2 Contents

COURSE MANUAL

Introduction to
Microeconomics
CC201

Modibbo Adama University of Technology

Open and Distance Learning Course Development Series
2016 Academic Collective.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any
form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission
of the copyright owner – Academic Collective.

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Tel: +234(8035617757)
E-mail: [email protected]
Website: www.cdl.mautech.edu.ng
4 Contents

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 Credits
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indicated. We therefore sincerely wish to acknowledge sources of the following images (in order of appearance):

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 Introduction to Microeconomics

Contents
ABOUT THIS COURSE MANUAL....................................................................................................... 1
How this Course Manual is structured 1

COURSE OVERVIEW............................................................................................................................ 3
Welcome to Introduction to Microeconomics CC201.1 3
Introduction to Microeconomics CC201.1—is this course for you? 3
Course outcomes 4
Timeframe 4
Need help? 5
Academic Support 5
Assessments 5
List of Figures 7
List of Tables 8

Study Session 1 ............................................................................................................. 9

Basic Issues in Economics .............................................................................................. 9
Introduction ................................................................................................................................................................................. 9
Session Preview......................................................................................................................................................................... 10
1.1 The Problem of Scarcity ................................................................................................................................................... 10
1.1.1 Human Wants and Scarcity .................................................................................................................................. 10
1.1.2 Choice in a World of Scarcity .............................................................................................................................. 12
How Individuals Make Choices Based on Their Budget Constraint...................................................... 12
The Concept of Opportunity Cost .................................................................................................................... 14
1.2 Use of Theories and Models to understand Economic Issues ........................................................................... 14
1.3 How Economies can be organized .............................................................................................................................. 16
1.3.1 Traditional Economy .............................................................................................................................................. 16
1.3.2 Command Economy ...............................................................................................................................................17
1.3.3 Market Economy ......................................................................................................................................................17
Globalisation and National Economies ..................................................................................................................... 18
Regulations: The Rules of the Game ............................................................................................................... 19
Focus: The Way to Provide Fuel for the Economy – Regulation or Deregulation? ........................................... 19
Session Review .......................................................................................................................................................................... 20
Assessment ................................................................................................................................................................................. 21
Resources .................................................................................................................................................................................... 21

Study Session 2 ........................................................................................................... 23

Demand and Supply ....................................................................................................... 23
Introduction ............................................................................................................................................................................... 23
Session Preview.........................................................................................................................................................................24
2.1 Demand of Goods and Services ................................................................................................................................... 25
2.1.1 How do we define Demand ................................................................................................................................ 25
2.1.2 Demand Schedule .................................................................................................................................................. 26
2.1.3 Demand Curve ........................................................................................................................................................ 26
2.1.4 Law of Demand ....................................................................................................................................................... 27
2.1.5 The Ceteris Paribus Assumption ....................................................................................................................... 28
 ii Contents

When does Ceteris Paribus apply? .................................................................................................................. 28

2.1.6 What Factors affect Demand? ............................................................................................................................ 29
2.1.7 Factors that shift Demand Curves .................................................................................................................... 29
Changing Tastes or Preferences ....................................................................................................................... 29
Changes in the Composition of the Population .......................................................................................... 30
Demand for Substitute Goods ........................................................................................................................... 30
Demand for Complement Goods ..................................................................................................................... 30
Changes in Expectations about Future Prices .............................................................................................. 30
2.1.8 Demand vs Quantity Demanded ...................................................................................................................... 31
2.2 Supply of Goods and Services ...................................................................................................................................... 32
2.2.1 Factors that affect Supply .................................................................................................................................... 32
Production Costs .................................................................................................................................................... 32
Other Factors that affect Supply ....................................................................................................................... 33
Summing Up Factors that Change Supply .................................................................................................... 33
2.3 Equilibrium — where Demand and Supply Intersect ...........................................................................................34
Focus: 2016 Scarcity: Minimum Wage can’t Buy a Bag of rice ................................................................................. 35
Session Review .......................................................................................................................................................................... 36
Assessment ................................................................................................................................................................................. 37
Resources .................................................................................................................................................................................... 37

Study Session 3 ........................................................................................................... 39

Elasticity of Demand and Supply .............................................................................. 39
Introduction ...............................................................................................................................................................................40
Session Preview.........................................................................................................................................................................40
3.1 Price Elasticities of Demand and Supply ...................................................................................................................42
3.2 Cases of Elasticity ..............................................................................................................................................................43
3.2.1 Infinite Elasticity or Perfect Elasticity ................................................................................................................43
3.2.2 Zero Elasticity or Perfect Inelasticity ................................................................................................................44
3.2.3 Constant Unitary Elasticity ..................................................................................................................................45
3.3 Elasticity and Pricing ........................................................................................................................................................46
Focus: Does raising Price bring in more Revenue? ......................................................................................................46
Can Costs be passed on to Consumers? .......................................................................................................48
Session Review ..........................................................................................................................................................................48
Assessment .................................................................................................................................................................................49
Resources ....................................................................................................................................................................................49

Study Session 4 ........................................................................................................... 51

Consumer Behaviour ...................................................................................................... 51
Introduction ............................................................................................................................................................................... 51
Session Preview......................................................................................................................................................................... 52
4.1 The Concept of Utility ...................................................................................................................................................... 53
4.1.1 Cardinal Utility Approach ..................................................................................................................................... 53
4.1.2 Ordinal Utility Approach ...................................................................................................................................... 53
4.2 Diminishing Marginal Rate of Substitution ..............................................................................................................54
4.3 Indifference Curves ..........................................................................................................................................................54
4.3.1 Properties of Indifferent Curves ........................................................................................................................ 55
Focus: Nigerian Consumers have Appetite for Unique, Quality Products ........................................................... 56
4.4 Total Utility and Marginal Utility .................................................................................................................................. 57
4.4.1 Marginal Decision-Making and Diminishing Marginal Utility ................................................................. 59
 4.4.2 A Rule for Maximizing Utility ............................................................................................................................. 60
Session Review .......................................................................................................................................................................... 60
Assessment ................................................................................................................................................................................. 61
Resources .................................................................................................................................................................................... 61

Study Session 5 ........................................................................................................... 63

Production Theory .......................................................................................................... 63
Introduction ............................................................................................................................................................................... 63
Session Preview.........................................................................................................................................................................64
5.1 What is Production?.......................................................................................................................................................... 65
5.1.1 Purpose of Production .......................................................................................................................................... 65
5.1.2 Types of Production .............................................................................................................................................. 66
Direct Production ................................................................................................................................................... 66
Indirect Production ................................................................................................................................................ 66
Primary Production .......................................................................................................................................... 66
Secondary Production ..................................................................................................................................... 67
Tertiary Production........................................................................................................................................... 67
5.2 Types of Goods .................................................................................................................................................................. 67
5.2.1 Consumer Goods ......................................................................................................................................... 67
5.2.2 Capital Goods ............................................................................................................................................... 67
5.3 Factors of Production ...................................................................................................................................................... 68
5.3.1 Land ............................................................................................................................................................................ 68
5.3.2 Labour........................................................................................................................................................................ 69
5.3.3 Capital ........................................................................................................................................................................ 69
5.3.4 Entrepreneur ........................................................................................................................................................... 70
Focus: Availability of Factors of Production: Land ........................................................................................................ 70
5.4 Production Function ........................................................................................................................................................ 72
5.5 Total Product (TP), Average Product (AP) and Marginal Product (MP) ......................................................... 72
5.5.1 Total Product ........................................................................................................................................................... 72
5.5.2 Average Product (AP) ........................................................................................................................................... 73
5.5.3 Marginal Cost .......................................................................................................................................................... 73
5.5.4 Marginal Product Curve for Labour ................................................................................................................ 74
5.6 The Law of Diminishing Returns in Production ...................................................................................................... 76
5.6.1 Return to Scale ........................................................................................................................................................ 76
Session Review .......................................................................................................................................................................... 77
Assessment ................................................................................................................................................................................. 78
Resources .................................................................................................................................................................................... 78

Study Session 6 ........................................................................................................... 79

Cost Theory ........................................................................................................................ 79
Introduction ............................................................................................................................................................................... 79
Study Session Preview ............................................................................................................................................................ 80
6.1 What is Cost of Production? .......................................................................................................................................... 81
6.1.1 Explicit Cost ............................................................................................................................................................... 81
6.1.2 Implicit Cost .............................................................................................................................................................. 82
Focus: Aircraft Harmonization to Reduce Effect of Rising Operational Cost ...................................................... 82
6.2 Time Horizon and Production Cost ............................................................................................................................ 83
6.2.1 The Short Run .......................................................................................................................................................... 83
6.2.2 The Long Run .......................................................................................................................................................... 83
6.2.3 Some Concepts of Cost .......................................................................................................................................84
 iv Contents

Total Fixed Cost (TFC) ...........................................................................................................................................84

Total Variable Cost (TVC) ....................................................................................................................................84
Total Cost (TC) .........................................................................................................................................................84
Average Total Cost (ATC) ....................................................................................................................................84
Average Fixed Cost (AFC) .................................................................................................................................... 85
Average Variable Cost (AVC) ............................................................................................................................. 85
Marginal Cost (MC) ............................................................................................................................................... 85
Long Run Average Cost Curves ........................................................................................................................ 87
6.2.4 Convergence Point of Marginal and Average Costs ................................................................................. 87
Session Review .......................................................................................................................................................................... 88
Assessment ................................................................................................................................................................................. 89
Resources .................................................................................................................................................................................... 89

Study Session 7 ........................................................................................................... 91

Introduction to Perfect Competition ....................................................................... 91
Introduction ............................................................................................................................................................................... 91
Study Session Preview ............................................................................................................................................................ 92
7.1 Perfect Competition and Why It Matters .................................................................................................................. 93
Focus: The Advantages of Competition in Nigeria – Telecommunication Industry .........................................94
7.2 How Perfectly Competitive Firms make Output Decisions ................................................................................. 95
Determining the Highest Profit by Comparing Total Revenue and Total Cost .......................................... 95
Comparing Marginal Revenue and Marginal Costs ............................................................................................. 96
Profits and Losses with the Average Cost Curve ................................................................................................... 97
The Shutdown Point .............................................................................................................................................. 98
Short-Run Outcomes for Perfectly Competitive Firms .............................................................................. 99
Marginal Cost and the Firm’s Supply Curve ............................................................................................... 100
Efficiency in Perfectly Competitive Markets ............................................................................................ 101
Session Review ........................................................................................................................................................................ 103
Assessment ............................................................................................................................................................................... 103
Resources .................................................................................................................................................................................. 104

Study Session 8 .........................................................................................................105

Introduction to Monopoly ........................................................................................ 105
Introduction ............................................................................................................................................................................. 105
Study Session Preview .......................................................................................................................................................... 106
8.1 How Monopolies Form .................................................................................................................................................. 107
8.1.1 Natural Monopoly................................................................................................................................................. 108
8.1.2 Legal Monopoly .................................................................................................................................................... 109
Promoting Innovation ........................................................................................................................................ 109
A trademark ...................................................................................................................................................... 109
8.1.3 Intimidating Potential Competition ................................................................................................................. 111
Summing Up Barriers to Entry .................................................................................................................................... 112
8.2 How a Profit-Maximizing Monopoly Chooses Output and Price .................................................................... 112
8.2.1 Demand Curves Perceived by a Perfectly Competitive Firm and by a Monopoly .......................... 112
8.2.2 What defines a Market........................................................................................................................................ 113
8.2.3 Marginal Revenue and Marginal Cost for a Monopolist ......................................................................... 115
Focus: Dangote gets Concessions for Cement Production ...................................................................................... 116
8.2.4 Maximizing Profits ................................................................................................................................................ 116
8.2.5 The Inefficiency of Monopoly ........................................................................................................................... 117
 8.2.6 Allocative Efficiency .............................................................................................................................................. 117
8.2.7 Production Possibility Frontier ......................................................................................................................... 118
Session Review ......................................................................................................................................................................... 119
Assessment ................................................................................................................................................................................ 119
Resources .................................................................................................................................................................................. 120

Study Session 9 .........................................................................................................121

Introduction to Monopolistic Competition ....................................................... 121
Introduction .............................................................................................................................................................................. 121
9.1 Monopolistic Competition ............................................................................................................................................ 122
9.1.1 Differentiated Products ....................................................................................................................................... 123
Focus: Coke Vs Pepsi ............................................................................................................................................................ 123
9.1.2 Perceived Demand for a Monopolistic Competitor ................................................................................. 124
9.2 Monopolistic Competition and Efficiency ............................................................................................................... 126
9.2.1 The Benefits of Variety and Product Differentiation ................................................................................ 126
9.3 How a Monopolistic Competitor determines how Much to Produce and at What Price ...................... 127
9.3.1 Monopolistic Competitors and Entry ............................................................................................................ 129
Session Review ........................................................................................................................................................................ 130
Assessment ............................................................................................................................................................................... 130
Resources ................................................................................................................................................................................... 131

Study Session 10 .......................................................................................................132

Introduction to Oligopoly ......................................................................................... 132
Introduction ............................................................................................................................................................................. 132
Study Session Preview .......................................................................................................................................................... 133
10.1 Why do Oligopolies Exist ............................................................................................................................................ 133
10.2 Collusion or Competition? ......................................................................................................................................... 134
10.2.1 Collusion versus Cartels .................................................................................................................................... 135
Focus: Oligopoly in Nigerian Banking Sector ............................................................................................................... 136
10.3 The Prisoner’s Dilemma .............................................................................................................................................. 137
10.3.1 How to Enforce Cooperation .......................................................................................................................... 138
10.3.2 Oligopoly Version of the Prisoner’s Dilemma .......................................................................................... 139
Session Review ........................................................................................................................................................................ 140
Assessment ................................................................................................................................................................................141
Resources ...................................................................................................................................................................................141
Feedback to SAQs ........................................................................................................ 142
Glossary of Terms ......................................................................................................... 146
 CC201 Introduction to Microeconomics

About this Course Manual

Introduction to Microeconomics CC201 is provided to you by MAUTECH-CDL, AS IS.
Module is mixed, and some selected modules are attributed to Libby Rittenberg and
Tim Tregarthen. It is localised and adapted to ODL format under the Academic
Collective.

How this Course Manual is

structured
Course overview
The course overview gives you a general introduction to the course. Information
contained in the course overview will help you determine:
 If the course is suitable for you.
 What you can expect from the course.
 How much time you will need to invest to complete the course.
 Where to get help.
 Course assessments.

We strongly recommend that you read the overview carefully before

starting your study.

The course content

The course is broken down into Study Sessions. Each Study Session comprises:
 An introduction to the Study Session content.
 Learning outcomes.
 Study Session preview.
 New terminology.
 Structured content of the study session with a variety of focus articles, learning
activities and learning devices.
 A Study Session review.
 Self-Assessments.
 Resources for further studying.

1
 About this Course Manual

Your comments
After completing Introduction to Microeconomics we would appreciate it if you would
take a few moments to give us your feedback on any aspect of this course. Your
feedback might include comments on:

 Course content and structure.

 Course reading materials and resources.

 Course assessments.

 Course duration.

Your constructive feedback will help us to improve and enhance this course.

2
 CC201 Introduction to Microeconomics

Course overview
Welcome to Introduction to
Microeconomics CC201
This course is designed to help you build an understanding of the economics of the
market place. Focus is on microeconomic principles that demonstrate the role and
limitations of both competitive and imperfectly competitive markets in motivating
socially efficient consumer, business, and public sector choices.
This course manual supplements and complements a blend of resources & platforms:
CC201 Audiobook – available via Audio Resources Library app on your official
mobile device and accessible online at: www.arlibrary.cdl.mautech.edu.ng.
CC201 Courseware – available in your course pack as a disk, it is also downloadable
from your course website: www.cdl.mautech.edu.ng/schoolboard.
Schoolboard –offers a multi-channel platform for you to discuss with content experts
and other learners from across the nation and the globe at large. You may also use the
platform to enrich your learning with engaging webinars, articulate presentations, smart
puzzles, audiobooks, podcasts, interactive glossaries, smart quizzes, case studies and
discussions. Schoolboard comes with updates and is accessible on web and on app. It is
also linkable from your course CD.

Introduction to Microeconomics
CC201—is this course for you?
This course is for you if you are willing to learn ways to think about how humans
allocate resources, determine prices. You capture in this course: consumer and producer
behaviour, how market works, risk and cost measurement. Use this knowledge for
further study in economics, or apply it to your everyday business dealings to make more
effective decisions.
You will need comprehension and arithmetic skills for this course.

CC101 is a prerequisite to this course.

CC201 is a 2 unit course, and a requirement for CC301.

3
 Course overview

Course outcomes
Upon completion of Introduction to Microeconomics CC201, you will be able to:

 fluent in the concepts of microeconomics

 present how consumers and producers interact in the marketplace
Outcomes  point out how demand and supply jointly determine market prices in
Outcomes equilibrium
 show how government policies affect markets
 estimate the government revenue raised by taxes, and the costs these
fees place on society
 explain the effects of government in remedying various market failures
 describe how firms make decisions in the short, and long-run, and how
to measure profits and quantities of goods produced

Study Skills
Being a self-learner has become increasingly feasible due to Open and Distance
Learning (ODL) Systems. Studying a course or obtaining a certificate for career
advancement can occur from the comfort of your home, on your own time, and at your
own pace.
You can be a successful higher education student by self learning, it isn't magic! But it
does require desire, dedication and a lot of work. Active listening to your audiobook,
desktop publishing on your laptops, reading comprehension in your course manual,
notetaking in the white margins, stress management, time management, assessment
taking, and memorization are study skills required for a self learner.
If you really want to learn how to become a successful student, then you should explore
the links that follow:
 http://www.oercommons.org/courses/communication-skills-study-skills-pdf/view
 http://www.edutechportal.org/resources/studyskills/

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 CC201 Introduction to Microeconomics

Timeframe
This is a 15 week course. It requires a formal study time of 12 hours. We
recommend you take an average of one to two hours for an extra personal study on
each Study Session. You can also benefit from online discussions with your course
tutor.

Need help?
You may contact via any of the following channels for information, learning
resources and library services.
CDL Student Support Desk
Tel: (+234) 703 355 2537
Email: [email protected]

For technical issues (computer problems, web access, and etcetera), please visit:
www.cdl.mautech.edu.ng/support; or send mail to [email protected].

Academic Support
A course facilitator is commissioned for this course. You have also been assigned
an academic tutor to provide learning support. See contacts of your course
facilitator and academic advisor at the course website:
www.cdl.mautech.edu.ng/schoolboard

Assessments
Generally, there are two types of assessment: formative assessment and summative
assessment. With regards to your formative assessment, there are three basic forms
of assessment in the course: in-text questions (SELF-CHECKs), self-assessment
questions (SAQs), and tutor marked assessment (TMAs). This manual provides you
with SELF-CHECKs and SAQs. Feedbacks to the SELF-CHECKs are placed
immediately after the questions, while the feedbacks to SAQs are at the rear of
manual.
You will receive your TMAs as assignments at the MAUTECH schoolboard
platform. These assignments will constitute 30 percent of your course marks.
Feedbacks to TMAs will be provided by your tutor in not more than 2 weeks after
entries.

5
 Course overview

Your summative assessment is your final examination. CC201 exam is in multiple

choice / essay format; and it carries 70 percent of your total earning in the course.

Schedule dates for submitting assignments and engaging in course activities is

available on the course website.

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 CC201 Introduction to Microeconomics

List of Figures
Figure 1.1 Nigerian currency – Naira ( )9
Figure 1.2 Street children sleeping on a street in Addis Ababa, Ethiopia 2007 11
Figure 1.4 Circular flow diagram 15
Figure 1.4 Fuelling station, Total Nigeria 19
Figure 2.1: Demand curve for tomatoes Error! Bookmark not defined.
Figure 2.2: Telephones in vogue 29
Figure 2.3a: Factors that increase demand 31
Figure 2.3b Factors that decrease demand 31
Figure 2.4a: Factors that increase supply 34
Figure 2.4b: Factors that decrease supply 34
Figure 2.5: Equilibrium point 35
Figure 3.1a: Perfectly elastic demand curve 44
Figure 3.1b: Perfectly elastic supply curve 44
Figure 3.2a: Perfectly inelastic demand curve 45
Figure 3.2b: Perfectly inelastic supply curve 45
Figure 3.3: Constant unitary elasticity graph 45
Figure 4.1: Indifference curve 55
Figure 4.2: Choice between Consumption Goods 57
Figure 5.1: Indirect production process 66
Figure 5.2: Mambila Plateau, Nigeria 70
Figure 5.2: Total product curve 72
Figure 5.3: Average product curve 73
Figure 5.4: Marginal Product Curve 73
Figure 5.5: Combined graphs of total, average and marginal products 74
Figure 6.1: Air Nigeria 82
Figure 6.1: Short run marginal and average cost curves 86
Figure 6.2 The U shape of LAC curve 87
Figure 7.1: Profit and loss curves 97
Figure 7.2 Profit, loss, shutdown 100
Figure 8.1: Legal monopoly curve 109
Figure 8.2: Perceived demand curve for a perfect competitor and a monopolist 113
Figure 8.3: Total Revenue and Total Cost for the Healthplus monopoly 114
Figure 8.5: Production Possibility Frontier 119
Figure 9.1: Air Nigeria 123
Figure 9.1 Perceived demand for firms in monopolistic competition 124
Figure 10.1: 2004/05 Bank merger in Nigeria 136

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 Course overview

List of Tables
Table 1.1 Extent of globalization (exports/GDP) 18
Table 2.1: A Demand Schedule for Tomatoes 26
Table 3.1 Elastic, Inelastic, and Unitary: Three Cases of Elasticity 42
Table 3.2 Selected Elasticity of Demand 46
Table 4.1: Total Utility of T-shirt and Movie 57
Table 4.2 Finding the choice with highest utility 58
Table 5.1: Total product, Average product and Marginal product Schedules 74
Table 5.2: Diminishing return on cowpea production 76
Table 6.1: Total, Average and Marginal Cost 86
Table 7.1 How a firm makes profits and losses 98
Table 8.1 Barriers to Entry 112
Table 8.2 Total Costs and Total Revenues of HealthPill 114
Table 8.3: Marginal revenue, Marginal cost, Marginal profit and total profit 117
Table 10.1 The Prisoner’s Dilemma Problem 138
Table 10.2 A Prisoner’s Dilemma for Oligopolists 139

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CC201 Introduction to Microeconomics

Study Session 1

Is your entire money able to buy all you want? Is your time (24 hours per day) sufficient
for you to do everything you wanted? Do you say no, that they aren’t sufficient? Yes,
resources to do everything is scare. Scarcity is the central theme of economics. We will
therefore commence our study in this course with a discussion on the problem of scarcity.
We will also examine division of labour, trades and markets, and use of theory in
economics.

Learning Outcomes
When you have studied this session, you should be able to:
the problem of scarcity
economic theory and model
between traditional, command and market economy

9
 Study Session 1 Basic Issues in Economics

Basic Issues in
Economics
Human wants and
scarcity
How individuals
Problem of scarcity
make choices
Choice in a world of
scarcity
Use of theories and Concept of
models opportunity cost

Organisation of
economies

Globalisation and
Regulations
national economies

This Study Session requires a one hour of formal study time. You may spend an
additional two hours for revision.

Terminologies

Economics is the study of how humans make decisions regarding their wants in the face
of scarcity. Human wants for goods, services and resources exceed what is available.

10
CC201 Introduction to Microeconomics

Resources, such as labour, tools, land, and raw materials are necessary to produce the
goods and services we want but they exist in limited supply. For instance, a scarce
resource is time- everyone, rich or poor, has just 24 hours in the day to try to acquire the
goods they want. At any point in time, there is only a finite amount of resources
available. Also, there are so many crucial but limited resource. Because these resources
are limited, so are the numbers of goods and services we produce with them. Combine
this with the fact that human wants seem to be virtually infinite, and you can see why
scarcity is a problem. Thus, it becomes imperative, that there are individual decisions,
family decisions, business decisions or societal decisions concerning the choice / use of
scarce resources.
If you still do not believe that scarcity is a problem, consider the following: Does
everyone need food to eat? Does everyone need a decent place to live? Does everyone
have access to healthcare? In every country in the world, there are people who are
hungry, homeless and in need of healthcare, just to focus on a few critical goods and
services. Why is this the case? It is because of scarcity. Let’s delve into the concept of
scarcity a little deeper, because it is crucial to understanding economics.

Think about all the things you consume: food, shelter, clothing, transportation,
healthcare, and entertainment. How do you acquire those items? You do not produce
them yourself. You buy them. How do you afford the things you buy? You work for pay.
Or if you do not, someone else does on your behalf. Yet most of us never have enough to
buy all the things we want. This is because of scarcity. So how do we solve it?
Every society, at every level, must make choices about how to use its resources. Families
must decide whether to spend their money on a new car or a fancy vacation. Towns must
choose whether to put more of the budget into police and fire protection or into the
school system. Nations must decide whether to devote more funds to national defence or
to protecting the environment. In most cases, there just isn’t enough money in the budget
to do everything. So why do we not each just produce all of the things we consume? The
simple answer is most of us do not know how, but that is not the main reason. (When you
study economics, you will discover that the obvious choice is not always the right

11
 Study Session 1 Basic Issues in Economics

answer—or at least the complete answer. Studying economics teaches you to think in a
different of way.) Think back to pioneer days, when individuals knew how to do so much
more than we do today, from building their homes, to growing their crops, to hunting for
food, to repairing their equipment. Most of us do not know how to do all—or any—of
those things. It is not because we could not learn. Rather, we do not have to. The reason
why something is called the division and specialization of labour, a production
innovation first put forth by Adam Smith.

You will learn quickly when you examine the relationship between economics and
scarcity that choices involve tradeoffs. Every choice has a cost.
English economist Lionel Robbins (1898–1984), in his Essay on the Nature and
Significance of Economic Science in 1932, described not always getting what you want
in this way:

The time at our disposal is limited. There are only twenty-four hours in
the day. We have to choose between the different uses to which they
may be put. ... Everywhere we turn, if we choose one thing we must
relinquish others which, in different circumstances, we would wish not
to have relinquished.

Scarcity of means to satisfy given ends is an almost ubiquitous condition of human

nature. Because people live in a world of scarcity, they cannot have all the time, money,
possessions, and experiences they wish. Neither can society.

Consider the typical consumer’s budget problem. Consumers have a limited amount of
income to spend on the things they need and want. Suppose Danladi has N1000 in
spending money each week that he can allocate between bus tickets for getting to work
and the meal that he eats for lunch. Meal cost N200 each, and bus tickets are N50 each.
Figure 1.3 shows Danladi’s budget constraint, that is, the outer boundary of his
opportunity set. The opportunity set identifies all the opportunities for spending within

12
CC201 Introduction to Microeconomics

his budget. The budget constraint indicates all the combinations of meals and bus tickets
Danladi can afford when he exhausts his budget, given the prices of the two goods.
Budget – N1000 Meal – N200 Bus tickets – N50

5
4

Meal
3
2
1
0
0 4 8 12 16 20
Bus Ticket

The vertical axis in the figure shows meal purchases and the horizontal axis shows bus
ticket purchases. If Danladi spends all his money on meal, he can afford five per week.
(N1000 per week/N200 per meal = 5 meals per week.) But if he does this, he will not be
able to afford any bus tickets. This choice (zero bus tickets and five meals) is shown by
point A in the figure. Alternatively, if Danladi spends all his money on bus tickets, he can
afford 20 per week. (N1000 per week/N50 per bus ticket = 20 bus tickets per week.)
Then, however, he will not be able to afford any meals. This alternative choice (20 bus
tickets and zero meals) is shown by point F.
If Danladi is like most people, he will choose some combination that includes both bus
tickets and meals. That is, he will choose some combination on the budget constraint that
connects points A and F. Every point on (or inside) the constraint shows a combination
of meals and bus tickets that Danladi can afford. Any point outside the constraint is not
affordable, because it would cost more money than Danladi has in his budget.
The budget constraint clearly shows the tradeoff Danladi faces in choosing between
meals and bus tickets. Suppose he is currently at point D, where he can afford 12 bus
tickets and two meals. What would it cost Danladi for one more meal? It would be
natural to answer N200, but that’s not the way economists think. Instead they ask, how
many bus tickets would Danladi have to give up to get one more meal, while staying
within his budget? The answer is four bus tickets. That is the true cost to Danladi of one
more meal.

See Appendix 1.1, linked here on how to construct Budget Constraint Graph

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 Study Session 1 Basic Issues in Economics

Economists use the term opportunity cost to indicate what must be given up to obtain
something that is desired.

Economists see the world through a different lens than anthropologists, biologists,
classicists, or practitioners of any other discipline. They analyse issues and problems
with economic theories that are based on particular assumptions about human behaviour
that are different than the assumptions an anthropologist or psychologist might use. A
theory is a simplified representation of how two or more variables interact with each
other. The purpose of a theory is to take a complex, real-world issue and simplify it down
to its essentials. If done well, this enables the analyst to understand the issue and any
problems around it. A good theory is simple enough to be understood, while complex
enough to capture the key features of the object or situation being studied. Sometimes
economists use the term model instead of theory. Strictly speaking,

a theory is a more abstract representation, while a model is more applied or

empirical representation. Models are used to test theories, but for this course
we will use the terms interchangeably.

A good model to start with in economics is the circular flow diagram, which is shown in
Figure 1.4. It pictures the economy as consisting of two groups—households and firms—
that interact in two markets: the goods and services market in which firms sell and
households buy and the labour market in which households sell labour to business firms
or other employees.

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CC201 Introduction to Microeconomics

The circular flow diagram shows how households and firms interact in the goods and
services market, and in the labour market. The direction of the arrows shows that in the
goods and services market, households receive goods and services and pay firms for
them. In the labour market, households provide labour and receive payment from firms
through wages, salaries, and benefits. Of course, in the real world, there are many
different markets for goods and services and markets for many different types of labour.
The circular flow diagram simplifies this to make the picture easier to grasp. In the
diagram, firms produce goods and services, which they sell to households in return for
revenues.
This is shown in the outer circle, and represents the two sides of the product market (for
example, the market for goods and services) in which households demand and firms
supply. Households sell their labour as workers to firms in return for wages, salaries and
benefits. This is shown in the inner circle and represents the two sides of the labour
market in which households supply and firms demand.

This version of the circular flow model is stripped down to the essentials, but it has
enough features to explain how the product and labour markets work in the economy. We
could easily add details to this basic model if we wanted to introduce more real-world
elements, like financial markets, governments, and interactions with the rest of the globe
(imports and exports). Economists carry a set of theories in their heads like a carpenter
carries around a toolkit. When they see an economic issue or problem, they go through
the theo6ries they know to see if they can find one that fits. Then they use the theory to

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 Study Session 1 Basic Issues in Economics

derive insights about the issue or problem. In economics, theories are expressed as
diagrams, graphs, or even as mathematical equations. Economists do not figure out the
answer to the problem first and then draw the graph to illustrate. Rather, they use the
graph of the theory to help them figure out the answer. Although at the introductory
level, you can sometimes figure out the right answer without applying a model, if you
keep studying economics, before too long you will run into issues and problems that you
will need to graph to solve. Both micro and macroeconomics are explained in terms of
theories and models. The most well-known theories are probably those of supply and
demand, but you will learn a number of others.

Think about what a complex system a modern economy is. It includes all production of
goods and services, all buying and selling, all employment. The economic life of every
individual is interrelated, at least to a small extent, with the economic lives of thousands
or even millions of other individuals. Who organizes and coordinates this system? Who
insures that, for example, the number of televisions a society provides is the same as the
amount it needs and wants? Who insures that the right number of employees work in the
electronics industry? Who insures that televisions are produced in the best way possible?
How does it all get done? There are at least three ways societies have found to organize
an economy.

The first is the traditional economy , which is the oldest economic system and can be
found in parts of Asia, Africa, and South America. Traditional economies organize their
economic affairs the way they have always done (i.e., tradition). Occupations stay in the
family. Most families are farmers who grow the crops they have always grown using
traditional methods. What you produce is what you get to consume. Because things are
driven by tradition, there is little economic progress or development.

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CC201 Introduction to Microeconomics

Command economies are very different. In a command economy, economic effort is

devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good
example: a large part of economic life was devoted to building pyramids. Medieval
manor life is another example: the lord provided the land for growing crops and
protection in the event of war. In return, vassals provided labour and soldiers to do the
lord’s bidding. In the last century, communism emphasized command economies. In a
command economy, the government decides what goods and services will be produced
and what prices will be charged for them. The government decides what methods of
production will be used and how much workers will be paid. Many necessities like
healthcare and education are provided for free. Currently, Cuba and North Korea have
command economies.

Although command economies have a very centralized structure for economic decisions,
market economies have a much decentralized structure. A market is an institution that
brings together buyers and sellers of goods or services, who may be either individuals or
businesses. In a market economy, decision making is decentralized. Market economies
are based on private enterprise: the means of production (resources and businesses) are
owned and operated by private individuals or groups of private individuals. Businesses
supply goods and services based on demand. (In a command economy, by contrast,
resources and businesses are owned by the government.) What goods and services are
supplied depends on what is demanded. A person’s income is based on his or her ability
to convert resources (especially labour) into something that society values. The more
society values the person’s output, the higher the income. Most economies in the real
world are mixed; they combine elements of command and market (and even traditional)
systems.
While primarily market-oriented economies have a greater degree of government
involvement in economic decisions than does the U.S. economy. China and Russia, while
they are closer to having a market-oriented system now than several decades ago, remain
closer to the command economy end of the spectrum.

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 Study Session 1 Basic Issues in Economics

Recent decades have seen a trend toward globalisation , which is the expanding cultural,
political, and economic connections between people around the world. One measure of
this is the increased buying and selling of goods, services, and assets across national
borders—in other words, international trade and financial capital flows. Globalization
has occurred for a number of reasons. Improvements in shipping and air cargo have
driven down transportation costs. Innovations in computing and telecommunications
have made it easier and cheaper to manage long-distance economic connections of
production and sales. Many valuable products and services in the modern economy can
take the form of information—for example: computer software; financial advice; travel
planning; music, books and movies. These products and many others can be transported
over telephones and computer networks at ever-lower costs. Finally, international
agreements and treaties between countries have encouraged greater trade.
Table 1.1 presents one measure of globalization. It shows the percentage of domestic
economic production that was exported for a selection of countries from 2010 to 2013,
according to an entity known as The World Bank. Exports are the goods and services
that are produced domestically and sold abroad. Imports are the goods and services that
are produced abroad and then sold domestically. The size of total production in an
economy is measured by the gross domestic product (GDP). Thus, the ratio of exports
divided by GDP measures what share of a country’s total economic production is sold in
other countries. Smaller economies like Nigeria, Ghana, and some other African
countries need to trade across their borders with other countries to take full advantage of
division of labour, specialization, and economies of scale.

Country 2010 2011 2012 2013

Higher Income Countries
United States 12.4 13.6 13.6 13.5
Belgium 76.2 81.4 82.2 82.8
Canada 29.1 30.7 30.0 30.1
France 26.0 27.8 28.1 28.3
Middle Income Countries
Brazil 10.9 11.9 12.6 12.6
Mexico 29.9 31.2 32.6 31.7
South Korea 49.4 55.7 56.3 53.9
Lower Income Countries
Chad 36.8 38.9 36.9 32.2
China 29.4 28.5 27.3 26.4
India 22.0 23.9 24.0 24.8
Nigeria 25.3 31.3 31.4 18.0
http://databank.worldbank.org/data/

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CC201 Introduction to Microeconomics

Table 1.1 also shows that many medium and low income countries around the world, like
Mexico and China, have also experienced a surge of globalization in recent decades.

Markets and government regulations are always entangled. There is no such thing as an
absolutely free market. Regulations always define the “rules of the game” in the
economy. Let’s take a practical view in the focus that follows.

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 Study Session 1 Basic Issues in Economics

1.1 Explain the problem of scarcity 1.2 Use economic theory and
Scarcity means that people want more than is model
available. Scarcity limits us both as individuals The main tools economists use are economic
and as a society. As individuals, limited income theories or models. A theory is not an
(and time and ability) keep us from doing and illustration of the answer to a problem. Rather,
having all that we might like. As a society, a theory is a tool for determining the answer,
limited resources (such as manpower, machinery, and model is a framework.
and natural resources) fix a maximum on the
1.3 Differentiate between
amount of goods and services that can be traditional, command and
produced. market economy
Scarcity requires choice. People must choose Societies can be organized as traditional,
which of their desires they will satisfy and which command, or market-oriented
they will leave unsatisfied. When we, either as economies. Most societies are a mix.
individuals or as a society, choose more of Notably, globalization evolve as a result
something, scarcity forces us to take less of of growth in commercial and financial
something else. networks that cross national borders,
making businesses and workers from

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CC201 Introduction to Microeconomics

When there is scarcity and choice, there are different economies increasingly
costs. The cost of any choice is the option or interdependent.
options that a person gives up.

SAQ 1.1 (tests Learning Outcome 1.1)

After you gained admission, your parents and, probably, your extended family members would have asked you to
make a list of what you will require in school. When you did so, were they able to provide everything you wrote?
Even if they wished to, the resources needed, in terms of cash or otherwise, might not be readily available, what
economics term best describes this shortage in means of providing your request?
SAQ 1.2 (tests Learning Outcome 1.2)
Assuming after school, Useni and Okon decides to work on yam plantation in order to have extra income. However,
whenever they get to the farm, they will both dig the ground and pull the yams out together. At the end of each day,
they were able to harvest 50 tubers of yams and they were very happy with their achievements. One day, an elderly
man advised them to separate their work. He advised Useni to be digging the ground while Okon should be pulling
out the yams. After applying the old man’s method, they were surprised to record a harvest of 200 tubers of yam.
What would you as an economist call the old man’s method? Give reasons for your answer.
SAQ 1.3 (tests Learning Outcome 1.3)
There are basically three ways of organizing the economy of any country. First is traditional economy which is how
people organize the economy in the olden days. The second is the command economy where the government makes
all the decisions in the market. In your own work, describe the third way of organizing the economy.

Articulate Presentation
This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

21
 CC201 Introduction to Microeconomics

Study Session 2

@CRM-Supermarket | How many bottles of drinks can you buy for your
next birthday? And how much really, are the producers of these drinks (i.e. goods) willing to bring to the
market and at what price?

In this study session, you will explore the issues surrounding demand and supply of
goods and services. You will also come across what economist refers to as ceteris
paribus, which means “all things being equal”.

Learning Outcomes
When you have studied this session, you should be able to:
2.1 and the terms in bold:
 demand schedule
 demand curve
 changes in demand
2.2 supply, supply curve and changes in supply
2.3 equilibrium point

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 Study Session 2 Demand and Supply

Defining demand

Demand and Supply

Demand schedule

Demand curve

Law of demand
Demand of goods
and services
Ceteris Paribus

Factors affecting
demand

Factors shifting
demand curve

Demand vs
Quantity demanded

Supply of goods Factors affecting

and services supply

Equilibrium

This Study Session requires a two hour of formal study time. You may spend an
additional two hours for revision.

Terminologies

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CC201 Introduction to Microeconomics

When economists talk about prices , they are not interested in making judgments but
they try to find a practical understanding of what determines prices and why prices
change. Consider a price most of us contend with daily: that of a litter of petrol. Why is
the average price of petrol in the Nigerian market about N90 per litre in June 2015?
Why did the price for petrol raise sharply to about N180 per litre by January 2016? To
explain these price movements, economists focus on the determinants of what petrol
buyers are willing to pay and what petrol sellers are willing to accept.
The concepts of demand and supply is very important in economic theory, it is so
important that it is being asserted that most of the economic problems we encounter
everyday can be explained by a careful examination of the demand for and supply of
goods and services.

Economists use the term demand to refer to the amount of some good or service
consumers are willing and able to purchase at each price. Demand is based on needs and
wants—a consumer may be able to differentiate between a need and a want, but from an
economist’s perspective they are the same thing. Demand is also based on ability to pay.
If you cannot pay for it, you have no effective demand. What a buyer pays for a unit of
the specific good or service is called price. The total number of units purchased at that
price is called the quantity demanded . A rise in price of a good or service almost
always decreases the quantity demanded of that good or service. Conversely, a fall in
price will increase the quantity demanded. When the price of a litre of petrol goes up,
for example, people look for ways to reduce their consumption by combining several
errands, commuting by Taxis or mass transit, or taking weekend or vacation trips closer
to home. Economists call this inverse relationship between price and quantity demanded
the law of demand. The law of demand assumes that all other variables that affect
demand are held constant. Demand therefore is defined as the quantity of a commodity
that a consumer is willing to buy at a given price and at a particular period of time.

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 Study Session 2 Demand and Supply

When a consumer’s demand is backed up by ability and willingness to pay for the
goods, it is called effective demand and this can be differentiated from mere wants or
desires which is the case when the demand is not backed up with money.

A demand schedule is a table which shows the different magnitudes of a commodity

being demanded for at various levels of prices. In other words, it indicates different
quantities of a commodity which will be bought at various prices, at a particular time.
For instance, given an individual demand function for tomatoes as Qdt = 24 – 2pt.
(When Qdt = quantity demand for t (tomatoes); Pt = Price of commodity t). Various
prices of commodity that can be substituted into the demand function to arrive at the
individuals demand schedule is as shown below:

Price of Tomatoes per Quantity Demanded per week

kg (Qdm) ( N1000)

70 2

65 4
62 6
58 10
55 14
50 18
45 20
From the above demand schedule, we can see the quantity demand for tomatoes at
various prices. This is however with the assumption that all other factors influencing
demand are kept constant. As the price of tomatoes falls, the individual demand for
tomato goes up.

A demand curve is the graphical representation of the relationship between the quantity
demanded of a commodity and its prices. For example, the above individual demand
schedule can be translated into a demand curve by plotting Pm against Qdm.
Demand curve shows the aggregate
demand in a curve. It should be noted
that market demand is the most
important to the producers because
they are interested more in the total
demand for their products.

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CC201 Introduction to Microeconomics

The graphical representation of demand shows that the curve slopes downwards from
left to right, i.e. it has a negative slope, this illustrates the law of demand which states
that “the higher the price, the lower the quantity demanded and the lower the price, the
higher the quantity demanded of a commodity’. The law however holds on the
assumption that all other factors remain constant (ceteris paribus). This law implies that
consumers purchase more of a commodity at a lower price than at a higher price.
Mathematically, it can be expressed as follows:
𝑄𝑑 𝛼 1/𝑝 𝑜𝑟 𝑄𝑑 = 𝐾 (1/𝑝)
The relationship between the quantity demanded and price gives a negatively sloped
curve. The law holds all the time if and only if all other factors remain unchanged but
for some exceptional cases which will be discussed later.

There are three reasons why more of a commodity is demanded as its price falls.
1. A fall in the price of a commodity makes it cheaper than substitute goods and
consumers will therefore switch to the commodity whose price has falling. This
is called substitution effect.
2. If the price of a commodity falls, all things being equal, the purchasing power
or real income of consumers will increase and they will be able to buy more of
the commodity. This is referred to as income effect.
3. As the price of a commodity falls, the consumer will consider that the marginal
utility has become higher than the price of the commodity and hence will
consume more of the commodity. This is referred to as law of diminishing
marginal utility effect.

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 Study Session 2 Demand and Supply

A demand curve or a supply curve is a relationship between two, and only two,
variables: quantity on the horizontal axis and price on the vertical axis. The assumption
behind a demand curve or a supply curve is that no relevant economic factors, other than
the product’s price, are changing. Economists call this assumption ceteris paribus , a
Latin phrase meaning “other things being equal.” Any given demand or supply curve is
based on the ceteris paribus assumption that all else is held equal. A demand curve or a
supply curve is a relationship between two, and only two, variables when all other
variables are kept constant. If all else is not held equal, then the laws of supply and
demand will not necessarily hold.

Ceteris paribus is typically applied when we look at how changes in price affect demand
or supply but it can also be applied more generally. In the real world, demand and
supply depend on more factors than just price. For example, a consumer’s demand
depends on income and a producer’s supply depends on the cost of producing the
product. How can we analyze the effect on demand or supply if multiple factors are
changing at the same time—say price rises and income falls? The answer is that we
examine the changes one at a time, assuming the other factors are held constant.
For example, we can say that an increase in the price reduces the amount consumers
will buy (assuming income, and anything else that affects demand, is unchanged).
Additionally, a decrease in income reduces the amount consumers can afford to buy
(assuming price, and anything else that affects demand, is unchanged). This is what the
ceteris paribus assumption really means. In this particular case, after we analyze each
factor separately, we can combine the results. The amount consumers buy falls for two
reasons: first because of the higher price and second because of the lower income.

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CC201 Introduction to Microeconomics

We defined demand as the amount of some product a consumer is willing and able to
purchase at each price. That suggests at least two factors in addition to price that affect
demand. Willingness to purchase suggests a desire, based on what economists call tastes
and preferences. If you neither need nor want something, you will not buy it. Ability to
purchase suggests that income is important. Professors are usually able to afford better
housing and transportation than students, because they have more income. Prices of
related goods can affect demand also. If you need a new car, the price of a Honda may
affect your demand for a Ford. Finally, the size or composition of the population can
affect demand. The more children a family has, the greater their demand for clothing.
The more driving-age children a family has, the greater their demand for car insurance,
and the less for diapers and baby formula.
These factors matter both for demand by an individual and demand by the market as a
whole. Exactly how do these various factors affect demand, and how do we show the
effects graphically? To answer those questions, we need the ceteris paribus assumption.

Income is not the only factor that causes a shift in demand. Other things that change
demand include tastes and preferences, the composition or size of the population, the
prices of related goods, and even expectations. A change in any one of the underlying
factors that determine what quantity people are willing to buy at a given price will cause
a shift in demand. Graphically, the new demand curve lies either to the right (an
increase) or to the left (a decrease) of the original demand curve. Let’s look at these
factors.

Taste refers to the likes or otherwise of a consumer while fashion relates to what is in
vogue at a particular time. A consumer would usually purchase more of the commodity
he likes and little or none of what he dislikes. If there is a change in taste in favour of a

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 Study Session 2 Demand and Supply

particular commodity, the demand for it will be on the increase while the reverse will be
the case if there is a change in taste against a commodity. If more consumers now prefer
poultry meat to cow meat, the demand for poultry meat will rise while the demand for
cow meat will fall. Demand for commodity that is in vogue will rise while the demands
for commodity which are out of fashion will fall.

A society with relatively more children will have greater demand for goods and services
like baby toys and day care facilities. A society with relatively more elderly persons, has
a higher demand for nursing homes and hearing aids. Similarly, changes in the size of
the population can affect the demand for housing and many other goods.

The demand for a product can also be affected by changes in the prices of related goods
such as substitutes or complements. A substitute is a good or service that can be used in
place of another good or service. As electronic books, like this one, become more
available, you would expect to see a decrease in demand for traditional printed books. A
lower price for a substitute decreases demand for the other product. For example, in
recent years, as the price of tablet computers has fallen, the quantity demanded has
increased (because of the law of demand). Since people are purchasing tablets, there has
been a decrease in demand for laptops, which can be shown graphically as a leftward
shift in the demand curve for laptops. A higher price for a substitute good has the
reverse effect.

Other goods are complements for each other, meaning that the goods are often used
together, because consumption of one good tends to enhance consumption of the other.
Examples include breakfast bread and tea; notebooks and pens or pencils, and petrol and
cars. If the price of printer rises, since the quantity demanded of printer falls (because of
the law of demand), demand for a complement good like cartridge decreases, too.
Similarly, a higher price for boat cruise would shift the demand curve for a complement
good like ocean view trips to the left, while a lower price for a complement has the
reverse effect.

While it is clear that the price of a good affects the quantity demanded, it is also true that
expectations about the future price (or expectations about tastes and preferences,
income, and so on) can affect demand. For example, if people learnt that the price of a
good like coffee is likely to rise in the future, they may head for the store to stock up on
coffee now. These changes in demand are shown as shifts in the curve. Therefore, a shift
in demand happens when a change in some economic factor (other than price) causes a
different quantity to be demanded at every price.

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CC201 Introduction to Microeconomics

In economic terminology, demand is not the same as quantity demanded. When

economists talk about demand, they mean the relationship between a range of prices and
the quantities demanded at those prices, as illustrated by a demand curve or a demand
schedule. When economists talk about quantity demanded, they mean only a certain

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 Study Session 2 Demand and Supply

point on the demand curve, or one quantity on the demand schedule. In short, demand
refers to the curve and quantity demanded refers to the (specific) point on the curve.

When economists talk about supply , they mean the amount of some good or service a
producer is willing to supply at each price. Price is what the producer receives for
selling one unit of a good or service. A rise in price almost always leads to an increase
in the quantity supplied of that good or service, while a fall in price will decrease the
quantity supplied. When the price of petrol rises, for example, it encourages profit-
seeking firms to take several actions: expand exploration for oil reserves; drill for more
oil; invest in more pipelines and oil tankers to bring the oil to plants where it can be
refined into petrol; build new oil refineries; purchase additional pipelines and trucks to
ship the petrol to gas stations; and open more gas stations or keep existing gas stations
open longer hours. Economists call this positive relationship between price and quantity
supplied—that a higher price leads to a higher quantity supplied and a lower price leads
to a lower quantity supplied—the law of supply. The law of supply assumes that all
other variables that affect supply (to be explained in the next module) are held constant.

A supply curve shows how quantity supplied will change as the price rises and falls,
assuming ceteris paribus so that no other economically relevant factors are changing. If
other factors relevant to supply do change, then the entire supply curve will shift. Just as
a shift in demand is represented by a change in the quantity demanded at every price, a
shift in supply means a change in the quantity supplied at every price. In thinking about
the factors that affect supply, remember what motivates firms: profits, which are the
difference between revenues and costs. Goods and services are produced using
combinations of labour, materials, and machinery, or what we call inputs or factors of
production. If a firm faces lower costs of production, while the prices for the good or
service the firm produces remain unchanged, a firm’s profits go up. When a firm’s
profits increase, it is more motivated to produce output, since the more it produces the
more profit it will earn. So, when costs of production fall, a firm will tend to supply a
larger quantity at any given price for its output. This can be shown by the supply curve
shifting to the right.
Take, for example, EMS Speed Post Company that delivers packages around Nigeria
and the world at large. The company may find that buying petrol is one of its main costs.
If the price of petrol falls, then the company will find it can deliver messages more
cheaply than before. Since lower costs correspond to higher profits, the messenger
company may now supply more of its services at any given price. For example, given
the lower petrol prices, the company can now serve a greater area, and increase its
supply.
Conversely, if a firm faces higher costs of production, then it will earn lower profits at
any given selling price for its products. As a result, a higher cost of production typically

32
CC201 Introduction to Microeconomics

causes a firm to supply a smaller quantity at any given price. In this case, the supply
curve shifts to the left.

Several other things affect the cost of production, too, such as changes in weather or
other natural conditions, new technologies for production, and some government
policies. The cost of production for many agricultural products will be affected by
changes in natural conditions. When a firm discovers a new technology that allows the
firm to produce at a lower cost, the supply curve will shift to the right, as well. A
technological improvement that reduces costs of production will shift supply to the
right, so that a greater quantity will be produced at any given price.
Government policies can affect the cost of production and the supply curve through
taxes, regulations, and subsidies. Taxes are treated as costs by businesses.
Other examples of policy that can affect cost are the wide array of government
regulations that require firms to spend money to provide a cleaner environment or a
safer workplace; complying with regulations increases costs.
A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs
when the government pays a firm directly or reduces the firm’s taxes if the firm carries
out certain actions. From the firm’s perspective, taxes or regulations are an additional
cost of production that shifts supply to the left, leading the firm to produce a lower
quantity at every given price. Government subsidies reduce the cost of production and
increase supply at every given price, shifting supply to the right.

Changes in the cost of inputs, natural disasters, new technologies, and the impact of
government decisions all affect the cost of production. In turn, these factors affect how
much firms are willing to supply at any given price.

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 Study Session 2 Demand and Supply

Because demand and supply curves appear on a two-dimensional diagram with only
price and quantity on the axes, an unwary visitor to the land of economics might be
fooled into believing that economics is about only four topics: demand, supply, price,
and quantity. However, demand and supply are really “umbrella” concepts: demand
covers all the factors that affect demand, and supply covers all the factors that affect
supply. Factors other than price that affect demand and supply are included by using
shifts in the demand or the supply curve. In this way, the two-dimensional demand and
supply model becomes a powerful tool for analysing a wide range of economic
circumstances.

Because the graphs for demand and supply curves both have price on the vertical axis
and quantity on the horizontal axis, the demand curve and supply curve for a particular

34
CC201 Introduction to Microeconomics

good or service can appear on the same graph. Together, demand and supply determine
the price and the quantity that will be bought and sold in a market.

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 Study Session 2 Demand and Supply

2.1 and the terms in bold:

Demand schedule is a table that shows the quantity demanded at different prices in the market.
Demand curve shows the relationship between quantity demanded and price in a given market on a
graph.
Changes in demand
- A change in price will result in a movement along a demand curve.
- A change in a non-price variable will result in a shift in the demand curve.
2.2 supply, supply curve and changes in supply
Supply schedule is a table that shows the quantity supplied at different prices in the market.
Supply curve shows the relationship between quantity supplied and price on a graph.
Changes in supply
- A supply curve assumes that other variables that affect the willingness of sellers to supply a good or
service are unchanged. It follows that a change in any of those variables will cause a change in
supply, which is a shift in the supply curve.
- A change that increases the quantity of a good or service supplied at each price shifts the supply
curve to the right.
- An event that reduces the quantity supplied at each price shifts the supply curve to the left.
- A variable that can change the quantity of a good or service supplied at each price is called a supply
shifter.
2.3 equilibrum point
The equilibrium price and equilibrium quantity occur where the supply and demand curves cross. The
equilibrium occurs where the quantity demanded is equal to the quantity supplied.

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CC201 Introduction to Microeconomics

SAQ 2.1 (tests Learning Outcome 2.1)

Nnamdi sells motor parts and Chidi is a mechanic that uses spare parts for his business, if the two of them engage
in business transaction, who will engage in demand? Explain the reasons for your answer. Try represent Chidi’s
demand on a curve and give reasons for what could lead to a change in his demand.
SAQ 2.2 (tests Learning Outcome 2.2)
If Patience comes late to class, Dr Ebele will not allow her in his Economics class. We assume that Dr Ebele came
before Patience, we assume that Patience is the only person that came late and we also assume that Dr Ebele is
always sending late comers out of his class. What economic term describes all these assumptions?
SAQ 2.3 (tests Learning Outcome 2.3)
If the petroleum Minister, Dr Ibe Kachuwuku should say there is going to be a temporal fuel scarcity due to the
upgrade of the nation’s refineries. What will happen to the demand for fuel?
SAQ 2.4 (tests Learning Outcome 2.4)
Mr. Raymond, who owns a transport business needs to replace his fleet of cars, called on Nnamdi, a car dealer to
provide him with 50 Hilux buses. Who, among the two will engaged in supply?

Articulate Presentation
This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

37
CC201 Introduction to Microeconomics

Study Session 3

39
 Study Session 3 Elasticity of Demand and Supply

As discussed in the prelimanary to this session, anyone who has studied economics
points out the law of demand: a higher price will lead to a lower quantity demanded.
What we may not know is how much lower the quantity demanded will be. Similarly,
the law of supply shows that a higher price will lead to a higher quantity supplied. The
question therefore is: How much higher? This Study Session will explain how to answer
these questions and why they are critically important in the real world. To find answers
to these questions, we will begin with the concept of elasticity.

Learning Outcomes
When you have studied this session, you should be able to:
3.1 elasticity of demand and supply
3.2 the cases of elasticity
3.3 how pricing affects elasticity

Elasticity of
Demand and Supply
Price elasticities of Infinite elasticity or
demand and supply Perfect elasticity

Zero elasticity or
Cases of elasticities
Perfect inelasticity

Constant unitary
elasticity

Elasticity and Can cost be passed

Pricing on to consumers?

This Study Session requires a one hour of formal study time. You may spend an
additional two hours for revision.

Terminologies

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CC201 Introduction to Microeconomics

41
 Study Session 3 Elasticity of Demand and Supply

Elasticity is an economics concept that measures responsiveness of one variable to

changes in another variable. Suppose you drop two items from a second-floor balcony.
The first item is a tennis ball. The second item is a brick. Which will bounce higher?
Obviously, the tennis ball. We would say that the tennis ball has greater elasticity. Every
time a firm considers raising the price that it initially charges, it must consider how
much a price increase will reduce the quantity demanded of what it sells. Conversely,
when a firm puts its products on sale, it must expect (or hope) that the lower price will
lead to a significantly higher quantity demanded.
Both the demand and supply curve show the relationship between price and the number
of units demanded or supplied. Price elasticity is the ratio between the percentage
change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent
change in price.
 The price elasticity of demand is the percentage change in the quantity
demanded of a good or service divided by the percentage change in the price.
 The price elasticity of supply is the percentage change in quantity supplied
divided by the percentage change in price.
Elasticities can be usefully divided into three broad categories: elastic, inelastic, and
unitary.
 An elastic demand or elastic supply is one in which the elasticity is greater than
one, indicating a high responsiveness to changes in price.
 Elasticities that are less than one indicate low responsiveness to price changes
and correspond to inelastic demand or inelastic supply.
 Unitary elasticities indicate proportional responsiveness of either demand or
supply, as summarized below.

To calculate elasticity, instead of using simple percentage changes in quantity and price,
economists use the average percent change in both quantity and price. This is called the
Midpoint Method for Elasticity, and is represented in the following equations:
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 = 𝑄2 – 𝑄1 / (𝑄2 + 𝑄1)2 × 100

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CC201 Introduction to Microeconomics

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 = 𝑃2 – 𝑃1 / (𝑃2 + 𝑃1)2 × 100

The advantage of these in Midpoint Method is that one obtains the same elasticity
between two price points whether there is a price increase or decrease. This is because
the formula uses the same base for both cases.

(a)
(b)

There are two extreme cases of elasticity: when elasticity equals zero and when it is
infinite. A third case is that of constant unitary elasticity. We will describe each case.

This refers to the extreme case where either the quantity demanded (Qd) or supplied
(Qs) changes by an infinite amount in response to any change in price at all. In both
cases, the supply and the demand curve are horizontal as shown in Figure 5.4. While
perfectly elastic supply curves are unrealistic, goods with readily available inputs and
whose production can be easily expanded will feature highly elastic supply curves.
Examples include cake, bread, books and pencils. Similarly, perfectly elastic demand is
an extreme example. But luxury goods, goods that take a large share of individuals’
income, and goods with many substitutes are likely to have highly elastic demand
curves. Examples of such goods are Caribbean cruises and sports vehicles.

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 Study Session 3 Elasticity of Demand and Supply

This refers to the extreme case in which a percentage change in price, no matter how
large, results in zero change in quantity. While a perfectly inelastic supply is an extreme
example, goods with limited supply of inputs are likely to feature highly inelastic supply
curves. Examples include diamond rings or housing in prime locations such as
apartments facing Central Park in Federal capita territory, Abuja. Similarly, while
perfectly inelastic demand is an extreme case, necessities with no close substitutes are

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CC201 Introduction to Microeconomics

likely to have highly inelastic demand curves. This is the case of life-saving drugs and
petrol.

In either a supply or demand curve, it occurs when a price change of one percent results
in a quantity change of one percent. As a result, a demand curve with constant unitary
elasticity moves from a steeper slope on the left and a flatter slope on the right—and a
curved shape overall.

Unlike the demand curve with unitary elasticity, the supply curve with unitary elasticity
is represented by a straight line.

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 Study Session 3 Elasticity of Demand and Supply

Studying elasticity is useful for a number of reasons, pricing being most important. Let’s
explore how elasticity relates to revenue and pricing, both in the long run and short run.
But first, let’s look at the elasticity of some common goods and services.
Table 3.2 shows a selection of demand elasticity for different goods and services drawn
from a variety of different studies by economists, listed in order of increasing elasticity.

Goods and Services Elasticity of Price

Housing 0.12

Electricity 0.20

Petrol 0.35

Wine 0.55

Beef 0.59

Kitchen and household appliances 0.63

Cable TV (basic rural) 0.69

Chicken 0.64

Soft drinks 0.70

Beer 0.80

Computer 1.44

Cable TV (basic urban) 1.51

Note that necessities such as housing and electricity are inelastic, while items that are
not necessities such as restaurant meals are more price-sensitive. If the price of the
restaurant meal increases by 10%, the quantity demanded will decrease by 22.7%. A
10% increase in the price of housing will cause a slight decrease of 1.2% in the quantity
of housing demanded.

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CC201 Introduction to Microeconomics

If Demand Is . . . Then . . . Therefore . . .

Elastic % change in Qd > % change A given % rise in P will be more than offset
in P by a larger %

Unitary % change in Qd = % change A given % rise in P will be exactly offset by

in P an equal fall in O so that total revenue (P*Q)
is unchanged

Inelastic % change in Qd < % change A given % rise in P will cause a smaller % fall
in P in Q so that revenue (P*Q) rises.

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 Study Session 3 Elasticity of Demand and Supply

Most businesses face a day-to-day struggle to figure out ways to produce at a lower cost,
as one pathway to their goal of earning higher profits. However, in some cases, the price
of a key input over which the firm has no control may rise. For example, many chemical
companies use petroleum as a key input, but they have no control over the world market
price for crude oil. Coffee shops use coffee as a key input, but they have no control over
the world market price of coffee. If the cost of a key input rises, can the firm pass those
higher costs along to consumers in the form of higher prices? Conversely, if new and
less expensive ways of producing are invented, can the firm keep the benefits in the
form of higher profits, or will the market pressure them to pass the gains along to
consumers in the form of lower prices? The price elasticity of demand plays a key role
in answering these questions.

3.1 elasticity of demand and elasticity of supply

Elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its
price. It is computed as the percentage change in quantity demanded (or supplied) divided by the
percentage change in price.
3.2 the cases of elasticity
Elasticity can be described as elastic (or very responsive), unit elastic, or inelastic (not very responsive).
Elastic demand or supply curves indicate that quantity demanded or supplied respond to price changes
in a greater than proportional manner.
Inelastic demand or supply curve is one where a given percentage change in price will cause a smaller
percentage change in quantity demanded or supplied.
Unitary elasticity means that a given percentage change in price leads to an equal percentage change in
quantity demanded or supplied.
3.3 how pricing affects elasticity
In the market for goods and services, quantity supplied and quantity demanded are often relatively slow
to react to changes in price in the short run, but react more substantially in the long run. As a result,
demand and supply often (but not always) tend to be relatively inelastic in the short run and relatively
elastic in the long run. The tax incidence depends on the relative price elasticity of supply and demand.
When supply is more elastic than demand, buyers bear most of the tax burden, and when demand is

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CC201 Introduction to Microeconomics

more elastic than supply, producers bear most of the cost of the tax. Tax revenue is larger the more
inelastic the demand and supply are.

SAQ 3.1 (tests Learning Outcome 3.1)

If at N50, you buy a bottle of coke every day. When the price increases to N100, you buy one bottle every day.
When the price gets to N150, you only buy one bottle per week. What economic term/model explains these actions?
Define the term in your own words
SAQ 3.2 (tests Learning Outcome 3.2)
There are different grades of Elasticities, if as the price of Coke increases from N50 to N100 and to N150, you still
continue to consume a bottle of coke every day, what grade of elasticity is that?
SAQ 3.3 (tests Learning Outcome 3.3)
Prices of goods and services is a major determinant of elasticity. True or false?

Articulate Presentation
This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

49
CC201 Introduction to Microeconomics

Study Session 4

Consumers, in the process of making choice is assumed to be rational, given his income
and the prices of the various products/services. He therefore plans the spending of his
income so as to attain the highest possible satisfaction. Consumer behaviour is based on
the concept of the preferences of consumer and their assumed utility function, it has to
do with the study of individuals, firms and government in the way they make their
choices, use, and dispose of their products and services and the effects on the consumer
and the society. In this study session, we want to look at theory of utility and its
measurement.

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 Study Session 4 Consumer Behaviour

Learning Outcomes
When you have studied this session, you should be able to:
4.1 utility
4.2 law of diminishing marginal utility
4.3 an indifference curve
4.4 between total utility and marginal utility

Consumer Behaviour Cardinal utility approach

Concept of Utility

Ordinal utility approach

Diminishing marginal
rate of substitution

Properties of indifferent
Indifference curves
curve

Marginal decision-making
Total utility and
diminishing marginal
utility
Rule for maxising utility

This Study Session requires a two hour of formal study time. You may spend an
additional four hours for revision.

Terminologies

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 CC201 Introduction to Microeconomics

Utility is derived from the way we make our choices, this is the satisfaction derived
from whatever we use our resources for. The concept of utility is therefore important to
the study of consumer behaviour. Utility is a measure of satisfaction derived from
application of resources, it is a measure of preferences over some sets of a goods and
services, and it represents satisfaction experienced by consumer of goods and services.
Utility derived from the consumption of goods and services is usually difficult to
measure quantitatively but it is possible to rank them in their order of preferences to the
consumer.
This ranking is however responsive to the price of the commodity and the income of the
consumer. It has earlier been assumed that consumers are rational in their behaviour and
so he will not spend money on an additional unit of good and service of which its
marginal utility is not at least equal or greater than that of a unit of an alternative good
and service. Therefore, price of a good and service is related to its marginal utility and
the consumer will rank his or her preferences accordingly. Utility can be measured using
two approaches:
i. Cardinal utility approach
ii. Ordinal utility approach.

The protagonist of cardinal utility approach is of the opinion that utility can be
measured by a unit called utils (i.e. unit of utility). For example, according to this
concept, a consumer gains a 30 utils from the consumption of milk and 15 utils from
margarine. The followings are assumptions under which Cardinal approach works.
i. One util equals one unit of money
ii. Utility of money remain constant
iii. The consumer is reasonably rational
iv. There is diminishing marginal utility of a good and services but a constant
.
marginal utility of money

Ordinal utility approach is based on the fact that the exact or absolute measurement
of utility is not possible, but can be ranked in order of preference. The consumer only
needs not know in specific units of the quantity for him to be able to rank various
commodities according to the satisfaction that each commodity gives him. The ranking
is usually expressed by the consumer’s utility function which may be unique to an
individual consumer. For example, if higher utility is derived from the consumption of
milk compare to the consumption of margarine, the utility derived from milk

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 Study Session 4 Consumer Behaviour

consumption can be ranked 1 while that for the consumption of margarine can be ranked
2.
This approach is hinge on the following assumptions:
i. The consumer has a perfect knowledge of the entire range of all available goods.
ii. The consumer has a perfect knowledge of his own income.
iii. The consumer is consistent in his ranking.
iv. A transitive relationship is preserved among commodities; for example, if a
consumer prefers sugar to honey and prefers honey to sweetener, he cannot
prefer sweetener to sugar.
v. The consumer is rational.
vi. Consumers are assumed to be non-satisfied.

This is the rate of which a commodity is substituted for another one by a consumer and
yet be of the same level of overall satisfaction. This assumption is an important concept
in indifference curve analysis. This assumption states that the rate of substitution
reduces as more of the commodities are consumed. It should be possible to identify a
number of different combination that give the consumer the same level of utility.
Indifferent curve is therefore the locus of points on the curve each representing a
different combination of two substitute goods which yield the same level of utility to a
consumer.

If all possible combination of commodities A, B, C, D, are ranked on the basis of their

utility contents. It should be possible to identify a number of different combination that
give the consumer the same level of utility.

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CC201 Introduction to Microeconomics

Indifference curve is therefore the locus of points on the curve each representing a
different combination of two substitute goods which yield the same level of utility to a
consumer. A consumer is indifferent between any two combinations of two goods when
it comes to making a choice between the two goods. This combinations can be plotted
on a graph and the resulting curve is called indifference curve or 180 – utility curve.

Indifference curves does not normally indicate the exact value of level of satisfaction
and this is because the indifference curve is based on the concept of ordinal utility,
which assets that only the qualitative differences in levels of satisfaction can be stated
by the consumers.

Properties of indifference curves are as follows:

I. It shapes downward from left to right: i.e. it has negative slope, this is based on
the assumption of non-satisfaction.
II. Indifference curve is convex to the origin: this implies the Marginal Rate of
Substitution (MRS) decreases and no two goods can be perfect substitute i.e.
convexity of indifference curve to the origin implies that MRS of good A for
good B falls as more quantity of A is substituted for good B.
III. Indifference curve cannot intersect each other: this implies that only one
indifference curve can pass through a point in indifference map.
IV. Indifference curve to the right of a given indifference curves are higher in terms
of satisfaction.

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 Study Session 4 Consumer Behaviour

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CC201 Introduction to Microeconomics

To understand how a household will make its choices, economists look at what
consumers can afford, as shown in a budget constraint line, and the total utility or
satisfaction derived from those choices. In a budget constraint line, the quantity of one
good is measured on the horizontal axis and the quantity of the other good is measured
on the vertical axis. The budget constraint line shows the various combinations of two
goods that are affordable given consumer income. Consider the situation of Joshua,
shown in the figure below. Joshua likes to collect T-shirts and watch movies.

In Table 4.1 the quantity of T-shirts is shown on the horizontal axis, while the quantity
of movies is shown on the vertical axis. If Joshua had unlimited income or goods were
free, then he could consume without limit. But Joshua, like all of us, faces a budget
constraint. Joshua has a total of N56 to spend. The price of T-shirts is N14 and the price
of movies is N7. Notice that the vertical intercept of the budget constraint line is at eight
movies and zero T-shirts (N56/N7=8). The horizontal intercept of the budget constraint
is four, where Joshua spends of all of his money on T-shirts and no movies (N56/14=4).
The slope of the budget constraint line is rise/run or –8/4=–2. The specific choices along
the budget constraint line show the combinations of T-shirts and movies that are
affordable.

T-Shirts Total Marginal Movies Total Marginal

(quantity) Utility Utility (quantity) Utility Utility

1 22 22 1 16 16
2 43 21 2 31 15
3 63 20 3 45 14
4 81 18 4 58 13
5 97 16 5 70 12
6 111 14 6 81 11
7 123 12 7 91 10
8 133 10 8 100 9

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 Study Session 4 Consumer Behaviour

Joshua has income of N56 (Budget constrain). Movies cost N7 and T-shirts cost N14.
The points on the budget constraint line show the combinations of movies and T-shirts
that are affordable. Joshua wishes to choose the combination that will provide him with
the greatest utility, which is the term economists use to describe a person’s level of
satisfaction or happiness with his or her choices.
Let’s begin with an assumption that Joshua can measure his own utility with something
called utils. (It is important to note that you cannot make comparisons between the utils
of individuals; if one person gets 20 utils from a cup of coffee and another gets 10 utils,
this does not mean that the first person gets more enjoyment from the coffee than the
other or that they enjoy the coffee twice as much.). The Table shows how Joshua’s
utility is connected with his consumption of T-shirts or movies. The first column of the
table shows the quantity of T-shirts consumed. The second column shows the total
utility, or total amount of satisfaction, that Joshua receives from consuming that number
of T-shirts. The most common pattern of total utility, as shown here, is that consuming
additional goods leads to greater total utility, but at a decreasing rate. The third column
shows marginal utility, which is the additional utility provided by one additional unit of
consumption. The equation for marginal utility is:
𝑀𝑈 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑜𝑡𝑎𝑙 𝑈𝑡𝑖𝑙𝑖𝑡𝑦/𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
Notice that marginal utility diminishes as additional units are consumed, which means
that each subsequent unit of a good consumed provides less additional utility. For
example, the first T-shirt Joshua picks is his favorite and it gives him an addition of 22
utils. The fourth T-shirt is just to something to wear when all his other clothes are in the
wash and yields only 18 additional utils. This is an example of the law of diminishing
marginal utility, which holds that the additional utility decreases with each unit added.
The rest of Table 4.1 shows the quantity of movies that Joshua attends, and his total and
marginal utility from seeing each movie. Total utility follows the expected pattern: it
increases as the number of movies seen rises. Marginal utility also follows the expected
pattern: each additional movie brings a smaller gain in utility than the previous one. The
first movie Joshua attends is the one he wanted to see the most, and thus provides him
with the highest level of utility or satisfaction. The fifth movie he attends is just to kill
time. Notice that total utility is also the sum of the marginal utilities.
Table 4.2 looks at each point on the budget constraint in Figure 4.1, and adds up
Joshua’s total utility for five possible combinations of T-shirts and movies.

Point T-shirts Movies Total utility

P 4 0 81 + 0 = 81

Q 3 2 63 + 31 = 94

R 2 4 43 + 58 = 101

S 1 6 22 + 81 = 103

T 0 8 0 + 100 = 100

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CC201 Introduction to Microeconomics

The budget constraint framework helps to emphasize that most choices in the real world
are not about getting all of one thing or all of another; that is, they are not about
choosing either the point at one end of the budget constraint or else the point all the way
at the other end. Instead, most choices involve marginal analysis, which means
comparing the benefits and costs of choosing a little more or a little less of a good.
People desire goods and services for the satisfaction or utility those goods and services
provide. Utility, is subjective but that does not make it less real. Economists typically
assume that the more of some good one consumes (for example, slices of bread), the
more utility one obtains. At the same time, the utility a person receives from consuming
the first unit of a good is typically more than the utility received from consuming the
fifth or the tenth unit of that same good. When Danladi chooses between meals and bus
tickets, for example, the first few bus rides that he chooses might provide him with a
great deal of utility—perhaps they help him get to a job interview or a doctor’s
appointment. But later bus rides might provide much less utility—they may only serve
to kill time on a rainy day. Similarly, the first meal that Danladi chooses to buy may be
on a day when he missed breakfast and is ravenously hungry. However, if Danladi has a
meal every single day, the last few meals may taste pretty boring. The general pattern
that consumption of the first few units of any good tends to bring a higher level of utility
to a person than consumption of later units is a common pattern. Economists refer to this
pattern as the law of diminishing marginal utility, which means that as a person receives
more of a good, the additional (or marginal) utility from each additional unit of the good
declines. In other words, the first slice of bread brings more satisfaction than the sixth.
The law of diminishing marginal utility explains why people and societies rarely make
all-or-nothing choices. You would not say, “My favourite food is ice cream, so I will eat
nothing but ice cream from now on.” Instead, even if you get a very high level of utility
from your favourite food, if you ate it exclusively, the additional or marginal utility from
those last few servings would not be very high. Similarly, most workers do not say: “I
enjoy leisure, so I’ll never work.” Instead, workers recognize that even though some
leisure is very nice, a combination of all leisure and no income is not so attractive. The
budget constraint framework suggests that when people make choices in a world of
scarcity, they will use marginal analysis and think about whether they would prefer a
little more or a little less.

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 Study Session 4 Consumer Behaviour

This process of decision making suggests a rule to follow when maximizing utility.
Since the price of T-shirts is twice as high as the price of movies, to maximize utility the
last T-shirt chosen needs to provide exactly twice the marginal utility (MU) of the last
movie. If the last T-shirt provides less than twice the marginal utility of the last movie,
then the T-shirt is providing less “bang for the buck” (i.e., marginal utility per dollar
spent) than if the same money were spent on movies. If this is so, Joshua should trade
the T-shirt for more movies to increase his total utility. Marginal utility per dollar
measures the additional utility that Joshua will enjoy given what he has to pay for the
good. If the last T-shirt provides more than twice the marginal utility of the last movie,
then the T-shirt is providing more “bang for the buck” or marginal utility per Naira, than
if the money were spent on movies. As a result, Joshua should buy more T-shirts. Notice
that at Joshua’s optimal choice of point S, the marginal utility from the first T-shirt, of
22 is exactly twice the marginal utility of the sixth movie, which is 11. At this choice,
the marginal utility per dollar is the same for both goods. This is a tell-tale signal that
Joshua has found the point with highest total utility.
This argument can be written as a general rule:
MU1/P1=MU2/P2
the utility-maximizing choice between consumption goods occurs
where the marginal utility per Naira is the same for both goods.

4.1 utility 4.4 between total

Utility refers to the satisfaction a consumer utility and marginal utility
derives from the consumption of a commodity. It is useful to distinguish between total
4.2 law of diminishing marginal
utility and marginal utility.
utility Total utility refers to the total
It notes that the more of a given commodity is satisfaction derived from consuming
consumed, the less the addition to total utility. some commodities. Marginal utility on
the other hand is the change in
4.3 an indifference curve
satisfaction resulting from consuming a
The curve shows all combinations of unit more or less of that commodity
commodities that yield the same level of
satisfaction to the household. It is downward
sloping indicating that if the household is to
have less of one commodity, it must have more
of the other to compensate. The slope of the
curve is the marginal rate of substitution.

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CC201 Introduction to Microeconomics

SAQ 4.1 (tests Learning Outcome 4.1)

You are just coming from school, hungry and tired. On getting to the room, your room-mate offered you a plate of
Apu and Egusi. After eating, you felt rejuvenated. What is the economic term of what you have derived from the
plate of Apu and Egusi? Explain.
SAQ 4.2 (tests Learning Outcome 4.2)
If you are able to measure the amount of utility you derived from the plate of Apu that you ate as 5 utils. What kind
of approach to Utility will you call that? Discuss.
SAQ 4.3 (tests Learning Outcome 4.3)
Say, after eating the first plate of Apu and gained 5 utils, you went ahead and took another plate and yet another
plate, what will happen to you utils? Discuss the Economic Law that explains the outcome of what happens to your
utils.

Articulate Presentation
This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

61
CC201 Introduction to Microeconomics

Study Session 5

A set of assumptions (i.e accepted facts) attempts to explain how “choice among
different ways of producing given commodity” is made; this set of verified and accepted
facts is known as production theory. It involves information on how inputs are related to
output. In this study session, we will examine in detail the relationship between input
and output in the form of production function.

Learning Outcomes
When you have studied this session, you should be able to:
5.1 the importance of production
5.2 the types of goods
5.3 the types of factors of production
5.4 between total, average and marginal products
5.5 the Law of Diminishing Returns

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 Study Session 5 Production Theory

Production Theory Purpose of production

What is production?

Types of production

Consumer goods

Types of goods

Capital goods

Factors of production

Production function

Total product, Average

product & Marginal
product

Law of diminishing
Return to scale
returns in production

This Study Session requires a two hour of formal study time. You may spend an additional
four hours for revision.

Terminologies

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CC201 Introduction to Microeconomics

Production involves the creation of utility. It is the creation of wealth in the form of
goods and provision of services which are capable of satisfying human wants.
It includes the services rendered by service providers like doctors, accountants,
engineers and others. It can also be defined as changing of resources into goods and
services e.g. making of cloth from cotton.

The purpose of production is to satisfy human wants. It will be a waste of resources to

produce things that people do not require. People also engage in production in order to
earn the means with which they will be able to satisfy their own wants and at the same
time satisfy the wants of others by producing those things which other people require.
For example, a farmer who produces yam helps to satisfy the wants of people for food
and at the same time satisfies himself either by consuming part of the yam he produces
or by making use of the money from the sales of his yam to purchase other things he
requires.

Increased production leads to increase consumption and the higher the level of
consumption, the higher the standard of the living of the people. Economic policy of
every country aims at increasing the volume of production so as to improve the welfare

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 Study Session 5 Production Theory

of their people. Increasing the materials welfare of the people can therefore be seen as
another aim of production.

This can also be referred to as the classification of industries. Production can be

classified into two major categories; these are direct and indirect productions;

This is the type of production in which an individual produces goods and services only
for family use or consumption. The goods and services so produced are not usually for
sale; rather they are for the use of the family. It is usually in very small size and family
labour is usually employed.

This is the type of production in which goods and services are produced in large scale
mainly for sales or in exchange for other goods. It involves the use of modern equipment
and skilled labour. Indirect production can be sub-divided into three categories. These
are:
i. Primary Production
ii. Secondary Production
iii. Tertiary Production

Secondary
Production:
Textile industry

Primary Production: Tertiary Production:

Cotton plantation Clothe sales

This is the production that involves the extraction of raw materials provided by nature. It
includes all branches of farming, fishing, mining, lumbering, quarrying etc.

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CC201 Introduction to Microeconomics

This type of production involves the transformation of basic raw materials or semi –
finished goods into final forms that are acceptable to the consumers. It includes all types
of manufacturing and construction work. It is in this type of production that the raw
materials from the primary production are converted to finished products. Examples are
production of beverages, bread, furniture items etc.

This is concerned with the provision of commercial and professional services to ensure
that the goods so produced at the primary and secondary production levels are
distributed to the final consumers. The people involved here are those in the commercial
services like wholesalers, retailers, transporters and those rendering professional
services like doctors, musicians, lawyers etc.

Goods produced are basically of two types:

These are goods that can satisfy individual or households directly. They are not required
for further process of production before they can be used by the consumers. They can be
further divided into two:
(i) Durable goods and
(ii) Perishable goods
Durable goods: These are consumer goods that can be used over and over again. They
last longer and have to be bought at longer intervals; examples are shoes, furniture,
radio, television etc.
Perishable goods: These are goods that are mostly used at once because they have the
nature of getting spoilt quickly. They do not last long and so have to be used soon after
purchase. Examples are dairy products, meat, yam, bread.

These are goods that are used for making other goods. They are also known as producer
or investment goods. Examples include motor cars, building factories etc. They are very

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 Study Session 5 Production Theory

vital because the larger they are in a country, the greater the amount of consumer goods
the country will be able to produce.

Factors of production refer to resources which are combined together to produce goods
and services. Factors of production are classified into four categories:

Land includes all natural resources such as soil, water, minerals etc. It is the most
important natural resources for agricultural production. The quality of a particular piece
of land is dependent on its fertility.

Characteristics of land are that it:

i. is immobile
ii. is fixed in supply
iii. varies in quality

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CC201 Introduction to Microeconomics

iv. has no cost of production

v. is heterogeneous in nature
vi. is subject to law of diminishing return.

This refers to all human efforts in production; it involves physical and mental efforts.
The quality or efficiency of labour can be improved by education, good health and
training.

Capital is defined as man-made wealth used in production, in other words they are man-
made assets or goods that are used to produce other goods and services. It may also be
defined as the stock of previous wealth invested in order to produce future wealth.
The reward for capital is interest.

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 Study Session 5 Production Theory

This is factor of production that coordinates and organizes other factors of production in
order to produce goods and services. Entrepreneur takes decision on what to produce,
how to produce, for whom to produce and where to produce.

The reward for Aliko Dangote, as an entrepreneur, is profit.

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CC201 Introduction to Microeconomics


(a)
(b)
(c)
(d)

(e)

(f)
(g)

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 Study Session 5 Production Theory

Production function is the technical relationship which describes the maximum

amount of products capable of being produced by a set of input under a given
technology. This could be depicted by a graph, table or an equation. A typical general
production function with labour, capital and land would mathematically look like:
Q = f (L, k, Ha),
Where
Q = Quantity of output
L = Labour in number of units
K = Quantity of capital
Ha = Quantity of land in hectare

This is the total quantity of product produced at a particular time by making use of the
combination of various inputs. Total Products is expressed mathematically as TP = AP ×
Quantity of product Input.

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CC201 Introduction to Microeconomics

This is defined as the output per unit of the variable factor used. It is obtained
mathematically by dividing the Total Product (TP) with the number of inputs employed.
For example, Average Product (AP) with respect to labour can be expressed as:
𝐴𝑃𝐿 = 𝑇𝑃 / 𝐿
Where, APL = Average product per labour used
TP = Total product
L = Unit of labour employed.
Average product can never be negative because negative amount of product can never
be produced.

This cost is the additional cost of producing one more unit of output. So it is not the cost
per unit of all units being produced, but only the next one (or next few). Marginal cost
can be calculated by taking the change in total cost and dividing it by the change in
quantity. The marginal cost curve is generally upward-sloping, because diminishing
marginal returns implies that additional units are more costly to produce. It can be
mathematically written as 𝑀𝑃𝐿 = ∆𝑇𝑃𝐿 / ∆𝐿 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑃 / 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑝𝑢𝑡

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 Study Session 5 Production Theory

The relationship between total product, Average product and Marginal product with
respect to labour input can be illustrated by the following schedule and combined
curves.

Labour Total Product of Average Product of Marginal Product of

Labour TPL (2) Labour (3) 2 ÷ 1 Labour MPL (4) ∆TP/∆L
1 8 8 -
2 24 12 16
3 48 16 24
4 80 20 32
5 90 18 10
6 96 16 6
7 91 13 -5

This combined curves and the schedule reveals the following:

I. MP is positive when TP is increasing, it is zero when TP is at constant
maximum, and negative when TP decreases. When TP is increasing at an
increasing rate, MP will be increasing, and when TP is increasing at a
decreasing rate, MP will be decreasing but positive and higher than the AP.
II. When AP is increasing, MP is greater than AP because for AP to increase as
more inputs are employed, the addition to the products from each additional
input (MP) must be greater than the AP from the preceding input.

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CC201 Introduction to Microeconomics

III. Also, when AP is decreasing, MP is less than AP. If AP doesn’t change as

more inputs are employed AP and MP are equal, that is AP = MP when AP is
maximum.







Units of labour per day 0 1 2 3 4 5 6 7 8

Rolls per day 0 2 5.5 9.5 12 14 15 15.5 15

MP

AP

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 Study Session 5 Production Theory

The law of diminishing return states that as successive units of variable factors are
combined with one or more fixed factors, the output will increase at first, but after some
time the addition of more inputs will result to less additional units of output i.e. the
addition to total output will begin to decrease and the total product from the input will
begin to increase at a decreasing rate. It is a short run law because all factors are variable
in the long run. The law can be illustrated using the table below.

Fixed factor Variable factor Total product Change in

Land (Acre) fertilizer (bag) cowpea (kg) output (MP)

1 1 10 -

1 2 30 20

1 3 60 30

1 4 120 60

1 5 100 20

1 6 90 -10

Return to scale describes the response of output to a change in the level of all inputs
employed. If the response of output to change in input is by the same proportion, we
have a situation of constant return to scale. That is, if for example all inputs is increased
by 5 percent and the new output is also 5 percent greater than the original output, the
production exhibits a constant return to scale, when this happens, we have a linear
relationship between the input and output. This nature of relationship is not
characteristics of agricultural productions.
If output increases by a smaller percentage than increase in input, we have a situation of
decreasing return to scale. For example, if all inputs are multiplied by 5 percent and the
new output is just 2.5 percent above the original output. The production process would
be said to exhibit decreasing return to scale. That is, each additional unit of the variable
input adds less to the output than the previous unit. This type of production process is
most common in agriculture.

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CC201 Introduction to Microeconomics

Increasing return to scale occurs if increase in input brings about a more than
proportionate increase in output, that is, for instance, if input employed is multiplied by
5 percent while increased in output is by 7 percent, we have a situation of increasing
return to scale. This situation occurs mainly at the early stages of agricultural
production.

5.1 highlight the importance of 5.4 differentiate between total,

production average and marginal products
Production is the process by which inputs are The total product is the total amount
combined, transformed, and turned into outputs. produced during some period of time by
It is therefore the major business of every all factors of production employed. The
economy. amount by which output rises with an
5.2 point out the types of goods additional unit of a variable factor is the
Basically, types of goods refers to the context to marginal product of the variable factor.
which commodities are put up to, vis-à-vis Average product of a variable factor is
consumer goods and capital goods. the output per unit of variable factor.
5.3 discuss the types of factors of 5.5 apply the law of Diminishing
production Returns
The factors of production in an economy are its This law seeks to explain the behaviour of
labour, capital and natural resources. output as a result of applying more or less of
- Labour is the human effort that can be variable factor to a fixed factor. The law
applied to the production of goods and states that "if increasing quantities of a
services. People who are employed or variable factor are applied to given fixed
would like to be are considered part of the factors, the marginal product and the average
labor available to the economy. product of the variable factor will eventually
- Capital is a factor of production that has decrease".
been produced for use in the production of
other goods and services. Office

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 Study Session 5 Production Theory

buildings, machinery, and tools are

examples of capital.
- Natural resources are the resources of
nature that can be used for the production
of goods and services.
Finally, we have entrepreneur who mixes the
other three factors of production.

SAQ 5.1 (tests Learning Outcome 5.1)

How important is production in an economy?
SAQ 5.2 (tests Learning Outcome 5.2)
There are two types of goods; one is consumable goods, which satisfies individual or households directly, what is
the other type of goods called? And what is it used for?
SAQ 5.3 (tests Learning Outcome 5.3)
If you are to start a production firm today, what are those Economic Factors that you will need?
SAQ 5.4 (tests Learning Outcome 5.4)
After securing Land, Labour, Capital and Entrepreneur, what are the other likely costs you will incur? From those
costs, can you differentiate which is Total, Average and Marginal cost? Can you explain your understanding of
these costs?
SAQ 5.5 (tests Learning Outcome 5.5)
If the law of diminishing return states that as successive units of variable factors are combined with one or more
fixed factors, the output will increase at first, but after some time the addition of more inputs will result to less
additional units of output, what is returns to scale.

Articulate Presentation
This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

78
CC201 Introduction to Microeconomics

Study Session 6

The previous Study Session exposes you to assumptions of production. In this study
session, we will examine cost of production. Theory of cost has to do with the cost of
producing a commodity. Costs is derived from the quantities of the variable and fixed
inputs used in producing. Take for instance, in a textile firm, money value of raw
materials, labour, power and manufacturing site all add up to cost of production. Cost
therefore expresses the relationship between total production cost and quantities of
output.

Learning Outcomes
Upon completion of this study session, you will be able to:
6.1 production cost
6.2 and different concepts of cost in relation to time Horizon
in cost of production

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 Study Session 6 Cost Theory

Cost Theory Explicit cost

What is cost of
production
Implicit cost

The short run

Time horizon and
production cost
The long run

Total fixed cost

Total variable cost

Total cost

Average total cost

Concepts of cost

Average fixed cost

Convergence of
marginal and average
cost
Average variable cost

Marginal cost

Long run average cost

curves

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CC201 Introduction to Microeconomics

This Study Session requires a one hour of formal study time. You may spend an
additional two hours for revision.

Terminologies

Cost of production refers to the monetary value of the inputs used in production process.
The cost of producing a product such as eggs, cat fish or maize is the expenses incurred
in producing a particular quantity of the product in a particular period of time. Profit is
arrived at by subtracting costs from revenue, the understanding of the nature and
structure of production cost is therefore very germane. The cost being referred to here is
the accounting costs of production, that is, the cost of raw materials used in the
production process such as cost of labour, planting materials, maintenance and other
administrative cost etc. This accounting cost is more important to the accountant than
any other cost. To the economists, cost of production encompasses accounting costs and
opportunity cost which may also be a cost to the society too. Accounting cost is always
referred to as private cost because it is the money cost which is the actual amount of
money spent by the producer in the process of production. It is the price that must be
paid to get the services of factors of production. Private costs are of two types:
(i) Explicit cost and
(ii) Implicit cost.

These costs are the money outlays made by the producer to meet the direct cost of
production, that is, the actual expenditures on the factors of production used in the
process of production e.g. payment for raw materials, wages and salaries administrative
cost, overhead costs etc.

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 Study Session 6 Cost Theory

These costs are the cost of self-owned assets or self-provided labour which are often
overlooked when computing the production expenses of the firm. For example, the
salary of sole proprietor of a poultry farm who does not set any salary aside for himself
but only takes the firm’s profit as payment for his effort in the business.

http://land.onlinenigeria.com/#ixzz46CXJMl6n

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CC201 Introduction to Microeconomics

o _____________ costs are the money outlays made by the producer to meet
the direct cost of production.

 The money outlays made by the producer to meet the direct cost of
production is referred to as Explicit cost

In production cost, it is important to recognize the difference between economic time

horizons: The short run and the long run.

In production is recognized as the production period which is so short for the firm to
vary the amount of its fixed factors such as land, building, machinery etc. It is assumed
that in the short run, one or more factors are fixed in quantity and variable factors can be
differentiated from fixed factors. In the short run, total production cost is made up of the
implicit and explicit cost of fixed input used in production and total expenditure on
variable input used.

This is a planning period in production that is long enough for the firm to be able to vary
the amount of all factors of production used in production process. All resources are
variable and we cannot be talking of classifying factors into variable and fixed. The long
run is a planning period while the short run is the production period. The long run is a
period which is sufficiently long enough to permit desired adjustments to the size of
enterprise (including the size of capital investment and production technology). It can
then be said that all inputs and hence all costs are variable in the long run.

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 Study Session 6 Cost Theory

This refers to the costs which do not vary with the level of production and which are
incurred whether production takes place or not, sometime, they are referred to as
overhead cost. Fixed cost includes all the cost of plant and machinery, land, buildings,
top management salaries etc. Total Fixed Cost is always constant in the short run.

This refers to the cost which varies with the level of production; it is the cost per unit for
all variable factors used in production. The higher the scale of production the greater the
variable cost. When the output is zero, the variable cost will also be zero and when the
level of production increases, the variable cost also increases. Examples are cost of
planting materials, fertilizers, animal feeds etc.

This is the total expenses of a firm in the production of a given level of output. It is the
sum of variable cost and fixed cost.
𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶

This is defined as the unit cost of production; it is derivable by dividing total cost by the
number of output produced.
𝐴𝑇𝐶 = 𝑇𝐶/𝑄
Average total cost can also be arrived at by adding the Average fixed cost to Average
variable cost: i.e.
𝐴𝑇𝐶 = 𝐴𝐹𝐶 + 𝐴𝑉𝐶
Average total cost (sometimes referred to simply as average cost) is total cost divided by
the quantity of output. Since the total cost of producing 40 haircuts is N320, the average
total cost for producing each of 40 haircuts is N320/40, orN8 per haircut. Average cost
curves are typically U-shaped, as shown below Average total cost starts off relatively
high, because at low levels of output total costs are dominated by the fixed cost;
mathematically, the denominator is so small that average total cost is large. Average
total cost then declines, as the fixed costs are spread over an increasing quantity of
output. In the average cost calculation, the rise in the numerator of total costs is
relatively small compared to the rise in the denominator of quantity produced. But as
output expands still further, the average cost begins to rise. At the right side of the
average cost curve, total costs begin rising more rapidly as diminishing returns kick in.

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CC201 Introduction to Microeconomics

This is derived from Total Fixed Cost (TFC) by dividing the Total Fixed Cost (TFC) by
the unit of output. Total fixed cost is constant at all levels of output and hence Average
Fixed Cost (AFC) will be falling as the level of output rises.
𝐴𝐹𝐶 = 𝑇𝐹𝐶/𝑄

This is the total variable cost divided by the unit of output produced; it can also be
defined as the increase in the total cost resulting from producing one additional unit of
output. Average variable cost obtained when variable cost is divided by quantity of
output. For example, the variable cost of producing 80 haircuts is N400, so the average
variable cost is N400/80, or N5 per haircut. Note that at any level of output, the average
variable cost curve will always lie below the curve for average total cost. The reason is
that average total cost includes average variable cost and average fixed cost. Thus, for Q
= 80 haircuts, the average total cost is N8 per haircut, while the average variable cost is
N5 per haircut. However, as output grows, fixed costs become relatively less important
(since they do not rise with output), so average variable cost sneaks closer to average
cost.

The marginal cost is the extra cost of producing one additional unit of output. Since the
fixed cost is constant, the marginal cost means extra variable cost.
The relationships between the Average Total Cost (ATC), Average Fixed Cost (AFC),
Average Variable Cost (AVC) and Marginal Cost are illustrated in Table 6.1 and figure
6.2.
From the Table and figure, the following should be noted:
 Average cost is equal to the marginal cost where the marginal cost is at
minimum.
 At low level of output, the marginal cost is below the average costs.
 The marginal cost also reaches its lowest point at a lower level of output than
the average variable cost and average cost curves.

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 Study Session 6 Cost Theory

Output TFC TVC TC AFC AVC AC MC

level (N) (N) (TFC + TVC) (TFC/Q) (TVC/Q) (AFC + AVC) (dTC/dQ)

1 1000 300 1300 1000 300 1300 -

2 1000 350 1350 500 175 675 5-
3 1000 800 1800 333.3 266.6 599.9 250
4 1000 100 2000 250 250 500 200
5 1000 1200 2200 200 240 440 200
6 1000 1450 2450 166.6 241 407.6 250
7 1000 1800 2800 142.8 257.10 399.9 350
8 1000 2500 3500 125 312.5 437.5 700
9 1000 3400 4400 111.1 377.7 488.8 900
10 1000 4400 5400 100 440 540 1000

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CC201 Introduction to Microeconomics

 Under what conditions is the profit of a firm maximized in the short run?

 The profit of a firm in the short run can be maximized under two scenario:
A. When the difference between total revenue and total cost is the
largest and positive and positive, and
B. When marginal cost equal marginal revenue, that is MC= MR

The long run in production is the period long enough for the entrepreneur to make
adjustments in the size of the enterprise. There are no fixed factors and hence no fixed
cost. i.e. all costs are variable and the firm is able to produce at desired scale. The long
run average cost curve, like short run average cost curves are U shaped but the reasons
for the U shape in each case differs. The reason for the initial decline in the average cost
in the short run is the law of diminishing returns which arises as a result of the presence
of fixed input in the short run. In the long run average cost curve, the decline in the
curve is as a result of economies of scale because there are no fixed inputs and
diseconomies of scale is responsible for the rising part of the LAC curve. As output
increases, increasing return to scale brings about decreasing cost and as output further
increases diseconomies of scale may set in, this causes a rise in the LAC curve. The
minimum level of the LAC curve depicts a constant return to scale level of operation
and this is assumed to be the optimum level of production.

The marginal cost line intersects the average cost line exactly at the bottom of the
average cost curve. The reason why the intersection occurs at this point is built into the
economic meaning of marginal and average costs. If the marginal cost of production is

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 Study Session 6 Cost Theory

below the average cost for producing previous units, as it is for the points to the left of
where MC crosses ATC, then producing one more additional unit will reduce average
costs overall—and the ATC curve will be downward- sloping in this zone.
Conversely, if the marginal cost of production for producing an additional unit is
above the average cost for producing the earlier units, as it is for points to the right of
where MC crosses ATC, then producing a marginal unit will increase average costs
overall—and the ATC curve must be upward-sloping in this zone. The point of
transition, between where MC is pulling ATC down and where it is pulling it up, must
occur at the minimum point of the ATC curve. This idea of the marginal cost “pulling
down” the average cost or “pulling up” the average cost may sound abstract, but
think about it in terms of your own grades. If the score on the most recent quiz you
take is lower than your average score on previous quizzes, then the marginal quiz pulls
down your average. If your score on the most recent quiz is higher than the average on
previous quizzes, the marginal quiz pulls up your average. In this same way, low
marginal costs of production first pull down average costs and then higher marginal
costs pull them up.

The numerical calculations behind average cost, average variable cost, and marginal
cost will change from firm to firm. However, the general patterns of these curves, and
the relationships and economic intuition behind them, will not change.

6.1 discuss production cost

Cost of production refers to the monetary value of the inputs used in production process. 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 fixed inputs.
Cost can either be explicit or implicit:
- Explicit costs are out of pocket expenses incurred by a firm; they involve the expenditure.
- Implicit costs are opportunity costs of using resources that are already owned by the firm.
6.2 discuss different concepts of cost in relation to time Horizon in cost of
production
In a short-run perspective, a firm total costs can be divided into fixed costs, which a firm must incur before
producing any output, and variable costs, which the firm incurs in the act of producing.
- Fixed costs are sunk costs; that is, because they are in the past and cannot be altered, they should
play no role in economic decisions about future production or pricing.
- Variable costs typically show diminishing marginal returns, so that the marginal cost of producing
higher levels of output rises.

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CC201 Introduction to Microeconomics

Marginal cost is calculated by taking the change in total cost (or the change in variable cost, which
will be the same thing) and dividing it by the change in output, for each possible change in output.
Marginal costs are typically rising.
A firm can compare marginal cost to the additional revenue it gains from selling another unit to
find out whether its marginal unit is adding to profit.
Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower
than the market price, a firm will be earning profits.
- Average total cost is calculated by taking total cost and dividing by total output at each
different level of output.
- Average variable cost is calculated by taking variable cost and dividing by the total output at
each level of output.
In the long run, firms can choose their production technology, and so all costs become variable costs. In
making this choice, firms will try to substitute relatively inexpensive inputs for relatively expensive
inputs where possible, so as to produce at the lowest possible long-run average cost.
- Economies of scale refers to a situation where as the level of output increases, the average cost
decreases.
- Constant returns to scale refers to a situation where average cost does not change as output
increases.
- Diseconomies of scale refers to a situation where as output increases, average costs increase
also.

SAQ 6.1 (tests Learning Outcome 6.1)

In production, you must incur some costs; costs like the purchase of factors of production, raw materials,
Transportation, and so on. What is this cost called in Economics.
SAQ 6.2 (tests Learning Outcome 6.2)
A long run in Economics is a time long enough for a firm to vary all its fixed factors of production. In your own
words, describe what you understand by short-run.
SAQ 6.3 ( test Learning Outcome 6.3)
As a producer, what will you consider to be your Total Cost, Total Fixed Cost, Average Cost and Marginal Cost?
Explain each of the concept.

Articulate Presentation

89
 Study Session 6 Cost Theory

This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

90
CC201 Introduction to Microeconomics

Study Session 7

In this study session, we will examine the world of perfect competition; how they make
output decision, how they determine profit and how they react to losses and profits.
Learning Outcomes

7.1 the characteristics of perfect competition

7.2 how a perfectly competitive firm make output decision and
determine highest profit

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 Study Session 7 Introduction to Perfect Competition

Perfect competition

Perfect competition Total revenue & Total

& why it matters cost

Marginal revenue &

Output decisions The shutdown point
Marginal costs

Profits & losses with

Short-run outcomes
average cost curve

Marginal cost &

Firm's supply

This Study Session requires a one hour of formal study time. You may spend an
additional two hours for revision.

Terminologies

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CC201 Introduction to Microeconomics

All businesses face two realities: no one is required to buy their products, and even
customers who might want those products may buy from other businesses instead. Firms
that operate in perfectly competitive markets face this reality. In this study session, you
will learn how such firms make decisions about how much to produce, how much profit
they make, whether to stay in business or not, and many others. Industries differ from
one another in terms of how many sellers there are in a specific market, how easy or
difficult it is for a new firm to enter, and the type of products that are sold. This is
referred to as the market structure of the industry. Here, we will focus on perfect
competition.
Firms are said to be in perfect competition when the following conditions occur:
1. Many firms produce identical products
2. Many buyers are available to buy the product, and many sellers are available to
sell the product;
3. Sellers and buyers have all relevant information to make rational decisions about
the product being bought and sold;
4. Firms can enter and leave the market without any restrictions—in other words,
there is free entry and exit into and out of the market.
A perfectly competitive firm is known as a price taker, because the pressure of
competing firms forces them to accept the prevailing equilibrium price in the market. If
a firm in a perfectly competitive market raises the price of its product by so much as a
penny, it will lose all of its sales to competitors. When a beans grower, wants to know
what the going price of beans is, he or she has to go to the computer or listen to the radio
to check. The market price is determined solely by supply and demand in the entire
market and not the individual farmer. Also, a perfectly competitive firm must be a very
small player in the overall market, so that it can increase or decrease output without
noticeably affecting the overall quantity supplied and price in the market.

A perfectly competitive market is a hypothetical extreme; however, producers in a

number of industries do face many competitor firms selling highly similar goods, in
which case they must often act as price takers. We shall be examining how a profit-

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seeking firms decide how much to produce in perfectly competitive markets. In the short
run, the perfectly competitive firm will seek the quantity of output where profits are
highest or, if profits are not possible, where losses are lowest. In this example, the
“short run” refers to a situation in which firms are producing with one fixed input and
incur fixed costs of production. (In the real world, firms can have many fixed inputs.)
In the long run, perfectly competitive firms will react to profits by increasing
production. They will respond to losses by reducing production or exiting the market.
Ultimately, a long-run equilibrium will be attained when no new firms want to enter the
market and existing firms do not want to leave the market, as economic profits have
been driven down to zero.





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A perfectly competitive firm has only one major decision to make namely, what quantity
to produce. To understand why this is so, consider a different way of writing out the
basic definition of profit:
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
= (𝑃𝑟𝑖𝑐𝑒) (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑)
− (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡) (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑)
Since a perfectly competitive firm must accept the price for its output as determined by
the product’s market demand and supply, it cannot choose the price it charges. This is
already determined in the profit equation, and so the perfectly competitive firm can sell
any number of units at exactly the same price. It implies that the firm faces a perfectly
elastic demand curve for its product: buyers are willing to buy any number of units of
output from the firm at the market price. When the perfectly competitive firm chooses
what quantity to produce, then this quantity—along with the prices prevailing in the
market for output and inputs—will determine the firm’s total revenue, total costs, and
ultimately, level of profits.

A perfectly competitive firm can sell as large a quantity as it wishes, as long as it

accepts the prevailing market price. Total revenue is going to increase as the firm sells
more, depending on the price of the product and the number of units sold. If you
increase the number of units sold at a given price, then total revenue will increase. If the
price of the product increases for every unit sold, then total revenue also increases.
Based on its total revenue and total cost curves, a perfectly competitive firm can
calculate the quantity of output that will provide the highest level of profit. At any given
quantity, total revenue minus total cost will equal profit. One way to determine the most
profitable quantity to produce is to see at what quantity total revenue exceeds total cost
by the largest amount.

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A higher price would mean that total revenue would be higher for every quantity sold. A
lower price would mean that total revenue would be lower for every quantity sold. What
happens if the price drops low enough so that the total revenue line is completely below
the total cost curve; that is, at every level of output, total costs are higher than total
revenues? In this instance, the best the firm can do is to suffer losses. But a profit-
maximizing firm will prefer the quantity of output where total revenues come closest to
total costs and thus where the losses are smallest.

Firms often do not have the necessary data they need to draw a complete total cost curve
for all levels of production. They cannot be sure of what total costs would look like if
they, say, doubled production or cut production in half, because they have not tried it.
Instead, firms experiment. They produce a slightly greater or lower quantity and observe
how profits are affected. In economic terms, this practical approach to maximizing
profits means looking at how changes in production affect marginal revenue and
marginal cost.
Since a perfectly competitive firm is a price taker, it can sell whatever quantity it wishes
at the market-determined price. Marginal cost , the cost per additional unit sold, is
calculated by dividing the change in total cost by the change in quantity. The formula
for marginal cost is:
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 / 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
Ordinarily, marginal cost changes as the firm produces a greater quantity. Marginal cost
will first decline as production increases, then starts to increase, displaying the typical
pattern of diminishing marginal returns. If a firm is producing at a quantity where MR >
MC, then it can increase profit by increasing output because the marginal revenue is
exceeding the marginal cost. If a firm is producing at a quantity where MC > MR, then
it can increase profit by reducing output because the reductions in marginal cost will
exceed the reductions in marginal revenue. The firm’s profit-maximizing choice of
output will occur where MR = MC (or at a choice close to that point). You will notice
that what occurs on the production side is exemplified on the cost side. This is referred
to as duality.
The profit-maximizing choice for a perfectly competitive firm will occur where
marginal revenue is equal to marginal cost—that is, where MR = MC. A profit-seeking
firm should keep expanding production as long as MR > MC. But at the level of output
where MR = MC, the firm should recognize that it has achieved the highest possible
level of economic profits. Expanding production into the zone where MR < MC will
only reduce economic profits. Because the marginal revenue received by a perfectly
competitive firm is equal to the price P, so that P = MR, the profit-maximizing rule for a
perfectly competitive firm can also be written as a recommendation to produce at the
quantity where P = MC.

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A.
B.
C.

Does maximizing profit (producing where MR = MC) imply an actual economic profit?
The answer depends on the relationship between price and average total cost. If the price
that a firm charges is higher than its average cost of production for that quantity
produced, then the firm will earn profits. Conversely, if the price that a firm charges is
lower than its average cost of production, the firm will suffer losses. You might think
that, in this situation, the farmer may want to shut down immediately. Remember,
however, that the firm has already paid for fixed costs, such as equipment, so it may
continue to produce and incur a loss.
a. Where price intersects marginal cost at a level above the average cost curve,
b. Where price intersects marginal cost at a level equal to the average cost curve,
and
c. Where price intersects marginal cost at a level below the average cost curve.

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If... Then...

Price > ATC Firm earns an economic profit

Price = ATC Firm earns zero economic profit

Price < ATC Firm earns a loss

The possibility that a firm may earn losses raises a question: Why can the firm not avoid
losses by shutting down and not producing at all? The answer is that shutting down can
reduce variable costs to zero, but in the short run, the firm has already paid for fixed
costs. As a result, if the firm produces a quantity of zero, it would still make losses
because it would still need to pay for its fixed costs. So, when a firm is experiencing
losses, it must face a question: should it continue producing or should it shut down?

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𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒– (𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡) = 0 – 𝑁10, 000 = 𝑁10, 000

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 – (𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡)

= 𝑁10, 000 − (𝑁10,000 + 𝑁15,000) = – 𝑁15,000

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 – (𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡)

= 𝑁20, 000 – (𝑁10, 000 + 𝑁15, 000) = – 𝑁5, 000

The intersection of the average variable cost curve and the marginal cost curve, which
shows the price where the firm would lack enough revenue to cover its variable costs, is
called the shutdown point. If the perfectly competitive firm can charge a price above the
shutdown point, then the firm is at least covering its average variable costs. It is also
making enough revenue to cover at least a portion of fixed costs, so it should limp ahead
even if it is making losses in the short run, since at least those losses will be smaller than
if the firm shuts down immediately and incurs a loss equal to total fixed costs. However,
if the firm is receiving a price below the price at the shutdown point, then the firm is not
even covering its variable costs. In this case, staying open is making the firm’s losses
larger, and it should shut down immediately. To summarize, if:
i. Price < minimum average variable cost, then firm shuts down
ii. Price = minimum average variable cost, then firm stays in business

The average cost and average variable cost curves divide the marginal cost curve into
three segments, as shown in Figure 7.2. At the market price, which the perfectly
competitive firm accepts as given, the profit-maximizing firm chooses the output level
where price or marginal revenue, which are the same thing for a perfectly competitive
firm, is equal to marginal cost: P = MR = MC.

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The marginal cost curve can be divided into three zones, based on where it is crossed by
the average cost and average variable cost curves. The point where MC crosses AC is
called the zero profit point. If the firm is operating at a level of output where the market
price is at a level higher than the zero-profit point, then price will be greater than
average cost and the firm is earning profits. If the price is exactly at the zero profit point,
then the firm is making zero profits. If price falls in the zone between the shutdown
point and the zero profit point, then the firm is making losses but will continue to
operate in the short run, since it is covering its variable costs. However, if price falls
below the price at the shutdown point, then the firm will shut down immediately, since it
is not even covering its variable costs.
First consider the upper zone, where prices are above the level where marginal cost
(MC) crosses average cost (AC) at the zero profit point. At any price above that level,
the firm will earn profits in the short run. If the price falls exactly on the zero profit
point where the MC and AC curves cross, then the firm earns zero profits. If a price falls
into the zone between the zero profit point, where MC crosses AC, and the shutdown
point, where MC crosses AVC, the firm will be making losses in the short run—but
since the firm is more than covering its variable costs, the losses are smaller than if the
firm shut down immediately. Finally, consider a price at or below the shutdown point
where MC crosses AVC. At any price like this one, the firm will shut down
immediately, because it cannot even cover its variable costs.

For a perfectly competitive firm, the marginal cost curve is identical to the firm’s supply
curve starting from the minimum point on the average variable cost curve. To
understand why this perhaps surprising insight holds true, first think about what the
supply curve means. A firm checks the market price and then looks at its supply curve to
decide what quantity to produce. Now, think about what it means to say that a firm will
maximize its profits by producing at the quantity where P = MC. This rule means that
the firm checks the market price, and then looks at its marginal cost to determine the
quantity to produce—and makes sure that the price is greater than the minimum average
variable cost. In other words, the marginal cost curve above the minimum point on the
average variable cost curve becomes the firm’s supply curve.

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Study Session on Demand and Supply

When profit-maximizing firms in perfectly competitive markets combine with utility-

maximizing consumers, something remarkable happens: the resulting quantities of
outputs of goods and services demonstrate both productive and allocative efficiency.
Productive efficiency means producing without waste, so that the choice is on the
production possibility frontier. In the long run in a perfectly competitive market,
because of the process of entry and exit, the price in the market is equal to the minimum
of the long-run average cost curve. In other words, goods are being produced and sold at
the lowest possible average cost.
Allocative efficiency means that among the points on the production possibility frontier,
the point that is chosen is socially preferred—at least in a particular and specific sense.
In a perfectly competitive market, price will be equal to the marginal cost of production.
Think about the price that is paid for a good as a measure of the social benefit received
for that good; after all, willingness to pay conveys what the good is worth to a buyer.
Then think about the marginal cost of producing the good as representing not just the
cost for the firm, but more broadly as the social cost of producing that good. When
perfectly competitive firms follow the rule that profits are maximized by producing at
the quantity where price is equal to marginal cost, they are thus ensuring that the social
benefits received from producing a good are in line with the social costs of production.

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To explore what is meant by allocative efficiency, it is useful to walk through an

example. Begin by assuming that the market for wholesale flowers is perfectly
competitive, and so P = MC. Now, consider what it would mean if firms in that market
produced a lesser quantity of flowers. At a lesser quantity, marginal costs will not yet
have increased as much, so that price will exceed marginal cost; that is, P > MC. In that
situation, the benefit to society as a whole of producing additional goods, as measured
by the willingness of consumers to pay for marginal units of a good, would be higher
than the cost of the inputs of labor and physical capital needed to produce the marginal
good. In other words, the gains to society as a whole from producing additional marginal
units will be greater than the costs.
Conversely, consider what it would mean if, compared to the level of output at the
allocatively efficient choice when P = MC, firms produced a greater quantity of flowers.
At a greater quantity, marginal costs of production will have increased so that P < MC.
In that case, the marginal costs of producing additional flowers is greater than the
benefit to society as measured by what people are willing to pay. For society as a whole,
since the costs are outstripping the benefits, it will make sense to produce a lower
quantity of such goods.
When perfectly competitive firms maximize their profits by producing the quantity
where P = MC, they also assure that the benefits to consumers of what they are buying,
as measured by the price they are willing to pay, is equal to the costs to society of
producing the marginal units, as measured by the marginal costs the firm must pay—and
thus that allocative efficiency holds.
The statements that a perfectly competitive market in the long run will feature both
productive and allocative efficiency do need to be taken with a few grains of salt.
Remember, economists are using the concept of “efficiency” in a particular and specific
sense, not as a synonym for “desirable in every way.” For one thing, consumers’ ability
to pay reflects the income distribution in a particular society. Thus, a homeless person
may have no ability to pay for housing because they have insufficient income.

Moreover, real-world markets include many issues that are assumed away in the model
of perfect competition, including pollution, inventions of new technology, poverty
which may make some people unable to pay for basic necessities of life, government
programs like national defense or education, discrimination in labor markets, and buyers
and sellers who must deal with imperfect and unclear information. However, the
theoretical efficiency of perfect competition does provide a useful benchmark for
comparing the issues that arise from these real-world problems.

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point out the characteristics of Perfect competition

Perfect competition means that there are many sellers, easy entry, and identical products. A perfectly
competitive firm is a price taker, it accepts the equilibrium price at which it sells goods.
7.2 show how a Perfectly Competitive firm make output decision and determine
highest profit
As a perfectly competitive firm produces a greater quantity of output, its total revenue steadily increases
at a constant rate determined by the given market price. Profits will be highest (or losses will be
smallest) at the quantity of output where total revenues exceed total costs by the greatest amount (or
where total revenues fall short of total costs by the smallest amount). Alternatively, profits will be
highest where marginal revenue, which is price for a perfectly competitive firm, is equal to marginal
cost.
- If the market price faced by a perfectly competitive firm is above average cost at the profit-
maximizing quantity of output, then the firm is making profits. If the market price is below
average cost at the profit-maximizing quantity of output, then the firm is making losses.
- If the market price is equal to average cost at the profit-maximizing level of output, then the
firm is making zero profits. The point where the marginal cost curve crosses the average cost
curve, at the minimum of the average cost curve, is called the zero profit point.
- If the market price faced by a perfectly competitive firm is below average variable cost at the
profit-maximizing quantity of output, then the firm should shut down operations immediately.
- If the market price faced by a perfectly competitive firm is above average variable cost, but
below average cost, then the firm should continue producing in the short run, but exit in the
long run. The point where the marginal cost curve crosses the average variable cost curve is
called the shutdown point.

SAQ 7.1 (tests Learning Outcome 7.1)

In Uromi market, you have many buyers and many independent sellers. In Economics, what type of market
structure is Uromi Market?
SAQ 7.2 (tests Learning Outcome 7.2)
1. A perfectly competitive firm is a price taker, what then does it do to maximise profit?
2. If Marginal cost is the cost per unit sold, what Marginal Revenue?
3. If Average total cost is less than price, what happens to the firm?
The firm will not make profit when Average total cost is greater than price. Yes or No?
4. In reference to the example in study session 7.5.1, when do you consider the Gym centre to have shut down?

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Articulate Presentation
This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

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Study Session 8

We have discussed what a perfect competition firm looks like in the last study session.
In this study session, however, we shall be discussing the Monopoly (the opposite of
monopoly), how they are formed and how they decide output in order to make profit.

Learning Outcomes

8.1 how monopolies are formed

8.2 how a profit-maximising monopoly choose output and price

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Natural monopoly

Introduction to
Monopoly
Legal monopoly

How monopolies form

Intimidating potential
competition

Summing up barriers to
entry

Demand curves

What defines a market?

Marginal revenue and

marginal cost

Profit making monopoly

- choosing output and Maximizing profits
price

Inefficiency of monopoly

Allocative efficiency

Production possibility
frontier

This Study Session requires a one hour of formal study time. You may spend an
additional two hours for revision.

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Terminologies

There is a widespread belief that top executives at firms are the strongest supporters of
market competition, but this belief is far from the truth. Think about it this way: If you
very much wanted to win an Olympic gold medal, would you rather be far better than
everyone else, or locked in competition with many athletes just as good as you are?
Similarly, if you would like to attain a very high level of profits, would you rather
manage a business with little or no competition, or struggle against many tough
competitors who are trying to sell to your customers? By now, you might have read the
study session on Perfect Competition. In this session, we explore the opposite extreme:
monopoly. If perfect competition is a market where firms have no market power and
they simply respond to the market price, monopoly is a market with no competition at
all, and firms have complete market power. In the case of monopoly, one firm produces
all of the output in a market. Since a monopoly faces no significant competition, it can
charge any price it wishes. While a monopoly, by definition, refers to a single firm, in
practice the term is often used to describe a market in which one firm merely has a very
high market share.
Even though there are very few true monopolies in existence, we do deal with some of
those few every day, often without realizing it: The Power Holdings Company of
Nigeria, Postal Service, and garbage collection companies are a few examples. Some
new drugs are produced by only one pharmaceutical firm—and no close substitutes for
that drug may exist.
Because of the lack of competition, monopolies tend to earn significant economic
profits. These profits should attract vigorous competition as described in Perfect
Competition, and yet, because of one particular characteristic of monopoly, they do not.
Barriers to entry can range from the simple and easily surmountable, such as the cost of
renting retail space, to the extremely restrictive. For example, there are a finite number

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of radio frequencies available for broadcasting. Once the rights to all of them have been
purchased, no new competitors can enter the market.
In some cases, barriers to entry may lead to monopoly. In other cases, they may limit
competition to a few firms. Barriers may block entry even if the firm or firms currently
in the market are earning profits. Thus, in markets with significant barriers to entry, it is
not true that abnormally high profits will attract new firms, and that this entry of new
firms will eventually cause the price to decline so that surviving firms earn only a
normal level of profit in the long run.

There are two types of monopoly, based on the types of barriers to entry they exploit.
One is natural monopoly, where the barriers to entry are something other than legal
prohibition. The other is legal monopoly, where laws prohibit (or severely limit)
competition.

A natural monopoly occurs when the quantity demanded is less than the minimum
quantity it takes to be at the bottom of the long-run average cost curve. This situation,
when economies of scale are large relative to the quantity demanded in the market, is
called a natural monopoly. Natural monopolies often arise in industries where the
marginal cost of adding an additional customer is very low, once the fixed costs of the
overall system are in place. Once the main water pipes are laid through a
neighbourhood, the marginal cost of providing water service to another home is fairly
low. Once electricity lines are installed through a neighbourhood, the marginal cost of
providing additional electrical service to one more home is very low. It would be costly
and duplicative for a second water company to enter the market and invest in a whole
second set of main water pipes, or for a second electricity company to enter the market
and invest in a whole new set of electrical wires. These industries offer an example
where, because of economies of scale, one producer can serve the entire market more
efficiently than a number of smaller producers that would need to make duplicate
physical capital investments.

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A natural monopoly can also arise in smaller local markets for products that are difficult
to transport. For example, cement production exhibits economies of scale, and the
quantity of cement demanded in a local area may not be much larger than what a single
plant can produce. Moreover, the costs of transporting cement over land are high, and so
a cement plant in an area without access to water transportation may be a natural
monopoly.

For some products, the government erects barriers to entry by prohibiting or limiting
competition. Many states or cities have laws or regulations that allow households a
choice of only one electric company, one water company, and one company to pick up
the garbage. Most legal monopolies are considered utilities—products necessary for
everyday life—that are socially beneficial to have. As a consequence, the government
allows producers to become regulated monopolies, to insure that an appropriate amount
of these products is provided to consumers. Such a situation is ascribed legal
monopoly . Additionally, legal monopolies are often subject to economies of scale, so it
makes sense to allow only one provider.

Innovation takes time and resources to achieve. Suppose a company invests in research
and development and finds the cure for the common cold. In this world of near
ubiquitous information, other companies could take the formula, produce the drug, and
because they did not incur the costs of research and development (R&D), undercut the
price of the company that discovered the drug. Given this possibility, many firms would
choose not to invest in research and development, and as a result, the world would have
less innovation.

This is an identifying symbol or name for a particular good, like Chiquita bananas,
Chevrolet cars, or the Nike “swoosh” that appears on shoes and athletic gear. A firm can
renew a trademark over and over again, as long as it remains in active use.

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This is a form of protection for original works of authorship including literary, dramatic,
musical, architectural, cartographic, choreographic, pantomimic, pictorial, graphic,
sculptural, and audio-visual creations.” No one can reproduce, display, or perform a
copyrighted work without permission of the author. Copyright protection ordinarily lasts
for the life of the author plus 70 years.
Roughly speaking, patent law covers inventions and copyright protects books, songs,
and art. But in certain areas, like the invention of new software, it has been unclear
whether patent or copyright protection should apply. There is also a body of law known
as trade secrets. Even if a company does not have a patent on an invention, competing
firms are not allowed to steal their secrets. One famous trade secret is the formula for
Coca-Cola, which is not protected under copyright or patent law, but is simply kept
secret by the company.
Taken together, this combination of patents, trademarks, copyrights, and trade secret law
is called intellectual property, because it implies ownership over an idea, concept, or
image, not a physical piece of property like a house or a car. Countries around the world
have enacted laws to protect intellectual property, although the time periods and exact
provisions of such laws vary across countries. There are ongoing negotiations, both
through the World Intellectual Property Organization (WIPO) and through international
treaties, to bring greater harmony to the intellectual property laws of different countries
to determine the extent to which patents and copyrights in one country will be respected
in other countries.
What products are considered utilities depend, in part, on the available technology.
About twenty years ago, local and long distance telephone service was provided over
wires. It did not make much sense to have multiple companies building multiple systems
of wiring across towns and across the country. NITEL lost its monopoly on long
distance service when the technology for providing phone service changed from wires to
microwave and satellite transmission, so that multiple firms could use the same
transmission mechanism. The same thing happened to local service, especially in recent
years, with the growth in cellular phone systems.
The combination of improvements in production technologies and a general sense that
the markets could provide services adequately led to a wave of deregulation. This wave
eliminated or reduced government restrictions on the firms that could enter, the prices
that could be charged, and the quantities that could be produced in many industries,
including telecommunications, airlines, trucking, banking, and electricity.
Around the world, from Africa to Europe to Latin America and Asia, many
governments continue to control and limit competition in what those governments
perceive to be key industries, including airlines, banks, steel companies, oil companies,
and telephone companies.

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A.
B.

Businesses have developed a number of schemes for creating barriers to entry by

deterring potential competitors from entering the market. One method is known as
predatory pricing, in which a firm uses the threat of sharp price cuts to discourage
competition. Predatory pricing is a violation of many countries’ antitrust law, but it is
difficult to prove.
Consider a large airline that provides most of the flights between two particular cities. A
new, small start-up airline decides to offer service between these two cities. The large
airline immediately slashes prices on this route to the bone, so that the new entrant
cannot make any money. After the new entrant has gone out of business, the incumbent
firm can raise prices again. After this pattern is repeated once or twice, potential new
entrants may decide that it is not wise to try to compete.
In some cases, large advertising gadgets can also act as a way of discouraging the
competition. If the only way to launch a successful new national cola drink is to spend
more than the promotional budgets of Coca-Cola and Pepsi Cola, not too many
companies will try. A firmly established brand name can be difficult to dislodge.

Question
o _____________ gives the inventor the exclusive legal right to make, use,
or sell the invention for a limited time.
A. Patent
B. Copyright
Feedback
 Patent, this is a monopoly situation, which arises because the government
has given one person or firm the exclusive right to sell some goods or
services.

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Table 8.1 lists the barriers to entry that have been discussed here. This list is not
exhaustive, since firms have proved to be highly creative in inventing business practices
that discourage competition. When barriers to entry exist, perfect competition is no
longer a reasonable description of how an industry works. When barriers to entry are
high enough, monopoly can result.

Barrier to Entry Government Role? Example

Natural monopoly Government often responds with Water and electric companies
regulation (or ownership)
Control of a physical No DeBeers for diamonds
resource
Legal monopoly Yes Post office, past regulation of
airlines and trucking
Patent, trademark, Yes, through protection of intellectual New drugs or software
and copyright property
Intimidating potential Somewhat Predatory pricing; well-known
competitors brand names

Consider a monopoly firm, comfortably surrounded by barriers to entry so that it need

not fear competition from other producers. How will this monopoly choose its profit-
maximizing quantity of output, and what price will it charge? Profits for the monopolist,
like any firm, will be equal to total revenues minus total costs. The pattern of costs for
the monopoly can be analysed within the same framework as the costs of a perfectly
competitive firm—that is, by using total cost, fixed cost, variable cost, marginal cost,
average cost, and average variable cost. However, because a monopoly faces no
competition, its situation and its decision process will differ from that of a perfectly
competitive firm.

A perfectly competitive firm acts as a price taker, so its calculation of total revenue is
made by taking the given market price and multiplying it by the quantity of output that
the firm chooses. The demand curve as it is perceived by a perfectly competitive firm
appears in Figure 8.2.

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i. A perfectly competitive firm perceives the demand curve that it faces to be flat.
The flat shape means that the firm can sell either a low quantity (Ql) or a high
quantity (Qh) at exactly the same price (P).
ii. A monopolist perceives the demand curve that it faces to be the same as the
market demand curve, which for most goods is downward-sloping. Thus, if the
monopolist chooses a high level of output (Qh), it can charge only a relatively
low price (Pl); conversely, if the monopolist chooses a low level of output (Ql),
it can then charge a higher price (Ph). The challenge for the monopolist is to
choose the combination of price and quantity that maximizes profits.

A monopoly is a firm that sells all or nearly all of the goods and services in a given
market. But what defines the “market”? In general, if a firm produces a product without
close substitutes, then the firm can be considered a monopoly producer in a single
market. But if buyers have a range of similar—even if not identical—options available
from other firms, then the firm is not a monopoly. Still, arguments over whether
substitutes are close or not close can be controversial.
While a monopolist can charge any price for its product, that price is nonetheless
constrained by demand for the firm’s product. No monopolist, even one that is
thoroughly protected by high barriers to entry, can require consumers to purchase its
product. Because the monopolist is the only firm in the market, its demand curve is the
same as the market demand curve, which is, unlike that for a perfectly competitive firm,
downward-sloping.

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Total Cost and Total Revenue for a Monopolist

Profits for a monopolist can be illustrated with a graph of total revenues and total costs,
as shown with the example of the hypothetical HealthPill firm in Figure 8.3. The total
cost curve has its typical shape; that is, total costs rise and the curve grows steeper as
output increases.

Total revenue for the monopoly firm called HealthPill first rises, then falls. Low levels
of output bring in relatively little total revenue, because the quantity is low. High levels
of output bring in relatively less revenue, because the high quantity pushes down the
market price. The total cost curve is upward-sloping. Profits will be highest at the
quantity of output where total revenue is most above total cost. Of the choices in Table
8.2, the highest profits happen at an output of 4. The profit-maximizing level of output is
not the same as the revenue-maximizing level of output, which should make sense,
because profits take costs into account and revenues do not.

QUANTITY TOTAL PRICE TOTAL PROFIT

COST REVENUE (REVENUE-COST)
1 1500 1200 1200 -300

2 1800 1100 2200 400

3 2200 1000 3000 800

4 2800 900 3600 900

5 3500 800 4000 700

6 4200 700 4200 0

7 5600 600 4200 -1400

8 7400 500 4000 -3400

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To calculate total revenue for a monopolist, start with the demand curve perceived by
the monopolist. The Fig. earlier shows quantities along the demand curve and the price
at each quantity demanded, and then calculates total revenue by multiplying price times
quantity at each level of output. (In this example, the output is given as 1, 2, 3, 4, and so
on, for the sake of simplicity. If you prefer a dash of greater realism, you can imagine
that these output levels and the corresponding prices are measured per 1,000 or 10,000
pills.) As the figure illustrates, total revenue for a monopolist rises, flattens out, and then
falls. In this example, total revenue is highest at a quantity of 6 or 7.
Clearly, the total revenue for a monopolist is not a straight upward-sloping line, in the
way that total revenue was for a perfectly competitive firm. The different total revenue
pattern for a monopolist occurs because the quantity that a monopolist chooses to
produce affects the market price, which was not true for a perfectly competitive firm. If
the monopolist charges a very high price, then quantity demanded drops, and so total
revenue is very low. If the monopolist charges a very low price, then, even if quantity
demanded is very high, total revenue will not add up to much. At some intermediate
level, total revenue will be highest.
However, the monopolist is not seeking to maximize revenue, but instead to earn the
highest possible profit. Profits are calculated in the final row of the table. Of the choices
given in the table, the highest profits occur at an output of 4, where profit is 900.

In the real world, a monopolist often does not have enough information to analyze its
entire total revenues or total costs curves; after all, the firm does not know exactly what
would happen if it were to alter production dramatically. But a monopolist often has
fairly reliable information about how changing output by small or moderate amounts
will affect its marginal revenues and marginal costs, because it has had experience with
such changes over time and because modest changes are easier to extrapolate from
current experience. A monopolist can use information on marginal revenue and marginal
cost to seek out the profit-maximizing combination of quantity and price. A monopolist
can determine its profit-maximizing price and quantity by analysing the marginal
revenue and marginal costs of producing an extra unit. If the marginal revenue exceeds
the marginal cost, then the firm should produce the extra unit.
Indeed, the monopoly could seek out the profit-maximizing level of output by increasing
quantity by a small amount, calculating marginal revenue and marginal cost, and then

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either increasing output as long as marginal revenue exceeds marginal cost or reducing
output if marginal cost exceeds marginal revenue. This process works without any need
to calculate total revenue and total cost. Thus, a profit-maximizing monopoly should
follow the rule of producing up to the quantity where marginal revenue is equal to
marginal cost—that is, MR = MC.

If you find it counterintuitive that producing where marginal revenue equals marginal
cost will maximize profits, working through the numbers will help.
Step 1. Remember that marginal cost is defined as the change in total cost from
producing a small amount of additional output.
𝑀𝐶 = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 / 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑
Step 2. Note that in Table 8.3, as output increases from 1 to 2 units, total cost increases
from N1500 to N1800. As a result, the marginal cost of the second unit will be:
𝑁1800 – 𝑁1500
𝑀𝐶 = = 𝑁300
1
Step 3. Remember that, similarly, marginal revenue is the change in total revenue from
selling a small amount of additional output.
𝑀𝑅 = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑜𝑙𝑑
Step 4. Note that in Table 8.3, as output increases from 1 to 2 units, total revenue
increases from N1200 to N2200. As a result, the marginal revenue of the second unit
will be:
𝑁2200 – 𝑁1200
𝑀𝑅 = = 𝑁1000
1

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QUANTITY MARGINAL MARGINAL MARGINAL TOTAL

REVENUE COST PROFIT PROFIT

1 1200 1500 -300 -300

2 1000 300 700 400

3 800 400 400 800

4 600 600 0 800

5 400 700 -300 500

6 200 900 -700 -200

7 0 1200 -1200 -1400

Most people criticize monopolies because they charge too high a price, but what
economists object to is that monopolies do not supply enough output to be allocatively
efficient. To understand why a monopoly is inefficient, it is useful to compare it with the
benchmark model of perfect competition.

This is a social concept. It refers to producing the optimal quantity of some output, the
quantity where the marginal benefit to society of one more unit just equals the marginal
cost. The rule of profit maximization in a world of perfect competition was for each firm
to produce the quantity of output where P = MC, where the price (P) is a measure of
how much buyers value the good and the marginal cost (MC) is a measure of what
marginal units cost society to produce. Following this rule assures allocative efficiency.
If P > MC, then the marginal benefit to society (as measured by P) is greater than the
marginal cost to society of producing additional units, and a greater quantity should be
produced. But in the case of monopoly, price is always greater than marginal cost at the
profit-maximizing level of output. Thus, consumers will suffer from a monopoly

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because a lower quantity will be sold in the market, at a higher price, than would have
been the case in a perfectly competitive market.
The problem of inefficiency for monopolies often runs even deeper than these issues,
and also involves incentives for efficiency over longer periods of time. There are
counterbalancing incentives here. On one side, firms may strive for new inventions and
new intellectual property because they want to become monopolies and earn high
profits—at least for a few years until the competition catches up. In this way,
monopolies may come to exist because of competitive pressures on firms. However,
once a barrier to entry is in place, a monopoly that does not need to fear competition can
just produce the same old products in the same old way—while still ringing up a healthy
rate of profit. John Hicks, who won the Nobel Prize for economics in 1972, wrote in
1935: “The best of all monopoly profits is a quiet life.” He did not mean the comment in
a complimentary way. He meant that monopolies may bank their profits and slack off on
trying to please their customers.
When NITEL provided all of the local and long-distance phone service in the Nigeria,
along with manufacturing most of the phone equipment, the payment plans and types of
phones did not change much. But around year 2000 when mobile telephone companies
found their ways into Nigeria, Nitel lost its monopoly power. Then an explosion of
innovation followed. Services like call waiting, caller ID, three-way calling, voice mail
through the Phone Company, mobile phones, and wireless connections to the Internet all
became available. A wide range of payment plans was offered, as well. The end of the
telephone monopoly brought lower prices, a greater quantity of services, and also a
wave of innovation aimed at attracting and pleasing customers.

Figure 8.5 illustrates these ideas using a production possibilities frontier between
healthcare and education. A production possibilities curve is a graphical representation
of the alternative combinations of goods and services an economy can produce. The
production possibilities frontier can illustrate two kinds of efficiency: productive
efficiency and allocative efficiency. Productive efficiency means it is impossible to
produce more of one good without decreasing the quantity that is produced of
another good. Thus, all choices along a given PPF like B, C, and D display
productive efficiency, but R does not.
Allocative efficiency means that the particular mix of goods being produced—that is,
the specific choice along the production possibilities frontier—represents the
allocation that society most desires.

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8.1 Explain how monopoly is formed 8.2 Discuss how a profit-

Barriers to entry prevent or discourage competitors maximising monopoly choose
from entering the market. These barriers include: output and price
economies of scale that lead to natural monopoly; The monopolist will select the profit-
control of a physical resource; legal restrictions on maximizing level of output where MR = MC,
competition; patent, trademark and copyright and then charge the price for that quantity of
protection; and practices to intimidate the output as determined by the market demand
competition like predatory pricing. curve. If that price is above average cost, the
monopolist earns positive profits.
Monopolists are not productively efficient,
because they do not produce at the minimum
of the average cost curve. Monopolists are
not allocatively efficient, because they do not
produce at the quantity where P = MC.

SAQ 8.1 (tests Learning Outcome 8.1)

1. If Natural Monopoly often arise in industries where the marginal cost of adding an additional customer
is very low once the fixed costs of the overall system are in place, what then is Legal Monopoly.
2. If you have an innovative idea that could change the world, what kind of protective laws can you obtain to
keep this idea safe?
3. Mr. Anthony owns a firm that produces Notebooks and sells at N50per notebook. After discovering that
Mr. Benson is also entering the market to be producing notebook, Mr. Anthony reduces the price to
N20per notebook. Since Mr. Benson cannot cover his cost of production, he ran into loss and was

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frustrated out of the market. What kind of pricing do Economist call the reduction Mr. Anthony carried
out? Explain.
SAQ 8.2 (tests Learning Outcome 8.2)
What is allocative efficiency?

Articulate Presentation
This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

120
CC201 Introduction to Microeconomics

Study Session 9

In this study session, we will discuss another variation of imperfect competition:

monopolistic competition. We will also examine the benefits of variety and
differentiation.

Learning Outcomes
When you have studied this session, you should be able to:
9.1 monopolistic competition
9.2 the process of efficiency in monopolistic competition
9.3 how a monopolistic competitor determines how much to
produce and at what price

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 Study Session 9 Introduction to Monopolistic Competition

Monopolistic Competition

Differentiated products

Overview of monopolistic
competition
Perceived demand for a
monopolistic competitor

Monopolistic competition Benefits of variety and

and efficiency product differentiation

Production volume and

Monopolistic competitors
price in monopolistic
and entry
competition

This Study Session requires a one hour of formal study time. You may spend an
additional two hours for revision.

Terminologies

A type of imperfect competition such that many producers

sell products that are differentiated from one another
hence are not perfect substitutes.

Monopolistic competition involves many firms competing against each other, but
selling products that are distinctive in some way. Examples include stores that sell
different styles of clothing; restaurants or grocery stores that sell different kinds of food;
and even products like golf balls or beer that may be at least somewhat similar but differ
in public perception because of advertising and brand names. When products are
distinctive, each firm has a mini-monopoly on its particular style or flavour or brand
name.

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However, firms producing such products must also compete with other styles, flavour
and brand names. The term “monopolistic competition” captures this mixture of mini-
monopoly and tough competition.

A firm can try to make its products different from those of its competitors in several
ways: physical aspects of the product, location from which the product is sold,
intangible aspects of the product, and perceptions of the product. Products that are
distinctive in one of these ways are called differentiated products.
Physical aspects of a product include all the phrases you hear in advertisements:
unbreakable bottle, non-stick surface, freezer-to-microwave, non-shrink, extra spicy,
newly redesigned for your comfort. The location of a firm can also create a difference
between producers. For example, a petrol station located at a heavily travelled
intersection can probably sell more petrol, because more cars drive by that corner. A
supplier to an automobile manufacturer may find that it is an advantage to locate close
to the car factory.
Intangible aspects can differentiate a product, too. Some intangible aspects may be
promises like a guarantee of satisfaction or money back, a reputation for high quality,
services like free delivery, or offering a loan to purchase the product.
Finally, product differentiation may occur in the minds of buyers. For example, many
people could not tell the difference in taste between common varieties of beer or
cigarettes if they were blindfolded but, because of past habits and advertising, they have
strong preferences for certain brands. Advertising can play a role in shaping these
intangible preferences.

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A monopolistically competitive firm perceives a demand for its goods; that is, an
intermediate case between monopoly and competition offers a reminder that the demand
curve as faced by a perfectly competitive firm is perfectly elastic or flat, because the
perfectly competitive firm can sell any quantity it wishes at the prevailing market price.
In contrast, the demand curve, as faced by a monopolist, is the market demand curve,
since a monopolist is the only firm in the market, and hence is downward sloping.

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The demand curve faced by a perfectly competitive firm is perfectly elastic, meaning it
can sell all the output it wishes at the prevailing market price. The demand curve faced
by a monopoly is the market demand. It can sell more output only by decreasing the
price it charges. The demand curve faced by a monopolistically competitive firm falls in
between.
The demand curve as faced by a monopolistic competitor is not flat, but rather
downward-sloping, which means that the monopolistic competitor can raise its price
without losing all of its customers or lower the price and gain more customers. Since
there are substitutes, the demand curve facing a monopolistically competitive firm is
more elastic than that of a monopoly where there are no close substitutes. If a
monopolist raises its price, some consumers will choose not to purchase its product—
but they will then need to buy a completely different product. However, when a
monopolistic competitor raises its price, some consumers will choose not to purchase
the product at all, but others will choose to buy a similar product from another firm. If a
monopolistic competitor raises its price, it will not lose as many customers as would a
perfectly competitive firm, but it will lose more customers than would a monopoly that
raised its prices.

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 Study Session 9 Introduction to Monopolistic Competition

The long-term result of entry and exit in a perfectly competitive market is that all firms
end up selling at the price level determined by the lowest point on the average cost
curve. This outcome is why perfect competition displays productive efficiency: goods
are being produced at the lowest possible average cost. However, in monopolistic
competition, the end result of entry and exit is that firms end up with a price that lies on
the downward-sloping portion of the average cost curve, not at the very bottom of the
AC curve. Thus, monopolistic competition will not be productively efficient.

Even though monopolistic competition does not provide productive efficiency or

allocative efficiency, it does have benefits of its own. Product differentiation is based on
variety and innovation. Many people would prefer to live in an economy with many kinds
of clothes, foods, and car styles; not in a world of perfect competition where everyone
will always wear blue jeans and white shirts, eat only spaghetti with plain red sauce, and
drive an identical model of car. Many people would prefer to live in an economy where
firms are struggling to figure out ways of attracting customers by methods like friendlier
service, free delivery, guarantees of quality, variations on existing products, and a better
shopping experience. Economists have struggled, with only partial success, to address the
question of whether a market-oriented economy produces the optimal amount of variety.
Critics of market-oriented economies argue that society does not really need dozens of
different athletic shoes or breakfast cereals or automobiles. They argue that much of the
cost of creating such a high degree of product differentiation, and then of advertising and
marketing this differentiation, is socially wasteful—that is, most people would be just as
happy with a smaller range of differentiated products produced and sold at a lower price.
Defenders of a market-oriented economy respond that if people do not want to buy
differentiated products or highly advertised brand names, no one is forcing them to do so.
Moreover, they argue that consumers benefit substantially when firms seek short-term
profits by providing differentiated products. This controversy may never be fully resolved,
in part because deciding on the optimal amount of variety is very difficult, and in part
because the two sides often place different values on what variety means for consumers.

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Question
o __________ involves many firms competing against each other, but
selling products that are distinctive in some way.
A. Perfect competition
B. Monopolistic competition
C. Monopoly
Feedback
 B - Monopolistic competition involves many firms selling products that
are similar but not identical. An example of monopolistic competition
market is the soft drink industry.

The process by which a monopolistic competitor chooses its profit-maximizing quantity

and price resembles closely how a monopoly makes these decisions process:
First, the firm selects the profit-maximizing quantity to produce. Then the firm decides
what price to charge for that quantity.
Step 1. The monopolistic competitor determines its profit-maximizing level of output.
In this case, the Plastic Company will determine the profit-maximizing quantity to
produce by considering its marginal revenues and marginal costs. Two scenarios are
possible:
 If the firm is producing at a quantity of output where marginal revenue exceeds
marginal cost, then the firm should keep expanding production, because each
marginal unit is adding to profit by bringing in more revenue than its cost. In
this way, the firm will produce up to the quantity where MR = MC.
 If the firm is producing at a quantity where marginal costs exceed marginal
revenue, then each marginal unit is costing more than the revenue it brings
in, and the firm will increase its profits by reducing the quantity of output until
MR = MC.

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 Study Session 9 Introduction to Monopolistic Competition

In this example, MR and MC intersect at a quantity of 40, which is the profit-

maximizing level of output for the firm.
Step 2. The monopolistic competitor decides what price to charge. When the firm has
determined its profit- maximizing quantity of output, it can then look to its perceived
demand curve to find out what it can charge for that quantity of output. On the graph,
this process can be shown as a vertical line reaching up through the profit-maximizing
quantity until it hits the firm’s perceived demand curve. See figure figure 9.3

Although the process by which a monopolistic competitor makes decisions about

quantity and price is similar to the way in which a monopolist makes such decisions,
two differences are worth remembering. First, although both a monopolist and a
monopolistic competitor face downward-sloping demand curves, the monopolist’s
perceived demand curve is the market demand curve, while the perceived demand curve
for a monopolistic competitor is based on the extent of its product differentiation and
how many competitors it faces. Second, a monopolist is surrounded by barriers to entry
and need not fear entry, but a monopolistic competitor who earns profits must expect the
entry of firms with similar, but differentiated, products.

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If one monopolistic competitor earns positive economic profits, other firms will be
tempted to enter the market. A petrol station with a great location must worry that other
petrol stations might open across the street or down the road—and perhaps the new
petrol stations will sell coffee or have a carwash or some other attraction to lure
customers. A successful restaurant with a unique barbecue sauce must be concerned that
other restaurants will try to copy the sauce or offer their own unique recipes. A laundry
detergent with a great reputation for quality must be concerned that other competitors
may seek to build their own reputations.
The entry of other firms into the same general market (like petrol, restaurants, or
detergent) shifts the demand curve faced by a monopolistically competitive firm. As
more firms enter the market, the quantity demanded at a given price for any particular
firm will decline, and the firm’s perceived demand curve will shift to the left. As a
firm’s perceived demand curve shifts to the left, its marginal revenue curve will shift to
the left, too. The shift in marginal revenue will change the profit-maximizing quantity
that the firm chooses to produce, since marginal revenue will then equal marginal cost at
a lower quantity.
Unlike a monopoly, with its high barriers to entry, a monopolistically competitive firm
with positive economic profits will attract competition.
As long as the firm is earning positive economic profits, new competitors will continue
to enter the market, reducing the original firm’s demand and marginal revenue curves.
When price is equal to average cost, economic profits are zero. Thus, although a
monopolistically competitive firm may earn positive economic profits in the short term,
the process of new entry will drive down economic profits to zero in the long run.
Remember that zero economic profit is not equivalent to zero accounting profit. A zero
economic profit means the firm’s accounting profit is equal to what its resources could
earn in their next best use.

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 Study Session 9 Introduction to Monopolistic Competition

9.1 Explain monopolistic competition

Monopolistic competition refers to a market where many firms sell differentiated products.
Differentiated products can arise from characteristics of the good or service, location from which the
product is sold, intangible aspects of the product, and perceptions of the product.
9.2 Outline the process of efficiency in monopolistic competition
A monopolistically competitive firm is not productively efficient because it does not produce at the
minimum of its average cost curve. A monopolistically competitive firm is not allocatively efficient
because it does not produce where P = MC, but instead produces where P > MC. Thus, a
monopolistically competitive firm will tend to produce a lower quantity at a higher cost and to charge a
higher price than a perfectly competitive firm.
9.3 Discuss how a monopolistic competitor determines how much to produce and
at what price
A profit-maximizing monopolistic competitor will seek out the quantity where marginal revenue is
equal to marginal cost. The monopolistic competitor will produce that level of output and charge the
price that is indicated by the firm’s demand curve.

SAQ 9.1 (tests Learning Outcome 9.1)

When firms are competing against each other, but selling products that are distinctive in same way is called
Monopolistic Competition. Yes or No? Give reasons for you answer.
SAQ 9.2 (tests Learning Outcome 9.2)
After a monopolistic firm chooses its profit maximising output, what is the next step it takes to maximise profit?
SAQ 9.3 (Test Learning Outcome 9.3)
Some critics of market oriented economy argued that much of the cost of creating a high degree of product
differentiation, and then of advertising and marketing this differentiation, is socially wasteful—that is, most people
would be just as happy with a smaller range of differentiated products produced and sold at a lower price. Do you
agree with them? Give your reasons.

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CC201 Introduction to Microeconomics

Articulate Presentation
This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

131
 Study Session 10 Introduction to Oligopoly

Study Session 10

In this study session, we will discuss another variation of imperfect competition:

oligopoly. This is a type of market structure in which there are only a few rival firms
whose economic well-being and behaviour is mutually interdependent. One firm’s
actions influence the actions of other firms. You are likely familiar with OPEC, it’s a
cartel of oil producing countries. OPEC is an example of oligopoly. Nigeria is a member
nation.

Learning Outcomes
When you have studied this session, you should be able to:
10.1 reasons why oligopoly exists
10.2 between collusion and competition
10.3 what Prisoner’s Dilemma is.

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CC201 Introduction to Microeconomics

Introduction to
Oligopoly
Why do oligopolies
exist?

Collusion or
Collusion vs cartels
competition?

How to enforce
cooperation
Proisoners dilemna
Oligopoly version of
prisoner's dilemna

This Study Session requires a one hour of formal study time. You may spend an
additional two hours for revision.

Terminologies

Many purchases that individuals make at the retail level are produced in markets that are
neither perfectly competitive, monopolies, nor monopolistically competitive. Rather,
they are oligopolies. Oligopoly arises when a small number of large firms have all or
most of the sales in an industry. Examples of oligopoly abound and include the auto
industry, cable television, and commercial air travel. Oligopolistic firms are like cats in
a bag. They can either scratch each other to pieces or cuddle up and get comfortable
with one another. If oligopolists compete hard, they may end up acting very much like
perfect competitors, driving down costs and leading to zero profits for all. If oligopolists
collude with each other, they may effectively act like a monopoly and succeed in
pushing up prices and earning consistently high levels of profit. Oligopolies are
typically characterized by mutual interdependence where various decisions such as
output, price, advertising, and so on, depend on the decisions of the other firm(s).
Analysing the choices of oligopolistic firms about pricing and quantity produced
involves considering the pros and cons of competition versus collusion at a given point
in time.

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A combination of the barriers to entry that create monopolies and the product
differentiation that characterizes monopolistic competition can create the setting for an
oligopoly.
For example, when a government grants a patent for an invention to one firm, it may
create a monopoly. When the government grants patents to, for example, three different
pharmaceutical companies that each has its own drug for reducing high blood pressure,
those three firms may become an oligopoly.
Similarly, a natural monopoly will arise when the quantity demanded in a market is only
large enough for a single firm to operate at the minimum of the long-run average cost
curve. In such a setting, the market has room for only one firm, because no smaller firm
can operate at a low enough average cost to compete, and no larger firm could sell what
it produced given the quantity demanded in the market.
Quantity demanded in the market may also be two or three times the quantity needed to
produce at the minimum of the average cost curve—which means that the market would
have room for only two or three oligopoly firms (and they need not produce
differentiated products). Again, smaller firms would have higher average costs and be
unable to compete, while additional large firms would produce such a high quantity that
they would not be able to sell it at a profitable price. This combination of economies of
scale and market demand creates the barrier to entry, which led to the Boeing-Airbus
oligopoly for large passenger aircraft.
The product differentiation at the heart of monopolistic competition can also play a role
in creating oligopoly. For example, firms may need to reach a certain minimum size
before they are able to spend enough on advertising and marketing to create a
recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is
not that producing fizzy drinks is technologically difficult, but rather that creating a
brand name and marketing effort to equal Coke or Pepsi is an enormous task.

Question
o Which assumption of oligopolistic firms is its most distinguish feature?
Feedback

 The most distinguish feature of oligopolistic firms is its mutual

interdependence among its members firms that made up the firms.

When oligopoly firms in a certain market decide what quantity to produce and what
price to charge, they face a temptation to act as if they were a monopoly. By acting
together, oligopolistic firms can hold down industry output, charge a higher price, and
divide up the profit among themselves. When firms act together in this way to reduce

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output and keep prices high, it is called collusion . A group of firms that have a formal
agreement to collude to produce the monopoly output and sell at the monopoly price is
called a cartel .

How can I tell which is which?

In the United States, unlike Nigeria, it is illegal for firms to collude since collusion is
anti-competitive behaviour, which is a violation of antitrust law. Both the Antitrust
Division of the Justice Department and the Federal Trade Commission have
responsibilities for preventing collusion in the United States.
The problem of enforcement is finding hard evidence of collusion. Cartels are formal
agreements to collude. Because cartel agreements provide evidence of collusion, they
are rare in the United States. Instead, most collusion is tacit, where firms implicitly
reach an understanding that competition is bad for profits.
The desire of businesses to avoid competing so that they can instead raise the prices that
they charge and earn higher profits has been well understood by economists. Adam
Smith wrote in Wealth of Nations in 1776: “People of the same trade seldom meet
together, even for merriment and diversion, but the conversation ends in a conspiracy
against the public, or in some contrivance to raise prices.”
Even when oligopolists recognize that they would benefit as a group by acting like a
monopoly, each individual oligopoly faces a private temptation to produce just a slightly
higher quantity and earn slightly higher profit—while still counting on the other
oligopolists to hold down their production and keep prices high. If at least some
oligopolists give in to this temptation and start producing more, then the market price
will fall. Indeed, a small handful of oligopoly firms may end up competing so fiercely
that they all end up earning zero economic profits—as if they were perfect competitors.

Question
o Fill the following blank spaces from the following options:
Oligopoly, Natural Monopoly, Collusion, Competition
1. __________ will arise when the quantity demanded in a market is
only large enough for a single firm to operate at the minimum of
the long-run average cost curve.
2. When firms act together in a way to reduce output and keep prices
high, it is called __________
Feedback
1. The situation that will arise when the quantity demanded in a
market is only large enough for a single firm to operate at the
minimum of the long-run average cost curve is called Natural
monopoly.

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2. Collusion arises when firms act together in a way to reduce output

and keep prices high.

IMB
Inland Bank International
Bank

First
Inland
Bank

NUB
First Atlantic
International
Bank
Bank

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Because of the complexity of oligopoly, which is the result of mutual interdependence

among firms, there is no single, generally-accepted theory of how oligopolies behave, in
the same way that we have theories for all the other market structures. Instead, economists
use game theory, a branch of mathematics that analyses situations in which players must
make decisions and then receive payoffs based on what other players decide to do. Game
theory has found widespread applications in the social sciences, as well as in business,
law, and military strategy.
The prisoner’s dilemma is a scenario in which the gains from cooperation are larger
than the rewards from pursuing self-interest. It applies well to oligopoly. The story
behind the prisoner’s dilemma goes like this:
Two co-conspiratorial criminals are arrested. When they are taken to the
police station, they refuse to say anything and are put in separate
interrogation rooms. Eventually, a police officer enters the room where
Prisoner A is being held and says: “You know what? Your partner in the
other room is confessing. So your partner is going to get a light prison
sentence of just one year, and because you’re remaining silent, the judge is
going to stick you with eight years in prison. Why don’t you get smart? If
you confess, too, we’ll cut your jail time down to five years, and your
partner will get five years, also.” Over in the next room, another police
officer is giving exactly the same speech to Prisoner B. What the police
officers do not say is that if both prisoners remain silent, the evidence
against them is not especially strong, and the prisoners will end up with
only two years in jail each.
The game theory situation facing the two prisoners is shown in Table 10.1. To
understand the dilemma, first consider the choices from Prisoner A’s point of view. If A
believes that B will confess, then A ought to confess, too, so as to not get stuck with the
eight years in prison. But if A believes that B will not confess, then A will be tempted to
act selfishly and confess, so as to serve only one year. The key point is that A has an
incentive to confess regardless of what choice B makes! B faces the same set of choices,
and thus will have an incentive to confess regardless of what choice A makes. Confess is
considered the dominant strategy or the strategy an individual (or firm) will pursue
regardless of the other individual’s (or firm’s) decision. The result is that if prisoners
pursue their own self-interest, both are likely to confess, and end up doing a total of 10
years of jail time between them.

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Prisoner B

Remain Silent Confess (do not

(cooperate with other cooperate with other
prisoner) prisoner)
Remain Silent A gets 2 years, B gets A gets 8 years, B
Prisoner (cooperate with other) 2 years gets 1 year
A prisoner)
Confess (do not A gets 1 year, B A gets 5 years B
cooperate with other) gets 8 years gets 5 years
prisoner)
The game is called a dilemma because if the two prisoners had cooperated by both
remaining silent, they would only have had to serve a total of four years of jail time
between them. If the two prisoners can work out some way of cooperating so that
neither one will confess, they will both be better off than if they each follow their own
individual self-interest, which in this case leads straight into longer jail terms.

How can parties who find themselves in a prisoner’s dilemma situation avoid the
undesired outcome and cooperate with each other? The way out of a prisoner’s dilemma
is to find a way to penalize those who do not cooperate. Perhaps the easiest approach for
colluding oligopolists, as you might imagine, would be to sign a contract with each other
that they will hold output low and keep prices high. Certain international organizations,
like the nations that are members of the Organization of Petroleum Exporting Countries
(OPEC), have signed international agreements to act like a monopoly, hold down
output, and keep prices high so that all of the countries can make high profits from oil
exports. Such agreements, however, because they fall in a gray area of international law,
are not legally enforceable. If Nigeria, for example, decides to start cutting prices and
selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop.

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The members of an oligopoly can face a prisoner’s dilemma, also. If each of the
oligopolists cooperates in holding down output, then high monopoly profits are possible.
Each oligopolist, however, must worry that while it is holding down output, other firms
are taking advantage of the high price by raising output and earning higher profits.
Table10.2. shows the prisoner’s dilemma for a two-firm oligopoly—known as a
duopoly. If Firms A and B both agree to hold down output, they are acting together as a
monopoly and will each earn N1,000 in profits. However, both firms’ dominant strategy
is to increase output, in which case each will earn N400 in profits.

Firm B

Hold Down Output Increase Output

(cooperate with other firm) (do not cooperate
with other firm)
Hold Down Output A gets N1,000, B gets A gets N200, B gets
Firm (cooperate with other firm) N1,000 N1,500

A Increase Output (do A gets N1,500, B gets N200 A gets N400, B gets
not cooperate with N400
other firm)
Can the two firms trust each other?
Consider the situation of Firm A:
 If A thinks that B will cheat on their agreement and increase output, then A will
increase output, too, because for A the profit of N400 when both firms increase
output (the bottom right-hand choice in Table 10.3) is better than a profit of only
N200 if A keeps output low and B raises output (the upper right-hand choice in
the table).
 If A thinks that B will cooperate by holding down output, then A may seize the
opportunity to earn higher profits by raising output. After all, if B is going to
hold down output, then A can earn N1,500 in profits by expanding output (the
bottom left-hand choice in the table) compared with only N1,000 by holding
down output as well (the upper left-hand choice in the table).
Thus, firm A will reason that it makes sense to expand output if B holds down output
and that it also makes sense to expand output if B raises output. Again, B faces a parallel
set of decisions.

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The result of this prisoner’s dilemma is often that even though A and B could make the
highest combined profits by cooperating in producing a lower level of output and acting
like a monopolist, the two firms may well end up in a situation where they each increase
output and earn only N400 each in profits.

Question
o __________ is a scenario in which the gains from cooperation are larger
than the rewards from pursuing self-interest.
A. the prisoner
B. the dilemma
C. the prisoner’s dilemma
Feedback

 The correct option is (C). A scenario in which the gains from cooperation
are larger than the rewards from pursuing self-interest is referred to as the
Prisoner’s dilemma.

10.1 give reasons why Oligopoly exists 10.3 explain what Prisoner’s
An oligopoly arises when a few firms sell most Dilemma is
or all of the goods in a market. Oligopolists The prisoner's dilemma is an example
earn their highest profits if they can band of game theory. It shows how, in
together as a cartel and act like a monopolist certain situations, all sides can benefit
by reducing output and raising price. from cooperative behavior rather than
10.2 differentiate between Collusion and
self-interested behavior. However, the
Competition challenge for the parties is to find
Collusion offers alternatives to engage in ways to encourage cooperative
competition among firms in an oligopolistic behavior.
market structure. Collusion is the act of firms
working together (cooperating) to establish the
price and level of output in a particular market.

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SAQ 10.1 (tests Learning Outcome 10.1)

“When the government grants patents to, for example, three different pharmaceutical companies that each has its
own drug for reducing high blood pressure, those three firms may become an oligopoly”
The above statement is one of the reasons for the existence of Oligopoly, list other reasons.
SAQ 10.2 (tests Learning Outcome 10.2)
When firms struggle to outsmart one another in other to make maximum profit, we call it Competition. In your own
words, explain what you understand by Collusion.
SAQ 10.3 (tests Learning Outcome 10.3)
The prisoner’s dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing
self-interest. Try create your own Prisoner’s Dilemma situation.

Articulate Presentation
This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack
(Schoolboard disc / online page), and also linked here.
Schoolboard
Access your schoolboard app, or visit www.schoolboard.edutechportal.org/introductiontomicroeconomics to access
updated online activities and resources related to the units of this Study Session.

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 Feedback to SAQs

SAQ 1.1

The fact that all you listed was not provided for you buttresses the issue of scarcity. Which shows that our
wants as human are infinite and the resources available to meet those wants are not sufficient.
SAQ 1.2
The old man’s method can be called Division of labour. Since Useni digs ground every day, he became a
master in it, on the other hand, Okon also became a professional in pulling out yams. Both of them became
specialized in their field which increased their productivity from 50 tubers to 200 tubers of yam.
SAQ 1.3
The third way of organizing the economy is called Market economy, which is a situation the forces of
demand and supply dictates what happens in the market.

SAQ 2.1
Since Chidi is the one requesting to buy things from Odafe, he is the one making the demand. (b)The
demand curve is a graphical representation of Chidi’s demand. (c) If Chidi’s customers’ income increases
that they now bring bigger car for Chidi to repair, his demand curve will shift because of this.
SAQ 2.2
All these assumption can be referred to as Ceteris paribus, which means all things being equal.
SAQ 2.3
Everybody will besiege the fuel station in order to stock fuel at home. Thereby shifting the demand curve
for fuel.
SAQ 2.4
Nnamdi who is the car dealer will be the one to make supply.

SAQ 3.1
The economic term that describes what happened is referred to as elasticity, and it studies the rate of
responsiveness of demand to changes in price.
SAQ 3.2
The situation whereby an increase in price of a commodity does not affect the demand for such
commodity is referred to as zero elasticity.
SAQ 3.3

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True. Price is the yardstick that is used to measure the rate of responsiveness of a commodity.

SAQ 4.1
The satisfaction you derived from eating a bowl of Apu and Egusi is what economist refers to as Utility.
SAQ 4.2
Your ability to measure the utility you derived from eating the Apu and Egusi in utils is called Cardinal
approach.
SAQ 4.3
What will set in as you continue to consume an additional plate of Apu and Egusi is what Economists
refer to as Diminishing marginal utility.

SAQ 5.1
Production is the process of transforming raw materials to finished product and it is very important
because there is nothing we use that is not produced.
SAQ 5.2
The other type of good is referred to as capital goods and it is used to produce other goods.
SAQ 5.3
Those factors are what Economists referred to as Factors of production.
SAQ 5.4
After acquiring factors of production, you will still need inputs (raw materials) to carry out production
processes. These other inputs are referred to as variable inputs.
SAQ 5.5
Return to scale describes the response of output to a change in the level of all inputs employed.

SAQ 6.1
These cost of production is what we refer to as factors of production.
SAQ 6.2
Short-run period is a production period which is short enough for firms not to vary all its factors of
production during production process.
SAQ 6.3
All factors of production will be considered as fixed cost while the inputs will be considered variable
cost. The combination of all costs is regarded as Total cost

SAQ 7.1

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 Feedback to SAQs

The situation at Uromi market is referred to as perfect competition where there are many buyers and
many independent sellers.
SAQ 7.2
1. As a competitive market, the firm can only determine the quantity that will give him maximum
profit.
2. Marginal revenue is the additional revenue that will be generated by increasing product sales by
one unit.
3. When the price is higher than average cost, the firm will definitely earn profit.
4. The gym centre should shut down when the price is less than minimum average variable cost.

SAQ 8.1
1. Legal monopoly offers a specific product or service at a regulated price and can either be
independently run and government regulated, or government run and regulated.
2. Copyright can be used to protect an innovative idea.
3. What Mr. Anthony did is call predatory pricing, which is the method firms use to discourage
firms from entering the market.
SAQ 8.2
Allocative efficiency refers to producing the optimal quantity of some output, the quantity where the
marginal benefit to society of one more unit just equals the marginal cost.

SAQ 9.1
Monopolistic competition is a type of imperfect competition such that many producers sell products that
are differentiated from one another (e.g. by branding or quality) and hence are not perfect substitutes. So
the answer is yes.
Monopolistic first choose the profit maximizing output and then decide what price to charge.
I will not agree with the critics because a free market allows both the buyer and the sellers to make
maximum use of the opportunity that exists in the market.

SAQ 10.1
A. A natural monopoly will arise when the quantity demanded in a market is only large enough for
a single firm to operate at the minimum of the long-run average cost curve.
B. Quantity demanded in the market may also be two or three times the quantity needed to produce
at the minimum of the average cost curve—which means that the market would have room for
only two or three oligopoly firms (and they need not produce differentiated products).
C. The product differentiation at the heart of monopolistic competition can also play a role in
creating oligopoly.

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SAQ 10.2
Collusion is when firms act together to hold down industry output, charge a higher price, and divide up
the profit among themselves.
SAQ 10.3
Imagine a situation where your lecturer caught you and your friend cheating but there no evidence to nail
the two of you. However, he has an evidence to nail the two of you for damaging a school property.
Create a prisoners’ dilemma with this information.

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 Glossary of Terms

Allocative Efficiency When the point that is chosen, among the points on the production
possibility frontier, is socially preferred in a particular and specific sense.

Arc Elasticity method An estimate of elasticity.

Budget Constrain It shows the various combinations of two goods that are affordable
given consumer income.

Cartel A group of firms that have a formal agreement to collude to produce

the monopoly output and sell at the monopoly price.

Collusion When firms act together in a way to reduce output and keep prices
high.

Constant Unitary Elasticity In either a supply or demand curve, it occurs when a price change of
one percent results in a quantity change of one percent.

Copyright A form of protection provided by the laws to protect ‘original works of

authorship’ including literary, dramatic, musical, architectural,
cartographic, choreographic, pantomimic, pictorial, graphic, sculptural,
and audiovisual creations.”

Cost of Production The monetary value of the inputs used in production process.

Cross Price Elasticity The idea that the price of one good is affecting the quantity demanded
of a different good.

Demand The quantity of a commodity that a consumer is willing to buy at a

given price and at a particular period of time

Demand curve The graphical representation of the relationship between the quantity
demanded of a commodity and its prices.

Demand schedule A table which shows the different magnitudes of a commodity being
demanded for at various levels of prices.

Diminishing marginal rate of It is the rate at which a commodity is substituted for another one by a
substitution consumer and yet be of the same level of overall satisfaction.

Direct Production This is the type of production in which an individual produces goods
and services only for family use or consumption.

Equilibrium The point on where quantity demanded equals quantity supplied

Explicit Cost The money outlays made by the producer to meet the direct cost of
production, that is, the actual expenditures on the factors of production
used in the process of production

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Firm This is a technical unit engaged in the production of goods and

services.

Globalization The process of expanding cultural, political, and economic connections

between people around the world.

Implicit Cost The cost of self-owned assets or self-provided labour which are often
overlooked when computing the production expenses of the firm.

Indirect Production It is the type of production in which goods and services are produced in
large scale mainly for sales or in exchange for other goods.

Input This is a factor or resource which when combined with other factors of
production helps to produce a given level of output. Examples are
labour, land, raw materials etc.

Long Run A period in production is a planning period that is long enough for the
firm to be able to vary the amount of all factors of production used in
production process.

Marginal cost The cost per additional unit sold

Marginal Revenue curve The curve which shows the additional revenue gained from selling one
more unit.

Model A simplified framework designed to illustrate complex processes

Monopolistic competition Firms competing against each other, but selling products that are
distinctive in some way.

Monopoly A firm that sells all or nearly all of the goods and services in a given
market.

Natural monopolies Arise in industries where the marginal cost of adding an additional
customer is very low, once the fixed costs of the overall system are in
place.

Natural Monopoly Arises when the quantity demanded in a market is only large enough
for a single firm to operate at the minimum of the long-run average
cost curve

Oligopolistic market A kind of market dominated by a small number of firms.

Output The product of combination of various resources which is usually

referred to as goods

Patent Gives the inventor the exclusive legal right to make, use, or sell the
invention for a limited time

Perfect competition Market structure which exists where there are many buyers and many
independent sellers in the market for the product.

Price Elasticity The ratio between the percentage change in the quantity demanded
(Qd) or supplied (Qs) and the corresponding percent change in price.

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 Glossary of Terms

Price Elasticity of Demand The percentage change in the quantity demanded of a good or service
divided by the percentage change in the price.

Price Elasticity Supply The percentage change in quantity supplied divided by the percentage
change in price.

Primary Production This is the production that involves the extraction of raw materials
provided by nature.

Prisoner’s Dilemma A scenario in which the gains from cooperation are larger than the
rewards from pursuing self-interest. It applies well to oligopoly

Production It is the creation of wealth in the form of goods and provision of

services which are capable of satisfying human wants

Productive Efficiency Means producing without waste, so that the choice is on the
production possibility frontier.

Scarcity The condition of having to choose among alternatives.

Secondary Production This type of production involves the transformation of basic raw
materials or semi – finished goods into final forms that are acceptable
to the consumers.

Short Run The production period which is so short for the firm to vary the amount
of its fixed factors such as land, building, machinery

Supply The quantity of goods and services that the producer is willing to sell at
a market price.

Supply curve The graphical representation of the relationship between the quantity
supplied and its prices

Supply schedule The table that shows the different magnitude of commodity that the
producer is willing to sell at various prices

Tertiary production This is concerned with the provision of commercial and professional
services to ensure that the goods so produced at the primary and
secondary production levels are distributed to the final consumers.

Theory A set of assumptions, propositions, or accepted facts that attempts to

provide a plausible or rational explanation of cause-and-effect (causal)
relationships among a group of observed phenomenon.

Trademark An identifying symbol or name for a particular good

Unitary Elasticity Proportional responsiveness of either demand or supply

Util Unit of utility

Utility This is a measure of satisfaction derived from application of resources.

It is a measure of preferences over some sets of a goods and services,

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and it represents satisfaction experienced by consumer of goods and

services.

Zero Elasticity The extreme case in which a percentage change in price, no matter
how large, results in zero change in quantity.

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