ECO 201 : Principles of Microeconomics I

Course Outline:

1. Introduction- Course Objectives and Review of Eco101

2. The Theory of Consumer Behaviour
3. Theory of Production
4. Theory of Cost
5. Theory of the Firm
6. Market Structures and Behaviour
(a) Perfect Competition
(b) Imperfect Competition- Monopoly,
(c ) Imperfect Competition- Monopolistic Competition
( d) Imperfect Competition- Oligopoly

Textbooks:

1 Modern Microeconomics by A.Koutsoyianis,

2.Aboyade O. (1983) Integrated Economics: A Study of developing economies: Addison-
Wesley Publishers Ltd.
3.Edwin Mansfield (2000) Microeconomics Ninth Edition Norton Publisher.
4.Jhingan M.L. (2007) Microeconomic Theory. Sixth Edition Vrinda Publications (P)
Ltd.
5.Joel N. Okafor (2005). Essentials of Modern Economics. Joanee Educational Publishers Ltd.
6.Oyeniyi T. A. (2005) Microeconomics , Theory and Applications. Third Edition; Cedars
Publishers (Nig) Ltd.
7.Google Internet Platform on the Topics in the Course Outline.

1
 Lecture One

1. Introduction and Review of Eco101

-Introduction

Eco 201 focuses on the analysis of two of economic units in the society, the households and the
firms. The course is micro in the sense that it concerns with the behaviour of individual agents,
different from macroeconomics where the focus of analysis is on the economy as a whole.
This course will afford students the opportunity to understand the simple laws that characterize
the workings of the modern market economy.

Microeconomics is a branch of economics that studies the allocative behaviour of isolated

economic units such as households, firms and government. It is distinct from macroeconomics
which studies the economy as a whole as measured by broad aggregates such as level of output,
inflation, the general price level and balance of payments. General equilibrium forms a bridge
between the two by using micro tools to examine the entire economy.

Economic theory aims at the construction of models are used for analysis and prediction in
explaining the behaviour of economic agents and the interaction between them. There are two
approaches to economic model building, partial and general equilibrium approaches.

Partial equilibrium analysis entails the examination of individual economic market in isolation
from the conditions prevailing in other markets in the economy by abstracting from the
interdependences that exist between them and the entire economy while the General equilibrium
analysis entails the examination of all markets and all decision making units in simultaneous
equilibrium. It exists if each market is cleared at a positive price, with each consuming agent
maximizing satisfaction and each firm maximizing profits.

It is important to study microeconomics because it helps to find out how economic agents(the
household, the firms and the government) go about using the resources at their disposal to satisfy
their numerous and often conflicting wants.
The course also intends to make the student acquaint self with the functioning of a market
economy , to determine the output level of the firm, the quantities of inputs to be purchased etc,
It also helps the understanding of the characteristics of different market structures perfect
competition, monopoly, etc. and how factor incomes are determined in the economy.

2
-Review of Eco 101

"Economics is a science which studies human behaviour as a relationship between ends and
scarce means, which have alternative uses". Basic concepts which underline the study of
economics are; scale of preference, scarcity, choice and opportunity cost. Every economy is
faced with resolving some basic economic questions, but the manner by which they resolve these
questions highlights the similarities and differences between different economic systems.
Economics is regarded as science because it involves the formation of hypothesis about reality.
Two methods of analysis used in economics are; functional representation and logical deduction.

Demand is the amount of a commodity that a consumer is willing to buy at a given price over a
period of time. Demand is also a flow concept. Several factors influence the amount of a
commodity demanded by consumers. Such factors include: the price of the commodity, prices of
other related commodities, income of the consumers population, taste and fashion, etc.

The first law of demand and supply states that, the lower the price the higher the quantity
demanded and vice-versa. Exceptions to the law are found in the case of inferior goods,
ostentations goods, etc.

Supply on the other hand is the amount of a commodity that sellers, are willing to sell at a given
price over a period of time. Several factors also affect supply. These are price of the commodity,
prices of other commodities, cost of production, weather, etc. There are however some
exceptional types of supply curves we have, i.e. the fixed supply curve, the backward sloping
supply curve, and expectation to future rise in price.

Equilibrium price is determined at the intersection of demand and supply curve, the point at
which there is no excess demand or excess supply i.e. demands is exactly equal to supply.

Price elasticity of demand is defined as the responsiveness of demand to a change in price.

There are different types of price elasticity of demand. These are elastic demand, inelastic
demand unitary elasticity demand, perfectly elastic demand and perfectly inelastic demand.

Several factors determine the elasticity of demand. These include the availability and cost of
close substitutes, the degree of necessities, the period of time and habit of the consumers.

Other types of elasticity of demands include cross elasticity of demand which measures the
responsiveness of quantity demanded of one commodity to changes in the prices of other related
commodities. Goods that are complementary have negative cross elasticity while substitutes have
positive cross elasticity.

3
Secondly, there is also the income elasticity of demand. These measures the responsiveness of
quantity demanded to changes in income. Goods with positive income elasticity are called
normal goods while inferior goods have negative income elasticity.

Similarly to price elasticity of demand, there is also the price elasticity of supply which measures
the responsiveness of supply to changes in price.

Practice Questions

1. Define economics?
2. Define the following economic concepts: a. Scarcity b. Choice c. Opportunity costs
d. Scale of preference.
3. What are the six basic problems faced by every economic system?
4. Why do you feel that economics is a science subject?
5. What is demand?
6. Distinguish between change in quantity demanded and change in demand.
7. What are the factors that influence quantity demanded?
8. State the first law of demand and supply? Are there exceptions to this law?
9. Why do the quantities demanded of a commodity vary inversely with its price?
10. Explain what you understand by equilibrium in economics.
11. Define price elasticity of demand.
12. With the aid of diagrams explain the following terms. a. elastic demand b. inelastic
demand c. Perfectly inelastic supply d. Unitary elastic supply

13. Distinguish between income and cross elasticity of demand.

14. What are the factors which you think can affect the elasticity of demand for a commodity.
15. If as a result of increase in the price of cigarette from N10 to N25 per stick, quantity
demanded changes from 20 to 18 sticks, calculate the value of price elasticity of demand for
cigarette. Is the demand for cigarette elastic or inelastic?

4
 Lecture Two

2. Consumer Behaviour

There are three sets of economic agents namely: household, firms and governments. Each
economic agent has to solve its economic problems. This is done by examining the concept of
utility and the basic approaches to its study namely cardinalist and ordinalist approach to utility
maximization

These two theories of consumer behavior are the utility theory and the theory of the indifference
curve. The utility theory is commonly associated with the classical economists while the theory
of the indifference curve belongs more to the modern economists.

The Utility Theory

Utility can be described as the satisfaction a consumer derives from the consumption of a
commodity. It is useful to distinguish between total utility and marginal utility.
Total utility refers to the total satisfaction derived from consuming some commodities. Marginal
utility on the other hand is the change in satisfaction resulting from consuming a unit more or
less of that commodity.

Utility Schedule and Graphs

The table below will help you to understand better the utility theory.

Number of plates of Total utility Marginal utility

rice consumed
0 0 –
1 4 4
2 7 3
3 9 2
4 10 1
5 10 0

Table 2.1 Total and Marginal schedule

The marginal utility column is derived from the changes in total utility by consuming an
additional plate of rice. For instance when you increase the plates of rice you consume form 2 to
3 plates, the total utility increases from 7 to 9 utils. This increase in the total utility (which is 2)
gives the value for marginal utility.
A cursory look at the marginal utility column in Table 2.1 will show one important characteristic
of marginal utility. This is the successive decline in marginal utility from additional consumption
of plates of rice. While the total utility has been increasing, marginal utility has been decreasing
as consumption of rice increases.

5
A question that may naturally come to mind is, can marginal utility ever reach zero? The answer
is yes, as you can see from Table 2.1. With more commodities consumed, there is a level of
marginal consumption after which additional consumption is zero. Commodities include, water,
beverages and even reading.

Figure below illustrates Total and Marginal Utilities

Fig. 2.1 Total and Marginal Utilities

Relationship between Total Utility and Marginal Utility

If total utility is increasing at a decreasing rate as depicted in our example, then the marginal
utility declines with increase in consumption. When total utility reaches its maximum point (at
point C) then the marginal utility is equal to zero. This is because after the point any additional
unit consumed would lead to a fall in total utility.
The declining slope of the Marginal Utility curve reflects the law of diminishing marginal utility
which states that the more of a given commodity consumed, the less the addition to total utility.

Maximizing Utility
Certain assumptions are made with respect to the utility theory of consumer behaviour. These
assumptions include that commodities are available, prices and incomes are fixed. Perhaps, the
most basic assumption is that members of the household seek to maximize their total utility.

The basic problem that faces the household is how to adjust its expenditure and to maximize the
total utility of its members. A rational household would go about this by arranging its
expenditure among commodities in such a way that the utility gained from the last Naira spent on
all commodities are equal. An example will make this point clear.

If a consumer is faced with two commodities X and Y with prices Px and Py respectively.
Furthermore, let MUx and MUy be the marginal utilities of the last unit of commodities X and Y
respectively.

If marginal utility derived from the last Naira spent on commodity X is greater than that of Y:
then the consumer will continue to substitute X for Y; as quantities of X consumed increases, its
marginal utility would fall: (law of diminishing marginal utility); while the fall in quantity of Y
will raise its marginal utility.

This process of substitution of X for Y will continue until the marginal utility per naira spent on

6
X and Yare equal.
Algebraically, this implies that the ratio of MU of X to its price is equal to the ratio of marginal
utility of Y to its own price. i.e. MUX/PX=MUY / PY . …………(1)
This is the fundamental equation of the utility theory of demand. Each household demands each
commodity up to the point at which the marginal utility per naira spent on it is the same as the
marginal utility per naira spent on every other commodity. When this condition is met, the
household cannot increase its total utility by shifting a kobo of expenditure from one commodity
to another.

For consumer equilibrium, two conditions must be met. The first is the one given by equation (1)
above. That is the ratio of marginal utility of one commodity to its price is equal to the ratio of
marginal utility of the other commodity to its own price.

The second requirement is that the total expenditure on the commodities be equal to the
household's income. That is in our former example

XPx + YPy = I. . . . . . . . . . . . . . . . (2)

where XPx is total expenditure on good X,
YPy is total expenditure on Y.
I is total income.
Px and Py represents price of X and price of Y respectively.
Paradox of Value:

Early economists were unable to explain the paradox of value because they erroneously believed
that commodities with high total utilities should be expensive because people valued them highly
and vice-versa. They were thus arguing that market values should be related to total utilities.
These economists referred to market values as exchange values and to total utilities as use
values. They posed their problem by saying what use values should be, but were observed not to
be related to exchange values.
However, we know that in real life, market behaviour is not related to total utility but marginal
utility.

Water is cheap because there is so much of it that people consume it to the point at which
marginal utility is very low and they are not prepared to pay a high price to obtain a little more of
it. Diamonds are very expensive because they are scarce and people have to stop consuming
them at the point where marginal utility is still high. Thus, consumers are prepared to pay a high
price for an additional diamond consumed.

7
Indifference Theory
The indifference theory of household behaviour was developed by Sir John R. Hicks in his book,
Value and Capital, published in 1939. The major innovation of this theory was that unlike the
utility theory, it did not invoke the notion of a measurable concept of utility.

An Indifference Curve
An indifference curve shows all combinations of commodities that yield the same level of
satisfaction to the household. A household is indifferent between the combinations indicated by
any two points on one indifference curve.
Bundle Clothing Food

A 30 5
B 18 10
C 13 15
D 10 20
E 8 25

Table 2.2: Alternative bundles of Food and Clothing giving equal satisfaction to a household

The table above could be converted into an indifference curve. See the figure below.
Fig. 2.2 An Indifference Curve

The household who owns the indifference curve above is indifferent between points a, b, c, d and
e.

8
Features of an Indifference Curve

1.Its downward sloping indicating that if the household is to have less of one commodity, it must
have more of the other to compensate. For instance, in the figure above, for the household to
move from point a to b, it he must reduce the quantity of clothing consumed from 30 units to 18
units while quantity of food consumed increase from 5 units to 10 units.

2 The Indifference Curve is also convex. Moving down the curve to the right, its slope gets
flatter and flatter. The slope of the curve is the marginal rate of substitution, the rate at which one
commodity must be substituted for the other in order to keep total utility constant.

An Indifference Map
A set of indifference curves is called an indifference map. The farther from the origin an
indifference curve is the higher the level of satisfaction associated with that indifference curve.
Thus, any curve above and to the right of an indifference curve will be preferred to the one below
it.

Fig. 2.3: An Indifference map for the household.

The Budget Line

An important assumption under the theory of demand is that the household spends all of its
income on goods and services for current consumption; it neither spends more than its income
nor saves any of it.

Fig. 2.4 The budget line

9
If for instance, we assume that a household income I is spent on two commodities, clothing and
food, then the budget line of such a household will reveal the amount of clothing and food the
household could afford given his income I, and the prices of the two commodities.

The Equilibrium of the Household

Whereas the indifference map describes the wish of the household (i.e. what he wants), what he
could actually demand is dictated by his budget line
Figure 2.5 below brings together the household's taste as shown by its indifference curve and
possibilities open to it, as shown by the budget line.

Fig. 2.5 The equilibrium of the household

Any point on the budget line is attainable. But the question is which one the household will
choose in its objective of maximizing satisfaction.
Suppose that it starts from point a in Fig.2.5 where it is on indifference curve I 1. If it moves to
point b, it is still on its budget line, but it has moved to a preferred position (since I 2 is greater
than I1). This process continues until it reaches point c, any point beyond point c, say d or e will
result in lower indifference curve.
Thus, it could be seen that the household reaches its maximum satisfaction at point c. At this
point, the indifference curve is tangential to the budget line. Hence, at point c, the slope of the
indifference curve (the marginal rate of substitution of the goods in the household's preferences
is equal to the slope of the budget line. The opportunity cost of one good in terms of the other is
determined by market prices.

Effects of Changes in income and prices on the Consumer Equilibrium

A Change in Income
Changes in income lead to a parallel shift of the budget line - inwards to the origin when income
falls, and outwards from the origin when it rises. For each level of income there will be an
equilibrium position at which an indifference curve is tangent to the relevant budget line. Each
such equilibrium position means that the household is doing as well as it possibly can for that
level of income.

10
 Fig. 2.6: The Income-Consumption line.

In Fig. 2.6 as the household's income is twice increased, the budget line moves outwards from a
tangency with indifference curve I1 to I2 to I3. As we move the budget line through all possible
levels of income and join all the points of equilibrium, we will trace what is called an Income
Consumption line. This line shows how consumption bundles changes as income changes, with
relative prices held constant. In other words, income consumption line shows the reaction of the
household to changes in its money income with money prices held constant.

A Change in Price
A change in the relative price of the two commodities, food and clothing changed the slope of the
budget line. For instance, given a budget line ab, a half cut in the price of food, (P r) while price
of clothing (Pc) is kept constant shifts the budget line to ag and if price is doubled the price
increase will' shift the budget line to ah.

Fig. 2:7: The price consumption line.

Therefore the locus of tangency between an indifference curve and a budget line as the
prices of food changes while price of clothing is held constant, gives, the Price Consumption
line. This line shows how consumption of the two commodities varies as the price of one
changes, the price of the other and the household's money income being kept constant.

11
Practice Questions
1. Define the term utility.
2. What do you understand by the 'paradox of value'? Explain using water and diamond as
illustration.
3. State the condition(s) for consumer equilibrium.
4. Define the following concepts.
a. Total utility
b. Marginal utility
c. price consumption line
d. Income consumption line.

Lecture Three
3. Theory of Production

Just as the consumers maximize utility, the producer also maximizes profits either by minimizing
cost or maximizing output. The theory of production examines how producers attempt to
maximize profits.
Given that one of the major functions of the firm is to turn inputs into outputs of commodities.
The technological process of performing this important function is called production function.
The production function therefore shows the technological relationship between inputs and
outputs. It shows the maximum units of output to be expected from a given input combination.

The Concept of Production

Production in economics is broader in scope and meaning than it is often assumed. It is

concerned with any activity, which creates economic value. It does not only imply the process of
fabricating commodities but also covers any activity concerned with the packaging, storage,
marketing of these products.

The Production Function

A firm’s production function represents the technology available to that firm within an industry.
It therefore includes all the technically efficient methods. Technically speaking, it is relationship
between the rate of flow of output and the rate of flow of corresponding inputs used to produce
it, given existing technology.

It can be expressed mathematically as

Q = f (X1, X2, X3…. Xn)

Where X1, X2… Xn represent quantities of various inputs and Q represents the quantity of
goods produced per unit of time.

12
The Production Process

This involves the combined system of activities by which various inputs are converted into
material goods and services per unit of time. Various methods and techniques of production can
be adopted to produce these goods and services. A firm may decide to use more capital relative
to labour. This is called capital intensive technique of production. Also more labour may be
employed relative to capital; this is referred to as labour intensive technique of production. The
choice of any particular technique is an economic one, usually based on prices.

Isoquant

It is the locus of all the technically efficient methods (or all the combinations of factors of
production e.g. capital and labour) capable of producing the same level of output. It is the
producer’s equivalent of the consumer’s indifference curve.

13
 K

a
δK
b Isoquant
δL

O Figure 3:1 Isoquant Curve L

The slope of the isoquant (-dk/dl) defines the degree of substitutability of the factors of
production as shown in the diagram above. The slope of the isoquant is called the marginal rate
of substitution of the factors.
−∂κ
=MRS LK
∂L
The slope of the isoquant decreases (in absolute terms) as we move downwards along the
isoquant, showing the increasing difficulty in substituting capital (K) for labour (L).
Given the production function
ϑ =f ( K , L ) ………………………………………….………… (1)
Taking a total differential of both sides of equation (1)
dϑ =F κ dκ + F L dL=0
F κ dκ=−F L dL
−dκ F L
= =MRTS
dL Fκ
Where FL/FK is the ratio of input prices
However, this production isoquant may assume various shapes depending on the degree of
substitutability of factors.

14
 Several isoquants are possible on the input space. The farther the isoquant from the
origin, the more output it can produce. A higher isoquant will always be preferred to a lower one.
However, this choice is limited by the isocost line as shown below.

isoquant

iq1 iq2 iq3

0 L

Figure 3:2

The isocost or expenditure line is the combination of inputs that just exhaust total expenditure. It
is represented as:
C = rK + wL …..………………. (2)

Total cost is equal to interest paid on capital multiplied by the units of capital plus wage rate
multiplied by labour units.

Where C = Total cost expended on factor input

K = Capital

L = Labour

r = Interest paid on capital

W = Wage paid on labour

C=rκ +wL
dc=rd κ+wdL=0
rd κ=−wdL
−dκ w
=
∂L r
15
At equilibrium

−dκ F L w
= =
dL Fκ r
w
MRTS=
r …………………..…. (3)

Equation (3) shows the optimum input mix because it represents a point where the isocost line is
tangential to the isoquant. It can be demonstrated geometrically as follows:

isoquant

iq1 iq2 iq3 isocost (rk +wL)

0 L

Figure 3:3

The equimarginal principle in production or efficiency criteria is given by

MP L P κ
=
MP κ P L
By cross multiplying
MP L⋅P L=MP κ⋅Pκ
For n – inputs
(1)
Pa X a +P b X b +⋯⋯P n X n =TC
MPX a MPX b MPX n
= =
(2) PX a PX b PX n

16
Expansion Path
The major objective of an entrepreneur is to maximize profit. He must thus organize production
in the most efficient way. Expansion path is the locus of optimum input combinations for each
possible rate of output when the prices of inputs remain constant.

Isoquant Expansion path

C
. B
A
iq1 iq2 iq3 isocost (rk +wL)

0 L

Figure 3:4

At points A, B and C, the rate at which a firm substitute one factor input for another is constant.
That is, MRTS is constant. The production expansion path also represents an isocline. An
isocline can be defined as a locus of points along which the MRTS is constant. This can assume
any shape.
However, the two are not the same, while an expansion path is an economically most
efficient rate of expansion; an isocline is the locus of input combinations that yield the same
MRTS. A production expansion path can be technically efficient as well as remain an isocline
but no isocline is automatically a production expansion path.

Return to Scale
This is a long run analysis of production. In the long run, all factor inputs are variable. In this
long run, output may be increased by changing all factors by the same proportion or by different
proportions. Three different cases are possible: increasing returns to scale, constant returns to
scale and decreasing returns to scale.

Increasing Returns to Scale

This refers to a situation whereby the proportionate change in output is more than the
proportional change in inputs.

17
 K

B
A

0 L
Figure 3:5

From Figure 3:5, output has more than double relative to increase in inputs.

B
A

0 L

Figure 3:6

Figure 3:6 shows that the output response is equal to that of input. This is called constant
returns to scale.
Under constant returns to scale, output and inputs will increase by the same proportion.

18
 K

C
B

0 L

Figure 3:7

Figure 3:7 shows decreasing returns to scale since an increase in inputs leads to less than
proportionate increase in output. Output will increase but not in the same proportion as inputs.

Returns to Scale and Homogeneous Function

A homogeneous function one which allows K to be factored out of the function after it has
multiplied each of the inputs in that function. If K cannot be factored out, the production
function is known as non-homogeneous.
If K is powered by V it is called the degree of homogeneity of the function
If V = 1, we have constant returns to scale. This can also be regarded as linear
homogeneous.
If V < 1 we have decreasing returns to scale
If V > 1 we have increasing returns to scale.

19
Example Suppose we have the production function
Q=2 x +3 y
¿
Q =2 ( vx ) +3 ( vy )
¿
Q =( vQ)
since v =1, we have constant returns to scale
2 2
Q=2 x +3 y
Q ¿ =2 ( vx )2 +3 ( vy )2
Q =2 ( v 2 x 2 ) + 3 ( v 2 y 2 )
¿

Q ¿ =v 2 [ 2 x 2 +3 y 2 ]
¿
Q =v 2 Q
v=2 this is an increasing returns to scale
but if
Q=2 x 0 .2 +3 y 0. 2
¿
Q =2 ( vx )0 .2 +3 ( vy )0 . 2
Q =2 ( v 0 . 2 x 0. 2 ) +3 ( v 0 .2 y 0 . 2 )
¿

Q =v 0 . 2 ( 2 x 0. 2 +3 y 0 . 2 )
¿

¿
Q =v 0 . 2 Q
Since output depends on inputs, in order to increase total output then the inputs used must also be
increased. But the firm cannot vary all its inputs with the same ease. For instance, while it is easy
to increase the number of workers at very short notice, it takes a relatively longer time to install a
new production plant.
Usually a commodity may be produced by various methods of production. For example a unit of
commodity X may be produced by the following processes:

Process A Process B Process C

Labour Units 3 4 5
Capital Units 4 3 2

Activities may be presented graphically by the length of lines from the origin to the point
determined by the labour and capital inputs. The three processes above are shown in fig 3.9.

20
 K

4 A

3 B

2 C

0 3 4 5 L

Fig 3.9 Production Processes

A method of production A is technically efficient relative to any other method B, if A uses less of
at least one factor and no more from the other factors as compared with B. for example,
commodity Y can be produced by two methods:

A B
Labour 3 4
Capital 4 4

Method B is technically inefficient as compared with A. The basic theory of production

concentrates only on efficient methods. Inefficient methods will not be used by rational
entrepreneurs. If process A uses less of some factors and more of some others as compared with
any other process B, then A and B cannot be directly compared on the criterion of technical
efficiency. For example, the activities below are not directly comparable.

A B
Labour 3 2
Capital 4 5
Both processes are considered as technically efficient and are included in the production
function (the technology). Which one of them will be chosen any particular time depends on the
prices of factors. The theory of production describes the laws of production. The choice of
particular techniques (among the set of technically efficient processes) is an economic one, based
on prices, and not a technical one.
The Short run
In the theory of the firm, a distinction is made between two periods of analysis - the short run
and the long run. In the short run, the assumption is that only few production factors can be
varied while some others are fixed. On the other hand, in the long run, all production factors are
variable.
Taking the short run period; we may assume for simplicity sake, that in the production
functions, labour is variable and capital is fixed. The equation can thus be rewritten as:
Q=f(L,K ) ----3 Where K implies that capital is fixed

21
Thus in the short run, output can only be increased by increasing the amount of the variable input
to a fixed input.
It is therefore useful at this point to define some important concepts.
i. Total Product (TP)
This is the total amount produced during some period of time by all factors of production
employed. If the inputs of all but one factor are held constant, total product will change as
more or less of the variable input is used.
i.e. q = f(L)
ii. Average Product (AP)
This is merely the total product per unit of the variable factor, which is labour in the
present illustration: AP = TP/L
iii. Marginal Product (MP)
Sometimes called incremental product is the change in total product resulting from the
use of one more (or one less) unit of the variable factor.
MP =  TP/L
Where, TP stands for the change in the total product and  L stands for the change in labour
input that caused TP to change.
The table below gives a hypothetical example. Capital is fixed at twenty units.

(1) (2) (3) (4)

Quantity of Total Product Average Product Marginal Product
Labour (TP) (AP) (MP)
1 6 6 –
2 14 7 8
3 26 8.7 12
4 37 9.3 11
5 46 9.2 9
6 52 8.7 6
7 57 8.1 5
8 60 7.5 3
9 61 6.8 1
10 58 5.8 -3

Table 3.1: Variation of output (one fixed, one variable factor).

22
 Fig. 3.2 showing the relationship among Total Product (TP) Average Product (AP) and Marginal
Product (MP)
From both the table and the curve, it is seen that as more of the variable factor is used,
average product first rises and then falls. The point where AP reaches a maximum is called the
POINT OF DIMINISHING AVERAGE PRODUCTIVITY. At this point also, MP and AP are
equal. It can also be observed from the curve that MP reaches its maximum at a lower level of
labour input than does AP.
The Hypothesis of Diminishing Returns
This is one of the famous hypotheses in economics. It is also referred to as the law of
diminishing returns. This law seeks to explain the behaviour of output as a result of applying
more or less of variable factor to a fixed factor. The law states that "if increasing quantities of a
variable factor are applied to given fixed factors, the marginal product and the average product of
the variable factor will eventually decrease".
There are many practical demonstrations of this law in real life. It is the reason for the
present fear about food crisis in most countries today. In countries with a high population growth
rate, it is feared that the increased number of workers on the fixed land will bring about an
inexorable decline in the marginal productivity of each worker and thus a shortage of food
output. The only way out of this trap of diminishing food returns is by improving on the
technique of production.
Practice Questions
1. States the law of diminishing returns: Give one of its applications in real life.
2. Explain the following concepts. a. Production function. b. Total product.
c. Marginal product. d. Average product.
3. Illustrate with examples your understanding of production processes
4. What is the important distinction between the short run and long run in economic analysis?
5. Explain clearly the following concepts;
a. Increasing returns to scale b.Constant return to scale c.Decreasing return to scale
6. Given a production function Q=f(K,L), derive the marginal rate of technical substitution.
What economic interpretation can you give to this ratio?
7. Given a cost function C=rK+wL, What is the equilibrium condition for the producer?

23
 Lecture Four

4. Theory of Cost

Cost in economics is an opportunity cost of a given action. Cost could be either explicit or
implicit. Explicit costs are those direct payments which a firm makes on factors of production for
their contribution towards the production process. Implicit cost on the other hand refers to the
cost for a firm using its own resources considering the fact that such resource, if put into
alternative uses could be expected to yield some returns.

Short run Cost Functions

A firm's cost will vary, depending on whether they are based on the short or long run. In the short
run, the firm cannot vary the size of plant and equipments it uses. These are the firm's fixed
inputs, and they determine the scale of its operations.
1. Total Fixed Costs: This is the total expenditure spent by the firm on its fixed inputs over a
period of time. Since the inputs are fixed, the total fixed cost will be the same whatever
the firm's level of output. Examples of fixed cost include, manager’s salaries, rent,
interest on bonds issued in the past, depreciation of machinery etc. The figure below
shows an example of fixed cost. The total fixed cost function is always a horizontal line,
since fixed costs do not vary with output

Costs

N100 fixed cost

0 1 2 3 4 Quantity

Fig 4.1 Fixed cost

2. Total variable Cost: This represents the firm's total expenditure on variable inputs per
period of time. Since higher output rate requires greater utilization of variable inputs, this
implies higher total variable cost. For instance, a firm that wants to increase output will
need to employ more labour, purchase more raw materials, etc. All these will add to total
cost of the firm.

24
Example of total variable cost is illustrated by the figure below:

Fig. 4.2: Total Variable Cost

The shape of the total variable cost looks like that of an inverted 'S'. This is due to the law of
diminishing marginal returns, total variable cost increases first at a decreasing rate, then at an
increasing rate.
3. Total Costs: This is the sum of total fixed cost and total variable cost.
This is illustrated below:

Fig 4.3 Total Cost

The total cost curve has the same shape as the total variable cost curve, since they differ by
only a constant amount (equal to total fixed cost).
Average Costs in the Short Run
An entrepreneur cares about his average cost as well as the total cost incurred in his operations,
so do economists. Average cost tells how much a product costs per unit of output. There are three
types of average cost functions, one corresponding to each of the three total cost functions.

25
 Fig. 4.4 Average Fixed Cost Curve

1. Average Fixed Cost: This is simply total fixed cost divided by the firm's output. Average
fixed cost (AFC) must decline with increases in output, since it equals a constant total
fixed cost divided by the output rate.
2. Average Variable Cost: This is total variable cost divided by output, the average variable
cost (AVC) is shown below:

Fig. 4.5 Average Variable Cost Curve

From the figure above we can see that at first, increase in the output rate results in decreases in
average variable cost, but beyond a point, they result in higher average variable cost. This is
because the law of diminishing marginal returns is in operation. As more and more of the
variable inputs are utilized, the extra output they produce decline beyond some point, so that the
amount spent on variable inputs per unit of output tends to increase.

26
3. Average Total Cost (ATC): This is simply the total cost divided by output. At any level of
output, average total cost equals average fixed cost plus average variable cost. This is easy to
prove.

ATC=AFC+AVC

Figure 4.6 Average Total Cost

The fact that average total cost is the sum of average fixed cost and average variable cost helps
explain the shape of the average cost function, if, as the output rate goes up, both average fixed
cost and average variable cost decrease, ATC must decrease too. But beyond some point, average
total cost must increase because increases in average variable cost eventually more than offset
decreases in average fixed cost. However, average total cost achieves its minimum after average
variable cost, because the increases in average variable cost are for a time more than offset by
decrease in average fixed cost.
Marginal cost in the Short Run
Marginal cost is the addition to total cost resulting from the addition of the last unit of output.
Algebraically, this can be expressed as
MC= ∆TQ/∆Q or TQ n+1-TQn/Q n+1-Q n
where MC = Marginal cost, ∆ represents change, TC is total cost and Q is output. The subscript
n, n + 1 are present and next period changes in the cost and output variables.
In general, marginal cost will vary depending on the firm's output level.

27
Figure 4.7 shows the marginal cost function graphically.

Figure 4.7 indicates that marginal cost, after decreasing with increases in output at low
output levels, increases with further increases in output. In other words, beyond some point it
becomes more and more costly for the firm to produce yet another unit of output.

Relationship between Marginal Cost and Average Cost Functions

The relationship between the marginal cost function and average cost functions must be noted.
Figure 4.8 shows the marginal cost curve together with the three average cost curves.

28
 Figure 4.9: MC, APC, AVC and ATC curves.

The traditional theory of cost postulates that in the short run the cost curves (AVC, ATC and
MC) are U shaped reflecting the law of Variable proportion. The minimum point of the ATC
occurs to the right of the minimum point of the AVC. This is due to the fact that ATC includes
AFC, and the latter falls continuously with increases in output. After the AVC has reached its
lowest point and starts rising, its rise is over a certain range offset by the fall in the AFC, so that
the ATC continues to fall despite the increase in AVC. However the rise in AVC eventually
becomes greater than the fall in the AFC so that the ATC starts increasing. The AVC approaches
the ATC asymptotically as output increases.
The long run Average cost curve is derived from short run cost curves. Each point on the
LAC curve correspond to a point on a short run cost curve, which is tangent to the LAC at that
point (see fig4.9)

29
Cost

0 Output
Fig. 4:10 Long Run Average cost curve

Let us examine the U shape of the LAC. This shape reflects the laws of return to scale.
According to these laws, the unit costs of production decreases as plant size increases, due to the
economies of scale which the larger plant sizes make possible.

Practice Questions
1. Explain carefully the following- terms:
a. fixed cost
b. average cost
c. marginal cost
d. average fixed cost
e. variable cost
2. Why does the marginal cost curve intersect the average variable cost curve at the latter
minimum point?
3. Why is the long run cost curve important in firms’ decision making?
4. Explain carefully your understanding of the term 'cost' in economics?

30
 Lecture Five
5. The Theory of Firm

Introduction:

The behavior of firm is similar to that of the household in the economy.

A firm is the economic agent who is concerned with the production and sale of commodities.
A firm covers all types of business organisations from the sole proprietorship to Joint Stock
Company.
The main assumption underlying the study of firms in economics is that they seek to maximize
their profit in other words; the goal of every firm is to maximize profit. This assumption helps to
understand and also predict the behaviour of the firms under different situations.
However, this assumption is not always true in real life because many firms often have more
than one objective such as, increasing scale of operation, creating goodwill among its customers,
etc. Hence the firm always seeks to pursue its activities in such a way that acceptable balance is
forged among these different objectives.
In spite of this obvious limitation, economic analysis of the firm still assumes that the
goal of the firm is profit maximization.
Profit (П ) is the difference between revenue realized from the sale of commodities (R) and the
cost of producing these commodities (C) i. e.
П= R – C.
In other words, it is possible to break the activities of the firms into two, its revenue and
cost of production. To an economist, "cost of using something in a particular venture is the
benefit foregone by not using it in its best alternative use”.
However, computational problems arise from this definition. While some costs are easily
identifiable and can be estimated, deriving the opportunity costs of some others may be
subjective. A
cost must also be assigned to factors of production that the firm neither purchases nor hires
because it already owns them. The cost of using such factors is called imputed costs. They are
estimated at values reflecting what the firm could earn if it shifted these factors to their next best
use.

Short run, Long run and the Very Long run

Short run or long run does not refer to a specific calendar period. It refers to the time period
necessary for economic resources to adjust its condition. The short run is defined as the period of
time over which inputs of some factors, called fixed factors, cannot be varied. In the short run,
production may be varied by changing the quantities used of those inputs that can be varied;
these are called variable factors.

31
The long run is defined as the period long enough for the inputs of all factors of production to be
varied, but not so long that the basic technology of production changes. The special importance
of the long run in production theory is that it corresponds to the situation facing the firm when it
is planning to go into business, or to expand or to contract the scale of its operations.
Unlike the short and the long run, the very long run is concerned with situations in which the
technological possibilities open to the firm are subject to change, leading to new and improved
products and new methods of production

The Equilibrium of a Profit Maximizing Firm

The rules for profit maximizing behaviour which applies to all firms depend on the structure of
the market the firms operate in, whether perfect or imperfect market structure. To understand this
behavior we need to understand some basic concepts.

Definition of concepts
Revenue refers to the total amount of money which a firm realises from the sales of its products.
Revenue can be sub-divided into three. That is:
1. Total Revenue (TR): This is also called revenue. It is the total amount that a firm receives
from the sales of its products. In normal cases, this revenue will vary directly with the
firm’s sales. That is to say, the higher the quantity of the products sold, the higher the
total revenue of the firm.
Total Revenue is equal to the quantity sold multiplied by the selling price of the
commodity, i.e.
TR = Pq.
Where P is the price per unit, q is the quantity
2. Average Revenue (AR): This is the total revenue divided by the quantity of the products
sold.
i.e. AR = TR/Q.
You will notice that this is also equal to the price of the commodity.
3. Marginal Revenue (MR): This is the change in total revenue resulting from increases in
total sales by one unit per period of time.
i.e. MRn = TRn + 1 - TRn
Where n refers to the number of units sold.

Behavioural Rules for profit Maximization

There are essentially three rules here:
a. A rule to decide whether to produce or not to produce
A firm has the option of either producing or not producing at all. If it produces nothing it
will have an operating loss equal to its fixed cost. The firm will however choose the
option of producing provided the output produced will add more to total revenue than to
costs. Thus, the first rule is that a firm should produce only if total revenue is equal to or
greater than total variable cost (TR ≥TVC). Put differently, a firm should produce only if
average revenue (i.e. price) is equal to or greater than average variable cost (P≥ AVC).

b. A rule to ensure that profit is either at a maximum or at a minimum

32
 A firm needs to decide on how much of a good it should produce. Generally, it pays a
firm to increase its output when marginal revenue of the last unit she produces is greater
than its corresponding marginal cost. If on the other hand, the firm finds that the marginal
cost of an additional unit of output exceeds the marginal revenue that firm should reduce
output.
Thus the second rule states that if a firm is to be in a position where it does not pay its
output i.e. in a profit maximizing position - it is necessary that marginal cost be equal to
marginal revenue.
c. A rule to ensure that profit is maximized rather than minimized
The fulfillment of the second rule however does not guarantee that profit if it exists is at a
maximum. The figure below will help you in understanding our point here.

Fig. 5.1: Minimum and Maximum Profit Positions

Marginal cost = marginal revenue is a necessary but not a sufficient condition for a
maximum profit.
In fig. 5.1, There are 2 output levels q 1 and q2 that satisfy rule two (that MR = MC). Output
q1 however is a minimum profit position because a change in output in either direction would
increase profit. On the other hand output q2 is a maximum profit position since at output, above it
MC exceeds MR and profit can be increased by reducing output towards q2.
Thus the condition for profit maximizing output is that the mc curve should intersect the MR
curve from below. This ensures that MC < MR to the left of q 2 and MC > MR to the right of the
profit maximizing output.
All the above three rules determine the output that will be chosen by any firm that
maximizes its profits.
Practice Questions
1. The only goal of the firm is profit maximization. True or False
2. Define the following economic concepts: a. cost b. profit
3. Distinguish between short run and long run in economics?
4. Define the following concepts a. Total revenue b. Marginal revenue c.
Average revenue
5. What are the rules that ensure that a firm is maximizing its profit at its present level of
output?

33
 Lecture Six

6. Market Structures and Behaviour

6(a)Perfect Competition

Market is classified according to the degree of competition available. Hence, a distinction is

usually made between perfect and imperfect competition.
The theory of' perfect competition is built on a number of assumptions. These are:
1. The firm is assumed to be a PRICE TAKER. This means that no individual is so big as to
influence the market price. Hence, the firm must accept as given whatever price is ruling
in the market.
2. The industry is also characterised by freedom of ENTRY AND EXIT. This implies that
any firm is free to join or leave the industry. Existing firms cannot bar the entry of new
firms and there are no legal restriction on entry' or exit.
3. The industry or market includes a LARGE NUMBER OF FIRMS (AND BUYERS), so
that each individual firm, however large, supplies only a small part of the total quantity
offered in the market. The buyers are also numerous so that no monopolistic power can
affect the working of the market.
Other important assumptions includes: perfect information about market prices, perfect
mobility of products dealt with, While it is perfectly true that a market structure in which all
these situations are present is rare in the real world, we have some approximations, e.g.
agricultural goods and industrial raw materials. In spite of this, there is no doubt that perfect
competition is an ideal situation.

Demand and Revenue Curve of the Perfectly Competitive Firm

A firm in a perfect competition is a price taker; therefore it faces a perfectly elastic demand curve
for its products. Also, since the market price is unaffected by changes in its output, it follows that
the marginal revenue resulting from an increase in volume of sales is constant and equal to the
price of the product. An example will make this point clearer. Let’s assume that a farmer faces a
perfectly elastic demand for yam at a market price of NI00.00 per tuber.

This implies that for each additional tuber sold, the farmer would realise N100.00 (this is his
marginal revenue). But this amount is also his average revenue (which is total revenue divided
by number of units sold). Thus, the demand curve facing the firm is then identical with both the
average marginal revenue curve. Thus, P = AR = MR: all remaining constant as output varies. It
is however, important to mention that since price is constant, each additional unit sold will
increase total revenue of the farmer. It therefore follows that total revenue rises steadily as output
rises.

Price(P)
AR = MR = P

34
 O q1
Fig 6.1a Average and marginal revenue

Short Run Equilibrium

Equilibrium Output of a Firm in Perfect Competition
Since the term in perfect competition faces a given market price the firm adjusts to different
market situations by changing its output. But, in the short run the firm is faced with a set of fixed
and variable factors. Hence, its practical method of adjustment is via the variation of its output
decision.

Fig 6.1b. Tota1 Revenue

Perfect competitive firm like any profit maximizing firm will seek to produce at the point
where marginal revenue is also equal to the marginal cost. And since, marginal revenue of a firm
is also equal to its price; it follows that the firm will equate marginal cost of its product with the
price of its output. Hence, the short run equilibrium position of the firm can be represented as
follows.
Fig. 6.2. The equilibrium output of the perfect competitor

Any other output is inefficient. For instance at output q 2, MC > P, thus it will pay the firm to
reduce its output. Conversely, at output q l, price > MC and it pays the firm to increase its output
level.
It should be reiterated that in the short run, the firm can make profit or losses or break-even. The
actual position of the firm depends on the position of the average cost. If at the equilibrium
output level of the firm, price is greater than its average cost then it will make profit.

On the other hand, it could make a loss if it is not covering average cost. Even when the firm is
making a loss at this point, it could still continue in business provided it is able to cover at least
its average variable cost (AVC).
Short run Supply Curves
The supply curve shows the relation between quantity supplied and price. As we said earlier the
competitive firm is a price taker. Therefore in order to derive its supply curves we need to know
how much the firm will supply at each different prices.

35
 The figure below shows a firm's marginal cost curve with three alternative demand curves.
The marginal cost curves show the quantity the firm is willing to supply at each price level. For
prices below AVC, the firm will supply zero. For prices above AVC, the firm will equate price
and marginal cost

Fig 6.3. i. MC and AVC curves ii. The supply curve

As price rises in the figure from 2 to 3 to 4, the firm wishes to increase its production from q l
to q2 to q3. For prices below N2; output would be zero because the firm is better off if it shut
down. The point El where price equals AVC is called the shut-down point. These points are then
transferred to curve ii to show the supply curve.
In perfect competition therefore the part of the firm's MC curve above the AVC curve has
the same shape as the firm's supply curve.
The Determination of short run equilibrium price:
The equilibrium price in the industry is determined by the forces of demand and supply in the
industry.

Fig. 6.4: The derivation of an industry supply curve

The industry's supply curve is simply the horizontal sum of the marginal cost curves of all the
individual firms in the industry. Let’s assume there are two firms A and B in the industry. If their
individual supply curves are as shown below, then the industry supply curve is simply the
horizontal summation of the two supply curves.

Although, no one firm can influence market price significantly, the collective actions of all
firms in the industry (as shown by the industry supply curve) and the collective actions of the
households (as shown by the industry's demand curve) together determine the market price at the

36
point where demand and supply curves intersect. (See Fig. 9.2 (iii) above.
At this equilibrium point, there is stability in the market and there is no motivation to change
in the short run. Also each firm is operating at the profit maximizing point at which its price is
equal to its marginal cost.

Long Run Equilibrium

The long run equilibrium under perfect competition is characterized by free entry and exit.
Earlier, we have said that in the short run equilibrium situation, firms may be making profits or
losses or just breaking even. If existing firms are making profits, new firms may be attracted to
the industry to share in the profit. On the other hand, if existing firms are making losses, some
firms will leave the industry and seek better returns elsewhere. However, when firms are just
breaking even, there is no incentive for other firms to enter the industry or for firms in the
industry to leave. These three situations can be further illustrated as follows

i ii iii

Fig. 6.5: Alternative Short Run Equilibrium Position of a Competitive Firm.

In Fig.6.5 (i), firms in the industry are making losses since price is lower than SRATC. This
will force some firms to leave the industry for elsewhere. When this happens, supply will
decrease and price will increase. This will continue until Fig. 6.5 (ii) position is attained. The
converse argument holds for Fig. 6.5 (iii).

In the Long run equilibrium situation three distinct features are obtained.
1. No firm will want to vary the output of its existing plants. Short run marginal cost
(SRMC) must equal price.
2. Profits earned by existing plants must be zero. This implies that short run ATC must equal
price.

3. No firm can earn profits by building a plant of a different size. This implies that each
existing firm must be producing at the lowest point on its long run average cost curve.
These conditions mean that all firms in the industry should be in the position illustrated in
Fig. 6.6.

37
 Fig. 6.6: The equilibrium position of a firm when the industry is in the long run equilibrium.

In the above situation, the firm is operating the optimum plant size (as represented by the
minimum point on its LRATC). Any plant size to the left or right of q x would be sub-optimal and
it will pay well to advice the firm to increase or decrease output as the case may be as regards its
existing plant size.
An industry is nothing more than a collection of firms; for an industry to be in long run
equilibrium each firm must be in their long run equilibrium. It follows that when a perfectly
competitive industry is in long run equilibrium, all firms in the industry will be selling at a price
equal to SRATC that is, and they must be in zero profit equilibrium.

6(b)Imperfect Competition- Monopoly

Introduction
A monopoly and a perfect competition represent two polar extremes of market situation.
Monopoly occurs when there is a single seller in the market. In this case, it is impossible to
distinguish between a firm and an industry. Also unlike the firm under perfect competition which
cannot influence market price, a monopolist has power to influence the market price. By
changing the level of his output, it can influence the ruling price level.
There are two major features of the market. First, a monopolist firm is the only producer of
its product. Hence, the demand curve it faces is the market demand curve.
Secondly, the average revenue of the monopolist which is the same as the market demand
curve is downward sloping. Furthermore, the marginal revenue curve is not equal to the demand
curve. This second feature represents a major difference between this type of market and that of
perfect competition.
The Relationship between a Monopolist's Average and Marginal Revenue
You were informed in the introductory section of this lecture that there are some important
differences between the average and marginal revenue cost of the monopolist and the perfect
competitive firm. Under perfect competition, both the marginal and average revenue curves are
the same and perfectly elastic. In the case of the monopolist, both are downward sloping and they
are not equal.

The marginal revenue curve is below the demand curve, since the sale of an extra unit reduces
the price at which all the units are sold resulting in a net addition to revenue of an amount less
than its own selling price.
A simple example can be used to illustrate our discussion at this juncture.

38
 Table 6.1: Alternative price and sales combination for a monopolist with the corresponding
revenue curves.

Price Rate of Total Marginal Averag

sales per revenue revenue e
year revenue

Scenari 1 N30.0 100 N3000 – 30

o 0
Scenari 2 N29.5 102 N3009 N4.5 29.5
o 0
Scenari 3 N29.0 104 N3016 N3.5 29
o 0

In Table6.1, when the price of the commodity is N30.00, the monopolist was making a sale of
100 units per year bringing total revenue of N3000. However , for the monopolist to boost its
sales to 102 units he has to reduce price, this reduction will not only affect the 102 units but all
the previous 100 units, this will lead to increase in total revenue, However, the marginal revenue
N4.5 is below the price and the average revenue.
The relationship between total, average and marginal revenue is illustrated below:

Fig.6.7 The relationship between total, average and marginal revenue.

The Equilibrium of a Monopolist

39
The technological facts of life are the same for the monopoly as for a competitive firm, so the
short run cost curves have the same stage in both cases. The difference lies in the demand
conditions. While the perfectly competitive firm is faced with a perfectly elastic demand for its
product, the monopoly is faced with a downward sloping demand curve.

Fig.6.8 Monopoly Downward Sloping Demand Curve

The equilibrium output and price are q l and Pl. This equilibrium meets the several conditions
for profit maximizing behaviour. Marginal cost equals marginal revenue; marginal cost cuts
marginal revenue from below; and price is greater than average variable cost.

The net profit in this case is represented by the shaded portion. However, there is nothing that
guarantees that a monopolist will make profit in the short run. Whether he makes profit or not
depends on the position of the ATC.

Where the ATC is tangential to the demand curve, the monopolist earns zero profit and output q l
as shown below:

Figure 6. 9 Short Run Equilibrium of a Monopolist

Firm and Industry, Short run and Long run
A monopoly is the only producer in an industry. Thus, there is no distinction between the firm
and the industry.
Unlike under perfect competition where there is no barrier to entry, the existence and
continuous operation of a monopolist depends on its ability to bar other firms from entering into
the industry where he is largely successful.

There might not be much difference between the short run and long run equilibrium position of
the firm. In other words, if the firm is making profit in the short run, this can also extend into the
long run if it can successfully discourage other firms from coming into the market.
40
Reasons for the Existence of Monopolies
1. Patent Laws: Patent laws may create and perpetuate monopolies by conferring on the
patent holder the sole right to produce a particular commodity. The government may
grant a firm a charter or a franchise that prohibits competition by law.
2. Economies of scale: Monopolies may also rise because of economies of scale. The
established firm may retain a monopoly through a cost advantage because it can produce
at a lower cost than could any new and necessarily smaller competitors.
3. Access to Raw Materials: In a situation where one firm has the sole access to the raw
material used for producing a commodity, other firms may not be able to enter into the
industry
4. A monopoly may also be perpetuated by force: Potential competitors can be intimidated
by threats ranging from sabotage to a price war which the established monopoly has
sufficient financial resources to win.

Price Discrimination
In general, price discrimination occurs when a producer sells a commodity to different buyers at
different prices for reasons not associated with differences in cost. For example, doctors,
lawyers, barbers sometimes vary their fees according to the incomes of their clients. Cinemas
also charge lower admission prices for children.
Price discrimination occurs because different units of a commodity can be sold at different
prices, and it will be profitable for the seller to take advantage of this if he can.
However, for price discrimination to be possible, certain conditions must be present. First, that it
can control what is offered to a particular buyer and second, that it can prevent the resale of the
commodity by one buyer to another.
The first of the two conditions - control over supply is the feature that makes price
discrimination an aspect of the theory of monopoly. Monopoly power in some form is necessary
(but not sufficient) for price discrimination.
The second of the two conditions - ability to prevent resale tends to be associated with the
character of the product, or the ability to classify buyers into readily identifiable groups. Services
are also easily resold than goods.
Equilibrium of a Price - Discriminating Monopolist
Consider a monopoly firm that sells a single product in two distinct markets, A and B. Let's also
assume that there is no possibility of resale from one market to another. Since the firm can
discriminate, it is under no obligation to charge the same price in market A that it charges in
market B. How then will it behave in each market? The marginal cost of producing another unit
for sale in market A will depend on how much is being produced for sale in market B and vice-
versa. To determine what overall production should be, we need to know the overall marginal
revenue, to find this we merely sum the separate quantities in each market that corresponds to
each marginal revenue. The firm’s total profit maximizing output is at Ql where MR1 and MC1
intersect at a value Cl, the firm will allocate sales between the markets until the marginal revenue
of the last unit sold in each market are the same.

41
Fig. 6.10 i. Market A ii. Market B iii. Both Markets.

6 ( c) Imperfect Competition - Monopolistic-Competition

Introduction
The two markets, that is, monopoly and perfect competition are not common in the real world
rather what one sees around is the mixture of the two extremes. The attempt to be more relevant
to reality gives rise to the study of the imperfect competition. Two foremost economists, that
pioneered the study of this type of market are; Joan Robinson and Chamberlain.
While under perfect competition, sellers face a perfectly elastic demand curve and are price
takers. In all other market forms, say for example, the monopolist monopolistic- competition and
oligopoly, the firms have some control over their price. In such circumstances we say that the
firms in the latter category can administer their own prices.
The theories of imperfect competition, the monopolistic-competition and the oligopoly will be
discussed. However, in the present lecture we shall discuss the monopolistic-competition.
Monopolistic-Competition
The term monopolistic-competition describes a situation similar to perfect competition, with the
singular important difference that each producer sells a product that is somewhat differentiated
from the products sold by his competitors.
Product differentiation implies that each firm does not face a perfectly elastic demand curve.
The firm is faced with a downward sloping demand curve; implying that if the firm raises its
price it will lose business to its competitors, but it will not lose all of its customers just because
its prices rise slightly (because he sells a differentiated product). The slope of the demand curve
will however depend on the extent to which the firm's product is differentiated from its
competitors.
The figure below denotes the short run equilibrium of the firm. The firm is faced with a
downward sloping but rather flat, demand curve. The firm will of course, have the usual U -
shaped short run cost curve. The short run equilibrium of the firm is exactly the same as that of a
monopolist. The firm is not a passive price taker; it may juggle price and quantity until profits
are maximized. This occurs at output qt and price Pt in the figure.

42
 Fig. 6.11: The short run equilibrium of a firm
Long Run Equilibrium
The firm shown in the figure above is earning profits equal to P 1 UVW1 and if it is typical of the
other firms in the industry, new entrants will be attracted. As more firms enter, the market
demand for the product must be shared out among the larger number of firms, so that each can
expect to have a smaller share of the market. Thus, at any given price, each firm can expect to
sell less than it did before the influx of new firms; each firm's demand curve shifts left. This must
continue until no profits are being earned; as long as profits exist, there is an attraction for new
firms to enter and the industry will continue to expand
The final position must be like what is indicated in the figure below. The demand curve
touches the average total cost curve at only one point, x, corresponding to quantity q1 and price
P1: the demand curve is tangential to the average cost curve at point x At this output, cost is just
being covered, since average revenue equals average total costs. Losses occur at any other level
of output, since average revenue is less than average total costs.

43
 Fig.6.12: The Long-run Equilibrium of a Firm under Monopolistic- Competition.
Two major lessons are derived from this equilibrium position. The first is that despite the
fact that the monopolistic-competitive firm is faced with a downward sloping demand curve;
zero profit equilibrium is still possible. The second lesson is that the firm now operates at a
position of excess or unused capacity. Although the firm could expand its output to q 2 and thus
reduce its ATC, but this does not pay the firm since the fall in price would be greater than the fall
in costs. Thus, the best position to operate is denoted by x above.
Advertising expenditure
Firms operating monopolistic competition engage in advertising as a means of differentiating
their products from others. A relevant question is, how much should a profit maximizing firm
spend on advertising?
A very simple model expresses quantity sold as a linear function of advertising expenditure
and assumes diminishing marginal returns to advertising. An additional assumption is that
changes in advertising do not alter price or marginal cost
If price is denoted by P and marginal cost by MC, then the gross marginal profits is P-MC.
By deducting additional advertising outlay from this we obtain net marginal profit
To maximize total net profit, the firm must ensure that advertising expenditures are at the
level where an extra gross profit equals to the extra naira of advertising cost.

In other words, if ΔQ is the number of extra units of output sold due to an extra naira of
advertising, advertising expenditures must be such that
ΔQ (P-MC) = 1
Where the right hand side represents the extra naira spent on advertising and the left hand
side is the marginal gross profit due to the last advertising naira. If both sides of the equation
above are multiply by P/ P-MC, we obtain
PΔQ = P
P-MC
Since for profit maximization MR must equals to MC, the equation can be written as
PΔQ = P
P-MR
Given that MR = P {1-1/Ed}
P
P-MR = Ed

While PΔQ = MR
In other words for profit to be maximized marginal revenue has to be equated with the
elasticity of demand

44
Differences between Perfect Competition and Monopolistic-Competition
1. This is a derivative of our discussion above. The equilibrium output of the
monopolistically competitive firm is less than the output where total cost is at a
minimum. (This is known as excess capacity theorem).
2. Under monopolistic-competition, equilibrium price is higher and output is lower, ceteris
paribus, than under perfect competition.
3. Under monopolistic-competition, equilibrium price is greater than marginal cost.
4. Monopolistically competitive firms will offer wider variety of brands, styles and possibly
qualities than firms in perfect competition.
5. Monopolistically competitive firms will engage in non- price competition whereas
perfectly competitive firm will not.

6(d) Imperfect Competition: Oligopoly

Introduction
The second form of market under the theories of imperfect competition is Oligopoly. This market
is characterised by few firms. Most manufacturing-industries in the capitalistic economies belong
to Oligopoly. A special type of oligopoly exists. This is a duopoly, which is an industry with only
two producing firms.
In this lecture, we shall examine the types of oligopoly we have, the equilibrium under
oligopoly and its other features.
Pricing and Output under Oligopoly
Oligopoly refers to a market situation where there are few sellers of a particular commodity such
that the activities of one of the sellers are particularly important to the others. The pricing,
output, sales promotional activities of a seller must take the reactions of others into account.

Usually, a single seller occupies a position of sufficient importance (market leader) in the product
market for changes in his market activities to have repercussions on others.
Oligopolies can be classified according to the degree of collusion achieved by the three:
i. organised collusive oligopoly;
ii. unorganised collusive oligopoly; and
iii. non-collusive oligopoly.

The first one refers to a cartel arrangement whereby a central organisation is set up which
determines the output and pricing arrangement among members of the cartel. A good example of
this is the Organisation of Petroleum Exporting Countries (OPEC).
The second category goes on an informal basis. There is a gentleman agreement among
members as to prices and output decisions. However, this might not be binding on members who
can flout this decision and yet escape prosecution.
The third category is a pure oligopolistic system whereby firms take independent actions of
their own. Activities of any of the firms can lead to bitter rivalry among the firms, for instance, a
price war.

45
Short Run Equilibrium Position under Oligopoly
For our purpose we shall take the case of non-collusive oligopoly. This one is characterised by
price wars and price rigidity. One seller may lower his price to increase sales. This takes
customers away from rivals and they may retaliate with a vengeance. The price war may spread
throughout the industry with each firm trying to undercut the others. The end result may be
disastrous for some individual firms.
The 'kinked' demand curve is the analytical devise frequently used to explain oligopolistic
price rigidity curve. The framework is however based on certain assumptions. First, that the
industry is a mature one, either with or without product differentiation. A cluster of prices or a
price fairly satisfactory to all has been established. Second, if one firm lowers price, others will
follow or undercut it in order to retain their shares of the market. Thus, price decreases might not
work to the advantage of the firm. Third, if one firm increases prices, other firms may not follow
the price increase. This firm would lose his customers to other firms who have not increased their
prices.

The demand curve faced by a single firm in such a situation is pictured diagrammatically in
the figure below as FDE.

Fig. 6.13: Short Run Equilibrium Position of an Oligopolistic Firm.

The firm has established a price at P. If it reduces its price below P, other firms follow and it
retains his share of the market. The demand curve faced by the firm for price increases is PD.
The demand curve FDE is not smooth but is kinked at the established price P.
The kinked demand curve has implications for the marginal revenue of the firm. The MR
curve is discontinuous at output X. The portion of the MR curve FA and SC corresponds to the
two portions of the demand curve FD and DE respectively.

Cost curves SAC and SMC are such that at price P some profit can be made. The MC curve cuts
the MR curve within its discontinuous part. Output X and price P are, in fact, the firm's profit
maximizing output and price. If output were less than X, MR would exceed MC and the firm's
output would be increased by expanding output to X. For outputs exceeding X, MC exceeds MR
and profits will decrease.
One implication of the discontinuity in the MR curve of the oligopolistic firm is that as long
as MC cuts MR curve at the discontinuous part of the marginal revenue curve, there is no
incentive for the oligopolist to change either price or output. e.g. SMC

46
The Long Run
Two types of adjustments are possible in oligopolistic industries in the long run. In the first
place, individual firms are free to vary the size of their plant; thus the relevant cost curves for the
firms are the long run average cost curve and the long run marginal cost curve. Second, some
industry adjustment may be possible in the form of entry into the industry or exit of old firms
from the industry. Non-Price Competition:
While Oligopolists may be reluctant to encroach upon each other's market shares by
lowering product price, they appear to use other methods to achieve this. Product differentiation
offers a more subtle and a much safer way of accomplishing approximately the same results,
Product differentiation occurs in two major ways:
1. Advertising; and 2. Variation in design and quality of product.

Practice Questions
1. Distinguish between the cost and revenue curves of the monopolist and a perfect
competitive firm.
2. Describe the equilibrium position of the monopoly. Is there a difference between the
equilibrium position of a firm and an industry under monopoly market?
3. What are the factors that give rise to or maintain a monopoly?
4. What is price discrimination? What is its distinguishing feature?
5. Explain the main characteristic of a perfect competitive market.
6. Why does the firm in perfect competition face a perfectly elastic demand curve?
7. Why must a perfect competitive firm in the long run be just breaking even?
8. Define monopolistic-competition.
9. Illustrate the short and long run equilibrium conditions under monopolistic-competition.
Are there any differences between the two equilibria.
10. Mention the differences between monopolistic-competition and
a. Perfect competition. b. Monopoly.
11. Highlight the similarities between monopolistic- competition and
a. Perfect competition b. Monopoly.
12. What do you understand by advertising expenditures?

13. What is oligopoly? Give examples of oligopolies in your country.

14. Describe the short run equilibrium position of the firm.
15. What are the important differences between short run and long run equilibrium condition
for oligopolistic firms?
15. What are the major methods of 'warfare' among oligopolistic firms?

GOOD LUCK BUT REMEMBER THAT PROPER PREPARATIONS PREVENT POOR

PERFORMANCE .

47