MICROECONOMICS

1. Introduction to Economics
2. Theories of Demand and Supply
3. Theory of Production
4. Market structures

1
The Main objectives of the course
General objective/Competency
 The aim of this course is to make students acquainted with definitions
and basic concepts of Economics
Specific objectives /learning outcomes
 Understand theory of demand and supply
 Understand different types of production relationships
 Explain market structures
I. Introduction to Economics
Definition and Scope of Economics

 There are two fundamental facts that provide the foundation for the field of
economics:

 Human or society’s material wants are unlimited and Economic resources

are scarce or limited in supply.

 Economic resources refer to anything natural or manmade that can be

used in production of goods and services.

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 By economic resources, we refer to the various types of labors, minerals,
buildings, trucks, oil deposit, communication facilities, etc.

 All these resources are scarce or limited in supply.

 On the one hand, society’s material wants are unlimited.

 These contradictory facts lay the foundation for the field of economics.

4
 Economics is defined as a “social science, which studies how societies allocate

scarce resources in the production and distribution of goods and services so as to

attain the maximum fulfillment of society’s material wants”.

 Economics is the study of decision making. People may decide on:

 What to Produce? Which product is profitable for producers in terms of revenue or

profit?

 How to produce? This is about which production method or technique to use and
about what inputs to use. E.g. Should we generate electricity from oil, coal, nuclear
power, solar power?

 For whom to produce? Who is going to get the output produced?

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 Where to produce? E.g. If students are the potential customers, it’s better to

locate the distribution centre around schools.

 When to produce? E.g. the demand for exercise book is high during the

Ethiopian New Year since schools open by then.

6
Branches of Economics
 Economics can be divided into: microeconomics and macroeconomics.

 Microeconomics: is concerned with economic behavior of individual

economic units, well-defined groups of individual economic units, and how
markets of individual commodities function.

 These individual economic units can be households or firms.

7
Macroeconomics: is the branch of economics that studies an economy
as whole and sub aggregates of the economy: It does not deal with
household, firm, or industry.

It deals with magnitudes such as the total output level in an

economy, national income of a country, the overall level of prices,
total employment in the economy, etc.

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 For example, in microeconomics we can study why the price of ‘teff’ increase or
decrease in Addis Ababa. But this increase or decrease in the price level of ‘teff’
is not the concern of macroeconomics.

 In short, in microeconomics we study a tree in a forest; but in macroeconomics

we study the forest, not a tree.

 Remember that, like macroeconomics, microeconomics also uses aggregates. For

example, we talk of the total market demand for wheat, total market demand for
maize…etc.

9
 In microeconomics, we aggregate over homogenous product, but

 In macroeconomics, the aggregation is at the economy level.

 In microeconomics, we cannot aggregate the total market demand for wheat

and maize together.

 In macroeconomics, we can aggregate the total of several products and talk

about the total level of outputs currently produced in a country this year.

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Concepts in Economics
 Factors of Production is an economic term used to describe the inputs that
are used in the production of goods or services in the attempt to make an
economic profit.

 The act of making goods and services is called production and the act of using
them is called consumption.

 Goods are tangible (e.g. shoes, bread), and services are intangible (e.g.
education, entertainment).

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 The four categories of factors of production are land, capital, labour and
entrepreneurship.

 Land - refers to all natural resources used to produce goods and services.

 This includes not just land, but anything that comes from the land.

 Some common land or natural resources are water, oil, minerals (such as copper),
and forests.

 The income that resource owners earn in return for land resources is called rent.

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 Capital - is the all man-made aids to production.

 These are the outputs produced to be used as inputs in further production.

 It includes machines, equipment, buildings humans use to produce goods

and services.

 Capital differs based on the worker and the type of work being done.

 For example, a doctor may use a stethoscope and an examination room to

provide medical services.

 The income earned by owners of capital resources is interest.

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 Labour - is the skills, abilities, knowledge (called human capital) and the
effort exerted by people in the production of goods and services.

 It includes skilled and unskilled labour.

 The income earned by labour resources is called wage.

 Entrepreneurship- An entrepreneur combines the other factors of production

by buying these factors to produce a saleable product.

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• This is the economic agent/a person who creates the enterprise.

• Without the entrepreneur combining land, labour, and capital in new ways,
many of the innovations we see around us would not exist.

• Think of the entrepreneurship of Henry Ford or Bill Gates. Without these people
and their ideas, no companies would ever exist.

• Entrepreneurial talent is paid profit.

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 Firm: E.g. Metahara Sugar Factory

 Industry: E.g. Sugar Industry (consists: Metahara Sugar Factory, Wenji

Sugar Factory, Ficha Sugar Factory, Tendaho Sugar Factory …)

 Economy: (consists: Sugar Industry, Soft Drink Industry, Detergent

Industry, Brewery Industry, Food Industry, Chemical Industry …)

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Scarcity and choice: Opportunity cost

 There is one central problem faced by all individuals and all societies and
from this problem all the other economic problems stem.

 This central economic problem is the problem of scarcity.

 The reasons for scarcity economic resources is human wants are virtually
unlimited, whereas the resources available to satisfy these wants are limited.

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 Scarcity as the excess of human wants over what can actually be produced.

 Because of scarcity, various choices have to be made between alternatives.

 Choice involves sacrifice. The more food you choose to buy, the less money
you will have to spend on other goods.

 In other words, the production or consumption of one thing involves the

sacrifice of alternatives.

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 This sacrifice of alternatives in the production (or consumption) of a good is
known as its opportunity cost.

 Opportunity cost is the cost of any activity measured in terms of the best
alternative forgone.

 Example; if the workers on a farm can produce either 1000 tons of wheat or
2000 tons of barley, then the opportunity cost of producing 1 tons of wheat is
the 2 tons of barley forgone.

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Economic system

 One important difference between societies is in the degree of government

control of the economy.

 Based on this, we have three types of economic systems: free market

economy, command or planned economy and mixed economy.

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 Free market economy is an economy where all economic decisions are taken
by individual households and firms and with no government intervention at all.

 Households decide how much labor and other factors to supply, and what goods
to consume.

 Firms decide what goods to produce and what factors to employ.

 The pattern of production and consumption that results depends on the

interactions of all these individual demand and supply decisions.

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 Command or centrally planned economy is an economy where all economic
decisions are taken by the central authorities/government.

 Mixed economy is a market economy where there is some government

intervention.

 Because of the problems of both free-market and command economies, all

real-world economies are a mixture of the two systems.

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Unit Two

Theory of Demand and Supply

Meaning of Demand

• Demand refers to the amount that consumers are willing and able to
purchase at alternative prices over a given period.

 Quantity demanded refers to the amount that consumers are willing

and able to purchase at a given price over a given period (e.g. a week

, or a month, or a year).

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Law of Demand

 Law of demand states that there is an inverse relationship between price of

a commodity and its quantity demand in the markets, keeping other factors
constant.

 The quantity of a good demanded per period of time will fall as price rises a
nd will rise as price falls, other things being equal (ceteris paribus).

 The two explanations to the law of demand are income effect and substitut
ion effect.

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 As the price of the commodity increases, people will feel poorer.

 They will not be able to afford to buy so much of the good with their money.

 The purchasing power of their income has fallen.

 This is called the income effect of a price rise.

 The good will now cost more than alternatives or ‘substitute’ goods, and people
will switch to these.

 This is called the substitution effect of a price rise.

25
 But the above law operates only under the assumption that “other things remain
constant” .

 These are: the number and price of substitute goods, the number and price of co
mplementary goods, income of consumer, tastes and preference, expectations of f
uture price changes, advertisement, past demand, and consumer future price and
income.

 Demand is, therefore, a multivariate function: Qd = f(P, Po T, S, I, E,Z).

26
 The law of demand can be represented in terms of curves, equations and tables.

 A demand schedule is defined as a table which presents the quantity demanded

at each price level during a specific time period.

• Demand schedule for an individual refers to a table showing the different qua
ntities of a good that a person is willing and able to buy at various prices over a
given period of time.

• Market demand schedule is defined as a table showing the different total quant
ities of a good that consumers are willing and able to buy at various prices over
a given period of time.

27
The Demand Schedule
Quantity
• Demand schedule: a table that shows the Price
of lattes dema
of lattes
relationship between the price of a good an nded

d the quantity demanded. $0.00 16

1.00 14
• Example: Helen’s demand for Ice cream. 2.00 12
3.00 10
4.00 8
5.00 6
 Notice that Helen’s preferences obey t 6.00 4
he Law of Demand.

28
 Demand curve is a graph showing the relationship between the price of a good
and the quantity of the good demanded over a given time period.

 Price is measured on the vertical axis; quantity demanded is measured on the

horizontal axis.

 It slopes downward from left to right: they have a negative slope.

 A demand curve can be for an individual consumer or group of consumers, or

more usually for the whole market.

29
Helen’s Demand Schedule & Curve
Price of L Price Quantity
attes of latt of lattes d
$6.00 es emanded
$0.00 16
$5.00
1.00 14
$4.00 2.00 12
$3.00 3.00 10
$2.00 4.00 8
5.00 6
$1.00
6.00 4
$0.00
Quantity o
0 5 10 15 f Lattes
30
Determinants of Demand

 Price is not the only factor that determines demand.

 Demand is also affected by the following.

 Tastes: the more desirable people find the good, the more they will demand.

 Tastes are affected by advertising, by fashion, by observing other consumers,

by considerations of health and by the experiences from consuming the good
on previous occasions.

 E.g. Animal fat leads to a higher risk of heart attacks. This results in low
demand for red meat.

31
 The number and price of substitute goods
 Substitute goods- such goods are substitute to one another.

 As a result, an increase in the price of such related goods leads to increase in

demand for the other good.

 Consider Pepsi Cola and Coca Cola. If the price of Coca Cola increases
consumers will shift from the consumption of Coca Cola to Pepsi Cola.

 This implies increase in the price of Coca Cola results in the increase of the
demand for Pepsi-Cola.

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 The number and price of complementary goods.
 Complementary goods are those that are consumed together: cars and petrol.

 As a result, a rise in the price of one such good results in decline in demand of
the other good.

 Consider the case of sugar and coffee.

 Coffee is consumed together with sugar. Thus, increase in the price of sugar
causes decline in demand for coffee.

 The converse is true for decrease in the price of sugar.

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 Income: As people’s incomes rise, their demand for most goods will
rise.

 Such goods are called normal goods.

 There are exceptions to this general rule, as people get richer, they
spend less on inferior goods.

34
Expectations of future price changes: If people think that
prices are going to rise in the future, they are likely to buy
more now before the price does go up.

Number of Buyers: Increase in number of buyers increases

demand.

35
Movements along and shifts in the demand curve
 A demand curve is constructed on the assumption that ‘other things
remain equal’ (ceteris paribus).

 In other words, it is assumed that none of the determinants of demand,

other than price, changes.

 The effect of a change in price is then simply illustrated by a movement

along the demand curve.

 What happens, then, when one of these other determinants does change?

36
 To distinguish between shifts in and movements along demand curves,
it is usual to distinguish between a change in demand and a change in
the quantity demanded.

 A shift in the demand curve is referred to as a change in demand,

 A movement along the demand curve as a result of a change in price

is referred to as a change in the quantity demanded.

37
Example: increase in number of buyers increases quantity demanded
at each price level, shifts demand curve to the right.
P
$6.00 Suppose the number of buyers
$5.00 increases.
Then, at each P,
$4.00
Qd will increase
$3.00 (by 5 in this example).
$2.00

$1.00

$0.00 Q
0 5 10 15 20 25 30

38
Shifts in the Demand Curve
Price of Ice-Cream

Increase
in demand

Decrease
in demand
Demand
curve, D 2
Demand
curve, D 1
Demand curve, D 3
0 Quantity of Ice-Cream
39
Demand function
 Is the relationship between the market demand for a good and the
determinants of demand in the form of an equation.
 Demand equations are often used to relate quantity demanded to just
one determinant.
 Thus an equation relating quantity demanded to price could be in the
form:
 For example: Qd= 10, 000 - 200P.

40
 The quantity demanded to two or more determinants.

For example, a demand function could be of the form:


Q
da
bP
d 
cY
dP
seP
c

Where Qd = quantity demanded;

p = price of the good;
Y= income;
Ps= price of substitute good;
Pc= price of complement good

41
Supply
 Supply refers to the various quantities of a product that sellers (producers)
are willing and able to provide at various prices in a given period of time,
citrus paribus.

 Note that quantity supplied and supply are two different concepts.

 Quantity supplied refers to a specific quantity that a supplier is willing

and able to provide at a specific price.

 But supply refers to the whole relationship between possible prices of a

product and the corresponding quantities supplied.

42
Law of Supply

 Law of supply states that, other things remain unchan

ged, as price of a product increases quantity supplie
d of the product increases, and as price decreases,
quantity supplied of the product decreases.

43
Supply can be represented using Supply Curve, Schedule and
Function
• Supply schedule: A table that s Price Quantity
hows the relationship between th of coff of coffee s
e price of a good and the quantit ee upplied
y supplied. $0.00 0
1.00 3
• Example: Starbucks’ supply of c
2.00 6
offee.
3.00 9
4.00 12
 Notice that Starbucks’ supply sche 5.00 15
dule obeys the Law of Supply. 6.00 18

44
Starbucks’ Supply Schedule & Curve
Price Quantity
P of coffe of coffee
$6.00 e supplied
$0.00 0
$5.00
1.00 3
$4.00
2.00 6
$3.00 3.00 9
$2.00 4.00 12
5.00 15
$1.00
6.00 18
$0.00 Q
0 5 10 15

45
Market Supply versus Individual Supply
• The quantity supplied in the market is the sum of
the quantities supplied by all sellers at each price.
• Suppose Starbucks and Jitters are the only two sellers in t
his market. (Qs = quantity supplied)
Price Starbucks Jitters Market Qs
$0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
6.00 18 + 12 = 30 46
The Market Supply Curve
QS (Mark
P
et)
P
$6.00 $0.00 0
1.00 5
$5.00
2.00 10
$4.00 3.00 15
$3.00 4.00 20
$2.00 5.00 25
6.00 30
$1.00

$0.00 Q
0 5 10 15 20 25 30 35

47
Determinants of Supply

 The other determinants of supply are as follows.

 The costs of production (price of inputs); the hig

her the costs of production, the less profit will be ma
de at any price.

 As costs rise, firms will cut back on production, prob

ably switching to alternative products whose costs ha
ve not raised so much.
48
 The profitability of alternative products (substitutes i

n supply); If a product which is a substitute in supply b

ecomes more profitable to supply than before, producers a

re likely to switch from the first good to this alternative.

49
Technology

 Advances in technology reduce the number of inputs need

ed to produce a given supply of goods.

 Costs go down, profits go up, leading to increased supply.

50
 The profitability of goods in joint supply; Sometimes when on

e good is produced, another good is also produced at the same ti

me.

 These are said to be goods in joint supply.

51
 Nature, ‘random shocks’ and other unpredictable e

vents; In this category, we would include the weather an

d diseases affecting farm output, wars affecting the supp

ly of imported raw materials, the breakdown of machine

ry, industrial disputes, earthquakes, floods and fire, etc.

52
 Expectations of future price changes; If price is exp

ected to rise, producers may temporarily reduce the am

ount they sell.

 Instead they are likely to build up their stocks and only

release them on to the market when the price does rise.

 The number of suppliers; If new firms enter the market, s

upply is likely to increase.

54
Taxes and Subsidies

• When taxes go up, costs go up, and profits go down, le

ading suppliers to reduce output.

• When government subsidies go up, costs go down, and

profits go up, leading suppliers to increase output.

55
Movements along and shifts in the supply curve

• The principle here is the same as with demand curves.

• The effect of a change in price is illustrated by a movement alo

ng the supply curve.

• If any other determinant of supply changes, the whole supply cu

rve will shift.

• A rightward shift illustrates an increase in supply.

• A leftward shift illustrates a decrease in supply.

56
What Shifts the Supply Curve?

•A “change in quantity supplied” is not the same as a “ch

ange in supply.”
– “Quantity supplied” changes only when the price of
a good changes.
• It is a movement along a fixed supply curve.
– “Supply” changes only when a non-price factor chan
ges.
• It is a shift in the entire supply curve.

A “change in Quantity Su
pplied” A “change in Sup
ply”
57
Change in Quantity Supplied

S0

B
Price (per unit)
$20

Change in quantity supp

A lied (a movement along
$15
the curve)

1,250 1,500
Quantity supplied (per unit of time)

58
Shifts in the Supply Curve: What causes them?
Price of
Ice-Cream Supply curve, S 3
Supply
Cone
curve, S 1
Supply
Decrease curve, S 2
in supply

Increase
in supply

0 Quantity of
Ice-Cream Cones 59
• Example: changes in input prices such as wages, pri
ces of raw materials.
• A fall in input prices makes production more profitabl
e at each output price, so firms supply a larger quantit
y at each price, and the S curve shifts to the right.

60
Input Prices

P Suppose the price

$6.00 of wheat falls.
At each price, the
$5.00
quantity of
$4.00 Macaroni supplied
will increase
$3.00
(by 5 in this examp
$2.00 le).
$1.00

$0.00 Q
0 5 10 15 20 25 30 35

61
Supply Function
 The simplest form of supply equation relates supply to just one d
eterminant.

E.g. Qs = 500 + 1000P

 More complex supply equations would relate supply to more tha
n one determinant.

• Where, P is the price of the good, a1 and a2 are the profitability’s

of two alternative goods that could be supplied instead, and j is t
he profitability of a good in joint supply.

62
Market Equilibrium
 The operation of the market depends on the interaction between
buyers and sellers.

 An equilibrium is the condition that exists when quantity

supplied and quantity demanded are equal.

 At equilibrium, there is no tendency for the market price to

change.

 The price where demand equals supply is called the

equilibrium price and the quantity where demand equals
supply is called the equilibrium quantity.
63
Supply and Demand Together

Demand Schedule Supply Schedule

At $2.00, the quantity demanded is equal to

the quantity supplied!
64
Equilibrium of supply and demand
Price of
Ice-Cream
Supply
$3.00
2.50 Equilibrium
Equilibrium
price
2.00
1.50
1.00
Equilibrium Demand
0.50 quantity

0 1 2 3 4 5 6 7 8 9 101112
Quantity of Ice-Cream Cones

65
Equilibrium price: the price that equates quantity supp
lied with quantity demanded
P
$6.00 D S P QD QS
$5.00 $0 24 0
$4.00 1 21 5

$3.00
2 18 10
3 15 15
$2.00
4 12 20
$1.00
5 9 25
$0.00 Q 6 6 30
0 5 10 15 20 25 30 35
66
Equilibrium quantity: the quantity supplied and quantit
y demanded at the equilibrium price
P
$6.00 D S P QD QS
$5.00 $0 24 0
$4.00 1 21 5

$3.00
2 18 10
3 15 15
$2.00
4 12 20
$1.00
5 9 25
$0.00 Q 6 6 30
0 5 10 15 20 25 30 35
67
Markets Not in Equilibrium
Surplus (excess supply): when quantity supplied is gre
ater than quantity demanded
P Example:
$6.00 D Surplus S
If P = $5,
$5.00
then QD = 9 lattes
$4.00

$3.00 and QS = 25 lattes

$2.00
resulting in a
$1.00 surplus of 16 lattes
$0.00 Q
0 5 10 15 20 25 30 35
68
Facing a surplus, sellers try
P to increase sales by cutting
$6.00 D Surplus S price.
$5.00 This causes QD to rise and Q
S to fall.
$4.00
…which reduces the surplus.
$3.00
Prices continue to fall until
$2.00
market reaches equilibriu
$1.00 m.
$0.00 Q
0 5 10 15 20 25 30 35
69
Shortage (excess demand):when quantity demanded is
greater than quantity supplied
P
$6.00 D S Example:
If P = $1,
$5.00
then
$4.00 QD = 21 lattes
$3.00 and
QS = 5 lattes
$2.00
resulting in a
$1.00 shortage of 16 lattes
$0.00 Shortage Q
0 5 10 15 20 25 30 35
70
Facing a shortage,
sellers raise the price, ca
P using QD to fall and QS t
D S o rise.
$5.00 …which reduces the sho
rtage.
Prices continue to rise un
til market reaches equilib
rium.
$0.00 Shortage
Q
0 5 10 15 20 25 30 35
71
72
Unit Three
Theory of Production

 In the production process, firms use inputs also called factors

of production.
 Therefore, we may conceive of firms as being sellers of good
s and services and buyers of factors of production.
 Firms buy factors of production and transform them into goo
ds and services.
 This process of transformation is called production.

73
The Production Function

A production function shows the technical relationshi

p between factor inputs and output.

 It describes the amount of output expected from differ

ent combination of input usage.

It can be expressed in tabular or graphic form or by a

mathematical formula.

74
 A production function reflects the best technology av
ailable for a given level of output in the production pr
ocess.

 Inferior combinations of factors of production (i.e., co

mbinations involving more of all inputs) to produce t
he same output are ignored.

 It represents maximum amount of output that can be

produced from any specified set of inputs, given exist
ing technology. 75
 Suppose a firm uses labor (L) and capital (K) to produce a give
n level of output.

 Let A and B be two different combinations of factor inputs:

A B
L 5 4
K 4 4
 Both A and B use the same quantity of capital but A uses more
labor than B. Then, input combination A will not be represente
d on the production function.

 Only methods that use the fewest inputs would be captured by

the production function.
76
 Factors of production could be fixed or variable.

 The difference between fixed and variable factors rela

tes to the time horizon involved.

 In economics, there are two main horizons; the short

run and the long run.

 The short run is a relatively short period of time in w

hich the quantity of some factors of production such a
s equipments and buildings cannot be varied. Such fa
ctors are called fixed factors.
77
 Factors of production whose quantity can be varied in
the short run are called variable factors.

 The long run, on the other hand, is a relatively long p

eriod which allows the variation of all factors of pro
duction including plants and equipment.

 In this section, we will focus on a production process

in which there are only two factors of production; lab
or and capital, where capital is the fixed factor and l
abor is the variable factor.
78
 The production function in this case is defined by
Yf
LK
 The bar on K indicates that capital is constant and va
riation in output depends on variation in labor L.

79
Average and Marginal Product Curves

 Total product (TP) is the total amount that is produce

d during a given period of time.

 If the inputs of all but one factor are held constant, tot
al product will change as the quantity of the variable f
actor used changes.

 Suppose capital is fixed at 5 units.

80
 By applying varying quantity of labor, the firm can
produce different levels of output.

Qty of capital (K) Qty of Labor (L) Total product (TP)

5 0 0
5 1 15
5 2 34
5 3 48
5 4 60
5 5 62
5 6 60
81
• Average product (AP) is the total product divided by
the number of units of the variable factor used to prod
uce it.

• If we let the number of units of labor be denoted by L

, the average product can be: AP = Q/L

• Marginal Product (MP) is the change in total produc

t resulting from the use of one unit more of a variable
factor. MP = Q/L
82
Total, Average, & Marginal Products of Labor, K = 2

Number of Total product (Q) Average product ( Marginal product (

workers (L) AP=Q/L) MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4
83
 AP first rises and then falls. The level of output at whi
ch AP reaches maximum is called the point of dimini
shing average productivity.
 Up to that point, average productivity is increasing; be
yond that point, average productivity is decreasing.
 At initial stages, MP increases as additional variable f
actors (labor) are employed. Then reaches maximum a
nd declines.
 After certain range, it becomes negative with employ
ment of additional variable factors.
 The level of output at which marginal product reaches
its maximum level is called point of diminishing mar
ginal productivity (inflection point).
84
Total, Average, & Marginal Products K = 2 (Graphic
al representation)

85
Total, Average & Marginal Product Curves

Q2

Q1 Total produc
t
Panel A
Q0

L0 L1 L2

MP cross AP when the latter is in its

maximum
Panel B

Average product

L0 L1 L2
Marginal product
86
The Law of Diminishing Returns
 As additional units of a variable input are combined with a fixe
d input, at some point the additional output (i.e., marginal prod
uct) starts to diminish.

 As more and more units of a variable factor (L) are combined

with fixed factors (in our case K), we may initially obtain incr
easingly larger additions to output, but we eventually obtain s
maller increments in output.

 This economic phenomenon is referred to as the principle of di

minishing returns .
87
 At early stage, since lower level of labor employment does not
allow the realization of full capacity of the machinery; therefor
e increase in labor employment increases productivity.

 Eventually as more and more labor is combined with the single

unit of capital, the machinery will fail to support the large num
ber of workers; therefore the productivity of labor will fall.

 Note, however, that diminishing returns is a short run phenom

enon because it is defined with at least one fixed factor.

88
Diminishing Returns

Variable Marginal
Input Total Product Product
(X) (Q or TP) (MP)
0 0 8
1 8 10 Diminishing
2 18 11 Returns
Begins
3 29 10 Here
4 39 8
5 47
5
6 52
4
7 56
8 52 -4

89
The Relationship between MP and AP: Graphic approach

• Graphically, AP at a particular level

of labor employment is given by the d
c
slope of a line from the origin to a
point on the TP curve which corres
ponds to the given level of employ b
ment.
a

91
The Relationship between MP and AP: Graphic approach

MP at a particular point on the TP c d

urve is graphically given as the slope
a
of the TP curve at that particular poi
nt.
MP at point a is the slope of the tan
gent line at that particular point.
 Up to point b, the slope of the tang
b
ent line increases as the level of emp
loyment increases.

94
The Stages of Production

Q1 Total produc
t

L1
Stage Stage
Stage I II III

Average product

L1
Marginal product
96
In stage I:
From zero units of the variable input to where A
P is at its maximum.
TP, AP and MP are increasing
TP is increasing at increasing rate
MP is grater than AP

97
In stage II:
 From the maximum AP to where MP reaches zero.
 TP is increasing at decreasing rate
 TP attain the maximum level
 Both AP and MP are decreasing but Positive
 AP is greater than MP
In stage III:
 From where MP=0 to negative MP.
 TP, AP and MP are declining
98
• The basic theory of production usually concentrates o

n the range of output over which the MP of a variable

factor (labor) decreases, but is positive, i.e., the range

of diminishing (but non- negative) productivity of the

factor.

• This range of production is given in Stage II.

102
• Formally, the efficient stage of production is defined
by the condition:


Q

MP
0MP
of
labor
should
be
posi

L
L


MP
2
L Q
 
0slope
of
MP
the
should
be
nega

L 
L2

103
Example:

Suppose the production function that a firm faces is give

n as
2

Qf(L
)K
8
L L3 2

3
Find the range of labor employment for stage I, stage II
and stage III.

104
The Long run Production Function
• In the long run, all factors of production are variable.
• Firms, therefore, can alter their output by varying all factors.
• At its simplest case with just two factors involved, the production fu
nction of a firm is defined by a set of isoquants each of which repres
enting certain level of output.
• The acquisition of factors of production, however, involves costs.
• The cost constraint that the firm faces is given by isocost lines.
• The firm determines its equilibrium by combining isoquants and iso
cost lines.

105
 Suppose that a production process involves just two factors, la
bor (L) and capital (K).

 In this case, the production function is defined as:


Qf(
L,K
)
 The production function we saw under previous section was dr
awn on the assumption that all other factors of production exce
pt labor are fixed.

 However, with two variable factors L and K, the relevant prod

uction function is defined by a set of isoquants.

 The word isoquant simply means equal quantities.

106
Unit Four

Market Structures

 Market structure refers to the nature and degree of competition with

in a particular market.

 It shows the number and relative size of firms in an industry.

 Market structures can be characterized by sellers or buyers or both; a

nd in fact, most economics texts classify markets by sellers.

107
• Perfect Competition: This is a theoretical market struct
ure in which there are many buyers and sellers with no
individual power to influence market price.

• Monopolistic Competition: In this market, there are ma

ny firms producing differentiated products.

108
• Oligopoly: Here, a few interdependent firms dominate the
market for the product (differentiated or similar products)
. This market is sometimes called ‘competition among the
few’ and is relatively common in manufacturing industrie
s.
• Duopoly is a special case of oligopoly where two firms d
ominate the entire market for the product.
• Monopoly: This refers to a single supplier for the whole
market.
• Clearly, the nature and degree of competition vary in thes
e markets. Examples of these market structures are presen
ted in table 6.1.

109
The different market structures
Type of market Number of firm Examples
s
Perfect competition Very many Agricultural markets (appro
ximately)
Monopolistic compe Many/ several Builders, restaurants, suitin
tition g, …
Oligopoly Few Cement, cars, electrical ap
pliances
Monopoly One Local water company, elect
ricity, train operators (over
particular routes)

110
Perfect competition Market

Assumptions of perfect competition market

 There must be a large number of buyers and sellers- Both bu

yers and sellers do not have an influence on market price.

 Products must be homogeneous- The product of any one firm

is identical to the products of all other firms.

 There must be freedom of entry and exit.

 Both buyers and sellers have perfect knowledge.

 Factors of production are perfectly mobile.

111
Features of the four market structures

Type of Number Freedom of Nature of Examples Implications for

market of firms entry product demand curve
faced by firm

Perfect Very Homogeneous Cabbages, carrots Horizontal:

competition many Unrestricted (undifferentiated) (approximately) firm is a price taker

Monopolistic Many / Builders, Downward sloping,

Unrestricted Differentiated but relatively elastic
competition several restaurants

Undifferentiated Cement Downward sloping.

Oligopoly Few Restricted Relatively inelastic
or differentiated cars, electrical (shape depends on
appliances reactions of rivals)

Local water Downward sloping:

Monopoly One Restricted or Unique company, train more inelastic than
completely operators (over oligopoly. Firm has
blocked particular routes) considerable
control over price

112