Introduction to

Agricultural
Economics
Samuel Awoniyi
1
Module 1
The Nature of Economics and Economic Problems

Introduction
Welcome to the inaugural module of our course, "Introduction to Agricultural Economics." In this
module, we embark on an exploration of the profound concepts underlying Agricultural
Economics, seeking a comprehensive understanding of its definition, importance, and its
indispensable role in the context of Nigeria. Agricultural Economics transcends the theoretical
realm; it assumes the mantle of a catalyst, shaping the economic tapestry of nations. In a country
like Nigeria, with a rich agricultural heritage, a profound comprehension of these principles
becomes not just an academic pursuit but a strategic imperative. As we traverse the upcoming
modules, the canvas will unfold, revealing the intricate brushstrokes that define the applications
of Agricultural Economics in the real world.

Definition and Importance

Agricultural Economics represents the nexus where the technical intricacies of agriculture
converge with the strategic facets of management, marketing, and finance. At its core, it is an
interdisciplinary field tasked with unraveling the intricate economic dynamics that govern the
production, distribution, and consumption of food and fiber in societies. The judicious utilization
of scarce resources lies at the heart of this discipline.
Agricultural Economics is the study of how societies use scarce resources to produce food and
fiber. It is a multidisciplinary field that draws on principles from economics, sociology,
anthropology, and biology to understand the complex factors that influence agricultural production
and decision-making.
In the annals of Nigeria's economic history, agriculture emerged as the linchpin, significantly
contributing to the nation's GDP and export earnings prior to the era of crude oil discovery. Today,
as Nigeria forges ahead with economic diversification, the principles of Agricultural Economics
retain their pivotal significance. They furnish invaluable insights into resource allocation, effective
management, and the dynamic forces steering the agricultural marketplace.
The statement highlights the multidisciplinary nature of Agricultural Economics, emphasizing
how it integrates various fields—economics, sociology, anthropology, and biology—to analyze
and solve complex issues in agriculture. Let's break down the link between each discipline and
Agricultural Economics:
1. Economics:Economics forms the core of Agricultural Economics, providing the fundamental
principles to analyze how resources are allocated within agricultural systems. Agricultural
economists use economic theories to understand issues like:Supply and demand: How market
forces affect the price of agricultural products and resource allocation.Cost-benefit analysis: To
2
evaluate the profitability and efficiency of farming operations and agricultural policies.Production
economics: Analyzing inputs (e.g., labor, land, and capital) and outputs
(e.g., crops, livestock) to maximize efficiency and profitability.Risk and uncertainty: Addressing
uncertainties in weather, market prices, and production outcomes that affect farm
decision-making.Policy and trade: Understanding how government policies (e.g., subsidies,
tariffs) and international trade impact agricultural markets and rural economies.
2. Sociology:Sociology provides insights into the social structures and relationships that influence
agricultural practices and rural development. It connects to Agricultural Economics by
focusing on:Rural communities: Studying the social dynamics, labor relations, and community
development in rural areas.Social capital: How networks of relationships, trust, and cooperation
among farmers and agricultural stakeholders affect productivity and innovation.Gender roles:
Exploring how gender influences access to resources like land, credit, and technology, and the
impact of these dynamics on agricultural production and household welfare.Cultural practices:
The role of tradition, social norms, and collective behavior in shaping agricultural systems and
decision-making.
3. Anthropology:Anthropology examines the cultural, historical, and human aspects of agriculture,
providing Agricultural Economics with a deeper understanding of how human
behaviors and cultural practices influence agriculture. Links include:Indigenous knowledge:
Understanding traditional farming practices and their economic significance in various
cultures.Cultural adaptation: How farmers adapt to environmental, technological, and market
changes in culturally diverse regions.Agrarian societies: Studying how agricultural systems
evolve over time within different cultural and environmental contexts.Food systems: Investigating
the cultural significance of food, dietary habits, and their implications for
agricultural production and market systems.
4. Biology:Biology plays a crucial role in Agricultural Economics by contributing to the
understanding of natural processes that affect agricultural productivity. Its link to Agricultural
Economics can be seen in:Crop and livestock science: Understanding the biological processes of
plant and animal growth to inform decisions on breeding, pest control, and sustainable
practices.Environmental economics: Examining the economic impact of environmental factors
such as soil health, water availability, and biodiversity on agricultural sustainability.Sustainable
agriculture: Studying how biological diversity, ecological interactions, and natural resources can
be managed to improve agricultural efficiency while minimizing environmental degradation.
Climate change: Analyzing how biological factors related to climate impact agricultural output
and how farmers adapt economically to these changes.
Conclusion:Agricultural Economics is not confined to economic principles alone. It incorporates
sociological, anthropological, and biological insights to understand the broader factors that
influence agricultural production, sustainability, and decision-making. This multidisciplinary
approach allows agricultural economists to devise more comprehensive solutions to challenges
like food security, rural development, and sustainable farming practices.
In Nigeria, agriculture has historically been a major driver of economic growth and development.
3
Prior to the discovery of oil in the 1970s, agriculture was the mainstay of the economy, accounting
for a significant portion of GDP and export earnings. Even today, agriculture remains an important
sector, employing millions of people and providing food security for the nation's growing
population.
The study of agricultural economics is essential for understanding the challenges and opportunities
facing the Nigerian agricultural sector. By understanding the economic principles that govern
agricultural production and decision-making, policymakers can develop effective strategies
promote agricultural growth, reduce poverty, and ensure food security for all Nigerians.

1. Defining Economics
Economics is fundamentally the science of choices. It is a social science that examines how
individuals, businesses, and governments allocate scarce resources to meet unlimited wants and
needs. This definition, while seemingly straightforward, encapsulates a vast and intricate field of
study that touches every aspect of human life.
At its core, economics is concerned with how people make decisions under conditions of scarcity.
Scarcity, a central concept in economics, refers to the basic problem that resources (such as land,
Labour, and capital) are limited, while human wants and needs are virtually infinite. This scarcity
forces individuals and societies to make choices about how to use their resources most effectively.
Economics is not just about money or markets; it’s about understanding the trade-offs that
individuals, businesses, and governments face in their pursuit of happiness, profit, and social
welfare. It studies how these agents respond to incentives, how they interact with each other, and
how these interactions shape the outcomes in markets and economies at large.
In the context of agriculture, the decisions made by farmers, agribusinesses, and policymakers are
inherently economic. These decisions involve selecting which crops to plant, how much land to
allocate, how to utilize technology, how to manage risks, and how to respond to market signals
like prices and consumer demand. Each decision reflects an attempt to optimize the use
of scarceresources—land, water, Labour, and capital—while balancing the risks and rewards
inherent inagricultural production.

Economic Decision-Making in Agriculture

The process of economic decision-making in agriculture is a dynamic one, involving continuous
assessment and reassessment of the costs and benefits associated with various choices. These
decisions are guided by the principles of marginal analysis, which involves evaluating the
additional (marginal) costs and benefits of a decision.
For example, a farmer deciding whether to plant an additional hectare of maize would consider the
marginal cost (e.g., the cost of seeds, Labour, fertilizer, and the opportunity cost of not planting
another crop) and the marginal benefit (e.g., the potential revenue from selling the maize). If the
marginal benefit exceeds the marginal cost, the farmer would likely choose to plant the maize.

4
However, if the marginal cost is higher, the farmer might opt for a different crop or use the land
for another purpose.
Economics, in essence, is about making informed choices in the face of scarcity. In agriculture,
these choices are crucial for determining not only the economic viability of farming operations but
also for ensuring food security and sustainable development. The ability to make sound economic

decisions—guided by the principles of marginal analysis and a deep understanding of the costs
and benefits involved—is fundamental to the success of agricultural endeavors.
Understanding economics as the science of choices provides a powerful lens through which to
view the myriad decisions that shape our economies and our lives. Whether it’s deciding what
crops to plant, how to allocate resources, or how to respond to market fluctuations, economics
offers the tools and insights needed to navigate these challenges effectively.
This holistic understanding of economics is essential for anyone involved in the agricultural sector,
from individual farmers to policymakers, as it provides the foundation for making decisions that
optimize resource use, enhance productivity, and contribute to the overall well-being of society.

2. Microeconomics vs. Macroeconomics

Economics, as a discipline, is traditionally divided into two broad categories: Microeconomics
and Macroeconomics. These two branches, while interconnected, serve distinct purposes and
focus on different aspects of economic behavior and outcomes.
Microeconomics: The Study of Individual Agents
Microeconomics is the branch of economics that zeroes in on the behaviour of individual agents
within the economy. These agents include households, firms, and markets. Microeconomics
examines how these entities make decisions, allocate resources, and interact within specific
markets.
At its core, microeconomics seeks to understand the mechanisms that drive individual choices and
how these choices aggregate to form market outcomes. It explores questions like:
• How do consumers decide what to purchase given their budget constraints?
• How do firms determine the optimal level of production to maximize profits?
• How do prices adjust in response to changes in supply and demand?
Microeconomics delves into the intricacies of supply and demand, price formation, market
structures (such as perfect competition, monopoly, and oligopoly), and the allocation of resources.
It is fundamentally concerned with efficiency and equity within specific markets and the effects of
government intervention on these markets.
Example: In agriculture, microeconomics would analyze how a farmer decides which crop to plant
based on input costs, expected market prices, and available resources. It would also study how
5
changes in the price of fertilizers or seeds impact the farmer's production decisions.

Graph: Supply and Demand in a Microeconomic Context

• Horizontal Axis: Represents the quantity of a good or service.

• Vertical Axis: Represents the price level of the good or service.
The supply curve typically slopes upward, indicating that as the price of a good increases,
producers are willing to supply more. The demand curve slopes downward, reflecting that as the
price decreases, consumers are willing to purchase more. The point where the supply and demand
curves intersect is the equilibrium price and quantity—the point where the market clears,
meaning supply equals demand.

Macroeconomics: The Study of the Economy as a Whole

In contrast, Macroeconomics focuses on the economy as a whole. It examines large-scale
economic factors that affect the overall performance and health of the economy. Macroeconomics
addresses broader questions such as:
6
 • What causes economic growth and how can it be sustained?
• What are the sources of inflation and how can it be controlled?
• How does unemployment affect economic stability and social welfare?
Macroeconomics analyzes aggregate indicators such as gross domestic product (GDP), national
income, inflation rates, unemployment rates, and overall economic growth. It studies how policies

implemented by governments and central banks influence these indicators and, by extension, the
well-being of the economy.
Example: In the agricultural sector, macroeconomics might examine how national agricultural
policies, such as subsidies or tariffs, impact the overall agricultural output, food prices, and the
country's trade balance. It would also explore how fluctuations in global markets or exchange rates
influence domestic agricultural production.
Graph: Aggregate Supply and Demand in a Macroeconomic Context

• Horizontal Axis: Represents the overall output of the economy (Real GDP).
• Vertical Axis: Represents the overall price level in the economy.
The aggregate demand curve (AD) slopes downward, indicating that as the price level falls, the
quantity of goods and services demanded increases. The aggregate supply curve (AS) can have
different shapes depending on the time frame considered (short-run vs. long-run). In the short-run,
it might slope upwards, while in the long-run, it could be vertical, reflecting the economy’s full
employment level of output. The intersection of AD and AS determines the equilibrium price level
and the level of output.

7
The Interconnection Between Microeconomics and Macroeconomics
While microeconomics and macroeconomics are distinct in their focus, they are deeply
interconnected. The decisions made by individual economic agents (studied in microeconomics)
collectively influence the broader economic indicators (studied in macroeconomics). Conversely,
macroeconomic trends and policies shape the environment within which individuals and firms
operate.

For instance, a government policy aimed at stimulating economic growth (a macroeconomic

concern) might involve subsidies for certain agricultural inputs, which would affect farmers'
decisions on what and how much to produce (a microeconomic concern). Similarly, inflation (a
macroeconomic phenomenon) can influence consumers' purchasing power, which in turn affects
the demand for goods and services at the microeconomic level.
Microeconomics and Macroeconomics are two sides of the same coin, each essential for
understanding the complexities of economic systems. Microeconomics provides insights into the
behavior of individual agents and the functioning of specific markets, while macroeconomics
offers a broader view of the economy’s overall performance and the factors that drive economic
growth and stability.
For anyone studying economics, appreciating the distinction and the interrelationship between
these two branches is crucial. It allows for a comprehensive understanding of both the detailed
workings of individual markets and the overarching forces that shape economic outcomes on a
national and global scale. Whether you are a policymaker, business leader, or academic, mastering
both microeconomic and macroeconomic concepts is key to making informed decisions that
contribute to economic prosperity and social well-being.

3. Fundamental Economic Problems

Every society, regardless of its economic system or level of development, faces three fundamental
economic problems: What to produce?, How to produce?, and For whom to produce? These
problems arise from the basic economic reality of scarcity, where the resources available to satisfy
human wants are limited, yet human desires are virtually limitless. Understanding and addressing
these fundamental problems is at the core of economic theory and practice.
a. What to Produce?
The first fundamental economic problem is determining what goods and services should be
produced with the limited resources available. Societies must decide which needs and wants are
the most pressing and allocate their resources accordingly. This decision involves trade-offs, as
producing more of one good typically means producing less of another.
For example, a society may need to choose between producing more agricultural goods to ensure
food security or allocating resources to industrial production to stimulate economic growth. These
decisions are influenced by factors such as consumer preferences, resource availability, and
8
government policies.
In agriculture, the question of "what to produce" can involve decisions about which crops to
cultivate based on market demand, soil fertility, climate conditions, and the availability of
technology and infrastructure.

b. How to Produce?
The second fundamental economic problem concerns the method of production—how to
producethe goods and services that society has decided upon. This problem involves determining
the mostefficient use of resources, including land, Labour, and capital, to maximize output.
Efficiency is key in this decision-making process, as it directly impacts the cost of production and,
ultimately, the price of goods and services. For instance, a society must decide whether to use
Labour-intensive methods, which might provide more employment but lower productivity, or
capital-intensive methods, which might increase productivity but require significant investment in
machinery and technology.
In agriculture, "how to produce" might involve choosing between traditional farming methods and
modern, technology-driven approaches like precision agriculture, which uses data and technology
to optimize the use of resources such as water, seeds, and fertilizers.

c. For Whom to Produce?

The third fundamental economic problem addresses the distribution of the goods and services
produced—for whom to produce. This problem is concerned with determining who will receive
the output of the economy and how the wealth generated will be distributed among the members
of society.
Different economic systems address this problem in various ways. In a market economy, goods
and services are typically distributed based on purchasing power—those who can afford to buy the
goods receive them. In contrast, in a planned economy, the government might allocate resources
and distribute goods based on a planned criteria, such as need or social equality.
In the context of agriculture, "for whom to produce" involves decisions about whether to focus on
subsistence farming to feed the local population or commercial farming aimed at generating profits
through exports. It also involves addressing issues of food security, ensuring that all segments of
the population have access to sufficient, nutritious food.

Fundamental Economic Problems

Imagine a triangle with each vertex representing one of the fundamental economic problems. At
9
the top of the triangle is "What to Produce?" This reflects the starting point of the economic
decision-making process—determining the goods and services that need to be produced.
The bottom left vertex represents "How to Produce?" This indicates the various methods and
processes that can be used to produce the selected goods and services, highlighting the importance
of efficiency and resource allocation.

The bottom right vertex represents "For Whom to Produce?" This captures the end goal of
production—deciding who will benefit from the goods and services produced and how they will
be distributed among the population.

Scarcity and the Fundamental Economic Problems

The underlying cause of these fundamental economic problems is scarcity. Scarcity means that
there are not enough resources to satisfy all human wants, which forces societies to make choices
about how to allocate resources. These choices inevitably involve trade-offs, where selecting one
option means giving up another.
For instance, a country may face a trade-off between investing in agricultural development to
ensure food security and investing in industrial growth to stimulate economic expansion. The
decision made will depend on the country’s priorities, available resources, and long-term goals.
Scarcity also forces individuals, firms, and governments to constantly evaluate the opportunity
cost—the next best alternative forgone when a decision is made. Understanding and managing
these trade-offs is essential for addressing the fundamental economic problems effectively.

10
The three fundamental economic problems—What to produce?, How to produce?, and For
whom to produce?—are at the heart of economic theory and practice. These problems arise from
the reality of scarcity and the need to make choices about how to allocate limited resources. By
understanding these problems, societies can make informed decisions that balance the needs and
wants of their populations, optimize the use of resources, and ensure a fair distribution of economic
output.

In agriculture, as in other sectors, these fundamental problems must be addressed to achieve

sustainable development, economic growth, and food security. Whether deciding on the crops to
plant, the methods of production to use, or the distribution of the harvest, the principles underlying
these economic problems guide decision-making processes that impact the well-being of society
as a whole.

Economic Problems and Agricultural Decisions

Agriculture is a cornerstone of human survival and economic development, providing food, raw
materials, employment, and sustaining livelihoods across the globe. However, the agricultural
sector is continually confronted with a myriad of economic problems such
as scarcity,opportunity cost, and resource allocation. These challenges profoundly influence
the decision-making processes of farmers, agribusinesses, and policymakers, impacting the
optimization ofproduction, food security, and the pursuit of economic sustainability.
Understanding how these economic problems intersect with agricultural decisions is essential for
developing strategies that enhance productivity, promote sustainable practices, and ensure
equitable distribution of resources and outputs.

1. The Impact of Scarcity on Agricultural Decisions

Scarcity refers to the fundamental economic problem of having seemingly unlimited human wants
in a world with limited resources. In agriculture, scarcity manifests in several forms:
• Land Scarcity: Arable land is finite and often under pressure from urbanization,
deforestation, and environmental degradation. Farmers must decide how best to utilize
available land to maximize yield and profitability.
• Water Scarcity: Water resources are limited and unevenly distributed, with agriculture
being one of the largest consumers of freshwater. Efficient water management is critical,
especially in regions prone to droughts or with limited water infrastructure.
• Labour Scarcity: The availability of skilled and unskilled Labour affects agricultural
productivity. Rural-urban migration and demographic changes can lead
11
 to Labour shortages, influencing decisions on mechanization and technology adoption.
• Capital Scarcity: Access to financial resources determines the ability to invest in inputs
like seeds, fertilizers, machinery, and technology. Limited capital forces farmers and
agribusinesses to prioritize certain investments over others.

Decision-Making under Scarcity

Given these scarcities, agricultural decision-makers must prioritize and make choices that balance
immediate needs with long-term sustainability. For example:

• Crop Selection: Farmers must choose crops that are suitable for the available land and
water resources while also considering market demand and profitability. Drought-resistant
or high-yield varieties may be preferred in resource-constrained settings.
• Resource Conservation: Implementing sustainable practices such as crop rotation,
conservation tillage, and efficient irrigation systems helps manage scarce resources
effectively and maintain soil health over time.
• Technology Adoption: Investing in agricultural technologies like precision farming tools,
genetically modified seeds, and automated equipment can help overcome resource
limitations by enhancing efficiency and productivity.
In regions like Sub-Saharan Africa, where water and fertile land are scarce, farmers adopt
techniques such as rainwater harvesting and agroforestry to optimize resource use. These
practices not only address immediate scarcity but also contribute to environmental conservation
and long-term sustainability.

Practice Questions
i. Discuss the role of microeconomic principles in agricultural decision-making. Use
examples to illustrate how individual farmers or agribusinesses might apply these
principles.

ii. Examine how macroeconomic factors, such as inflation and national income, can
influence agricultural production and policy in Nigeria. Provide specific examples to
support your argument.

iii. Analyze the interconnection between microeconomics and macroeconomics,

specifically in how individual agricultural decisions can impact broader economic
indicators and vice versa.

iv. How do the fundamental economic problems of "what to produce," "how to produce,"
and "for whom to produce" manifest in the agricultural sector? Discuss how these
13
 problems are addressed in both subsistence and commercial farming contexts.

Suggested Reading
1. "Agricultural Production Economics" by David L. Debertin
2. "Agricultural Economics" by H. Evan Drummond and John W. Goodwin
3. "Agricultural Development: An International Perspective" by Yūjirō Hayami and Vernon
W. Ruttan

Module 2
The Concept of Opportunity Cost
Introduction
Opportunity cost is a pivotal concept in economics that influences decision-making across various
sectors, including agriculture. It represents the value of the next best alternative that is foregone
when a choice is made. This concept is fundamental in economic analysis as it brings attention to
the trade-offs involved in every decision, encouraging a comprehensive evaluation of the benefits
and costs of various options.

Understanding Opportunity Cost

Opportunity cost is tied to the concept of scarcity, which dictates that resources such as time,
money, Labour, and raw materials are limited. Because these resources are scarce, choosing one
option means that another must be sacrificed. The opportunity cost of any action is the value of
the best alternative that is not chosen.
Example: Consider a farmer who has a piece of land that can be used to grow either maize or
tomatoes. If the farmer decides to grow maize, the opportunity cost is the potential profit that could
have been earned from growing tomatoes.
Calculation Example: Assume the following:
• Profit from maize per hectare: ₦1,000
• Profit from tomatoes per hectare: ₦1,500

If the farmer chooses to grow maize on a 10-hectare plot:

• Total profit from maize: 10×1000 =10,000 naira

The opportunity cost of growing maize instead of tomatoes:

• Potential profit from tomatoes: 10×1500=15,000 naira

14
 • Opportunity cost: 15,000 − 10,000 = 5,000 naira

This ₦5,000 represents the value of the foregone alternative, highlighting the trade-off the farmer
faces.

Opportunity Cost in Everyday Life

Opportunity cost applies to various aspects of daily life, influencing decisions ranging from
education to government spending.

1. Education vs. Work: A student deciding between attending university or working full-
time incurs an opportunity cost equal to the wages they would have earned if they had
chosen to work instead of studying.
Calculation Example:
o Annual wage from full-time work: ₦30,000
o University costs (including tuition and fees): ₦20,000 per year
o Total cost for a 4-year degree: ₦80,000
Opportunity cost over 4 years (foregone earnings): 4×30,000 = 120,000 naira
The total cost of education (including opportunity cost): 120,000+80,000 = 200,000 naira.
The student must evaluate if the long-term benefits of the degree outweigh this cost.

2. Government Spending: When a government chooses to build infrastructure rather than

invest in healthcare, the opportunity cost is the improvement in public health that could
have been achieved with the funds allocated to healthcare.
Calculation Example:
o Infrastructure project cost: ₦500 million
o Estimated improvement in public health from an equivalent healthcare investment:
A reduction in mortality rate by 10% in the next decade.
The opportunity cost here is the health benefits that the population will not experience because the
funds were directed toward infrastructure instead.

15
 3. Investment Decisions: A business deciding to invest in new technology rather than
expanding its workforce faces an opportunity cost, which is the potential return from
workforce expansion.
Calculation Example:
o Return on investment (ROI) from new technology: 15%
o ROI from workforce expansion: 10%
If the business invests ₦1 million in technology:
o Profit from technology investment: 1,000,000 × 0.15 = 150,000 naira
Opportunity cost (if the business had chosen workforce expansion):
o Potential profit from workforce expansion: 1,000,000 × 0.10 = 100,000 naira.

o
The difference between the two options indicates that the business is potentially
gaining more with technology, but it must consider other factors like long-term
workforce stability.
Opportunity Cost in Agricultural Economics
In agriculture, opportunity cost is especially important because the resources (land, Labour,
capital) are finite. Farmers and policymakers must decide how best to allocate these resources to
maximize economic returns.
1. Crop Selection:
A farmer must evaluate the opportunity cost of choosing one crop over another. This
decision involves assessing market demand, climate conditions, and resource availability.
Calculation Example:
o Profit from wheat per hectare: ₦800
o Profit from corn per hectare: ₦1,200
If a farmer uses 50 hectares for wheat:
o Total profit from wheat: 50 × 800 = 40,000 naira

o Opportunity cost (if corn were planted): 50 × 1200 = 60,000 naira

o The opportunity cost of planting wheat is 60,000 − 40,000 = 20,000 naira.

2. Land Use: Governments face opportunity costs when deciding whether to allocate land for
agriculture or urban development. They must weigh the benefits of food production against
potential economic gains from urbanization.
16
Calculation Example:
o Potential profit from agriculture (food production):
₦10 million Problems:
o Economic

o Potential profit from urban development: ₦25 million

Opportunity cost of choosing agriculture over urban development:
25 – 10 = 15 million naira.
The decision
o depends on Factors:
External broader economic and social considerations.

3. Resource Allocation: In agricultural policies, opportunity

costs must be considered when
deciding on resource allocation, such as between
drought-resistant crops and high-yield
varieties.
2. Decision-Making Process:
Calculation Example:
o Assessment:
o Investment in drought-resistant crops: ₦2 million,
with an expected increase in
yield by 10%
o Investment in high-yield varieties: ₦2 million, with
an expected increase in yield
o Planning:
by 15%
Opportunity cost of investing in drought-resistant crops instead
of high-yield varieties: Theforegone yield increase of 5%.

o of
Implications Implementation:
Ignoring Opportunity Cost
Ignoring opportunity costs can lead to poor decision-making with
significant consequences:
1. Misallocation of Resources: Resources may be allocated
inefficiently, leading to lower
economic growth. and Evaluation:
o Monitoring
2. Inadequate Policy Design: Policies that do not account for
opportunity costs may miss
out on more beneficial alternatives, resulting in missed
opportunities for social and
economic improvements.

17
 3.
3. Personal Financial Losses: On a personal level, failing to consider opportunity costs in
financial decisions, such as investments, can lead to lower returns and financial instability
over time.

Opportunity Cost in Agricultural Decision-Making

o Food Security:
In agriculture, understanding opportunity cost is vital for optimizing resource use. Every decision
involves trade-offs, whether it’s about crop selection, land use, or investment in new technologies.
1. Land Use Decisions: Choosing to plant a specific crop on a piece of land involves
calculating the potential
o Economic profits from other crops or alternative land uses.
Sustainability:
2. Investment Choices: Farmers must decide whether to invest in new machinery, irrigation
systems, or other improvements, considering the opportunity costs of each choice.
3. Time Management: Effective time management in farming operations can lead to better
productivity and profitability. Opportunity cost here could involve the time spent on one
4. task over another that might yield higher returns.

Agricultural Decision-Making Process

To better understand how economic problems influence agricultural decisions, a structured
decision-making process can be conceptualized, including a diagram that visualizes the stages of
decision-making in agriculture.

Diagram Components:
1. Inputs:

▪ Scarcity
▪ Opportunity Cost
▪ Resource Allocation Challenges

▪ Market Demand and Prices

▪ Environmental Conditions
▪ Technological Advancements
▪ Policy and Regulatory Environment

18
 ▪ Evaluating available resources and constraints.
▪ Analyzing market conditions and opportunities.
▪ Considering environmental and social impacts.

▪ Setting production goals and objectives.

▪ Developing strategies for resource utilization.
▪ Identifying risk management approaches.

▪ Executing production plans.

▪ Allocating resources according to strategies.
▪ Adopting technologies and practices.

▪ Tracking performance and outcomes.

▪ Assessing efficiency and effectiveness.
▪ Making adjustments and improvements.

Outcomes:
o Optimized Production:
▪ Increased yields and productivity.
▪ Enhanced product quality.

▪ Stable and sufficient food supply.

▪ Improved access and nutrition.

▪ Profitable and resilient farming systems.

▪ Sustainable use of resources.
▪ Social and economic equity.
 Feedback Loops:
o Learning and Adaptation:
▪ Using outcomes and evaluations to inform future decisions.
▪ Continuously improving practices and strategies.
o Policy and Market Responses:
▪ Adjusting policies based on agricultural performance.
▪ Market signals influencing future assessments.

Opportunity cost is integral to economic thinking, guiding individuals, businesses, and

governments toward more informed, efficient, and effective decisions. In the agricultural sector,
understanding and applying the concept of opportunity cost is crucial for optimizing resource use,
maximizing production, and ensuring sustainable development. By recognizing the trade-offs
inherent in every decision, stakeholders can navigate the complexities of agricultural economics,
leading to better economic outcomes and enhanced societal well-being.
MODULE 3
The Basics of Supply and Demand
The purpose of this Module is to develop one of the most powerful methods of analysis in the economist's
tool kit. In this Module we will develop the model of a simple market – supply and demand (the industry
in pure competition – discussed further in Module 8). The demand schedule and supply schedule will be
developed and put together to form the analysis of a market. The market presented here is the starting point
for the analysis of all market structures.

3.1 Markets
A market is nothing more or less than the locus of exchange, it is not necessarily a place, but simply buyers
and sellers coming together for transactions. Transactions occur because consumers and suppliers are able
to purchase and sell at a price that is determined through the free interaction of demand and supply. Adam
Smith, in the Wealth of Nations, described markets as almost mystical things. He wrote that the interaction
of supply and demand "as though moved by an invisible hand" would determine the price and the quantity
of a good exchanged. In fact, there is nothing mystical about markets. If competitive, a market will always
satisfy those consumers willing and able to pay the market price and provide suppliers with the opportunity
to sell their wares at the market price. To understand the market, one need only understand the ideas of
supply and demand and how they interact.

3.2 Demand
The law of demand is a principle of economics because it has been consistently observed and predicts
consumers’ behaviour accurately.
The law of demand states that as price increases (decreases) consumers will purchase less (more) of
the specific commodity, ceteris paribus.
In other words, there is an inverse relationship between the quantity demanded and the price of a particular
commodity. This law of demand is a general rule. Most people behave this way, they buy more the lower
the price. However, everyone knows of a specific individual who may not behave as predicted by the law
of demand, but remember the fallacy of composition -- because an individual or small group behaves
contrary to the law of demand does not negate it.

The demand schedule (demand curve) reflects the law of demand. The demand curve is a downward sloping
function (reflecting the inverse relationship of price to quantity demanded) and is a schedule of the quantity
demanded at each and every price.
As price falls from P1 to P2 the quantity demanded increases from Q1 to Q2. This is a negative relation
between price and quantity, hence the negative slope of the demand schedule; as predicted by the law of
demand. Consumers obtain utility (use, pleasure, jollies) from the consumption of commodities.
Economists have long recognized that past some point, the consumption of additional units of a commodity
bring consumers less and less utility.
The change in utility derived from the consumption of one more unit of a commodity is called
marginal utility.
The idea that utility with the amount added to total utility will decline when additional units are
consumed past some point has also the status of principle. This principle is called diminishing
marginal utility
Because consumers make rational choices, that is they act in their own self-interest, there are two effects
that follow from their attempts to maximize their well-being when the price of a commodity changes. These
two effects are called the;
(1) income effect, and
(2) the substitution effect. Together these effects guarantee a downward sloping demand curve.

1. The income effect is the fact that as a person's income increases (or the price of item goes
down [which effectively increases command over goods] more of everything will be
demanded. The income effect suggests that as income goes down (price increases) then less of the
commodity will be purchased.

2. The substitution effect is the fact that as the price of a commodity increases, consumers will
buy less of it and more of other commodities. In other words, a consumer will attempt to
substitute other goods that are cheaper for the commodity that became more expensive. The
substitution effect simply reinforces the idea of a downward sloping demand curve.

The demand schedule can be expressed as a table of price and quantity data, a series of equations, or in a
downward sloping graph. To this point, our discussion has focused on individuals and their behaviour.
Assuming that at least a significant majority of consumers are rational, it is a simple matter to obtain a
market demand curve. One needs only to sum all of the quantities demanded by individuals at each price
to obtain the market demand curve.
Changes in the price of a commodity cause movements along the demand curve; such movements are called
changes in the quantity demanded. If price decreases, then we move down and to the right along the
demand curve; this is an increase in the quantity demanded. If price increases, then we move upward and
to left along the demand curve, this is a decrease in the quantity demanded. Remember, (it is important)
such changes are called changes in the quantity demanded because the demand curve is a schedule of the
quantities demanded at each price.

Movements of the demand curve itself, either to the left or right are called changes in demand. A change
in demand is caused by a change in one or more of the nonprice determinants of demand. A shift to the right
of the demand curve is called an increase in demand; and a shift to the left of the demand curve is called a
decrease in demand. The nonprice determinants of demand are;
(1) tastes and preferences of consumers,
(2) the number of consumers,
(3) the money incomes of consumers,
(4) the prices of related goods, and
(5) consumers' expectations concerning future availability or prices of the commodity.

If the tastes and preferences of consumers change they will shift the demand curve. If consumers find a
commodity more desirable, ceteris paribus, then an increase in demand will be observed. If consumer tastes
wane for a particular product then there will be a shift to the left of the demand (a decrease in demand).

An increase in the number of consumers or their money income will result in a shift to the right of the
demand curve (an increase in demand). A decrease in the number of consumers or their income will result
in a shift of the demand curve toward the origin (a decrease in demand). Consumers will also react to
expectations concerning future prices and availability. If consumers expect future prices to increase, their
present demand curve will shift to the right; if consumers expect prices to fall then we will observe a
decrease in current demand.

The prices of related commodities also affect the demand curve. There are two classes of related
commodities of importance in determining the position of the demand curve, these are
(1) substitutes, and
(2) complements.
A substitute is something that is alternative commodity, i.e., Pepsi is a substitute for Coca-Cola. A
complement is something that is required to enjoy the commodity, i.e., gasoline and automobiles. If the
price of a substitute increases, then the demand for a commodity will increase. If the price of a substitute
decreases, so too will the demand for a commodity. In other words, the price of a substitute and the demand
for a commodity move in the same direction. For complements, the price of the complement and the demand
for a commodity move in opposite directions. If the price of a complement increases, the demand for a
commodity will decrease. If the price of a complement decreases, the demand for a commodity will
increase.
An increase in demand is shown in the first panel, notice that at each price there is a greater quantity
demanded along D2 (the dotted line) than was demanded with D1 (the solid line). The second panel shows
a decrease in demand, notice that there is a lower quantity demanded at each price along D2 (the dotted
line) than was demanded with D1 (the solid line).

Movement along a demand curve is called a change in the quantity demanded. Changes in quantities
demanded are caused by changes in price. When price decreases from P1 to P2 the quantity demanded
increases from Q1 to Q2; when price increases from P2 to P1 the quantity demanded decreases from Q2 to
Q1.

3.3 Supply
The law of supply is that producers will supply more the higher the price of the commodity. The supply
curve is an upward sloping function showing a direct relationship between prices and the quantity supplied.
In other words, the supply curve has a positive slope that shows that as price increase (decreases) so too
does quantity supplied. As with the demand curve a change in the price will result in a change in the
quantity supplied. An increase in price will result in an increase in the quantity supplied, and a decrease
in price will result in a decrease in the quantity supplied. Again, this is because the supply curve is a schedule
of the quantities supplied at each price.

Changes in one or more of the nonprice determinants of supply cause the supply curve to shift. A shift to
the left of the supply curve is called a decrease in supply; a shift to the right is called an increase in supply.
The nonprice determinants of supply are;
(1) resource prices,
(2) technology,
(3) taxes and subsidies,
(4) prices of other goods,
(5) expectations concerning future prices, and
(6) the number of sellers.

When resource prices increase, supply decreases (shifts left); and when resource prices decrease, supply
increases (shifts right). If a more cost effective technology is discovered then supply increases, increases in
taxes cause the supply curve to shift left (decrease). An increase in a subsidy effects the supply curve in the
same way as a cut in taxes, an increase in supply. If the price of other goods a producer can supply increases,
the producer will reallocate resources away from current production (decrease in supply) and to the goods
with a higher market price. For example, if the price of corn drops, a farmer will supply more beans. If
producers expect future prices to increase, current supply will decline in favour of selling inventories at
higher prices later. In other words, supply will decrease (a shift to the left, and exactly the opposite response
will occur if producer expect future prices to be lower. If the number of suppliers increases, so too will
supply, but if the number of producers declines, so too will supply.

A decrease in supply is shown in the first panel, notice that there is a lower quantity supplied at each price
with S2 (dotted line) than with S1 (solid line). The second panel shows an increase in supply, notice that
there is a larger quantity supplied at each price with S2 (dotted line) than with S1 (solid line).

Changes in price cause changes in quantity supplied, an increase in price from P2 to P1 causes an increase
in the quantity supplied from Q2 to Q1; a decrease in price from P1 to P2 causes a decrease in the quantity
supplied from Q1 to Q2.
3.4 Market Equilibrium
Market equilibrium occurs where supply equals demand (supply curve intersects demand curve). An
equilibrium implies that there is no force that will cause further changes in price, hence quantity exchanged
in the market.

The following graphical analysis portrays a market in equilibrium. Where the supply and demand curves
intersect, equilibrium price is determined (Pe) and equilibrium quantity is determined (Qe)

The graph of a market in equilibrium can also be expressed using a series of equations. Both the demand
and supply curve can be expressed as equations.

Demand Curve is Qd = 22 - P
(Notice the negative sign in front the price variable, indicating a downward sloping function)

Supply Curve is Qs = 10 + P

(Notice the positive sign in front of the price variable, indicating an upward sloping function)

The equilibrium condition is Qd = Qs

(For this market to obtain equilibrium, the quantity demanded must equal the quantity supplied in this
market)
Therefore:
22 - P = 10 + P
adding P to both sides of the equation yields:
22 = 10 + 2P
subtracting 10 from both sides of the equation yields:
12 = 2P or P = 6
To find the equilibrium quantity, we plug 6 (for P) into either the supply or
demand curve and get:
22 - 6 = 16 (Demand side) & 10 + 6 = 16 (Supply side)

The system of equations approach to solving for equilibrium gives a specific number for price and for
quantity. Unless the numbers are specified along the price axis and the quantity axis, the graph does not
yield a specific number for price and quantity. However, the graph provides a visual demonstration of
equilibrium which may aid learning. Changes in supply and demand in a market result in new equilibria.
The following graphs demonstrate what happens in a market when there are changes in nonprice
determinants of supply and demand.

Movement of the demand curve from D1 (solid line) to D2 (dashed line) is a decrease in demand (as
demonstrated in the above graph). Such decreases are caused by a change in a nonprice determinant of
demand (for example, the number of consumers in the market declined or the price of a substitute declined).
With a decrease in demand there is a shift of the demand curve to the left along the supply curve, therefore
both equilibrium price and quantity decline. If we move from D2 to D1 that is called an increase in demand,
possibly due to an increase in the price of a substitute good or an increase in the number of consumers in
the market. When demand increases both equilibrium price and quantity increase as a result.

Considering the following graph, movement of the supply curve from S1 (solid line) to S2 (dashed line) is
an increase in supply. Such increases are caused by a change in a nonprice determinant (for example, the
number of suppliers in the market increased or the cost of capital decreased). With an increase in supply
there is a shift of the supply curve to the right along the demand curve, therefore equilibrium price and
quantity move in opposite directions (price decreases, quantity increases). If we move from S2 to S1 that is
called an decrease in supply, possibly due to an increase in the price of a productive resource (capital) or
the number of suppliers decreased. When supply decreases, equilibrium price increases and the quantity
decreases as a result. That is the result of the supply curve moving up along the negatively sloped demand
curve (which remains unchanged).

If both the demand curve and supply curve change at the same time the analysis becomes more complicated.
Consider the following graphs:

Notice that the quantity remains the same in both graphs. Therefore, the change in the equilibrium quantity
is indeterminant and its direction and size depends on the relative strength of the changes between supply
and demand. In both cases, the equilibrium price changes. In the first case where demand increases, but
supply decreases the equilibrium price increases. In the second panel where demand decreases and supply
increases, the equilibrium price decreases.

In the event that demand and supply both increase then price remains the same (is indeterminant) and
quantity increases, and if both decrease then price is indeterminant and quantity decreases. These results
are illustrated in the following diagrams:
The graphs show that price remains the same (is indeterminant) but when supply and demand both increase
quantity increases to Q2. When both supply and demand decrease quantity decrease to Q2.

3.5 Shortages and Surpluses

There is some rationale for limited government intervention in a free market economy. Perhaps the most
powerful rationale for limited government arises from the effects of price controls in competitive markets.
Shortages and surpluses can only result because by having some sort of price controls in the market. For
example, the Former Soviet Union had a centrally planned economy and the government decided what
would be produced and for what price that production would be sold. The government also was the sole
employer and paid very low wages, therefore prices were also controlled at below market equilibrium
levels. The result was that whenever any commodity was available in the market, there were long lines
observed at any store with anything to sell, prices were low but there was nothing to buy (shortages).

Shortage is caused by an effective price ceiling (the maximum price you can charge for the product).
Effective, in this sense, means that the government can and does actively enforce the price ceiling. With the
exception of the Second World War, there is little evidence that the government can effectively enforce
price ceilings. Consider the following diagram that demonstrates the effect of a price ceiling in an otherwise
purely competitive industry.

For a price ceiling to be effective it must be imposed below the competitive equilibrium price. Note that the
Qs is below the Qd, which means that there is an excess demand for this commodity that is not being
satisfied by suppliers at this artificially low price. The distance between Qs and Qd is called a shortage. If
government is going to control prices, they must be prepared to control virtually all other aspects of doing
business.

Surplus is caused by an effective price floor (minimum you can charge): For a price floor to be effective it
must be above the competitive equilibrium price. Notice that at the floor price Qd is less than Qs, the
distance between Qd and Qs is the amount of the surplus. Minimum wages are the best known examples of
price floors and will be discussed in greater detail in Module 11.

Implicit in these analyses is the fact that without government we could have neither shortage or surplus. In
large measure, the suspicion of government is because it has the power to create these sorts of peculiar
market situations. Even with the power of government to enforce law, the only way that a shortage or
surplus could occur is if the price ceiling or the price floor were effective.

3.6 The problem of agricultural prices

Throughout history agricultural markets for foodstuffs and in primary products such as cocoa have
experienced two closely' related problems. Firstly, there has been: a long-run trend for agricultural prices
to fall relative to those of manufactured goods and secondly, prices have fluctuated considerably from year
to year. The long~run trend can be explained by shift in the demand and supply curves for agricultural
product over extended periods of time. This is depicted in diagram below where the equilibrium price for
an agricultural product in an early historical period is shown at P1. Over time, both the demand and· supply
curves have shifted to the right, caused for example by rising incomes and population growth shifting the
demand curve, while improved methods of farming have increased supply. Indeed for many farm products,
the shift in supply brought about by improved crop yields, and increased agricultural productivity, have
greatly exceeded the shifts in demand, resulting in the fall to the lower equilibrium price P 2, illustrated in
the Figure below.
3.6.1 Short run fluctuations in agricultural prices
Agricultural production is often characterized by a relatively long production period, compared for example
with many types of manufacturing: Arable farmers make decisions to grow crops several months before the
harvest, while in a similar way livestock farmers must breed animals for meat production many months
before slaughter. It is possible therefore, that farmers form their market plans on how much to supply to the
market on the basis of last year’s price rather than on the prices current this year. Because of the length of
the production period, there is a supply lag between the decision to produce and the actual supply coming
onto the market. The possible effects of such a supply lag are explained by the' cobweb' theory which is
illustrated in the figures below. The first figure illustrates a stable “cobweb" in which the market price
eventually converges to equilibrium at E, where the long-run demand and supply curves intersect. We shall
assume that the first Figure illustrates the market for pigs and that an outbreak of swine disease reduces the
number of pigs coming onto the market Q1 to Q2. Within the current year (Year· 1) the maximum number
of pigs that can be sold on the market can be shown by a vertical line drawn through Q2' A new price P2,
determined at point A on this vertical line, encourages farmers to supply O3 onto the market in the next
year (Year 2). Again, a vertical line can be drawn through Q3 to represent the maximum possible supply in
Year 2 .. But when the supply Q3 comes onto the market, the price drops to P3 causing farmers to reduce
the supply available in Year 3 to Q4 . Price and output then continue to oscillate in a series of decreasing
fluctuations until eventually - in the absence of any further 'shock' to the market - converging to the long-
run equilibrium at E.
3.6.2 Price-Support Policies
Year-to-year instability in farm prices can be caused by random shifts of the short-run supply curve in
response to fluctuations in the harvest. In the Figure below we have drawn three shortrun supply curves: a
'good harvest’ supply curve S1; a 'bad harvest' supply curve S2; and a 'normal harvest' supply curve S3drawn
mid-way between S1 and S2.. Weather conditions and other factors outside the farmers' control will shift the
position of the supply curve from year-toyear between the limits set by S1 and S2' Quite clearly, market
prices will also fluctuate from year-to-year within the range Pl' to P2·

suppose now that the' government wishes to stabilise 'the good's price at the 'normal' year price, P3. Follow
fig a' good harvest’, the government buys up the quantify Q’-Q3 to prevent the market price falling below
P3. In the event of a bad harvest in the next year, the government wi1l supplement supply by releasing the
product onto the market from the previously accumulated stock thereby preventing the price from rising
above P3 to P2.
The support-buying policy we have just described operates on the 'buffer-stock" principle, in which the
government or perhaps an association of producers, accumulates a buffer-stock when the harvest is good
for releasing onto the market in the event of a crop failure. Instead of completely stabilising the price at P3
in the Figure, support-buying can also be used to reduce rather than to eliminate fluctuations resulting from
free-market forces. The government or a support buying agency establishes upper and lower intervention
prices, shown respectively as P ̂and P bar in the Figure below. When the supply curve shifts to S1 following
a good harvest, the market price falls towards PI. As the price falls through P bar, the support-buying agency
steps into the market and begins to accumulate a 'buffer-stock', thereby preventing any further fall in the
price. In effect the demand curve now becomes D bar, comprising market demand D1, plus the 'artificial'
demand of the support-buying agency.

3.7 Markets and Reality

As intuitively pleasing as these analyses are, they are only models, and these models are based on
assumptions that are not very good approximations of reality. In Module 8 the analysis of a purely
competitive market is offered. What this Module presents is the industry in pure competition, which is based
on assumptions that do not exist in reality. The assumptions are (1) perfect information about all past, and
future prices, (2) no barriers to entry or exit from the market, (3) no non-price competition (advertising
etc.), (4) atomized competition (so many suppliers and consumers that none can appreciably affect price or
quantity), and (5) there is a standardized product (corn is corn is corn). If all of these assumptions accurately
represent reality, then the firm must sell at whatever price is established in the industry. To sell at a lower
price denies the firm revenue it could have otherwise earned, and to sell at a higher price would mean the
firm could sell nothing. In other words, the competitive industry impose price discipline on all of the firms
that together comprise that competitive industry.

Part of the controversy in almost any discussion of microeconomic activity is whether the results of policy
can be predicted by the simple supply and demand model. Often the results of the simple supply and demand
diagram are not bad rough approximations of reality – but remember that it is only a rough approximation
– based on assumptions that are not very accurate depictions of reality. However, more often imperfect
market models are more accurate approximations of reality – because one or more the assumptions
underpinning those models more accurately reflects reality. One must be careful in applying these models,
and in policy debates concerning these models. To the extent that the assumptions are not fulfilled, then the
results may not be accurate. The real value of the simple supply and demand model is to provide a beginning
point for coming to understand how markets really work. In most respects the simple supply and demand
model is little more than the beginning point for constructing one of the more realistic market models. Pure
monopoly, monopolistic competition and oligopoly are, in some important respects, refinements from the
purely competitive market model.

Question
1. Demonstrate what happens to a market equilibrium when: (1) demand increases, supply increases,
(2) demand decreases, supply decreases, (3) demand increases, supply decreases, and (4) demand
decreases, and supply increases. Do the same exercise showing only the demand curve increasing
and decreasing and only the supply curve increasing or decreasing.

2. Demonstrate the effects of a price floor: (1) above the competitive equilibrium, and (2) below the
competitive equilibrium. Repeat exercise 2, using a price ceiling.

3. Using the system: Qd = Qs, where Qd = 124 - 4P and Qs = -16 + 3P

What is the equilibrium price and quantity exchanged in this market? What would happen if there were a
price floor of 6 imposed in this market? If 6 was a price ceiling would that change your answer? If so, how
and why?
MODULE 4
Supply & Demand: Elasticities
The purpose of this Module is to extend the supply and demand analysis presented in the previous Module.
Specifically, this Module will develop the methods employed by economists to measure consumer
responsiveness to price changes – the price elasticity of demand. Other topics examined in this Module are
the price elasticity of supply, cross-elasticities, the income elasticity of demand and the interest elasticity
of demand.

4.1 Price Elasticity of Demand

The price elasticity of demand is how economists measure the responsiveness of consumers to changes in
prices for a commodity. In other words, as price increases (decreases), the quantity demanded by consumers
will decrease (increase). The relative proportions of the changes in price and the respective quantities
demanded are the responses of consumers and are referred to as the price elasticity of demand. It is this
consumer responsiveness that is the subject of this Module. Business decisions concerning prices are not
always a simple matter of adding some margin to the cost of production of the commodity (cost-plus
pricing). Suppliers will wish to obtain the most revenue the market will bear from the sales of their products
– in other words, maximize their profits. It is therefore necessary for business to have some idea of what
the market will bear, and that is where the price elasticity of demand enters the picture in business decision-
making. There are three methods that are used to measure the price elasticity of demand, these are; (1) the
price elasticity coefficient (midpoints formula), (2) the total revenue test, and (3) a simple examination of
the demand curve.

4.1.1 Elasticity Coefficient

The elasticity coefficient is a number calculated using price and quantity data to determine how responsive
consumers are to changes in the price of a commodity. The elasticity coefficient may be calculated in two
distinct ways. Point elasticity is measuring responsiveness at a specific point along a demand curve. The
other method is using the mid-point of the difference in the price and the mid-point in the difference of the
quantity numbers. Because the midpoints formula cuts down on the confusion of which prices and quantities
are to be used, it is the only coefficient we will use in this course.

The price elasticity coefficient (midpoints) is calculated using the midpoints formula:

Calculating the elasticity coefficient will yield a specific number. The value of that number provides the
answer as to whether demand is price elastic or price inelastic. Elastic demand means that the consumers'
quantities demanded respond (more than proportionately) to changes in price; with elastic demand the
coefficient is more than one. Inelastic demand means that the consumers' quantities demanded do not
respond very much to changes in price; with inelastic demand the coefficient is less than one. Unit elastic
demand means that the consumers' quantity demanded respond proportionately to change in price; with
unit elastic demand the coefficient is exactly one.

What this equation states is illustrated in the graph below. The midpoint between price one (P1) and price
two (P2) is labelled Midpoint along the price axis and M on the quantity axis.

On the graph this number is the difference between Q1 and Q2 divided by the distance between the origin
and the point labelled M on the quantity axis for the numerator and the difference between P1 and P2
divided the distance between the origin and the point labelled midpoint on the price axis for denominator.
The ratio of the numerator to the denominator on this graph is the same number yielded by the equation.
Examining the demand curve can also provide clues concerning the price elasticity of demand. A perfectly
vertical demand curve indicates that the quantity demanded will be exactly the same, regardless of price.
This type of demand curve is called a perfectly inelastic demand curve. A perfectly horizontal demand curve
indicates that consumers will have almost any quantity demanded, but only at that price. This is called a
perfectly elastic demand curve. Perfectly unit elastic demand curves are not linear, they have slopes that
vary across ranges.

Perfectly Elastic and Perfectly Inelastic Demand Curves

There is a trick to remembering inelastic and elastic demand. Notice in the above graphs that the perfectly
elastic demand curve is horizontal, (add one more horizontal line at the top of the price axis and it will look
like an E). The perfectly inelastic demand curve is vertical (looks like an I). If you have problems
remembering the concept of inelastic or elastic demand you need only draw the curves above and observe
what happens to the quantity demanded when the price changes. In the case of perfectly inelastic demand
consumers will buy exactly the same quantity of a product without regard for its price. In the case of a
perfectly elastic demand curve, if producers raise the price of the product, then they will sell nothing. Slope
and elasticity are two different concepts. With linear demand curves, elasticity changes along the demand
curve, however its slope does not.

Elasticity is concerned with responses in one variable to changes in the other variable. The slope of the
curve is concerned with values of the respective variables at each position along the curve (i.e., its' shape
and direction).

Demand Curve and Total Revenue (total revenue = P x Q) Curve

The total revenue curve in the bottom graph is plotted by multiplying price and quantity to obtain total
revenue and then plotting total revenue against quantity. In examining the above graphs, notice that as total
revenue is increasing, demand is elastic. When the total revenue curve flattens-out at the top then demand
becomes unit elastic, and when total revenue falls demand is inelastic. In other words, moving from left to
right on the demand curve, as price and total revenue move in the opposite direction demand is price elastic,
and when price and total revenue move in the same direction demand is price inelastic. The total revenue
test uses the relation between the total revenue curve and the demand curve to determine the price elasticity
of demand. In general, price and total revenue will move in the same direction of the demand is price
inelastic (hence consumers are unresponsive in quantity purchased when price changes) and move in
opposite directions if price elastic (consumers’ quantities being responsive to price changes).
Consider the following numerical example:
Marginal revenue is the change in total revenue due to a change in quantity demanded.
The total revenue test relies on changes in total revenue (marginal revenue) to determine elasticity. If the
change in total revenue (marginal revenue) is positive the demand is price elastic, if the change in
total revenue is negative the demand is price inelastic. If the marginal revenue is exactly zero then
demand is unit elastic.

The following determinants of the price elasticity of demand will determine how responsive the quantity
demanded by consumers is to changes in price. The determinants of the price elasticity of demand are;
(1) substitutability of other commodities,
(2) the proportion of income spent on the commodity,
(3) whether the commodity is a luxury or a necessity, and
(4) the amount of time that a consumer can postpone the purchase.

If there are no close substitutes then the demand for the commodity will be price inelastic, ceteris paribus.
If there are substitutes then consumers can switch their purchasing habits in the case of a price increase, but
if there are no substitutes then consumers are more likely to buy even if price goes up. For example, if the
price of Pepsi goes up, then certain consumers will buy Coke, if the price of Coke has not increased, hence
the demand for Pepsi is likely to be elastic. All other things equal, the higher the proportion of income spent
for the commodity more price elastic will be the demand. Most home owners are familiar with how this
determinant works. The demand for single family dwellings is likely to be more elastic than the demand for
apartments, because a higher proportion of your income will be spent on housing when you own your home.
Commodities that are viewed as luxuries typically have price elastic demand, and commodities that are
necessities have price inelastic demand. There is simply no substitute for a insulin, if you are an insulin
dependent diabetic. Because insulin is a necessity for which there is no substitute, the demand will be price
inelastic.
Time is an important determinant of price elasticity. If a price changes, it may take consumers a certain
amount of time to discover alternative lifestyles or commodities to account for the price change. For
example, if the price of cars increases, a family that planned to buy a car may wait for their income or
wealth to increase to make buying a new car viable alternative to continuing to drive an older vehicle. In
other words, the longer the time frame for the decision to purchase the more price elastic the demand for
the commodity.

4.2 Price Elasticity of Supply

The price elasticity of supply measures the responsiveness of suppliers to changes in price. The price
elasticity of supply is determined by the following time frames;
(1) market period,
(2) short-run, and
(3) long-run.
The more time a producer has to adjust output the more elastic is supply.

It is important to understand the basic idea behind this classification of time as it relates to price elasticity.
The market period is defined to be that period in which the producer can vary nothing therefore the supply
is perfectly inelastic. The long-run is the period in which the producer can vary everything, therefore the
supply is perfectly elastic. The short-run is the period in which plant and equipment cannot be varied, but
most other factors' usage can be varied, therefore it depends on a producer’s capital - intensity as to how
elastic supply is at any particular point.

3.3 Other Elasticities

There are three other standard applications of the elasticity of demand. The cross elasticity of demand, the
income elasticity of demand, and the interest rate elasticity of demand. Each of these will be examined, in
turn, in the remaining paragraphs of this Module.

The cross elasticity of demand measures the responsiveness of the quantity demanded of one product to
changes in the price of another product.
For example, the quantity demanded of Coca-Cola to changes in the price of Pepsi. Cross elasticity of
demand gives an indication of how close a substitute or complement one commodity is for another. This
concept has substantial practical value in formulating marketing strategies for most products. For example,
as the price of coke increases, then consumers may purchase proportionately more Pepsi products. In such
a case, the cross elasticity of demand of Pepsi to the price of coke would be termed elastic. The equation
for the cross elasticity of demand described here is presented below.
The income elasticity of demand measures the responsiveness of the quantity demanded of a
commodity to changes in consumers' incomes. This is typically measured by replacing the price variable
with income (economists use the letter Y to denote income) in the midpoints formula. Again, in business
planning the responsiveness of consumers to changes in their income may be very important. Housing and
automobiles, as well as, several big ticket luxury items have demand that is sensitive to changes in income.
The income elasticity formula is presented below.

Often interest rates will also present a limitation on a consumer’s quantity of demand for a particular
commodity. As with income, often big ticket items are very sensitive to interest rates on the loans necessary
to make those purchases. The interest rate elasticity formula is (where interest rate is
“r”):

These analyses are important to businesses in determining what issues are important to the successful sales
of their products. There are industries that have not been particularly good at understanding the notions of
cross elasticity or price elasticity – the airlines in particular, and many of these firms have suffered as a
result. The bankruptcies of United Airlines and US Air being excellent examples. The automobile
companies have been, in some measure, forced into the financing business because of the interest rate
sensitivity of consumers. By offering financing the car companies are, essentially, maintaining some
modicum of control over one important aspect of their business. Interest rate sensitivity can also be
understood from another perspective. The total cost of a commodity is not just its price, but also what must
be paid to borrow money to purchase that item. With modern views of instant gratification, it is rare for
someone to save to purchase a house, or any other big-ticket item, what is more common is to borrow the
money, buy the item, and make instalment payments. Therefore, the interest charges are a part of the total
cost of acquiring that big ticket item – hence consumer sensitivity to interest rates when buying a house or
a car. It is also noteworthy, that purely competitive firms are price takers, and it is the imperfectly
competitive firm that has a pricing policy. What is often referred to as “pricing power” in the business press,
means the ability to take advantage of the price elasticity of demand or one of the other elasticities examined
here – hence implying some market structure, hence market power not otherwise identified in the model of
pure competition.

Examples
A. Price elasticity of Demand
Suppose you're given the following question:
Demand is Q = 110 - 4P. What is price (point) elasticity at ₦5?
We can calculate elasticity by the formula:
Elasticity of Z with respect to Y = (dZ / dY)*(Y/Z)

In the case of price elasticity of demand, we are interested in the elasticity of quantity demand with
respect to price. Thus we can use the following equation:
Price elasticity of demand: = (dQ / dP)*(P/Q)

In order to use this equation, we must have quantity alone on the left-hand side, and the right-hand side be
some function of price. That is the case in our demand equation of Q = 110 - 4P. Thus we differentiate
with respect to P and get:

dQ/dP = -4

So we substitute dQ/dP = -4 and Q = 110 - 4P into our price elasticity of demand equation:
Price elasticity of demand: = (dQ / dP)*(P/Q)
Price elasticity of demand: = (-4)*(P/(110-4P)
Price elasticity of demand: = -4P/(110-4P)
We're interested in finding what the price elasticity is at P = 5, so we substitute this into our price
elasticity of demand equation:
Price elasticity of demand: = -4P/(110-4P)
Price elasticity of demand: = -20/90
Price elasticity of demand: = -2/9

Thus our price elasticity of demand is -2/9. Since it is less than 1 in absolute terms, we say that Demand is
Price Inelastic.

B. Income Elasticity of Demand

Given the following question:
Demand is Q = -110P +0.32I, where P is the price of the good and I is the consumers income. What is the
income elasticity of demand when income is 20,000 and price is ₦5?

We saw that we can calculate any elasticity by the formula:

Elasticity of Z with respect to Y = (dZ / dY)*(Y/Z)

In the case of income elasticity of demand, we are interested in the elasticity of quantity demand with
respect to income. Thus, we can use the following equation:
Price elasticity of income: = (dQ / dI)*(I/Q)

In order to use this equation, we must have quantity alone on the left-hand side, and the right-hand side be
some function of income. That is the case in our demand equation of Q = -110P +0.32I. Thus we
differentiate with respect to I and get:

dQ/dI = 0.32

Q = -110P +0.32I into our price elasticity of income equation:

Income elasticity of demand: = (dQ / dI)*(I/Q)
Income elasticity of demand: = (0.32)*(I/(-110P +0.32I))
Income elasticity of demand: = 0.32I/(-110P +0.32I)
We're interested in finding what the income elasticity is at P = 5 and I = 20,000, so we substitute this into
our income elasticity of demand equation:
Income elasticity of demand: = 0.32I/(-110P +0.32I)
Income elasticity of demand: = 6400/(-550 + 6400)
Income elasticity of demand: = 6400/5850
Income elasticity of demand: = 1.094

Thus our income elasticity of demand is 1.094. Since it is greater than 1 in absolute terms, we say that
Demand is Income Elastic, which also means that our good is a luxury good.

C. Cross/price Elasticity of Demand

Given the following question:
Demand is Q = 3000 - 4P + 5ln(P') , where P is the price for good Q, and P' is the price of the competitors
good. What is the cross-price elasticity of demand when our price is ₦5 and our competitor is charging
₦10?

We saw that we can calculate any elasticity by the formula:

Elasticity of Z with respect to Y = (dZ / dY)*(Y/Z)

In the case of cross-price elasticity of demand, we are interested in the elasticity of quantity demand with
respect to the other firm's price P'. Thus we can use the following equation:
Cross-price elasticity of demand = (dQ / dP')*(P'/Q)

In order to use this equation, we must have quantity alone on the left-hand side, and the right-hand side be
some function of the other firms price. That is the case in our demand equation of Q = 3000 - 4P +
5ln(P'). Thus we differentiate with respect to P' and get:

dQ/dP' = 5/P'

So we substitute dQ/dP' = 5/P' and Q = 3000 - 4P + 5ln(P') into our cross-price elasticity of demand
equation:
Cross-price elasticity of demand = (dQ / dP')*(P'/Q)
Cross-price elasticity of demand = (5/P')*(P'/(3000 -4P + 5ln(P')))
We're interested in finding what the cross-price elasticity of demand is at P = 5 and P' = 10, so we
substitute these into our cross-price elasticity of demand equation:
Cross-price elasticity of demand = (5/P')*(P'/(3000 -4P + 5ln(P')))
Cross-price elasticity of demand = (5/10)*(10/(3000 - 20 + 5ln(10)))
Cross-price elasticity of demand = 0.5 * (10 / 3000 - 20 + 11.51)
Cross-price elasticity of demand: = 0.5 * (10 / 2991.51)
Cross-price elasticity of demand: = 0.5 * 0.0033
Cross-price elasticity of demand: = 0.00167

Thus our cross-price elasticity of demand is 0.00167. Since it is greater than 0, we say that goods are
substitutes.

D. Price Elasticity of Supply

Given the following question:
Demand is Q = 100 - 3C - 2C2, where Q is the amount of the good supplied, and C is the production cost
of the good. What is the price elasticity of supply when our per unit cost is ₦2?
We saw that we can calculate any elasticity by the formula:
Elasticity of Z with respect to Y = (dZ / dY)*(Y/Z)

In the case of price elasticity of supply, we are interested in the elasticity of quantity supplied with respect
to our unit cost C. Thus we can use the following equation:
Price elasticity of supply = (dQ / dC)*(C/Q)

In order to use this equation, we must have quantity alone on the left-hand side, and the right-hand side be
some function of cost. That is the case in our demand equation of Q = 400 - 3C - 2C2. Thus we
differentiate with respect to C and get:

dQ/dC = -3-4C

So we substitute dQ/dC = -3-4C and Q = 400 - 3C - 2C2 into our price elasticity of supply equation:
Price elasticity of supply = (dQ / dC)*(C/Q)
Price elasticity of supply = (-3-4C)*(C/(400 - 3C - 2C2))
We're interested in finding what the price elasticity of supply is at C = 2, so we substitute these into our
price elasticity of supply equation:
Price elasticity of supply = (-3-4C)*(C/(100 - 3C - 2C2))
Price elasticity of supply = (-3-8)*(2/(100 - 6 - 8))
Price elasticity of supply = (-11)*(2/(100 - 6 - 8))
Price elasticity of supply = (-11)*(2/86)
Price elasticity of supply = -0.256
Thus our price elasticity of supply is -0.256. Since it is less than 1 in absolute terms, we say that goods
are substitutes.

Question
1. List and explain the determinants of the price elasticity of demand and of supply.
2. What are the income and cross elasticities of demand? Why might they be useful? Explain.
3. Consider the following data:

Price Quantity Total Revenue Marginal Revenue

i. 2000 2000
ii. 1900 3800
iii 1750 5250
iv 1550 6200
v 1250 6250
vi 900 5400
vii 400 2800
viii 100 800

Calculate the marginal revenue for each change in price. Perform a total revenue test and determine the
ranges of price elastic and price inelastic demand. Draw the demand curve and the total revenue curve and
show these ranges thereon.
4. Using the data in question 3 above calculate the price elasticity coefficient moving from price of 3
to a price of 4; from a price of 5 to a price of 6.
5. Explain what the price elasticity of demand is and why it is of interest in examining markets. Might
it be useful in the airline industry? Why?
MODULE 5
Consumer Behaviour
The purpose of this Module is to refine the income and substitution effects introduced in Module 4. This
Module will also introduce the idea of Giffin’s Paradox, consumer equilibrium, and the utility maximization
rule.

5.1 Income and Substitution Effects Revisited

The income and substitution effects combine to cause the demand curve to slope downwards as was
discussed earlier in Module 4. In fact, an individual consumer's demand curve can be rigorously derived
using concepts indifference curves which illustrate, graphically, the income and substitution effects.

The income effect results from the price of a commodity going down having the effect of a consumer having
to spend less on that commodity, hence the same as having more resources. However, as price increases,
the consumer will purchase less of that commodity and buy more of a substitute, this is the substitution
effect. It is the combination of the income and substitution effects, and their relative strength, that causes
an individual (hence generally a market) demand curve to slope downward. However, there is an interesting
exception to this general rule -- Giffin's Paradox.

Giffin's Paradox is the fact that some commodities may have an upward sloping demand curve. Such
commodities are called inferior products. (Not necessarily because of quality problems with the product,
but because the analysis is inferior -- not generalizable to all commodities). This happens because the
income effect results in a lesser demand for a product. (In other words, the income effect overwhelms the
substitution effect). There are at least two types of goods that often exhibit an upward sloping demand
curve. One is necessity for very poor people and the other is one for which a high price creates a snob effect.
Each case will be reviewed, in turn, in the following paragraphs.

In the diagram above notice that as price is decreased from P1 to P2 the quantity demanded decreases,
hence snob appeal may go down from the loss of a prestigiously high price – consumers who value the
product simply because it is high priced leave the market as the price falls. As price increases from P2 to
P1 poor people can’t afford other more luxurious items therefore they have to buy more of the very
commodity whose price wrecked their budgets. In the case of poor people who experienced the price of
necessity increasing, their limited resources may result in their buying more of the commodity when its
price increases.

For example, if the price of rice increases in a less developed country, people may buy more of it because
of the pressure placed on their budget prevents them from buying beans or fish to go with their rice. To
maintain their caloric intake rice will be substituted for the still more expensive beans and fish. The other
situation is where a luxury is involved. There is the snob appeal possibility where the higher the price, the
more desired the commodity is. Often people will drive expensive cars, simply because of the image it
creates. If the car is extremely expensive, i.e., Rolls Royce, the snob effect may be the primary motivation
for the purchase. This also works with less expensive commodities. For example, Joy Perfume advertised
itself as the world's most expensive to attract consumers that their marketing surveys indicated would
respond to the snob effect.
Rational behaviour was defined as economic agents acting in their self interest. It is the idea of rational
behaviour that permits the rigorous examination of economic activity. Without rationality, our analyses fail
to conform with the basic underlying assumption upon which most of economics is based. Consumers
(when acting in their own self interest) will generally attempt to maximize their utility, given some fixed
level of available resources and income with which to purchase goods and services. The utility maximizing
rule is that consumers will balance the utility they receive from the consumption of each good or service
against the cost of each commodity they purchase, to arrive at how much of each good they need to
maximize their total utility. The algebraic restatement of the rule:

MUa/Pa = MUb/Pb = . . . = MUz/Pz

When the consumer reaches equilibrium each of the ratios of marginal utility to price will be equal to one.
If any single ratio is greater than one, the marginal utility received from the consumption of the good is
greater than the price, and this means the consumer has not purchased enough of that good. Therefore the
consumer must purchase more of that good (causing price to increase and marginal utility to go down to
the point they are equal), where MU > P. If the ratio is less than one, where MU< P, then the consumer has
purchased too much of the commodity (price is larger than the marginal utility received from the
commodity) and needs to cut back. Whether consciously or not, rationality requires each individual
consumer to allocate their resources in such a manner as to meet the restrictions of the above equation that
is when the consumer is said to be in equilibrium. In reality, a consumer is always seeking those levels, but
because of changing prices and changing preferences, it is understood that the consumer is always seeking,
but never quite at equilibrium.

Question
1. What is utility and diminishing marginal utility? Explain.
2. In detail, explain the utility maximization rule? Critically evaluate this concept.
3. How is a market demand curve derived? What does this have to do with indifference curves and
budget constraints?
MODULE 6
Costs and Production
The purpose of this Module is to examine the production costs of a firm. The first section develops the
economic concepts of production necessary for understanding the cost structure of a firm. The second
section presents the models of short-run costs. The final section develops the long-run average total cost
curve and discusses its implications for the strategic management of a farm business.

6.1 Production and Costs

The reason that an entrepreneur (farmer) assumes the risk of starting a business is to earn profits. The
fundamental assumption in the theory of production is that a rational owner of a business will seek to
maximize the profits (or minimize the losses) from the operation of his business. However, before anything
can be said about profits we must first understand costs and revenues. This Module will develop the basic
concepts of production costs.

An economist's view of costs includes both explicit and implicit costs. Explicit costs are accounting costs,
and implicit costs are the opportunity costs of an allocation of resources (i.e., business decisions).
Accountants subtract total cost from total revenue and arrive at a total accounting profits. An economist,
however, would include in the total costs of the firm the profits that could have been made in the next best
business opportunity (e.g., the opportunity cost). Therefore, there is a significant difference in how
accountants' and economists' view profits i.e. economic profits versus accounting profits. For the purposes
of economic analysis, a normal profit includes the cost of the lost opportunity of the next best alternative
allocation of the firm’s resources. In a purely competitive world, a business should be able to cover their
costs of production and the opportunity cost of the next best alternative (and nothing more in the long-run).
In an accounting sense there is no benchmark to determine whether the resource allocation was wise.
Instead, various financial ratios are used to determine how the firm has done with respect to similarly
situated companies.

6.2 Time Periods Revisited

As was discussed briefly in the section of elasticity of supply in Module 5, time periods for economic
analysis are defined by the types of costs observed. These time periods differ from industry to industry, and
will differ by the technology employed between firms. Again, these time periods are; (1) the market period,
(2) the short-run, and (3) the long-run. In the market period, all costs are fixed costs (nothing can be varied).
In the short-run, there are both fixed and variable costs observed. Generally, plant, equipment, and
technology are fixed, and things like labour, electricity, and materials can still be varied. In the long-run
everything is variable. That is, the plant, equipment, and even the business into which you put productive
assets can all be changed. In the long-run, even the country in which the business is located can be changed.
Because everything is fixed in the market period, this period is of little interest in economic analysis.
Therefore, economists typically begin their analysis of costs with the short-run and proceed to examine the
operation of the firm and the industry. The long-run is of interest because it is also the planning horizon for
the business.

6.3 Production
Another view of the short-run cost structure is that fixed costs are those that must be paid whether the firm
produces anything or not. Variable costs are called variable because they increase or decrease with the level
of production. Therefore, to understand short-run costs, you must first understand production.
i. Total product or total output is the total number of units of production obtained from the
productive resources employed.
ii. Average product is total product divided by the number of units of the variable factor employed.
iii. Marginal product is the change in total product associated with a change in units of a variable
factor of production.

As a firm increases its output it normally makes more efficient use of its available capital. However, with a
fixed level of available capital as variable factors are added to the production process, there is a point where
the increases in total output begin to diminish.

The law of diminishing returns is the fact that as you add variable factors of production to a fixed
factor, at some point, the increases in total output begin to become smaller. In fact, it is possible, at
some point, that further additions in the units variable factors to a fixed level of capital could actually reduce
the total output of the firm. This is called the uneconomic range of production. In reality, most firms come
to realize that their total additions to total output diminish, long before they begin to experience negative
returns to additions to their workforce or other variable factors.

The following diagram provides a graphical presentation of total, average, and marginal products for a
hypothetical firm.
The top graph shows total product. After total product reaches its maximum marginal product where
marginal product changes from positive to negative (first derivative is zero, second derivative is negative).
When the total product curve reaches its maximum, increased output results in negative marginal product.
The maximum on the marginal product curve is also associated with the first inflection point (the
acceleration or where the curve becomes steeper) on the total product curve. The ranges of marginal returns
are identified on the above graphs. The beginning point in developing the cost structure of a firm is to
examine total costs in the short run. Total costs (TC) are equal to variable costs (VC) plus fixed costs (FC).

TC = VC + FC

Variable costs are those costs that can be varied in the short-run, i.e., the cost of hiring labour. Fixed costs
are those costs that cannot be varied in the short-run, i.e. plant (interest). Therefore, total costs consist of a
fixed component and a variable component. These relations are presented in a graphical form in the
following diagram:

The fixed cost curve is a horizontal line. These costs are illustrated with a horizontal line because they do
not vary with quantity of output. The variable cost curve has a positive slope because it varies with output.
Notice that the total cost curve has the same shape as the variable cost curve, but is above the variable cost
curve by a distance equal to the amount of the fixed cost. This is because we added fixed cost (the horizontal
line) to variable cost (the positively sloped line). From the total, variable and fixed cost curves we can
obtain other relations.

These are the marginal cost, and the total, variable, and fixed costs relation to various levels of output
(averages). Average total cost (ATC) is total cost (TC) divided by quantity of output (Q), average variable
cost (AVC) is variable cost (VC) divided by quantity of output (Q), and average fixed cost (AFC) is fixed
cost (FC) divided by quantity of output (Q). Marginal cost (MC) is the change (denoted by the Greek symbol
delta), in total cost (TC) divided by the change in the quantity of output (Q).
These relations are presented in equation form below:
ATC = TC/Q
AVC = VC/Q
AFC = FC/Q
MC = ∆TC/∆Q; where ∆ stands for change in.

The following diagram presents the average costs and marginal cost curve in graphical form.

Please notice that the average fixed cost approaches zero as quantity increases. This occurs because a
constant is being divided by increasingly large numbers. Average total cost is the summation of the average
fixed and average variable cost curves. Because average fixed cost approaches zero, the difference between
average variable cost and average total cost also approaches zero (the difference between ATC and AVC is
AFC). The marginal cost curve intersects both the average total cost and average variable cost curves at
their respective minimums. In other words, as marginal cost is below average total (and average variable)
cost the average function is falling to meet marginal cost. As marginal cost is rising above the average
function then average total (and average variable) cost are increasing.

The following graph relates average and marginal product to average variable and marginal cost. Notice
that at the maximum point on the marginal product curve, marginal cost reaches a minimum. Where
marginal cost equals average variable cost, the marginal product curve intersects the average product curve.
In other words, the cost structure of the firm mirrors the engineering principles giving rise to the firm’s
production, hence its costs. This presents some interesting disconnects from how business is presently
evolving. The high compensation level of executives seems to not reflect the actual output of their labours.
In other words, the costs of production seemingly fail to account for the history of the 21st century thus far.
As it turns out, these issues can be explained by neo-classical economics, and will be in Modules 10 and
11.

6.4 The Long Run Average Total Cost Curve

In the long-run all costs are variable. In other words, a firm can vary its plant, equipment, technology and
any of the factors that were either fixed or variable in the short-run. Therefore, anything that is
technologically feasible is available to this firm in the long-run. Further, any short-run average total cost
curve (consistent with any size of operation) could be selected for use in the long-run. The long-run average
total cost curve (LRATC) is therefore a mapping of all minimum points of all possible short-run average
total cost curves (allowing technology and all factors of production (i.e., costs) to vary). The enveloping of
these short-run total cost curves map all potential scales of operation in the long-run. Therefore, the LRATC
is also called the planning horizon for the firm. The following diagram illustrates a LRATC:

The shape of the LRATC is dependent upon the available resources and technology that a firm can utilize
to produce a given commodity. The downward sloping range of the LRATC is due to economies of scale,
the upward sloping range of the LRATC is due to diseconomies of scale, and if there is a flat range at the
minimum point of the LRATC this is called a range of constant returns to scale. Economies of scale are
benefits obtained from a company becoming large and diseconomies of scale are additional costs inflicted
because a firm has become too large. The causes of economies of scale are that as a firm becomes larger it
may be able to utilize labour and managerial specialization more effectively, capital more effectively, and
may be able to profitably use by-products from its operations. Diseconomies of scale result from the
organization becoming too large to effectively manage and inefficiencies developing. Constant returns to
scale are large ranges of operations where the firm's size matters little. In very capital intensive operations
that must cover some peak demand, the size of the firm may matter very little. Several public utilities, such
as electric generating companies, telephone company, and water and sewer service have relatively large
ranges of constant returns to scale.

Where the LRATC curve reaches its minimum, this is called the minimum efficient scale (size of operation).
Minimum efficient scale is the smallest size of operations where the firm can minimize its long-run average
costs. Minimum efficient scale varies significantly by commodity produced and technology. There is an
interesting implication of the LRATC analysis. There are instances where competition may be an unrealistic
waste of resources. A natural monopoly is a market situation where per unit costs are minimized by having
only one firm serve the market. Minimum efficient scale is the point on the LRATC where it reaches its
minimum. If that happens to be at the beginning of a long range of constant costs, it is the first point (on
the left of the range) where costs are at their minimum. Remember, that technical efficiency requires that a
firm produce at where it has attained minimum total long-run costs. Where minimum efficient scale is very
large for capital intensive operations, it may be more cost effective to permit one company to spread its
fixed costs over a very large number of consumers, rather than have several competing firms suffer the
fixed costs of a minimum efficient scale and have to share a customer base. There are several industries that
are very capital intensive and require large initial investments to operate. These types of firms are frequently
natural monopolies. Railroads, electric generating companies, and air lines requires tens of billions of naira
in fixed costs.

Question
1. Explain, in detail, why normal profit is included in average total costs?
2. Draw a LRATC demonstrating diseconomies, economies and constant returns to scale. Explain why
each range of the LRATC curve is observed. What does this have to do with planning? Explain.
MODULE 7
Pure Competition
Module 4 developed the supply and demand diagram. The simple supply and demand diagram is the model
of a perfectly competitive industry. That model will be revisited and extended in this Module. The purpose
of this Module is to introduce models of the firm that are not purely competitive. After a brief introduction
to imperfectly competitive models we will turn our attention to the purely competitive industry and firm.
In particular, this Module will develop the model of the perfectly competitive firm, examine its relation to
the industry, and then offer some critical evaluation of this important paradigm.

7.1 Firms and Market Structure

There are several models of market structure. In the product market, the two extremes are perfect
competition and pure monopoly. This Module will examine pure competition and the following Module
examines monopoly. However, there are intermediate market structures. These intermediate market
structures are oligopoly and monopolistic competition.

The assumptions in pure competition are:

(1) there is atomized competition (a large number of very small suppliers and buyers relative to the market),
(2) there is complete freedom of entry and exit into and from this market,
(3) there is no nonprice competition,
(4) suppliers offer a standardized product, and
(5) firms in this industry must accept the price determined in the industry.

Purely competitive firms and industries do not exist in reality. Probably as close as the real world comes to
the competitive ideal is agriculture, during the period in which this industry was dominated by the relatively
small family farms prior to World War II.

The assumptions in pure monopoly are:

(1) there is one seller that supplies a large number of independent buyers,
(2) entry and exit into this market is completely blocked,
(3) the firm offers unique product,
(4) there is nonprice competition (mostly public information advertising), and
(5) this firm is a constrained price dictator.
Pure monopolies abound in reality, including public utilities and manufacturing firms producing products
protected from competition by patents or copyrights. A monopolist will produce less than a competitive
industry and charge a higher price, ceteris paribus. The assumptions underlying the model of a
monopolistically competitive industry are:

(1) a relatively small number of sellers compared to pure competition, but this number can still be large, in
some cases a few hundred independent sellers,
(2) pricing policies exist in these firms,
(3) entry into this market is generally somewhat difficult,
(4) there is substantial nonprice competition, mostly designed to create product differentiation, at least some
of which is spurious.

Numerous industries are properly characterized as monopolistic competition. These industries include
computer manufacturers, software manufacturers, most retail industries, and liquor distillers. In general,
monopolistic competitors produce less than pure competitors but more that pure monopolists, and charge
prices that also fall between competition and monopoly. In general, the graphical analysis of a monopolistic
competitive industry is identical to a monopoly, except the demand curve is somewhat more elastic than
the monopolists. The assumptions upon which the model of oligopoly are founded are:

(1) that there are few sellers (generally a dozen or less), these firms often collude or implicitly cooperate
through such practices as price leadership,
(2) entry into this market is generally difficult,
(3) there is normally very intensive non price competition in an attempt to create product differentiation,
often spurious.

Examples of oligopolies abound, in Nigeria, the soft-drink industry, the brewing industry, and segments of
the fast-food industry. Oligopoly will generally produce less than monopolistic competitors and charge
higher prices, if price leadership or other collusive arrangements exist an oligopoly may be a close
approximation to a pure monopoly. All of these market structures also assume perfect knowledge
concerning present and future prices (by both producers and consumers) and all other information relative
to the operation of the market, i.e., product availability, quality etc. This perfect knowledge assumption is
not realistic, however, it does little violence to the models because people typically learn very quickly in
aggregate, and hence there expectations approximate perfect knowledge over large numbers of persons.

7.2 The Purely Competitive Firm

Total, average and marginal product were developed with the various cost curves in Module 7. The missing
piece of the puzzle is revenue. Because a purely competitive firm sells its output at the one price determined
in the industry, price does not change as the quantity sold increases. In other words, the demand curve is
horizontal, or perfectly elastic. The result is that average revenue is equal marginal revenue, and both of
these are equal to price. Further , total revenue is P x Q which is the total area under the demand curve for
the purely competitive firm. A firm is assumed to be rationally managed and therefore it will attempt to
maximize its profits. The profit maximizing rule is that a firm will maximize profits where marginal cost
(MC) is equal to marginal revenue (MR). The reason for this is relatively simple. There is still a positive
amount of revenue that can be had in excess of costs of the firm produces at a quantity less than where MC
= MR. If a firm produces at a quantity in excess of where MC = MR, the firm adds more to its costs than it
receives in revenues. Therefore, the optimal, or profit maximizing level of output is exactly where MC =
MR. The model of the purely competitive industry is the simple supply and demand diagram you mastered
in Module 4. The simple supply and demand diagram is a representation of the aggregation of a large
number of independent firms and consumers. This model is revisited below:

The firm in perfect competition is just one of thousands that are summed to arrive at the industry levels of
output and price. Because of the atomized competition, it a firm charges a higher price that the industry it
will sell nothing because consumers can obtain exactly the same commodity at a lower price elsewhere. If
the firm charges a price lower that the price established in the industry it is irrational and will lose revenue
it could have otherwise had. Therefore, a firm operating in a perfectly competitive industry has no choice
save to sell its output at the industry established price. Because the firm sells at the single price established
in the industry it has a perfectly elastic demand curve. (In other words, it is horizontal and not downward
sloping).

The demand curve for the perfectly competitive firm is illustrated below:

Because the firm is a price taker, meaning that it charges the same price across all quantities of output,
marginal revenue is always equal to price, and average revenue will always be equal to price. Therefore the
demand curve intersects the price axis and is horizontal (perfectly elastic) at the price determined in the
industry. Establishing the price in the industry is simply setting the equilibrium in the familiar supply and
demand diagram, and that is the price at which the firm is obliged to sell its output. The following diagram
illustrates how this is done:

Again, the price is established by the interaction of supply and demand in the industry (Pe) and the quantity
exchanged in the industry is the summation of all of the quantities sold by the firms in the industry.
However, this yields little information save what price will be charged and what quantity the industry
produce. To determine what each firm will produce and what profits each firm will earn, we must add the
cost structure (developed in the previous Module). Economic profits are total revenues in excess of total
costs. Remember from Module 7, that profits from the next best alternative allocation of resources is
included in the total costs of the firm. In this short-run it plausible that some firms in pure competition can
exact an economic profit from consumers, but because of freedom of entry, the economic profit will attract
new firms to the industry, hence increasing supply, and thereby lowering price and wiping out the short-run
economic profits. The following diagram adds the costs structure to the purely competitive firm’s demand
curve and with this information it is possible to determine the profits that this firm makes:

The firm produces at where MC = MR, this establishes Qe. At the point where MC = MR the average total
cost (ATC) is below the demand curve (AR) and therefore costs are less than revenue, and an economic
profit is made. The reason for this is that the opportunity cost of the next best allocation of the firm's
productive resources is already added into the firm's ATC. However, the firm cannot continue to operate at
an economic profit because those profits are a signal to other firms to enter the market (free entry). As firms
enter the market, the industry supply curve shifts to the right reducing price and thereby eliminating
economic profits. Because of the atomized competition assumption, the number of firms that must enter the
market to increase industry supply must be Price substantial. The following diagram illustrates the purely
competitive firm making a normal profit:

The case where a firm is making a normal profit is illustrated above. Where MC = MR is where the firm
produces, and at that point ATC is exactly tangent to the demand curve. Because the ATC includes the
profits from the next best alternative allocation of resources this firm is making a normal profit. A firm in
pure competition can also make an economic loss. The following diagram shows a firm in pure competition
that is making an economic loss: The case of an economic loss is illustrated above. The firm produces where
MC = MR, however, at that level of production the ATC is above the demand curve, in other words, costs
exceed revenues and the firm is making a loss.

Even though the firm is making a loss it may still operate. The relation of average total cost with average
revenue determines the amount of profit or loss, but we to know what relation average revenue has with
average variable cost to determine whether the firm will continue in business. In the above case, the firm
continues to operate because it can cover all of its variable costs and have something left to pay at least a
part of its fixed costs. It is shuts down it would lose all of its fixed costs, therefore the rational approach
is to continue to operate to minimize losses. Therefore, the profit maximizing rule of producing at where
MC = MR is also the rule to determine where a firm can minimize any losses it may suffer. In sum, to
determine whether a firm is making a loss or profit we must consider the relation of average total cost with
average revenue. To determine whether a firm that is making a loss should continue in business we must
consider the relation between average variable cost and average revenue. The following diagram illustrates
the shutdown case for the firm making a loss:
In the case above you can see that the AVC is above the demand curve at where MC=MR, therefore the
firm cannot even cover its variable costs and will shut down to minimize its losses. If the firm continues to
operate it cannot cover its variable costs and will accrue losses in excess of the fixed costs. If the firm shuts-
down, all that is lost is the fixed costs. Therefore the firm should shut-down in order to minimize its losses.
What may not be intuitively obvious is that this analysis determines the industry supply curve. Because
firms cannot operate along the marginal cost curve below the average variable cost curve, the firm’s supply
curve is its marginal cost curve above average variable cost. To obtain the industry’s supply curve one needs
only sum all of the firms’ marginal cost curves about their average variable cost curves.

6.3 Pure Competition and Efficiency

Allocative efficiency criteria are satisfied by the competitive model. Because P = MC, in every market in
the economy there is no over- or under- allocation of resources in this economy. This is because the cost of
production for the last unit of production is what determines supply, and that cost of production includes
only the engineering costs. However, this result is obtained only if all industries in that economic system
are purely competitive. This is the contribution of the models of distribution created by economists working
in the marginalists traditions. The problem is that this is economic theory that is not necessarily supported
by empirical evidence. Additionally, the technical or productive efficiency criteria are also satisfied by the
competitive model because price is equal to the minimum average total cost. In the real world the ideal of
technical efficiency is rarely attained. However, this criterion provides a useful benchmark to use in
measuring how well a firm is doing with respect to minimizing costs for a specified level of total output.
As you may recall from the definition of economic efficiency, allocative and technical efficiency are only
two of the three necessary and sufficient conditions for economic efficiency. The third condition necessary
for economic efficiency is full employment. If full employment is also in evidence, then a purely
competitive world is economically efficient.

6.3.1 Criticism of Pure Competition as a Mode of Analysis for the Real World.
In theory, the purely competitive world is utopia. There are several problems that are not excluded by
meeting the assumptions behind the competitive models. As wealth increases, predation could easily
develop and monopoly power could be gained by the occasional ruthless businessman, especially in cases
where government has been significantly limited. Public goods and other commodities may not be available
through competitive industries because of the lack of a profit potential. The competitive economic models
are motivated by the suppliers seeking to maximize profits, and without the profit motive, there can be no
market. Further because of technical efficiency requirements, externalities such as pollution, work
environment safety, and other such problems are likely to arise because of the constraint imposed on the
firms by the price being determined by the industry. Without strong government and appropriate regulations
to protect the environment or workplace, it is unlikely that any private incentive system could impose
sufficient discipline upon producers to properly internalize the costs of production that can be allowed to
flow to the public in general. The distribution of income may lack equity or even technical efficiency. In a
purely competitive world, workers will be paid the value of what they contribute to the total output of the
firm. If the product they produce is not highly valued then some workers could be paid very low wages,
even though the human capital and effort requirements are substantial. For example, a mathematician or a
physicist may be paid less than a baseball player or musician – even though the value of what the
mathematician or physicist is far greater than the athlete’s contribution. This type of result often creates
substantial social problems, i.e., alienation, occasionally resulting in alienation, crime, drug abuse, and in
the developing world even political instability.

If all industries are purely competitive there be consumer dissatisfaction because each firm offers a
standardized product. This standardization might very well result in a substantial loss of consumer choice.
For example, if the soft drink industry was purely competitive, the product offered might well be a single
cola, someplace between Coca-Cola and Pepsi-Cola, and might very well suite nobody’s tastes and
preferences.
The present state of technology simply requires the existence of many natural monopolies. The problems
with natural monopolies are that under-production occurs at too high of a market price for the product. This
misallocation of resources results in an insufficient amount of some commodities, with an excess of
resources available to other products, and prices that are not specifically determined by the actual costs of
production. Even so, if the natural monopolies are properly regulated at something near a competitive price,
then the damage to the economy may be minimized. This issue will be discussed in greater detail in the
following Module (Module 9, Monopoly).

Adam Smith suspicious of the motivations of businessmen, and craftsmen in the pursuit of their own self-
interest. He witnessed the monopolization of many markets in Scotland and in England, and he had also
been the Director of the world’s largest monopoly of the time the East India Company. Adam Smith,
therefore, had first hand experience with the early beginnings of monopoly and knew their potential for
evil. Smith was not only an advocate of competition, but knew that competition is what provided the
consumer with alternatives in the marketplace, and hence an ability to
choose among various suppliers. It is this consumer ability to choose, that motivated Smith’s view that
capitalism would produce socially beneficial results – and monopoly power is a threat to those results.
(Hence the invisible hand)
Question
1. Outline and critically evaluate the assumptions underpinning the purely competitive model.
2. Why is the profit maximizing (loss minimizing) point where Marginal Cost equals Marginal
Revenue? Explain, fully.
3. Draw each of the following cases of the firm in pure competition: (1) long-run profit maximizing,
(2) short-run, economic profit, (3) short-run, economic loss, and (4) shut down point.
 1. Supply and Demand
1. Given the demand function Qd = 100−2P;_ and
the supply function Qs = 20+3P
find the equilibrium price and quantity.

2. If the price of a good increases from ₦10 to ₦12, calculate the change in quantity demanded given
Qd = 80−4P
3. A subsidy of ₦5 is introduced to producers. Modify the supply function Qs = 10+2P and find the
new equilibrium.
4. If a price floor is set at ₦15 and the equilibrium price is ₦10, calculate the surplus or shortage using
Qd = 50−P and Qs =2P.
5. Determine the price elasticity of demand at P = 20 for the demand curve Qd = 200−5P.
6. Calculate consumer surplus if the demand curve is Qd = 120−2P and equilibrium price is ₦25.
7. A new tax of ₦3 per unit is imposed. Adjust the supply curve Qs = 50+2P and find the new
equilibrium.
8. Derive the effect on equilibrium if the demand curve shifts to Qd = 150−3P while the supply curve
remains Qs = 20+2P.
9. A market operates at a price of ₦30 with Qd = 60−P and Qs = 10+2P. Calculate the market shortage
or surplus.
10. If the government sets a price ceiling at ₦8, calculate the resulting shortage given Qd = 100−5P
and Qs = 20+3P.

2. Supply and Demand Elasticities

1. Calculate the price elasticity of demand when the price increases from ₦10 to ₦12 for Qd = 80−4P.
2. Compute the cross-price elasticity of demand when the price of a substitute increases by 10%, and
demand rises from 50 to 60 units.
3. Determine the income elasticity of demand if income increases from ₦2000 to ₦2500 and quantity
demanded rises from 100 to 120.
4. Using Qd = 300−10P, find the price elasticity of demand at P=15.
5. If Qs = 30+2P, calculate the price elasticity of supply when the price rises from ₦20 to ₦25.
6. A 15% increase in income causes demand for a good to rise by 20%. Classify the good based on
income elasticity.
7. Given Qd = 150−3P, compute the elasticity of demand at P = 25 and interpret the result.
8. If Qd = 100−5P and the price falls from ₦12 to ₦10, calculate the percentage change in quantity
demanded.
9. A tax increases the price of a good from ₦8 to ₦10, and the quantity demanded falls from 60 to 40.
Calculate the elasticity of demand.
10. The price of a good falls from ₦25 to ₦20, causing the supply to fall from 150 to 120. Compute
the price elasticity of supply.

3. Consumer Behaviour
1. Given a budget constraint 5X+10Y = 100, find the combination of X and Y when X =10.
2. A consumer’s utility function is U(X,Y) = XY. If the budget is ₦50, with PX = 5 and PY = 10, find
the optimal consumption bundle.
3. Derive the marginal rate of substitution (MRS) for U(X,Y) = X2 + Y2.
4. If the price of X increases from ₦2 to ₦4, calculate the substitution and income effects using the
demand function Q = 20−P.
5. A consumer spends their income equally on two goods, X and Y. If income doubles, find the new
consumption levels for X and Y.
6. Calculate the change in total utility if consumption changes from (X,Y) = (2,3) to (X,Y) = (4,5) for
U(X,Y) = X+2Y.
7. A consumer’s budget is ₦120, with PX=3 and PY = 4. Find the maximum quantity of Y they can
buy if X=10.
8. For a consumer with U(X,Y) = X⋅Y2, derive the demand function for X given PX = 2, PY=3, and I
= 100.
9. Determine the consumer surplus when Qd = 50−P and the price is ₦10.

4. Cost and Production

1. Calculate the total cost (TC) if FC=100 and VC=20Q, and Q=10.
2. Given TC = 50+5Q, find the marginal cost (MC) and average total cost (ATC) at Q = 10.
3. If Q = 10K0.5L0.5, find the output when K=16 and L=25.
4. For TC = Q2+10Q + 50, derive the MC and ATC functions.
5. Given the production function Q = 2L0.5K0.5, find the marginal product of labor (MPL) when L=16
and K=9.
6. Calculate the profit if P = 20, Q = 10, TC = 50+2Q.
7. If AVC = 10 + Q, find the total cost at Q = 5 when FC = 50.
8. Derive the break-even point for TC = 100+4Q and P = 8.
9. Find the level of Q that minimizes AC given TC = 40+Q2.
10. Calculate the elasticity of cost for TC = 50+3Q at Q = 20.

5. Pure Competition
1. Determine the profit-maximizing output if P=10, MC = 2Q, and TC = 50+Q2.
2. If P=15 and ATC=12, calculate the profit for Q=10.
3. Derive the shutdown price for TC = 100+Q2 when AVC = Q.
4. Given the market supply function Qs = 10+2P, find the equilibrium price when demand is Qd =
60−P.
5. If the market price falls to ₦8, calculate the firm’s output given MC=2Q and AVC = Q.
6. Calculate the economic profit for P = 20, Q = 15, and TC = 150+2Q.
7. A perfectly competitive firm faces P = 30 and MC = 2Q. Determine the firm’s supply curve.
8. If P = 18, calculate the profit or loss when TC = 50+2Q and Q = 10.
9. Derive the condition for profit maximization using TR = PQ and TC = 50+2Q2.
10. Find the break-even price for TC=100+4Q and ATC = 4+Q.

More Supply and Demand Questions

1. The demand for maize is Qd = 100−5P, and the supply is Qs = 20+2P. Find the equilibrium price
and quantity.
2. If a price ceiling of ₦8 is imposed on maize, calculate the shortage or surplus using Qd = 150−5P
and Qs = 30+2P.
3. An agricultural subsidy of ₦3 per unit is introduced for wheat, shifting the supply curve from Qs
= 40+2P to Qs = 40+2(P+3). Find the new equilibrium price and quantity if Qd = 100−4P.
4. A drought shifts the supply curve for rice from Qs = 50+3P to Qs = 40+3P. Calculate the new
equilibrium price and quantity if Qd = 120−2P.
5. Calculate the price elasticity of demand at P=10 for Qd = 80−4P.
6. Compute the consumer surplus when the equilibrium price of cassava is ₦12, and the demand curve
is Qd = 100−5P.
7. At a price of ₦15, the market operates with Qd = 50−2P and Qs = 10+P. Calculate if there’s a
surplus or shortage and by how much.
8. If the price of fertilizer increases, the supply of maize changes from Qs = 30+2P to Qs = 20+2P.
Find the new equilibrium when Qd = 100−3P.
9. The government introduces a tax of ₦2 per unit on farmers. Adjust the supply curve Qs = 50+2P
and find the new equilibrium price if Qd = 100−3P.
10. For Qd = 200−6P and Qs = 50+2P, plot the supply and demand curves and find the equilibrium.
11. The demand for maize is Qd = 100−2P. Calculate the price elasticity of demand when P=20.
12. If the price of rice increases from ₦30 to ₦33 and the quantity demanded falls from 500 kg to 450
kg, calculate the price elasticity of demand.
13. The supply of wheat is Qs = 50+4P. Find the price elasticity of supply when P=15.

14. A farmer increases the price of oranges by 10%, and the quantity demanded falls by 25%. Calculate
the price elasticity of demand.
15. The cross-price elasticity of demand for cassava with respect to yam is 0.8. If the price of yam
increases by 5%, calculate the percentage change in the demand for cassava.
16. The income elasticity of demand for beef is 1.2. If consumer income increases by 10%, calculate
the percentage change in the demand for beef.
17. A supply curve for fertilizer is Qs = 30+2P. Calculate the elasticity of supply between P=10 and
P=15.
18. The quantity demanded for tomatoes is 100 units when the price is ₦10. When the price decreases
to ₦8, the quantity demanded increases to 140 units. Calculate the price elasticity of demand.
19. Calculate the elasticity of demand for rice at P=12 when Qd = 120−4P.
20. The demand for cocoa is Qd = 200−5P. Calculate the price elasticity of demand at P=10 and Qd =
150.
21. A consumer's utility function is U(x,y) = x⋅y. If the budget is ₦100, and the price of xxx is ₦10
and y is ₦5, find the optimal quantities of x and y.

22. If the price of rice increases from ₦20 to ₦22, calculate the change in the consumer's expenditure
if the demand is Qd = 150−3P.
23. Given a budget of ₦50, a consumer spends ₦30 on yam and ₦20 on beans. If yam's price doubles,
how does the consumption bundle change? Assume the consumer maximizes utility.
24. Calculate the marginal rate of substitution (MRS) if the utility function is U(x,y) = 2x2+y2 at x = 2
and y =.
25. The indifference curve for a consumer is y=20−2x. Calculate the MRS at x=5.
26. A farmer allocates ₦100 between seeds and fertilizer. If the price of seeds is ₦5 and fertilizer is
₦10, calculate the consumption bundle.
27. Given a demand curve Qd = 80−5P, calculate consumer surplus if the price decreases from ₦12 to
₦10.
28. If a consumer’s utility function is U(x,y) = x0.5⋅y0.5 and they have ₦100, with Px=10 and Py=5,
calculate the optimal quantities of x and y.
29. A consumer buys 4 units of apples and 6 units of oranges when P_a = ₦3 and P_o = ₦2. If income
increases by ₦10, calculate the change in consumption if preferences remain constant.
 4. Cost and Production Questions
1. A firm’s total cost (TC) is given as TC = 100+4Q2. Calculate the marginal cost (MC) when Q = 10.
2. If the total fixed cost (TFC) is ₦500 and the total variable cost (TVC) is 20Q+2, calculate the
average total cost (ATC) at Q=10.
3. A farmer’s production function is Q = 4L0.5K0.5, where L is labor and K is capital. If L=16 and K=9,
calculate the output Q.
4. A firm’s total cost function is TC = 50+5Q+3Q2. Calculate the average cost (AC) and marginal cost
(MC) when Q=5.
5. Given a production function Q = 10K+5L, calculate the marginal product of labor (MPL) and
capital (MPK).
6. If a farmer spends ₦300 on labor and capital, with PL = 15 and PK = 30, how many units of labour
(L) and capital (K) can the farmer purchase?
7. The short-run production function for a firm is Q = 20L−0.5L2. Calculate the value of L that
maximizes output.
8. A firm’s average cost (AC) is given by AC = 30+10/Q. Calculate the total cost (TC) at Q=5.
9. If a firm's marginal cost (MC) is MC = 4Q and fixed costs are ₦100, calculate total cost (TC) when
Q=10.
10. A production function is Q = 3K+2L. If K=5 and L=8, calculate Q and the returns to scale when
inputs are doubled.

5. Pure Competition Questions

1. A competitive firm faces a market price of ₦10. If the firm’s cost function is TC=50+4Q+Q2,
calculate the profit-maximizing output level.
2. The market demand for a product is Qd = 300−2P, and the market supply is Qs = 4P−200. Find the
equilibrium price and quantity.
3. A perfectly competitive firm sells 50 units of maize at a market price of ₦15. If the total cost of
production is ₦700, calculate the firm’s profit.
4. The total revenue (TR) function of a firm is TR = 20Q, and the total cost (TC) function is TC =
100+10Q. Calculate the profit at Q=10.
5. If the market price is ₦8 and the firm’s marginal cost (MC) is MC = 2Q, calculate the profit-
maximizing output.
6. A market has 20 firms, each with a supply function Qs = 5P. Calculate the market supply curve.
7. The demand function is Qd = 500−4P, and the supply function is Qs = 100+2P. Calculate the
equilibrium price and quantity.
8. A farmer’s cost function is TC = 80+6Q+Q2. If the market price is ₦20, calculate the profit-
maximizing output.
9. If a perfectly competitive firm has a fixed cost of ₦100 and a variable cost of 3Q2, calculate the
break-even price at Q=10.
10. A competitive firm produces at a price of ₦12, and its total cost is TC = 100+4Q+0.5Q2. Calculate
the profit at