have stable prices. If inflation (a rise in the general

level of prices) occurs, workers need more money to pay for food,
clothing, and shelter. People who live on a fixed income (an income that
does not increase even though prices go up) find that bills are harder to
pay and that planning for the future is more difficult. High rates of
inflation can discourage business activity. When there is inflation,
interest rates tend to increase. High interest rates discourage businesses
both from borrowing and spending. Price stability makes budgeting
easier and adds a degree of certainty to the future.

Economic Growth

The last major goal of most Nigerians is economic growth. Most people
hope to have a better job, a newer car, better clothes, their own home,
and a number of other things in the future. Growth is needed so that
people can have more goods and services. Because the nation’s
population is likely to grow, economic growth is necessary to meet
everyone’s needs.

SELF-ASSESSMENT EXERCISE

How can an economic performance be evaluated?

3.3 Capitalism And Economic Freedom

A market economy is normally based on a system of capitalism, where

private citizens, many of whom are entrepreneurs, own the factors of
production. Free enterprise is another term used to describe capitalist
economy. In a free enterprise economy, competition is allowed to
flourish with a minimum of government interference.
A free enterprise economy has five important characteristics. Economic
freedom, voluntary exchange, private property rights, the profit motive,
and competition.

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1. Economic Freedom

Individuals as well as businesses enjoy economic freedom, which is the

first characteristic of capitalism. People, for example, have the freedom
to choose their occupation and their employer. To a lesser extent, they
can choose to work where and when they want. With economic freedom,
people can choose to have their own business or to work for someone
else. They can apply for jobs, and they have the right to accept or reject
employment if offered. Economic freedom also means that people can
leave jobs and move on to others things that offer greater opportunity.
Businesses also enjoy economic freedom. They are free to hire the best
workers, and they have the freedom to produce the goods and services
they feel will be the most profitable. Businesses can make as many or as
few goods and services as they want, and they can sell them wherever
they please. They have the right to charge whatever price they feel is
profitable, and they are free to risk success or failure.

2. Voluntary Exchange

A second characteristic of capitalism is voluntary exchange (the act of

buyers and sellers freely and willingly engaging in market transactions).
Moreover, transactions are made in such a way that both the buyer and
the seller are better off after the exchange than before it occurred.
Buyers, for example, can do many things with their money. They can
deposit it in the bank, hide it under a mattress, or exchange it for goods
or services. If they spend their money on a product, they must believe
that the item being purchased is of greater value to them than the money
they gave up.

With voluntary exchange, sellers also have many opportunities to sell

their products. If they exchange their goods and services for cash, they
must feel that the money received is more valuable than the product
being sold, or they would not sell in the first place. In the end, the
transaction benefits both buyer and seller or it would not have taken
place. Both the buyer and the seller obtained something they believed
had more value than the money or products they gave up.

3. Private Property Right

Another major feature of capitalism is the concept of private property

rights, the privilege that entitles people to own and control their
possessions. Private property includes both tangible items such as
houses and cars, and intangible items such as skills and talents. People
are free to make decisions about their property and their own abilities.
They have the right to use or abuse their property as long as they do not
interfere with the rights of others. Private property gives people the

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incentives to work, save, and invest. When people are free to do as they
wish with their property, they are not afraid to use, accumulate, or lend
it. Private property gives people the incentive to be successful; they
know that if they succeed they will be able to keep any rewards they
might earn.

4. Profit Motive

Under free enterprise and capitalism, people are free to risk their savings
or any part of their wealth in a business venture. If the venture goes well
for them, they will earn rewards for their efforts. If things go poorly,
they could lose part or all of their investment. The very possibility of
financial gain, however, encourages many people to become
entrepreneurs, or those who risk entering business in hopes of earning a
profit.

What, however, is profit? Consider the earlier case of voluntary

exchange. Remember that the buyer gives up money to obtain a product,
and the seller gives up the product to obtain money. Unless both parties
believe they will be better off afterward than before, neither will make
the exchange. When exchange takes place, it does so only because both
parties feel they will make a profit. Profit, then, is the extent to which
persons or organisations are better off at the end of a period than they
were at the beginning. The profit motive (the driving force that
encourages people and organisations to improve their material
wellbeing) is largely responsible for the growth of a free enterprise
system based on capitalism.

5. Competition

Finally, capitalism thrives on competition (the struggle among sellers to

attract consumers while lowering costs). Competition is possible
because private individuals, acting as entrepreneurs, own the factors of
production and have the freedom to produce the products they think will
be the most profitable. Because capitalism is based on freedom and
voluntary exchange, buyers compete to find the best products at the
lowest prices. The result is that goods and services are produced at the
lowest cost and are allocated to those who are willing and able to pay for
them.

SELF-ASSESSMENT EXERCISE

What do you understand about the concept of economic freedom?

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4.0 CONCLUSION

 Every society as an economy, or economic system, has a way of

allocating goods and services to satisfy the what, how, and for
whom questions of production.
 In a traditional economy, the major economic decisions are made
according to custom and habit. Life in these economies tends to
be stable, predictable, and continuous.
 In a command economy, government makes the major economic
decisions. Command economies can change direction drastically
in a short time, focusing on whatever the government chooses to
promote.
 A market economy features decentralised decision making with
people and firms operating in their own self-interests.
 The social and economic goals of the Nigerian society include
economic freedom, economic efficiency, economic equity,
economic security, full employment, price stability, and
economic growth.
 When goals conflict, society evaluates the costs and benefits of
each in order to promote one goal over another; many election
issues reflect these conflicts and choices.
 Capitalism is a competitive economic system in which private
citizens own the factors of production
 The five characteristics of capitalism are economic freedom,
voluntary exchange, private property rights, profit motive, and
competition.
 In capitalism, firms are in business to make a profit. To do this
they must offer products consumers want at competitive prices.

5.0 SUMMARY

The unit focused on decision making and the economic system. The
topic captures the different economic systems with emphasis on
traditional, command and the market economic system. The traditional
economy is based on customs and ethics, command system is a centrally
planned economy, while the market system is characterised by minimal
government interventions. The strength and weaknesses of those
economic systems were also discussed.

6.0 TUTOR-MARKED ASSIGNMENT

1. Describe the main strength and weakness of a traditional,

command and market economies.
2. Describe the seven major economic goals which most market
economy agrees on.

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3. State how people and businesses benefit from economic freedom.

7.0 REFERENCES/FURTHER READING

Gary, E. C. (2001). Principles and Practices of Economics. New York:

McGraw-Hill.

Hall, R. E. & Marc, L. (2013). Economics: Principles and Applications.

(6th ed.). Mason, OH: South-Western Cengage Learning.

Samuelson, P. A. & William, B. N. (2010). Economics. (19th ed.). New

York: McGraw-Hill.

Robert, S. P. & Daniel, L. R. (2009). Microeconomics. (7th ed.). New

Jersey: Pearson Education International.

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UNIT 3 COMPARATIVE STATIC AND DYNAMIC

ANALYSIS

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Comparative Static
3.2 The Dynamic Analysis
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Comparative static and dynamic analyses are commonly used to study

changes in supply and demand when analysing a single market, and to
study changes in monetary or fiscal policy when analysing the whole
economy. Comparative static simply compares different equilibrium
state, while dynamic analysis studies the market disequilibrium state and
its adjustment process.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 explain and differentiate between static and dynamic analysis

 analyse the Cobweb model
 analyse the static and dynamic Cobweb diagrams.

3.0 MAIN CONTENT

3.1 COMPARATIVE STATIC

We are often interested in analysing how the consumer’s choice varies

with changes in his wealth and in prices. The examination of a change in
outcome in response to a change in underlying economic parameters is
known as comparative static analysis.

Comparative static analysis is the comparison of two different

equilibrium states, after the process of adjustment. It does not study the
motion towards equilibrium, nor the process of the change itself.

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P
S

D2

D1 e2

P2
e1
P1

Q1 Q2 Q

Fig. 1.2: Comparative Static Equilibrium

In Figure 1.2, comparative statics shows an increase in demand causing

a shift in price and quantity. In comparing two equilibrium states,
comparative statics does not describe how the increases actually occur.

Using Figure 1.2 for example, the initial equilibrium position, price and
quantity for the market is e1, P1 and Q1 respectively. Assuming there is
an expansion in demand over time, this will lead to a new equilibrium at
e2, which is higher than the initial equilibrium. Under comparative
statics, the focus is on comparing these two equilibriums without regard
to the process of adjustment from one equilibrium to another.

3.1.1 Linear Approximation

Comparative statics results are usually derived by using the implicit

function theorem to calculate a linear approximation to the system of
equations that defines the equilibrium, under the assumption that the
equilibrium is stable. That is, if we consider a sufficiently small change
in some exogenous parameter, we can calculate how each endogenous
variable changes using only the first derivatives of the terms that appear
in the equilibrium equations.

For example, suppose the equilibrium value of some endogenous

variable x is determined by the following equation:

Where α is an exogenous parameter. Then, to a first-order

approximation, the change in x caused by a small change in α must
satisfy:

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Here and represent the changes in and , respectively,

while and are the partial derivatives of with respect
to and (evaluated at the initial values of and ), respectively.

Equivalently, we can write the change in as:

The elements of are sometimes called the multipliers of the

elements of a on the elements of x.

3.1.2 Application for Profit Maximisation

Suppose a firm produces n goods in quantities . The firm's

profit is a function p of and of m exogenous
parameters which may represent, for instance, various tax
rates. Provided the profit function satisfies the smoothness and
concavity requirements, the comparative statics method above describes
the changes in the firm's profit due to small changes in the tax rates.

3.1.3 Limitations of Comparative Statics

One limitation of comparative statics using the implicit function theorem

is that results are valid only in a (potentially very small) neighborhood
of the optimum-that is, only for very small changes in the exogenous
variables. Another limitation is the potentially overly restrictive nature
of the assumptions conventionally used to justify comparative statics
procedures.

SELF-ASSESSMENT EXERCISE

Explain the comparative statics model and its application for profit
maximisation.

3.2 Dynamic Analysis

Supply often does not respond freely to price changes. If there is an

increase in the price of a product, except where there is a stock of
inventory, producers must first organise the factors of production
towards producing more of the commodity before there can be an
increase in supply. Thus there is a time lag in supply’s response to price
changes. Dynamic analysis studies the time part of market
disequilibrium or fluctuation and the possibility of market adjustment
process towards equilibrium over time.

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A simple dynamic model to be considered is a situation where supply

responds to price with a time lag (one period of time), while demand
responds to price in the same period without a time lag nor in
anticipation of future price. Such a model is known as the Cobweb
model. It reflects certain markets in reality such as the agricultural
produce or the crop market where supply cannot be changed at short
notice.

3.2.1 The Cobweb Model

The cobweb model or cobweb theory is an economic model that

explains why prices might be subject to periodic fluctuations in certain
types of markets. It describes cyclical supply and demand in a market
where the amount produced must be chosen before prices are observed.
Producers' expectations about prices are assumed to be based on
observations of previous prices. The model shows how achieving supply
and demand equilibrium might be so automatic if, as seems reasonable,
the suppliers set the price and the consumers react with a quantity
demanded. For some of the demand and supply curves, the equilibrium
can be unstable.

The cobweb model is the classic demonstration that dynamic behaviour

by economic agents might not converge to a stable equilibrium with
supply equal to demand. This application provides two ways to show the
outcome and lets us experiment with the key parameter that determines
whether the outcome is stable or not.
P

The Convergence case: Each

P1 new outcome is successively
closer to the intersection of
P3
supply and demand
P2

D
Q
Q1 Q3 Q2

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S
P3

P1 The Divergent case: Each new

outcome is successively further from
the intersection of supply and demand.

P2

D
Q
Q3 Q1 Q2

Fig. 1.3: The Cobweb Model

The Model

The cobweb model is based on a time lag between supply and demand
decisions. Agricultural markets are a context where the cobweb model
might apply, since there is a lag between planting and harvesting.
Suppose that as a result of unexpectedly bad weather, farmers go to
market with an unusually small crop of produce. This shortage,
equivalent to a leftward shift in the market's supply curve, results in high
prices. If farmers expect these high price conditions to continue, then in
the following year, they will raise their production relative to other
crops. Therefore when they go to market the supply will be high,
resulting in low prices. If they then expect low prices to continue, they
will decrease their production for the next year, resulting in high prices
again. This process is illustrated in the first diagram. The equilibrium
price is at the intersection of the supply and demand curves. A poor
harvest in Period 1 means supply falls to Q1, so that prices rise to P1. If
producers plan their Period 2.

Productions under the expectation that this high price will continue, and
then the Period 2 supply will be higher, at Q2. Prices therefore fall to P2
when they try to sell all their output. As this process repeats itself,
oscillating between periods of low supply with high prices and then high
supply with low prices, the price and quantity trace out a spiral. They
may spiral inwards, as in the first figure, in which case the economy
converges to the equilibrium where supply and demand cross; or they
may spiral outwards, with the fluctuations increasing in magnitude.

Simplifying, the cobweb model can have two main types of outcomes:

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(i) If the supply curve is steeper than the demand curve, then the
fluctuations decrease in magnitude with each cycle, so a plot of
the prices and quantities over time would look like an inward
spiral, as shown in the first diagram. This is called the stable or
convergent case.

(ii) If the slope of the supply curve is less than the absolute value of
the slope of the demand curve, then the fluctuations increase in
magnitude with each cycle, so that prices and quantities spiral
outwards. This is called the unstable or divergent case.

Two other possibilities are:

(i) Fluctuations may also remain of constant magnitude, so a plot of

the outcomes would produce a simple rectangle, if the supply and
demand curves have exactly the same slope (in absolute value).
(ii) If the supply curve is less steep than the demand curve near the
point where the two curves cross, but more steep when we move
sufficiently far away, then prices and quantities will spiral away
from the equilibrium price but will not diverge indefinitely;
instead, they may converge to a limit cycle.

SELF-ASSESSMENT EXERCISE

Define dynamic analysis and explain the cobweb model.

4.0 CONCLUSION

In this unit, you have been introduced to the concepts of comparative

static and dynamic analysis. You also understand the difference between
static and dynamic analysis. Linear approximation was calculated using
implicit function before its application for profit maximisation was
treated. It is believed that the student clearly understands the cobweb
model analysis of equilibrium and the limitations of comparative statics.

5.0 SUMMARY

The concepts of comparative static and dynamic analysis were

discussed. A diagram was presented to analyse the comparative static
model as well as the convergence and divergence diagrams of the
cobweb model which explains the stability and instability of markets.

6.0 TUTOR-MARKED ASSIGNMENT

1. What is comparative static analyses

2. What is dynamic analysis

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3. Differentiate between static and dynamic analysis

4. Draw and analyse the comparative static and dynamic cobweb
diagram.

7.0 REFERENCES/FURTHER READING

Frank, R. H. & Bernanke, B. (2013). Principles of Economics. (5th ed.).

New York: McGraw-Hill.

Sexton, R. L. (2013). Exploring Economics. (6th ed.). Mason, OH:

South-Western Cengage Learning.

Rittenberg, L. & Tregarthen, T. (2012). Principles of Economics. V2.0.

Washington, DC: Flat World Knowledge.

Robert, S. P. & Rubinfeld, D. L. (2009). Microeconomics. (7th ed.).

New Jersey: Pearson Education International.

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MODULE 2 THEORY OF DEMAND, CONSUMER

BEHAVIOUR AND OPTIMISATION

Unit 1 Theory of Demand

Unit 2 Elasticities of Demand
Unit 3 Budget Constraint
Unit 4 Theory of Utility Maximisation

UNIT 1 THEORY OF DEMAND

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Individual and Market Demand
3.2 Normal versus Inferior Goods
3.3 Substitution and Complements
3.4 Consumer Surplus
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

The purpose of the theory of demand is to determine the various factors

that affect demand. Demand is a multivariate relationship, that is, it is
determined by many factors simultaneously. Some of the most important
determinants of the market demand for a particular product are its own
price, consumer’s income, prices of other goods, consumer’s tastes,
income, total production, consumer wealth, credit availability,
government policy, past level of demand and income. Traditional theory
of demand has concentrated on four of the above determinants, the price
of the good, price of other goods, income and taste.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 identify the determinants of demand

 differentiate between individual and market demand
 differentiate between normal and inferior goods
 explain the concept of consumer surplus.

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3.0 MAIN CONTENT

3.1 Individual and Market Demand

Demand, a chief economic principle, is the effective want for something

and the willingness and ability to pay for it. A relative concept, demand
is always attached to a certain price point at a particular point in time.
Quantitative demand analysis provides useful guidance to companies
and investors trying to determine their market strategy and the growth
potential of a product. There are two basic types of demand: individual
and market. While both principles overlap in many ways, the scope of
individual demand is much narrower than market demand.

3.1.1 Individual Demand

The individual demand is the demand of one individual or firm. It

represents the quantity of a good that a single consumer would buy at a
specific price point at a specific point in time. While the term is
somewhat vague, individual demand can be represented by the point of
view of one person, a single family, or a single household.

10

D
Q
2
Fig. 2.1: The Demand4 Curve

Based on the above demand, it shows that an increase in price from 5 to

10 led to a fall in quantity demanded from 4 to 2 and vice versa. This
depicts the individual demand curve.

3.1.2 Market Demand

Market demand provides the total quantity demanded by all consumers.

In other words, it represents the aggregate of all individual demands.
There are two basic types of market demand: primary and selective.
Primary demand is the total demand for all of the brands that represent a

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given product or service, such as all phones or all high-end watches.

Selective demand is the demand for one particular brand of product or
service, such as the iPhone. Market demand is an important economic
marker because it reflects the competitiveness of a marketplace, a
consumer’s willingness to buy certain products and the ability of a
company to leverage itself in a competitive landscape. If market demand
is low, it signals to a company that they should terminate a product or
service, or restructure it so that it is more appealing to consumers.

In a clear manner, market demand is the combination of all individual

demand. Let us assume, there are three consumers in the market who
purchase the goods at various prices. The individual demand curves are
dA, dB and dC in Figure 2.2. When the price is P2, consumer A cannot
purchase any good, consumer B purchase 5 units, while consumer C
bought 15 units. The total purchases at price P2 are (10 + 15) = 25 units
of good. If the price is P, the combined purchases of all the consumers
are 35 units of good (3 + 13 + 19).

b1 b2 B
P1
a2
a1
A
P2

d2 D*
d1

Q
Fig. 2.2: Derivation of Market Demand Curve

Figure 2.2 depicts the summation of individual demand to give market

demand. The market demand was derived from the individual demand
curves by horizontally summing the individual curves. At each price, we
sum the quantities each consumer will buy to obtain the total demanded
at their prices.

3.1.3 Factors Influencing Demand

There are several factors that influence individual and market demand.
Individual demand is influenced by an individual’s age, sex, income,
habits, expectations and the prices of competing goods in the
marketplace. Market demand is influenced by the same factors, but on a

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broader scale, the taste, habits and expectations of a community and so

on. It also considers the number of buyers in the market, the rate at
which a certain community is growing and the level of innovation
erupting in the marketplace. Market demand can be measured on an
international, national, regional, local, or even smaller level.

SELF-ASSESSMENT EXERCISE

Define and differentiate between individual demand and market

demand.

3.2 Normal versus Inferior Goods

When the income consumption curve has a positive slope, the quantity
demanded increases with incomes. As a result, the income elasticity of
demand is positive. The greater the shift to the right of the demand
curve, the larger the income elasticity. In this case, the goods are
described as normal (consumers want to buy more of them as their
income increases).

In some cases, the quantity demanded falls as income increases; the

income elasticity of demand is negative. We then describe the good as
inferior. The term inferior simply means that consumption falls when
income rises. For example, Garri is inferior for some people: As their
income increases, they buy less Garri and more corn-flakes. Figure 2.3
shows the income-consumption curve for an inferior good. For relatively
low income levels both Garri and corn-flakes are normal goods. As
income rises, however, the income-consumption curve bends backward
(from point B to C). This shift occurs because Garri has become an
inferior good, and its consumption has fallen as income increased.

CF
15
Income Consumption Curve

10 C
U3

B
5
U2
A U1

G
5 10 20 30
CF = Corn-Flakes G = Garri
Fig. 2.3: Income vs. Consumption

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An increase in a person’s income can lead to less consumption of one of

the two goods being purchased. Here, Garri, though a normal good
between A and B, becomes an inferior good when the income-
consumption curve bends backward between B and C.

3.2.2 Indifference Curve Approach to Normal and Inferior

Goods

Good X
IC1 IC2

X1

X2

BC1
Good Y
Y1 Y2 BC2
Fig. 2.4: Indifference Curve (IC = Indifference
Curve BC = Budget Constraint)

Depending on indifference curve, the amount of a good bought can

either increase, decrease, or stay the same when income increases. In
Figure 2.4, good Y is a normal good since the amount purchased
increases from Y1 to Y2 as the budget constraint shifts from BC1 to the
higher income BC2. Good X is an inferior good since the amount bought
decreases from X1 to X2 as income increases.

SELF-ASSESSMENT EXERCISE

Describe the inferior and normal goods using indifference curve and
income consumption curve

3.3 Substitution and Complements

The demand curve shows the relationship between the price of a good
and the quantity demanded, with preferences, income, and prices of
other goods held constant. Examples of complementary goods are
football boot and football, bread and tea, computer hardware and

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software, etc. other goods such as Milo and Bournvita, flour and wheat,
movie ticket and DVD disk, tend to substitute for one another. Two
goods are substitutes if an increase in the price of one leads to an
increase in the quantity demanded of the other. If the price of a movie
ticket rises, we would expect individuals to rent or buy more DVD discs,
because movie ticket and DVD disc are substitutes. Similarly, two goods
are complements if an increase in the price of one good leads to a
decrease in the quantity demanded of another good. For example, if the
price of petrol goes up, causing petrol consumption to fall, we would
expect the consumption of motor oil to fall as well, because petrol and
motor oil are used together. Two goods are however independent if a
change in the price of one good has no effect in the quantity demanded
of the other.

3.4 Consumer Surplus

Consumer surplus is the monetary gain obtained by consumers because

they are able to purchase a product for a price that is less than the
highest price that they would be willing to pay. The concept of
consumer surplus was introduced to deal with novel complexity raised
by the dominance of monopoly capital. On a supply and demand
diagram, consumer surplus is the area above the equilibrium price of the
good and below the demand curve. This reflects the fact that consumers
would have been willing to buy a single unit of the good at a price
higher than the equilibrium price, a second unit at a price below that but
still above equilibrium, etc., yet they in fact pay just the equilibrium
price for each unit they buy.

Put differently, consumer surplus is the difference between the

maximum price a consumer is willing to pay and the actual price he does
pay. If a consumer is willing to pay more than the current asking price,
then they are getting more benefit from the purchased product than they
spent to buy it. An example of a good with generally high consumer
surplus is drinking water. People would pay very high prices for
drinking water, as they need it to survive. The difference in the price that
they would pay if they had to, and the amount that they pay now is their
consumer surplus. Note that the utility of the first few liters of drinking
water is very high (as it prevents death), so the first few liters would
likely have more consumer surplus than subsequent liters.

The maximum amount a consumer would be willing to pay for a given

quantity of a good is the sum of the maximum price he would be willing
to pay for the first unit, the (lower) maximum price he would be willing
to pay for the second unit, etc. Typically these prices are decreasing;
they are given by the individual demand curve. For a given price the
consumer buys the amount for which the consumer surplus is highest,

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where consumer surplus is the sum, over all units, of the excess of the
maximum willingness to pay over the equilibrium (market) price. The
consumer's surplus is highest at the largest number of units for which,
even for the last unit, the maximum willingness to pay is not below the
market price. Figure 2.5 depicts the consumer surplus.

Consumer Surplus

Q
8
Figure 2.5: Consumer Surplus

SELF-ASSESSMENT EXERCISE

Explain the concept of consumer surplus with graphical illustration.

4.0 CONCLUSION

From our discussion so far on the theory of demand, we can infer the
following:

 income, taste, price and other prices are the major determinants
of demand according to the traditional theory of demand
 individual demand is different from market demand, and for
market demand to hold, individual demand must be summed
together
 as income increases, proportion of income spent on inferior good
tends to reduce and vice versa
 when two goods are used together, and the use of one does not
reduce the use of another, those goods are tagged complimentary
goods otherwise substitutes.
 consumer surplus occurs whenever a consumer pay below the
price he is willing to pay for a good.

5.0 SUMMARY

We discussed the theory of demand where determinants of demand were

identified. Income, taste, price of a commodity and other prices were
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mentioned as the major determinants of demand according to the

traditional theory of demand. In order to analyse market demand,
individual demand were put into consideration, and we can infer that the
summation of all individual demand gives the market demand. Income
consumption curve and the indifference curve were used to explain
inferior and normal goods, and it was confirmed that as the household
income increases, consumption of inferior goods decreases, thus leading
to an increase in the consumption of a normal good. Concept of
substitution and complementary goods were discussed. It was concluded
that if an increase in the price of one good leads to a fall in the demand
of another good, thus the goods concerned are complementary goods,
otherwise substitute. Finally, consumer surplus was discussed, and the
demand curve diagram was used to identify consumer surplus position.
We can infer that the consumer surplus position lies above the supply
curve and equilibrium, but below the demand curve. This simply means
the consumer is paying less than what he was willing to pay ab initio.

6.0 TUTOR-MARKED ASSIGNMENT

Submit an essay of two pages (A4, 1.5 spacing, 12pts, Times New
Roman Font) on the theory of demand, analysis of consumer surplus
using demand curve diagram, inferior and normal good using Income-
Consumption curve and the Indifference Curve.

7.0 REFERENCES/FURTHER READING

Peter, E. & Peter, C. (1990). Principles of Microeconomics. Unwin

Hyman.

Robert, S. P. & Daniel, L. R. (2009). Microeconomics. (7th ed.). New

Jersey: Pearson Education International.

Stephen, H. (1999). Applied Microeconomics. Wiley.

Sexton, R. L. (2013). Exploring Economics. (6th ed.). Mason, OH:

South-Western Cengage Learning,

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UNIT 2 ELASTICITIES OF DEMAND

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Elastic Demand
3.2 Inelastic Demand
3.3 Price Elasticity of Demand
3.4 Arc Elasticity of Demand
3.5 Income Elasticity of Demand
3.6 Cross Elasticity of Demand
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Elasticity of demand is an important variation of the concept of demand.

Demand can be classified as elastic or inelastic. It is the degree to which
the demand for a good or service varies with its price. Normally, sales
increase with drop in prices and decrease with rise in prices. As a
general rule, appliances, cars, confectionary and other non-essentials
show elasticity of demand whereas most necessities (food, medicine,
basic clothing) show inelasticity of demand (do not sell significantly
more or less with changes in price).

An elastic demand is one in which the change in quantity demanded due

to a change in price is large. An inelastic demand is one in which the
change in quantity demanded due to a change in price is small. The
formula for computing elasticity of demand is:

If the formula creates a number greater than 1, the demand is elastic. In

other words, quantity changes faster than price. If the number is less
than 1, demand is inelastic. In other words, quantity changes slower than
price. If the number is equal to 1, elasticity of demand is unitary. In
other words, quantity changes at the same rate as price.

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2.0 OBJECTIVES

At the end of this unit, you should be able to:

 define and calculate elasticity of demand

 define and calculate the price elasticity of demand and its effect
on normal and inferior goods
 have an in-depth knowledge of the term arc elasticity of demand
and cross elasticity of demand.

3.0 MAIN CONTENT

3.1 Elastic Demand

Elasticity of demand is illustrated in Figure 2.6 Note that a change in

price results in a large change in quantity demanded. An example of
products with an elastic demand is consumer durable which is depicted
in Figure 2.6. These are items that are purchased infrequently, like a
washing machine or an automobile, and can be postponed if price rises.
For example, automobile rebates have been very successful in increasing
automobile sales by reducing price. Close substitutes for a product affect
the elasticity of demand. If another product can easily be substituted for
your product, consumers will quickly switch to the other product if the
price of your product rises or the price of the other product declines. For
example, beef, pork and poultry are all meat products. The declining
price of poultry in recent years has caused the consumption of poultry to
increase, at the expense of beef and pork. So products with close
substitutes tend to have elastic demand.

P1

P2

DD

Q
Q1 Q2
Fig. 2.6: Elastic Demand

For example, if P1 = N10

P2 = N8
Q1 = 30

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Q2 = 50

Elasticity using the above formula = = 20 ÷ 80/ 2 ÷ 18

Elasticity = 9/4 = 2.25.

SELF-ASSESSMENT EXERCISE

How can you determine if demand is elastic?

3.2 Inelastic Demand

Inelastic demand is shown in Figure 2.7. Note that a change in price

results in only a small change in quantity demanded. In other words, the
quantity demanded is not very responsive to changes in price. Examples
of this are necessities like food and fuel consumers will not reduce their
food purchases if food prices rise, although there may be shifts in the
types of food they purchase. Also, consumers will not greatly change
their driving behaviour if gasoline prices rise.

Price

P1

P2

Demand

Q1 Q2 Quantity
Fig. 2.7: Inelastic Demand

For example, assuming:

P1 = N12
P2 = N6
Q1 = 40
Q2 = 50
= 10÷90 / 6÷18

Elasticity = 3/9 = 0.33.

This does not mean that the demand for an individual producer is
inelastic. For example, a rise in the price of petroleum at all stations may

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not reduce petroleum sales significantly. However, a rise of an

individual station’s price will significantly affect that station’s sales.

SELF-ASSESSMENT EXERCISE

How do we determine inelastic demand?

3.3 Price or Point Elasticity of Demand

This is a measure of responsiveness of the quantity of a raw good or

service demanded to changes in its price. The formula for the price
elasticity of demand is:

PED = (% change in Quantity demanded) / (% change in Price).

For example, if the price of a mobile phone changes from N9 to N10,

and quantity bought changes from 150 to 110, calculate the price
elasticity of demand.

P0 = 9
P1 = 10
Q0 = 150
Q1 = 110

Where P0 and Q0 represent the old price and quantity and P1 and Q1
represent the new price and quantity. To calculate the price elasticity, we
need to know what the percentage change in quantity demand is and
what the percentage change in price is. It's best to calculate this one at a
time.

Q1 – Q0/Q0 = Percentage change in quantity.

(110-150) / 150 = -0.2667 (1)

The above figure is the percentage change in quantity demanded. We

need to also calculate the percentage change in price.

P1 – P0/P0 = Percentage change in price

(10 – 9) / 9 = 0.1111 (2)

Applying the (1) and (2) to the PED formula gives the PED figure.
PED = (-0.2667) / (0.1111) = -2.4005.

In analysing price elasticities, we are concerned with their absolute

value, so we ignore the negative sign. Based on the final outcome of the
PED, conclusion can be drawn that the price elasticity of demand when
the price increases from N9 to N10 is 2.4005.

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Interpretation of Price Elasticity of Demand

If PED > 1, then demand is price elastic (demand is sensitive to price

changes)

If PED = 1, then demand is unit elastic

If PED < 1, then demand is price inelastic (demand is not sensitive to

price changes)

SELF-ASSESSMENT EXERCISE

What are the decision rules for price elasticity of demand?

3.4 Arc Elasticity of Demand

The arc elasticity is the elasticity of one variable with respect to another
between two given points. It is the ratio of the percentage change of one
of the variables between the two points to the percentage change of the
other variable. It contrasts with the point or price elasticity, which is the
limit of the arc elasticity, as the distance between the two point
approaches zero and which hence, is defined at a single point rather for a
pair of points.

This approach is used when there is no general function to define the

relationship of the two variables. Arc elasticity of demand is the
percentage change in quantity demanded for a unit change in price. Arc
elasticity computes the percentage change between two points in relation
to the average of the two prices and the average of the two quantities,
rather than the change from one point to the next.

The y arc elasticity of x is defined as:

Ex,y=

Where the percentage change in going from point 1 to point 2 is usually

calculated relative to the midpoint:

% change in x =

% change in y =

The arc elasticity of quantity demanded Q with respect to price P is

broadly calculated as:

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(% change in Q) / (% change in P).

For example, suppose that the two points on a demand curve, (Q1, P1)
and (Q2, P2) are known, the arc elasticity is obtained using the formula:

Ep =

Suppose the quantity of meat-pie demanded at halftime of football

games is measured at two different games: at one measurement it is 80
units, and at the other measurement it is 120 units. The percent change,
measured against the average, would be (120-80)/((120+80)/2))=40%.
In contrast, if the percentage change were measured against the initial
value, the result would be (120-80)/80= 50%. The percent change for
the opposite trend, 120 units to 80 units, would be (80-120)/120 = -
33.3%. The midpoint formula has the benefit that a movement from A to
B is measured as the same as a movement from B to A in absolute value.
(In this case, the movement from 120 to 80 would be measured as -40
%.)

Suppose that the change in the price of meat-pie, which led to this
change in quantity demanded from 80 to 120, was from N3 to N1. The
percent change in price measured against the midpoint would be (1-3)/2
= -100%, so the price elasticity of demand is 40%/(-100%) or -40%. It is
common to refer to the absolute value of the price elasticity as simply
price elasticity, since for a normal (decreasing) demand curve the
elasticity is always negative and so the "minus" part can be made
implicit. Thus the demand of the football fans for meat-pie has 40%
elasticity.

SELF-ASSESSMENT EXERCISE

Why do we ignore the negative sign of arc elasticity of demand?

3.5 Income Elasticity of Demand

This is a measure of the relationship between a change in the quantity

demanded for a particular good and a change in real income. Put
differently, income elasticity of demand measures the responsiveness of
the demand for a good to a change in the income of the people
demanding the good, ceteris paribus. It is calculated as the ratio of the
percentage change in demand to the percentage change in income, i.e.
in response to a 10% increase in income, the demand for a good

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increased by 20%, the income elasticity of demand would be 20%/10%

= 2.

Income elasticity of demand is calculated basically using this formula:

IED = (% change in quantity demanded) / (% change in income).

Consider another example where the quantity demanded of a good

increases by 15% due to a 10% increase in income, the income elasticity
of demand would be 15% / 10% = 1.5. The degree to which the quantity
demanded for good changes in response to a change in income depends
on whether the good is a necessity or a luxury.

Normal good have positive income elasticity of demand. As income

rises, more goods are demanded at each price level. The quantity
demanded for normal necessities will increase with income, but at a
slower rate than luxury goods. This is because consumers, rather than
buying more of the necessities, will likely use their increased income to
purchase more luxury goods and services. During a period of increasing
incomes, the quantity demanded for luxury products tends to increase at
a higher rate than the quantity demanded for necessities. The quantity
demanded for luxury goods is very sensitive to changes in income. On
the other hand, inferior goods have a negative income elasticity of
demand - the quantity demanded for inferior goods falls as income rise.
For example, the quantity demanded for generic food items tends to
decrease during periods of increased incomes.

Possible outcome of income elasticity of demand

(i) High income elasticity of demand: In this case, increase in

income is accompanied by relatively larger increase in quantity
demanded. Here the value of coefficient Ey is greater than unity
(Ey>1). E.g.: 20% increase in quantity demanded due to 10%
increase in income.
(ii) Unitary income elasticity of demand: In this case increase in
income is accompanied by exactly equal proportionate increase in
quantity demanded. Here the value of coefficient Ey is equal to
unity (Ey=1). E.g.: 10% increase in quantity demanded due to
10% increase in income.
(iii) Low income elasticity of demand: In this case proportionate
increase in income is accompanied by relatively lower increase in
quantity demanded. Here the value of coefficient Ey is less than
unity (Ey<1). E.g.: 5% increase in quantity demanded due to 10%
increase in income.
(iv) Zero income elasticity of demand: This shows that quantity
bought is constant regardless of changes in income. Here the

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value of coefficient Ey is equal to zero (Ey=0). E.g.: No change

in quantity demanded even 10% increase in income.
(v) Negative income elasticity of demand: In this case increase in
income is accompanied by decrease in quantity demanded. Here
the value of coefficient Ey is less than zero/negative (Ey<0). E.g.:
5% decrease in quantity demanded due to 10% increase in
income.

SELF-ASSESSMENT EXERCISE

What is the formula for calculating income elasticity of demand?

3.6 Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of the demand

for a good to a change in the price of another good. It is measured as the
percentage change in demand for the first good that occurs in response
to a percentage change in price of the second good. For example, if in
response to a 10% increase in the price of fuel, the demand of a new cars
that are fuel sufficient decreased by 20%, the cross elasticity of demand
would be: -20% / 10% = -2.

A negative cross elasticity denotes two products that are complements,

while a positive cross elasticity denotes two substitute products.
Assuming products A and B are complements, meaning that an increase
in the demand for A is caused by an increase in the quantity demanded
for B. Therefore, if the price of product B decreases, then the demand
for product A shifts to the right, increasing A’s demand, resulting in a
negative value for the cross elasticity of demand. The exact opposite
reasoning holds for substitutes.

Or

Where:

P1A = The price of good A at time period 1

P2A = The price of good A at time period 2
Q1B = The quantity demanded of good B at the time period 1
Q2B = The quantity demanded of good B at the time period 2
ΔQB = The change in the quantity demanded of good B
ΔPA = The change in price of good A

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The cross elasticity of demand for substitute goods will always be

positive, because the demand for one good will increase if the price for
the other good increases. For example, if the price of coffee increases
(but everything else stays the same), the quantity demanded for tea (a
substitute beverage) will increase as consumers switch to an alternative.
On the other hand, the coefficient for complements will be negative. For
example, if the price of coffee increases (but everything else stays the
same), the quantity demanded for coffee stir sticks will drop as
consumers will purchase fewer sticks. If the coefficient is 0, then the
two goods are not related.

SELF-ASSESSMENT EXERCISE

Define the term cross elasticity of demand.

4.0 CONCLUSION

From our discussion so far on the elasticity of demand, we can infer the
following:

 when an increase in price leads to a decrease in quantity

demanded, such demand can be refer to as inelastic otherwise
elastic
 percentage change in quantity demanded of product A divided by
the percentage change in price of product B gives the cross
elasticity of demand
 income elasticity of demand is calculated as the percentage
change in quantity demanded divided by percentage change in
income.

5.0 SUMMARY

Elasticity of demand is classified into elastic and inelastic. When the

change in price results in a large change in quantity demand; such
demand is elastic otherwise inelastic. Price elasticity of demand was
reviewed, and it is understood that it measures the responsiveness of the
quantity demanded of a good to changes in its price. Arc elasticity of
demand measures the elasticity of one variable with respect to another
between two given points. Income elasticity of demand was also
reviewed. This measures the relationship between a change in the
quantity demanded for a particular good and a change in real income.
Finally, the cross elasticity of demand measures the responsiveness of
the demand for a good to a change in the price of another good.

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6.0 TUTOR-MARKED ASSIGNMENT

1. Assuming an increase in price from N10 to N15 led to a decrease

in the quantity demanded from 20 to 12.

(a) Calculate the elasticity of demand and interpret the result.

(b) Calculate the price elasticity of demand

2. P1 = 5, P2 = 7
Q1 = 4, Q2 = 2
Using the above information, calculate:

(a) Arc elasticity of demand

(b) Cross elasticity of demand.

7.0 REFERENCES/FURTHER READING

Koutsoyiannis, A. (n. d.). Modern Microeconomics. (2nd ed.).

International.

McEachern, W. A. (2014). Economics: A Contemporary Introduction.

(10th ed.). Mason, OH: South-Western Cengage Learning.

Miller, R. L. (2014). Economics Today. (17th ed.). Upper Saddle River,

NJ: Pearson.

O'Sullivan, et al. (2014). Economics: Principles, Applications, and

Tools. (8th ed.). Upper Saddle River, N. J.: Pearson.

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UNIT 3 BUDGET CONSTRAINT

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 The Concept of Budget
3.2 The Concept of Budget Constraint
3.3 Properties of the Budget Set
3.4 How the Budget Line Changes
3.5 Implication of Taxes and Subsidies on Budget
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

A budget is a quantitative expression of a plan for a defined period of

time. It may include planned sales volumes and revenues, resource
quantities, costs and expenses, assets, liabilities and cash flows. It
expresses strategic plans of business units, organisations, activities or
events in measurable terms. Budget constraint represents all the
combinations of goods and services that a consumer may purchase given
current prices within his or her given income.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 define and analyse the term budget constraint

 explain the effect of price and income change on the budget line
 analyse how the budget line changes
 describe the combine effect of price and subsidy on consumer
income.

3.0 MAIN CONTENT

3.1 The Concept of Budget

Budget is an estimation of the revenue and expenses over a specified

future period of time. A budget can be made for a person, family, group
of people, business, government, country, multinational organisation or
just about anything else that makes and spends money. A budget is a

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microeconomic concept that shows the tradeoff made when one good is
exchanged for another. In other words, a budget is an important concept
in microeconomics, which uses a budget line to illustrate the trade-offs
between two or more goods.

Budget helps to aid the planning of actual operations by forcing

producers to consider how the conditions might change and what steps
should be taken now and by encouraging managers to consider problems
before they arise. It also helps co-ordinate the activities of the
organisation by compelling managers to examine relationships between
their own operation and those of other departments.

A surplus budget means profits are anticipated, while a balanced budget

means that revenues are expected to equal expenses. A deficit budget
means expenses will exceed revenues. Budgets are usually compiled and
re-evaluated on a periodic basis. Adjustments are made to budgets based
on the goals of the budgeting organisation. In some cases, budget
makers are happy to operate at a deficit, while in other cases, operating
at a deficit is seen as financially irresponsible.

SELF-ASSESSMENT EXERCISE

Define the term budget.

3.2 The Concept of Budget Constraint

A budget constraint is an accounting identity that describes the

consumption options available to a consumer with a limited income (or
wealth) to allocate among various goods. It is important to understand
that the budget constraint is an accounting identity, not a behavioural
relationship. A consumer may well determine his behaviour by
considering his budget constraint, but his budget constraint is a given
element of the problem he faces. For instance, suppose that there is
some set of goods from which the consumer can choose. In real life
there are many goods to consume, but for our purposes it is convenient
to consider only the case of two goods. We will indicate the consumer's
consumption bundle by (xl, x2). This is simply a list of two numbers that
tells us how much the consumer is choosing to consume of good 1, xl,
and how much the consumer is choosing to consume of good 2, x2.

We suppose that we can observe the prices of the two goods, (pl and p2),
and the amount of money the consumer has to spend, m. Then the
budget constraint of the consumer can be written as:

(1)

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Here, p1x1 is the amount of money the consumer is spending on Good

1, and p2x2 is the amount of money the consumer is spending on Good 2.

The budget constraint of the consumer requires that the amount of

money spent on the two goods be no more than the total amount the
consumer has to spend. The consumer's affordable consumption bundles
are those that don't cost any more than m. We call this set of affordable
consumption bundles at prices (pl, p2) and income m the budget set of
the consumer.

The two-good assumption is more general, since we can often interpret

one of the goods as representing everything else the consumer might
want to consume. For example, if we are interested in studying a
consumer's demand for milk, we might let xl measure his or her
consumption of milk in tins per month. We can then let x2 stand for
everything else the consumer might want to consume.

When we adopt this interpretation, it is convenient to think of good 2 as

being the naira that the consumer can use to spend on other goods.
Under this interpretation the price of good 2 will automatically be 1,
since the price of one naira is one naira. Thus the budget constraint will
take the form:

(2)

This expression simply says that the amount of money spent on Good 1,
p1x1, plus the amount of money spent on all other Goods, x2, must be no
more than the total amount of money the consumer has to spend, m.

We say that Good 2 represents a composite good that stands for

everything else that the consumer might want to consume other than
Good 1. Such a composite good is invariably measured in naira to be
spent on goods other than Good 1. As far as the algebraic form of the
budget constraint is concerned, equation (2) is just a special case of the
formula given in equation (1), with p2 = 1, so everything that we have to
say about the budget constraint in general will hold under the composite
good interpretation.

SELF-ASSESSMENT EXERCISE

i. What is budget constraint?

ii. Express budget constraint algebraically.

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3.3 Properties of the Budget Set

Budget set consist of all bundles that are affordable at the given prices
and income. The budget line is the set of bundles that cost exactly m:

(3)

These are the bundles of goods that just exhaust the consumer's income.
The budget set is depicted in diagram below. The downward sloping line
is the budget line which also represents the bundles that cost exactly m,
and the bundles below this line are those that cost strictly less than m.

x2

Vertical
intercept Budget line slope = -p1/p2
= m/p2

x1
Horizontal intercept = m/pt
Fig. 2.7a: Budget Line Analysis

Rearranging the budget line in equation (3) gives us the formula:

(4)

The above formula tells us how many units of Good 2 the consumer
needs to consume in order to just satisfy the budget constraint if she is
consuming xl units of Good 1.

Here is an easy way to draw a budget line given prices (pl , p2) and
income m. The question of how much of Good 2 the consumer could
buy if she spent all of her money on Good 2 is then asked. The answer
is, of course, m/p2. Then ask how much of Good 1 the consumer could
buy if she spent all of her money on Good 1. The answer is m/pl. Thus,
the horizontal and vertical intercepts measure how much the consumer
could get if she spent all of her money on Goods 1 and 2, respectively.

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The slope of the budget line has a nice economic interpretation. It

measures the rate at which the market is willing to "substitute" Good l
for Good 2. Suppose for example that the consumer is going to increase
her consumption of Good 1 by ∆xl.' How much will her consumption of
Good 2 have to change in order to satisfy her budget constraint? Let us
use ∆x2 to indicate her change in the consumption of Good 2. Now note
that if she satisfies her budget constraint before and after making the
change she must satisfy:

And

Subtracting the first equation from the second gives:

This says that the total value of the change in her consumption must be
zero. Solving for ∆x2/∆xl, the rate at which Good 2 can be substituted
for Good 1 while still satisfying the budget constraint, gives:

This is just the slope of the budget line. The negative sign is there since
∆xl and ∆x2 must always have opposite signs. If you consume more of
Good 1, you have to consume less of Good 2 and vice versa if you
continue to satisfy the budget constraint.

SELF-ASSESSMENT EXERCISE

Identify the properties of a budget line.

3.4 How the Budget Line Changes

When prices and incomes change, the set of goods that a consumer can
afford changes as well. To determine how these changes affect the
budget set, we will have to consider changes in income. It is easy to see
from equation (4) that an increase in income will increase the vertical
intercept and not affect the slope of the line. Thus, an increase in income
will result in a parallel shift outward of the budget line as in Figure 2.7b.
Similarly, a decrease in income will cause a parallel shift inward.

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x2

m1/p2
Budget lines

m/p2

Slope = -p1/p2

x1
m/p1 m1/p1
Fig. 2.7b: Budget Line Analysis

We need to consider changes in price as well, in order to do this, let us

first consider increasing price 1 while holding price 2 and income fixed.
According to equation (4), increasing pl will not change the vertical
intercept, but it will make the budget line steeper since pl/p2 will become
larger.

Another way to see how the budget line changes is to use the trick
described earlier for drawing the budget line. If you are spending all of
your money on Good 2, then increasing the price of Good 1 does not
change the maximum amount of Good 2 you could buy, thus the vertical
intercept of the budget line does not change. But if you are spending all
of your money on Good 1, and Good 1 becomes more expensive, then
your consumption of Good 1 must decrease. Thus the horizontal
intercept of the budget line must shift inward, resulting in the Figure
2.7c.
X2

m/p2
Budget Line

Slope=-p1/p2
Slope=-p11/p2
X1
m/p11 m/p1

Fig. 2.7c: Budget Line Analysis

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What happens to the budget line when the prices of Good 1 and Good 2
change at the same time? Suppose for example that we double the prices
of both Goods 1 and 2. In this case, both the horizontal and vertical
intercepts shift inward by a factor of one-half, and therefore the budget
line shifts inward by one-half as well. Multiplying both prices by two is
just like dividing income by 2. We can also see this algebraically.
Suppose our original budget line is:

Now suppose that both prices become t times as large. Multiplying both
prices by t yields:

But this equation is the same as:

Thus, multiplying both prices by a constant amount t is just like dividing

income by the same constant t. It follows that if we multiply both prices
by t and we multiply income by t, then the budget line will not change at
all. We can also consider price and income changes together. What
happens if both prices go up and income goes down? Think about what
happens to the horizontal and vertical intercepts. If m decreases and pl
and p2 both increase, then the intercepts m/pl and m/p2 must both
decrease. This means that the budget line will shift inward. What about
the slope of the budget line? If Price 2 increases more than Price 1, so
that -pl/p2 decreases (in absolute value), then the budget line will be
flatter; if Price 2 increases less than Price 1, the budget line will be
steeper.

SELF-ASSESSMENT EXERCISE

Highlight and explain the factors that cause changes in budget line.

3.5 Implication of Taxes and Subsidies on Budget

Economic policy often uses tools that affect a consumer's budget

constraint, such as taxes. For example, if the government imposes a
quantity tax, this means that the consumer has to pay a certain amount to
the government for each unit of the good he purchases. Consider for
example, a #15 tax on a liter of petroleum. How does this quantity tax
affect the budget line of a consumer? From the viewpoint of the
consumer, the tax is just like a higher price. Thus, a quantity tax of t

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naira per unit of Good 1 simply changes the price of Good 1 from pl to
pl+ t. This implies that the budget line must get steeper.

Another kind of tax is a value tax. As the name implies, this is a tax on
the value-the price-of a good, rather than the quantity purchased of a
good. A value tax is usually expressed in percentage terms. Consider for
example if the sales tax is 6 per cent, then a good that is priced at #1
naira will actually sell for #1.06. (Value taxes are also known as ad-
valorem taxes).If Good 1 has a price of pl but is subject to a sales tax at
rate 7, then the actual price facing the consumer is (1 + t)pl. The
consumer has to pay pl to the supplier and tpl to the government for each
unit of the good. Therefore, the total cost of the good to the consumer is
(1 + t)pl.

A subsidy is the opposite of a tax. In the case of a quantity subsidy, the

government gives an amount to the consumer that depends on the
amount of the good purchased. If, for example, the consumption of milk
were subsidised, the government would pay some amount of money to
each consumer of milk depending on the amount that consumer
purchased. If the subsidy is s naira per unit of consumption of Good 1,
then from the viewpoint of the consumer, the price of Good 1 be pl - s.
This would therefore make the budget line flatter.

Similarly, an ad-valorem subsidy is a subsidy based on the price of the

good being subsidised. If the government gives you back #1 for every #2
you donate to charity, then your donations to charity are being
subsidised at a rate of 50 per cent. In general, if the price of Good 1 is pl
and Good 1 is subject to an ad-valorem subsidy at rate a, then the actual
price of Good 1 facing the consumer is (1 - a)pl .

We can see that taxes and subsidies affect prices in exactly the same
way except for the algebraic sign: a tax increases the price to the
consumer, and a subsidy decreases it. Another kind of tax or subsidy
that the government might use is a lump sum tax or subsidy. In the case
of a tax, this means that the government takes away some fixed amount
of money, regardless of the individual's behaviour. Thus, a lump-sum
tax means that the budget line of a consumer will shift inward because
his money income has been reduced. Similarly, a lump-sum subsidy
means that the budget line will shift outward. Quantity taxes and value
taxes tilt the budget line one way or the other depending on which good
is being taxed, but a lump-sum tax shifts the budget line inward.

Governments also sometimes impose rationing constraints. This means

that the level of consumption of some good is fixed to be no larger than
some amount. Suppose, for example, that Good 1 were rationed so that
no more than x1* could be consumed by a given consumer. Then the

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budget set of the consumer would look like that depicted in the diagram
below: it would be the old budget set with a piece lopped off. The
lopped-off piece consists of all the consumption bundles that are
affordable but have xl> x1*.

x2

Budget line

Budget
set

x1
X1*
Fig. 2.7d: Budget Line Analysis

Sometimes taxes, subsidies, and rationing are combined. For example,

we could consider a situation where a consumer could consume Good 1
at a price of p1 up to some level x1, and then had to pay a tax t on all
consumption in excess of xI. The budget set for this consumer is
depicted in Figure 2.7e. Here the budget line has a slope of -pl/p2 to the
left of x1, and a slope of -(pl + t)/p2 to the right of x1.

x2

Budget line

Slope = -p1/p2

Budget
set Slope = -(p1 + t)/p2

x1
X1*
Fig. 2.7e: Budget Line Analysis

SELF-ASSESSMENT EXERCISE

What are the effects of subsidy and taxes on the budget line?

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4.0 CONCLUSION

From our discussion so far on budget constraint, we can infer the

following:

 that the amount of money consumers can spend on goods cannot

be more than his income
 p1x1+p2x2=m represents the budget constraint, that is, the prices
and goods that money income (m) can buy at a point in time
 when prices and incomes change, the set of goods that a
consumer can afford changes as well
 when the price of Good A increases while price of Good B and
income remain constant, the budget line becomes steeper and
vice versa
 when both prices of Good A and B go up while income reduces,
the budget line shifts inward.

5.0 SUMMARY

The budget set consists of all bundles of goods that the consumer can
afford at given prices and income. We assumed that there are only two
goods, but this assumption is more general than it seems. The budget
line is written as plxl +p2x2 = m. It has a slope of -pl/p2, a vertical
intercept of m/p2, and a horizontal intercept of m/pl. Increasing income
shifts the budget line outward. Increasing the price of good 1 makes the
budget line steeper. Increasing the price of good 2 makes the budget line
flatter. Taxes, subsidies, and rationing change the slope and position of
the budget line by changing the prices paid by the consumer.

6.0 TUTOR-MARKED ASSIGNMENT

1. If the income of the consumer increases and one of the prices

decreases at the same time, will the consumer necessarily be at
least as well-off?
2. If the price of Good 1 doubles and the price of Good 2 triples do
the budget line become flatter or steeper?
3. Suppose that the government puts a tax of #20 naira on a liter of
petroleum and then later decides to put a subsidy on petroleum at
a rate of #12 naira per liter. What net tax is this combination
equivalent to?
4. What happens to the budget line if the price of Good 2 increases,
but the price of Good 1 and income remain constant?
5. Originally the consumer faces the budget line plxl + p2x2 = m.
Then the price of Good 1 doubles, the price of Good 2 becomes 8
times larger, and income becomes 4 times larger. Write down an

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equation for the new budget line in terms of the original prices
and income.

7.0 REFERENCES/FURTHER READING

Cowen, T. & Alex, T. (2012). Modern Principles: Economics. (2nd ed.).

New York: Worth Publishers.

Frank, R. H. & Bernanke, B. (2013). Principles of Economics. (5th ed.).

New York: McGraw-Hill.

Gottheil, F. M. (2014). Principles of Economics. (7th ed.). Mason, OH:

South-Western Cengage Learning.

Koutsoyiannis, A. (n. d.). Modern Microeconomics. (International ed.).

Varian, H. R. (n. d.). Intermediate Microeconomics: A Modern

Approach. (7th ed.).

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UNIT 4 THEORY OF UTILITY MAXIMISATION

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Cardinal Utility Theory
3.2 Ordinal Utility Theory
3.3 Diamond-Water Paradox
3.4 Principle of Optimisation
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Utility is the ability of a good to satisfy needs or wants. Utility is also a

representation of preferences over some set of goods and services.
Preferences have a (continuous) utility representation so long as they are
transitive, complete, and continuous. Utility is an important concept in
economics and game theory, because it represents satisfaction
experienced by the consumer of a good. Not coincidently, a good is
something that satisfies human wants and provides utility, for example,
to a consumer making a purchase. It was recognised that one cannot
directly measure benefit, satisfaction or happiness from a good or
service, so instead economists have devised ways of representing and
measuring utility in terms of economic choices that can be counted.

Economists have attempted to perfect highly abstract methods of

comparing utilities by observing and calculating economic choices. In
the simplest sense, economists consider utility to be revealed in people's
willingness to pay different amounts for different goods. There are two
basic approaches to problem of comparison of utilities, the cardinalist
approach and the ordinalist approach.

2.0 OBJECTIVES

At end of this unit, you should be able to:

 differentiate between cardinal and ordinal utility theory

 explain the assumptions of Revealed Preference Hypothesis and
indifference curves
 analyse the Revealed Preference Hypothesis and indifference
curves

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 describe the Diamond-Water paradox

 explain optimisation.

3.0 MAIN CONTENT

3.1 Cardinal Utility Theory

A measure of utility, or satisfaction derived from the consumption of

goods and services that can be measured using an absolute scale.
Cardinal utility exists if the utility derived from consumption is
measurable in the same way that other physical characteristics (like
height and weight) are measured using a scale that is comparable
between people. Put differently, cardinal utility theory argues that a
consumer has the capacity to measure the level of satisfaction that she
derives from consumption of a given quantity of a commodity.

Utility is a prejudiced or introspective notion associated with the internal

perceptions and feelings of the customer. Therefore, it is certainly not
possible for you to gauge the utility of a product to a shopper directly.

However an indirect measure of utility is present in the price that is paid

by the consumer for the specific commodity. The higher the price
compensated by the customer for a product, greater will be its utility.
Price could, therefore, be a measure of the utility of a commodity. For
example, if a shopper is willing to spend #2 naira for an apple and #1
naira for an orange, and then the utility of the apple to the buyer is twice
that of the orange. To put it differently, the utilities of two distinct goods
to one particular customer could be measured by the prices that he or she
would like to pay for them. Money is, hence, a measuring rod, which is
often used by the economists to determine utilities of goods.

Assumptions

1. Rationality: The consumer is rational. He aims at the

maximisation of his utility subject to the constraint imposed by
his income.
2. Cardinal utility: The utility of each commodity is measurable.
Utility is a cardinal concept, and the most convenient measure is
money (measured by the monetary unit the consumer is willing to
pay for another unit of the commodity).
3. Constant marginal utility of money: This assumption necessary if
money is used as the measure of utility. The standard of
measurement must be constant. If the marginal utility of money
changes as income increases (or decreases), the measuring-rod
for utility becomes like an elastic ruler, thus inappropriate for
measurement.

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4. Diminishing marginal utility: The utility gained from

consumption of successive units of a commodity diminishes. That
is, the marginal utility of a commodity diminishes as the
consumer acquires larger quantities of it. This is an axiom of
diminishing marginal utility.
5. The total utility of a basket of goods depends on the quantity of
the individual commodities. If there are n commodities in the
bundle with quantities x1, x2, . . ., xn, the total utility is:
U = ƒ(x1, x2, . . .,xn).

Critique of the cardinal approach

There are three basic weaknesses in the cardinalist approach. They are:

1. The assumptions of cardinal utility theory are unrealistic.

2. The satisfaction derived from various commodities cannot be
measured objectively.
3. The assumption of constant utility of money is unrealistic. As
income increases, the marginal utility of money changes.

SELF-ASSESSMENT EXERCISE

List the assumptions of the cardinal utility theory.

3.1.1 Total and Marginal Utility

In order to analyse the above, we begin with a simple model of a single

commodity x. The consumer can either buy x or retain his money
income Y. under these conditions, the consumer is in equilibrium when
the marginal utility of x is equated to its market price (Px).

MUx = Px

If the marginal utility of x is greater than its price, the consumer can
increase his welfare by purchasing more of unit x. Similarly, if the
marginal utility of unit x is less than its price, the consumer will increase
his total satisfaction by cutting down the quantity of x and keeping more
of his income unspent. Therefore, he attains the maximisation of his
utility when MUx = Px. If there are more commodities, the condition for
the equilibrium of the consumer is the equality of the ratios of the
marginal utilities of the individual commodities to their prices:

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Total Utility

Total utility, as the term indicates, is the utility derived from all units of
a commodity consumed. Suppose that a person consumes 10 oranges. In
this case, the total utility is obtained by adding the utility derived from
each unit of orange. In our example (Table below), the total utility
derived from the first six oranges is 21 (21 = 6 + 5 + 4 + 3 + 2 + 1).

Marginal Utility

Marginal utility is the utility from the consumption of successive units

of a commodity. To put it simply, marginal utility represents the utility
derived from each unit of commodity under consideration.

Symbolically,

MU =ΔTU/ΔC where,
TU = total utility
ΔTU = change in total utility (TUn – TUn-1)
C = consumption and ΔC = 1 unit or

In other words, marginal utility of nth unit of commodity A is the

difference between the total utility of nth unit and the total utility of (n-1)
th
unit of the commodity.

Symbolically,

MUn = TUn – TUn-1

Where,

MUn = Marginal utility of nth unit

TUn = Total utility of nth unit
TUn-1 = Total utility of (n-1)th unit

In our example (Table 2.1), the marginal utility of the 4th orange is
MU4 = TU4 – TU3= 18 – 15 = 3. Figure 2.8 details the path of total
utility and marginal utility curves. The total utility curve rises initially
and after certain stage, the curve starts declining. At this stage, the
marginal utility curve enters into the negative zone.

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TU
&
MU
TU

No of Oranges

Fig. 2.8: Total and Marginal Utility

MU

SELF-ASSESSMENT EXERCISE

Differentiate between total and marginal utility

3.1.2 Diminishing Marginal Utility

The law of diminishing marginal utility states that the utility derived
from each successive unit of a commodity diminishes. To put it simply,
even the most beautiful place of the world or the sweetest music can
make you feel bored after certain stage. The law further states that when
an individual consumes more of a commodity the total utility increases
at a decreasing rate. However, after certain stage, the total utility also
starts decreasing and the marginal utility becomes negative (Table 2.1).
This means that the individual does not need the commodity further.

Table 2.1: Total and Marginal Utility for Orange Consumption

Number of Oranges Total Utility Marginal Utility

1 6 6
2 11 5
3 15 4
4 18 3
5 20 2
6 21 1
7 21 0
8 20 -1

The law of satiable wants is also referred to as the law of diminishing

marginal utility. The law of satiable wants postulated that an
individual’s want for a particular commodity gets satiated when he or

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she consumes more and more of it. After certain stage, the individual is
not willing to consume the commodity anymore.

Assumptions of the Law of Diminishing Marginal Utility

Homogeneity: Each unit of the commodity under consideration is

identical in all aspects such as quality, taste, color, size and so on.

Reasonability: Each unit of commodity under consideration must be

same and standard. For example, 100 ml of coffee, 200 grams of apple
and so on.

Constancy: The law of diminishing marginal utility assumes that

consumer’s consumption pattern, tastes, preferences, income, and price
of the commodity and its substitutes are constant during the process of
consumption.

Continuity: The law further assumes that consumption is a continuous

process and there is no room for any time gap.

Rationality: For the law to hold well, the consumer must be a rational
economic man. In addition, the law assumes that the consumer’s mental
condition remains normal during the process of consumption.

SELF-ASSESSMENT EXERCISE

Explain briefly what you understand by the term diminishing marginal

utility.

3.2 Ordinal Utility Theory

Ordinal utility theory argues that a consumer cannot measure

satisfaction numerically or subjectively. Instead she can rank the
different baskets or bundles so as to choose the best basket. Put
differently, the ordinalists uphold that amounts of utility are naturally
non-measurable technically, conceptually as well as practically. They
consider that the basic principles of consumer’s behaviour could be
described without the notion of quantifiable utility. As per the idea of
ordinal utility, the utilities resulting from the usage of goods can never
be measured. The ordinal principle allows us to claim simply that the
customer prefers an apple to an orange; however, it fails to reveal by
how much. It really does not allow us to compare the value of utilities
acquired from the two goods.

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3.2.1 Revealed Preference Hypothesis

Revealed preference hypothesis was introduced by Samuelson in 1938.

The revealed preference hypothesis is considered a major breakthrough
in the theory of demand because it has made possible the establishment
of the law of demand directly (on the basis of the revealed preference
axiom) without the use of indifference curves and all the restrictive
assumptions.

Revealed preference hypothesis is an economic theory of consumption

behaviour which asserts that the best way to measure consumer
preferences is to observe their purchasing behaviour. Revealed
preference theory works on the assumption that consumers have
considered a set of alternatives before making a purchasing decision.
Thus, given that a consumer chooses one option out of the set, this
option must be the preferred option.

Revealed preference theory came about because existing theories of

consumer demand were based on a diminishing marginal rate of
substitution (MRS). This diminishing MRS relied on the assumption that
consumers make consumption decisions to maximise their utility. While
utility maximisation was not a controversial assumption, the underlying
utility functions could not be measured with great certainty. Revealed
Preference theory was a means to reconcile demand theory by defining
utility functions and observing behaviour.

Assumptions

Rationality: The consumer is assumed to behave rationally, in that he

prefers bundles of goods that include more quantities of the
commodities.

Consistency: The consumer behaves consistently, that is, if he chooses

bundle A in a situation in which bundle B was also available to him, he
will not choose B in any other situation in which A is also available.

Symbolically,

If A > B, then B ≯A
> = Greater than
≯ = Not Greater than.

Transitivity: If any particular situation A > B and B > C, then A > C.

The revealed preference axiom: The consumer, by choosing a

collection of goods in any one budget situation, reveals his preference

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for that particular collection. The chosen bundle is revealed preferred

among all other alternative bundles available under the budget
constraint.

Consider a situation whereby a consumer is faced with a budget line AB

as shown in the diagram below, and chooses the collection of goods
denoted by point Z, thus revealing his preference for this batch. Suppose
that the price of x falls so that the new budget line facing the consumer
is AC. It can be shown that the new batch will include a larger quantity
of x.
y

A1
Z
W N

x
0 x2 B B1 C
x1 x3
Fig. 2.9: The Revealed Preference

Finally, we make a compensating variation of the income, which

consists in the reduction of income so that the consumer has just enough
income to enable him to continue purchasing Z if he so wishes. The
compensating variation is shown in above diagram by a parallel shift of
the new budget line so that the compensated budget line A1B1 passes
through Z. Since the collection of Z is still available to him, the
consumer will not choose any bundle to the left of Z on the segment
A1Z, because his choice would be inconsistent, given the original
situation, all the batches on A1Z were revealed inferior to Z. Hence, the
consumer will either continue to buy Z or he chooses a segment on the
batch ZB1, such as W, which includes a larger quantity of x (namely x2).
Secondly, if we remove the reduction in income and allow the consumer
to move to the new budget line AC, he will choose a batch (such as N)
to the right of W (if commodity x is normal with a positive income
effect). The new revealed equilibrium (N) includes a larger quantity of x
(i.e. x3) resulting from fall in its price.

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The Weak and Strong Axiom of Revealed Preference (WARP and

SARP)

WARP is one of the criteria which need to be satisfied in order to make

sure that the consumer is consistent with his preferences. If a bundle of
goods A is chosen over another bundle B when both are affordable, then
the consumer reveals that he prefers A over B. WARP says that when
preferences remain the same, there are no circumstances (budget set)
where the consumer strictly prefers B over A. By choosing A over B
when both bundles are affordable, the consumer reveals that his
preferences are such that he will never choose B over A regardless of
income and prices.

If A > B, then B ≯ A

Note: ≯ is referred to as “Not preferred”

SARP is equivalent to the weak axiom of revealed preferences, except
that the consumer is not allowed to be indifferent between the two
bundles that are compared. That is, if WARP concludes that A ≯ B,
SARP goes a step further and conclude that A > B.
Note: ≥ is referred to as “greater than or equal to”.

If A is directly revealed preferred to B, and B is directly revealed

preferred to C, then we say A is indirectly revealed preferred to C.

SELF-ASSESSMENT EXERCISE

Analyse the concept of consistency in the consumer choice

3.2.2 Indifference Curves

The Cardinal Utility Approach is basically criticised for its assumption

that utility is a measurable entity. Ordinalists believe that measurement
of subjective utility on an absolute scale is neither possible nor
necessary. This skepticism about the measurement of utility forced them
to evolve an alternative approach to analyse consumer behaviour. The
culmination of this search is the indifference curve theory. This
approach does not require that consumers be able to measure utility in
any specific units of measurement but does assume that consumers are
able to rank their preferences for combinations of goods. An
indifference curve is a locus of points, particular combinations or
bundles of goods which yield the same utility (level of satisfaction) to
the consumers, so that he is indifferent as to the particular combination
he consumes.

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Assumptions

Complete: The completeness assumption states that the consumer has a

definite order of preferences or rank ordering for every conceivable
combination of commodities. The completeness assumption is
sometimes called the trichotomy assumption for the following reason.
Suppose there are two different combinations of goods, A and B. this
axiom assume that the consumer must state – “I prefer A to B” or “I
prefer B to A” or “A and B” are equally preferred.” The consumer is not
in a state of indecision. According to Hal R. Varian, “one might imagine
extreme situations involving life or death choices where ranking the
alternatives might be difficult or even impossible but such choices are
for the most part outside the domain of economic analysis.”

Consistency or transitivity: Along with complete ordering, we expect

that the consumer preferences are not self-contradictory or conflicting
with each other. This is the assumption of transitivity (the technical
name for consistency is transitive). This means that if A is preferred to
B, and B is preferred to C, then A is preferred over C.

Symbolically, if A > B, and B > C, then A > C.

Non Satiation: The third important assumption is that consumers

always prefer more goods to less. It means that the consumer is not
satiated at least not in all goods. More precisely, if bundle A contains at
least as much of every commodity as bundle B and more of at least one
commodity, then A is preferred to B.

Substitutability: The goods consumed by the consumers are

substitutable.

Optimality: Finally, the optimally assumption means the consumer tries

to maximise utility given his income and market prices.

Fig. 2.10a: Indifference Curve

IC1 is a lower indifference curve, and thus offer lower level of

satisfaction compare to ICII and ICIII. The higher the IC, the higher the
y

Indifference Curves

III

II

I
x

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level of satisfaction derived.

Marginal Rate of Substitution (MRS)

The shape of an indifference curve provides useful information about

preferences. Indifference curve replaces the concept of the marginal rate
of substitution for the concept of marginal utility.

The negative slope of an indifference curve is called the marginal rate of

substitution (MRS) of the two commodities concerned (say x and y), and
is given by the slope of the tangent at that point.

According to Leftwich, “The marginal rate of substitution of X for Y

(MRSxy) is defined as the maximum amount of Y the consumer is
willing to give up getting an additional unit of X and still remaining on
the same indifference curve.” Thus, the marginal rate of substitution is
just a fancy name for an acceptable trade-off between two goods.

Diminishing Marginal Rate of Substitution (DMRS)

Table 4.2 can be used to explain the concept of diminishing marginal

rate of substitution. Since Y decrease and X increases, the change in Y is
negative (i.e., -ΔY), so the equation is:

MRSxy = -ΔY/ΔX andMRSyx = -ΔX/ΔY

However, as with price elasticity of demand, the convention is to ignore

the minus sign

i.e., MRSxy = ΔY/ΔX and MRSyx = ΔX/ΔY

In Table 2.2, oranges is denoted by X and apples by Y, we have the

following marginal rate of substitution MRSx for y

Between A and B: AA1/A1B = 6/3 = 2.0

Between B and C: BB1/B1C = 3/2 = 1.5
Between C and D: CC1/C1D = 4/10 = 0.4

Thus, MRSx for y diminishes with increasing X. This is the principle of

diminishing marginal rate of substitution.

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Table 2.2: Diminishing Marginal Rate of Substitution

Combinations X (Oranges) Y (Apples)

A 2 15
B 5 9
C 7 6
D 17 2

Income and Substitution Effect of Price Change

The Slutsky’s theorem states that “the substitution effect of a price

change is always negative”. A fall in the price of x from say p1 to p2
will lead to an increase in quantity demand from say x1 to x2. This
effect is referred to as the total price effect which may be split into
income effect and substitution effect. The substitution effect of a price
change is the increase in the quantity bought as the price of the
commodity falls, after adjusting income so as to keep the real
purchasing power of the consumer the same as before. This adjustment
in income is called compensating variation, and is shown graphically by
a parallel shift of the new budget line until it becomes tangent to the
initial indifference curve.

y
Substitution Effect

Income Effect
A

Compensated Budget line

II

0 x
x1 x11 B x2 b1
Fig. 2.10b: Indifference Curve showing Income and
Substitution Effect

The purpose of the compensating variation is to allow the consumer to

remain on the same level of satisfaction as before the price change. The
compensated budget line will be tangent to the original indifference
curve 1 at the first stage of equilibrium, because this line is parallel to
the new budget line which is less steep than the original one when the
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price of x falls. Movement from x1 to x11 shows the substitution effect of

the price change; the consumer buys more of x now that it is cheaper,
substituting y for x.

The movement to a higher indifference curve was caused by a fall in the

price of x, and the consumer now has a higher purchasing power, and if
the commodity is normal, he will spend some of the increased real
income on x, thus moving from x11 to x2. This is the income effect of the
price change. The income effect of a price change is negative for normal
goods and it reinforces the substitution effect of the diagram above. If,
however, the commodity is inferior, the income effect of the price
change will be positive; as the purchasing power increases, less of x will
be bought.

SELF-ASSESSMENT EXERCISE

Analyse the indifference curve theory.

3.3 Diamond-Water Paradox

The diamond-water paradox poses the perplexing observations: Even

though water is obviously important to human activity (life cannot exist
without water), the price of water is relatively low. Alternatively,
diamonds are clearly much less important to human existence, but the
price of diamonds is substantially higher. In other words, the utility
obtained from water is obviously very great, while the utility obtained
from diamonds is substantially less. The key question that arises is: Why
are diamonds so much more expensive than water?

Total and Marginal

Let take an insight into and clarification of the diamond-water paradox

results by differentiating between total utility and marginal utility.

Total Utility: This is the overall satisfaction of wants and needs

obtained from consuming a good. That is, total utility is the accumulated
amount of satisfaction, or the total value, generated by several units of a
good.

Marginal Utility: This is the extra satisfaction of wants and needs

obtained from consuming one additional unit of good. That is, marginal
utility is the incremental satisfaction generated by, and the value of, a
single unit of a good.

Water provides humans with an enormous amount of total utility. Water

satisfies a lot of wants and needs for a lot of people. Water provides a

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high level of total utility because it is plentiful. However, because it is so

plentiful, the marginal utility of water is relatively low. An extra liter of
water provides very little additional satisfaction. In contrast, the total
utility generated by diamonds is relatively limited. Diamonds do not
provide much overall satisfaction of wants and needs, compared to
water. Many humans spend their entire lives without achieving any
satisfaction from diamonds. Diamonds have very little total utility
because they are not nearly as plentiful as water. Most houses do not
have hot and cold running diamonds. Most people do not drink eight
glasses of diamonds a day, take showers in diamonds, or fill their
Olympic-sized swimming pools with hundreds of gallons of diamonds.
However, because they are less plentiful, the marginal utility of
diamonds is relatively high. An extra ounce of diamonds provides a
great deal of extra satisfaction.

Solving the Paradox

The apparent contradiction between price and utility is cleared up by

distinguishing between marginal utility and total utility, and with the
understanding that marginal utility and not total utility is the key to
determining price. Moreover, this paradox can be turned on its head by
considering what might happen should the relative abundance of water
and diamonds change.

1. If water were as limited as diamonds, then the marginal utility

and thus price would also be quite high. In fact, if water and
diamonds were equally limited in supply, the price of water
would likely be several times the price of diamonds.
2. If diamonds were as plentiful as water, then the marginal utility
and price would also be quite low. If water and diamonds were
equally abundant in supply, then the price of diamonds would
likely be only a fraction of the price of water.

SELF-ASSESSMENT EXERCISE

Why is diamond valued more than water?

3.4 Principle of Optimisation

3.4.1 Introduction

Decision-makers (e.g. consumers, firms, governments) in standard

economic theory are assumed to be "rational". That is, each decision-
maker is assumed to have a preference ordering over the outcomes to
which her actions lead and to choose an action, among those feasible,
that is most preferred according to this ordering. We usually make

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assumptions that guarantee that a decision-makers preference ordering is

represented by a payoff function (sometimes called utility function), so
that we can present the decision-makers problem as one of choosing an
action, among those feasible, that maximises the value of this function.
Whenever we try to explain the behaviour of human beings we need to
have a framework on which our analysis can be based. In much of
economics we use a framework built on the following two simple
principles.

The optimisation principle: People try to choose the best patterns of

consumption that they can afford.

The equilibrium principle: Prices adjust until the amount that people
demand of something is equal to the amount that is supplied.

Let us consider these two principles. If people are free to choose their
actions, it is reasonable to assume that they will try to choose things they
want rather than things they don't want. Of course there are exceptions
to this general principle, but they typically lie outside the domain of
economic behaviour. The second notion is a bit more problematic. It is
at least conceivable that at any given time peoples' demands and
supplies are not compatible, and hence something must be changing.
These changes may take a long time to work themselves out, and, even
worse, they may induce other changes that might "destabilise" the whole
system.

This kind of thing can happen, but it usually doesn't. In the case of
apartments, we typically see a fairly stable rental price from month to
month. It is this equilibrium price that we are interested in, not in how
the market gets to this equilibrium or how it might change over long
periods of time. It is worth observing that the definition used for
equilibrium may be different in different models. In the case of the
simple market we will examine here, the demand and supply equilibrium
idea will be adequate for our needs. Typically, equilibrium will require
that the economic agents' actions must be consistent with each other.
How do we use these two principles to determine the answers to the
questions we raised above?

3.4.2 Demand Side Analysis

Suppose that we consider all of the possible renters of the apartments

and ask each of them the maximum amount that he or she would be
willing to pay to rent one of the apartments. Assuming there is someone
at the top who is willing to pay the highest price. Perhaps this person has
a lot of money; perhaps he is very lazy and doesn't want to walk far.
Suppose that this person is willing to pay N500 a month for an

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apartment. If there is only one person who is willing to pay N500 a

month to rent an apartment, then if the price for apartments were N500 a
month, exactly one apartment would be rented to the one person who
was willing to pay that price.

Suppose that the next highest price that anyone is willing to pay is #490.
Then if the market price were #499, there would still be only one
apartment rented: the person who was willing to pay #500 would rent an
apartment, but the person who was willing to pay #490 would not. And
so it goes. Only one apartment would be rented if the price were #498,
#497, #496, and so on until we reach a price of #490. At that price,
exactly two apartments would be rented: one to the #500 person and one
to the #490 person. Similarly, two apartments would be rented until we
reach the maximum price that the person with the third highest price
would be willing to pay, and so on.

Economists call a person's maximum willingness to pay for something

as that person's reservation price. The reservation price is the highest
price that a given person will accept and still purchase the good. In other
words, a person's reservation price is the price at which he or she is just
indifferent between purchasing and not purchasing the good. In our
example, if a person has a reservation price p it means that he or she
would be just indifferent between living in the inner ring and paying a
price p and living in the outer ring. Thus, the number of apartments that
will be rented at a given price p* will just be the number of people who
have a reservation price greater than or equal to p*. For if the market
price is p*, then everyone who is willing to pay at least p* for an
apartment will want an apartment in the inner ring, and everyone who is
not willing to pay p* will choose to live in the outer ring.

Here, the price is depicted on the vertical axis and the number of people
who are willing to pay that price or more is depicted on the horizontal
axis. Another way to view the diagram is to think of it as measuring how
many people would want to rent apartments at any particular price. Such
a curve is an example of a demand curve-a curve that relates the quantity
demanded to price. When the market price is above #500, zero
apartments will be rented. When the price is between #500 and #490,
one apartment will be rented. When it is between #490 and the third
highest reservation price, two apartments will be rented, and so on. The
demand curve describes the quantity demanded at each of the possible
prices.

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Reservation Price

No of Apartments
Fig. 2.10c: Demand Side Analysis

SELF-ASSESSMENT EXERCISE

Analyse the demand side optimization.

3.4.3 Supply Side Analysis

Here we have to think about the nature of the market we are examining.
The case to consider here is where there are many independent landlords
who are out to rent their apartments for the highest price the market will
bear. We will refer to this as the case of a competitive market. Other
sorts of market arrangements are certainly possible. Consider the case
where there are many landlords who all operate independently. It is clear
that if all landlords are trying to do the best they can and if the renters
are fully informed about the prices the landlords charge, then the
equilibrium price of all apartments in the inner ring must be the same.

The argument is not difficult. Suppose instead that there is some high
price, ph, and some low price, pl, being charged for apartments. The
people who are renting their apartments for a high price could go to a
landlord renting for a low price and offer to pay a rent somewhere
between ph and pl. A transaction at such a price would make both the
renter and the landlord better off. To the extent that all parties are
seeking to further their own interests and are aware of the alternative
prices being charged, a situation with different prices being charged for
the same good cannot persist in equilibrium. But what will this single
equilibrium price be? Consider a situation where a price is picked, and
question on how many apartments will be supplied at that price was
asked.

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The answer depends to some degree on the time frame in which we are
examining the market. If we are considering a time frame of several
years, so that new construction can take place, the number of apartments
will certainly respond to the price that is charged. But in the "short run"-
within a given year, say the number of apartments is more or less fixed.

Reservation Price
Supply

s No of Apartments
Fig. 2.10d: Supply Side Analysis

If we consider only this short-run case, the supply of apartments will be

constant at some predetermined level. The supply curve in this market is
depicted in diagram above as a vertical line. Whatever price is being
charged, the same number of apartments will be rented, namely, all the
apartments that are available at that time.

SELF-ASSESSMENT EXERCISE

Explain supply side optimization.

3.4.4 Market Equilibrium

We now have a way of representing the demand and the supply side of
the apartment market. Let us put them together and ask what the
equilibrium behaviour of the market is. We do this by drawing both the
demand and the supply curve on the same graph (Figure 2.10e).

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Reservation Price
Supply

p* Demand

s No of Apartments
Fig. 2.10e: Market Equilibrium

In this graph, we have used p* to denote the price where the quantity of
apartments demanded equals the quantity supplied. This is the
equilibrium price of apartments. At this price, each consumer who is
willing to pay at least p* is able to find an apartment to rent, and each
landlord will be able to rent apartments at the going market price.
Neither the consumers nor the landlords have any reason to change their
behaviour. This is why we refer to this as equilibrium; no changes in
behaviour will be observed.

To better understand this point, let us consider what would happen at a

price other than p*. For example, consider some price p < p* where
demand is greater than supply. Can this price persist? At this price, at
least some of the landlords will have more renters than they can handle.
There will be lines of people hoping to get an apartment at that price;
there are more people who are willing to pay the price p than there are
apartments. Certainly some of the landlords would find it in their
interest to raise the price of the apartments they are offering.

Similarly, suppose that the price of apartments is some p greater than p*.

Then some of the apartments will be vacant: there are fewer people who
are willing to pay p than there are apartments. Some of the landlords are
now in danger of getting no rent at all for their apartments. Thus they
will have an incentive to lower their price in order to attract more
renters.

If the price is above p* there are too few renters; if it is below p* there
are too many renters. Only at the price p* is the number of people who

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are willing to rent at that price equal to the number of apartments

available for rent. Only at that price does demand equal supply.

At the price p* the landlords' and the renters' behaviours are compatible
in the sense that the number of apartments demanded by the renters at p*
is equal to the number of apartments supplied by the landlords. This is
the equilibrium price in the market for apartments.

Once we have determined the market price for the inner-ring apartments,
we can ask who ends up getting these apartments and who is exiled to
the farther-away apartments. In the market equilibrium, everyone who is
willing to pay p* or more gets an apartment in the inner ring, and
everyone who is willing to pay less than p* gets one in the outer ring.
The person who has a reservation price of p* is just indifferent between
taking an apartment in the inner ring and taking one in the outer ring.
The other people in the inner ring are getting their apartments at less
than the maximum they would be willing to pay for them. Thus the
assignment of apartments to renters is determined by how much they are
willing to pay.

SELF-ASSESSMENT EXERCISE

How can equilibrium be reached in the apartment demand and supply

scenario?

4.0 CONCLUSION

 According to the cardinal theory, utility can be quantified in

terms of the money a consumer is willing to pay for it, thus
MUx=Px.
 Ordinal theory stated that utility cannot be measured in terms of
monetary value due to changes in the utility of money.
 Revealed preference hypothesis stated that if Good A is revealed
preferred to Good B when Good A is available, then it will not
happen that Good B is preferred to Good A when Good A is
available. This is termed the principle of consistency or
transitivity.
 Higher indifference curve gives a higher satisfaction.
 Changes in the price of good x will lead to a change in its
quantity demanded, thus substituting between good x and y.
 Goods x and y can be consumed in different orders that maximise
the consumer's utility. Water is essential to human existence, yet
commands low price compared to diamond.

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5.0 SUMMARY
This unit focused on consumer behaviour, and topics that capture how
rational consumers behave were discussed. In particular, ordinal and
cardinal utility theory was discussed, with special attention to the
quantification of utility through marginal and diminishing marginal
utility, before countering it with revealed preference hypothesis and the
indifference curves. The concept of diamond-water paradox was visited
in order to better understand the theory of value, and why diamond
commands higher price than water which is essential to life. Finally, the
principle of optimisation which focuses on the rationality of consumers
and decision maker in the economy was discussed. Consumers want to
maximise their utility while firms want to minimise their cost of
production. In order to analyse these two concepts, the demand and
supply side analysis was applied to apartment demand in order to arrive
at equilibrium.

6.0 TUTOR-MARKED ASSIGNMENT

1. Suppose that there were 25 people who had a reservation price of
#500, and the 26th person had a reservation price of #200. What
would the demand curve look like?
2. If people have different reservation prices, why does the market
demand curve slope down?
3. If the price of apartments increased in the short run from #500 to
#520 under the supply side analysis, what will happen to the
number of apartments available for rent?
4. Analyse the apartment market equilibrium.
5. If our model of rent control allowed for unrestricted subletting,
who would end up getting apartments in the inner circle? Would
the outcome be Pareto efficient?

7.0 REFERENCES/FURTHER READING

Koutsoyiannis, A. (n. d.). Modern Microeconomics. (2nd ed.).
Varian, H. R. (n. d.). Intermediate Microeconomics: A Modern
Approach. (7th ed.).
Robert, S. P. & Rubinfeld, D. L. (2009). Microeconomics. (7th ed.).
New Jersey: Pearson Education International.

Taylor, J. & Akila, W. (2012). Principles of Economics. (7th ed.).

Mason, OH: South-Western Cengage Learning.

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MODULE 3 THEORY OF PRODUCTION AND COST

Unit 1 Theory of Production

Unit 2 Theory of Cost
Unit 3 Labour-Leisure Trade-Off

UNIT 1 THEORY OF PRODUCTION

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Laws of Production
3.2 The Production Process
3.3 Production Function
3.4 Technological Progress
3.5 Objectives of a Firm
3.6 Equilibrium of the Firm
3.7 Substitution among Inputs
3.8 Diminishing Marginal Returns
3.9 Diminishing Marginal Rate of Technical Substitution
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Whether it is a big or small firm that markets a single product, suppliers

usually face a difficult task. Producing an economic good or service
requires a combination of land, labour, capital, and entrepreneurs. The
theory of production deals with the relationship between the factors of
production and the output of goods and services. The theory of
production is generally based on the short run; a period of production
that allows producers to change only the amount of the variable input
called labour. This contrasts with the long run, a period of production
long enough for producers to adjust the quantities of all their resources,
including capital. For example, Ford Motors hiring 300 extra workers
for one of its plants is a short-run adjustment. If Ford builds a new
factory, this is a long-run adjustment.

Put differently, the technical conditions facing the firm are summarised
in the production function. The production function is a mathematical
statement of the physical relationship given by technology, between a

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firm’s input of productive resources and its output of goods and services
per unit of time. A firm’s production function establishes the
relationship between the rate of flow of output and the rate of flow of
corresponding inputs needed to produce it, given existing technology.

A production function can be expressed mathematically as:

Q = ƒ(X1, X2, X3, …,Xn)

Where X1, X2, X3, …,Xn represents quantities of various inputs and Q
represents the quantity of goods they can generate per unit of time.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 explain the theory of production

 describe the three stages of production
 explain the law of variable proportion
 explain the economics of scale.

3.0 MAIN CONTENT

3.1 Law of Variable Proportions

The law of variable proportions states that, “in the short run, output
will change as one input is varied while the others are held constant.”
For example, if you are preparing a meal, you know that a little bit of
salt will make the food taste better. A bit more may make it tastier still.
Yet, at some point, too much salt will ruin the meal. As the amount of
the input (salt) varies, so does the output - the quality of the meal. The
law of variable proportions deals with the relationship between the input
of productive resources and the output of final products. This law helps
answer the question: How is the output of the final product affected as
more units of one variable input or resource are added to a fixed amount
of other resources?

A farmer, for example, may have all the land, machines, workers, and
other items needed to produce a crop. However, the farmer may have
some questions about the use of fertilizer. How will the crop yield be
affected if different amounts of fertilizer are added to fixed amounts of
the other inputs? In this case, the variable input is the fertilizer added per
acre. Of course, it is possible to vary all the inputs at the same time. The
farmer may want to know what will happen to output if the fertilizer and
other factors of production are varied. Economists do not like to do this,

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however, because when more than one factor of production is varied, it

becomes harder to gauge the impact of a single variable on total output.

SELF-ASSESSMENT EXERCISE

Explain the law of variable proportions.

3.2 Production Function

The law of variable proportions can be illustrated by using a

production function - a concept that describes the relationship between
changes in output to different amounts of a single input while other
inputs are held constant. The production function can be illustrated with
a schedule, such as Table 3.1. The production schedule in Figure 3.1
lists hypothetical output as the number of workers is varied from zero to
12. With no workers, for example, there is no output. If the number of
workers increases by one, output rises to seven. Add yet another worker
and total output rises to 20. This information can be used to construct
the production function. In this example only the number of workers
changed. No changes occur in the amount of machinery used, the level
of technology, or the quantities of raw materials—unprocessed natural
products used in production. Under these conditions, any change in
output must be the result of the variation in the number of workers.

Total Product

The second column in the production schedule in Table 3.1 shows total
product, or total output produced by the firm. The numbers indicate that
the plant barely operates when it has only one or two workers. As a
result, some resources stand idle much of the time. As more workers are
added, however, total product rises. More workers can operate more
machinery, and plant output rises. Additional workers also mean that the
workers can specialise. For example, one group runs the machines,
another handles maintenance, and a third group assembles the products.
By working in this way - as a coordinated whole - the firm can be more
productive.

As even more workers are added output continues to rise, but it does so
at a slower rate until it can grow no further. Finally, the addition of the
eleventh and twelfth workers cause total output to decline because these
workers just get in the way of the others. Although the ideal number of
workers cannot be determined until costs are considered, it is clear that
the eleventh and twelfth workers will not be hired.

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Table 3.1: The Production Schedule

No of Total Average Marginal Stages of

Workers Product Product Product Production
0 0 0 0
1 7 7 7
2 20 10 13 Stage I
3 38 12.6 18
4 62 15.5 24
5 90 18 28

6 110 18.3 20
7 129 18.3 19
8 138 17.3 9 Stage II
9 144 16 6
10 148 14.8 4

11 145 13.2 -3 Stage III

12 135 11.3 -10

Average Product

The quantity of total output produced per unit of a variable input,

holding all other inputs fixed. Average product (AP) is found by
dividing total product by the quantity of the variable input. Average
product, which is also known as Average Physical Product (APP), is one
of two measures derived from total product. Put differently, average
product is the per unit production of a firm. Conceptually, it is simply
the arithmetic mean of total product calculated for each variable input
over a whole range of variable input quantities. Average product is
generally considered less important than total product and marginal
product in the analysis of short-run production.

Fig. 3.1: Production Function

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Marginal Product

The measure shown in the third column of the production schedule

above is an important concept in economics. The measure is known as
marginal product, the extra output or change in total product caused by
the addition of one more unit of variable input. As we can see in the
Figure 3.1, the marginal product, or extra output of the first worker, is
seven. Likewise, the marginal product of the second worker-which is
equal to the change in total product - is 13. Together, both workers
account for 20 units of total product. When it comes to determining the
optimal number of variable units to be used in production, changes in
marginal product are of special interest. The production schedule shows
the three stages of production - increasing returns, diminishing returns,
and negative returns - that are based on the way marginal product
changes as the variable input of labour is changed.

In Stage I, the first workers hired cannot work efficiently because there
are too many resources per worker. As the number of workers increases,
they make better use of their machinery and resources. This results in
increasing returns (or increasing marginal products) for the first five
workers hired. As long as each new worker hired contributes more to
total output than the worker before, total output rises at an increasingly
faster rate. Because marginal output increases by a larger amount every
time a new worker is added, Stage I is known as the stage of increasing
returns. Companies, however, do not knowingly produce in Stage I for
very long. As soon as a firm discovers that each new worker adds more
output than the last, the firm is tempted to hire another worker.

In Stage II of production the total production keeps growing but by

smaller and smaller amounts. Any additional workers hired may stock
shelves, package parts, and do other jobs that leave the machine
operators free to do their jobs. The rate of increase in total production,
however, is now starting to slow down. Each additional worker, then, is
making a diminishing, but still positive, contribution to total output.
Stage II illustrates the principle of diminishing returns, the stage where
output increases at a diminishing rate as more units of a variable input
are added. In the above table, Stage II begins when the sixth worker is
hired, because the 20-unit marginal product of that worker is less than
the 28-unit marginal product of the fifth worker.

The third stage of production begins when the eleventh worker is added.
By this time, the firm has hired too many workers, and they are starting
to get in each other’s way. Marginal product becomes negative and total
plant output decreases. Most companies do not hire workers whose
addition would cause total production to decrease. Therefore, the
number of workers hired would be found only in Stage II. The exact

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number of workers hired depends on the cost of each worker. If the cost
is low, the firm should hire at least six, but no more than 10, workers.

SELF-ASSESSMENT EXERCISE

What is the difference between total product, average product and

marginal product?

3.3 Technological Progress

As knowledge of new and more efficient methods of production become

available, technology changes. Furthermore, new inventions may result
in the increase of the efficiency of all methods of production. At the
same time, some techniques may become inefficient and drop out from
the production function. These changes in technology constitute
technological progress. Graphically, the effect of innovation in
processes is shown with an upward shift of the production function in
Figure 3.2(a) or a downward movement of the production isoquants
graph in Figure 3.2(b). This shift shows that the same output may be
produced by fewer factor inputs, or more output may be obtained with
the same inputs.

X! = f(L)
X!
X = f(L)
X

L
(a)
Fig. 3.2a: Technological Progress

X0

X0
L
(b)
Fig. 3.2b: Technological Progress

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Technical progress may also change the shape of the isoquants. Hicks
have distinguished three type of technical progress, depending on its
effect on the rate of substitution of the factors of production. They are:

1. Capital-deepening technical progress

2. Labour-deepening technical progress
3. Neutral-technical progress

SELF-ASSESSMENT EXERCISE

What are the effects of technological progress?

3.4 Returns to Scale

Increasing returns to scale

This is a situation where a given proportional change in all resources in

the long run results in a proportional greater change in production.
Increasing returns to scale exists if a firm increases all resources, labour,
capital, and other inputs by a given proportion (say 10 per cent) and
output increases by more than this proportion (that is more than 10 per
cent). This is one of three returns to scale. The other two are decreasing
returns to scale and constant returns to scale. If output is more than
doubles when inputs are doubled, there are increasing returns to scale.
This might arise because the larger scale of operation allows the
managers and workers to specialise in their tasks and to make use of
more sophisticated, large-scale factories and equipment. The prospect of
increasing return to scale is an important issue from a public-policy
perspective. If there are increasing returns, then it is economically
advantageous to have one large firm producing (at relatively low cost)
rather than to have many small firms produce.

Constant returns to scale

A second possibility with respect to the scale of production is that output

may double when inputs are doubled. In this case, we say there are
constant returns to scale. With constant returns to scale, the size of the
firms operation does not affect the productivity of its factors: Because
one plant using a particular production process can easily be replicated,
two plants produce twice as much output. For example, a large travel
agency might provide the same service per client and use the same ratio
of capital (office space) and labour (travel agents) as a small agency that
services fewer clients.

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Decreasing returns to scale

Finally, output may less than double when all inputs double. This case
of decreasing returns to scale applies to some firms with large-scale
operations. Eventually, difficulties in organising and running a large-
scale operation may lead to decreased productivity of both labour and
capital. Communication between workers and managers can become
difficult to monitor as the workplace becomes more impersonal. Thus,
the decreasing returns case is likely to be associated with the problem of
coordinating tasks and maintaining a useful line of communication
between managers and workers.

SELF-ASSESSMENT EXERCISE

List and explain the economies of scale.

3.5 Substitution among Inputs

With two inputs that can be varied, a manager will want to consider
substituting one input for another. The slope of each isoquant indicates
how the quantity of one input can be traded off against the quantity of
the other, while output is held constant. When the negative sign is
removed, we call the slope the marginal rate of technical substitution
(MRTS). The marginal rate of technical substitution of labour for capital
is the amount by which the input of capital can be reduced when one
extra unit of labour is used, so that output remains constant. This is
analogous to the marginal rate of substitution in consumer theory. The
MRTS is always measured as a positive quantity.

MRTS = - Change in capital input ÷ Change in labour input

∆K/∆L (for a fixed level of q)

Where ∆K and ∆L are small changes in capital and labour along an

isoquants.

Diminishing Marginal Rate of Technical Substitution

With diminishing MRTS, that is, the MRTS falls as we move down
along the isoquants. The mathematical implication is that isoquants, like
indifference curves, are convex, or bowed inward. This is indeed the
case for most production technologies. The diminishing MRTS tells us
that the productivity of any one input is limited. As more and more units
of labour are added to the production process in place of capital; the
productivity of labour falls. Similarly, when more capital is added in
place of labour, the productivity of capital falls. Production needs a
balanced mix of both inputs.

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Based on the above discussion, we can infer that the MRTS is closely
related to the marginal products of labour MPL and capital MPK. To see
how, imagine adding some labour and reducing the amount of capital
sufficient to keep output constant. The additional output resulting from
the increased labour input is equal to the additional output per unit of
additional labour times the number of units of additional labour.

Additional output from increased use of labour = (MPL)*(∆L)

Similarly, the decrease in output resulting from the reduction in capital

is the loss of output per unit reduction in capital times the number of
units of capital reduction:

Reduction in output from decreased use of capital = (MPK)*(∆K)

As we are keeping output constant by moving along an isoquants, the

total change in output must be zero. Thus,

(MPL)*(∆L) + (MPK)*(∆K) = 0

Now, by rearranging terms, we see that:

(MPL) / (MPK) = - (∆K/∆L) = MRTS

The above equation tells us that the marginal rate of technical

substitution between two inputs is equal to the ratio of the marginal
products of the inputs.

SELF-ASSESSMENT EXERCISE

Differentiate between MRTS and MRS.

4.0 CONCLUSION

From our discussion so far on the theory of production, we can infer the
following:

 a change in the variable input called labour results in a change in

production
 the law of variable proportions states that output will change as
one input is varied while others are held constant
 as the number of labour units increases with capital held constant,
the output increases, and decreases after some time
 as knowledge of new and more efficient method of production
become available, technology changes

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 if output more than doubles when inputs is doubled, there is

increasing returns to scale. If otherwise, there is decreasing
returns to scale
 the slope of isoquants for two substitute inputs indicates how the
quantity of one input can be traded off against the quantity of the
other while output is held constant.

5.0 SUMMARY
The law of variable proportions was discussed, and you should have
understood that when one input is increased while others are held
constant, output will increase in the short run. This law deals with the
relationship between the inputs of productive resources and the final
product. The production functions describe the relationship between
changes in output to different amounts of a single input while other
inputs are held constant. The concept of total and marginal product was
discussed; the effect of technological progress on production was also
discussed.

6.0 TUTOR-MARKED ASSIGNMENT

1. State the theory of production and law of variable proportions.
2. Explain the meaning of the following:
- production function
- total product
- marginal product
- stages of production
- diminishing returns.
3. Explain how marginal product changes in each of the three stages
of production.
4. Identify what point will eventually be reached if companies
continue adding workers.
5. Provide an example of a time when you entered a period of
diminishing returns or even negative returns. Explain why this
might have occurred.

7.0 REFERENCES/FURTHER READING

Gary, E. C. (2001). Principles and Practices of Economics. (Interactive
student ed.). New York: McGraw-Hill.

Koutsoyiannis, A. (n. d.). Modern Microeconomics. (2nd ed.).

Robert, S. P. & Rubinfeld, D. L. (2009). Microeconomics. (7th ed.).

New Jersey: Pearson Education International.

Tucker, I. B. (2014). Economics for Today. (8th ed.). Mason, OH:

South-Western Cengage Learning.

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UNIT 2 THEORY OF COST

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Implicit and Explicit Cost
3.2 Internal and External Economies of Scale
3.3 Constrained Cost Minimisation
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Economists generally emphasise costs to be one of the major elements

that profit maximising firms seek to control closely. The overall
yardstick for the measurement of managerial efficiency in a firm is
profitability, and profit is basically the difference between cost and
revenue. To any firm, the basic factor underlying its willingness and
ability to supply a commodity is its cost of production. Costs are very
important elements in supply decisions since the production of any
commodity involves the use of economic resources that are scarce and
thus command a price, which constitutes costs to the firm. A firm that
manages its costs prudently can succeed in reducing its unit cost over
those of competing firms in the industry, as this offer the firm a
competitive edge over others in the industry and greater opportunity for
profit making.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 differentiate between implicit and explicit cost

 explain the difference between economic profit and accounting
profit
 define the concept of marginal and average cost
 describe internal and external economies of scale.

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3.0 MAIN CONTENT

3.1 Implicit and Explicit Costs

Explicit Costs

Explicit costs comprise those clear cut historical payments or money

outlays for inputs bought or hired by the firm and are documented in the
firm’s expenses recorded during a given production period. Example of
explicit costs includes wages and salaries paid, rent, interest expense and
so on.

Implicit Costs

Implicit costs are the opportunity costs associated with self-employed

resources in the business. They comprise all of the remuneration that
owner-employed resources in the firm could have earned an alternative
employment if the owners had not engaged them in their own business.
Examples if implicit costs include the implicit rent that could have been
paid in the case of business premises owned by the proprietor, implicit
wages and salaries for the owner and his wife, for example, who have
spent much of their time working in the business but without a stipulated
remuneration and so on.

Accounting vs. Economic profit

The distinction between accounting and economic profit stems from the
difference between implicit and explicit costs. To the accountant, profit
is simply the excess of total revenue over historical cost, i.e., cost of the
firm for which actual payments have been effected in the past or for
which the firm is committed to future payments. This accountant’s
restriction on costs to explicit cost has the advantage of ensuring
objectivity.

Records of transaction exist, backed up with receipts for payment made,

and appropriate documentation for credit transaction. A business profit
is defined as the difference between revenue and explicit costs are
generally referred to as accounting profit. Economists, however, the
concept of historical costs is considered to be too narrow when
estimating the total cost and the profits of running a business. The
economists therefore consider profits to be the excess of total revenue
over the explicit and implicit opportunity costs of the firm. From the
above discussion, we can infer that a firm considered profitable from the
accountant’s viewpoint may actually be suffering losses from the
economist’s viewpoint.

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For example, examine the profit position of Ajibola and Sons Ltd.,
whose revenue and cost data are given as:

Total revenue #40, 000

Less Cost of goods sold #22, 000
Gross Profit ………………………………… #18, 000

Less Operating Expenses:

Fixed Cost #8, 000

Variable Costs #2, 000 #10, 000
Net Income (Accounting Profit) …………………………. #8, 000

Less:

Implicit Rental Expense #2, 000

Implicit Salary Expense #4, 000
Implicit Interest Expense #500 #6, 500
Economic Profit ……………………………………………#1, 500

Cost vs. Outlay

All cash outlay or expenditure does not necessarily represent cost.

Expenditure on items such as automobiles, air-conditioners, engine oil,
meat pie, etc. cannot be classified as cost because some of them can last
for a long time. For example, if a firm decides to purchase a new car for
#200, 000, its wealth position or net worth remains unaltered. It has
merely substituted a financial asset (cash) with a real asset (car). If 12
months later, it decides to sell the car for #180, 000, the cost of using the
car for 12 months is #20, 000. If the firm chooses to keep the car until it
is fully depreciated, then the cost of the car to the firm each period is the
amount of depreciation apportioned to that price. Cash outlays for
durable assets are not necessarily costs because there are still
opportunities for some residual alternatives ahead. The car for example
could be sold at the end of the second year for #160, 000 and the money
can be put into alternative uses. In the case of consumable good like
meat-pie, their service is fully utilised almost immediately and thus they
are classified as costs.

A natural starting point in cost analysis is to assume the existence of a

direct, well defined relationship between the costs of production and the
level of output. This relationship between cost and output at various
levels is known as the cost function. Thus the cost function of
production depends on the level of output.
This can be expressed algebraically as:

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C = ƒ(Q)

Where C = naira cost of production

Q = quantity

Note: output rate depends on inputs. This can be expressed as:

Q = ƒ(I)

Where I = resources/inputs.

The production function establishes the technical relationship between

input and output flows. Thus, given input prices and the relevant
production function, the cost of any giving level of output can be
computed. We can therefore say precisely that the cost behaviour of a
firm depends on the character of its production function and the prices
of its inputs. And the nature of production function determines the shape
of the total cost curve.

SELF-ASSESSMENT EXERCISE

Differentiate between implicit and explicit cost, economic and

accounting profit.

3.3 Marginal and Average Cost

Marginal Cost

Marginal cost is the change in total cost divided by the corresponding

change in the output, or the rate of change of total cost as output
changes. The change in total cost may be an increase or a decrease
brought about by an increase or a decrease in output. Marginal cost
(MC) is thus give or measured by:

Where TC = Change in total cost

DQ = Change in output,

d(TC)/dQ = The rate of change of total cost as output changes. It is the

derivative or slope of the total cost curve. Because of the fixed cost (FC)
component in total cost (TC), there is economy of scale in the short run
as output increased.

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Note that total cost (TC) = Fixed Cost (FC) + Variable Cost (VC).

Variable Costs

Variable costs are the costs of such inputs as raw materials, intermediate
inputs and labour, all of which vary as output varies over time.

Marginal Cost

Marginal cost is the change in total cost that comes from making or
producing one additional item. The purpose of analysing marginal cost
is to determine at what point an organisation can achieve economies of
scale. The calculation is most often used among manufacturers as a
means of isolating an optimum production level. Put differently,
manufacturing concerns often examine the cost of adding one more unit
to their production schedules. This is because at some point, the benefit
of producing one additional unit and generating revenue from that item
will bring the overall cost of producing the product line down. The key
to optimising manufacturing costs is to find that point or level as quickly
as possible.

MC

Fig. 3.3a: Marginal Cost

Fixed Costs

Fixed costs, indirect costs or overheads are business expenses that are
not dependent on the level of goods or services produced by the
business. They tend to be time-related, such as salaries or rents being
paid per month, and are often referred to as overhead costs.

Fixed costs are not permanently fixed; they will change over time, but
are fixed in relation to the quantity of production for the relevant period.
For example, a company may have unexpected and unpredictable

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expenses unrelated to production; and warehouse costs and the like are
fixed only over the time period of the lease. There are no fixed costs in
the long run, because the long run is a sufficient period of time for all
short-run fixed inputs to become variable.

Average Costs

Similar to the above, the average cost (AC) or cost per unit of output
will first fall and eventually rise. It will initially fall because the fixed
costs can be spread over larger and larger outputs, thus leading to lower
and lower overhead cost per unit of output. However, average cost will
rise because of the diminishing marginal productivity of variable factors
which are being increased while fixed factors are kept constant. It may
also be due to the rising prices and costs of the scarce inputs or raw
materials as more and more are demanded. So the AC curve will first
fall from a high level and eventually rise, giving a U-shape. The
relationship between marginal cost and average cost is such that when
average cost is falling, marginal cost is below average cost, and when
average costs is rising, marginal cost is above it. All this implies that
marginal costs cuts average costs at the minimum or turning point of
average cost. In other words, when marginal cost is less than average
cost, it pulls down average costs, and when marginal cost is higher than
average cost, it pulls up average cost.

MC

MC

AC
A

Q
Fig. 3.3b: Marginal and Average Cost

Another aspect of average cost is its behaviour in the long run. In the
short run, some costs are fixed which relative to the installed production
capacity. In the long run all costs are variable since the production
capacity of plant size can be varied to suit demand. Thus, the long run
average cost (LAC) will be the locus of points of the lowest attainable
average cost of production for every output level using various plants
sizes. Thus LAC curve will envelop the short run average costs curves

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touching each of them underneath. This is illustrated in the diagram

below.

Short run AC’s

LAC

Fig. 3.3c: Average Cost

When average cost decreases with input using appropriate plant sizes,
the industry is said to be characterised by decreasing cost or increasing
returns and when average costs are constant, we have constant returns.
But when long run average cost rises with output, we have increasing
cost or decreasing returns in the industry. Since marginal cost is less
than average cost when average cost is falling, it means that a situation
when marginal cost is less than average cost implies decreasing costs or
increasing returns or existing economy of scale.

SELF-ASSESSMENT EXERCISE

Explain the concept of average cost?

3.4 Internal and External Economies of Scale

Economies or diseconomies of scale are said to be internal to the firm if

the firm can cause them by enlarging its scale of production or plant
size. Economies of scale are external if they result from the action of the
entire industry and cannot be attained by a single firm changing its scale
of production. Internal economies involve movements along given cost
function of the firm. External economies entail a shift in the entire cost
function. Internal and external economies or diseconomies of scale can
otherwise be referred to as internal or external effects.

An external effect is said to exist when a firm’s production function or

cost function contains as a variable the output of the entire industry.
Thus, an external effect is said to be experienced if the overall expansion
of all firms in the industry alters the production of the individual in such
a manner as to increase or reduce output or reduce the cost function. The
simultaneous expansion of output by most firms in an industry may

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result in driving up the price of certain key raw materials. This will
entail extra cost for raw materials on all the firms. Similarly, if several
firms are located in a geographical zone, this may attract the extension
of railroad services to that region. This will cheapen the cost of
transportation to all the firms in the area. This could not have occurred if
just one or a few firms expanded their scale of production.

SELF-ASSESSMENT EXERCISE

What is the effect of external economies of scale?

3.5 Constrained Cost Minimisation

A manufacturing firm may wish to determine the minimum amount to

spend on variable inputs to achieve a given level of output. In this
regard, the function to be minimised is the cost function. The constraint
equation is the production function.

Let the cost function be given as:

(1)

The production function is given as:

(2)

The related Lagrangian function can be written as:

(3)

The first order condition requires that:

(4)
(5)
(6)

From equation (4) and (5),

P1 = ƛƒ1
P2 = ƛƒ2

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Thus, the first order condition that the price ratio of the inputs must
equal the ratio of their marginal products is met. This is to say that the
slope of the isocost must equal the slope of the related isoquants.

4.0 CONCLUSION

From our discussion so far on the theory of firm, we can infer the
following:

 Cost is a major element of a profit maximising firm.

 Explicit cost comprises of historical outlays for inputs bought or
hired by the firm which are recorded as expenses during a
production period. Implicit costs are the opportunity costs
associated with self-employed resources in the firm which could
have earned alternative employment somewhere else.
 Expenditure on automobile, air conditioners, engine oil etc. is not
to be classified as cost.
 Marginal cost is the change in total cost divided by the
corresponding change in the output. Average cost will fall first
and eventually rise because the fixed costs can be spread over
larger outputs which lower the overhead cost per unit output.
 Constrained cost minimisation aims at the minimisation of cost in
order to attain a given level of output.

5.0 SUMMARY
The concept of implicit and explicit cost was discussed. The accounting
and economic profit concept was reviewed. From an accounting point of
view, once marginal revenue is greater than the cost, the company is
making profit. However, from an economist’s point of view, when
marginal revenue is equal to marginal cost, the firm is in equilibrium,
and thus competitive profit exists for the firm. Variable costs are those
cost of inputs which may vary over time, while fixed costs are the costs
of machinery and other fixed assets.

6.0 TUTOR-MARKED ASSIGNMENT

1. Differentiate between accounting profit and economic profit
2. Analyse the concept of marginal and average cost
3. What do we mean by internal and external economies of scale?

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7.0 REFERENCES/FURTHER READING

Gary, E. C. (2001). Principles and Practices of Economics. (Interactive
student ed.). New York: McGraw-Hill.

Miller, R. L. (2014). Economics Today. (17th ed.). Upper Saddle River,

NJ: Pearson.

O'Sullivan, et al. (2014). Economics: Principles, Applications, and

Tools. (8th ed.). Upper Saddle River, NJ: Pearson.

Parkin, M. (2014). Economics. (11th ed.). Upper Saddle River, NJ:

Pearson.

Robert, S. P. & Daniel, L. R. (2009). Microeconomics. (7th ed.). New

Jersey: Pearson Education International.

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UNIT 3 LABOUR-LEISURE TRADEOFF

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 The Model
3.2 Backward Bending Labour Supply
3.3 Assumptions and Caveat
3.4 Inverted S-shaped Labour Supply Curve
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Leisure is considered one good (often put on the horizontal-axis) and

consumption is considered the other good. Since a consumer has a finite
amount of time, he must make a choice between leisure (which earns no
income for consumption) and labour (which does earn income for
consumption).

The total amount of time that an individual has to allocate is known as

his time endowment (denoted by T). The amount an individual allocates
to labour (denoted by L) and leisure (l) is constrained by T such that:

or

A person's consumption is the amount of labour they choose multiplied

by the amount they are paid per hour of labour (their wage, denoted by
w). Thus, the amount that a person consumes is:

When a consumer chooses no

leisure then and .

From this labour-leisure tradeoff model, the substitution effect from

various changes in price caused by welfare benefits, labour taxation, or
tax credits can be analysed.

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OBJECTIVES

At the end of this unit, you should be able to:

 explain the relationship between labour and leisure

 analyse the backward bending and inverted S-shaped labour
supply curve
 state the assumptions and caveat.

2.0 MAIN CONTENT

3.1 The Model

The labour supply decision is regarded as the ultimate trade-off between

consumption and leisure. The advantage of working more is increased
consumption; by working more hours, you earn more income and can
purchase and consume more goods. The disadvantage of working more
is decreased leisure; by working more hours, you have fewer hours to
spend outside of work to sleep, raise children, watch TV, etc. (The
economic definition of leisure is any time spent outside of work).
Therefore, the goal of choosing how many hours you want to work-i.e.,
choosing your personal quantity of labour supplied-is to choose the
consumption-leisure combination available to you that you like best.

For example, Shola can earn a wage of N10 an hour, and there’s 24 x 7
= 168 hours in the week. If she works 20 hours a week, she can
consume 20 x N10 = N200 in goods and services a week and have 168 –
20 = 148 hours of leisure time left. However, if she works 40 hours a
week, she can consume 40 x N10 = N400 in goods and services a week
but only has 168 – 40 = 128 hours of leisure time left. This means that
Shola’s choice between working (a) 20 hours a week and (b) 40 hours a
week is actually a choice between (a) consuming N200 in goods and
services and enjoying 148 hours of leisure and (b) consuming N400 in
goods and services and enjoying 128 hours of leisure. Which will Shola
pick? She will pick the consumption-leisure combination that she likes
the best. If she is the easygoing type, she probably likes leisure more
than consumption, will pick (a), and work 20 hours a week. If she is the
driven type, she probably likes consumption more than leisure, will pick
(b), and work 40 hours a week.

Of course, Shola certainly has more choices than working 20 or 40 hours

a week. She could work 30 hours a week, or 50, or not at all. Let’s find
out what Shola’s consumption and leisure are per week at each number
of hours Shola works per week (or, alternately, at each of Shola’s
personal quantity of labour transacted):

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Table 3.1: Shola’s Consumption-Leisure Possibilities, No Non-

labour Income N=Naira

Weekly Wage Weekly Weekly

Labour Consumption Leisure
= W*L =168 hours - L
0 N10 N0 168
10 N10 N100 158
20 N10 N200 148
30 N10 N300 138
40 N10 N400 128
50 N10 N500 118

If we plot consumption against leisure, we would get a downward

sloping line whose slope would equal the negative wage (-10). The x-
intercept equals the maximum amount of leisure time Shola could enjoy:
168 hours, the amount of hours in a week, the amount of hours of leisure
Shola would have if she didn’t work at all. The y-intercept equals the
maximum amount of consumption Shola could enjoy: N1680 a week or
the amount of income Shola would earn if she worked all 168 hours of
the week.

C
N1680

-10

168 hours l

Fig. 3.4a: Consumption against Leisure

Every consumption-leisure combination on this line is available to

Shola. Every consumption-leisure combination outside it is not
available to her. Economists call this line a budget constraint. All Shola
has to do to make the best labour supply decision is to pick the
consumption-leisure combination on the budget constraint that she likes
the best, and then work the number of hours necessary to get that

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combination. For example, if Shola likes N400 of consumption and 128

hours of leisure the best, she will want to work 40 hours a week.

C
N1680

-10

N400

128 168 l
L = 40

Fig. 3.4b: Budget Constraint

We have so far assumed that Shola earns all her income and
consequently pays for all her consumption by working. But she may
earn income from non-labour sources-interest from savings accounts or
bonds, dividends from stocks, welfare payments, etc. Suppose Shola
earns N200 in non-labour income each week. This is income she earns
no matter how much she works, so we can account for it by adding
N200 in extra consumption at each level of labour supply:

Table 3.2: Shola’s Consumption-Leisure Possibilities, Non-labour

Income = N200

Weekly Wage Non- Weekly Weekly

Labour labour Consumption Leisure
Income
= W*L =168 hours
-L
0 N10 N200 N0 168
10 N10 N200 N100 158
20 N10 N200 N200 148
30 N10 N200 N300 138
40 N10 N200 N400 128
50 N10 N200 N500 118

If we plot consumption and leisure against each other in this case, we

would get a budget constraint like that at the left: a straight line coming
up from the maximum amount of leisure (i.e., the amount of time

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available) to the level of non-labour income, then a line with a slope

equal to the negative wage that intercepts the vertical axis at the
maximum amount of consumption.

C
N1880

N200
168 l

Fig. 3.4c: Consumption-Leisure Possibilities

We can generalise this budget constraint to the budget constraint in at

left, where w equals the employee wage, T equals the amount of time
available to allocate between labour and leisure, and y equals non-labour
income.

C
wT + y

y
T l

Fig. 3.4d: Generic Budget Constraint

So which consumption-leisure combination does Shola pick? An

economist would answer that she would pick the combination that offers
her the most utility. Utility is, for lack of a better synonym, an all-
encompassing “goodness.” It is a mythical variable that tells us just
how much a consumer gets out of something. For example, if I get more
enjoyment, stimulation, laughs, or what not out of an hour of watching
television than out of an hour of playing football, then I get more utility
out of an hour of watching television than out of an hour of playing
football.

SELF-ASSESSMENT EXERCISE

What is the relationship between labour supply and leisure?

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3.2 Backward Bending Labour Supply

As wages increase above the subsistence level, there are two

considerations affecting a worker's choice of how many hours to work
per unit of time (usually day, week, or month). The first is the
substitution or incentive effect. With wages rising, this says that the
trade-off between working an additional hour for pay and taking one
extra hour of non-paid time changes in favour of working. Thus, more
hours of labour-time will be offered at the higher wage than the lower
one. The second and countervailing effect is that the hours worked at the
old wage rate now all gain more income than before, creating an income
effect that encourages more leisure to be chosen because it is more
affordable. Most economists assume that non-paid time (or "leisure") is
a "normal" good which means that people want more of it as their
incomes (or wealth) rise. Since a rising wage rate raises incomes, all else
constant, the attraction of non-paid time rises, eventually cancelling out
the substitution effect and implying the backward bend.

Fig. 3.5: Backward Bend Supply

Referring to Figure 3.5, if real wages were to increase from W1 to W2

then for an individual worker the substitution effect outweighs the
income effect; therefore, they would be willing to increase their hours
worked for pay from L1 to L2. However, if the real wage increased from
W2 to W3, then the number of hours offered to work for pay would fall
from L2 to L3. This is because the strength of the income effect now
exceeds that of the substitution effect: the utility to be gained from an
extra hour of non-paid time is now greater than the utility to be gained
from extra income that could be earned by working the extra hour.

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The above analysis only examines the effect of changing wage rates on
workers already subject to those rates-that is, only these individuals'
labour supply response was considered. It did not consider the additional
labour supplied by workers working in other sectors (or unemployed),
who are now more attracted to the jobs in the sector paying higher
wages. Thus, for a given market, the wage at which the labour supply
curve bends backward may be higher than the wage at which a given
worker's curve bends back.

On the other hand, for the aggregate labour market, that is, a labour
market without "other sectors" for workers to come from, the original
story of the backward-bending labour-supply curve applies, except to
the extent that some workers suffer from involuntary unemployment.

3.3 Assumptions and Caveat

Assumptions

 Workers choose their hours.

 There are no contractual obligations to work a certain number of
hours.
 Workers are utility maximising agents.
 Work provides disutility that must be compensated for by paying
wages.
 Non-paid time is a "normal" good.

Caveat

Higher pay for overtime hours can reduce or negate the effect of a
backward bending labour supply curve, by increasing wages only for
hours worked beyond a certain amount. Overtime maintains the
substitution effect at high labour supply, but the income effect from
wages increasing on all previous hours worked is eliminated. Thus
higher hourly overtime pay can cause workers to work more hours than
they would if the higher rate was paid on all hours.

SELF-ASSESSMENT EXERCISE

Analyse the backward bending labour supply and state the assumptions
and caveats.

3.4 Inverted S-Shaped Labour Supply Curve

At very low wage levels-that is, near the subsistence level-the supply
curve may also be curved backwards for a completely different reason.
This effect creates an "inverted S" or "backward S" shape: a tail is added

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at the bottom of the labour-supply curve shown in the graph above with
the quantity of labour-time supplied falling as wages rise. In this case,
because families face some minimum level of income needed to meet
their subsistence requirements, lowering wages increases the amount of
labour-time offered for sale. Similarly, a rise in wages can cause a
decrease in the amount of labour-time offered for sale: individuals take
advantage of the higher wage to spend time on needed self-or family-
maintenance activities.

SELF-ASSESSMENT EXERCISE

How is an inverted s-shaped labour supply curve determined?

3.0 CONCLUSION

From our discussion so far on the labour-leisure trade-off, we can infer

the following:

 consumption is increased by working more hours

 disadvantage of increased work hour is reduced leisure time
 backward bending labour supply emphasises that as wages
increase above the subsistence level, substitution or income effect
takes place
 higher pay for overtime hours can reduce or negate the effect of a
backward bending labour supply curve.

4.0 SUMMARY

Leisure is considered one good and consumption is considered another

good. A consumer must make a choice between leisure and
consumption. A person's consumption is the amount of labour they
choose multiplied by the amount they are paid per hour labour. The
disadvantage of working more is decreased leisure and vice versa.
Backward bending labour supply curve emphasise that as wages
increase above the subsistence level, there are two possible outcomes
which are "income and substitution effects".

5.0 TUTOR-MARKED ASSIGNMENT

1. What is the effect of increased wage rate in the backward bending

labour supply curve?
2. What are the assumptions and caveats of s-shaped labour supply
curve?
3. How is consumption-leisure combination chosen?
4. What are the causes of inverted s-shaped labour supply curve?

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7.0 REFERENCES/FURTHER READING

Anderson, D. & Ray, M. (2011). Krugman's Economics for AP. (1st

ed.). New York: Worth Publishers.

Arnold, R. A. (2014). Economics. (11th ed.). Mason, OH: South-

Western Cengage Learning.

Bade, R. & Michael, P. (2011). Foundations of Economics, AP Edition.

(5th ed.). Upper Saddle River, NJ: Pearson.

Baumol, W. J. & Alan, S. B. (2012). Economics: Principles and Policy.

(12th ed.). Mason, OH: South-Western Cengage Learning.

Robert, S. P. & Daniel, L. R. (2009). Microeconomics. (7th ed.). New

Jersey: Pearson Education International.

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MODULE 4 MARKET STRUCTURE

Unit 1 Perfect Competition, Monopolistic Competition and

Monopoly
Unit 2 Price Discrimination, Bilateral Monopoly and Monopsony
Unit 3 Collusive Oligopoly and Non-Collusive Oligopoly

UNIT 1 PERFECT COMPETITION, MONOPOLISTIC

COMPETITION AND MONOPOLY

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Perfect Competition
3.2 Monopolistic Competition
3.3 Monopoly
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Market structure refers to the number of sellers and buyers in a market

for a well-defined product or family of products, the distribution among
the sellers or buyers of market shares, and the extent of multiplicity,
differentiation, similarity or homogeneity of the products. In this
module, our focus is on sellers’ market structure, which refers to the
number of the firms operating in the market area, the extent of product
differentiation and multiplicity, and the distribution of market share
among the firms. This concept of sellers’ market structure is the most
widely used in the characterisation of market structure in the theory of
the firm.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 explain the concept of perfect competition, monopolistic

competition and monopoly
 explain both the short run and long run equilibrium in perfect and
monopoly market

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 advise firms in the different markets to shut down or continue

production in both the short and long run.

3.0 MAIN CONTENT

3.1 Perfect Competition

The major characteristic of the perfect market is the existence of

innumerable buyers and sellers, each independent in making decision, so
that none of them can influence number of or control price. The buyers
or sellers in perfect competitive market are price-takers; the quantity he
decides to buy or sell has no effect on price. The firm in a perfect market
faces a perfectly-elastic demand curve or price line (P = AR = MR)
implying that price remains constant with respect to its output (q). In
other words, price will never change in response to any change in the
output of the firm. Any fluctuation in the market price will be due to
extraneous or exogenous factors and not because of any firm’s decision.
Since price (p) is constant in this respect, so also will the average
revenue (AR) and marginal revenue (MR) be constant and equal. That
is, p = AR = MR.

This can be demonstrated as follows:

(i) but R = pq, so that

(ii)

But since R1 = pq1 and R0 = pq0, MR = (pq1 – pq0) / (q1- q0)

= p(q1 – q0) / (q1 – q0) = P and MR = P = AR.
This illustrates the equilibrium condition of a profit-maximising firm in
a perfectly-competitive market.

AC
MC

P P = AR = MR

q
0
q0
Fig. 4.1: Profit-Maximising Equilibrium of the
Firm in a Perfect Market

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Short Run Equilibrium

The short run is the period during which some costs are fixed,
particularly the fixed capital formation. Once the plant has been
installed, the cost has been incurred and it cannot significantly vary as
the firm varies its output within the output capacity of the plant. If the
firm discovers that the investment is not worth it, it cannot throw it away
as long as something can be salvaged from the investment.

In other words, if the revenue from the business covers more than the
cost of variable inputs (variable cost), it does not pay to close down the
business even if total cost exceeds revenue and losses are being
sustained. If the firm should shut down, the loss would be fixed costs of
operation. We can show this formally as:
Profit (PR) is revenue (R) – Cost (C)

That is:

PR = R – C

Such that if there is a situation of loss, it is equal to C – R.

Loss can be defined as Total cost – Total Revenue

Loss = TC – TR

But, C = FC + VC, so that Loss = (FC + VC) – R

Where the firm shuts down, VC = 0, R = 0, so that Loss = FC

Where the firm operates and R > VC,

Loss = FC + (VC – R) < FC

Since VC – R is negative.

In other words, it pays to continue operation in the short run if the

revenue more than covers the variable cost, i.e., R > VC.

For example, suppose R = 200, FC = 100 and VC = 150.

Profit = 200 – (100 + 150) = -50

Loss = 250 – 200 = 50

If the firm shuts down, R = 0, VC = 0 and Loss = FC = 100.

The loss is greater when the firm shuts down than when it continues
operation because revenue is greater than variable cost. And since profit

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maximisation implies loss minimisation, the profit-maximising firm will

continue to operate in the short run whether at a loss or not, as long as
revenue exceeds variable cost (R > VC).

Long Run Equilibrium

Since the firm intends to maximise profit, it will shut down in the long
run if loss is being sustained. In the long run, all costs are variable. The
firm can change its investment decisions in the long run; it can
experiment with different plant sizes to search for the most suitable one;
it can try various methods of production or alternative technologies. If
after this entire maneuver, the firm still sustains a loss, it is predicted
that it will shut down. So, the condition for continued operation in the
long run is that revenue must cover all costs or profit must not be
negative.

i.e., R ≥ C implying AR ≥ AC
PR = R – C ≥ 0 implies also that R ≥ C or AR ≥ AC

i.e., average revenue is greater than or equal to average cost; or profit is

greater than or equal to zero or not negative. This is a general condition
for all profit-maximising firms.

In particular, a firm in a perfect market cannot hold on to pure profit in

the long run, since the existence of profit will attract other firms which
can make their free entry into the market or industry. As many other
firms enter the market, equilibrium price falls, and quantity supplied
falls, average revenue falls thus reducing the profit until there is no
more. For as long as there is profit, more firms will be entering the
market until all profit is competed away. Long run equilibrium of a
profit maximising firm in a perfectly competitive market is given as:
MC = MR = AR = AC.

This is illustrated IN Figure 4.2.

P
MC AC

P = AR

q
0
q0
Fig. 4.2: Long Run Equilibrium of the Profit-
Maximising Firm in a Perfect Market

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In Figure 4.2, AC = AR implying zero profit: but AR = p = MR for a

firm in a perfect marker. While MC = MR = AR = AC.
q0 is the output level that maximises profit; it is also the output that
minimises average cost as well as gives the maximum and only possible
output that can be produced without sustaining any loss. Thus the goal
of output maximisation and average cost minimisation coincide with that
of profit maximising output.

3.2 Monopolistic Competition

Monopolistic competition is perfect competition among many. There are

many firms, each purporting to produce a different commodity whereas
they produce quite similar commodities which are differentiated by
brand names and other superficial means. However, because of a large
number of suppliers of similar commodities, the firm in monopolistic
competition faces a very elastic downward-sloping demand curve. Its
features are similar to those of the monopoly or oligopoly except that
there is little or no restriction to entry by new firms. This ensures that
the firm in a monopolistic competition cannot hold on to profit in the
long run as it will tend to be competed away. Figure 4.3 illustrates the
profit-maximising equilibrium conditions for a firm in a monopolistic
competition in the long run.

MC
P Profit

ATC

atc
P

MR
0 Q
mc
Q

Fig. 4.3: Profit Maximising Equilibrium of the Monopoly or

Oligopoly Firm

So, the short run and long run equilibrium condition of monopolistically
competitive firm with profit maximising goal are respectively:

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Short run: MC = MR; AR > AVC

Long run: MC = MR; AR = AC

It is often remarked that the firms in monopolistic competition are

characterised by excess capacity as shown in Figure 4.3. At the tangency
of demand curve and average cost curves, production is much below the
capacity of the plant size (AC curve) or the minimum average cost
(where MC cuts AC).

3.3 Monopoly

The monopoly is a situation where a single firm is the market for a given
commodity or is an industry. In reality, we can speak of a monopoly
firm when the supply is dominated by the firm. The firm is said to be the
industry in the case of monopoly. The market is monopolised because of
the existence of a barrier to entry for other firms.

Short and Long Run Equilibrium

The monopoly firm is capable of making losses as well as profits in the

short run. When losses are sustained, the firm continues operation if AR
> AVC, otherwise it shuts down, if the goal of the firm is profit
maximisation. The marginal revenue (MR) is also equated to marginal
cost (MC) to obtain the profit-maximising output. Where the firm makes
profit, it can hold on to the profit in the long run because of barrier to
competition by the new firms.

The marginal revenue (MR) of a monopoly firm is downward sloping,

unlike the perfectly-competitive firm, because the monopoly firm faces
a downward-sloping demand curve.

Demand curve is the price line or the average revenue (AR) curve. Since
the AR or demand is falling with output, the marginal revenue (MR)
must be below it, pulling it down. It is the general principle that when
the average of any variable is falling, the marginal is below the average
to pull it down, and when the average is rising, the marginal is above it
to pull it up.

Figure 4.4 depicts the monopoly situation, with MR curve below AR

curve, and equilibrium output (q0) determined at the interception of MC
and MR curves.

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P Economic Profit Loss

MC ATC2
1
P
ATC1
P1

atc Allocative Inefficiency

Q1 Q
MR

Fig. 4.4: Profit-Maximising Equilibrium of the Firm in

Monopolistic Competition

Based on the diagram, at the interception of marginal revenue (MR) and

marginal cost (MC) determines the quantity supplied to the market,
tracing it upward to the interception of first average total cost (ATC1)
shows the cost of producing the good. Further tracing of the trend to the
demand curve gives the market price. At the market price, the cost of
producing the good is lower than the selling price, thus, the firm is
making super-normal profit. However, the monopolist is not efficient
with its production, because Allocative efficiency will occur if it
produces its output at the point where marginal cost (MC) cuts the
demand curve (D). The inability of the monopolist to produce at this
point led to Allocative inefficiency and thus deadweight loss to the
economy. Let us introduce a higher average total cost curve (ATC2),
this shows that the cost of producing the output is greater than the
market price, thus a loss to the monopolist. However, let’s consider a
situation whereby the monopolist is producing at the interception of
marginal cost (MC) and demand curve (D), which is the efficient point,
it was observe that the firm will still be making super-normal profit,
though it is minimal to the initial super-normal profit.

4.0 CONCLUSION

Based on our discussion so far, the follow can be inferred:

 the firms in a perfect market face a perfectly elastic demand

curve or price line P=AR=MR
 in the short run, if the revenue is greater than average variable
cost, the firm can continue production otherwise it shuts down
 monopolistic competition firm is filled with many buyers and
sellers selling homogenous but differentiated goods

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 the marginal revenue curve of a monopoly firm is downward

sloping.

5.0 SUMMARY

Market structure refers to numbers of buyers and sellers in a market for

a well-defined product. Perfect competition is characterised by large
number of buyers and sellers, and no single buyer or seller can single
handedly change the market price. Equilibrium is attained when the
marginal revenue is equal to marginal cost, that is, where the supply and
demand curve cut each other. Monopolistic firm is similar to perfect
competition, as there is no barrier to market entry. The firms sell similar
but differentiated goods, and in the short-run when the average revenue
is greater than the average variable cost, the firm can remain in business
otherwise it shuts down. Monopoly is a situation where there is only a
single seller, thus he has the power to either control the price or his
output, but not the two at the same time.

6.0 TUTOR-MARKED ASSIGNMENT

1. Highlight the profit maximising condition of a monopolist.

2. What is the difference between perfect competition and
monopolistic competition?
3. Discuss the minimal price making power of sellers in the
monopolistic competition.

7.0 REFERENCES/FURTHER READING

Chiang, E. (2014). Core Economics. (3rd ed.). New York: Worth

Publishers.

Mansfield, E. (1975). Microeconomics, Theory and Application. (2nd

ed.). New York: W. W. Norton and Company Inc.

Fashola, M. A. (2009). Microeconomic Theory, Highlights & Policy

Extentions for Less-Developed Economies.

Robert, S. P. & Daniel, L. R. (2009). Microeconomics (7th ed.). New

York: Pearson Education International.

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UNIT 2 PRICE DISCRIMINATION AND MONOPSONY

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Price Discrimination
3.2 Bilateral Monopoly
3.3 Monopsony
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Price discrimination is a pricing strategy where identical or largely

similar goods or services are transacted at different prices by the same
provider in different markets or territories. The term differential pricing
is also used to describe the practice of charging different prices to
different buyers for the same quality and quantity of a product, but it can
also refer to a combination of price differentiation and product
differentiation. Other terms used to refer to price discrimination include
equity pricing, preferential pricing and tiered pricing.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 define the terms price discrimination, bilateral monopoly and

monopsony
 explain how price discrimination is applied in different markets
 determine the conditions for price discrimination and the type of
discrimination
 analyse monopsony, price discrimination and bilateral monopoly
in the Nigeria context.

3.0 MAIN CONTENT

3.1 Price Discrimination

Price discrimination is a situation where consumers of various categories

are charged different prices persistently by a firm for an identical
product, or for differentiated products where the differences in

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production costs are negligible or insignificant relative to the differences

in the prices charged. There may occur, normally and usually, some
differences in the market price of the same product in different market
locations or for different quantities bought by a buyer, which reflect
marginal differences in production, packaging or transportation cost, and
do not amount to price discrimination.

In a theoretical market with perfect information, perfect substitutes, and

no transaction costs or prohibition on secondary exchange (or re-selling)
to prevent arbitrage, price discrimination can only be a feature of
monopolist and oligopolistic markets, where market power can be
exercised. Otherwise, the moment the seller tries to sell the same good at
different prices, the seller at the lower price can arbitrage by selling to
the consumer buying at the higher price but with a tiny discount.
However, product heterogeneity, market frictions or high fixed costs
(which make marginal-cost pricing unsustainable in the long run) can
allow for some degree of differential pricing to different consumers,
even in fully competitive retail or industrial markets.

Price discrimination often occurs between home markets and foreign

markets for a commodity produced by a firm that enjoys monopoly or
remarkable market power at home. The firm may further be protected at
home by import tariffs, quotas or outright ban, giving the firm undue
competitive advantage in the sale of the commodity at home, while it
faces perfect competition in the international market. Price
discrimination usually does occur between industrial users and
household consumers for various goods and services, on account of the
form, specification, or standard units in which the commodity is
demanded by the industrial user as opposed to the household consumer.
It may also occur among various groups of industrial users or among
various socioeconomic classes of household consumers, especially for
social and personal services. Examples include electricity charges for
industrial and household consumers, charges for utilities like gas, water
and refuse disposal. Industrial products like aluminum, iron and steel,
caustic soda, salt, glass, drugs and solid minerals are also sold at
discriminatory prices between industrial users and household
consumers, and even between small scale and large scale enterprises.

Conditions for Price Discrimination

It is obvious that such price discrimination will be feasible only when:

(i) the producers or sellers can control the supply to the market
(ii) the markets or buyers for which discriminatory prices are charged
are or can be segregated to prevent resale between them.

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For condition (i), only monopoly firm or monopoly organisation of

producers or sellers can control the market supply. Firms in a
competitive market cannot control supply. If all producers or sellers
form a cartel or a monopoly organisation, they may be able to control
supply.

For condition (ii), markets may be geographically separated such that

resale by consumers in different markets becomes too costly due to
transportation cost. Markets may also be separated geographically and
politically as between two countries such that resale is impossible owing
to transportation, diplomatic and political obstacles involved in crossing
international boundaries as well as visa and customs regulations.
Markets or buyers can also be segregated by socio-economic classes,
specifically for social and personal services. Examples are first-class and
second-class or economy-class categorisation of the services in order to
charge discriminatory prices that are not reflected in the differences in
the costs of the services.

Price discrimination is profitable if feasible, given the fact that

consumers have different elasticities of demand or willingness to pay.
This is because profit maximisation occurs at the point where marginal
cost (MC) equals marginal revenue (MR). MR depends on the price
elasticity of demand according to the relationship;

MR = P(1 – 1/ƹ), where ƹ is the price elasticity of demand.

If consumers with higher willingness to pay, which is reflected by the

elasticity of demand, are separated from those with lower elasticity of
demand, we can impose higher price on the former and impose lower
price on the latter without reducing the price for the former, as opposed
to a single-price monopoly where the lowest price is imposed on all, as
determined by the consumer with the lowest willingness to pay.

The profit of a discriminating monopolist is the difference between his

total revenue from both markets and his total cost of production. The
mathematical approach to the optimising behaviour of the discriminating
monopolist is presented herewith.

The profit maximising rule is that:

Profit (Đ) = max, when MR in each market equals MC of output as a

whole.

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Assume a monopolist operates in two markets A and B, his cost function

is given as:

TC = C(qA) + C(qB) = C(qA + qB) (1)

TR = TRA + TRB = RA(qA) + RB(qB) (2)

His profit function will be given as:

Profit (Đ) = RA(qA) + RA(qB) – C(qA + qB) (3)

Where qA and qB are the quantities sold in the two markets and RA(qA)
and RB(qB) is the revenue functions for both markets.

∂Đ/∂QA = R!A(qA) – C!(qA + qB) = 0 (4)

∂Đ/∂QB = R!B(qB) – C!(qA + qB) = 0 (5)
Thus R!A(qA) = R!B(qB) = C!(qA + qB)

Equation (4) and (5) show that profit is maximised when MRA = MRB
= MC of output as a whole. If the MR’s are not equal, the monopolist
can increase profit without affecting his TC by shifting sales from the
market with low MR to the one with high MR.

Types of Price Discrimination

First Degree price Discrimination

This type of price discrimination requires the monopoly seller of a good

or service to know the absolute maximum price (or reservation price)
that every consumer is willing to pay. In knowing the reservation price,
the seller is able to sell the good or service to each consumer at the
maximum price he is willing to pay, and thus transform the consumer
surplus into revenues. So the profit is equal to the sum of consumer
surplus and producer surplus. The marginal consumer is the one whose
reservation price equals the marginal cost of the product. The seller
produces more of his product than he would to achieve monopoly profits
with no price discrimination, which means that there is no deadweight
loss. Examples of where this might be observed are in markets where
consumers bid for tenders, though, in this case, the practice of collusive
tendering could reduce the market efficiency.

Second Degree Price Discrimination

In second degree price discrimination, price varies according to quantity

demanded. Larger quantities are available at a lower unit price. This is
particularly widespread in sales to industrial customers, where bulk
buyers enjoy higher discounts. Additional to second degree price

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discrimination, sellers are not able to differentiate between different

types of consumers. Thus, the suppliers will provide incentives for the
consumers to differentiate themselves according to preference. As
above, quantity "discounts", or non-linear pricing, is a means by which
suppliers use consumer preference to distinguish classes of consumers.
This allows the supplier to set different prices to the different groups and
capture a larger portion of the total market surplus. In reality, different
pricing may apply to differences in product quality as well as quantity.
For example, airlines often offer multiple classes of seats on flights,
such as first class and economy class. This is a way to differentiate
consumers based on preference, and therefore allows the airline to
capture greater consumers’ surplus.

Third Degree Price Discrimination

In third degree price discrimination, price varies by attributes such as

location or by customer segment, or in the most extreme case, by the
individual customer's identity; where the attribute in question is used as
a proxy for ability/willingness to pay. This involves charging a different
price to different groups of consumers. These groups of consumers can
be identified by particular characteristics such as age, sex or location.

SELF-ASSESSMENT EXERCISE

What are the conditions for price discrimination?

3.2 Bilateral Monopoly

The bilateral monopoly model, with a single buyer and a single seller,
can be used to analyse many types of markets, but it is most relevant for
factor markets, especially those for labour services. The bilateral
monopoly model was developed to explain assorted labour markets
operating in the early days of the U.S. industrial revolution, the late
1800s and early 1900s. During this period, large industrial activities
(factories, mines, lumber operations) commonly created monopsony
markets by dominating the labour market of a given community (a so-
called company town). The expected monopsony outcome, especially
low wages, inevitably resulted.

The workers sought to counter these less than desirable situations, by

forming labour unions. The expressed goal of most unions was to
monopolise the selling side of a labour market and balance the
monopsony power of the employer. This resulted in a bilateral
monopoly. Bilateral monopoly is a market containing a single buyer and
a single seller, or the combination of a monopoly market and a
monopsony market. A market dominated by a profit-maximising

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monopoly tends to charge a higher price. A market dominated by a

profit-maximising monopsony tends to pay a lower price. When
combined into a bilateral monopoly, the buyer and seller both cannot
maximise profit simultaneously and are forced to negotiate a price and
quantity. The resulting price could be anywhere between the higher
monopoly price and the lower monopsony price. The final price depends
on the relative negotiating power of each side.

Modern Example of Monopsony

Markets dominated by a company-town-type monopsony employer on

the buying side and a monopoly labour union on the selling side are rare
in the modern economy, but the bilateral monopoly model provides
insight into other markets. Consider the following:

Industrial Labour: While the company town might be largely a thing

of the past, a number of modern labour markets contain a dominant
employer on the buying side and a dominant labour union on the selling
side. Negotiations between large corporations and labour unions over
wages and working conditions approximate the bilateral monopoly
model. While these markets are not, strictly speaking, comprised of pure
monopoly sellers and pure monopsony buyers, they do have a definite
bilateral monopoly flavor.

Consumer Goods: A number of modern consumption purchases, such

as buying a house or a car, tend to fit the bilateral monopoly model.
These purchases often include a single buyer and a single seller. As the
bilateral model suggests, one-on-one negotiation over the price is a
common feature of such purchases.

Athletic Labour Services: Perhaps the factor markets that come closest
to the bilateral monopoly model are those involving the labour services
of professional athletes. Players in each league are also represented by a
players’ union, including the National Football League Players
Association. While the wage rates tend to be significantly higher for
athletes than for factory workers, the underlying process is much the
same.

SELF-ASSESSMENT EXERCISE

What do you understand by the term bilateral monopoly?

3.3 Monopsony

Monopsony is a market in which a single buyer completely controls the

demand for a good. While the market for any type of good, service,

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resource, or commodity could, in principle, function as monopsony, this

form of market structure tends to be most pronounced for the exchange
of factor services. While the real world does not contain monopsony in
its absolute purest form, labour markets in which a single large factory is
the dominate employer in a small community comes as close as any.
Like a monopoly seller, a monopsony buyer is a price maker with
complete market control. Monopsony is also comparable to monopoly in
terms of inefficiency. Monopsony does not generate an efficient
allocation of resources. The price paid by a monopsony is lower and the
quantity exchanged is less than with the benchmark of perfect
competition.

Characteristics

The three key characteristics of monopsony are:

(1) a single firm buying all output in a market

(2) no alternative buyers
(3) restrictions on entry into the industry.

Single Buyer: First and foremost, a monopsony is a monopsony

because it is the only buyer in the market. The word monopsony actually
translates as "one buyer." As the only buyer, a monopsony controls the
demand-side of the market completely. If anyone wants to sell the good,
they must sell to the monopsony.

No Alternatives: A monopsony achieves single-buyer status because

sellers have no alternative buyers for their goods. This is the key
characteristic that usually prevents monopsony from existing in the real
world in its pure, ideal form. Sellers almost always have alternatives.

Barriers to Entry: A monopsony often acquires, and generally

maintains single buyer status due to restrictions on the entry of other
buyers into the market. The key barriers to entry are much the same as
those that exist for monopoly:

(1) government license or franchise

(2) resource ownership
(3) patents and copyrights
(4) high start-up cost
(5) decreasing average total cost.

SELF-ASSESSMENT EXERCISE

What are the characteristics of monopsony?

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4.0 CONCLUSION

 A monopsony buyer is a price maker, and does not generate an

efficient allocation of resources.
 For price discrimination to occur, the producer or seller must
control the supply to the market, and be sure of segregated
markets in other to avoid resale between them.
 Bilateral monopoly is a market for a single buyer and seller or the
combination of a monopoly market and a monopsony market.
 Profit cannot be made by both the buyers and sellers
simultaneously in the bilateral monopoly market, so they are both
forced to resort to negotiation on price and quantity, with the
winner being the better negotiator.

5.0 SUMMARY

Price discrimination can only be a feature of monopolistic and

oligopolistic markets where there is perfect information, perfect
substitutes and no transaction costs or prohibition on secondary
exchange to prevent arbitrage. Price discrimination often occurs between
the home markets and foreign markets for a commodity produced by a
firm that enjoys monopoly or remarkable market power at home.
Bilateral monopoly is a market containing a single buyer and a single
seller, or the combination of a monopoly market and a monopsony
market, as a market dominated by a profit maximising monopoly tends
to charge a higher price, and a market dominated by a profit maximising
monopsony tends to pay a lower price, thus when combined into a
bilateral monopoly, the buyer and the seller both cannot maximise profit
simultaneously and are forced to negotiate a price and quantity.
Monopsony is where a single buyer completely controls the demand for
a good. A monopsony buyer is a price maker with complete market
control.

6.0 TUTOR-MARKED ASSIGNMENT

1. Differentiate between the different types of price discrimination.

2. Analyse how the single buyers and sellers interact in a bilateral
monopoly market.
3. Give an example of a monopsony market in Nigeria.

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7.0 REFERENCES/FURTHER READING

Case, et al. (2014). Principles of Economics. (11th ed.). Upper Saddle

River, N J: Pearson.

Chiang, E. (2014). Core Economics. (3rd ed.). New York: Worth

Publishers.

Colander, D. C. (2013). Economics. (9th ed.). New York: McGraw-Hill.

Fashola, M. A. (2009). Microeconomic theory, Highlights & Policy

Extentions for Less-Developed Economies.

Robert, S. P. & Rubinfeld, D. L. (2009). Microeconomics. (7th ed.).

New York: Pearson Education International.

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UNIT 3 COLLUSIVE OLIGOPOLY AND NON-

COLLUSIVE OLIGOPOLY

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Collusive and Non-Collusive Oligopoly
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Oligopoly consists of a few dominant firms in the industry. This means

that the number of firms in the industry may be small or large provided
that a few (four to nine) dominate the market or control more than 50%
of market share. Concentration ratio is often used to determine whether
the marker is an oligopoly. When the number of firms is very small, the
oligopoly market may be capable of engaging in collusion deliberately
or tacitly. When the number is not quite few, the firms will tend to
behave as if they are in a perfectly competitive market by assuming that
prices will remain constant as each firm alters its output.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 analyse the Bertrand, Cournot, Stackelberg, Edgeworth and the

Chamberlin oligopolistic model
 state the reactions and functions of rival firms in an oligopolistic
market
 determine the profit condition of oligopolistic firms
 explain the effect of price and output variation on profit.

3.0 MAIN CONTENT

3.1 Collusive and Non-Collusive Oligopoly

The Bertrand Model

This model addresses the case of not so many numbers of firms in the
market, such that each firm believes or assumes that its activity will not

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alter the market price for the product. So the firm then attempts to
maximise its profit, holding the price constant. In this case, the marginal
revenue is constant and equal to the price. The profit maximising
equilibrium of the firm is then given by MC = P. This oligopoly model
tends to produce minimum profit and the largest output among all types
of oligopoly models, as illustrated in Figure 4.5

MC
P
MR
AC

AR

Q
MR = MC MC = P
Fig. 4.5: Equilibrium of Bertrand oligopoly model at
MC=P

The monopoly output is much lower at MC = MR

SELF-ASSESSMENT EXERCISE

Explain the Bertrand’s oligopoly model

The Cournot Classical Model

In the Cournot classical model, the firm assumes that other firms will
not change their output as it changes its own output. On that count, the
firm maximises profit by equating the marginal cost (MC) to its
marginal revenue (MR). The reality is, however, that other firms will
change their output and this forces price and the marginal revenue of the
firm down, requiring the firm to reduce its output as a reaction to the
other firms’ action. So, initially, the firms will tend to produce more
than the collusion oligopoly and realise less profit. They will however
achieve equilibrium eventually. This can be illustrated by the
intersection of reaction curves of the firms in a duopoly model.

P = f(Q1, Q2)

Profits for the firms are respectively:

P1 = R1 – C1, where R1 = f(Q1), and C1 = f(Q1)

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P2 = R2 – C2, where R2 = f(Q2), and C2 = f(Q2)

Since revenue R1 = PQ1 = f(Q1, Q2)Q1 and R2 = PQ2 = f(Q1, Q2)Q2,

the reactions function obtained by taking the partial derivatives of
profits of the firms and equating it to zero, produces two equations in
two unknown, Q1 and Q2, with definite solutions. The output so derived
produce small outputs than with Bertrand oligopoly model, but larger
outputs than what it is produced with the collusion model. While the
profits are larger than with the Bertrand model, but smaller than what is
obtainable with the collusion model.

This can be illustrated with a numerical example.

Suppose price (P) = 300 – 2(Q1 + Q2),

Cost (C1) = 8Q1, and C2 = 10Q2, profit functions are respectively:

Đ1 = R1 – C1 = PQ1 – C1 = [300 – 2(Q1 + Q2)]Q1 – 8Q1

= 300Q1 – 2Q12 – 2Q1Q2 – 8Q1

Đ2 = R2 – C2 = PQ2 - C2 = [300 – 2(Q1 + Q2)]Q2 – 10Q2

= 300Q2 – 2Q22 – 2Q1Q2 – 10Q2

The reaction functions are then as follows:

∂Đ1/∂Q1 = 300 – 4Q1 – 2Q2 – 8 = 0

∂Đ2/∂Q2 = 300 – 4Q2 – 2Q1 – 10 = 0

The solution is given by Q1 = 49 and Q2 = 48. This could be checked

and it will be observed that it produces smaller profit and larger total
output if the total profit of the oligopoly firms were to be maximized in
a collusion model.

Assumptions of Cournot Model

1. Cournot assumes the existence of a costless monopolist whose

market is penetrated by a second firm with identical cost
conditions. This results in the existence of a duopoly situation
consisting of firms I and II.
2. Each firm produces identical products.
3. There is perfect flow of information. Each firm is fully aware of
the demand curve facing the market and identical prices.
4. It is a costless monopoly, as MC = 0
5. Each duopolist acts independently (absence of collusion) under
the assumption that rivals output will remain exactly where it is
now even if firm I changes its output. While this assumption is

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rather old and naïve, Figure 4.6 demonstrates the simplified

Cournot model.

Price per Unit

AR

P1
P2
P3

Qty of commodity
Q1 Q3 Q2 Qc x per unit

MR1
MR2
Fig. 4.6: The Cournot Model

Assume Firm I enter the market first with market demand and marginal
revenue curves represented by AR and MR1 respectively. Operating as a
pure monopolist, he will produce an equilibrium output 0Q1 where
MR=MC=0, and sell at a per unit price of OP1. This is a monopoly price
and the firm secures a monopoly profit. Note that if pure competition
prevailed, the market equilibrium output would be 0Qc since MC=0 and
P=0.

Now, assume that firm II enters the market believing that firm I’s output
will be invariant at 0Q1, he regards AQc as the remaining market
demand. Introducing his MR curve (MR2) from point A, the profit
maximising output for firm II (Q1Q) is half the remaining market (AQc)
which is one fourth of the entire market. He then equates his MR and
MC at output level 0Q2. His price is 0P2. Both firms now sell at the
price 0P2.

Firm I in turn assume that firm II’s output will remain fixed at Q2C2
which is ¼ of the entire market. Thus the total market demand he now
faces becomes 3/4., which is equivalent to 0Q2. He now proceeds to
maximise his profit by producing half of the market which is ½ of ¾ of
the market. This process continues until a limit or convergence point is
reached. In equilibrium, the two duopolists will produce two thirds of
the competitive output (2/3 Qc) and charge two thirds of the monopoly
price (2/3 P1). Their joint profit is 2/3 of the monopoly profit.

SELF-ASSESSMENT EXERCISE

What are the central assumptions of the Cournot approach to

oligopolistic market conduct?

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Edgeworth’s Model

An English economist Francis Edgeworth developed a model similar to

Bertrand’s in the assumption of zero conjectural variation in prices. He
however differs from Bertrand in assuming that the two firms have
limited capacity to produce OQc units at P=0, (Figure 4.6), then a lower
limit could be established beyond which price could not fall. But such a
price would be unstable. However, once it is reached; one of the rivals
will assume the other will stick to that price where it reaches its capacity
limit. It then perceives that at such a point:

(i) The rival firm cannot sell more because it has reaches its capacity
limit.
(ii) An increase in price will increase profits.

Consequently one of the firms will raise its price to a point where it
maximises its profits in the remaining markets. The others will
presumably follow suit, but to a level slightly below that of the first
firm. The first firm naturally reacts with another price cut. As the
process continues, the price level falls back to the lower limit. At this
point, the opportunity for any of the firms to gain once more by raising
price recurs and price goes up again. This Edgeworth proposed, goes on
and on, as long as each firm adheres to the assumption of zero
conjectural variation in prices on the part of rival firms.

SELF-ASSESSMENT EXERCISE

What are the major differences between the Cournot model and the
Edgeworth model?

Stackelberg Model

This model gives comprehensive possibilities to oligopoly market

behaviour by assuming realistically that the firm in an oligopoly market
is aware that its profits and prospects depend not only on its own output
decisions but also on the decisions of rival firms about the level of their
output, among others. Thus, the model recognises oligopolistic
interdependence and its influence on output and price decisions of the
firm. This specifically means that the behaviour of the oligopoly firm in
respect of output or price decisions takes into account the reactions of
rival firms. Although, Stackelberg assumes two firms in the market, the
analysis may be extended to more than two firms.

Suppose “n” represents the number of firms in the oligopoly market, and
then the profit of each firm “I” depends directly on its own output levels
of other firms. Thus given that:

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:
Qi = ƒi(Q1, Q2, Q3, . . . Qn); I = 1, 2, 3, . . ., n,
the equilibrium of the profit maximising oligopoly firms are respectively
given by:

(1)

(2)

(3)

Restricting the analysis as presented by Stackelberg to two oligopoly

firms (A and B), the profit function is given by:

(4)

(5)

The cross partial derivatives (∂QB/∂QA) and (∂QA/∂QB) relating the

output of firm B to that of firm A and vice versa, respectively, in terms
involving the chain rule in the system (4) describe the reaction of firm B
to output decision of firm A, and the reaction of firm A to output
decision of form B, while and describe the profit maximising
response of firm A to the output expansion of firm B, and vice versa.
The problem with this model is that each firm may not be able to predict
the reaction to its output decisions by the rival firms. And that is why
the model of Bertrand and Cournot made the simple assumption that the
oligopoly firm would, in the pursuit of its profit-maximising goal,
disregard the reaction of the rival firms in its possible impact on the
market prices or aggregate.

To address the problem of the ability, Stackelberg proposed four

possibilities.

1. Firm A plays leadership role by being in a position to know or

dictate the reaction of firm B that plays the followership role.
Firm B, on the other hand, would react to the decision of firm A
according to the understanding between them. In that case, the
simultaneous system has a solution known as Stackelberg
equilibrium. Thus, the cross partial derivative (∂QB/∂QA)
vanishes while the cross partial derivative (∂QA/∂QB) has a
known functional value.
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2. The above solution is also true in a case where firm B plays

leadership role while firm A plays the followership role.
3. This is when both firm play followership roles, each expecting
that the other firm will not at all react to the decision taken by
them. Thus the term involving the cross partial derivatives
(∂QB/∂QA) and (∂QA/∂QB) vanishes, and so do the terms
involving the chain rule. So, the system reduces to that of the
Cournot model.
4. Both firms are unable to predict the reaction of the other firms,
and so the term involving the cross partial derivatives in the chain
rule have an unknown functional value. There will therefore be
no solution to the system, and we then have Stackelberg
disequilibrium. The two firms are unable to reach an
understanding in their behaviour and this is tantamount to each
firm asserting its independence, or both playing leadership roles
as Stackelberg puts it.

SELF-ASSESSMENT EXERCISE

How can you predict the reaction of a rival firm under Stackelberg
model?

The Collusion Model

The Chamberlin’s small group oligopoly model consists of very few

firms, and permission of collusion without open agreement but with tacit
understanding. This leads to a monopoly solution with maximum total
profit and minimum total output. The equilibrium in such a model is that
maximisation of total profit requires that marginal total profit with
respect to the output of every firm be equated to zero (i.e. ∂P/∂Qi = 0; I
= 1, 2, . . ., n).

Tacit collusion can be obtained through many strategies: One is the price
leadership, where the leading firm fixes price and others follow, and so
competition is largely non-price but by advertisements and other
methods. Another strategy is sharing of markets by regions, by quotas in
an informal manner. Tacitly, also, firms may not engage in price war
and each operates to stabilise price and only compete through other
strategies like advertisement. The kinked demand model is consistent
with the collusion model as with other models.

SELF-ASSESSMENT EXERCISE

Given that:

Profit = 300 – 0.5Q

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Where Q = QA + QB
CA = 4000 – 20QA + 0.2QA2 and
CB = 3000 + 15B + 0.25QB2

Calculate the total profit.

The Kinked Demand Model

This model postulates that oligopoly firms realise their interdependence

such that they will avoid price competition below a particular level. If
any firm cuts price below that level (or kinked), others will react by
cutting their own price, so that the first to cut price will not divert
customers in a significant manner to the firm whose price has been cut.
With the reaction of others, the firm will not gain any significant number
of customers. Therefore, the demand curve below shows that price level
(the kink) is much more inelastic than the segment of the demand curve
above the kink. This illustration is presented in Figure 4.7.

Kink

Fig. 4.7: The Kinked Demand Curve

If any firm attempts to raise its price, others are not likely to follow,
with the consequence that the firm will lose a lot of customers to its
competitors. So, there is a tendency for prices to cluster at or a little
above the kink. Except when there is a case of price leadership by a
dominant firm, price increase by one firm will not be followed by
others. When there is a recognised leader and price leadership exists, a
price increase by the dominant firm may be followed by the others,
leading to a new kink on the demand curve.

SELF-ASSESSMENT EXERCISE

Is it possible for an oligopolistic firm confronted with a kinked demand

curve situation to increase its short run profits by increasing its short run
expenditure on sales promotion?

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4.0 CONCLUSION

We have so far examined the classical solution of Cournot, Chamberlin

.et al to the oligopolistic market behaviour. These theories explained the
reason for price rigidity in an oligopolistic industry, and why prices
change simultaneously throughout the industry whenever it occurs. We
then discussed how oligopolistic firms decide upon a particular price.

5.0 SUMMARY

Based on the discussion on Collusive and Non Collusive Oligopoly, the

following can be inferred:

 Kinked demand is a model of steady prices in non-collusive

oligopolistic market
 An oligopolist firm will refrain from independent initiating price
cut because this will elicit prompt reaction from rival firms with
similar cuts, thus wiping off any anticipated gains in profits and
market share position.
 The price charged by an oligopolist firm tends to be rigid but the
output however tends to respond to moderate changes in market
demand conditions.
 Oligopolist firms cannot coexist by charging substantially
different prices for essentially similar commodities. Firms with
higher prices will price themselves out of business as lower
priced competitors make the sale. Consequently, prices tend to
remain steady in oligopolistic markets.
 The price and quantity produced per unit of time by an
oligopolistic firm tend to remain rigid in the face of moderate
cost changes.

6.0 TUTOR-MARKED ASSIGNMENT

1. Consider an oligopoly market with two firms A and B, facing the

demand function:
a. P=300 – 0.5Q
b. Suppose their cost functions are respectively:
c. CA = 4000 + 20QA + 0.2QA2 and CB = 3000 + 15QB +
0.25QB2
d. Derive the reaction functions of the firm and the profit
maximising equilibrium under Cournot (classical
oligopoly), Bertrand and the Collusive model.
2. What are the essential differences between the Cournot,
Edgeworth, Stackelberg, Chamberlin and Bertrand Model?

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7.0 REFERENCES/FURTHER READING

Robert, S. P. & Daniel, L. R. (2009). Microeconomics. (7th ed.).

Pearson Education International.

Koutsoyiannis, A. (n. d.). Modern Microeconomics. (2nd ed.).

Mansfield, Edwin. (1975). Microeconomics, Theory and Application

(2nd ed.). New York: W. W. Norton and Company Inc.

Fashola, M. A. (2009). Microeconomic theory: Highlights & Policy

Extensions for Less-Developed Economies.

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MODULE 5 LINEAR PROGRAMMING, GENERAL

EQUILIBRIUM AND SOCIAL WELFARE

Unit 1 Linear Programming

Unit 2 General Equilibrium
Unit 3 Social Welfare

UNIT 1 LINEAR PROGRAMMING

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Assumptions of Linear Programming
3.2 Advantages and Limitations
3.3 Construction of the Model
3.4 Canonical Tableaux
3.5 Introduction to Simplex Algorithm/Method
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

The linear programming problem is that of choosing nonnegative values

of certain variables so as to maximise or minimise a given linear
function subject to a given set of linear inequality constraints. It can also
be referred to as the use of linear mathematical relations to plan
production activities. Linear programming is a resource allocation tool
in production economics.

Linear programs are problems that can be expressed in canonical form:

where x represents the vector of variables (to be

determined), c and b are vectors of (known) coefficients, A is a
(known) matrix of coefficients, and is the matrix transpose The
expression to be maximised or minimised is called the objective
function(cTx in this case). The inequalities Ax ≤ b and x ≥ 0 are the

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constraints which specify a convex polytopeover which the objective

function is to be optimised. In this context, two vectors are comparable
when they have the same dimensions. If every entry in the first is less-
than or equal-to the corresponding entry in the second then we can say
the first vector is less-than or equal-to the second vector.

Linear programming can be applied to various fields of study. It is used

in business and economics, but can also be utilised for some engineering
problems. Industries that use linear programming models include
transportation, energy, telecommunications, and manufacturing. It has
proved useful in modeling diverse types of problems in planning,
routing, scheduling, assignment, and design.

Linear programming maximum problem looks like the equation

presented below:

Max ƒ(x) = cx
Subject to Ax ≤ b, x ≥ 0.
More generally,
Max Z= P1X1 + P2X2
Subject to

a11x1 + a12x2 + …. + a1nxn ≤ b1

a21x1 + a22x2 + …. + a2nxn ≤ b2

am1x1 + am2x2 + …. + amnxn ≤ bm

x1 ≥ 0, x2 ≥0, . . . , xn ≥ 0.

Where a11is the amount of resources required to produce a unit of

activity, i.e. the recommended unit of output to produce specified
quantity of output (Linear programming has to do with using the optimal
level of input to achieve an optimum number of output).

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 state the assumptions of linear programming

 state the advantages and disadvantages of linear programming
 explain the standard form canonical tableaux
 solve maximisation and minimisation problem.

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3.0 MAIN CONTENT

3.1 Assumptions of LP for Production

 The objective function is linear

 There is an additivity of resources and activities
 Activities and resources are non-negative
 Resources and activities are infinitely divisible
 Resources and activities are finite
 There is a linear relationship between activities and resources
 Linear programming models are deterministic and not stochastic.

3.2 Advantages and Limitations

Advantages

 It helps decision-makers to use their productive resources

effectively.
 The decision-making approach of the user becomes more
objective and less subjective.
 In a production process, bottlenecks may occur. For example, in a
factory, some machines may be in great demand, while others
may lie idle for some times. A significant advantage of linear
programming is highlighting such bottle necks.

Limitations

 Linear programming is applicable only to problems where the

constraints and objective function are linear i.e., where they can
be expressed as equations which represents straight lines. In real
life situations, when constraints or objective functions are not
linear, this technique cannot be used.
 Factors such as uncertainty and time are not taken into
consideration.
 Parameters in the model are assumed to be constant but in real
life situations, they are not constant.
 Linear programming deals with only single objectives, whereas in
real life situations, we may have multiple and conflicting
objectives.
 In solving linear programming problem, there is no guarantee that
we will get an integer value. In some cases of no men/machine, a
non-integer value is meaningless.

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SELF-ASSESSMENT EXERCISE

What are the advantages and disadvantages of linear programming?

3.3 Construction of the Model

The transformation of a linear programme to one in standard form may

be accomplished as follows. First, for each variable with a lower bound
other than 0, a new variable is introduced representing the difference
between the variable and the bound. The original variable can then be
eliminated by substitution. For example, given the constraint:

X1 ≥ 5

a new variable, y1 is introduced with

y1 = x1 – 5
x1 = y1 + 5

The second equation may be used to eliminate x1 from the linear

programme. In this way, all lower bound constraints may be changed to
non-negative restrictions. Second, for each remaining inequality
constraint, a new variable, called a slack variable, is introduced to
change the constraint to an equality constraint. This variable represents
the difference between the two sides of the inequality and is assumed to
be nonnegative. For example the inequalities:

x2 + 2x3 ≤ 3
-x4 + 3x5 ≥ 2

Are replaced with

x2 + 2x3 + s1 = 3
-x4 + 3x5 + s2 = 2
s1, s2 ≥ 0

It is much easier to perform algebraic manipulation on inequalities in

this form. Third, each unrestricted variable is eliminated from the linear
program. This can be done in two ways, one is by solving for the
variable in one of the equations in which it appears and then eliminating
the variable by substitution. The other is to replace the variable with the
difference of two restricted variables. For example if z1 is unrestricted
then write:

z1 = z 1 + - z1 -
z1+, z1- ≥0

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The equation may be used to eliminate z1 from the linear program.

When this process is complete the feasible region will be in the form:
Ax = b, xi ≥ 0

3.4 Canonical Tableaux

A linear programme in standard form can be represented as a tableau of

the form:

The first row defines the objective function and the remaining rows
specify the constraints. If the columns of A can be rearranged so that it
contains the identity matrix of order p (the number of rows in A) then
the tableau is said to be in canonical form. The variables corresponding
to the columns of the identity matrix are called basic variables while the
remaining variables are called non-basic or free variables. If the non-
basic variables are assumed to be 0, then the values of the basic
variables are easily obtained as entries in b and this solution is a basic
feasible solution.

Conversely, given a basic feasible solution, the columns corresponding

to the nonzero variables can be expanded to a nonsingular matrix. If the
corresponding tableau is multiplied by the inverse of this matrix then the
result is a tableau in canonical form.

Let be a tableau in canonical form. Additional row-addition

transformations can be applied to remove the coefficients cTB from the
objective function. This process is called pricing out and a result in a
canonical tableau wherezB is the value of the objective function at the
corresponding basic feasible solution. The updated coefficients, also
known as relative cost coefficients, are the rates of change of the
objective function with respect to the non-basic variables.

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3.5 Introduction to Simplex Algorithm/Method

Let a linear program be given by a canonical tableau. The simplex

algorithm proceeds by performing successive pivot operations which
each give an improved basic feasible solution; the choice of pivot
element at each step is largely determined by the requirement that this
pivot improve the solution.

For example, consider the production function:

Max Z= 200x1 +240x2

Subject to

30x1 + 15x2 ≤ 2400

20x1 + 30x2 ≤ 2400

First thing to do is to get rid of (≤) by introducing the slack element.

Thus, we rewrite the model as:
30x1 + 15x2 + s1 + 0s2 = 2400 (1)
20x1 + 30x2 + 0s1 + s2 =2400 (2)

The above equation fills the stage one of this table

Table 5.1: Simplex Algorithm/Method

Stage 1
Pj - - 200 240 0 0 ϴ
Activity Resources X1 X2 S1 S2 -
0 S1 2400 30 15 1 0 160
0 S2 2400 20 [30] 0 1 80

Zj 0 0 0 0 0
Pj - Zj - 200 240 0 0
Stage 2
0 S1 1200 19.95 0 1 -0.45 60.15
240 X2 80 0.67 1 0 0.03 119.4

Zj 19,200 160.8 240 0 7.2

Pj - Zj - 39.2 0 0 -7.2
Stage 3
200 X1 60.2 1 0 0.05 -0.02
240 X2 39.7 0 1 -0.03 0.04
Zj 21568 200 240 2.8 70.4
Pj - Zj - 0 0 -2.8 -70.4

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Note: stage three (3) maximises the equation.

The bolded row and column are both our pivot row and column, while
the pivot element is acquired by observing the highest value in row Pj –
Zj and the lowest values in column ϴ. The pivot value is the value is
block bracket ([30]) in stage 1.

For plan 2, we make x2 the subject of the formula in Equation 2.

20x1 + 30x2 + 0s1 + s2 =2400

30x2 = 2400 - 20x1 - 0s1 - s2

Dividing through by 30 gives:

x2 = 80 - 0.67x1 - 0s1 - 0.03s2 (3)

Impute equation (4) into (1) gives:

30x1 + 15(80 - 0.67x1 - 0s1 - 0.03s2) + s1 + 0s2 = 2400

30x1 + 1200 – 10.05x1 – 0s1 – 0.45s2 + s1 + 0s2 = 2400
19.95x1 + s1 – 0.45s2 = 1200 (4)

Making x1 the subject of the formula:

x1 = 60.2 – 0.05s1 + 0.02s2 (5)

Imputing (5) into (3) gives:

x2 = 80 - 0.67x1 - 0s1 - 0.03s2

By rearranging the above equation gives:

0.67x1 + 1x2 -0s1 + 0.03s2 = 80

Thus our model gives:

0.67(60.2 – 0.05s1 + 0.02s2) + x2 + 0.03s2 = 80
40.3 – 0.03s1 + 0.01s2 + x2 + 0.03s2 = 80
x2 – 0.03s1 +0.04s2 = 39.7

The maximising equation is thus:

200x1 + 240x2
200 (60.2) + 240 (39.7) = 21,568.
This maximises the value Z. i.e., revenue is maximise at the production
of 60.2x1 and 39.7x2 goods.

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4.0 CONCLUSION

From our discussion so far on linear programming, we can infer the

following:
 The problem of linear programming is that of choosing non-
negative values of certain variables so as to maximise or
minimise a given linear function subject to a given set of linear
inequality constraints.
 The objective function according to the linear programming
assumption is that the objective function is linear and that there is
an additivity of resources and activities.
 The canonical tableau is presented as a better way of presenting
linear programming in standard form.
 Simplex algorithm performs successive pivot operations which
each gives an improved basic feasible solution, and the choice of
pivot element at each step is largely determined by the
requirement that the pivot improve the solution.

5.0 SUMMARY
 The concept of linear programming problem is that of choosing
nonnegative values of certain variables so as to maximise or
minimise a given linear function, subject to a given set of linear
inequality constraints.
 In order to construct the model, the transformation of a linear
program to one in standard form may be required.
 The standard form of presenting a linear problem was discussed.
Similarly, the simplex algorithm method of analysing linear
programming was discussed.

6.0 TUTOR-MARKED ASSIGNMENT

1. max Z = 4x1 + 6x2
Subject to: x1 + 2x2 ≤ 20
3x1 + 2x2 ≤ 30
4x1 + x2 ≤ 32.5
2. What are the assumptions of Linear Programming?
3. What are the advantages and limitation of Linear Programming?
4. max Z = 4x1 + 6x2 + 8x3
Subject to: 2x1 + x2 + 3x3 ≤ 80
x1 + 5x2 + 2x3 ≤ 100
3x1 + 2x2 + x3 ≤ 60

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7.0 REFERENCES/FURTHER READING

Micheal, D. I. (2002). “Mathematical Optimisation and Economic

Theory.” An applied Mathematics. Philadelphia: Society for
Industrial and Applied Mathematics.

Jan, S. (2005). Practical Mathematical Optimisation: An Introduction to

Basic Optimisation Theory and Classical and New Gradient-
based Algorithms (Applied Optimisation). Springer.

Mokhtar, et al. (2010). Linear Programming and Network Flows. (4th

ed.). Wiley-Blackwell.

Jiri, M. (2013). Understanding and Using Linear Programming.

Springer.

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UNIT 2 GENERAL EQUILIBRIUM

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Assumptions of the Walrasian System
3.2 The Household and Consumer Equilibrium
3.3 Two Interdependent Markets Moving to General
Equilibrium
3.4 Efficiency in Exchange and the Advantage of Trade
3.5 Theory of Distribution (Wage, Rent, Profit and Interest)
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

There were many interesting and important contributions to the science

of economics during the neo-classical era. Two of the most notable
writers whose ideas have become important to the subsequent
development of economic analysis were Alfred Marshall and Neon
Walras. Both men were concerned with the theoretical foundation of
price formation. Although each man approached the subject of market
equilibrium from a different theoretical stance, yet each had a
resounding impact on the science of economics. While Marshall
developed the framework for partial equilibrium, Walras developed the
contemporary framework for general equilibrium analysis.

General equilibrium theory is a concept of theoretical economics. It

seeks to explain the behaviour of supply, demand, and prices in a whole
economy with several or many interacting markets, by seeking to prove
that a set of prices exists that will result in an overall equilibrium.
General equilibrium theory both studies economies using the model of
equilibrium pricing and seeks to determine the circumstances in which
the assumptions of general equilibrium will hold.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 differentiate between partial and general equilibrium

 state the assumptions of Walras theory
 analyse the household and consumer equilibrium

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 discuss the incidence in two markets coming together to form

general equilibrium.

3.0 MAIN CONTENT

3.1 Assumptions of the Walrasian System

1. In the Walrasian system, the price which equilibrates the supply

and demand sides of the market for consumer goods were
assumed to be established by an auctioning process. No
transactions took place until equilibrium was established in the
same manner.
2. He assumed the existence of perfect competition in the
commodities and factor markets. This assumption is central to
general equilibrium theory because it is only within perfectly
competitive system that a general equilibrium solution exists.
3. For the purpose of simplicity, he assumed the existence of only
two factors of production, labour and capital (L and K). They are
assumed to be homogenous and perfectly divisible.
4. For the purpose of simplicity, he assumed the existence of only
two individuals A and B producing and exchanging two
commodities X and Y. Their preferences for the two commodities
are given by their respective indifference curves. Given the state
of technology, the properties of the production functions are
given by their respective isoquant maps.
5. The optimising goal of the consumers is utility maximisation
subject to the constraints of their incomes and the prices of the
commodities.
6. The optimising goal of each firm is profit maximisation subject to
the constraint of their budgets
7. The factors of production are completely owned by the
households who constitute the ultimate consumers.
8. There is full employment of all factors of production and their
owners spend all incomes received.

In this system, general equilibrium is attained when the four markets (2

commodities (X and Y) and 2 factor markets (L and K) are cleared at a
set of prices Px, Py, w and r respectively, and the participating
institutions namely consumers and producers are in equilibrium. A
general equilibrium solution involves the determination of the values of
the following variables:

(i) The total quantities of commodities x and y to be produced by the

firms.
(ii) The quantities of L and K to be employed in their production.

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(iii) The distribution of the two commodities between the two

individuals A and B.
(iv) The equilibrium prices Px, Py, w and r.

SELF-ASSESSMENT EXERCISE

List the Walrasian assumption of general equilibrium

3.2 The Household and Consumer Equilibrium

Households perform dual functions in general equilibrium analysis.

They constitute the ultimate consumer of output. They are also the
suppliers of factors of production to the business firms for the
production of goods and services, which they turn around and purchase.
With this, we can observe a circular interdependence subsisting between
the two sectors. Households maximise their utility in consumption by
equating the ratio of marginal utilities with the price ratios of the
products they consume. We can express this criterion quantitatively for
the two products as:

(1)

Recall that the ratio of marginal utilities measures the slope of

indifference curves otherwise known as the MRS. Thus given two
commodities X and Y, equilibrium is attained when:

(2)

In general equilibrium, the MRS for the two commodities is the same
for all consumers regardless of their preferences, age, sex or wealth.
Households sell productive factors to the business firms. They maximise
their utility by selling their factors to the highest bidder, and equilibrium
in the factor market is attained in the same manner as above.

Consumers Equilibrium

Recall that in our analysis, we have assumed a hypothetical economy of

two individuals (A and B) consuming and exchanging two commodities
X and Y. From equation 2 above, the condition for joint consumer’s
equilibrium is given as:

(3)

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Equation 3 states that MRSxy for the two consumers are identical and
must equal the price ratios of the products.

Business Firms and Production Equilibrium

Business firms employ productive resources in the production of goods

and services. The economic decisions of the firms involve the
determination of what to produce, how to produce, what quantities to
produce and what quantities of required factors to employ. The
quantities to produce depend on the prices of the product and cost of
production which in turn depends on the quantities of required resources
and their respective prices. The condition for equilibrium for the firm is
given as follows:

(4)
And MR = MC (5)
Where w = wage rate
r = cost of capital.

SELF-ASSESSMENT EXERCISE

How is equilibrium attained in the household and firm?

3.3 Two Interdependent Markets Moving to G-E

To study the interdependence of markets, let us examine the competitive

markets for DVD rentals and movie theater tickets. The two markets are
closely related because DVD players give most consumers the option of
watching movies at home as well as at the theater. Changes in pricing
policies that affect one market are likely to affect the other, which will
in turn cause feedback effects in the first market. Figure 5.1 shows the
supply and demand curve for DVD’s and movies. In part (a), the price of
movie tickets is initially N6; the market is in equilibrium at the
intersection of DM and SM. In part (b), the DVD market is also in
equilibrium with a price of N3.

Now suppose that the government places a tax of N1 on each movie

ticket purchased. The effect of this tax is determined on a partial
equilibrium basis by shifting the supply curve for movies upward by N1,
from SM to SM* in the part (a) of the figure. Initially, this shift causes the
price of movie to increase to N6.35 and the quantity of movie tickets
sold to fall from QM to Q’M. This is as far as partial equilibrium analysis
takes us. We can go further with a general equilibrium analysis by doing
two things: (1) looking at the effects of the movie tax on the market for
DVD’s and (2) seeing whether there are any feedback effects from the
DVD market to the movie market.
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Price (N) S*M

6.82
SM

6.75

6.35
D*M
6.00 D’M
DM
No of Movie
Q’M Q’’M Q*M QM Tickets

(a)

The movie tax affects the market for DVD’s because movies and DVD’s
are substitutes. A higher movie price shifts the demand for DVD’s from
DV and D’V in the part (b) of the diagram. In turn, this shift causes the
rental price of DVD’s to increase from N3 to N3.5.

The original demand for movies presumed that the price of DVD’s was
unchanged at N3. But because that price is now 3.5, the demand for
movies will shift upward, from DM to D’M in part (a) of the diagram.
The new equilibrium price of movies is N6.75, instead of N6.35, and the
quantity of movie tickets purchased has increased from Q’M to Q’’M.
Thus a partial equilibrium analysis would have underestimated the effect
of the tax on the price of movies. The DVD market is so closely related
to the market for movies that to determine the tax’s full effect, we need a
general equilibrium analysis.

Fig. 5.1: Supply and Demand curves for (a) Movie Tickets and
(b)DVD’s

Price (N) Sv

3.58

3.50

3.00
D*M
D’M

DM

No of DVD’s
Qv Q’v Q*v

(b)

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Reaching General Equilibrium

Our analysis is not yet complete. The change in the market price of
movies will generate a feedback effect on the price of DVDs that, in
turn, will affect the price of movies, and so on. In the end, we must
determine the equilibrium prices and quantities of both movies and
DVDs simultaneously. The equilibrium movie price of N6.82 is given in
part (a) of the diagram above by the intersection of the equilibrium
supply and demand curves for movie tickets (SM* and DM*). The
equilibrium DVD price of N3.58 is given in part (b) of the above
diagram by the intersection of the supply and demand curve for DVDs
(SV and DV*). These are the correct general equilibrium prices because
the DVD market supply and demand curves have been drawn on the
assumption that the price of movie tickets is N6.82. Likewise, the movie
ticket curves have been drawn on the assumption that the price of DVDs
is N3.58. In other words, both sets of curves are consistent with the
prices in related markets, and we have no reason to expect that the
supply and demand curves in either market will shift further. To find the
general equilibrium prices in practice, we must simultaneously find two
prices that equate quantity demanded and quantity supplied in all related
markets. For our two markets, we need to find the solution to four
equations (supply of movie tickets, demand for movie tickets, supply of
DVDs and demand for DVDs).

Note that even if we were only interested in the market for movies, it
would be important to account for the DVD market when determining
the impact of a movie tax. In this example, partial equilibrium analysis
would lead us to conclude that the tax will increase the price of movie
tickets from N6 to N6.35. A general equilibrium analysis, however,
shows us that the impact of the tax on the price of movie tickets is
greater: it would in fact increase to N6.82.

Movies and DVD’s are substitute goods. By drawing figures analogous

to those in the diagram, you should be able to convince yourself that if
the goods in question are complements, a partial equilibrium analysis
will overstate the impact of a tax. Think about petroleum and
automobiles, for example. A tax on petroleum will cause its price to go
up, but this increase will reduce demand for automobiles, which in turn
reduces the demand for petroleum, causing its price to fall somewhat.

SELF-ASSESSMENT EXERCISE

How is general equilibrium attained in two different markets?

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3.4 Efficiency in Exchange and the Advantage of Trade

To examine the concept of economic efficiency, we start with an

exchange economy, analysing the behaviour of two consumers who can
trade either of two goods between themselves. This analysis also applies
to trade between two countries. Suppose the two goods are initially
allocated so that both consumers can make themselves better off by
trading with each other. In this case, the initial allocation of goods is
economically inefficient. In an efficient allocation of goods, no one can
be made better off without making someone else worse off.

Advantage of Trade

As a rule, voluntary trade between two people or two countries is

mutually beneficial. To see how trade makes people better off let us
consider a two person exchange, assuming that the exchange itself it
costless. Suppose Tola and Bola have 10 units of food and 6 units of
clothing between them. Table 5.2 shows that initially, Tola has 7 units
of food and 1 unit of clothing, and Bola has 3 units of food and 5 units
of clothing. To decide whether trade would be advantageous, we need to
know their preferences for food and clothing. Suppose that because Bola
has a lot of clothing and little food, her marginal rate of substitution
(MRS) for food is 3: to get 1 unit of food, she will give up 3 units of
clothing. However, Tola’s MRS of food for clothing is only ½: he will
give up only ½ unit of clothing to get 1 unit of food.

Table 5.2: Marginal Rate of Substitution

Individual Initial Allocation Trade Final

Allocation
Tola 7F, 1C -1F, +1C 6F, 2C
Bola 3F, 5C +1F, -1C 4F, 4C

There is thus room for mutually advantageous trade because Tola values
clothing more highly than Bola does, whereas, Bola values food more
highly than Tola does. To get another unit of food, Bola would be
willing to trade up to 3 units of clothing. But Tola will give up 1 unit of
food for ½ unit of clothing. The actual terms of trade depend on the
bargaining process. Among the possible outcomes are trade of 1unit of
food by Tola for anywhere between ½ and 3 units of clothing from Bola.

Suppose Bola offer Tola 1 unit of clothing for 1 unit of food, and Tola
agrees, both will be better off. Tola will have more clothing, which he
values more than food. Whenever two consumer’s MRS’s are different,
there is room for mutually trade because the allocation of resources is
inefficient. Through trading, both consumers will be made better off.

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SELF-ASSESSMENT EXERCISE

Write an essay on how efficient trade can be carried out between two
consumers with different initial allocations.

3.5 Theory of Distribution

Wage

In analysing the earnings of labour, it is necessary to take account the

imperfections of the labour market and the actions of trade unions.
Imperfections in the market make for a certain amount of indeterminacy
in which considerations of fairness, equity, and tradition play a part.
These affect the structure of wages - i.e., the relationships between
wages for various kinds of labour and various skills. Therefore one
cannot say that the income difference between a carpenter and a
physician, or between a bank clerk and a truck driver, is completely
determined by marginal productivity, although it is true that in the long
run the wage structure is influenced by supply and demand. The role of
the trade unions has been a subject of much debate. The naive view that
unions can raise wages by their efforts irrespective of market forces is,
of course, incorrect. In any particular industry, exaggerated wage claims
may lead to a loss of employment; this is generally recognised by union
leaders. The opposite view, that trade unions cannot influence wages at
all (unless they alter the basic relationship between supply and demand
for labour), is held by a number of economists with respect to the real
wage level of the economy as a whole. They agree that unions may push
up the money wage level, especially in a tight labour market, but argue
that this will lead to higher prices and so the real wage rate for the
economy as a whole will not be increased accordingly. These
economists also point out that high wages tend to encourage substitution
of capital for labour (the cornerstone of neoclassical theory). These
factors do indeed operate to check the power of trade unions, although
the extreme position that the unions have no power at all against the iron
laws of the market system is untenable. It is safe to say that basic
economic forces do far more to determine labour’s share than do the
policies of the unions. The main function of the unions lies rather in
modifying the wage structure; they are able to raise the bargaining
power of weak groups of workers and prevent them from lagging behind
the others.

Interest and Profit

The earnings of capital are determined by various factors. Capital stems

from two sources: from saving (by households, financial institutions,
and businesses) and from the creation of money by the banks. The

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creation of money depresses the rate of interest below what may be

called its natural rate. At this lower rate, businessmen will invest more,
the capital stock will increase, and the marginal productivity of capital
will decline. Although this chain of reactions has drawn the attention of
monetary theorists, its impact on income distribution is probably not
very important, at least not in the long run. There are also other factors,
such as government borrowing, that may affect the distribution of
income; it is difficult to say in what direction. The basic and
predominant determinant is marginal productivity; the continuous
accumulation of capital depresses the rate of interest.

One type of earning that is not explained by the neoclassical theory of

distribution is profit, a circumstance that is especially awkward because
profits form a substantial part of national income (20–25 per cent); they
are an important incentive to production and risk taking as well as being
an important source of funds for investment. The reason for the failure
to explain profit lies in the essentially static character of the neoclassical
theory and in its preoccupation with perfect competition. Under such
assumptions, profit tends to disappear. In the real world, which is not
static and where competition does not conform to the theoretical
assumptions, profit may be explained by five causes. One is uncertainty;
an essential characteristic of business enterprise is that not all future
developments can be foreseen or insured against. Frank H. Knight
(1921) introduced the distinction between risk, which can be insured for
and thus treated as a regular cost of production, and uncertainty, which
cannot. In a free enterprise economy, the willingness to cope with the
uninsurable has to be remunerated, and thus it is a factor of production.
A second way of accounting for profits is to explain them as a premium
for introducing new technology or for producing more efficiently than
one’s competitors. This dynamic element in profits was stressed by
Joseph Schumpeter (1911). In his view, prices are determined by the
level of costs in the least progressive firms; the firms that introduce a
new product or a new method will benefit from lower costs than its
competitors. A third source of profits is monopoly and related forms of
market power, whether deliberate as with cartels and other restrictive
practices or arising from the industrial structure itself. Some economists
have developed theories in which the main influence determining
distributive shares is the relative “degree of monopoly” exerted by
various factors of production, but this seems a bit one-sided. A fourth
source of profits is sudden shifts in demand for a given product-so-
called windfall profits, which may be accompanied by losses elsewhere.
Finally, there are profits arising from general increases in total demand
caused by a certain kind of inflationary process when costs, especially
wages, lag behind rising prices. Such is not always the case in modern
inflations.

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Rent

In classical economics, rent was the return to an "owner" of land. In later

economic theory, this term is expanded as economic rent to include
other forms of unearned income typically realised from barriers to entry.
Land ownership is considered to be a barrier to entry because land
owners make no contribution to the production process. They simply
prevent others from using that which would otherwise be useful.

Rent is that portion of the produce of the earth, which is paid to the
landlord for the use of the original and indestructible powers of the soil.
It is often, however, confounded with the interest and profit of capital,
and, in popular language, the term is applied to whatever is annually
paid by a farmer to his landlord.

SELF-ASSESSMENT EXERCISE

Discuss the theory of distribution

4.0 CONCLUSION

The concept of general equilibrium focuses on the explanation of the

supply, demand and prices in the whole economy with several
interacting markets. Households and consumers attain equilibrium when
the marginal utility of a particular good is equal to its market price,
while for firms, it is when the marginal revenue is equal to its marginal
cost. Mutual trade between consumers exists so as to make them better-
off than they were before.

5.0 SUMMARY

 Partial equilibrium analysis of markets assumes that related

markets are unaffected. General equilibrium analysis examines
all markets simultaneously, taking into account feedback effects
to other markets on the market being studied.
 An allocation is efficient when no consumer can be made better
off by trade without making someone else worse off. When
consumers make all mutually advantageous trades, the outcome is
Pareto efficient.
 A competitive equilibrium describes a set of prices and
quantities. When each consumer chooses her most preferred
allocation, the quantity demanded is equal to the quantity
supplied in every market.
 Efficiency in the allocation of goods to consumers is achieved
only when the marginal rate of substitution of one good for

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another in consumption is equal to the marginal rate of

transformation of one good for another in production.
 Free international trade expands a country’s production
possibilities frontier, and as a result, consumers are better off.

6.0 TUTOR-MARKED ASSIGNMENT

1. Discuss the theory of Distribution.

2. Discuss the household and firm equilibrium.
3. Discuss the advantages of trade.
4. Explain the assumptions of the Walrasian system of general
equilibrium.

7.0 REFERENCES/FURTHER READING

Colander, D. C. (2013). Economics. (9th ed.). New York: McGraw-Hill.

Cowen, T. & Alex, T. (2012). Modern Principles: Economics. (2nd ed.).

New York: Worth Publishers.

Koutsoyiannis, A. (n. d.). Modern Microeconomics. (2nd ed.).

Robert, S. P. & Daniel, L. R. (2009). Microeconomics. (7th ed.). New

Jersey: Pearson Education International.

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UNIT 3 SOCIAL WELFARE

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Criteria of Social Welfare
3.2 Social Welfare Maximisation
3.3 Individualistic Social Welfare Functions
3.4 Fair Allocation
3.5 Envy and Equity
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading

1.0 INTRODUCTION

Welfare economics is concerned with the evaluation of alternative

economic situations from the point of view of the society’s well-being.
Assume that the total welfare in a country is W, but given the factor
endowment (resources) and the state of technology, suppose that this
welfare could be larger, for example, W*. The task of welfare
economics are to (1) show that in the present state, W < W*, and (2) to
seeks ways of raising W to W*.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

 describe the different criteria of social welfare

 explain the social welfare function
 apply the individualist approach to welfare maximisation
 determine a fair and equal allocation in the society.

3.0 MAIN CONTENT

3.1 Criteria of Social Welfare

To evaluate alternative economic situation, we need some criterion of

social wellbeing or welfare. The measurement of social welfare requires
some ethical standard and interpersonal comparison, both of which
involve subjective value judgments. Objective comparisons and
judgments of the deservingness or worthiness of different individuals are

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virtually impossible. Various criteria of social welfare have been

suggested by economists at different times.

3.1.1 Growth of GNP Criterion

Adam Smith implicitly accepted the growth of the wealth of a society,

that is, the growth of the gross national product, as a welfare criterion.
He believed that economic growth resulted in the increase of social
welfare because growth increased employment and the goods available
for consumption to the community. To Adam Smith, economic growth
meant bringing W closer W*.

The growth criterion implies acceptance of the status quo of income

distribution as ethical or just. Furthermore, growth may lead to a
reduction in the social welfare, depending on who avails mostly from it.
However, the growth criterion highlights the importance of efficiency in
social welfare, given that social welfare depends on the amount of goods
and services as well as its means of distribution.

3.1.2 Bentham’s Criterion

Jeremy Bentham, an English economist, argued that welfare is improved

when the greatest good is secured for the greatest number. Implicit in
this dictum is the assumption that the total welfare is the sum of the
utilities of the individuals of the society. The application of the
Bentham’s ethical system to economics has serious shortcomings. To
highlight the pitfall in this criterion, let us assume that the society
consists of three individuals, A, B and C, so that

W = U A + UB + UC

According to Bentham, ∆W > 0 if (∆UA + ∆UB + ∆UC) > 0. However,

assume that the change which resulted in the changes in the individuals
utilities is such that A’s and B’s utility increases, while C’s utility
decreases, but (∆UA + ∆UB) > ∆UC. In other words, two individuals are
better-off while the third is worse-off after the change has taken place,
but the sum of the increase in utilities of A and B is greater that the
decrease in the utility of C. This criterion implies that A and B have
greater worthiness than C. That is, implicit in Bentham’s criterion is an
interpersonal comparison of the deservingness of the members of the
society. Another difficulty of this criterion is that it cannot be applied to
compare situations where the greatest good and the greatest numbers do
not exist simultaneously.

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3.1.3 Cardinalist Criterion

Several economists proposed the use of the law of diminishing marginal

utility as a criterion of welfare. To illustrate their argument, assume that
the society consists of three individuals: A has an income of 1000 naira,
while B and C have income of 500 naira each. Consumer A can buy
double quantities of goods compared to B and C. However, given the
law of diminishing marginal, A’s total utility is less than double the total
utility of either B or C; because A’s marginal utility of money is less
than that of B and C. Thus, W < W*. To increase social welfare, income
should be redistributed among the three individuals. In fact, cardinal
welfare maintained that social welfare would be maximised if income
was equally distributed to all members of the society. The cardinalist
approach to welfare has a serious flaw; it assumes that all individuals
have identical utility functions for money, so that with an equal income
distribution, all would have the same marginal utility of money. This
assumption is too strong. Individuals differ in their attitude towards
money. A rich person may have a utility for money function that lies far
above the utility function of poorer individuals. In this case, a
redistribution of income might reduce total welfare.

3.1.4 Pareto Optimality Criterion

The criterion refers to economic efficiency which can be objectively

measured. It is called the Pareto criterion after the famous Italian
economist Vilfredo Pareto. According to this criterion, any change that
makes at least one individual better-off and no one worse-off is an
improvement in social welfare. Conversely, a change that makes no one
better-off and at least one worse-off is a decrease in social welfare.
Stating this criterion differently, a situation in which is it impossible to
make anyone better-off without making someone worse-off is said to be
Pareto-optimal or Pareto-efficient. The three marginal conditions
accepted for the attainment of a Pareto-efficient situation in an economy
is stated below:

1. Efficiency of distribution of commodities among consumers

(efficiency in exchange)
2. Efficiency of the allocation of factors among firms (efficiency of
production)
3. Efficiency in the allocation of factors among commodities
(efficiency in product-mix, or composition of output).

3.1.5 The Kaldor-Hicks Compensation Criterion

Nicholas Kaldor and John Hicks suggested the following approach to

estimating a welfare criterion. Assume that a change in the economy is

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being considered, which will benefit some (gainers) and hurt some
(losers). One can ask the gainers how much money they would be
prepared to pay in order to have the change and the losers how much
money they would be prepared to pay in order to prevent the change. If
the amount of money of the gainers is greater than the amount of the
losers, the change constitutes an improvement in welfare, because the
gainers could compensate the losers and still have some net gain. Thus,
the Kaldor-Hicks compensation criterion states that a change constitutes
an improvement in social welfare if those who benefit from it could
compensate those who are hurt, and still be left with some net gain.

The Kaldor-Hicks criterion evaluates alternative situation on the basis of

monetary evaluation of different persons. Thus, it implicitly assumes
that the marginal utility of money is the same for all the individuals in
the society. Given that the income distribution is unequal in the real
world, this assumption is absurd. Assume, for example, that the
economy consists of two individuals, A, who is a millionaire, and B,
who has an income of #4000. Suppose that the change (being considered
by the government) will benefit A, who is willing to pay #2000 for this
change to happen, while it hurt B, who is prepared to pay #1000 to
prevent the change. According to the Kaldor-Hicks criterion, the change
will increase the social welfare (since the net gain to A, after he
compensates B, is #1000). However, the gain of #2000 gives very little
additional utility to millionaire A, while the loss of #1000 will decrease
a lot the well-being of B who has greater marginal utility of money than
A. Thus, the total welfare will be reduced if the change takes place.
Only if the marginal utility of money is equal for all the individuals
would the Kaldor-Hicks criterion be a correct welfare measure.

SELF-ASSESSMENT EXERCISE

Identify the different criteria of social welfare

3.2 Social Welfare Maximisation

The condition for social welfare maximisation in the simple two factors,
two commodities, and two consumer model is stated below.

1. There are two factors, labour L and capital K, whose quantities

are given (in perfectly inelastic supply). These factors are
homogenous and perfectly divisible.
2. Two products, X and Y, are produced by two firms. Each firm
produces only one commodity. The production function gives rise
to smooth isoquants, convex to the origin, with constant returns
to scale. Indivisibilities in the production process are ruled out.

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3. There are two consumers whose preferences are presented by

indifference curves, which are continuous, convex to the origin
and do not intercept.
4. The goal of consumers is utility maximisation and the goal of
firms is profit maximisation.
5. The production functions are independent. This rules-out joint
products and external economies and diseconomies in production.
6. The utilities of consumers are independent, Bandwagon, snob and
Veblen effects are ruled out. There are no external economies or
diseconomies in consumption.
7. The ownership of factors, that is, the distribution of the given L
and K between the two consumers, is exogenously determined.
8. A social welfare function, W = ƒ(UA, UB), exists. This permits a
unique preference-ordering of all possible states, based on the
position of the two consumers in their own preference maps. This
welfare function incorporates an ethical valuation of the relative
deservingness or worthiness of the two consumers.

SELF-ASSESSMENT EXERCISE

What are the conditions of social welfare maximisation?

3.3 Individualistic Social Welfare Functions

Up until now we have been thinking of individual preferences as being

defined over entire allocations rather than over each individual's bundle
of goods. As we remarked earlier however, individuals might only care
about their own bundles. In this case, we can use xi to denote individual
i's consumption bundle, and let ui(xi) be individual i's utility level using
some fixed representation of utility. Then a social welfare function will
have the form:

W = W(ui(xi), . . ., un(xn)).

The welfare function is directly a function of the individuals' utility

levels, but it is indirectly a function of the individual agents'
consumption bundles. This special form of welfare function is known as
an individualistic welfare function or a Bergson-Samuelson welfare
function. If each agent's utility depends only on his or her own
consumption, then there are no consumption externalities. Thus, we
have an intimate relationship between Pareto efficient allocations and
market equilibria: All competitive equilibria are Pareto efficient, and,
under appropriate convexity assumptions, all Pareto efficient allocations
are competitive equilibria. Now we can carry this categorisation one step
further. Given the relationship between Pareto efficiency and welfare
maxima described above, we can conclude that all welfare maxima are

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competitive equilibria and that all competitive equilibria are welfare

maxima for some welfare functions.

3.4 Fair Allocation

The welfare function approach is a very general way to describe social

welfare. As it is so general, it can be used to summarise the properties of
many kinds of moral judgments. On the other hand, it isn't much use in
deciding what kinds of ethical judgments might be reasonable ones.
Another approach is to start with some specific moral judgments and
then examine their implications for economic distribution. This is the
approach taken in the study of fair allocations. We start with a definition
of what might be considered a fair way to divide a bundle of goods, and
then use our understanding of economic analysis to investigate its
implications. Suppose that you were given some goods to divide fairly
among (n) equally deserving people. How would you do it? It is
probably safe to say that in this problem most people would divide the
goods equally among the n agents. Given that they are by hypothesis
equally deserving, what else could you do? What is appealing about this
idea of equal division? One appealing feature is that it is symmetric.
Each agent has the same bundle of goods; no agent prefers any other
agent's bundle of goods to his or her own, since they all have exactly the
same thing.

Unfortunately, an equal division will not necessarily be Pareto efficient.

If agents have different tastes, they will generally desire to trade away
from equal division. Let us suppose that this trade takes place and that it
moves us to a Pareto efficient allocation. The question arises: Is this
Pareto efficient allocation still fair in any sense? Does trade from equal
division inherit any of the symmetry of the starting points? The answer
is not necessarily. Consider the following example. We have three
people, A, B, and C. A and B have the same tastes, and C has different
tastes. We start from an equal division and suppose that A and C get
together and trade. Then they will typically both be made better off.
Now B, who didn't have the opportunity to trade with C, will envy A,
that is, he would prefer A's bundle to his own. Even though A and B
started with the same allocation, A was luckier in her trading, and this
destroyed the symmetry of the original allocation. This means that
arbitrary trading from an equal division will not necessarily preserve the
symmetry of the starting point of equal division. We might well ask if
there is any allocation that preserves this symmetry. Is there any way to
get an allocation that is both Pareto efficient and equitable at the same
time?

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SELF-ASSESSMENT EXERCISE

How is fair allocation determined?

3.5 Envy and Equity

What do we mean by "symmetric" or "equitable" anyway? One possible

set of definitions is as follows. We say an allocation is equitable if no
agent prefers any other agent’s bundle of goods to his or her own. If
some agent i does prefer some other agent j's bundle of goods, we say
that i envies j. Finally, if an allocation is both equitable and Pareto
efficient, we will say that it is a fair allocation. These are ways of
formalising the idea of symmetry alluded to above. An equal division
allocation has the property that no agent envies any other agent-but there
are many other allocations that have this same property. Consider the
diagram to determine whether any allocation is equitable or not, just
look at the allocation that results if the two agents swap bundles. If this
swapped allocation lies "below" each agent's indifference curve through
the original allocation, then the original allocation is an equitable
allocation. Note also that the allocation in diagram is also Pareto
efficient. Thus it is not only equitable, in the sense that we defined the
term, but it is also efficient. By our definition, it is a fair allocation.

w1/2

Good 2 Person B
IC’s

Fair Allocation

w2/2 w2/2

Swapped Allocation

Person A
w1/2
Good 1

Fig. 5.2: The Edgeworth Box

SELF-ASSESSMENT EXERCISE

How can an allocation be shared equally without envy?

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4.0 CONCLUSION
From our discussion so far, we can infer that:

 Welfare functions are often used by economists of one sort or

another to represent distributional judgments about allocations.
 As long as the welfare function is increasing in each individual's
utility, a welfare maximum will be Pareto efficient. Furthermore,
every Pareto efficient allocation can be thought of as maximising
some welfare function.
 The idea of fair allocations provides an alternative way to make
distributional judgments. This idea emphasises the idea of
symmetric treatment.
 Even when the initial allocation is symmetric, arbitrary methods
of trade will not necessarily produce a fair allocation. However, it
turns out that the market mechanism will provide a fair
allocation.

5.0 SUMMARY
The concept of social welfare was reviewed, with extensive discussion
on different criteria of social welfare. Pareto efficient allocation and the
criteria emphasise the allocation efficiency in the society. Different
conditions for social welfare maximisation were also discussed before
individualistic social function was reviewed. Finally, fair allocations as
well as envy and equity concept of the social welfare were discussed.

6.0 TUTOR-MARKED ASSIGNMENT

1. Suppose that an allocation is Pareto efficient, and that each
individual only cares about his own consumption. Prove that
there must be some individual that envies no one.
2. Analyse the concept of social welfare function, fair allocation and
the social welfare criterion.

7.0 REFERENCES/FURTHER READING

Koutsoyiannis, A. (n. d.). Modern Microeconomics. (2nd ed.).

Krugman, P. & Robin, W. (2012). Economics. (3rd ed.). New York:

Worth Publishers.

Lipsey, et al. (2008). Economics. (13th ed.). Upper Saddle River, NJ:
Pearson.

Robert, S. P. & Daniel, L. R. (2009). Microeconomics. (7th ed.). New

Jersey: Pearson Education International.

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